Not that long ago, small businesses had personal relationships with their local banks.
But that was before the financial crisis of 2007-08 and the global economic collapse, followed by the consolidation of many institutions into fewer and fewer banks.
Today’s banks, more often than not, are national or multi-national entities that don’t see enough profit margin in giving out small business loans.
The number of loans issued by 10 of the largest banks in the U.S. has decreased 38 percent to $44.7 billion in 2014, the Wall Street Journal reports. This is compared to 2006, when it was at its peak at $72.5 billion, which was one year before the financial crisis.
A working paper published by the Harvard Business School, written by Karen Gordon Mills and Brayden McCarthy titled, “The State of Small Business Lending: Credit Access during the Recovery and How Technology May Change the Game” (PDF) goes into great detail about why there is a credit shortage in the small business sector and the impact it is having on the largest private workforce employer in the U.S.
This has led the authors to ask “Is there a credit gap in small business lending?”
According to the Federal Deposit Insurance Corp., as reported on the WSJ, loans to large companies has increased by 37 percent from 2008 to 2015. During the same period, banks of all sizes went from holding $711 billion in small business loans to $598 billion. This clearly answers the question the Harvard paper asks.
By contrast, the Biz2Credit Small Business Lending Index for October 2015 revealed large banks with $10 billion or more in assets have actually increased loans to small businesses. In the report, Biz2Credit CEO Rohit Arora explains, “As interest rates start going up, we expect further increase in the Big Banks appetite for small business loans. Big Banks are also warming up to buy more loans from the marketplace lenders.”
But what is important to remember here is the low overall approval rate for small business loans, which was at 49 percent for October of 2015 at big banks, the Biz2Credit index reminds us. So even though loan approvals are increasing at big banks, small businesses are still hearing “no” more than half the time.
The need for loans by small businesses along with the reluctance of large banks to give them has increased the market share of non-bank lenders from 10 to 26 percent. But some of the rates for these loans are quite high when compared to traditional loans.
The Wall Street Journal article has an example of a restaurant owner in Los Angeles who was charged rates above 80 percent by two online lenders for a $25,000 loan. He was forced to choose this alternative after he was turned down by the bank he had been doing business with for several years.
The large banks don’t see the benefit of making these small loans, because it takes just about the same amount of effort to originate small and large loans. For small businesses, it now means getting a credit card from the large banks with the amount needed. And considering how much the non-bank lenders charge, the 12.85 percent average real banks charge for credit cards make more sense.
So why have large banks lowered their loan approval rates when it comes to small businesses? The answer is increased regulation put in place after the financial crisis, decline in community banking and lower profit margins on smaller loans.
Jay DesMarteau, head of small business banking at TD Bank, told the Wall Street Journal, “We all struggle to make money on the lending side. It’s a lot of work to try and find these little companies, underwrite them and manage the book.”
As for the banks, they are working together with not for profit lenders to provide credit to small firms. So if you are a small business looking for a loan, ask the big banks if they have such arrangements before you go and apply with a non-bank lender online that could charge you 80 plus percent.
It is important to point out not all alternative lenders charge the rates highlighted by the Wall Street Journal report. So shopper be ware and take your time, because there are many alternative lenders out there.
Read the entire Small Business Trends article here.