Grand Rapids Banks Chairman And CEO Testifies In Congress
As is true for the rest of the country, these small companies provide the vast majority of the job growth in our area. We understand the importance of bank financing to these enterprises and to our community. We are in business to help our customers and communities for a lifetime, not just this week or this year.
We cannot ignore, however, changes in our local and national economies. The economy has certainly shifted into lower gear and therefore, our approach must naturally be more cautious. Any experienced driver knows to slow down when the road gets rough. The same is true of bank lending as economic conditions get bumpy.
I would like to make three points:
- Small business lending is a core part of banking's business;
- Small business lending continues to grow, but economic conditions suggest caution; and;
- Congressional action can help small business access to credit.
Let me discuss each in greater detail.
Small business lending is a core part of our business — Banks are the primary source of credit to small businesses and farmers. Small businesses make up nearly half of all commercial and industrial loan customers and three-quarters of all business banking customers. Adding middle market customers pushes the percentages above 90 percent.
Today, banks have more than $230 billion in loans outstanding to small businesses —almost a 10 percent increase from the last year — and we continue to meet the needs of small businesses. Moreover, according to the U.S. Department of Agriculture, banks are the primary source of credit for farmers.
At United Bank, we have $240 million in assets, with roughly 60 percent devoted to loans to businesses of all types. More than 99 percent of our business lending is to small businesses. We specialize in SBA loans, which constitute 35 percent of our small business loans. For United Bank, loan demand was very strong in 2000, growing at a 15 percent annual rate, and continues to grow at about 8 percent this year.
Banks are keenly aware of the needs of small business because most banks are themselves small businesses. Half the 8,600 banks in the U.S. employ fewer than 30 people and nearly 14 percent have fewer than 10 employees. Finding funds to support loans is the No. 1 challenge facing banks today.
This is where banks presently need the most assistance in lending to small businesses. Banks are struggling to attract deposits to fund loans.
The past two decades have seen major changes in the financial services industry, with many new competitors vying for the consumer’s dollar. Our biggest competition is Wall Street, not the bank across Main Street. Growth in money market funds, stock prices and mutual funds has lured core deposits away from us in a dramatic shift out of bank checking accounts (demand deposits) and into money market funds. Similarly, the money that used to be in savings accounts (time deposits) at banks is increasingly going into mutual funds.
High regulatory, examination, and compliance costs make it very difficult for banks to be competitive with these other firms. Although Wall Street competes with us for savings dollars, those Wall Street dollars do not end up funding the needs of small businesses. That job is left to the bank.
Credit Caution is the Watchword — Over the last half-dozen years, bank business lending grew rapidly, reflecting the strong economy. Economic conditions have downshifted and so must our approach to lending. The local economy that my bank serves is highly dependent upon manufacturing. United Bank has been in business for over a century — we know that economic downturns hit us sooner and harder, and last longer, than other regions of the country. Therefore, we must watch for early signs that the winds have changed, and prepare sooner than perhaps others of my colleagues around the country.
Bank have been tightening underwriting standards. This process began following the Russian default in August of 1998. Credit markets worldwide were shaken, and the default served as a reminder of how quickly good times can fade. A slight rise in bank non-performing loans over the last several years has also put a real face on difficulties businesses have been encountering.
As the economy continues to slow, the process of tightening has become more widespread. The uncertain economic outlook was the reason most frequently cited for these adjustments, followed by worsening of industry-specific problems and a reduced tolerance for risk.
Let me be very clear: We are in the business of lending, and that is what we intend to do. Good creditworthy borrowers will always have access to funding and we are always mindful of our role in helping our economy return to sustainable growth. However, the risks of lending today are certainly greater than they were a year or two ago.
We are looking more carefully at our loans and asking our customers more questions about their business plans and whether those plans accurately reflect the slowdown in economic activity. Not surprisingly, nationally the demand for business loans has slowed with the economy. Such conservative approaches to both borrowing and lending are prudent in the face of uncertain economic times.
There is a tendency to compare the current slowdown today with the credit conditions in the early 1990s. There are two areas to consider: the financial condition of banks and the regulatory environment. The financial condition of the banking industry today is much better than it was in the early 1990s.
Bank capital plus reserves for loan losses has climbed to record heights and is nearly $600 billion — two and a half times the capital level in 1990. As I mentioned, non-performing loans are still low by historical standards. And banks have diversified their sources of income over the last decade, which has enhanced an already strong and stable revenue base. Banks have the financial strength to weather any storm and to continue to lend to creditworthy borrowers.
The regulatory environment in the early 1990's was not one that encouraged lending. Every loan, particularly related to real estate, was scrutinized. The message sent to bankers then was "make no mistake in lending" and the result was negative growth in lending for several years. Obviously, neither the regulators nor banks want to repeat that experience. In today's environment, it is critical that banks and bank regulators take a balanced, thoughtful approach to lending.
Aggressive rate cuts by the Federal Reserve have eased some of the pressure on business loans outstanding today (as they are typically tied to the prime lending rate which has declined) and has lowered the average cost of new loans.
Congressional action can help small business access to credit — You asked what changes could be made that would facilitate access to credit for small businesses. I will discuss briefly some ideas that I believe would help, but before I do, I want to acknowledge some important laws that have recently been enacted that will help.
In particular, the merchant banking provisions in the Gramm-Leach-Bliley Act of 1999 (GLB Act) will serve an important function in providing needed capital to businesses. Start-up businesses often lack equity, thereby limiting their ability to qualify for debt financing to grow their businesses. The merchant banking provisions in the GLB Act will allow banks to take an equity stake in these firms and provide these businesses with additional financial resources.
The merchant banking powers will help preserve Main Street by assisting in the intergenerational transfer of family-owned businesses. Implementation of these provisions by regulators must be done carefully so as not to discourage the very purpose this provision was designed to address
Repealing the estate tax would also help these intergenerational transfers for family-owned businesses considerably.
The GLB Act also expanded the collateral that could qualify for Federal Home Loan Bank advances. This allows small business and small agri-business loans to qualify as eligible collateral for advances and will certainly improve the funding for many Main Street businesses. Again, implementation of these laws by all 12 of the Federal Home Loan Banks must be done in a way that promotes these benefits.
Let me now turn to a very important issue related to the SBA Guaranteed Loan Program. This program can be one of the most cost-effective, high impact tools that Congress can provide. The program's resources are targeted to small businesses that do not typically meet bank-underwriting standards.
The guarantee helps protect banks against losses and provides credit that would otherwise be unavailable — a win-win situation and an example of an effective public-private partnership. For these small businesses, the assistance can make a critical difference between financial survival and failure.
My bank specialized in SBA lending, but we have scaled back considerably because of the rising fees associated with this program. These loans — which require considerable expertise by bank employees — are quickly losing their attractiveness for banks like mine.
The recent budget proposals that are being suggested — which would once again raise fees for both the borrower and the lender for the 7(a) program — are likely to spoil this product altogether, making what is now a marginal business completely uneconomical. I also worry that the timing of such a change will reduce the credit available for these small business borrowers as they seek access to funds in a slowing economy.
There are also tax incentives that would be helpful. I've already mentioned how the repeal of the estate tax would help the intergenerational transfers of small businesses. Below I've briefly described a few additional tax provisions.
FFARRM Accounts: Farmers, fishermen and ranchers often have incomes that change dramatically from year to year. The Farm, Fishing and Ranch Risk Management Accounts (FFARRM accounts) allow participants to deposit up to 20 percent of taxable income in a year in a special bank account. Participants would make withdrawals from the account over the next five years, with the withdrawals being taxed as income in the year the withdrawal takes place. This allows farmers, fishermen and ranchers to smooth income for tax purposes, providing an incentive to save for bad times and manage the inherent financial risks of their businesses. FFARRM accounts would provide a badly needed source of funding for all types of lending.
Strengthen Aggie Bonds: Aggie bonds are state industrial revenue bonds for agricultural borrowers … a cost-effective method of providing reduced interest rate loans to young and beginning farmers for capital purchases of farmland and equipment. Unfortunately, aggie bonds are subject to a federal volume cap on industrial revenue bonds (IRBs) and must compete with industrial projects for bond allocation.
This results in insufficient volume for aggie bond programs. Therefore, small beginning young farmers and startup businesses in rural and under-served areas are often left without adequate access to aggie bonds. Aggie bonds should be exempt from the state bond volume caps. This would encourage states to start aggie bond programs and provide more beginning farmers with low-cost capital.
Improve and Expand Subchapter S To create greater opportunities to raise capital and preserve small business lending, improvements in Subchapter S should be made. This would help many small businesses, including small community banks.
To help small businesses, the following changes to Subchapter S are recommended:
- Expand the shareholder threshold from 75 shareholders to 150. Expanding Subchapter S eligibility to more small businesses would eliminate an artificial constraint on small businesses to raise capital.
- Expand the type of shareholders. Currently, Subchapter S eligibility requirements exclude many types of institutional shareholders, such as family limited partnerships and individual retirement accounts thus limiting the sources of potential capital.
- Authorize a second class of stock. Currently, Subchapter S businesses can only issue one class of stock. This restriction on stock offerings constrains the ability of small businesses to raise capital.
- Modernize the passive income rules Currently, Subchapter S businesses are subject to a corporate-level tax on excess passive investment income. Modernizing the passive investment rules would encourage the growth of small businesses and alleviate unnecessary investment costs.
Small businesses are vital to a strong economy and often the centerpiece of banks' lending activities. Bankers know the critical role we play in helping these businesses grow and be successful, and we know the broader implications for job growth and economic vitality of our local communities.
Regardless of the economic cycle, we are always looking to meet the needs of creditworthy borrowers. We must also be cognizant of changes in economic activity. The risk of lending today is far greater than it was a year or two ago and our lending decisions must naturally take this into account.
Of particular importance to small business lending has been the SBA Guaranteed Loan Program. I urge a careful review of recommendations to add costs to both the lender and the borrower on these programs, as they will likely reduce the amount of credit to small businesses.