Further Reading: large banks fail small businesses

Almost a year into the Covid-19 pandemic, the financial and economic fallout has differed from the credit crunch of 2008 in several important ways.

Twelve years ago, after an insolvent global banking system was bailed out by governments, lenders restricted access to credit in an effort to de-risk their balance sheets. This time round, as lockdown measures rolled across advanced economies, millions of firms were given government grants or loans to help them survive, often administered by large lenders which entered the crisis with stronger capital and liquidity levels.

One constant throughout all of these events has been the consistent anecdotal evidence to suggest that when left to their own devices, banks either overlook or under-serve smaller businesses, despite the fact that in aggregate, small and medium-size enterprises (SMEs) are the largest employers in many countries.

In the UK, for example, SMEs both account for around two-thirds of all employment and are highly-dependent on bank funding. Yet the anecdotal evidence of recent years – most notably depicted in 2013 by the government-commissioned Tomlinson Report – has pointed to a pattern of ill-treatment of SMEs at the hands of large banks.

However, until recently, academia had yet to definitively establish whether the shape of the banking sector itself played a role in exacerbating financial constraints in the economy.

We now have an answer, according to the authors of the largest empirical study of the relationship between bank size, customer size and loan provision. Using a massive dataset covering more than 14,000 US banks of varying sizes from 1994 to 2013, Achraf Mkhaiber, from the Association for Research on Banking and the Economy and Richard Werner, a professor at the universities of De Montfort and Fudan, found that large banks tend to lend to large firms, and small banks only tend to lend to small firms.

To establish this, the researchers looked at the ratio of both small business loans (defined as less than $1m) and micro-business loans (less than $100,000) to banks’ total business loans.

“The propensity of banks to lend to small businesses decreases as the size of the banks become larger, and vice versa,” Mkhaiber and Werner concluded, noting that the results were consistent both before and after the 2008 financial crisis, and across different forms of lending.

The findings seem to support one theory of bank business models – that large lenders have the edge in transactional lending and thus prefer large transparent borrowers, while small banks are good at relationship building and thus focused on small, opaque firms.

Intuitively, the results might also sound obvious. But their structural implications – assuming observations gleaned from the world’s largest and most diverse banking market hold true for other countries – are profound; namely, the fewer the number of small lenders, the worse small businesses are likely to be served. In turn, that is likely to impact the growth and job creation prospects of the largest aggregate employers in many economies.

“It is not unreasonable to speculate that a key barrier to growth of SMEs could possibly be overcome by influencing the structure of the banking system such that it is dominated by a large number of small, local banks,” Mkhaiber and Werner state, pointing to the US and Germany as positive examples of this dynamic, and in stark contrast to the UK.

The authors also suggest that the creation of thousands of small and medium-sized banks in China in the wake of Deng Xiao Ping’s reforms helped to dispense with a Soviet-style centralised lending model and instead focus on a far more productive form of local credit creation.

How the paper might inform policy in the middle of a global pandemic remains to be seen. In the UK, structural reform of a sector as complicated and top-heavy as banking is likely to take many years, even as the likes of NatWest promise to increase their focus on SME lending.

Nonetheless, recent evidence suggests that even the supposedly hyper-local US banking market has failed to arrest deepening inequalities in the access to debt.

Companies large enough to access the corporate bond market – which often means issuing at least $200m at a time – have encountered plentiful access to yield-hungry cash holders. But further down the credit ladder, the Federal Reserve’s Main Street Lending Program has started to stutter, while loans to small corporates outside the $525bn so-called Payment Protection Program have contracted sharply.

 ‘The relationship between bank size and the propensity to lend to small firms: New empirical evidence from a large sample’, by Achraf Mkhaiber & Richard Werner, is published in the February issue of the Journal of International Money and Finance and can be read here.