Business 10th Edition by Ferrell,Geoffrey Hirt,Linda Ferrell

Exercise 4

Controversy over Bank Lending Policies
The last financial crisis affected people and businesses in different ways, including the temporary restriction of credit both for businesses and individuals. As the recent recession worsened, banks turned inward and significantly reduced or stopped lending money, and businesses began having difficulty accessing credit. Bank credit usually falls under a business's notes payable or long-term debt. This increases liabilities on the balance sheet because businesses must pay off this debt over a certain time period. A company that depends too much on credit might incur long-term debt that it will be unable to pay off, resulting in bankruptcy. However, during the recession, the opposite problem occurred: a severe reduction in credit and loans.
While credit does result in debt, it is usually necessary in order for small business owners to have the necessary funds available to start a business. Indeed, small business owners were among those most affected by the loss of credit, which in turn harmed the economy. It is estimated that the United States alone supports 23 million small businesses, making up roughly 54 percent of all U.S. sales. Many small businesses that rely on credit to survive were forced to lay off employees or shut down altogether, resulting in the loss of hundreds of thousands of jobs.
The main roadblock that faced people seeking these types of loans was their credit score. Banks hesitated to lend to anyone with a credit score of less than 700 out of 850, while the average credit score hovers around 680. Financial experts advise individuals to focus on improving their credit scores as a critical component of financial security. Additionally, a healthy amount of current assets that are liquid-easily converted to cash-is advisable for businesses, which can then use this cash to pay for inventory, equipment, or debt in case credit becomes unavailable.
Now that the United States appears to be in a recovery, one would think that bank lending would increase. However, this is not necessarily the case. Bank loans and leases are lower than they were in 2008. This decrease in lending is occurring for several reasons. At the four largest banks-Wells Fargo, Bank of America, JPMorgan Chase, and Citigroup-lending has fallen significantly. Interestingly, regulation might be one of the reasons for the decrease. Due to increased regulation, large banks feel pressured to get rid of their risky loans. This bodes ill for large banks but is good for smaller regional banks that are not subject to these regulatory requirements. The extension of credit at smaller banks has gone up. Small banks may be closer to their customers and can better assess risk, especially in areas such as small business loans and real estate. Many large banks have to manage risks on a global basis.
Another potential theory for why banks are not lending is that they are provided with an incentive not to lend. Some economists believe that because the Fed is paying banks interest on their reserves, these interest payments are convincing banks to hold more money in reserve. Every bank is required to hold a certain amount of money in reserve as a form of protection. Traditionally, banks want to hold as little in reserve as necessary because money that is in reserve cannot earn income. However, in 2008 the Fed began to pay interest on reserves. Could this be one reason why banks are not extending as much credit?
Banks themselves claim otherwise. They state that the reason that they are not extending as much credit is due to lack of demand. Nonbanking financial institutions such as insurance companies, finance companies, and venture capital firms are extending loans to businesses globally. These financial institutions are called shadow banks and now represent an estimated 25 percent of all business loans. Therefore, perhaps banks should share some of the blame for not being more aggressive in making loans to businesses that have had to go to other financial institutions to acquire the credit they need to operate. Of course, as recovery gains strength, it is possible that by the time you read this, banks may be lending more but facing increasing competition from shadow banks 17.
How do you think people can improve their credit scores in order to look more attractive for loans?