Will Small Businesses Squelch the Recovery?

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Forget gold futures. For many economists, small business lending is the safest gauge of the economic recovery’s strength. Too bad it’s headed in the wrong direction.

Loans to small businesses dropped 8.6% at the end of March from one year ago, according to the most recent data from the Federal Deposit Insurance Corporation, which tracks loans of less than $1 million. Another analysis by the Federal Reserve Bank of Kansas City found big banks’ loans to small businesses dropped 14% over roughly the same period, according to the Wall Street Journal. That’s not just bad news for the mom and pop shops down the street. It’s a big hitch in the recovery that could drag down the economy for years to come.”Small businesses are the drivers of innovation and job creation in our economy, and they’re being suffocated by banks and institutional investors that aren’t willing to lend,” says John Paglia, a finance professor at Pepperdine University and author of a recent study on small business lending.

The Pepperdine study, which polled more than 1,200 entrepreneurs, showed a vast spread between big and small businesses’ abilities to access bank capital. Only 17% of businesses with less than $5 million in annual revenue said they secured bank lending over the past six months, whereas 37% of larger private companies — with revenues of at least $25 million — said the same.

So what gives? Bigger businesses, especially publicly traded firms, are having an easier time, partly because small and medium-sized businesses have to go to banks for access to credit, whereas the country’s biggest firms often turn to the equity markets to raise capital. Indeed, big U.S. firms generated $1.68 trillion in profit in the last quarter of 2010 alone, and now they’re flush with cash. And yet, smaller businesses account for a greater share — roughly 60 to 80% — of U.S. jobs growth. “There will be no robust recovery until small businesses are both willing and able to expand hiring,” says Benn Steil, an economist at the Council on Foreign Relations.  Given the clamp down on lending, 70% of small businesses say they have no plans to expand their staffs over the next 12 months, according to a recent U.S. Bancorp survey.

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Bigger companies are also able to secure loans based on their cash flow only, whereas most smaller businesses have to put up collateral (business assets like equipment and office space) or personal savings to qualify for a loan. That explains why the Federal Reserve’s attempts to jolt the economy with quantitative easing and rock bottom interest rates haven’t bumped small business loans. With the housing market still in the dumps and many households wallowing in debt, the old methods of self-funding a business — maxing out credit cards or taking a home-equity loan — are no longer as viable. Less than half the private businesses in the Pepperdine study managed to raise capital over the past six months, and of those that did, only 20% secured financing from friends and family.

Smaller businesses also tend to rely on smaller banks for loans. And unlike the country’s biggest banks, which received bailout help through the Troubled Asset Relief Program and lend to larger companies, many of those smaller banks are still saddled with toxic mortgage-related debt. As a result, those banks are “either unable or unwilling to dispose of bad assets, and until they do so they will be very reluctant to increase their lending significantly,” says Steil.

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Stodgy private equity markets haven’t helped either. A lot of private equity funding is being used to prop up weak existing investments, which leaves little excess capital for investing in new businesses. Only 13% of privately-held businesses in the Pepperdine survey reported getting funding from angel investors, venture capitalists or private equity. And the idle funding institutional investors do have on offer is going into ventures that are in a later, less risky stage of development, says Paglia.

So what’s the solution to reviving small businesses? The fact is, there aren’t many options. A few years ago, the best route would have been to follow the original TARP plan, argues Steil, which focused on buying the toxic mortgage-related assets from banks to free up their balance sheets. Instead, the government opted to inject only the country’s biggest banks with equity as a way to calm markets. With their reputations at risk, those big banks scrambled to pay back the injections as quickly as possible, rather than using the funds to increase lending. At this stage, another round of TARP is politically out of bounds, given the heated debate in Washington over how to pay down government debt. That leaves small banks destined to sit idle on bad loans until they either go under or their bad assets are revived by a rebound in housing.

For very small businesses there are small signs of hope. More of those firms are turning to “peer-to-peer” lending, the eBay-esque Internet sites that pair pre-qualified borrowers with big pools of lenders. Sites like Prosper Marketplace Inc. and Lending Club Corp., the country’s biggest peer-to-peer lending sites, have seen a sharp uptick in loans to small businesses recently. But lending on those sites can also be very risky, since default rates are high and pursuing borrowers who default can be difficult.

The market is creating ways to get around the crunch, says Paglia, “but the process will take a very long time.” In the meantime, expect the economic recovery to look much like the market for small business loans: slow and weak.

Roya Wolverson is a writer at TIME. Find her on Twitter at @royaclare. You can also continue the discussion on TIME’s Facebook page and on Twitter at @TIME.