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Small businesses may be losing a lifeline

The Great Recession produced a startling change in the makeup of America's banks. According to a report from the Federal Reserve Bank of Richmond, from 2007 through 2013 the number of new commercial banks fell by 14 percent. Most of the decline came from community banks, the type of institution most of us think of when we hear the term "traditional bank."

And given the how much small businesses rely on community banks for funding, this shrinkage could have an impact on the formation and survival of small business enterprises.

Richmond Fed

What's driving this trend? Surprisingly, the loss of more than 800 independent banks wasn't due to an unusually large number of bank exits during the financial crisis. Instead, it was due to a fall in bank entries, from around 100 new banks per year prior to the Great Recession to just three per year on average since 2010 (only four new banks appeared from 2011 to 2013).

Indeed, this could have important implications for small businesses. Large businesses have many ways of raising funds when needed. They can issue new stocks, sell bonds, sell commercial paper, borrow from megabanks and so on. They're not forced to rely just on loans from a local bank for their survival.

However, small businesses don't usually have such varied options. Community banks become experts at assessing local business conditions, and over time they develop relationships with small businesses in their area as loans are made and repaid. Those relationships allow the businesses assessed as trustworthy access to relatively easy credit when they need it.

When these banks disappear and aren't replaced by new banks, the relationships and local expertise are lost, and so is an important source of funding for small businesses. Or it's at least hampered.

Why have bank entries tumbled? The report cites two possible explanations: the fall in bank profits during the Great Recession, and regulatory changes from the Dodd-Frank legislation. The drop in bank profits appears to be the biggest factor, but earnings also fell to similar levels during previous recessions, yet bank formation didn't turn down as much. So, changing regulations may be at work as well.

Which one of these factors turns out to be the primary cause has implications for the banking system's structure in the future. If falling profits are to blame, then bank entries ought to recover as the economy rebounds. But if regulations are holding back entries, the difficulties that creates for small business could be more permanent.

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