Consolidation - ignited by interstate banking - will continue to shrink the number of banks and squeeze small-business credit even further, Federal Reserve Board economists predicted Wednesday.

The Fed paper, presented Wednesday to the Society of Government Economists, predicts a 32% drop in small-business lending in the next five years. This follows a 34% drop between 1989 and 1994.

The falloff in small-business lending is the result of thousands of bank mergers that have taken place since states began opening their borders in 1979, Fed economist Allen N. Berger said.

Interstate banking, Mr. Berger said, will reduce the size of the banking industry to 2,000 holding companies by the year 2016, from more than 8,000 today. The industry already has lost more than 4,000 banking organizations since 1979, he said.

The bank-industry consolidation will further depress small-business lending, Mr. Berger declared. Large banks historically commit less of their assets to small business loans than do small banks, he said. This held true in 1994 when the big banks devoted just 2.5% of their loan volume to small business lending, while 82% of small-bank loan volume went to small businesses.

The Fed economist based his predictions on data collected from call reports banks filed between 1979 and 1994. Mr. Berger, and his co-authors, University of Chicago economist Anil K. Kashyap and Fed economist Joseph M. Scalise, found a clear relationship between creation of the first interstate banking companies in 1979 and the drop in small-business lending.

The consolidations also have significantly reduced the number of small banks, which held 14% of the banking industry's assets in 1979, but today control less than half that amount.

Banks with more than $1 billion in assets grew substantially during this period, doubling their assets to 18% of the industry's total.

The study also noted that nonbanks and foreign banks are increasingly taking away business from commercial banks. For example, foreign banks make 48% of all large commercial loans today.

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