HOW DID THE FINANCIAL CRISIS AFFECT SMALL‐BUSINESS LENDING IN THE UNITED STATES?

• Author: Jason Damm,Rebel A. Cole
• DOI: http://doi.org/10.1111/jfir.12225
• Published date: 01 December 2020
• Date: 01 December 2020

The Journal of Financial Research Vol. XLIII, No. 4 Pages 767–820 Winter 2020

DOI: 10.1111/jfir.12225

HOW DID THE FINANCIAL CRISIS AFFECT SMALL‐BUSINESS LENDING

IN THE UNITED STATES?

Rebel A. Cole

Florida Atlantic University

Jason Damm

Florida Atlantic University

Abstract

We analyze changes in lending by U.S. banks to businesses from 1994 to 2011.

We find that lending to businesses, and in particular to small businesses,

declined precipitously following onset of the financial crisis. We also examine

the relative changes in business lending by banks that did, and did not, receive

Troubled Asset Relief Program (TARP) funds from the U.S. Treasury, and

find that banks receiving capital injections from the TARP failed to increase

their small‐business lending. Finally, we find strong and significant positive

relations of both bank capital adequacy and profitability with small‐business

lending.

JEL Classification: G01, G21, G28, G32, H08, H25

I. Introduction

When the U.S. residential housing bubble burst in 2007–2008, credit markets in the

United States and around the world seized up. Lax underwriting standards saddled

U.S. banks, large and small, with levels of nonperforming loans not seen since the

banking crisis of the late 1980s. During 2009, the Federal Deposit Insurance

Corporation (FDIC) closed more than 100 banks, for the first time since 1992. From

2009 to 2011, a total of 397 banks were closed. As of year‐end 2011, 813 banks

appeared on the FDIC’slistof“problem banks”—up more than an order

of magnitude from a mere 76 as of year‐end 2007, but down from a high of

almost 900 as of year‐end 2010.

1

Almost 600 additional banks disappeared as a

result of mergers, with the majority being motivated by capital‐adequacy issues.

We are grateful to Allen Berger, Lamont Black, Jere Glover, Paul Kupiec, Jose Liberti, Jason Sturgess,

Haluk Unal, David Walker, Victoria Williams, and session participants at the 2012 Annual Meeting of the

Financial Management Association in Atlanta; the 2013 AIDEA Bicentennial Conference in Lecce, Italy; and the

2014 Annual Meeting of the Midwest Finance Association in Orlando, Florida for comments on earlier drafts of

this study. Funding for this research was provided by the U.S. Small Business Administration’s Office of

Advocacy, for which we are extremely grateful.

1

A“problem bank”is one that is deemed by regulators as likely to fail in the near term, receiving a

composite CAMELS rating of 4 or 5 on its most recent on‐site examination.

767

© 2020 The Southern Finance Association and the Southwestern Finance Association

Anecdotal evidence suggests that small businesses, which largely rely on banks for

credit, were hit especially hard by the financial crisis.

2

In addition, the Federal Reserve

System’s quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices found

evidence that lending standards for small business loans tightened during 2008–2009, as

lenders’tolerance for risk decreased following onset of the crisis.

3

In response to the

financial crisis, Congress passed laws aimed at boosting the availability of capital to small

businesses, beginning with the Troubled Asset Relief Program (TARP) in 2008. Table A1

in the Appendix provides a summary of these legislative efforts.

The availability of credit is one of the most fundamental issues facing a small

business and therefore has received much attention in the academic literature (see, e.g.,

Petersen and Rajan 1994; Berger and Udell 1995, 1998; Cole 1998; Cole, Goldberg,

and White 2004; Berger et al. 2005). In this article, we extend this literature by

analyzing data on small‐business lending collected by U.S. banking regulators to

provide new evidence on how the financial crisis affected bank lending to small

businesses. Our analysis reveals that from 2008 to 2011, small‐business lending

declined by $98 billion, or almost 15%, from $658 billion to only $560 billion.

4

Small

commercial and industrial (C&I) lending declined by even more, falling by more than

17% over the same period. The bottom of the collapse did not occur until 2013, and the

recovery during 2014–2019 was anemic.

We also examine the relative changes in small‐business lending by banks that did,

and did not, receive funds from the TARP. As part of the TARP, the U.S. Treasury injected

more than $200 billion of capital into more than 700 U.S. banking organizations to stabilize

their subsidiary banks and promote lending, especially lending to small businesses. This

effort is more formally known as the Capital Purchase Program (CPP), which began in late

October 2008 with capital injections into the eight largest bank holding companies. With a

few notable exceptions, the success of the CPP in promoting lending in general, and small‐

business lending in particular, has been neglected until now.

Why is this analysis of importance? According to the U.S. Department of

Treasury and Internal Revenue Service, there were almost 33 million businesses that

filed taxes for 2012, of which 23 million were nonfarm sole proprietorships, 4 million

were S‐corporations, 3 million were partnerships, and 2 million were C‐corporations;

all but about 10,000 C‐corporations are privately held and the vast majority have

annual revenues less than $1 million.

5

Small firms are vital to the U.S. economy.

According to the U.S. Small Business Administration (SBA), small businesses account

for 99.9% of all businesses, 48% of private‐sector employment, half of all U.S. private‐

sector employment, and produced 63% of net job growth in the United States between

2

Using data from the Federal Reserve’s 1993, 1998, and 2003 Surveys of Small Business Finances

(SSBFs), Cole (2010) finds that about 60% of all small firms use some form of bank credit.

3

The results of these Federal Reserve surveys can be downloaded from http://www.federalreserve.gov/

boarddocs/snloansurvey/.

4

See Table A2 in the Appendix, which is based on annual data provided by the June Call Reports.

5

See the U.S. Internal Revenue Service statistics for integrated business data at https://www.irs.gov/uac/soi-

tax-stats-integrated-business-data. The year 2012 is used for reference because it was the latest year for which

statistics were available at the time this article was written.

768 The Journal of Financial Research

1992 and 2013.

6

Therefore, by better understanding how bank credit to small businesses

was affected by the financial crisis, we can help policy makers take actions that will lead to

more credit, which will translate into more jobs and faster economic growth.

Here, we provide new evidence on how successful, or more accurately, how

unsuccessful the CPP turned out to be. Our evidence shows that small‐business lending

by banks participating in the CPP fell even more than at banks not receiving funds from

the CPP. In other words, TARP banks took the taxpayers’money but then cut back on

lending by even more than banks not receiving taxpayer dollars.

Figure I shows the amount of TARP money injected into the largest financial

institutions in 2008. On October 28, 2008, the 8 largest received $115 billion: Citibank,

JPMorgan Chase, and Wells Fargo each received $25 billion; Bank of America

received $15 billion; Goldman Sachs and Morgan Stanley (both primarily investment

rather than commercial banks) each received $10 billion; and Bank of New York and

State Street received $3 billion and $2 billion, respectively. On November 14, 2008, an

additional 21 banks received another $33.6 billion in TARP funds.

Figure II shows the percentage decline in small‐business lending from 2008 to

2011 at these same institutions.

7

At 11 of the 16 large bank holding companies shown,

small‐business lending declined by more than 20%; at 13, by more than 10%; and all

16 reduced small‐business lending.

Moreover, these cutbacks in bank lending dwarfed other governmental efforts to

boost the amount of credit available to small businesses, such as the SBA’s 7a and 504

programs, which saw an increase of $10 billion following onset of the financial crisis.

Figures III and IV show use of the SBA’s 7a and 504 programs, respectively, over fiscal

years 2001–2011.

Additional analysis incorporating county‐year fixed effects reveals that the relative

declines in lending by TARP banks is due in part to differences in local‐market demand.

However, this analysis finds no evidence that TARP banks increased their small‐business

lending. In summary, these results show that the TARP’sCPPfailedtoboostbanksmall‐

business lending—one of its primary goals. We acknowledge that one cannot know how

much the TARP banks would have lent had they not participated in the CCP. Their

observed lending could be a significant increase over this counterfactual.

We contribute to the literature on the availability of credit to small businesses

in at least six important ways. First, we provide new evidence of how severely bank

lending to businesses, and especially small businesses, in the United States was

curtailed by the financial crisis. Both theory, dating back to Schumpeter (1934),

8

and

more recent empirical research (e.g., King and Levine 1993a, 1993b; Rajan and

Zingales 1998) indicate that capital‐constrained firms grow more slowly, hire fewer

6

See “Frequently Asked Questions,”Office of Advocacy, U.S. Small Business Administration (2016) at

https://www.sba.gov/sites/default/files/advocacy/SB-FAQ-2016_WEB.pdf. The SBA defines a small business as

“an independent firm with fewer than 500 employees.”We follow that definition in this article.

7

We exclude Bank of New York, Goldman Sachs, Morgan Stanley, and State Street Bank because these

financial institutions had little or no presence in the small‐business loan market before the financial crisis.

8

Aghion and Howitt (1988) provide a comprehensive exposition of Schumpeter’s (1934) theory of

economic growth.

769U.S. Small‐Business Lending