Rising interest rates are leading to a credit crunch for small businesses

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The big question at this week’s Federal Open Market Committee (FOMC) meeting was whether Fed Chairman Jerome Powell would announce a continuation of rate hikes. As we saw, the answer was yes.

In announcing a 0.25% interest rate hike on Wednesday, Powell pointed to spending and output growth, job growth, continued low unemployment and elevated inflation as factors in the decision.

The Fed chairman said recent developments, such as the collapse of the SVB, are likely to lead to tighter credit conditions for both households and businesses. Nevertheless, the Committee remains very attentive to inflation and continues to aim for an inflation rate of 2% in the long term. In support of these goals, the FOMC has decided to raise the target range for the federal funds rate to 4-3/4 to 5%.

Powell said isolated incidents, if left unaddressed, could undermine confidence in healthy banks and threaten the wealth of the banking system as a whole. The Fed, the Treasury Department and the FDIC have taken steps to bolster public confidence in the banking system and have Bank term financing program to support U.S. businesses and households by making additional funding available to eligible depositories to ensure banks are able to meet the needs of all their depositors.

According to Powell, this program effectively addresses the unusual funding needs that some banks have faced and demonstrates that there is sufficient liquidity available in the system.

The Fed chairman said higher interest rates and slower growth appear to be weighing on corporate investment and that the FOMC expects subdued growth to continue. Meanwhile, the unemployment rate remained low in February at 3.6 percent. Labor participation has increased slightly in recent months and wage growth shows some signs of easing.

Small businesses are struggling right now. High material costs, fluctuations in gas prices and a tight labor market (leading to higher wages) all lead to higher cost structures that hurt cash flow. Meanwhile, since many small business loans are adjustable-rate loans, businesses find that the cost of existing debt increases.

Some good news for corporate borrowers is that the Fed has not argued that more interest rates are on the horizon to quell inflation. This most recent rate hike may have been debated a few days before the announcement, but the Fed probably didn’t want people to see a halt in planned hikes as a sign of panic after SVB and Signature Bank collapses.

Undoubtedly, the turmoil in the banking sector and the broken trust in medium-sized and community banks will hamper small businesses’ access to capital, as the smaller banks are responsible for a large percentage of small business financing. In particular, they have been a reliable source of credit for women-owned and minority-owned businesses.

According to the latter Biz2Credit Small Business Loan Index (February 2023 figures) small business loan application approval rates at major banks have declined for nine consecutive months with only 14.2% of applications being approved. In February 2022, the eve of the pandemic, they approved almost double that percentage (28.3%).

Meanwhile, regional and community banks approved 21.3% of funding applications. While that number is greater than the figure from major banks, it pales in comparison to February 2020, when they approved more than half (50.3%) of applications.

The recent events are likely to lead to increased caution among banks. Those who have experienced significant deposit withdrawals may be even more reluctant to lend to small businesses. Right now we are in a small business credit crunch, and we can expect that soon when the March credit numbers are released.

While raising interest rates has been a historically successful tactic to combat high inflation, the rising cost of capital is putting pressure on small business owners. Often, small business loans its variable rate loans, and continuously rising interest rates increase the portion of their income that goes to debt service. Many small businesses are already struggling with cash flow problems.

If we combine the rising cost of capital with banks’ reluctance to lend in recent weeks, the result is a credit crunch for small businesses. Companies are now looking to nonbank alternative sources of credit for working capital and money for growth. Unfortunately, those institutions charge higher interest rates than banks.

Due to the speed of the transaction and the greater likelihood of securing capital from alternative lenders, using these lenders is often an attractive option for companies that need working capital and financing for growth. But those already worried about the rising costs of existing debt and cash flow problems may indeed put off borrowing plans for the foreseeable future until interest rates stabilize.