Closing the Gap in Small Business Lending
November 24 is Small Business Saturday, so now is a good time to recognize the vital force of small businesses for our nation’s economy. Defined by the Small Business Administration (SBA) as having fewer than 500 paid employees, U.S. small businesses employ almost half (48 percent) of the civilian population. These 5.9 million non-sole-proprietorships also are responsible for 41 cents of every dollar earned by American workers. In essence, 40 percent of consumer spending power is a function of small business employment.
However, with the Great Recession now a decade past, recent findings show that small businesses’ lack of access to credit – their lifeblood for investment – played a notable role in the modesty of the economic recovery. As Figure 1 shows, annual GDP growth averaged 2.1 percent through 2017 versus 3.0 percent over the three previous decades.
Figure 1: Annual GDP growth has been modest during the recovery
To wit, a 2017 study from Harvard University, The Decline of Big-Bank Lending to Small Business: Dynamic Impacts on Local Credit and Labor Markets, found a significant contraction in the supply of credit to small businesses during and following the recession. That development, by many indications, persists today. The study found that, although all banks have reduced their small business lending activity since 2006, the major banks pulled back the most. (See Figure 2.) Even though this dynamic opened the door for fintech lenders, these firms did not have the market presence or capacity to amply fill this “credit gap.” Ultimately, the reduced flow of small business credit contributed significantly to lower employment, wages and economic activity as the recession ended. In fact, Harvard’s report found that 14 percent of the rise in unemployment from 2006 to 2010 was a result of the small business credit gap, which equates to over 1 million jobs lost during that period!
Figure 2: Major banks have pulled back on small business lending and remain on the sidelines
In our latest Research Insights study, Gimme Credit: Faster, Simpler, Safer Credit for Main Street America, Raddon partnered with PayNet to examine the implications of Harvard’s findings through the lens of small business data and research from Raddon and PayNet. (PayNet’s proprietary database of over 23 million small business loan contracts totaling more than $1.4 trillion in outstanding loans was sourced for the Harvard study.)
While a variety of factors – including high charge-off rates, increased capital requirements, heightened regulation – influenced the larger banks to decrease small business lending, the central challenge remains the inability of financial institutions to profitably extend loans with terms and conditions that are attractive to small business borrowers. Our joint research finds that a key factor preventing community institutions from closing this gap is the loan process itself. A time-series analysis by PayNet of the traditional loan process – a largely human-intensive process still deployed by many lenders today – exposed two critical issues with these outmoded processes.
The first is cost: High costs to underwrite and review loans make it financially prohibitive for lenders to meet the needs of small business borrowers. Consider that, according to Small Business National Research from Raddon, 95 percent of small businesses seek loans of less than $250,000; the average loan amount sought is only $75,000. Using PayNet’s process costs and applying some standard cost assumptions for funding, a net-present-value analysis by Raddon shows that a financial institution would need to charge an interest rate of 9.49 percent just to break even on a five-year loan for this average loan amount. Would a small business borrower view an interest rate north of 10 percent as competitive today? Likewise, charging a 5.00 percent interest rate on a five-year loan with the same process and funding costs would entail a breakeven balance of over $860,000 – substantially higher than $75,000.
The second issue is a combination of time and effort: Inefficiencies result in a challenging application process and long duration – 30 days or more in too many instances – to adjudication. These are untenable for potential borrowers (especially those requesting a modest loan amount). Indeed, according to the Federal Reserve Bank’s 2015 Small Business Credit Survey, 52 percent of small businesses cited the difficult application process and 43 percent cited the long wait for a credit decision as sources of dissatisfaction when they sought to borrow from small banks. And the 2018 Small Business Survey from Raddon revealed that 47 percent of small businesses agreed with the statement, “Getting a business loan is a long and difficult process.”
These economics and sentiments demonstrate a key source of the credit gap. They also illuminate the need for small business lenders to examine and streamline (i.e., modernize) their loan processes to compete effectively in this space. Certainly, technology (think APIs, data analysis) plays an important role here, but institutions should also assess resource allocation, asking themselves if they are spending the same time and effort on a loan that is one-third the size or risk of another loan. They need to explore additional data investment that can better inform and advance credit decisions as well.
Ultimately, a vibrant small business arena helps the economy thrive. But the research shows that a broken credit system is inhibiting the full potential of this space. Institutions that can close the gap in their own loan processes (the aforementioned fintechs should be emulated rather than feared) will be better equipped to capitalize on the clear opportunity at hand. And perhaps faster, simpler, safer credit for main street America will enable a stronger recovery from the inevitable next recession. To learn more, see our research study.