Thursday, November 19, 2009

The view that there is a disconnect between large firms with a direct access to financial markets on the one side and medium-sized/smaller firms as well as households which mostly rely on banks for external capital on the other is gaining more followers. I have frequently written about this subject (see for example Small is beautiful dated Nov 3). The fundamental environment for small businessess, especially in the US, has changed dramatically. They rely heavily on bank credit and are more dependent on the domestic economy than the larger firms. Furthermore, in past recessions they did not lay off a significant amount of people whereas they were responsible for a high share of job growth during growth periods. Now, however, the combination of a heavy reliance on bank capital as well as on the domestic economy means that their access to external capital has become very difficult. Banks either cant lend (as they are poorly capitalised) or wont lend (amid the higher credit risk for domestically focused operations). For me, this is one of the top challenges facing various economies. First, smaller businesses are usually more innovative and flexible than their larger counterparts and therefore a more difficult environment for small businesses should be putting downward pressure on trend growth. Additionally, as the small business sector gets smaller, the large businesses get relatively larger, leading to an increased concentration in many industries, hurting competition and increasing rent-seeking behaviour by those large corporates.
This week, Nouriel Roubini has been making a similar point in 'A Tale of Two American Economies'. To quote: "The story of the U.S. is, indeed, one of two economies. There is a smaller one that is slowly recovering and a larger one that is still in a deep and persistent downturn...Prime borrowers with good credit scores and investment-grade firms are not experiencing a credit crunch at this point, as the former have access to mortgages and consumer credit while the latter have access to bond and equity markets. But non-prime borrowers – about one-third of U.S. households – do not have much access to mortgages and credit cards. They live from paycheque to paycheque – often a shrinking paycheque, owing to the decline in hourly wages and hours worked. And the credit crunch for non-investment-grade firms and smaller firms, which rely mostly on access to bank loans rather than capital markets, is still severe. Or consider bankruptcies and defaults by households and firms. Larger firms – even those with large debt problems – can refinance their excessive liabilities in or out of court, but an unprecedented number of small businesses are going bankrupt...Consider also what is happening to private consumption and retail sales. Recent monthly figures suggest a rise in retail sales. But, because the official statistics capture mostly sales by larger retailers and exclude the fall by hundreds of thousands of smaller stores and businesses that have failed, consumption looks better than it really is."
A lot of small businesses also rely on small banks for loan financing, however, these small and regional banks themselves remain in a more challenging environment than the larger banks as the growing number of failing banks suggests. Furthermore, also the large banks do not lend to small businesses. To quote this article 'Small business loans: $10billion evaporates':"The 22 banks that got the most help from the Treasury's bailout programs cut their small business loan balances by a collective $10.5 billion over the past six months, according to a government report released Monday. Three of the 22 banks make no small business loans at all. Of the remaining 19 banks, 15 have reduced their small business loan balance since April, when the Treasury department began requiring the biggest banks receiving Troubled Asset Relief Program (TARP) funding to report monthly on their small business lending. Over the six months that the reporting requirement has been in effect, the banks have cut their collective small business lending by 4%. Their cumulative balance stood at $258.7 billion as of Sept. 30, according to a Treasury Department report. The bank with the biggest lending drop was Wells Fargo, which cut its loan balances by $3 billion. However, Wells Fargo also remains by far the biggest small business lender, with $73.8 billion lent out to small companies. No other bank comes close to that tally. Some banks are unapologetic about their cutbacks. Small business defaults are soaring, and banks are under pressure to shore up their balance sheets and reduce their exposure to risky loans. Two key small business lenders, CIT Group and Advanta, filed for bankruptcy this month."
Lending freefall
Source: Treasury Department via

To me this is further confirmation that indeed there is a disconnect between the state of large (quoted) firms which are gaining market share on the one side and smaller firms/households which continue to face a recessionary environment. Growth is not yet self-sustaining and any economic dynamic remains dependent on the support provided by fiscal and monetary authorities. I still do not see how trend growth over the next decade can match the levels of the past decade.

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