April 26, 2023
It has been said that small businesses are the backbone of the US economy. According to the Small Business Administration, small businesses make up 44% of the domestic economy.1 Companies with less than 500 employees make up 52% of total employment2 and more than 99% of all firms in the US.3 Those same companies account for over 30% of total exports.3
Tightening lending and the potential challenges for small businesses
Deposits continue to shift away from smaller banks, which according to the US Federal Reserve is defined as all banks outside of the 25 largest banks. We think that this shift has meaningful implications for the US economy in the future. There are more than 4,000 banks in the US. The top 25 largest banks make up roughly 65% of all total loans. After the recent banking stress, deposits have been leaving the banking system, especially for smaller banks. In this uncertain environment, banks will likely make the decision to reduce the availability of credit in order to offset the loss of deposits. Even though banks have already tightened significantly, we expect their lending standards to tighten even further.
Most small businesses use smaller banks for their banking needs. The breakdown of loans derived from smaller banks shows some interesting takeaways. As you can see in the chart, smaller banks account for more than 65% of all commercial real estate loans. Some parts of commercial real estate, particularly office buildings, are already under pressure. As smaller banks restrict the supply of bank loans, we think this pressure could intensify. Smaller banks also account for more than 25% of all commercial and industrial loans, with most of these presumably derived from small businesses. It would be difficult for large banks to fill the void if smaller banks restrict their small business lending practices as large banks typically don’t have the local footprint nor the desire to take on these types of loans. For example: It could be difficult for a small business operating a chain of grocery stores in several small neighboring towns to obtain additional funding if its local bank slashes the business’s credit availability. At the very least, if another bank were to provide funding, it could charge higher interest rates for the loan.
Why is this important?
For starters, we think active management might be able to benefit from this situation. Active managers could avoid potential areas of risk if they understand how lending could be reduced in certain parts of the US economy. Also, as we highlighted in a previous piece, bank lending standards have a high correlation with gross domestic product (GDP) growth. Lending standards have already tightened to levels that suggest a recession, and a further tightening could result in further headwinds for the US economy. Thus, a reduction in loan availability and a higher cost for loans would likely result in further economic weakness and fewer jobs. While the acute phase of recent banking stress seems to have abated, we think this could be the calm before the storm for the US economy.
Smaller banks: Share of total US bank loans
Note: Chart data as of April 5, 2023
Chart sources: Macquarie, Macrobond, and US Federal Reserve.
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