October 11,2016

If there is one person that knows the Small Business Lending market better than anyone its Karen Mills. From 2009 to 2013 Mills was in charge of the Small Business Administration and a member of Barack Obama’s cabinet. Mills is now a Senior Fellow at Harvard Kennedy School of Government and recently published an eye opening working paper focused on small business loans and the small business lending market. The paper is titled: State of the Small Business Lending Market and the Role Technology May Play.

The US economy is highly dependent on small business and yet, small business was very slow to recover from the Global Financial Crisis. Why? The research all points to one key factor – a lack of supply of small business finance.

When liquidity dried up during the GFC, the supply of small business credit dried up too. The return of liquidity to markets was accompanied by some structural shifts in the Banking sector as well as significant changes to Bank regulations. The combination of these two factors ended up having a devastating impact on the small business lending market and saw small businesses miss out when liquidity returned to other segments of the credit markets. In the Harvard Business School (HBS) paper Mills and her co-author explains these forces, discusses why the Banks have retreated from small business lending and how innovative non-bank lenders are stepping in to fill the void.

Politicians and journalists are good at using an anecdote about the “main street” business owner when talking about the state of the economy. But few seem to fully appreciate the importance of small business to the country. Here’s the simple facts:

Fact 1: Small business employs over half the private sector work force in the United States;

Fact 2. Small business is the marginal employer in the economy – small business have been responsible for almost two thirds of all jobs created in the US since 1995; and

Fact 3: If you combine the above two facts, it tells you that small business fight well above their weight when it comes to stimulating the economy – 50% of labor force but 2/3 of job growth. This multiplier effect means that small business often holds the key to job creation coming out of a recession. The reasons that small business tend to hire more than larger businesses in a growth phase of the economy is multi-facets but two very practical aspects play a role. Firstly, owners of small business are more incentivized to hire in a growth phase as, on the one hand, they personally get a disproportionate share of the returns from the growth of the business and on the other hand, they are often directly impacted by being short staffed when business is busy. And secondly, small businesses are nimble and can act quickly to add staff when business improves – they are very often earlier in the cycle to hire than larger businesses.

But grow requires capital and this is where small businesses are at a distinct disadvantage to other segments of the economy. Most often, small business gets a bad deal on trade terms – cash on delivery for purchases and then being forced to provide their own customers with long payment terms – sometimes 60 to 90 or even as long as 120 days. As a result, the working capital requirement to support growth of small business is relatively large compared to bigger businesses and access to capital to fund the growth becomes critical.

Small businesses have very limited options when it comes to capital. Unlike larger businesses, small businesses typically don’t have the ability to issue equity or raise public debt. In addition, many of the specialized financing products that are designed for business are best suited to larger businesses where there is stronger credit counterparties and better collateral positions for the lender. Finally, most small businesses do not produce large internal cash flow to fund growth. Cash reserves are usually at a minimum which means internal funding of growth is difficult. A National Survey conducted by the Federal Reserve in 2003 found that almost 60 percent of the small business finances are used to maintain cash flow. All of these factors point to one key point that is highlighted in the HBS work paper:
More so than any other segment, small businesses are reliant on Bank debt for financing business growth.

Small business lending is the fastest shrinking loan market in the US. The HBS study highlights how drastic the reduction in bank lending to small businesses has been:
“The small business share of total commercial loans reduced from 51 percent to 29 percent over a period of 17 years.”

Why is This Happening? According to Mills and her co-author, a combination of factors have resulted in Banks retreating from small business lending. Many of these factors are structural in nature and therefore unlikely to self-correct in the future.

Here are some of the reasons:
• No Equity in Home. Banks prefer to take property collateral to secure small business loans. Following the GFC, with declines in house values, most small business owners don’t have as much equity in their homes to offer as collateral for a small business loan;

• Community Bank Consolidation. Many community banks, who were once the first call for many small businesses seeking bank funding, have been bought up by or merged with larger Banks in recent years. This trend is partly due to the increased Bank regulation making it more difficult for small Banks to survive. In total, the number of Banks in the US has more than halved since 1984 – from 14,507 to 6,840. With the consolidation of the sector, the once small business friendly lending practices of the Community Banks has all but disappeared, replaced by the more ‘institutionalized’ credit policies of larger Banks.

• Bank Regulation Favors Mortgage Lending. Changes to Bank capital adequacy ratios mean that Banks favor lending against secured property vs. unsecured small business loans. Basel III stipulates that Banks need to hold a lower level of capital against a property secured loan as against an unsecured business loan. As a result, the return on capital that a Bank can make from a home loan is almost always more than what they can make from an unsecured loan. This is the case even when taking account of the higher interest rate on an unsecured loan.

Scale Economies Work against Small Business Loans. Loan processing costs are the same whether a Bank is processing a large loan or a small loan. As a result, Banks are incentivized to focus on larger loans where the loan processing cost can be spread across a larger amount of interest income.

The Call Report data published by the Federal Deposit Insurance Corporation show that commercial bank loans, for less than or equal to $1 million, offered to small businesses steadily declined through 2012, and are down by 20 percent since the recession of 2008. Demand figures are harder to come by, but it’s fair to assume that small business credit demand has remained at least steady and has probably grown. So what happens when you have growing demand and shrinking supply?

High school economics tells us that the price for credit should rise to the point where the demand and supply curves intersect. The reality however, is that to a large degree, Banks pull back on small business lending isn’t so much about price. It’s simply that they don’t want to lend to small business for the reasons mentioned earlier. In other words, the credit supply curve is flat. Or to put yet another way, if the small business owner who gets rejected for credit from his bank offers to pay an additional 3% or 4% in interest on their small business loan, the Bank is still likely to say “No”. The result, unfortunately, is financial exclusion for a large number of good credit quality small businesses.

These types of conditions describe a “failed market” – a market that doesn’t work how it is supposed to. The GFC is probably the best recent example of a failed credit market. Credit liquidity disappeared almost overnight and good credit quality counterparties could not get access to funding no matter what the price. We know in that case, that government stepped in and took action to “fix” the market and get credit flowing again. It worked. Credit markets were “unfrozen” relatively quickly – although they didn’t return to pre-GFC levels for some time. Credit for small business, on the other hand, never returned post GFC.

When governments don’t step in to mend a failed market it is left to market forces to try to solve the problem. With problems of supply-demand imbalance that usually means innovation on the supply side – and this is exactly what is occurring in the small business loan market today. Alternative lenders – both platforms and direct lenders – have entered the space and are filling the gap in credit supply. Companies such as Lendio and Biz2Credit are effectively aggregators helping small businesses source loans from either Banks, via the Small Business Administration or from non-bank lenders. Others such as Kabbage and Ondeck Capital are direct lenders that use technology to decrease their costs of origination and loan processing to be able to lend to small businesses in a cost effective and efficient way. The Harvard Business Review paper highlights the following statistics from these alternative lenders:

1. Alternative lenders are approving loans 3 times as many loan applicants as the major banks.
2. Alternative lenders are growing their exposure to the small business loans at a 100 percent growth rate.

Off a low base, these alternative lenders are starting to make a big difference in small business lending. Ondeck for example, went public in December with a market valuation greater than $1.3 billion. They have to date provided more than $1.7b in small business loans. But this is still a drop in the ocean compared to the unsatisfied demand for small business credit.
This from Mills in the Harvard Business School paper:
“These are early days for the online small business loan market. The market is attracting robust attention from traditional players, entrepreneurs and venture capitalists. It is unclear as yet if the winning business models have emerged. The good news is that the marketplace is innovating and the new products that are emerging have the potential to fill an important gap in the small business loan market.”

The long term impact of the alternative lenders on the small business market will largely be determined by the reaction of government and the Banks themselves.
To date, the US government has taken a relatively “hands ‘off” stance to the small business credit problem. This contrast with the philosophy of the UK government which has gone to the great lengths to kick-start small business lending. Some of their policies include:
(a) Launching their own government owned business bank;
(b) A ‘funding for lending’ program which provides government funds to Banks and non-banks that lend to small business; and
(c) An industry consultation paper that calls for Banks to be required to placed their rejected Business Loans on an aggregation platform for non-bank lenders to bid for.

In terms of Bank response to innovative business lenders, we are seeing the first signs of the Banks looking to either copy or partner with the leaders in the alternative lending space. This could see a dramatic shift in market in the coming years – one which should be positive for small business. As we have seen in the consumer lending space (see Lending Club), when the alternative finance channels mature, the traditional Bank want to reenter the market in some form. In the case of Lending Club, Banks are now some of largest investors of loans on the peer to peer platform. This has occurred to such a large degree that some commentators believe the sector should be called “Bank To Peer” not “Peer to Peer”. It is too early to tell whether Banks will reemerge in this way in the small business lending market but it’s a fair guess that as the opportunity of alternative small business lending gets bigger, the Banks will want to participate in some shape or form.

To sum up, it is clear that we are in the first innings in this dramatic shift from traditional bank products to alternative finance. This is the case across the board in almost every financial product or service you can think of. Payments, loans, investments, lending, wealth management, the list goes on. There are players in each segment either disintermediating or intermediating to offer better customer solutions or to fix market failings. The innovation that is occurring in the small business loan market is arguably behind that of other areas in financial services – but the momentum is strong and accelerating.

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