SME ACCESS TO FINANCING, LENDING TECHNOLOGIES AND THE FINANCIAL CRISIS

Gregory F. UdellChase Chair of Banking and Finance

Kelley School of Business

Indiana University

Presented at:

The Conference on

“The Financing of Small- and Medium-Sized Firms”Jointly organized by

The OECD, the Marche Region and the Faculty of Economics

University of Urbino “Carlo Bo”

April 21-22, 2009

“Increasingly complex financial instruments have contributed to the development of a far more flexible, efficient and hence resilient financial system than the one that existed a quarter century ago.”

- Alan Greenspan, November 2005

“The bright new financial system – for all its rich rewards and unimaginable wealth for some – has failed the test of the marketplace by repeatedly risking a cascading breakdown of the system as a whole.”

- Paul Volcker, April 2008

2007

4th

Countrywide narrowlyavoids bankruptcy

Merrill has$5.5 B loss

2008

Bear Stearns acquired byJPM

IndyMacfails

2nd1st 3rd

Am. New Century Financial (largest Subprime lender) files for bankruptcy

Fed pumpsin $41 B

First Fed TAF

Paulson regulatoryreform proposal

Merrill - BoAdeal

Lehmanbankruptcy

AIG Bailout

CRISIS TIMELINE

Freddie Mac stops buying subprimes

4th2nd1st 3rd

2009

1st

AIG bonuscontroversy

Treasury systemicrisk proposal

Run on Northern Rock

UBS reports 1st annual loss

MY PRESENTATION• The context: bubble-driven financial crisis

• Lax regulation

• The impact on the banking system• The “direct” effect: a credit crunch• Small business lending technologies

• And lending channels• Lending technologies, SMEs and the crunch

• The U.S. Case• Developing economies

• “Indirect” effects on SMEs

See: “How Will a Credit Crunch Affect Small Business Finance” by G. Udell, FRBSF Economic Letter, No. 2009-09, March 6, 2009, www.frbsf.org

BACKGROUND – GENESIS OF A CRISIS

• Primary cause: a popped real estate bubble• Deja vu all over again

• US: 1974, 1990, 2007• Japan 1990

• Exacerbated by innovations plus layers of agency problems

• 2007: securitization; SIVs• 1974: REITs

HOUSING PRICES DECELERATED

Case-Shiller Home Price Index

Home price index change (percent change over prior year)

OFHEO price index

THE REAL ESTATE MESS

• Lending standards clearly fell dramatically– Mortgage underwriting criteria

• LTV ratios, FICO scores, (crazy) Option ARMs, “No Doc” loans

– Pro-cyclical forces• Bubble-driven valuations• Herding behavior• Institutional memory problem

– Securitization laced with agency problems– Risk management AWOL

• Banks aggressively shifted towards real estate– Including commercial real estate loans

Large Bank Loans(2000)

Construction 4%

Commercial RE 10%

Multifamily Res 2%

Non-Real Estate61% Farmland

0%

1-4 Family23%

Large Bank Loans(2007) Construction

7%

Commercial RE 11%

Multifamily Res 2%

1-4 Family31%Farmland

0%

Non-Real Estate49%

Small Bank Loans(2000)

Construction 7%

Commercial RE 22%

Farmland 4%

Non-Real Estate36%

1-4 Family29%

Multifamily Res 2%

Small Bank Loans(2007)

Farmland 4%

1-4 Family23%

Multifamily Res 2%

Commercial RE 28%

Construction 16%

Non-Real Estate27%

FAILURE OF THE GATEKEEPERS:SHOULD WE BE SURPRISED?

• Mortgage bankers (conflict of interest)• Appraisers (conflict of interest)• Rating agencies (conflict of interest)• Underwriters (conflict of interest)• Accounting and accounting firms (conflict of interest,

and backward looking)• SEC (not charged w. financial stability, no resources)• Basle II – quant risk management (controversial)

• Bank regulators Federal Reserve -- WE SHOULD BE SURPRISED!

Substantial resources (20,000 employees vs 3,400 at SEC Mission includes prudential supervision, consumer

protection, financial stability & monetary policy

THE FEDERAL RESERVE• Why did the Fed fail?

– Ideological? – See beginning Greenspan quote– Greenspan blocked fellow governor’s (Edward

Gramlich) proposal to crack down on predatory lending in 2000

– “triumphal narrative of American exceptionalism” (S. O’Bryan)

– A “one in a hundred year event” (?)

– Excess confidence in Basle II math

THE FEDERAL RESERVE (cont.)• Why did the Fed fail? (cont.)

– Bank examination process flawed– Item examination to process examination

(1980s)– Focus on individual bank solvency

– No aggregation (e.g., CDS concentration at AIG)– Pressure to not take away the “punchbowl”

just when the party’s roaring– Ignoring the warning signs

– See bank loan pie charts– Looking inside innovations (just like REITs in 1970s)

THE FEDERAL RESERVE (cont.)• Why did the Fed fail? (cont.)

– Financial stability mission not imbedded organizationally

• No dedicated stability division or section• Stability analysis fragmented in other

divisions/sections (e.g., monetary policy, financial markets, banking research, and supervision and regulation)

• No periodic financial stability report• Unlike ECB• Unlike many other countries

• The U.S. did not participate in the IMF/World participate in the IMF/World Bank Financial Sector Surveillance Program Bank Financial Sector Surveillance Program since its inception in 1999.since its inception in 1999.

THE DIRECT EFFECT:A CREDIT CRUNCH

• What is a credit crunch?

– A significant contraction in the supply of credit

• Mitigating the credit crunch is the primary economic motivation for TARP, plus … @#%& …

WHY BANKS CONTRACT

• Banks suffer a shock that affects their ability and/or incentive to lend

– Many types of potential shocks: historical shocks include, for example:

• Capital shock (US 1990-92, Japan 1990-2000)• Regulatory reporting shock (US 1990-92)• Regulatory scrutiny shock (US 1990-92)• Risk-based capital shock (US 1990-92)

• The shock now is a “capital shock” caused initially by losses in the subprime mortgage market• Followed by losses in other markets

WSJ 1/18/08 Economist (August 9-15, 2008)

BANK LOSSES: Jan 2008 v. Aug 2008(Loan Loss Prov: $151B in ’08 v. $57B in ’09)

MECHANICS OF A CAPITAL SHOCK

• Banks must meet required capital requirements Banks have target capital requirements driven by reputation/credibility effects

• Losses deplete capital (i.e., stockholders equity)

• Banks must either– Raise more equity (e.g., from sovereign wealth

funds), or– Reduce assets by contracting lending

- i.e., contract the supply of credit

EVIDENCE OF A CRUNCH

• Bank liquidity creation fell dramatically.

• Fed’s Senior Loan Officer Survey began showing “tightening” loan standards

– Index went “tight” in early 2007 escalating in third quarter

– In the October 2008 survey, the net percentage of large banks, and the net percentage of smaller banks, that reported a tightening of standards to larger firms was 84.4% and 82.6% respectively, and to small firms was 71.9% and 78.3% respectively. None of the surveyed banks reported any easing of standards. A colossal level of tightening. (Continued in Jan Survey.)

THE CREDIT CRUNCH: EVIDENCE

Fed Senior Loan Officer Survey

-40.0

-20.0

0.0

20.0

40.0

60.0

80.0

100.0

Jul-9

0

Jul-9

2

Jul-9

4

Jul-9

6

Jul-9

8

Jul-0

0

Jul-0

2

Jul-0

4

Jul-0

6

Jul-0

8

Per

cen

t T

igh

ten

ing

Large and Medium Firms

Small Firms

WHO GETS HURT?

• Large firms

– Most of the current focus in U.S.– e.g., GM, Ford, Chrysler, Circuit City

• Small firms may get hurt even worse– Many small firms are dependent on small banks

• Relationship borrowers• Small banks may be the next shoe to fall

– Small banks loaded up on real estate even more than large banks (see slides above)

LENDING TECHNOLOGIES

• A lending technology is comprised of a combination of screening mechanisms, contract structures, and monitoring strategies. e.g.,• Relationship lending• Financial statement lending• Factoring

• A lending channel is a two dimensional concept• Lending technology offered by a financial

institution

SMALL BUSINESS LENDING:THE ROLE OF “LENDING TECHNOLOGIES”

(The U.S. Case)

Large Small Large Com. Small Com.Banks Banks Finance Cos. Finance Cos. Corporations

Relationship Lending oFinancial Statement Lending o oAsset-Based Lending o o o oFactoring o o o oEquipment Lending o o o oLeasing o o o oReal Estate-Based Lending o o Small Bus. Credit Scoring o Trade Credit o

THE EFFECT OF THE CRUNCH ON SMALL BUSINESS FINANCE IN THE U.S.

o = open “lending channel”x = constricted “lending channel”? = we don’t know yet

LOT’S OF UNKNOWNS

• How bad will bank failures be?• How will small banks do?

• Which borrowers will get “crunched”?• Shorter/weaker relationships?

• Will commercial finance companies help fill in the lending gap?

• Will TARP, PPIP, + … @#%& work?

• Can trade credit help fill in the gap?• Requires a normal functioning of the commercial

paper market

DEVELOPING ECONOMIES

• Fewer lending technologies• But, large banks do offer transactions-based

lending (e.g., see de la Torre, Martinez Peria and Schmukler 2008 in Latin America)

• Can these technologies (e.g., factoring, trade credit, leasing) offset the crunch?

• Other technologies notwithstanding, relationship lending may be more important in developing economies• Probably not delivered by large banks, state-

owned banks or foreign-owned banks

SOME INDIRECT EFFECTS• Lost relationships

• Fewer small banks• Could be as many as 1,000 small banks failing in the U.S.• Less relationship lending overall?• Loss of relationships

• Permanent change in market structure (?)• Concentration (see Carbo Valverde, Rodríguez-Fernández and

Udell 2009)

• Bank size structure (see Berger, Rosen and Udell 2007)• Distance (see Alessandrini, Presbitero and Zazzaro 2009)

• Operational distance• Functional distance

• Permanent change in governance(?)• More state-owned banks(?)• Fewer foreign-owned banks(?)