FINANCING RURAL AMERICA IN THE FUTURE

by

Mark Drabenstott

Vice President and Economist Federal Reserve Bank of Kansas City

Testimony before the

Senate Committee on Agriculture, Nutrition, and Forestry

Washington, DC

September 4, 1997

The views expressed are strictly those of the author and do not necessarily represent those of the Federal Reserve Bank of Kansas City or the Federal Reserve System. Capital is key to rural America's future. Notwithstanding a solid turnaround in the rural economy in the 1990s, rural leaders remain concerned about their economic future. In part, this concern stems from the uneven nature of the rural expansion. Our research at the Kansas City Federal Reserve Bank shows that the rural rebound in the 1990s has been heavily concentrated in about a third of the nation's 2,300-odd rural counties, mainly emerging retail and financial centers, counties near metropolitan areas, or those with scenic amenities. Meanwhile, many rural counties have had only anemic growth since 1990. Across the board, however, rural communities recognize that capital is essential to diversifying their economies, adding to their housing stock, and improving their infrastructure.

Given the critical role of capital in the rural economic outlook, it is useful for public and private officials to consider how rural capital markets are working today and where they are headed. Thus, I congratulate this Committee on sponsoring a hearing on an issue so vital to rural America.

At the outset, it is worth noting that rural America's future capital needs are broader than traditionally defined in public policy in at least two important respects. First, the United States has a long history of policy initiatives aimed at improving the availability of credit to U.S. agriculture. After nearly a century of policy steps and market innovations, the agricultural credit market by all accounts works very well. Yet the credit needs in much of rural America now lie beyond agriculture. Indeed, many rural entrepreneurs have far fewer sources of credit than the farmer who lives outside of town. Second, rural America has capital needs that go well beyond credit. In the case of agriculture at least, credit has been the primary target of federal policy initiatives. Yet for many rural businesses, equity capital is an even bigger issue than credit. Thus, a shift in focus from agricultural to rural issues is appropriate, and attention should be given to capital markets generally, and not just to credit.

Two questions loom large as policymakers consider new policy initiatives in rural capital markets. Are there shortcomings in rural capital markets? And if so, what might be done to resolve these shortcomings? My testimony provides some insight on these two questions, drawing on a book recently published by the Federal Reserve Bank of Kansas City entitled, Financing Rural America (Federal Reserve Bank of Kansas City). This book is based on a conference our bank sponsored to provide a better understanding of how rural capital markets work and how they might be improved. The conference drew together 125 of the nation's economic experts, rural business leaders, and public officials.

In brief, my testimony will show that the available evidence from rural financial markets suggests the markets appear to have some shortcomings, although economists do not agree on the precise nature of the market gaps or their extent. My testimony will also suggest that public policy might play some role in improving rural capital markets, especially if attention is given to encouraging market innovations that provide rural businesses with a wider range of financial choices.

HOW WELL DO RURAL CAPITAL MARKETS WORK?

While financial markets are critical to the rural economy, they are not well understood. Throughout this century, researchers have paid far more attention to agricultural capital markets than to broader rural capital issues. Participants at our conference provided many individual assessments of how rural capital markets work. Taken together, the conclusions of the conference remain suggestive. That said, the available evidence on rural capital markets does point to a handful of general conclusions about how well the markets are working.

The first conclusion is that rural businesses have fewer sources of capital than their metropolitan counterparts. Business owners and economists alike underscored this point. One clear indication that rural businesses have fewer sources of capital comes from a national survey of small business finance conducted by the Board of Governors (Cole and Wolken). In 1993, the most recent survey currently available, roughly a third of all metropolitan small businesses used financial services from nondepository financial institutions, such as finance companies and leasing companies. Only a fifth of rural small businesses used these broader sources of capital. Due to a more limited menu of financial service providers, rural businesses often must pay higher transaction costs or may have difficulty finding sources of capital beyond traditional bank financing.

The second conclusion, closely related to the first, is that community banks remain by far the primary source of credit and capital for rural businesses. The dependence of rural business owners on locally owned banks was a frequent refrain at our conference. The Board of Governor's small business finance survey corroborates this view. Small businesses in rural areas were nearly 33 percent more likely to depend on commercial banks for credit than businesses in metropolitan areas. Urban businesses have a much longer menu of financial service providers from which to choose, whereas rural businesses most often go to the local bank.

The third conclusion is that many rural community banks face a limited or declining supply of loanable funds. Bankers and others at our conference repeatedly made the point that banks face much more competition for deposits than in the past, and deposits often leave the local community when heirs, many of whom live in metropolitan areas, settle the estates of rural residents. Moreover, in the 1990s the demand for loans has generally grown faster than the supply of loanable funds, driving up loan-deposit ratios at rural banks and reducing their capacity to make additional loans. Our survey of agricultural banks across the seven states of the Tenth Federal Reserve District shows that the average loan-deposit ratio at rural community banks now stands at 65.0 percent, some 13 percentage points higher than when the current economic expansion began, and the highest ratio since we began our survey in 1976 (Ryckman and Lamb).

The fourth conclusion is that the changing structure of the banking industry is thinning the ranks of community lenders, possibly reducing the availability of credit to some rural borrowers. When large metropolitan or out-of-state banks acquire rural banks, some customers find the acquired bank is no longer interested in serving small rural businesses. Research in our Tenth District, for example, shows that banks owned by metropolitan or out-of-state companies are less likely than similar-sized independent banks to lend to the small businesses that dominate rural areas (Keeton). A number of conference participants suggested that bank consolidation seems more likely to hurt borrowers in rural areas than in metropolitan areas, simply because there is less competition for the rural borrower's business. In short, commercial banks have been the major source of credit and capital for rural borrowers, and continued consolidation is likely to make the community banks that remain even more important sources of credit for rural businesses.

The fifth conclusion is that rural secondary markets are poorly developed and little used. Several conference participants noted how slowly rural secondary markets have developed. Rural homeowners are eligible to participate in mortgage secondary markets, including Fannie Mae and Freddie Mac, but it appears that relatively few do so. No secondary markets for rural business loans are in operation. And Farmer Mac has had difficulty developing a threshold of business since its creation in 1987.

The last conclusion is that access to equity capital is extremely limited in rural America. Conference participants agreed that this is the most overlooked feature of rural capital markets, and might be the most important to the rural economic outlook. The scarcity of equity capital is hard to quantify due to the scarcity of data, yet all the available evidence suggests the supply is meager. A conference participant pointed out, for example, that firms located in rural counties accounted for a mere 10 percent of the nation's initial public offerings over the past decade. The lack of well-developed equity capital markets means that rural entrepreneurs must seek out family or other local investors on their own. Thus, it is not surprising that the national survey of small business finance found that rural business owners in 1993 were more likely than urban businesses to obtain financing from family members. Overall, the market links between rural business owners and equity investors nationwide are poorly developed, and many rural entrepreneurs are unable to tap these markets. As a result, many rural businesses use less equity capital and more debt capital. A higher dependence on debt probably leaves rural businesses more vulnerable to changing business conditions.

Taken together, these general conclusions suggest that rural capital markets do have some shortcomings. But how serious are these gaps? That is a question for which there is no definitive answer today. Conference participants generally agreed that rural capital markets are "reasonably efficient" (Duncan). Yet they also agreed that these markets must provide a wider range of financial services if rural America is to achieve its economic potential. Thus, there appears to be good reason for public policy to examine rural capital markets, especially if it can encourage market-based solutions to any current gaps.

WHAT MIGHT BE DONE TO IMPROVE RURAL CAPITAL MARKETS?

The primary focus of our conference was a discussion of steps that might be used to improve the operation of rural capital markets. Three steps received primary consideration: improving rural secondary markets, expanding community bank access to loanable funds, and developing rural equity capital markets.

Improving rural secondary markets

Secondary markets are an attractive tool for addressing rural capital needs for several reasons. First, they provide a useful market mechanism for rural community banks to alleviate their liquidity problems, since they can originate loans that are not funded by local deposits. Second, secondary markets allow banks to manage their interest rate risk. While most commercial banks want to be portfolio lenders, the term structure of some loans may create an unmatched interest rate risk in their portfolio. By selling the loan to investors, the bank can pass this risk on to investors willing to accept it. Finally, secondary markets put rural business borrowers in touch with investors in broader capital markets, allowing capital to flow to rural deals with returns greater than or equal to market returns. Notwithstanding these benefits, historically there have been almost no secondary markets for rural loans.

Market experts at our conference pointed out a few key challenges that must be overcome before secondary markets can flourish in rural America. Impediments include the small scale of the rural loan market, the general lack of loan poolers, and the lack of complete information on rural business loans and their performance. Economists often point out that securitizing small business loans is hard to do because it is difficult to standardize information about small business owners, who are the linchpin to the success of the business and good performance on their business loans (Beshouri and Nigro).

In general, conference participants agreed that better secondary markets for rural loans would be a welcome addition to rural capital markets. A secondary market for rural business loans would provide the greatest benefits. There is no clear method for creating such a market. Most felt that a government sponsored enterprise (GSE) would likely be necessary for a secondary market for rural business loans to succeed. But there was no agreement on which GSE was best suited to the task. Many participants supported a "specialization" approach in which rural housing loans would be securitized by Fannie Mae and Freddie Mac, farm real estate loans would be securitized by Farmer Mac, and a new GSE would be created to securitize rural business loans (Vandell). Most also agreed, however, that the government's role in any new GSE should be limited, mainly to providing temporary sponsorship during start-up. In other words, GSE status might be required to launch such a market, but in the long run it should stand on its own.

New policy steps that would use GSEs to help meet rural capital needs obviously cannot and should not be undertaken lightly, since they would pose additional contingent liabilities for taxpayers. One of the major obstacles in considering an enlarged public role in rural capital markets is that broad policy goals for federal programs in rural America are not clearly defined. Thus, there is no clear objective to weigh against the added liability posed by any new initiatives with a GSE. In every case where public policy has helped launch a GSE to fill a financial market gap, the new institution has been compatible with other broad public goals. Fannie Mae, for example, helped encourage home ownership. Sallie Mae helped encourage more students to go to college. What is the public goal that any enlarged GSE presence in rural capital markets would serve? There may well be one or more such rural goals, but they have not been articulated in public policy.

In sum, secondary markets remain limited in rural America, and adding such markets for rural business loans would provide a useful capital market mechanism for rural lenders and borrowers alike. A secondary market for rural business loans would allow community banks to tap broader capital markets and also manage their interest rate risk. There are problems that must be overcome to create such a market, but many remain optimistic that the challenges can be met (Altman). A central issue will be the role of a GSE in launching such a market. Whether to enlarge the public involvement is very difficult to weigh in the balance given the absence of clearly defined policy objectives for rural America.

Expanding community bank access to loanable funds

Participants at our conference agreed that enhancing the liquidity of rural community banks will remain an important issue for the foreseeable future, but they did not agree on what, if anything, to do about it. Bankers and some rural business interests generally expressed support for expanding community bank access to either FHLB or FCS funds. Others expressed concern that extending the charter of either institution would amount to a confounding of their traditional mission, and would add to taxpayers' contingent liability.

In principle, expanding community bank access to FHLB or FCS funds raises many of the same issues as creating a secondary market for rural business loans. One is still left to weigh the potential costs of increased public involvement against what is, at this point, a nebulous public goal for rural America. If policymakers were to make banks eligible for either FCS or FHLB funds, taxpayers would face a bigger contingent liability.

One factor that seems especially important in considering steps to improve liquidity for rural community banks is cooperation and teamwork among rural lenders, community leaders, and business owners. Many participants at our conference made the point that rural America's financial resources will remain limited in the future, and thus it will be important for rural lenders to cooperate in serving the capital needs of rural businesses (Beery; Sims). In that respect, granting community banks new access to FCS funds is a step that will require cooperation on both parts. Since banks and the FCS already compete in most rural markets, there is an inherent conflict of interest that must be overcome for expanded access to work. Some conference participants doubted a new partnership can be forged, while others were more optimistic.

Developing rural equity capital markets

By all accounts, rural entrepreneurs have difficulty obtaining equity capital to fund their businesses. This appears to be mainly a problem of insufficient access to the supply of equity capital. The number of rural deals remains disproportionately low relative to the overall number of rural firms. An encouraging bit of evidence, however, is that rural firms fare well once they do make their way to national equity markets. One market expert noted that rural companies that do tap national equity capital markets are able to do so on terms very competitive with urban firms (Brophy). That is, there appears to be little variation in the pricing terms or investment performance of initial public offerings for rural firms versus urban firms.

Improving rural equity capital markets could be relatively easy, according to market experts. States in predominantly rural parts of the nation, such as the Heartland, could facilitate interstate venture capital pools by making securities laws uniform across the region. Currently, wide differences in state securities laws inhibit the formation of such pools. Rural businesses and state government officials could take steps to encourage stronger rural participation in federal programs, such as the SBA's Small Business Investment Corporation program. The SBA and SEC have relaxed regulations to help nurture small business, and these efforts may not be widely understood in rural areas. Educational institutions might be harnessed more effectively, say as business incubators, to provide a focal point for potential investors. And finally, steps might be taken to more effectively mobilize the capital located in rural regions. Regional development funds can be formed. More generally, existing investment funds in rural regions may be willing to invest more in the region but lack a convenient means of identifying rural opportunities. This suggests the need for more brokers, and some suggest that a licensing program for "business investment finders" may be one answer.

CONCLUSIONS

The rural economy is expanding, but growth is uneven across rural America. Looking ahead, leaders in both high- and low-growth rural areas remain concerned about the rural economic outlook generally, and access to capital that will fuel continued growth, more specifically. There is widespread agreement that capital is key to rural America's economic future.

While rural capital markets appear to be reasonably efficient, it is also clear that rural businesses have fewer sources of capital than their metropolitan counterparts. This shorter menu means that rural businesses depend more on banks for credit, have less access to equity capital, and generally have more difficulty putting their capital package together. With banking consolidation thinning the ranks of community banks in rural areas, this appears to be a good time to explore market innovations that might improve rural access to capital.

The public role in these market innovations will not be easy to determine. Developing secondary markets and expanding community bank access to loanable funds opens the question of enlarging the role of GSEs in rural America. GSEs have been created to address financial market gaps, but they have also served a broader public goal. In the case of rural America, that public goal has yet to be clearly defined. Moreover, the history of GSEs suggests that such institutions rarely sever themselves from the public guarantees that promote their early success. Thus, any discussion of expanding the role of GSEs in rural America will benefit from emphasizing the public role in chartering an institution that fills a gap while charting a course that encourages private ownership over time.

In this regard, the history of public initiatives in agricultural credit markets offers lessons apropos to the subject of this hearing. The record of these markets in the twentieth century argues for federal programs that serve as catalyst in making markets more efficient while avoiding costly direct subsidies to borrowers. The evidence shows that enhancing market efficiency through the chartering of new institutions can provide substantial long-term dividends. The chartering of the Farm Credit System, for instance, increased competition while also broadening agriculture's access to broader capital markets. Indeed, more generally researchers have shown that the most successful federal credit programs have aimed to enhance market efficiency while limiting direct credit subsidies (Bosworth).

REFERENCES

Altman, Frank L. 1997. "Commentary on Improving Secondary Markets in Rural America," in Financing Rural America, Federal Reserve Bank of Kansas City, pp. 121-29.

Beery, Kathleen. 1997. "Closing Panel Comments," in Financing Rural America, Federal Reserve Bank of Kansas City, pp. 185-86.

Beshouri, Christopher, and Peter Nigro. 1994. "Securitization of Small Business Loans," Office of the Comptroller of the Currency, Economic and Policy Analysis Working Paper 94-8.

Bosworth, Barry P., Andrew S. Carron, and Elisabeth H. Rhyne. 1987. The Economics of Federal Credit Programs, The Brookings Institution, Washington, D.C.

Brophy, David J. 1997. "Developing Rural Equity Capital Markets," in Financing Rural America, Federal Reserve Bank of Kansas City, pp. 159-72.

Cole, Rebel A., and John D. Wolken. 1995. "Financial Services Used by Small Businesses: Evidence from the 1993 National Survey of Small Business Finances," Board of Governors of the Federal Reserve System, Federal Reserve Bulletin, July, pp. 629-67.

Duncan, Marvin. 1997. "Where are Rural Capital Markets Headed?" in Financing Rural America, Federal Reserve Bank of Kansas City, pp. 11-45.

Federal Reserve Bank of Kansas City. 1997. Financing Rural America.

Keeton, William R. 1995. "Multi-Office Bank Lending to Small Businesses: Some New Evidence," Federal Reserve Bank of Kansas City, Economic Review, Second Quarter, pp. 45-57.

Ryckman, Scott, and Russell L. Lamb. 1997. "Survey of Agricultural Credit Conditions," Federal Reserve Bank of Kansas City, Regional Economic Digest, Second Quarter, pp. 6-9.

Sims, Douglas D. 1997. "Closing Panel Comments," in Financing Rural America, Federal Reserve Bank of Kansas City, pp. 183-84.

Vandell, Kerry D. 1997. "Improving Secondary Markets in Rural America," in Financing Rural America, Federal Reserve Bank of Kansas City, pp. 85-120.