Banks and the Availability of Smal ! Business Loans

Investigators exammning problems with credit availability during the most recent recession have been unable to provide definitive evidence that the decline in bank loans was, at least in part, a supply phenomenon. Furthermore, they have not focused on the subset of loans made to borrowers most likely to be dependent on bank financing. This study overcomes these flaws. By examining formal regulatory actions, we clearly identify a supply shock that caused an abrupt decline in bank lending that cannot be attributed to demand. Furthermore, we find that this decreased lending occurred at institutions and in lendinm categories serving those firms most likely to be dependent on bank financinc. This decline in lending to small businesses was likely a contributin~ factor to the unprecedented increase in bus~ness failures in New England. *Professor of Economics, Boston College, and Visiting Economist, Federal Reserve Bank of Boston **Vice President and Economlst, Federal Reserve Bank of Boston We thank Robert Chicoski and Lucille Rexroad for able research assistance. We have benefitted from the comments of Fabio Schiant~relli, Steven A. Sharpe and an anonymous referee, as well as participants of seminars at the Federal Reserve Bank of Boston, the Office of the Comptroller of the Currency and the Southern Economic Association meetings. The views expressed in this paper are those of the .authors and do not necessarily reflect positions of the Federal Reserve Bank of Boston or the Federa! Reserve System. Recently, much attention has been focused on the "lending" (or "credit") view of the transmission of monetary policy as a supplement to the traditional "money" vlew. This literature emphasizes the imperfect substitutability of bank loans and open market financial instruments as sources of financing for firms (for example, Bernanke and Blinder 1988; Kashyap and Stein 1993). The bank lending channel becomes more important the smaller the degree of substitutability available to firms, making small firms a key element in the transmission mechanism. Such firms tend to be "bank-dependent," having no direct access to nationa! credit markets and limited, if any, access to large banks outside the loca! area or to large nonbank lenders such-as life insurance companies or pension funds. Thus, when local banks reduce credit availability, the lack of alternative sources of credit can result in a sharp deterioration in the economic viability of