To say we live in a time of mixed messages would be an understatement. On the one hand, you have bankers saying their institutions are ready to lend. On the other, detractors claim the opposite is true. We caught up with William Phelan, president of PayNet, Inc. to help us understand why small businesses and their bankers can’t quite seem to connect these days. One thing seems certain – things are uncertain.
Pick Your Poison
When it comes to understanding what keeps small businesses constrained from investing these days, Phelan notes it’s a matter of “picking your poison.” Be it healthcare reform, the Eurozone crisis or the impending presidential elections, he contends, “There are so many uncertain issues out there, it’s not too hard to find one that presents increasing degrees of uncertainty. But I think the big one is the deficit spending and the national debt rapidly rising. When you stack all of those issues together, it’s got to be tough for a business owner to make decisions these days.”
With that in mind, Phelan notes that much of the data these days points in the same direction … namely that small businesses are holding back from making investments geared toward expansion. “We don’t see these small companies having an appetite for property, plant and equipment investment. I wouldn’t say it has fallen off the table but we do know the Thomson Reuters/PayNet Small Business Lending Index (SBLI) has stalled out at 103.8, and I think that feeds into this theme of uncertainty that everybody is talking about.”
For example, the SBLI rose slightly from 100.5 in June to 103.8 in July which is very little growth for the year. At the same time, the Small Business Outlook indicates the conditions are right for small businesses to acquire capital. So, if interest rates are favorable and credit is in healthy supply, what’s the holdback?
Phelan explains, “The challenge with small businesses is you can’t get good information about them. Financial statements and tax returns aren’t available and you can’t get inside of their heads. But what we can ascertain is when these business owners are voting with their pocketbooks. That’s a really good indicator of where their heads are. If you look at the data here, one thing that jumps out is there’s a lot of capital out there. Deposits are flowing into the banks, but you’ve got loan to deposit ratios at very low levels. When I talk to the bankers, they tell me that they lend to 30% of their commercial depositors and that there’s this great reservoir of capital ready to be deployed. What does all this tell us? When we see the Small Business Lending Index at 103.8 and we see interest rates at all-time lows with a very low loan to deposit ratio, you can pretty much bet it all points to a lack of demand on the part of borrowers.”
More ‘Cold Turkey’ on the Horizon?
We can’t help but wonder: are small business owners still licking their wounds from their bankers’ abruptly pulling credit lines in the darkest days of 2009?
Phelan admits this might be in the mix. He notes, “Perhaps those lines should have been tightened in late 2007 or early 2008 rather than cut off in 2009. Gradual transitions are much easier than going ‘cold turkey.’ So, the question might be: are we setting ourselves up for more? It could happen because there’s a big disconnect today between bankers’ perception of the economy as opposed to that of the small business owners’.”
While Phelan acknowledges that bankers are skilled at understanding credit risk on a historical basis, their industry lacks the systems to grasp those risks on a current and future basis. He explains, “What happened in 2009 was bankers got neck deep in the swamp before they really knew it and reacted by turning the spigot off completely. As a result, you get these accentuated boom and bust cycles and that stems from the banks’ inability to assess their risks both today and tomorrow. What’s so striking about today, is when you utilize these backward-looking systems on a slowing economy with small business owners who are becoming increasingly more cautious, you could have the makings for another shut down in the credit markets.”
Can a second serving of cold turkey be prevented? Phelan thinks so and says the answer lies in technology. “These tools exist and they’ve been around for quite some time. For example, pension fund managers have tools to assess how their investments are going to perform. And generally, they are very good at projecting that future performance. Banks, and by banks I mean all commercial finance companies, need to start thinking in terms of forward-looking tools and focus on putting economic factors into the mix. Credit scores are very good for the rank order of risk, but they are not a good measure for understanding the absolute measure of risk. And that’s where the banks miss it … they use a rank ordering based on a historical system that was built five years ago, but they don’t understand what risk is going to be over the next two years.”
If the technology exists, why hasn’t it been embraced? Phelan notes, “It really does boil down to a fear of change. But in the end, these technologies win out because they make life better. They give us the ability to see around the corners, and that’s a big driver of future enhancements for banks’ rating systems.”
And of course, a little push doesn’t hurt either. He explains, “All of these pieces are coming together right now with some of the new stress testing rules coming into effect. The biggest regulatory challenge right now for those institutions $10 billion and above, is compliance with the new Federal Reserve Board Stress Test requirements scheduled for this November. The scenarios are being developed with 14 different economic variables, and these backward-looking systems just won’t yield a quality stress test program.
“We actually ran the stress test scenario on the so-called fiscal cliff, and we see that business defaults would actually triple from roughly 2% up to about 6% through the next cycle. In 2009, they peaked at 6.2% so the fiscal cliff could be almost as bad as the last go-round.”
And while no one wants to be a bearer of bad news, Phelan stresses the power of such knowledge arms bankers with the ability to prepare for a worst case scenario. He stresses, “We’re not making a recessionary projection here because that’s not what we do. But we do see a slowdown occurring here. But the bigger point is the power of these tools. Businesses like to adjust, they like certainty and they like knowledge … it gives them time to make rational decisions. In the end, that’s better for the economy.”
Small Business Owners: The Alpha Dogs of Risk Taking
At a time where virtually everyone is asking the same question, I took the opportunity to ask Phelan what it will take to break the current economic cycle and push business investment beyond pre-recessionary measures and into expansion mode, particularly for small businesses.
He says, “Policy makers have their hands full, and there are a lot of changes occurring and that complicates things. We’re not policy makers so I can’t tell you which lever to push or which one to throttle back on, but we can see how these small businesses are reacting, and they are 50% of GDP. If they were a standalone economy, these small businesses would be number two or three in the world, and nobody knows anything about them.”
And, Phelan notes, they have done an admirable job in getting their shops in order. “You can really see it in the data … they have gotten loan payment delinquencies down to pre-recessionary levels and even lower than they were in 2005. 30-day loan delinquencies rose for the first time in 30 months to 1.20%. Severe loan delinquencies fell further to 0.26% on the 90-days, indicating overall very good financial condition. They are making sure their balance sheets are strong; they are paying their bills on time and depositing a lot of cash in the bank. But they aren’t investing in property, plant and equipment.”
All this indicates that many small companies are erring toward caution and Phelan is confident that as today’s uncertainties resolve themselves one way or the other, these entrepreneurs will be back in the game. “These small business owners are not afraid. They are the ‘alpha dogs’ of risk taking, and when the uncertainties get better they’ll start investing again,” Phelan explains. “They are unusual people in their ability to understand business and take the appropriate risks. As for today, they aren’t saying ‘never,’ they’re saying ‘not now.’”
Yet, these entrepreneurs aren’t without their vulnerabilities. The PayNet Small Business Outlook forecasts small business failures to increase by 16% from 2012 to 2013 – the first reversal since the default peak in 2009. Phelan comments: “What we’re doing here is factoring in the macro-economic environment such as the GDP and interest rates. With the slowing GDP, we see risks rising in the small business economy. These small businesses are captive to their local markets and not all have deep enough pockets to hoard cash indefinitely like large corporations do. They can get tossed around by the rough seas of the economy and some of them have a tougher time making it.”
Some Final Thoughts
What more can be drawn from the data? Phelan says, “What strikes me most is how varied the risk is for the different geographic regions within the U.S. You’ve got vastly different regions reflecting different local economies. And that’s the message here … there’s growth to be had in certain industries that still want to expand and make investments in property, plant and equipment. High tech comes to mind. Why? Because machines make businesses more productive.”
He concludes, “And finally, I think the big issue these days is again this disconnect between the banker and the borrower. The banker is piling on right now trying to put earning assets on the books. He’s doing that by easing terms to make borrowing more favorable. At the same time you have the business owner who is hunkering down and trying to be cautious. We see these trends in the data and we have to be careful that we don’t wind up with another credit bubble.”