Risk Overhang and Loan Portfolio Decisions: Small Business Loan Supply Before and During the Financial Crisis

Sun Dec 06 13:47:00 EST 2015
By Dr. Anne Gron, with Robert DeYoung, Gokhan Torna, and Andy Winton

This paper, published in the Journal of Finance, investigates business lending by smaller, relatively diversified banks over a period of economic expansion and financial crisis. The analysis finds that, on average, small banks reduced their credit supply to businesses during the financial crisis as existing bank-held business loans became less profitable and more illiquid. The analysis also identifies a group of small banks strategically focused on relationship-lending to commercial entities that increased new loan supply during the financial crisis. These findings are particularly relevant for small businesses because they tend to be more reliant on bank financing and tend to be the typical small bank’s business borrowers.

The findings are consistent with the following market dynamic: As bank lending becomes more profitable during economic expansion, banks’ equity capital, lending capacity, and tolerance for risk will all increase. The resulting increase in loan supply will be further enhanced by the relatively liquid nature of well-performing loans. As the expansion continues, at some point banks will need to compete for new business by providing loans to riskier borrowers and/or by providing loans at lower interest rates. When the expansion inevitably ends, defaulting loans will reduce bank capital, lending capacity, and risk tolerance. Increased credit risk and loan illiquidity will further reduce banks’ already declining lending capacity. These effects will be moderated if banks hold precautionary balances of equity capital and liquid assets, if banks hold significant portions of their loans in uncorrelated sectors or in sectors that are robust to economic downturns, or if (as highlighted in this paper) banks are strategically committed to relationship-based small business lending.

The journal abstract may be viewed on the Journal of Finance website.