Statement by David W. Mullins, Jr., Vice Chairman, Board of Governors of the Federal Reserve System, before the Committee on Small Business, U.S. Senate, March 4, 1993

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I am pleased to be here this morning to discuss the credit crunch and the availability of credit for small businesses.

The financing of small business enterprises is a central issue in the future growth and vitality of the U.S. economy. Small businesses account for almost two-thirds of the nation's work force. They created 80 percent of the new jobs in the 1980s, a decade in which the U. S. economy created almost twenty million jobs, despite the fact that Fortune 500 firms reduced their employment.

The sources of small business financing are substantially more limited than those of large firms that have continuous access to the depth and liquidity of public capital markets. For debt financing, small businesses are generally dependent on financial institutions, primarily commercial banking firms. Because of the importance of small businesses to the growth of the U.S. economy, especially job growth, the protracted weakness in business loans at banks is an important public policy concern--one worthy of rigorous analysis and concrete action.

Why have business loans by banks fallen? In our view, there are several contributing factors on both the demand side and the supply side of this market.

First, the demand for bank loans typically declines during recessions as economic activity slows, reducing firms' needs for working capital and new plant and equipment. In the recent downturn this decline has been amplified by a broad-based desire by businesses to reduce their dependence on debt financing. This deleveraging phenomenon, which has been apparent for both businesses and households, followed a decade in which debt financing expanded to historically very high levels. Excess leverage in conjunction with a weak economy reduced the creditworthiness of many firms as well.

Federal Reserve surveys indicate that supply side constraints on the availability of financing may have played a role in reduced business borrowing. The surveys demonstrate that large banks have systematically tightened the terms and standards for granting business loans to customers of all sizes. Of course, some of this tightening was likely justified as an appropriate response to the lax credit standards of the 1980s and the resulting heavy loan losses of the early 1990s. Although no substantial reversal or easing is yet apparent, our surveys indicate that tightening of credit standards has ceased.

An important factor influencing the availability of financing during this period has been the condition of the U.S. banking industry. The debt financing of the 1980s left banks with record nonperforming loans--especially commercial real estate loans--in the early 1990s. These asset-quality problems produced large loan losses that reduced the capital base of the U.S. banking industry. In response, the banking industry over the past 21/2 years has focused on identifying and working out bad loans, and rebuilding capital and liquidity. In short, the banking industry has been engaged in an intensive process of financial healing--dealing with embedded asset-quality problems and rebuilding its financial strength.

This retrenchment process has involved reducing loan growth, investing in government securities, cutting expenses to enhance earnings, retaining a larger portion of these earnings, and issuing new equity to bolster depleted capital bases. Although this process may have adversely affected loan growth in the short term, it was a necessary prerequisite to the industry's return to financial strength that is capable of supporting and sustaining new lending and growth.

In our view, the Basle risk-based regulatory capital standards appear not to have played a significant role in motivating banks to curtail lending. During this entire retrenchment period, the overwhelming majority of U.S. banks met these minimum standards, most by a very wide margin. Indeed, those banks with capital far above the minimum standards have been responsible for the overwhelming majority of bank investment in government securities. …