Statement by Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Small Business, U.S. House of Representatives, March 25, 1993 - Statements to the Congress - Transcript

Federal Reserve Bulletin, May, 1993

I am pleased to appear before this committee to discuss the availability of bank credit to small businesses. It is clear that any assessment of the outlook for the economy as a whole--especially employment--has to focus on the health of our small business sector--including its ability to obtain finance. Indeed, the importance of bank credit flows to small business was highlighted by the President's recent announcement of joint actions by all the banking agencies to facilitate such lending.

Given the importance of small businesses to the economy and the clear dependence of such firms on banks, the decline in overall business loans in the 1990s underlines the importance of understanding the difficulties of bank credit availability. Even more important, it emphasizes the need to continue to do whatever is possible to remove those sources of restriction that do not imperil the safety and soundness of the banking system.

Assessing the true nature of small business bank credit availability is especially complicated, in part because it seems clear that a substantial share of the decline in the 1990s of total business loans at banks reflects significant balance sheet restructuring by large firms. Many larger businesses have taken advantage of the decline in interest rates and the increase in stock prices to refinance their bank loans.

The declines in business loans associated with balance sheet restructuring by the larger firms were superimposed on a secular downtrend in business credit flows by banks to large firms that have been increasingly relying on nonbank finance. And overlaying the interest rate- and stock market-induced repayment of bank loans by large firms, and their secular shift to nonbank credit, has been a normal cyclical decline in the demand for credit during the recession and modest recovery.

However, I do not believe that cycles, trends, and refinancing are the sole explanations for the decline in business loans. There has been a substantial tightening of lending terms and standards, and it has affected small businesses. This tightening of terms and standards has been clear in our periodic surveys of senior loan officers at large banks since the start of the decade, although this aspect of loan pricing seems to have stabilized in 1992. Evidence from the National Federation of Independent Business is also suggestive. For example, owners of the larger small businesses report greater difficulty obtaining credit than three years ago. The period of credit stringency appears to have lasted longer than in other recent downturns. And, small business credit problems have been very intense in some regions of the United States. Clearly, New England has borne a disproportionately large burden.

The sources of tighter credit availability are not hard to find. A significant part of our current problems reflects a too-expansive credit policy throughout most of the 1980s. Large numbers of lenders mistakenly perceived that financing real estate was very profitable, and virtually risk-free because of the near certainty of continued real estate inflation. But inflation in real estate not only ended; it was in many cases reversed, exposing the lax underwriting standards that had evolved.

The resulting acceleration of nonperforming loans, and associated reserving and write-offs, not only cut sharply into capital--causing many banks to fail and others to be greatly weakened--but also shook the confidence of lending officers and management. Indeed, despite the low rate of failures of depository institutions so far in 1993, we should not forget that the past several years have seen many more failures of depository institutions than all the other years since World War II combined. The almost inevitable result of these traumatic experiences has been that bank lending policies have gone through a period of exaggeratedly high underwriting standards--the same error as in the 1980s but in the opposite direction. Although there appears to have been no further tightening in recent months, the effect on banks of excess optimism in real estate in the 1980s is not, I am afraid, as yet behind us.

Commercial real estate prices have not stabilized enough to allow most banks to feel confident that they know what collateral is really worth. Thus, a kind of traditional bank liquidity--a sense that real estate collateral could be liquidated expeditiously within a known price range--has not yet returned to bank balance sheets. Although improving significantly from the dark period of 1989-91, we do not yet have the turnover and transactions required to instill adequate confidence in most bankers about either their existing or new loans secured by commercial property.

The real estate market plays an important role in small business credit because a significant portion of loans to small businesses involves some real estate collateral. And, even though banks often do not look to that real estate as the intended source of repayment, I am still concerned that a real estate market that has not found its feet is retarding the availability of small business credit. This impact is both direct--in evaluating both the bank's own capital, as well as particular loans--and indirect--by coloring bankers' sense of general confidence.