The metaphor has been repeated countless times: Small businesses (SMBs) are the backbone of the economy. So, access to capital isn’t just essential for these companies to survive — it’s critical for the economy to thrive.
Yet, the small business lending gap remains. For banks, the reason often comes down to profits. According to Bill Phelan, president of small business credit rating firm PayNet, banks aren’t interested in making loans under $800,000, but most small businesses are only looking for financing up to about $250,000.
In a new report, PayNet and financial research firm Raddon examined the state of small business lending in the U.S. While the analysis uncovered much to be optimistic about, their report also explored how this financing gap is slowing down economic growth and outlined the steps financial institutions (FIs) can take to address the gap.
In recognition of Small Business Saturday, Raddon and PayNet highlighted some of the key findings of their report, “Gimme Credit: Faster, Simpler, Safer Credit for Main Street America,” which found that small businesses’ struggle to access capital “played a notable role in the modesty of the economic recovery” post-Great Recession.
On the upside, researchers found small businesses’ demand for loans is at its highest level since 2012. Nearly half of all small businesses surveyed plan to take out a loan in the next year, and nearly two-thirds anticipate a sales increase (only 5 percent expect their sales to decline). In short, small businesses are feeling financially confident.
Yet, to invest in their growth, small businesses need financing. However, banks’ risk-aversion initiatives, and the inability to make sub-$250,000 loans profitable, have left SMBs high and dry.
“We all know banks are a key source of capital for small and medium businesses,” Phelan told PYMNTS in a recent interview. “What we didn’t know until this study was the size of the credit market for small businesses. It’s probably bigger than anybody really understands — in the trillions of dollars.”
Banks have not invested in their small business lending operations to improve the process for the borrower, though. As Phelan explained, the automation and digitization that has enhanced financial services across so many areas has failed to make its mark in small business bank lending. Researchers also found that most small businesses don’t have a dedicated CFO, nor the time and resources necessary to seek the credit they need.
All in all, the report found, the implications are huge — and not only for the small business community.
“What really stood out for me [in the report] is the gap, and its impact on the economy,” Phelan said, adding that small businesses in the U.S. are equivalent to an economy larger than that of France, Great Britain and Germany combined. A funding gap is a “serious impediment” to economic growth, he noted.
Filling The Gap
One of the most puzzling findings from the report, Phelan pointed out, is that the majority of SMBs bank with one of the nation’s top-six institutions, creating a disconnect in what they provide to banks versus what banks provide back. Seventy-one percent of SMBs put their capital into a top-six bank, yet those banks aren’t reinvesting that capital into their small business clients.
While it would be in banks’ best interest to fill this gap, thereby bolstering the resilience of the markets, traditional institutions won’t invest in unprofitable business ventures.
It is indeed possible to make small business lending profitable, however. According to PayNet and Raddon’s report, there are three key steps FIs can take: separate loan applications by size and segment, underwriting processes by loan-risk profile; implement technology to automate the application process and data collection to analyze business risk; and adopt industry intelligence to optimize the lending process.
Interestingly, the steps that traditional banks need to take to fill this credit gap have already been taken by the alternative FinTech market, which has introduced a standard to digitization, automation, speed and convenience for SMB borrowers. Alternative finance, though, while growing, makes up only a fraction of the broader small business lending space in the U.S. today.
According to Phelan, even so, FinTech firms are playing an important role in this market by lighting the way for banks to understand what they need to compete and improve their SMB finance offerings. It’s their emphasis on technology that really makes FinTech firms a leader in SMB finance, even if their share of the small business lending market remains minimal.
“Some banks are still using manilla folders, and they’re emblematic of the banks’ inability to adopt technology,” Phelan said. “[FinTech firms] are still a drop in the bucket, but they’re showing the way. They’re leading by putting their money to work. They’re taking risks and chances. … [FinTech firms] are the guiding light, showing the art of the possible, and showing how this technology could be [a] harness to lower the cost of delivering financial profits.”