The Credit Drought

Zachary Davis and Kendra Baker, 30-something co-owners of a small ice-cream manufacturing and retail shop in Santa Cruz, California, sat next to first lady Michelle Obama at the 2011 State of the Union address in honor of their entrepreneurship. They traveled a rocky road to their seats in the House gallery, one that reveals the parlous state of small-business finance—an endangered ecosystem whose diminished capacity to nurture new jobs is retarding the rebound from the Great Recession.

The two friends, he a computer-industry dropout, she a pastry chef, decided to open the Penny Ice Creamery in early 2009. Though it was during the depths of the downturn, they weren’t crazy to start a new business. Entrepreneurs often see recessions as a time to start new businesses because downturns expose or sweep away inefficient, incompetent, or archaic incumbents. After surveying the chain-dominated local landscape, Davis and Baker saw a niche for ice cream made from locally procured organic ingredients blended in equipment sporting the “Made in the USA” label.

Armed with that patriotic dream and a carefully crafted business plan, Davis and Baker visited six banks. They brought to the table $100,000 from family and friends—the “angel capital” raised informally that often helps bankroll small-business start-ups. Four of the banks turned them down with minimal due diligence. “Wells Fargo tried to sell us a lot of products we didn’t need,” Davis recalls.

Finally, they found a receptive ear at a three-year-old community bank, itself a somewhat imperiled species. However, Lighthouse Bank insisted on securing the $250,000 loan not just with liens on the business’s assets and the owners’ homes—typical encumbrances for small enterprises—but with a Small Business Administration (SBA) guarantee made possible by the American Recovery and Reinvestment Act (ARRA). “The only way we could do a loan to a start-up company in this crazy environment was with the help of the SBA and its new 90 percent loan program,” says Bob Dennis, vice president at Lighthouse. Since the expiration of the stimulus act, the SBA has returned to guaranteeing 75 percent of the value of asset-backed loans. Without the ARRA, there would have been no Penny Ice Creamery.

The business succeeded beyond everyone’s expectations. Penny Ice Creamery last year racked up $800,000 in sales. In addition to employing 25 skilled workers during construction, Davis and Baker hired 40 full- and part-time employees, up from 3 when they opened in August 2010. Lighthouse “had a lot of people sign up to transfer money from the big banks,” Davis says. “They’re doing a tremendous service to our community.”



Unfortunately, successful start-ups like Penny Ice Creamery are a rare phenomenon, a fact that’s contributing to the dearth of new jobs in this fragile recovery. Commerce Department surveys show that small-business formation over the past five years has remained relatively stagnant at about 600,000 a year. That represents a long-term decline when adjusted for population and the size of the economy.

Moreover, the number of new businesses that hire people other than the proprietor has declined as a share of the total. In their place has come the rise of involuntary entrepreneurship—laid-off white-collar experts or blue-collar tradesmen who hang out a shingle as consultants or perform odd jobs while looking for full-time work. A new business today employs an average of 4.9 people compared to 7.5 in the 1990s. “People are starting self-employed businesses just to make ends meet,” says Zoltan J. Acs, director of the Center for Entrepreneurship and Public Policy at George Mason University in Virginia. “We’re not going to become a better society because of that.”

The difficulty in financing start-ups parallels what is going on at many existing small businesses, which need working capital to grow. Lee Erickson, president of the VRX Company outside Knoxville, employs five people who design and market a device that links a surveillance camera to cash-register receipts in order to minimize employee theft—a major issue for retailers with mostly cash transactions like convenience stores. But with typically only about $20,000 cash on hand, he can order just 200 devices at a time from his contract manufacturer. That freezes him out of bidding on larger sales contracts with major retail chains.

“I wanted something in place where I could quickly double my inventory,” Erickson says. “Banks essentially wanted the deed to my home—assets outside the company’s assets. I talked to the regional bank where I do my checking and savings and got the same answer. When there are these opportunities for large orders, we have to tell [the retailer] they’ll have to make a big payment up front. That makes it difficult for them, and they get cold feet.”

Commercial and industrial lending to small businesses has stayed depressed even though the economic recovery is now more than two years old. Though GDP has now surpassed pre-recession levels, the roughly $1.3 trillion in outstanding commercial and industrial loans at the nation’s financial institutions is nearly 15 percent below the levels of mid-2008, according to the Federal Deposit Insurance Corporation (FDIC). A recent analysis by economists at the Federal Reserve Bank of Cleveland showed that the decline was most severe in the small-business sector, with loans of less than $100,000 declining 18.1 percent and loans between $100,000 and $250,000 down 16.7 percent.

The latest data also showed that the small-business disadvantage is growing. In last year’s third quarter, overall commercial and industrial lending grew by $44.8 billion, or 3.6 percent, over the previous quarter for its fifth consecutive gain. But smaller loans (those less than $1 million) fell by $3.1 billion, or 1.1 percent, according to the FDIC. Gains were “concentrated in loans to large and middle-market firms rather than in loans to smaller firms,” the U.S. Federal Reserve noted in its October quarterly survey of bank-lending officers.

“Access to capital is just [a] huge [problem] right now,” says John Arensmeyer, chief executive officer of Small Business Majority, an advocacy group that backed health-care reform and other progressive solutions to small-business problems. “It’s always been a problem for small business, but now it’s really about having working lines of credit. That’s just gone away.”

Economists employed by mainstream small-business and community-banking trade groups dismiss claims that access to credit is a major stumbling block for small business. “They tell us credit conditions are not their top problem,” says William Dunkelberg, chief economist at the National Federation of Independent Business, which surveys its constituency monthly.

Some community bankers echo that view. “I don’t see companies knocking on our door who can’t get credit,” says Scott Cote, the president of the $650 million Pentucket Bank, which has five branches in Massachusetts and New Hampshire. “A lot of businesses are fairly conservative right now. They don’t want to hire people until they see demand pick up for their products.”

Clearly, sluggish growth and high unemployment affect sales at small businesses, just as at large ones. But with consumer purchasing power returned to pre-recession levels and consumer confidence starting to rebound, there is mounting evidence that small businesses face a far tighter financing environment than is warranted by current economic conditions.



Interviews with government officials, economists, community bankers, small-business groups, venture and angel capitalists, and academics reveal a complex web of factors that limits many small businesses’ access to capital. One major contributor is the steady decline of the community-banking sector. Over the years, community banks have been a major source of local small-business finance. But today there are 1,124, or 13.1 percent, fewer U.S. financial institutions than there were in 2007, and the disappeared consist entirely of banks with less than $1 billion in assets.

Financial assets have become concentrated in ever fewer large institutions, which have little appetite for financing new entrepreneurs, because the deals and fees are smaller and the transaction costs, higher. The top 106 banking giants, defined as institutions with more than $10 billion in assets, held 79.4 percent of the nation’s $13.8 trillion in financial assets in 2011, up from 116 firms with just 69.1 percent of $12.7 trillion in total assets in 2007. Mega-banks like Citibank, Goldman Sachs, and JPMorgan Chase are far more likely to finance a Fortune 1000 firm than a locally owned ice-cream shop.

Another factor dampening the lending environment for small businesses is the slow recovery in their balance sheets. Sales fell sharply during the downturn, so cash-flow statements for the past three years (the rearview mirror used by most bankers) may look far worse than current prospects. Just as important, many companies’ primary assets—their land and buildings—fell sharply in value during the downturn and have only partially rebounded. “Fifty-six percent of loans are secured by real estate,” says Richard Brown, chief economist for the FDIC. “When that real estate is in an underwater environment, it’s harder to justify any new loans.”

The weaker balance sheets and declining value of collateral in turn triggered tougher government oversight of community banks. Some local bankers say tougher standards are making it more difficult to extend credit, even to their best customers. Noah Wilcox, president of the Grand Rapids State Bank in Grand Rapids, Minnesota (population 10,000), claims his bank’s small--business customers are rejecting the tougher demands of his overseers that he must pass along. “They’re being told they need a quarterly accountant--prepared statement as a direct result of regulatory pressure,” he says. “And they say to us, ‘Forget it. I’ve been here for 25 years. I’ve never missed a payment. I’ll give you a self-prepared statement and my tax return at the end of the year.’ And we’re saying, ‘That’s not good enough anymore.’”

Thanks to the Troubled Asset Relief Program (TARP), which mostly helped the largest banks, bad loans at big banks by the end of the third quarter of 2011 were down to 1.3 percent of outstanding credits. But among banks in the asset range of $100 million to $1 billion, bad credits still totaled 2.3 percent of all commercial and industrial loans, unchanged from two years earlier.

That environment—where troubled local banks appear unable to meet re-emerging small-business credit needs—would normally be an ideal environment for new banking institutions to emerge. Historically, the FDIC issued anywhere from 100 to 200 new charters a year. But new community- or savings-bank entrants have all but evaporated in the aftermath of the Great Recession, falling to 11 in 2010 and just 3 in 2011. Six months recently went by with no new applicants—the first time that has happened in the 78-year history of the FDIC.

“We’re not getting as many applications in, and those we take in we have to look at their economic prospects for success,” says Serena Owens, associate director of risk-management supervision at the agency. “It’s hard to justify when we’ve seen so many that failed.” Perhaps, but the failure ratio isn’t unique, only the agency’s response. There were comparable losses to insured financial institutions during the S&L crisis of the late 1980s and early 1990s. But during the earlier crisis, the government set up the Resolution Trust Corporation to help community banks and savings institutions unload the nonperforming commercial real-estate loans, which made it easier for them to resume lending. Nothing comparable happened this time around.

Indeed, the government response to the current small-business financing crisis can best be described as half-hearted. The Obama administration’s stimulus package did loosen requirements on SBA–backed loans, which allowed more lenders and borrowers to take advantage of its two main programs—section 7(a) working-capital loans and section 504 asset-backed loans. But while total loans from the two programs rose to $24.5 billion in 2011 from $20.6 billion in 2007, the average loan size soared to nearly $400,000, more than twice the average loan made before the recession, and some 50,000 fewer borrowers took advantage of the program.

Meanwhile, rather than focusing on the bulk of small businesses engaged in retail and wholesale trade, construction, and manufacturing, the administration is emphasizing an “innovation” agenda to spur new small-business formation. It launched the Startup America Partnership, headed by Steve Case, who founded AOL, and Reid Hoffman, who created LinkedIn. It poured $1 billion into an “early-stage innovation fund” to match start-up investments by small-business investment companies.

The focus on stimulating the fast-growing technology firms certainly has a compelling logic behind it. The pioneering work of MIT professor David Birch in the early 1980s recognized that most new small-business jobs came from high-growth start-ups, which he dubbed “gazelles.” While not all such firms were technology driven, many were.

But the returns to Main Street America from such a strategy are limited. The American dream of launching the next science-driven new thing, whether in computers, software, telecommunications, biotechnology, or clean energy, lives on, but its benefits accrue to select precincts, generally found along the coasts or in a handful of university towns across the heartland.

“The information economy is a driver, but it’s not a major factor in creating jobs,” adds Rick Burnes, a partner at Charles River Ventures. Citing breakouts by companies like Facebook, Google, and Twitter, Burnes says, “We’re relatively early in this technology. It will shake out over the next ten years in ways we cannot see. But in terms of employing a lot of people, it’s not going to.”

To be sure, access to capital is not the only challenge faced by entrepreneurs. Clean energy should be a natural candidate for high-growth and technical innovation. But absent a radical change in federal policy like a carbon tax or cap-and-trade, clean-energy technology firms will continue to struggle. They face politically powerful entrenched incumbents in the oil, gas, coal, and electric-generation industries, whose allies in Congress want to kill various incentive programs (while seeking to expand fossil-fuel subsidies, which are ten times greater in value).

Health-care innovation firms—a huge emphasis for state and local economic-development efforts across the country—face their own set of constraints. The medical payoff from the huge government investment over many decades in molecular biology, cancer research, and the Human Genome Project is beginning to bear fruit. Angel investors and some venture-capital firms are pouring money into medical--device and boutique drug-development firms. But money is getting harder to come by, as health-insurance reimbursements face financial limits.



America remains the most entrepreneurial country on earth. Business schools report that courses on how to start a business are now the most popular offerings, not the financial-engineering classes that animated the last several generations of B-school students. “It used to be the smart guys went to Wall Street or consulting firms,” says Burnes of Charles River Ventures. “Now they’re starting new businesses.” Across the country, the same spirit is animating young people, who are legitimately fearful that the future economy won’t allow them to marry, raise children, and become part of a stable middle class.

But a lot more needs to be done. Beyond reversing the tilt in regulatory policy that favors large businesses and large banks, the government must rebuild both the research and financing infrastructure that sustains small-business development. A first step would be a major new commitment to investing in science through the National Institutes of Health, the National Science Foundation, and other agencies that over the last half-century provided the ideas and technologies that spawned the computer age, the Internet, new health-care technologies, and more.

The government should also make major new commitments to the Small Business Innovation Research grant program, where science-based agencies set aside money for private firms seeking to commercialize cutting-edge technologies. “The companies that got those grants are doing substantially better than others, at least if they were located in areas of the country with entrepreneurial clusters,” says Joshua Lerner, a professor who studies innovation at the Harvard Business School.

The government also needs to rejuvenate the infrastructure that supports local entrepreneurship outside the innovation clusters, which is being eviscerated by the budget cuts imposed in last summer’s debt-ceiling deal. For instance, the Economic Development Administration, which funds business start-up incubators across the country, saw its budget slashed from $133 million in 2011 to $112 million this year. The National Institute of Standards and Technology, which runs training programs for the nation’s small manufacturers, saw its $750 million appropriation frozen and its technology-innovation program eliminated.

The coming debate over business taxes and tax reform provides a huge opportunity to promote small-business development. Current policy encourages debt-financed private-equity takeovers, which allow firms like Mitt Romney’s Bain Capital to strip-mine companies’ best assets, flip them to new investors, and pocket the proceeds at preferential tax rates. The code should end the interest deduction for debt-financed takeovers and reserve long-term capital-gains rates for legitimate long-term investments. While the costs of regulatory compliance are exaggerated, there are some deserving candidates for streamlining, such as simplified accounting standards for small businesses under the 2002 Sarbanes-Oxley Act.

Finally, government should confront the real-estate debt crisis head on and take steps to resolve the underwater loans that are burdening the balance sheets of small banks and businesses alike. “The government needs to guarantee pools of credit, not fully secured, based on the overall risk factors of the pool,” says Small Business Majority’s Arensmeyer. “Why should businesses with collateral have an advantage over those that don’t? It should be a function of how worthy the business is.” ª

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