A Borrower Be

 
In the aftermath of this unusual period, even big banks may turn away from their largely unsuccessful ventures in the securities markets.

When the strength of big business returns, big banks may remember that the costs of writing and collecting a large loan are not that much greater than the costs involved with a small loan, and the large loan generates more income for the bank. Then you can say "so long" to special favors for the small-business customer. Instead, small-business borrowers may once again be reminded that the way big banks handle small loans -- through "credit scoring" by Dilbert-like drones in anonymous cubicles -- does not create a satisfying long-term relationship.

And keep in mind, when push comes to shove, many local banks can be coaxed to meet rates that are being offered by credit unions. Louisiana banker Rusty Cloutier, reached right after a meeting in which he exhorted his lending officers to go out and find leads, says, "The market down here is very competitive. There's some business we do here today [as low as] New York prime, though we might look at interest rates a little bit if the credit is weaker."

It's not just generosity. Local banks are facing tremendous new competition. A by-product of the bank-merger movement of the 1990s, which forced many borrowers to work with unfamiliar and sometimes unwelcome banking officers, has been a burst of new banking charters from both state and federal authorities. The new banks, formed to cater to local business, are among the fastest-growing financial institutions in the country.

Even well-established local banks in thriving communities are feeling the pressures of the new competition for the business of small companies. Walter Daller, CEO of the Harleysville National Bank and Trust, a community bank in suburban Philadelphia with $2.5 billion in assets, says his bank isn't anticipating more demand in the immediate future, even though his community is growing fast. His problem is that he lacks pricing power. "There's simply too much competition," Daller says. And his competition comes not only from new banks but also from savings-and-loan associations and credit unions, which, in his view, "do not have the same discipline in asset quality, the same awareness of risk, that we have."

Beyond the awful news of late for big business, what accounts for the new easing of credit? The current phenomenon certainly hasn't always been the case during a downturn in the business cycle. What chokes off a boom is usually actions by the central bank -- the Federal Reserve -- to cut back on the capacity of banks to extend credit to enterprises. Small businesses can be hit particularly hard, as the banks cut off credit to the finance companies, leasing companies, and factorers that specialize in lending to smaller enterprises.

But this time it didn't happen that way. Confronted with the Asian collapse in 1997, the Russian default, the destruction of the world's biggest and most famous hedge fund in 1998, and the worries about possible computer disasters in Y2K, the Fed kept pumping money into the financial and stock-market bubble through its bursting in the spring of 2000. Later that year, when the ship began to take on considerable water, small businesses briefly found money relatively scarce, and their problems were among the reasons the Fed in 2001 aggressively expanded the money supply and reduced interest rates on overnight money loaned from one bank to another (the only important rate the Fed actually controls). Those rates are now the lowest since the middle of the last century -- good enough to create a favorable credit climate for small business, but too late for the big-business boomers who had already created an alternate credit universe not so easily controlled by the Fed.

Most of the unsound lending that characterized the boom was done directly in the market rather than by banks. In the 1990s large nonfinancial as well as financial companies received most of their short-term credit in the commercial paper market, stopping off at the banks only to arrange very cheap backup lines. Longer-term money, notoriously, came from venture capitalists, initial public offerings, and high-yielding junk bonds that Wall Street could sell for anybody with a convincing story. The system malfunctioned and ended up shipping too much money into hopeless business plans and the pockets of promoters. The door to the commercial paper market swung closed in early 2002, and the junk-bond market all but died. For good reason.

Of the "speculative grade" junk bonds issued from 1997 to 1999, no less than 40% had gone into default by this past fall, according to the Fitch ratings agency. Junk bonds rated below "investment grade" now sell to yield 13% or even more, at a time when 10-year government bonds yield 4%. In 2001, according to the New York Stock Exchange, more than half the Nasdaq-listed companies reported losses, not profits.

The most recent study by federal examiners of the "shared credits" that big banks have jointly extended to their largest borrowers found 13% of them in some kind of trouble, up from less than 9% two years ago. And while the Fed has continued to pump out money, the banks have put an increasing share of it into government and government-backed securities rather than into loans. Bank Credit Analysts, a Canadian company that watches trends across the border, reports that the percentage of bank assets that were held in such securities was up from just over 30% in early 2001 to 40% in the second half of 2002. Let them eat cake, the big banks are in effect telling big business, even though the easy-money cake of VCs, IPOs, and junk bonds has fallen flat.

In the aftermath of this unusual period, even big banks may turn away from their largely unsuccessful ventures in the securities markets to concentrate on the business they do better than other lenders -- the supply of finance to growing companies.

In any event, today's climate gives small companies a chance that's unprecedented in recent years to establish relationships with mainstream financial institutions. Then, when things turn up (and they always do, though sometimes it takes a little longer than one would hope), both banks and the enterprises that borrow from them may find that the traditional lending arrangements that many of them jettisoned in the last quarter of the last century work better than the financial engineering that enraptured so many lenders only a few years ago.

Martin Mayer is the author of more than 30 books, including his classic, The Bankers (Ballantine Books), and, most recently, The Fed: The Inside Story of How the World's Most Powerful Institution Drives the Markets (Free Press). He is currently a guest scholar at the Brookings Institution.

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