Why Aren't Banks Lending to Small Business?

This question is in the news often and held up often as a potential obstacle to an economic recovery. I would suggest that a primary reason is due to Fed policy and 0% interest rates. If you are a bank and have had a bad year and have a lot of commercial real estate loans outstanding that may yet go bad in 2010, you would be smart to use Fed policy to your advantage. This means that you would take a 0% loan from the Fed discount window and invest much of it in 3% or 4% treasury bonds.

This bank money would have went to borrowers who aren't necessarily bad borrowers but may not be the absolute best credit risks. A portion of bank lending that would have went to marginally ok borrowers to start a business is not going to them because banks have probably decided it is obviously less risky to pocket a net gain of 3% to 4% rather than lend it and incur a risk that your borrower may not pay it back, especially because this is a bad economy. Even if a business idea is good it could still tank in this environment. So banks end up lending to only very good credit risks. Which makes sense. But those who have sterling credit are often not the high-end entrepreneur risk takers that make fortunes and spur economic recoveries. People with no debt whatsoever tend to be pretty practical people. Not all debt is bad provided that it is incurred to provide an investment with a solid stream of future income.

Unless banks stop acting in their self interest and pocket the spread they can get between T-Bills and Fed 0% rates, lending will probably stay poor. And an economic recovery will not be gangbusters. This is an example of the unintended consequences of government intervention.