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State of Small Business Lending Overview

The foundations of the US economy lie firmly in the number – and prosperity – of the nation’s small businesses.

They already account for around 50% of America’s public sector jobs. That’s around 120 million people. However, the importance of owner-managers, like us, could well become even more significant in the coming years.

Because small businesses have been responsible for creating around 75% of the net new jobs in the USA since 1995.

Yet ours are the businesses which feel the impact of economic policies and the recession most. And finding ways to fund our continued growth – or even our survival – is a struggle.

Is enough being done to nurture small businesses, with viable credit arrangements? Are traditional lenders creating too many barriers for start-ups and growth plans?

Will newer, more flexible lenders be the solution? Is the answer financial organisations that use advanced digital formulas to assess applications for credit, offering fast, 24-hour access to funding?

There are also important considerations about this new breed of commercial credit providers. How will they be regulated? And will they force traditional lenders into becoming more competitive?

Perhaps most significantly, could alternative commercial lenders create a new credit crisis similar to the personal lending one that stimulated the recession? If small businesses with questionable business plans lend indiscriminately, what are the risks?

Read on, as I dig further into these issues in this article.

<b>State of the nation – the small business imperative</b>

There are 28.7 million small businesses in the USA. The majority of which are sole traders. Around 14 million of small businesses are home-based. 

Many others are small mom-and-pop type family ventures which employ local folk. 

These enterprises create employment as I mentioned, but they also serve another vital economic purpose.

They are pivotal for the supply chain. Larger corporate ventures on small businesses for unfathomable amounts of components, products and services. Our ability to be more agile and competitive on price enables larger US companies to keep their profitability up.

Yet times have been tough recently for small businesses.

In a five-year period to 2012, we lost jobs at a significantly higher rate than bigger companies did. In fact, around 60% of net job losses in the US in that period were in smaller businesses.

The financial crises have also decreased survival rates for small ventures, far more than larger corporations.

There is plenty of evidence to suggest that this bleak picture is not about failures in innovation, business planning or management. Instead, the vulnerability of small businesses lies in our reliance on bank capital.

Capital from loans funds both start-ups and growth plans. It enables us to innovate and go after new markets with additional employees and machinery. It supports technological advancement and creative research and development.

Bank credit is also needed when larger corporations are slow to pay. When cash flow is strangled, small businesses can’t rely on public institutional debt and equity capital markets. Bank credit is often a matter of being able to survive, not just thrive.

As I mentioned in the introduction to this article, small businesses are returning back to being a major driver in the creation of new jobs in America.

However, even that does not mean that job creation levels are sufficient to truly heal the wounds inflicted on the US during the recession.

The slow recovery could well mean a sluggish lending market.

<b>Are lenders strangling small businesses?</b>

Traditional lenders are cautious and keen not to repeat the mistakes of the past by allowing Americans to borrow more than they can repay.

Which means that main street banks have stricter criteria than ever when assessing applications for commercial credit. Perhaps more so when it’s a small business with fewer assets and credit history. More on that later.

The financial institutions report that capital investment is still there for small business owners to access, but that applications need to “tick all the right boxes”.

They attribute the slump in lending to their increased regulation and higher compliance costs, making it harder to agree lending on anything other than hard, cold facts.

There is also a degree of inevitability that banks will look for applications that offer the greatest chance of healthy returns when lending capital is limited.

However, many of the nation’s small businesses are deeply unhappy with this situation. There is a belief that traditional lenders have made the hurdles too high, and it’s impossible to win the funding they need.

This uneasy relationship is all the starker when you consider that some 48% of business owner-managers acknowledge that major banks are pivotal to their financial management. Some 34% have their financial arrangements interwoven with regional or community banks.

<b>Mind the gap</b>

How many of the small businesses who find bank doors shut in their faces actually had viable business plans that don't become a reality due to lack of credit?

That’s clearly impossible to know.

However, there is plenty of evidence that lack of access to credit is suppressing the small business sector to an alarming extent.

Sources for this include national surveys by the National Federation of Independent Businesses (NFIB) and regional surveys led by the Federal Reserve. 

These are not cast-iron statistics, but sufficient data shows that credit is in decline during the recovery and tends to cluster around ventures considered to be a “safe bet”.

It is illustrated by the balance sheets of banks. These show a 20% drop in loans to small ventures in recent years, in absolute terms. Yet since the financial crisis, bank lending to bigger enterprises has risen by 4%.

Put it another way. Small business loans in 1995 were around 50% of bank lending, and by 2012 this fell to 30%.

I hear enough from small business owners to know they also believe that banks are not actively marketing their credit arrangements to them with anything like the same enthusiasm as in the past.

<b>Are small businesses too big a risk?</b>

The financial crisis in America has been described as a “perfect storm”. Unfortunately, the damage done is still being repaired. This includes restoring faith between lenders and borrowers.

Some of the small businesses applying for lending are not yet in a position to show strong sales forecasts and buoyant order books.

Nor are owner-managers always backed by strong personal or business collateral to offset risk. More specifically, property prices have dropped.

Also, self-employed Americans saw a substantial fall in their incomes from 2007 to 2010, as reported by the Federal Reserve’s Survey of Consumer Finances. 

They may even be held back by a limited or chequered credit history.

It all means that we come to the table with a significant number of the risk factors that make banks nervous, especially as the Federal Reserve Senior Loan Officer Survey has urged a tightening of lending criteria.

<b>Change face of US banks</b>

The pool of commercial lenders has seen its own survival problems too, with bank failures and difficulties in 2008 reaching an all-time high since the Great Depression.

Nor are new players emerging in sufficient numbers to take their place. In one 12-month period, no new bank charters were submitted to the FDIC – a unique occurrence since the institution was founded 80 years ago.

Banks and bank examiners are naturally ultra-sensitive to risk, and more likely to opt for what they consider to be safer applications for capital.

They also genuinely do operate within a new level of constraint and control, with far stronger regulation. 

In recent times, there has also been a move towards consolidating banking assets within a smaller group of institutions. By 2012, the country’s leading 106 banks were holding 80% of the nation’s $14 trillion in financial assets.

This is partly due to the fact community banks have merged with main street names. This – coupled with the bank failures I referred to above – has meant the number of community banks has halved in recent years. Even though bank asset averages have risen.

It means a smaller number of targets for small business lending applicants.

<b>Other hurdles to securing small business loans</b>

What other factors are causing the apparent stresses in the relationship between America's small businesses, and traditional sources of credit?

There is evidence to suggest that the cost of lending applications – in terms of time and money – has become more onerous.

Federal Reserve reports suggest that almost 25 hours of work is required by small businesses to complete loan paperwork and negotiate with potential lenders. And for them, time is money.

There can also be long delays in having applications processed, leaving applicants struggling even if funding is eventually approved.

Some banks are transparent in their unwillingness to even consider applications for certain types of small businesses or those with projected revenue lower than $2 million. 

Instead, banks may steer low dollar loans to credit card products aimed at small businesses. These are easier to administer and create higher yields. 

From the banks' point of view, this fragmenting of the relationship is not just about the risk of lending to small businesses. The costs of administering small business loans (usually classified as less than $1 million) make these transactions less profitable than larger loans.

It can also be a more time-consuming process to complete checks on the creditworthiness of small businesses. Information can be patchy or inconsistent with pre-set fields of enquiry. There is also limited public quoted information on them, as small businesses are not obliged to publish financial reports. Some don't keep clear financial records either, such as digitalised accounts.

In the past, especially with community banks, there has been currency in the relationship forged between small business and their lenders. Much of this has been lost to financial expediency and the switch to using digital methodology.

Now banks are forced to try to fit the diversity of small businesses – including their widely differing types, financial records and plans – into standardised assessment fields.

It is also more of a challenge for banks to approach the secondary market, to securitise and sell pools of small business loans.

<b>A new breed of lender</b>

The advance of technology has stimulated a new crop of “virtual” commercial lenders.

They use different evaluation, approval and management processes from traditional lenders.

Their offering is based on data‐driven algorithms that can screen lending applications instantly online, and sift through to find creditworthy businesses.

Their advantages include an easier application process, but also the speed of decision making. Around the clock, small businesses can apply for credit and have an answer more or less instantly.

There are three primary variations of this type of online lending for small businesses:

Lenders such as Kabbage and OnDeck base their lending on their own balance sheet. Their capital comes from institutional investors. Proprietary risk scoring models are used to formulate lending decisions.

There is also peer‐to‐peer platforms for lending to small businesses. These include, for example, Lending Club, Funding Circle and Prosper. These are agencies brokering institutional and retail investor capital to prime and sub‐prime quality borrowers. 

Thirdly, there is the lender‐agnostic model. Examples include Fundera and Biz2Credit. The way they operate is to create digital marketplaces for businesses to “shop” around for willing lenders, from amongst both traditional and new players.

<b>Response from the banks</b>

This sort of online lending activity is challenging traditional main street banks – and credit card companies – to rethink their own promotional, assessment and delivery systems.

Many are considering ways to combine some of the speed and agility of this new type of lending, with their own tried and trusted ways of operating. This results in partnerships and mergers between the old and the new.

Other traditional lenders see this new breed of players as a threat.

There are increasing calls from various parts of the financial services sector – and policymakers – for greater controls to be applied to this new credit source.

<b>Regulation of new lenders</b>

The speed and intensity of any regulation are much debated. Not least, as there are fears that stringent new rules could strangle yet another source of small business credit.

On the other hand, leaving this new group of commercial lenders unregulated could be storing up trouble. It could even be a slippery slope to the next sub‐prime lending crisis. 

One of the leading questions in this arena of debate is which body would be the most appropriate to start creating checks and measures. The answer is far from clear.

Nor is it straightforward to agree the degree of transparency that should be imposed. 

What is certain, is that America’s small businesses survive – and thrive – according to a flow of credit. Whatever comes next needs to safeguard that, at the same time as mitigating the risk of over-borrowing.

Lee Pruitt