Transcript Presentation Title

SME ACCESS TO FINANCING, LENDING
TECHNOLOGIES AND THE FINANCIAL CRISIS
Gregory F. Udell
Chase Chair of Banking and Finance
Kelley School of Business
Indiana University
Presented at:
The Conference on
“The Financing of Small- and Medium-Sized Firms”
Jointly organized by
The OECD, the Marche Region and the Faculty of Economics
University of Urbino “Carlo Bo”
April 21-22, 2009
“Increasingly complex financial instruments
have contributed to the development of a far
more flexible, efficient and hence resilient
financial system than the one that existed a
quarter century ago.”
- Alan Greenspan, November 2005
“The bright new financial system – for all its rich
rewards and unimaginable wealth for some – has
failed the test of the marketplace by repeatedly
risking a cascading breakdown of the system as
a whole.”
- Paul Volcker, April 2008
Bear
Stearns
acquired
by
JPM
CRISIS TIMELINE
Countrywide
narrowly
avoids
bankruptcy
Am. New Century Financial
(largest Subprime lender)
files for bankruptcy
UBS reports 1st
annual loss
Fed pumps
in $41 B
2007
1st
Lehman
bankruptcy
AIG bonus
controversy
Merrill - BoA
deal
AIG Bailout
2008
2nd
3rd
4th
1st
2009
2nd
Run on
Northern
Rock
Merrill has
$5.5 B loss
4th
1st
IndyMac
fails
First
Fed TAF
Freddie Mac
stops buying
subprimes
3rd
Paulson
regulatory
reform
proposal
Treasury systemic
risk proposal
MY PRESENTATION
• The context: bubble-driven financial crisis
• Lax regulation
• The impact on the banking system
• The “direct” effect: a credit crunch
• Small business lending technologies
• And lending channels
• Lending technologies, SMEs and the crunch
• The U.S. Case
• Developing economies
• “Indirect” effects on SMEs
See: “How Will a Credit Crunch Affect Small Business Finance” by G. Udell,
FRBSF Economic Letter, No. 2009-09, March 6, 2009, www.frbsf.org
BACKGROUND – GENESIS OF A
CRISIS
• Primary cause: a popped real estate bubble
• Deja vu all over again
• US: 1974, 1990, 2007
• Japan 1990
• Exacerbated by innovations plus layers of agency
problems
• 2007: securitization; SIVs
• 1974: REITs
HOUSING PRICES DECELERATED
Home price index change
(percent change over prior year)
Case-Shiller Home Price Index
20
15
10
5
OFHEO price index
0
-5
'75
'80
'85
'90
'95
2000
'05
THE REAL ESTATE MESS
• Lending standards clearly fell
dramatically
– Mortgage underwriting criteria
• LTV ratios, FICO scores, (crazy) Option ARMs, “No Doc” loans
– Pro-cyclical forces
• Bubble-driven valuations
• Herding behavior
• Institutional memory problem
– Securitization laced with agency problems
– Risk management AWOL
• Banks aggressively shifted towards
real estate
– Including commercial real estate loans
Large Bank Loans
(2000)
Construction
4%
Commercial RE
10%
Multifamily Res
2%
1-4 Family
23%
Non-Real Estate
61%
Farmland
0%
Large Bank Loans
(2007)
Construction
7%
Commercial RE
11%
Multifamily Res
2%
Non-Real Estate
49%
Farmland
0%
1-4 Family
31%
Small Bank Loans
(2000)
Non-Real Estate
36%
Construction
7%
Commercial RE
22%
Multifamily Res
2%
Farmland
4%
1-4 Family
29%
Small Bank Loans
(2007)
Non-Real Estate
27%
Farmland
4%
1-4 Family
23%
Construction
16%
Commercial RE
28%
Multifamily Res
2%
FAILURE OF THE GATEKEEPERS:
SHOULD WE BE SURPRISED?
•
•
•
•
•
Mortgage bankers (conflict of interest)
Appraisers (conflict of interest)
Rating agencies (conflict of interest)
Underwriters (conflict of interest)
Accounting and accounting firms (conflict of interest,
and backward looking)
• SEC (not charged w. financial stability, no resources)
• Basle II – quant risk management (controversial)
• Bank regulators
 Federal Reserve -- WE SHOULD BE SURPRISED!

 Substantial resources (20,000 employees vs 3,400 at SEC
 Mission includes prudential supervision, consumer
protection, financial stability & monetary policy
THE FEDERAL RESERVE
• Why did the Fed fail?
– Ideological?
– See beginning Greenspan quote
– Greenspan blocked fellow governor’s (Edward
Gramlich) proposal to crack down on predatory
lending in 2000
– “triumphal narrative of American exceptionalism”
(S. O’Bryan)
– A “one in a hundred year event” (?)
– Excess confidence in Basle II math
THE FEDERAL RESERVE (cont.)
• Why did the Fed fail? (cont.)
– Bank examination process flawed
– Item examination to process examination
(1980s)
– Focus on individual bank solvency
– No aggregation (e.g., CDS concentration at AIG)
– Pressure to not take away the “punchbowl”
just when the party’s roaring
– Ignoring the warning signs
– See bank loan pie charts
– Looking inside innovations (just like REITs in 1970s)
THE FEDERAL RESERVE (cont.)
• Why did the Fed fail? (cont.)
– Financial stability mission not imbedded
organizationally
• No dedicated stability division or section
• Stability analysis fragmented in other
divisions/sections (e.g., monetary policy, financial
markets, banking research, and supervision and
regulation)
• No periodic financial stability report
• Unlike ECB
• Unlike many other countries
• The U.S. did not participate in the IMF/World
Bank Financial Sector Surveillance Program
since its inception in 1999.
THE DIRECT EFFECT:
A CREDIT CRUNCH
• What is a credit crunch?
– A significant contraction in the supply of credit
• Mitigating the credit crunch is the primary
economic motivation for TARP, plus …
@#%& …
WHY BANKS CONTRACT
• Banks suffer a shock that affects their ability
and/or incentive to lend
– Many types of potential shocks: historical shocks
include, for example:
•
•
•
•
Capital shock (US 1990-92, Japan 1990-2000)
Regulatory reporting shock (US 1990-92)
Regulatory scrutiny shock (US 1990-92)
Risk-based capital shock (US 1990-92)
• The shock now is a “capital shock” caused
initially by losses in the subprime mortgage
market
• Followed by losses in other markets
BANK LOSSES: Jan 2008 v. Aug 2008
(Loan Loss Prov: $151B in ’08 v. $57B in ’09)
WSJ 1/18/08
Economist (August 9-15, 2008)
MECHANICS OF A CAPITAL SHOCK
• Banks must meet required capital requirements
Banks have target capital requirements driven by
reputation/credibility effects
• Losses deplete capital (i.e., stockholders equity)
• Banks must either
– Raise more equity (e.g., from sovereign wealth
funds), or
– Reduce assets by contracting lending
- i.e., contract the supply of credit
EVIDENCE OF A CRUNCH
• Bank liquidity creation fell dramatically.
• Fed’s Senior Loan Officer Survey began
showing “tightening” loan standards
– Index went “tight” in early 2007 escalating in third
quarter
– In the October 2008 survey, the net percentage of
large banks, and the net percentage of smaller
banks, that reported a tightening of standards to
larger firms was 84.4% and 82.6% respectively,
and to small firms was 71.9% and 78.3%
respectively. None of the surveyed banks
reported any easing of standards. A colossal
level of tightening. (Continued in Jan Survey.)
THE CREDIT CRUNCH: EVIDENCE
Fed Senior Loan Officer Survey
100.0
60.0
40.0
Large and Medium Firms
Small Firms
20.0
Jul-08
Jul-06
Jul-04
Jul-02
Jul-00
Jul-98
Jul-96
-40.0
Jul-94
-20.0
Jul-92
0.0
Jul-90
Percent Tightening
80.0
WHO GETS HURT?
• Large firms
– Most of the current focus in U.S.
– e.g., GM, Ford, Chrysler, Circuit City
• Small firms may get hurt even worse
– Many small firms are dependent on small banks
• Relationship borrowers
• Small banks may be the next shoe to fall
– Small banks loaded up on real estate even
more than large banks (see slides above)
LENDING TECHNOLOGIES
• A lending technology is comprised of a
combination of screening mechanisms,
contract structures, and monitoring
strategies. e.g.,
• Relationship lending
• Financial statement lending
• Factoring
• A lending channel is a two dimensional
concept
• Lending technology offered by a financial
institution
SMALL BUSINESS LENDING:
THE ROLE OF “LENDING TECHNOLOGIES”
(The U.S. Case)
Large
Banks
Relationship Lending
Financial Statement Lending
Asset-Based Lending
Factoring
Equipment Lending
Leasing
Real Estate-Based Lending
Small Bus. Credit Scoring
Trade Credit
o
o
o
o
o
o
o
Small
Banks
o
o
o
o
o
o
o
Large Com.
Finance Cos.
Small Com.
Finance Cos.
o
o
o
o
o
o
o
o
Corporations
o
THE EFFECT OF THE CRUNCH ON
SMALL BUSINESS FINANCE IN THE U.S.
o = open “lending channel”
x = constricted “lending channel”
? = we don’t know yet
LOT’S OF UNKNOWNS
• How bad will bank failures be?
• How will small banks do?
• Which borrowers will get “crunched”?
• Shorter/weaker relationships?
• Will commercial finance companies help fill
in the lending gap?
• Will TARP, PPIP, + … @#%& work?
• Can trade credit help fill in the gap?
• Requires a normal functioning of the commercial
paper market
DEVELOPING ECONOMIES
• Fewer lending technologies
• But, large banks do offer transactions-based
lending (e.g., see de la Torre, Martinez Peria and
Schmukler 2008 in Latin America)
• Can these technologies (e.g., factoring, trade
credit, leasing) offset the crunch?
• Other technologies notwithstanding,
relationship lending may be more important
in developing economies
• Probably not delivered by large banks, stateowned banks or foreign-owned banks
SOME INDIRECT EFFECTS
• Lost relationships
• Fewer small banks
• Could be as many as 1,000 small banks failing in the U.S.
• Less relationship lending overall?
• Loss of relationships
• Permanent change in market structure (?)
• Concentration (see Carbo Valverde, Rodríguez-Fernández and
Udell 2009)
• Bank size structure (see Berger, Rosen and Udell 2007)
• Distance (see Alessandrini, Presbitero and Zazzaro 2009)
• Operational distance
• Functional distance
• Permanent change in governance(?)
• More state-owned banks(?)
• Fewer foreign-owned banks(?)