David R. Evanson
Present Value: Essays on Community Banking, Winter, 2005
In some ways, there is a chicken-or-the-egg aspect to American entrepreneurship and banking. Which came first? Did the rise of small business in America owe its existence to the many banks that were available to distribute debt capital to them? Or was it the banks that profited from the inexorable, expansionary push from the country’s entrepreneurs?
Regardless of what begot what, it’s indisputable that new and emerging businesses have a dramatic impact on the fortunes of commercial banks and, to a lesser degree, savings banks. To see this connection, consider the balance sheets of commercial banks in the United States during the late 1990s, when the Small Business Administration conducted an extensive study of lending to small businesses in the United States.
At the time, commercial banks had total assets of approximately $5.4 trillion, according to the FDIC. Fully $3.2 trillion of the total assets was held as loans and leases, and some $1.3 trillion of the $3.2 trillion was real estate loans. Another $97 billion represented loans made to other depositories, with $46 billion to farms and $571 billion to individuals. After real estate, commercial loans constituted the banks’ largest market, totaling $899 billion.
By comparison, according to a 1998 study by the Small Business Administration entitled “Financing Patterns of Small Firms,” the total debt of small and emerging businesses was approximately $700 billion or almost 80 percent of all commercial debt held by FDIC-insured institutions. Without American entrepreneurship, banks would have a commercial loan franchise that is just one-fifth of its current size. In short, loans to entrepreneurs drive bank profitability.
This holds true around the world: Banks need financial intermediary activity to pursue. Consider the Japanese banking system. When Japan’s economy stagnated through the 1990s, growing just 1 percent annually, the Japanese banking industry fell into malaise.
What’s important to understand about the Small Business Administration’s figures, in terms of their impact on small and regional U.S. banks, is that loan demand from this market is — for cultural and social reasons — a renewable resource. It’s nice to wax poetically about the American free spirit, but this spirit is in fact an engine of economic growth. One of the byproducts of a country that was founded on change is that it readily accepts disruption of the status quo. This state of constant evolution creates opportunities that must be financed.
To understand how deeply entrepreneurship is ingrained in American culture, consider first a 2002 comparison of entrepreneurship levels among various industrialized countries, which were analyzed in the “Global Entrepreneurship Monitor,” a study conducted annually by Babson College and the London School of Economics.
Less Entrepreneurial Activity More Entrepreneurial Activity
Japan New Zealand
Netherlands United States
Countries with more open cultures tend to have more entrepreneurial activity than those countries with more conservative or reserved cultures. This seems to play out with the entries on Chart #XXX. Hungary was the first Soviet bloc country to rattle the cage of communism, while the island nations of New Zealand and Australia have always been proud of their “we’re on our own, can-do attitude.” On the other side of the ledger, nations such as Germany, Japan and the Netherlands actively stamp out nonconformity. As the saying goes in Japan, “The nail that sticks up gets hammered down.”
The study identified key cultural and social norms that are critical determinants of increased entrepreneurial activity. Some of these are pervasive in American society:
• Encouraging women and minorities to become more entrepreneurial
• Improving the risk investment culture in the financial community
• Improving the ability of lending institutions and equity investors to assess opportunities
• Increasing respect for entrepreneurs
It’s worth quantifying entrepreneurship in the United States and comparing it with entrepreneurship in other industrialized countries to understand the impact that it has on banking and the wealth of bank investors. The 29 countries studied in Babson’s “Global Entrepreneurship Monitor” have a total working population of 1.4 billion, and the incidence of entrepreneurship is approximately 10 percent or 140 million people. Although the United States placed fifth in the overall incidence of activity, it placed first in the level of activity, which is opportunity driven. That’s distinct from entrepreneurial and new business activity, which is necessity driven. Specifically, 85 percent of entrepreneurial activity in the United States is linked to opportunity.
This distinction is vital to the interests of bank investors. Necessity-based entrepreneurship satisfies the need of the proprietor to earn a living and, as a result, occurs on a much more modest scale. On the other hand, opportunity-driven entrepreneurship satisfies the perceived or very real need of an entirely new market.
In the United States, home improvement warehouses, fitness centers, retirement housing communities, and wellness spas are some of the opportunity-driven entrepreneurial activity that has had a dramatic impact on wealth creation.
Even the quest for a better hamburger has resulted in a Fortune 500 company and the creation of $5 billion in new wealth. It all started in 1969, when David Thomas reached the conclusion that fast food, particularly hamburgers, simply did not measure up. Thomas staked his reputation on building a better one, naming the idea for his new restaurant concept after his daughter Wendy. Even with the intense competition, Thomas was able to find a niche inside the deep and diverse American market for dining services. Today, there are some 6,400 Wendy’s, and the company has expanded into other markets with an aggregate total of 9,000 restaurants, $2.5 billion in sales, 48,000 employees, and more than 5 million customers each day. The company’s market capitalization is more than $5 billion.
The true effect of Wendy’s success, particularly for banks, goes beyond revenue and earnings. Based on figures in the company’s Securities and Exchange Commission filings, Wendy’s spent approximately $1.1 million per location — before furniture, fixtures and equipment. Applying this figure to the 5,000 franchised Wendy’s restaurants (omitting the more than 2,500 Tim Horton’s restaurants) means that the kind of opportunity-based entrepreneurship that drove Wendy’s created some $4 to $5 billion in loan opportunities to build out franchise territories.
Data From Wendy’s 2003 Securities and Exchange Commission Filings
Total franchised Wendy’s restaurants 5016
Total company-owned Wendy’s restaurants 1312
Total Horton’s Restaurants 2527
Total company-operated Baja Fresh restaurants 132
Total franchised Baja Fresh restaurants 151
Total investment in land $459.0 million
Total investment in buildings $886.0 million
Total investment $1.3 billion
Investment per company-owned building $1.0 million
This provides a graphic illustration of the fact that a significant amount of entrepreneurial activity in the United States has a real estate component. That’s in contrast with entrepreneurship based on the development and deployment of new technology, which in turn is financed — at least initially — with equity. The addition of real estate to the entrepreneurial equation often means that activity occurs on a grander scale, creates more jobs, propagates a larger ripple effect, and tends to have a larger impact on gross domestic product.
Of course, real estate carries with it real risks, as illustrated by Japan’s recent trouble. According to the Asia Times, at the close of 2002 Japanese banks were wallowing in some $272 billion in bad debt. “The growth of the bad loans swamping banks continues unabated, as major sources of collateral backing loans (mainly property) continue to erode in value,” the publication reported in March 2002.
There’s a critical difference between Japan and the United States: Through the 1990s, Japan experienced either flat or declining loan demand, while in the United States a vibrant entrepreneurial and small business sector continued to bolster the balance sheets of American banks. Commercial and industrial loans grew from $536 billion in 1992 to $912 billion in 2002, representing a compound annual growth rate of 5.45 percent.
This seemingly modest figure does in fact represent a rate of growth that exceeds the overall rate of growth of the U.S. economy. Given the overall size of the entrepreneurial economy, this annual increase offers manifold opportunities for bankers, particularly those who specialize in the nonstandardized loans that entrepreneurs typically require.
Concerning the chicken-or-the-egg conundrum, it appears as if a subtle transformation has occurred. Initially, the large base of banks ensured the financing of new business activities. Currently, the entrepreneurial culture that has taken hold is driving — and will continue to drive — bank earnings.