credit lendingIn managing credit for small businesses, the Federal Reserve faces the difficult task of doing it exactly right. The trick is to avoid the extremes of providing an excess amount of financing or becoming overly risk averse and making too little funding available.

The situation is further complicated by regulators who want banks to improve their own financial situation and reduce risk simultaneously. Also, while lending to small business was “red hot” prior to the Great Recession, it is definitely “too cold” today, and small businesses are suffering the consequences.

Financial institutions claim that sound businesses can borrow what they need, and that they avoid lending to those who are poor credit risks. However, the facts don’t bear this out because lending to small businesses has decreased far more that what was needed to correct the over-heated tempo of the mid-2000s. Consequently, providing access to credit for small business owners has not shown any signs of improvement since the start of the economic recovery three years ago.

FDIC data reveal that the dollar value of business loans less than $1 million decreased by 17 percent between 2009 and 2011, and the total number of loans decreased by 8 percent. Although the amount of credit currently available to small businesses is insufficient, lenders should avoid lending to business owners that are insufficiently creditworthy and may be unable to repay their loan.

When credit is readily available, entrepreneurs start businesses on a whim and business owners borrow rather than cutting costs or increasing sales. The outcome is that their companies soon become burdened with debt that they are incapable of handling with bankruptcy as their only option.

Ben Bernanke, Federal Reserve Chairman, should take the lead and have banks apply more realistic lending standards to create the right temperature in the credit market.

Read more at BusinessWeek.