Efficient Capital Allocation to Small and Medium Sized Businesses

Reading a recent post by David McCombie III regarding FED intervention to mitigate the economic damage caused by the pandemic, the point is made that the intervention is not relevant to private businesses. I agree as the FED is not a lender (other than to financial institutions) and requires banks and other financial intermediaries to allocate capital to credit worthy enterprises. The recent PPP exercise which crammed $349BB in loans in 2 weeks through an SBA lending channel that normally does $28BB a year is an extreme example of how the FED uses the banking system to allocate capital. There is no shortage of disagreement over the way the allocations were made and frankly with no credit risk to the banks, the allocations were made primarily to those with existing bank relationships.

By definition a bank relationship is when you can get a banker to return a phone call during a credit crisis. Some business owners found out that despite doing business with a bank for a long time, there was no one to call when the crisis hit.

The definition of a SMB or SME (small and medium sized business or enterprise respectively) is fairly arbitrary. Depending on the source 500 employees and under $250MM in revenue is probably a good estimate for the upper range with the more prevalent numbers much lower. There are around 29 million businesses with fewer than 500 employees in the US representing 99.7% of all US businesses and nearly half of all private sector employment according to Deloitte.

I believe we will see things get materially worse for SMBs as the economic fallout from the pandemic continues.

One reason is that one of the largest sources of capital allocation for SMBs has practically disappeared in the last 20 years. We've lost 10,000 banks since 1990 and the bulk of them were small community banks under $10BB in assets. These small banks normally supply nearly half of SMB lending nationwide. The numbers have been declining as banks continue to be acquired and more SMBs have turned to Fintechs, MCAs or other non-bank lenders for capital. While they are fast efficient and digital, the Fintechs are not particularly built for relationship banking. When things are great you don't want to talk to someone - when things are terrible you need to.

There have been just a handful of new banks that have opened since 2009.

Why has this occurred? Well for a while during the financial crisis the FDIC was not approving new applications. They have since become extremely accommodating, hosting conferences on new bank (denovo) formation and shortening the regulatory denovo period from 7 back to 3 years. What has continued to be an impediment to new bank formation is the new capital requirements that make it extremely difficult for new groups to raise the money necessary to gain approval. When our group opened a denovo bank in Ft Lauderdale in 2009 we were required to raise $12.5MM in capital. Today it would be more like $20MM and many approved applications have been withdrawn for lack of meeting capital requirements.

Having more moderate capital requirements for new banks would help stimulate bank formation. Lets face it, how much damage to the FDIC insurance fund is done by the failure of a small $200MM bank. The failure of Wachovia or Washington Mutual created a bigger loss than the failure of every community bank ever (I don't know if that's true but it sounds good and probably is). I know that is not how regulators are supposed to think but relaxing the capital requirements would definitely help new groups start banks.

As we face a crisis without small banks to help small business its time to rethink bank formation to help communities rebuild their small businesses. It will be a difficult process no matter but with new community bank formation and fresh capital to deploy, we can help restore the small and medium sized local businesses that are the true backbone of our American economy.