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America's banking industry sees massive changes

By James McCusker
Business 101

All recessions are difficult, and some, like this one, can be especially painful for smaller businesses. When the financial markets collapsed, the small business credit system seized up, aggravating what was already a difficult situation caused by declining consumer demand.

One of the economic truths of this recession is that most small businesses recognized the economic contraction long before Wall Street or Washington, D.C. woke up to it. We can see it in the economic data, where, for example, retail sales, especially of discretionary purchases, began to decline as much as two years before the stock market finally began its slide.

The other economic truth of this recession is that while Wall Street credit markets went through some difficult times, the small business credit market was best described as nonexistent for a considerable amount of time — and it is still less than wonderful.

There are several reasons what this was so, and they will continue to affect business enterprises, especially the smaller ones who tend to be more dependent on bank credit, even after this recession is over.

Certainly one factor is the changing structure of American banking. In 1934, when the Federal Deposit Insurance Corporation (FDIC) began, there were 14, 146 insured banking institutions in the United States. And that number didn't really change for half over a century.

In 1986, though, Congress changed the banking laws to allow interstate banking. That set off a wave of mergers, acquisitions, and banking consolidation that continues today — and, in fact, was accelerated by the recent banking crisis. The result is that by the end of last year there were only 7,086 insured banking institutions left in the country.

The purpose behind allowing interstate banking was to strengthen banks and upsize them to meet foreign competition. The upsizing worked, certainly. The strengthening obviously still needs some work.

One of the unintended consequences of the change to the banking laws was that it triggered massive imbalances in our banking system — large sectors were under-banked and other sectors were over-banked. Some of this, to be sure, was the result of demographic changes in the U.S., which produced equally large imbalances; crowding the coasts and depopulating the interior.

A major part of the problem for smaller businesses, though, was the result of structural differences between large and small banks. Loans to smaller businesses are the heart and soul of small banks. In large banks, small business loans are a “product line” just like any other.

The difference between the two is that, generally, smaller banks do not have a lot of other product lines competing for resources and management's attention. In large banks there are systems in place that generally allocate resources to the product lines that either show or promise the highest profits.

Because of their overhead and processing costs, loans to small businesses, even in the dreamland of spread sheets, are never going to deliver or even promise the monumental profits that highly leveraged financial finagling does. And even in conservative banks, the mathematics of resource allocation comes down to this: success gets funded.

There is an economic force in our financial structure, then, that exerts a downward pressure on the size of small business lending. It is more visible in some banks than in others for various reasons, but it is there, built into the math of modern corporate management.

The cumulative effect of that economic force is a matter for economic policy makers, for any downward pressure on small business lending is also a downward pressure on new job creation. It isn't an accident, for example, that this economic recovery, with its understandable emphasis on the bailouts of large banks, has had difficulty coming up with new jobs.

In the on-the-ground, real world of smaller business, though, there is something we can do — in fact there are two things. The first is to assume that all short term revolving loan arrangements are just that…short term. Don't count on that money being there next year, because your bank may have other priorities then. Who knows? Maybe by then they will be putting all their money into cocoa market derivatives. Enjoy the relationship — there are a lot of great loan officers out there — but make sure that you have a backup plan.

The second thing we can do is to work out a plan that for internal financing that will eventually, say in five years, reduce or eliminate the need for bank loans to support our working capital needs. This is a smart plan to develop anyway, even if never used, for it will tell us a lot about how our business actually works and what it is capable of — good things to know in any economic situation.

James McCusker, a Bothell economist, educator and small-business consultant, writes “Your Business” in The Herald each Sunday. He can be reached by sending e-mail to otisrep@aol.com.