How the banking crisis could hammer small businesses

The fallout from a spate of bank failures is rippling throughout the economy, threatening to ignite a credit crunch that could hit small business the hardest.

The Federal Reserve and Wall Street economists are warning that lending standards may become drastically more restrictive in coming months amid ongoing turmoil within the financial system sparked by the stunning implosion of Silicon Valley Bank and Signature Bank.

During a credit crunch, banks significantly raise their lending standards, making it difficult for businesses or households to get loans. Borrowers may have to agree to more stringent terms like high interest rates as banks try to reduce the financial risk on their end. 

"Tighter conditions can happen and occur outside the official tightening of the Fed funds rate. There are so many other variables," Jeffrey Roach, chief economist at LPL Financial, told FOX Business. "A banking crisis, in essence, can tighten conditions. … I think it’s fair to say that the current banking crisis could also be an equivalent to say, a 50 basis point rate hike."

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Small businesses are particularly vulnerable to tighter credit conditions, particularly with regional banks at the epicenter of the crisis. Businesses with fewer than 99 employees tend to make up the bulk of business customers at regional banks, community banks and credit unions. 

"Banks are tightening lending conditions, so, yes, availability of credit is shrinking. And that’s clearly going to impact small businesses," Roach said. "Regional banks do provide a large chunk of small business loans. When there’s a challenge there, small businesses are going to feel it right away."

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Banks were already tightening lending standards before the crisis within the industry began. A quarterly survey of loan officers published by the Fed showed that a growing number of banks tightened lending standards and saw reduced demand in the final three months of 2022.

That's because Fed officials are in the midst of the most aggressive tightening campaign since the 1980s as they try to crush inflation still running about three times higher than the pre-pandemic average. 

But fears over a broader financial crisis complicated the Fed's efforts because the rapid rise in interest rates played a direct role in the failure of Silicon Valley Bank. Increasing interest rates threaten to exacerbate instability within the financial system. 

Chairman Jerome Powell acknowledged during the Fed's two-day meeting last week that upheaval within the financial sector could tighten credit for American households. He suggested that stricter lending standards could have a similar effect on inflation that a rate increase can.

"Such a tightening in financial conditions would work in the same direction as rate tightening," Powell said. "You can think of it as being the equivalent of a rate hike or perhaps more than that."

His comments came shortly after policymakers delivered another quarter-percentage point rate hike, lifting the benchmark funds rate to a range of 4.75% to 5%, the highest since 2007. It marked the ninth consecutive rate increase aimed at combating high inflation.

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"Financial conditions seem to have tightened and probably by more than the traditional indexes say," he said. "The question for us, though, is how significant will that be — what will be the extent of it and what will be the duration of it?

 "We’ll be looking to see how serious is this and does it look like it’s going to be sustained. And, if it is, it could easily have a significant macroeconomic effect, and we would factor that into our policy decisions."

SVB largely catered to tech companies, venture capital firms and high net worth individuals who were pulling cash at a rapid pace as the once red-hot tech sector cooled. When the bank announced it was trying to raise capital from investors and that it would take a $1.3 billion loss on long-term securities that had tumbled in value amid higher interest rates, depositors panicked and a bank run ensued.

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Within days, U.S. regulators took extraordinary steps to contain the fallout from the bank's collapse and shore up wavering confidence in the financial system, including protecting all deposits at the two institutions — even those holding funds that exceeded the FDIC's $250,000 insurance limit. 

The Fed also launched a new emergency backstop for lenders to help them meet deposit withdrawals under favorable terms.