Resilient small businesses bolster community banks' credit quality

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Recession worries fester. Elevated costs brought on by a generational surge in inflation remain a burden. High interest rates add another layer of concern.

But small businesses continue to navigate the choppy economic environment and make loan payments on time. It is a welcome resiliency for community banks whose bread-and-butter clientele largely consists of Main Street business owners and other small commercial borrowers.

Bankers this year feared cracks in credit quality might form first among small businesses, given they often work on narrower margins than their larger brethren. This makes them more vulnerable to the one-two punch of soaring inflation and rapidly rising interest rates. Inflation hit a 40-year high in 2022 and remains elevated this year. To curb cost pressures, the Federal Reserve has hiked interest rates multiple times. But this has increased borrowing costs and heightened risk for defaults among clients with adjustable-rate loans.

Yet most banks have reported low losses, including among small-business credits, while continuing to underwrite new loans through the third quarter. In fact, on the whole, community banks are reporting either flattish or modestly increasing levels of new loans to small businesses, according to Rohit Arora, CEO of Biz2Credit, an online financing platform for small businesses. 

Approval rates for small-business loans at small banks rose from 19.1% in August to 19.5% in October, according to the latest Biz2Credit Small Business Lending Index. Approval rates had dipped below 14% earlier this year.

Lending by small and midsize banks "has slowly but surely been increasing," reflecting confidence in borrowers, Arora said.

One big reason: the vulnerable but buoyant U.S. economy. Bolstered by a strong job market and robust consumer spending, U.S. gross domestic product expanded at a 4.9% seasonally adjusted annual rate in the third quarter, according to the Commerce Department. That was more than double the 2.1% rate of the prior quarter and strong enough to tamp down recession expectations.

"The strength in consumer demand has been one of the defining characteristics of a very resilient U.S. economy," said Eugenio Alemán, chief economist at Raymond James.

All of that is not to say small businesses are immune to increasing expenses. Many are absorbing rising costs by passing them along to customers. Should those customers pull back on spending late this year or next, it could make it harder for businesses to repay existing loans and banks still might face higher levels of loan losses.

The Fed's latest Senior Loan Officer Opinion Survey, released in early November, found that bankers are cautious. They tightened commercial lending standards across the board in recent months, the survey showed, indicating that credit for business owners is not only more expensive but harder to secure.

James Knightley, ING's chief international economist, noted the Fed survey also found businesses are growing "wary of taking on additional borrowing," and this means waning demand could make it more difficult for banks to grow loan portfolios. It also keeps the specter of a slowing economy looming large, he said.

Scott Siefers, an analyst at Piper Sandler, agreed. "Every major loan category suggested weaker demand" and "standards continue to tighten," he said. "The silver lining is that the degree of degradation may not be as bad as in the last couple surveys. But still, sobering results overall."

During third-quarter earnings calls, several bankers said they expected loan growth to slow in the current quarter, reflecting a combination of lighter demand and their own decisions to turn away some loan applicants they might approve in more certain economic circumstances.

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The $6.5 billion-asset MidWestOne Financial Group in Iowa City is one example. CEO Charles Reeves said he is building the bank for strong growth in the coming years. But loan growth slowed in the third quarter and likely will remain relatively light this quarter, "given the general economic outlook and our own selectivity."

The bank had reported double-digit percentage growth earlier this year but said that eased into the single digits in the third quarter.

The $7.6 billion-asset Central Pacific Financial in Honolulu sounded a similar tune. The bank, which also operates on the U.S. mainland, reported flat lending levels for the third quarter and expects that to continue in the near term.

"As part of our strong risk management focus, we continue to moderate loan growth," said Central Pacific President and CEO Arnold Martines. "We're being very selective."

One big reason for the caution: A rash of vacant office space in the wake of the pandemic and enduring remote work trends threaten to not only hurt landlords' ability to repay loans but potentially owners of nearby small-business properties. When high-rise office buildings lose tenants, fewer people are flowing in and out of workplaces and neighboring businesses that cater to that office traffic also are prone to setbacks, according to the National Federation of Independent Business, an advocacy group for small-business owners.

This helps to explain why the NFIB Small Business Optimism Index decreased half of a point in September to 90.8. September's reading marked the 21st consecutive month below the 49-year average of 98.  

"Owners remain pessimistic about future business conditions," said Bill Dunkelberg, NFIB chief economist.