Fintech, Small Business & the American Dream

by Karen G Mills

  Consolidation Is Problematic for Small Business Lending

  Bank consolidations and the disappearance of local community banks have been a problem for many small business owners. Tommy Davis, the North Carolina small business owner mentioned earlier, closed his Nationwide Insurance office in Colerain and moved to Windsor, a larger town 25 miles away, after the local community bank closed. For Tommy, it was “like a death sentence for a small town because the bank is the center of all activity.”26

  Economists have found that community bank closings have had a prolonged negative impact on the credit supply available to local small businesses.27 Interestingly, this decline persisted despite the opening of new banks. These results underscore the importance of lender-specific relationships and local information for small business lending. This information is often held within local bank branch personnel and lending systems, and can disappear or become less relevant if large banks bring in different personnel or more automated lending systems. Of particular concern are the findings showing that the negative effect on small business lending was concentrated in low-income and high-minority neighborhoods, where local relationships may be a more significant factor in lending decisions.28

  Relationship Lending and Large Banks

  As banks get larger, they typically have more branches, are more geographically dispersed than community banks, and have more employees to coordinate. Because of this, large banks need explicit rules and underwriting guidelines to keep loan officers rowing in the same direction and producing consistent outcomes.29

  Larger banks, especially those with more than $10 billion in assets, are more likely to use a “cookie cutter” approach to lending, relying on standardized data such as a borrower’s FICO (Fair Isaac Corporation) credit scores and financial statements. They find it hard to manage a relationship approach to lending and include “soft” or subjective information, such as a borrower’s character, in their loan decisions.30 In addition, larger banks tend to be less creative in developing customized loan structures tailored to a small business’s needs. According to the 2017 FDIC Small Business Lending Survey, large banks use standardized small business loan products 65 percent of the time versus 9 percent at smaller banks.31

  As the number of community banks declines and as larger banks create even more automated and standardized lending decisions and loans, the concern arises that there will be more market barriers and frictions. The smallest and newest businesses, especially those that do not have as much financial information or have endured financial issues in the past, will likely have a harder time accessing capital from traditional sources. More borrowers will find themselves judged only by rigid formulas, unable to make a case for themselves to a banker with an open ear, increasing the possibility that creditworthy borrowers will slip through the cracks, opening up further gaps in small business lending markets.

  A challenge for the future is how to continue to capture soft factors, but also increase automation and reduce costs. Relationship lending is expensive and its cost tends to affect the smallest loans most. One solution is to “harden” soft information by finding new data that brings additional insights to traditional automated lending formulas. We will explore these new data sources and insights in later chapters; however, it is unclear whether these processes can ever fully replace relationship lending.

  Small Business Loans Are Less Profitable

  Another serious structural issue is that small business loans are less profitable for banks than many other lines of business. The chief obstacles are difficulties and costs of the traditional methods of underwriting small business loans, and the lack of ways for banks to offload small loans from their balance sheets, as the secondary market for small business loans is not robust.

  Information about small business borrowers is important because small business lending is riskier than large business lending. Small businesses are more sensitive to swings in the economy, have higher failure rates, and generally have fewer assets to use as collateral for loans.

  But, as we have discussed, reliable information on small businesses is difficult to obtain because the operating performance, financials, and growth prospects of small businesses are hard to see and predict. There is little public information about the performance of most small businesses because they rarely issue publicly traded equity or debt securities. Many small businesses are run by inexperienced or busy owners who may lack detailed balance sheets, understate their tax returns, or keep inadequate income statements. This information opacity makes it more difficult for lenders to tell creditworthy and noncreditworthy borrowers apart.

  Another factor working against small business lending is that the cost of loan underwriting does not scale with the size of the loan. In other words, it costs about as much for a bank to process a $100,000 loan as a $1 million loan. That means that smaller-dollar loans are less profitable for banks. As a result, banks are less likely to lend at lower dollar amounts.

  One response for a bank is to move away from small business lending and focus on more profitable activities. Some banks have reduced or eliminated loans below a certain threshold, typically $100,000, and some will not lend to small businesses with annual revenues of less than $2 million. Often, the largest banks will refer businesses below a certain size to their small business credit card products, which are usually more expensive for borrowers.

  Most Small Business Loans Cannot Be Easily Sold

  One way for banks to reduce their risk exposure and increase the funds they have available to lend is to sell off some of their loan portfolio. They often do this by securitizing loans, which involves bundling loans they have made into a single security that can be sold on a secondary market. This is common with mortgage loans, which can be easily bundled because most of them are underwritten using standardized formats.

  Until recent years, there has been essentially no secondary market for small business loans. Loans to small firms are not easy to standardize, since they vary in how they are documented and the terms given to companies in different markets. In addition, there is a general lack of data available on their performance. One exception is loans made through the Small Business Administration’s (SBA’s) 7(a) program, which are sold with a government guarantee. Historically, about 40 to 45 percent of SBA loans have been securitized.

  Creating a secondary market for small business loans is not a new idea. In the 1990s, Congress considered creating a government agency similar to Fannie Mae and Freddie Mac to sponsor securitization transactions.32 In 1994, Congress took a different approach by reducing barriers to securitizing small business loans, but those changes ultimately had little effect.33

  If accurate data on small businesses’ credit were standardized and widely available, the securitization of small business loans would also be more widespread, making capital more fluid and accessible, and benefiting small business lending overall. This may be on the horizon. One set of new fintechs called peer-to-peer lenders have emerged who match investors with borrowers, and as a result, the details of each loan are published online. These lenders allow banks to purchase individual or packaged small business loans after origination to hold on their balance sheets.

  Even with full disclosure of the underlying loan details, many concerns have arisen about the heterogeneity of small business loans and the ability to accurately assess the risk in a packaged tranche or portfolio. These issues and others have meant that the new secondary markets have gotten off to a slow start. However, as metrics-driven lending develops, the ability to eventually identify and describe risk pools may improve the packaging and pricing of small business loans and allow them to trade more seamlessly.

  Searching for Small Business Financing Is Costly and Frustrating

  As a result of these structural factors, even qualified small business borrowers can struggle to find willing lenders. Successful applicants for bank loans report waiting a week or more for the funds to be approved and transferred into their accounts. Research from
the Federal Reserve Bank of New York found that in 2013, the average small business borrower spent more than 25 hours on paperwork for bank loans and approached multiple banks during the application process.34 Some banks have even refused to lend to businesses within specific industries that they consider particularly risky, such as restaurants.

  The reduction in the number and role of community banks has made searching for and securing a bank loan even more time-consuming and costly. Meanwhile, the low relative profitability of small business lending combined with a lack of accurate data on small business borrowers has meant that other banks have not stepped in to fill the role traditionally played by local lenders. In this environment, everyone is frustrated. Small businesses often feel that banks don’t know them anymore and don’t care about their business. Bankers rail against the post-crisis regulatory regimes and feel oppressed by the costly and confusing morass of compliance requirements.

  The solution is to look forward rather than backward. The structural changes in U.S. banking are not likely to reverse themselves, even if the regulatory environment is optimized (Chapters 10 and 11 take on the flaws in the current regulatory environment and propose principles for a “smarter” regulatory structure). We will not return to an environment of 15,000 banks, most of which are owned and operated in local communities, anytime soon.

  But there are other ways to solve the problem. We know that small businesses need access to capital to grow and operate their businesses, and that banks are increasingly finding these loans less appealing to make. But just because banks have not been making these loans does not mean that there are no profitable loans to be made. Chapters 6 and 7 focus on how technology is changing the dynamics of lending. Fintech entrepreneurs have identified innovative solutions to some of these structural barriers that have been putting pressure on small business credit markets.

  But first, it’s important to ask, what exactly is the problem we are trying to solve? The next chapter examines what small businesses want, including what size and type of loans they need, and identifies gaps where the current lending market is failing to deliver.

  © The Author(s) 2018

  Karen G. MillsFintech, Small Business & the American Dreamhttps://doi.org/10.1007/978-3-030-03620-1_5

  5. What Small Businesses Want

  Karen G. Mills1

  (1)Harvard Business School, Harvard University, Boston, MA, USA

  Karen G. Mills

  Email: kmills@hbs.edu

  The financial crisis reminded us that capital is the fuel that small businesses rely on to grow and create jobs. The most common sources of funding for small firms are retained earnings and the owners’ personal resources. However, bank credit is a vital source of external funding for many, especially the economy’s Main Street businesses. The Great Recession made bank funding more difficult to obtain, and in its aftermath, there was a robust public debate about whether banks were ramping up small business lending fast enough. In 2014, this debate was in full swing—was there really a gap in small business financing?

  The question was not an easy one to answer because of the lack of good data on U.S. small business lending. No one tracks loan originations to small businesses in the aggregate, much less in detail. Banks, of course, have the raw data about their own loan businesses, but it is not collected as part of the Federal Deposit Insurance Corporation (FDIC) call reports or other regulatory activity. The FDIC does collect data on the stock of loans on the balance sheets of banks, but since that number is a net of the additions and pay downs of loans, the flow of new loans can be obscured. Survey results, particularly from the Federal Reserve (Fed), are helpful resources, as are loan numbers from the Small Business Administration (SBA) and from reporting required under the Community Reinvestment Act (CRA). However, these sources of data don’t tell the whole story.

  Good policy requires real-time information on loan originations to small businesses. Other countries, such as the United Kingdom, have taken on this data collection successfully, viewing it as vital to small business policy. One provision of the Dodd-Frank Act (Section 1071) required the collection of this data, and delegated that responsibility to the Consumer Financial Protection Bureau (CFPB). However, the provision has yet to be implemented.

  Using the best available data, however, a worrisome picture emerges. In the slow recovery years, there was a gap in small business lending in smaller size loans. Banks generally define small loans as those under $250,000, but the most severe gap was for loans under $100,000.1 For loans above those thresholds, and even more so above $1 million, there was robust competition. Regional banks such as Zions, Regions, and Key Bank had targeted loans between $500,000 and $5 million to fuel their growth. They saw that it would be profitable to give larger small business loans to well-run small businesses recovering from the recession or looking to buy equipment or fuel expansion. For loans of this size, the traditional model worked, with bankers cultivating a relationship and providing advice and additional banking services.

  But what about the creditworthy Main Street business who wanted a small line of credit, or $20,000 to buy a van? Banks pushed these customers toward business credit cards or declined to serve them at all. This was a serious concern because small-dollar loans were what most small businesses wanted. Thus, for many years during the recovery, the smallest firms were having more trouble obtaining bank funding, in part because they were the ones seeking the smallest loans. This unmet need made the industry ripe for disruption by the new fintechs, as we will see in Chapter 6.

  The Small-Dollar Loan Gap

  How many small businesses seek outside financing and how many want small loans? The limited data sources we have tell different stories.2 A report from Javelin research in 2016 showed that just about one-eighth of small businesses planned to apply for a loan the following year.3 Meanwhile, the Fed’s 2017 Small Business Credit Survey indicated that 40 percent of small businesses applied for credit in the past 12 months.4

  We do have better data, however, on the size of loans small businesses want. Three-quarters of small business loan applications from employer firms were for small-dollar loans—loans under $250,000—and more than half of the loan applications were for amounts under $100,000 (Figure 5.1).

  Figure 5.1 Small Businesses Want Small-Dollar Loans

  Percentage of applications from small businesses by loan size

  Source: “2017 Small Business Credit Survey: Report on Employer Firms,” Federal Reserve Banks, May 2018.

  This means that 75 percent of the small business owners approaching a bank for a loan want a product that the bank would, in many cases, prefer not to provide or cannot provide profitably. As we saw earlier, it takes as much time and effort, if not more, to make a small loan as it does to make a large one. The revenue from the fees and interest are lower and the risk is often higher. Banks do make money providing credit cards for these small-dollar needs, as the fees tend to be higher and the credit process is automated. But credit cards are usually more expensive to the small business owner than loans, and not all expenses can be paid using a card, making them a less than optimal solution in many cases.

  The Smallest Businesses Struggle the Most

  Access to capital is the most difficult for the smallest businesses. In 2015, loan approval rates for micro-firms—those with less than $100,000 in annual revenue—were the lowest of any cohort of businesses. Micro-firms applying for loans faced a funding shortfall about two-thirds of the time, while companies with over $10 million in annual revenue had a shortfall less than one-third of the time (Figure 5.2).

  Figure 5.2 Micro-Firms Have the Greatest Unmet Need

  Percentage of loan applicants receiving full funding versus those funded partially or not at all

  Source: “2015 Small Business Credit Survey: Report on Employer Firms,” Federal Reserve Banks, March 2016.

  It is unsurprising that micro-firms have more trouble with financing because, in general, the smaller the firm, the riskier it is, t
he more likely it is to fail, and the fewer assets it has to offer as collateral for a loan. The smallest firms are also the most informationally opaque. They often don’t have complete financial statements and their taxes can understate their profits. Gathering a bank package to apply for a loan can be a long and tortuous process. And once it is completed, it is often not as compelling as it could be—the business owner may well be good at their business, but inexperienced in financial analysis and presentation.

  Even controlling for credit score, Fed data shows that smaller businesses have a harder time getting loans. In 2016, firms in the “low credit risk” category with revenues of less than $1 million had an approval rate 10 percent lower than low credit risk firms with more than $1 million in revenue. In the “high credit risk” category, the approval rate was 20 percent lower for small firms.5

  With this knowledge we return to the question: How important is the gap in access to capital for small-dollar loans for the smallest firms? Significantly, 80 percent of firms with annual revenues under $250,000 want a loan of less than $100,000.6 Thus, this large pool of very small businesses—the same ones that are more informationally opaque and often riskier—wants the smallest, least appealing loans for banks to provide.