Small firms vulnerable as credit squeeze seeps into real economy
Small businesses and farmers are vulnerable in this turbulent period
Small businesses are especially vulnerable, because they rely so heavily on banks for credit to pay wages
Interbank lending markets have been in crisis since the bankruptcy of US investment bank Lehman Brothers in mid-September, though barometers of financial stress have moved off their peak levels over the past week.
While much of the attention has focused on the lack of lending among banks, it is the credit freeze being felt by businesses where the rubber hits the road for economic activity.
What makes the current crisis in credit markets different from previous shocks to the global financial system is that the multiple sources of funding normally available for businesses have all essentially dried up at the same time.
Companies are finding it difficult to get credit from banks. In addition, capital markets have shut down, so businesses are not able to raise funds by issuing bonds and commercial paper.
This seizing up in both banks and capital markets is highly unusual -- and potentially catastrophic for the real economy. Unlike previous episodes of financial stress, economies this time are not benefiting from having diversified sources of credit. It is like getting a flat tyre, only to discover that the spare tyre is also flat.
Consider what happened a decade ago during the global financial crisis that began in Asia and spread to the rest of the world.
Default
After the Russian government defaulted on its foreign debt in August 1998, capital markets in many advanced economies seized up. Fortunately, as the issuance of corporate bonds ground to a halt, banks stepped up to the plate and increased their lending.
The acceleration in bank lending filled the gap in funding for businesses and averted a credit crunch. As a result, the turmoil in financial markets during that period had only a muted effect on economic activity in advanced economies.
What happened in 1998 was that banks replaced capital markets. The opposite occurred in America in 1990, after the property bubble burst. Bank lending seized up as property prices tanked and banks' balance sheets deteriorated, but large companies were able to turn to largely unaffected capital markets for funds.
In addition, mortgage lenders were able to continue to sell mortgage-backed securities to investors during the downturn, which prevented a sharp contraction in mortgage credit.
No such luck this time.
Banks are in crisis and capital markets are not functioning, a combination that suggests that we are in for a protracted credit crunch.
Of course, the authorities have responded aggressively. Governments have made public money available to guarantee banks' debts and recapitalise banks. Along with other initiatives to provide liquidity to credit markets, the US Federal Reserve -- America's central bank -- recently began to provide direct funding to businesses by buying three-month commercial paper, a form of short-term financing that many businesses rely on to finance day-to-day activities.
The Fed's actions have boosted the commercial paper market, with companies such as American Express and General Electric among those that have sold commercial paper to the Fed.
While measures to backstop the commercial paper market will provide some relief to large corporations, they will do little to help small businesses that are also feeling the effects of the credit crunch.
Small businesses are especially vulnerable, because they rely so heavily on banks for credit to pay wages, buy supplies and to meet their day-to-day obligations.
Moreover, even if a small business does have access to sufficient credit, it faces growing risks that some of its customers may fold because of the credit squeeze.
No wonder then that small business group Irish Small and Medium Enterprise (ISME) and the Irish Farmers Association (IFA) are up in arms about difficulties their members are having in securing credit from banks. ISME rightly points out that the Government's guarantee scheme for banks' borrowings was supposed to provide a backstop for banks' lending to the wider economy.
Banks have access to cash thanks to the guarantee, but there are questions as to whether the funds will ultimately trickle down to small businesses and farmers that need them to keep going.
ISME favours special credit facilities for small businesses. Government-backed credit guarantee schemes, as in other countries, might be worth considering, though the jury is still out on whether such programmes are effective.
The real problem is that the Government's guarantee scheme did nothing to rebuild the banks' capital positions. The simple fact is that the quantity of loans that a bank can make is proportional to the amount of capital it holds. Bad property loans are forcing Irish banks to deleverage; that is, to curtail lending to bring it in line with diminished levels of capital. The solution is more capital. As Davy Stockbrokers pointed out yesterday following the release of AIB's trading statement, the bank's target of 7pc for core capital is low compared with banks in other countries.
This is not to say that banks would not pull back somewhat from lending in the current economic environment even if they had ample capital. Banks can reasonably be expected to tighten lending criteria during recessions as customers' financial prospects dim and risks increase.
But the worry is that genuinely profitable businesses will not be able to get credit to sustain operations. This could lead to bankruptcies and losses among banks' borrowers and therefore further erosion in the banks' loan books.
ISME and the IFA are not the only lobby groups complaining about the credit squeeze. The Construction Industry Federation (CIF) is unhappy that banks are attempting to increase margins on existing loans.
There is a certain irony in the CIF's complaints, since the squeeze in credit facing small businesses and farmers is in no small part a result of the excess lending that currently is directed towards the construction sector.
There is only so much credit to go around, so continued financial support from banks to de facto bankrupt property companies is happening at the expense of small businesses and farmers.
This would suggest that the authorities should persuade the banks to redirect credit from zombie property companies to more deserving customers. Scarce resources continue to be misallocated. Is it not time to put an end to the crowding out by property of other sectors in our economy?
- Alan Ahearne
