LOMBARD, Ill.–The recent Small Business Saturday was a reminder of the huge role of the segment in the U.S. economy–5.9 million non-sole-proprietorships also are responsible for 41 cents of every dollar earned by American workers–but also a good time to recognize many small businesses lack access to credit, according to Raddon.
Raddon pointed to a 2017 study from Harvard University, “The Decline of Big-Bank Lending to Small Business: Dynamic Impacts on Local Credit and Labor Markets,” which found a significant contraction in the supply of credit to small businesses during and following the recession.
“That development, by many indications, persists today,” Raddon stated. “The study found that, although all banks have reduced their small business lending activity since 2006, the major banks pulled back the most. 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 its latest Research Insights study, Gimme Credit: Faster, Simpler, Safer Credit for Main Street America, Raddon said it 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, Raddon noted.)
“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,” Raddon stated. “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.”
Two Critical Issues
Cost: High costs to underwrite and review loans make it financially prohibitive for lenders to meet the needs of small business borrowers, Raddon said.
“Consider that, according to Small Business National Research from Raddon, 95% of small businesses seek loans of less than $250,000; the average loan amount sought is only $75,000,” Raddon said in its analysis. “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% 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%as competitive today?”
Likewise, added Raddon, charging a 5% 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.
Time and Effort: Inefficiencies result in a challenging application process and long duration – 30 days or more in too many instances – to adjudication, according to Raddon.
“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% of small businesses cited the difficult application process and 43% cited the long wait for a credit decision as sources of dissatisfaction when they sought to borrow from small banks,” Raddon said. “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.’”
What is Being Demonstrated
According to Raddon, 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,” Raddon said. “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.”
Go here for more information on the research study.