We are still feeling the effects of the recession that started in fall 2007. When small business owners read financial literature, listen to pundits on television or radio, or visit with their local bankers, they still encounter conflicting information regarding the near- and long-term prospects of both the Arizona and United States economies.
Small business lending
The most common form of bank loan for small businesses is a so-called working capital loan, collateralized by accounts receivables. One issue that’s uppermost in the minds of small business owners is whether banks are still making these working capital loans. The answer is yes, but specifically to new customers. Remember, banks do not make money unless they lend money. However, in times of economic uncertainty, banks want to be prudent and avoid any potential future losses, specifically after 2007 and 2008. Banks cannot afford to lose the principal of a loan.
For example, if a banker is asked to write a $200,000 loan at a 7 percent interest rate with a three-year term, then the banker will receive approximately $22,000 in interest payments (profit) and the return of principal. If the loan goes bad, the banker not only loses the $22,000 of potential profit, but more significantly, also the $200,000 in principal. Bankers will tell you they have to be right 999 times out of 1,000 in their underwriting efforts to stay in business.
Insurance companies, mortgage companies and banks all have underwriters to evaluate risk. In most cases, the banks also employ economists to evaluate the local and national economies and set standards for the acceptance of loan proposals. In other words, it may not be your branch manager telling the borrower “no.” The loan officer’s hands may be tied by the corporate economist who does not think the recession is over, believes things will remain difficult and sees that the probability for future bankruptcies still exists — therefore, no lending activity.
The major fly in the ointment is, pure and simple, jobs. Jobs, employment and unemployment numbers tell the story. In October 2008, one year into the recession, unemployment in Arizona was at 6.2 percent. By October 2009, unemployment in Arizona was up to 9.1 percent. Two years ago, October 2007, unemployment in Arizona was just 3.9 percent.
So, if the underwriter here at your local bank, acting on guidance or instructions from the bank headquarters, says “no” to a loan application, that decision may be based on the feeling that the local economy is not improving, that there may be future layoffs, etc. Therefore, the probability that your loan may not be repaid is high, so no loan.
Local and regional banks
So, do small businesses have a better chance of obtaining a loan or a line of credit from local or regional banks than they do from the national behemoths? Small, local banks do have more freedom in underwriting and risk analysis than the larger national banks. This is true. Smaller banks also will syndicate loans with larger banks, with the local bank being the lead lender. However, while the federal government guarantees Small Business Administration loans, the loan itself still must go through the risk analysis process in order to be approved. The risk analysis still is based on changing national and local economic indicators. These indicators have been improving for six months, but very slowly and at small increments.
That said, what are the arguments for the borrowers? The federal funds rate set by the Federal Reserve was recently at .25 percent, practically an all-time low. The source of capital to banks, the Federal Reserve and corresponding Federal Reserve banks, is essentially free to the banks. Currently, the banks are sitting on $823 billion of reserve capital available for lending. This is compared to $2.4 billion a year ago. As a point of reference, the March federal stimulus bill was $790 billion. The banks have more capital than the total dollar amount of the stimulus bill.
Banks are sitting on that $823 billion because they say charge-offs — bad loans and debts — are at a point not seen since the Great Depression. The banks cite $116 billion in charge-offs year-to-date, or a 2.9 percent charge-off rate that increased to 3.4 percent in the third quarter of 2009. Banks cannot endure charge-offs. Charge-offs have put more than 100 banks out of business this year. Therefore, banks are sitting on their reserve capital in anticipation of more costly charge-offs. However, bottom line, the banks do have the capital to lend.
Banks do not make any money sitting on $800 billion. To make money, they must lend money. Eventually, and sooner rather than later, the banks have to start lending again. But the $64 or $64 billion questions are: Is this turnaround self-sustaining? Will it continue in 2010? Will the turnaround in the economy create a sufficient number of jobs to sustain the economic growth in 2010?
Until banks loosen their grip, small businesses do have options in obtaining money to keep their businesses not just going, but also growing.
Small business can look to leasing alternatives and trade credit from suppliers to replace the financing they would normally receive from banks. Flooring (inventory) financing, commercial credit from companies such CIT, factoring of invoices, trade, or vendor credit from suppliers all can be sources of alternative financing for small businesses.
Businesses also have reduced the levels of required financing by laying off employees, reducing salaries, cutting fixed costs, reducing profit margins — anything and everything possible to stay in business until the economic cycle turns positive.
Let’s hope the federal government’s stimulus bill and the excess in bank capital will prove sufficient to generate economic growth going forward, and open up the traditional institutional financing necessary for small business development and growth. It is time that small business owners catch a break.
George Olander, Ph.D., is a finance lecturer at the W. P. Carey School of Business at Arizona State University