It’s no secret that within the last 7 years big banks are failing to loan money to small businesses. In fact, according to the Federal Reserve Bank of Cleveland, the number of commercial and industrial loans dropped by 344,000 from 2007 to 2012, even though the number of these types of small businesses increased by 100,000. And, the numbers reflect a similar pattern of decline across all industries.
As a small business owner, trying to get funding from a large bank may be a major point of frustration. In an effort to help shed some light on why big banks are failing to lend, this article will discuss what small business loans are, the major reasons for the decline in big bank funding to small businesses, and potential alternative lending options for small business owners.
What is a Small Business Loan?
There are a few types of small business loans available today that range anywhere from $1,000 to 10 million or more, although today the term is widely understood as any business loan under 1 million. A borrower can receive funding from private or alternative lenders or they can receive funding from a bank. Depending on the credit of the borrower and the circumstances surrounding the loan, the bank can either lend all of the money at the bank’s risk, or have part of the funds backed by the SBA.
An SBA small business loan is still a widely used financial instrument today although the availability of these loans have decreased significantly since 2008 as did overall bank lending to small business. According to the U.S. Small Business Administration, when it comes to small business loans, there are very specific terms that are negotiated between a borrower and an SBA-approved lender. These loan terms vary depending on the type of loan, but include requirements for fees, interest rates, and percentages per guarantee. The borrower must also meet very strict requirements such as corporation type, personal investment thresholds, and several other qualifying factors. Ultimately, these terms set limitations on SBA-approved lending.
SBA loans are somewhat diverse in the types of businesses they can provide a small business loan to if the company meets certain requirements. In fact, according to the U.S. Bank, SBA loans can provide financing for almost any business purpose, and loan amounts typically range anywhere from $250,000 to $11.25 million.
While SBA loans are diverse in the type of business they can approve funding for, it’s important to understand that the SBA doesn’t loan money directly to borrowers. Rather, the SBA sets up guidelines for loans that are negotiated with SBA-approved partners (mostly big banks), and the SBA will guarantee a portion of the loan.
For example, the SBA can guarantee as much as 85% on loans of up to $150,000 and 75% of loans of more than $150,000. In terms of maximum exposure amounts, the SBA’s maximum is $3,750,000. In other words, if a business receives an SBA-approved loan for $5 million, the maximum guarantee will be $3,750,000 (or 75%).
The chart below represents other SBA provisions on common types of business loans.
|Loan Type||Maximum Loan Amount|
|SBA Express Loans||$350,000|
|SBA Export Express Loans||$500,000|
|SBA 504 (For Asset Purchases)||$6,000,000 (for Wells Fargo portion of loan)|
|SBA Microloan Program||$50,000|
|SBA 7(a) and 504 Loans||$11.25 million|
As you can see, when it comes to borrowing from a big bank that negotiates terms with the SBA, there are strong guidelines that must be followed. This makes borrowing and lending in the traditional world of big banking much more difficult. Not only is lending difficult under SBA requirements, since the financial fallout banks have been subject to stricter regulations lending under any circumstance.
Reasons for The Decline In Small Business Lending
- Lending Standards Have Tightened
Because of increased government regulations, banks have been forced to significantly tighten their lending standards which has resulted in the decline in small business loans. In a recent Huffington Post article, representatives from four of the nation’s biggest banks (Bank of America, Citibank, Chase, and Wells Fargo) shared what requirements they have for issuing a small business loan. Here are some of the most interesting highlights.
Common criteria to secure a small business loan:
- 20 million in revenues or less
- Need collateral
- Excellent credit (700+ FICO)
- Proven ability to pay back loan
- Reliable cash flow
- Manageable debt load
- Solid payment history
- Long-term relationship with the bank
While these are all certainly good criteria for banks, they are also inherently problematic for many business owners for a few reasons.
First, people don’t often start their businesses with a lot of reliable cash flow or a long and solid payment history to the bank. That’s why business owners need a loan in the first place. It’s difficult to meet the financial expectations they are requiring before you have even started your business.
Second, many small business lenders don’t have long-term relationships with banks due to age of the company, the inability to secure previous business or personal loans, or poor credit history.
Finally, more than 75% of Americans have a credit score below 700, which is not high enough to receive a traditional bank loan, especially with a decent interest rate.
All of these factors work together to make it difficult for small businesses to get funding from big banks. While tightening traditional lending standards helps protect banks from losing money, it does little to help small businesses thrive, allow job creation to continue, or give small businesses the money they need in order to grow a business.
- Small Businesses Are Less Creditworthy Than They Used To Be
While it’s easy to point fingers at big banks and the federal government, a large portion of the fault does in fact lie with borrowers. As mentioned above, more than 75% of Americans have a credit score below 700, and this isn’t the only problem lenders face when it comes to determining loan worthiness.
According to Forbes.com, a borrower may not even have a debt-to-income ratio of greater than 43 percent when applying for a loan. Additionally, there may be large gaps in employment status, income history, credit history, other outstanding debts, bankruptcies, and other types of no interest loans that they need to account for when determining whether or not to issue a loan.
While it’s true that many business owners have fallen behind on their bills because of economic hardship, it is still the responsibility of business owners to prove they are worthy and capable of making money and paying back loans. It’s difficult for a big bank, especially one that needs to follow stringent regulations, to justify lending to someone with multiple negative marks in their credit and financial history.
In the event that a borrower with a lower credit score does secure funding from a big bank, the lower their credit score is, the higher the interest rate will be. This only further perpetuates the cycle and often results in problems paying back the loan quickly or according to the original loan terms.
It’s true that there are many reasons for the decline in small business lending from big banks, but some of the fault does in fact lie with the nationwide decline in good credit history.
- Banks Have Shifted to Larger Loans To Make More Money
Finally, another top reason for the decline is that big banks have shifted their attention to larger loans in order to make more money. Since new regulations have been imposed on big banks, it has made running a bank much more expensive than it was in the past. As a result, big banks will typically fund projects that will make them more money, rather than focusing on smaller businesses that take just as much time and attention, but aren’t as profitable for the bank.
As an example, Harvard Business School reports some of the reasons why a big bank will opt to fund a larger business than a small business. They note that the cost of processing a $100K loan is the same as processing a $1M loan, and often results in less profit. Some of the reasons they cite include high failure rates of small businesses and varying use of borrowed funds, among others. The bottom line is it makes more sense for a big bank to invest in a bigger business loan than a small business loan. Recent data also supports this claim. According to the FDIC, loans that total less than $1M have been steadily declining the past 15 years.
When it comes right down to it, lending to small businesses is just more risky and less attractive for big banks. So what should a small business owner do if they need financing?
What is Alternative Lending?
While it is possible to get an SBA-approved business loan, thankfully, there are also other options: a result of creative money lenders interested in providing additional funding sources as well as internet based platforms pooling resources from individuals and investors. These alternative options are unregulated in most ways and are very flexible in terms as well as the approval process. Alternative lenders include private lenders structured in various ways and supported by private and institutional investments, peer to peer lending, and crowdfunding which constitute the majority of business funding resources available in alternative lending.
As background, crowdfunding is when a project is funded by raising small amounts of money from a large number of people or sources. This usually takes place on the internet through the collective efforts of friends, families, and other interested parties. Top crowdfunding sites include Kickstarter and Gofundme.
Alternative lenders such as merchant cash advance companies or “private lenders”, on the other hand, are privately pooled funds from individuals or large investment groups such as Goldman Sachs or Google that lend to business owners that do not meet traditional banking standards. Some of the most popular alternative lenders include Shield Funding, OnDeck, and Can Capital. These companies typically lend anywhere from $5,000 to 1 million to small business owners that have a company generating revenue and do not meet traditional financing standards. The funding process is less restrictive and because the lenders do not fall under banking regulation the process for approving and delivering the funds is much quicker, and they can lend to any borrower of their choosing.
Prosper and Lending Club are another type of alternative lender that offers borrowers loans mainly off of their personal credit history. Loan amounts range from $1,000 to $150,000. These lenders are more selective than private lenders and merchant cash advance companies, but they offer funding at better rates.
Everyday more and more of these alternative lending companies surface with new and creative ways to fund people. These type of business funding options are a nice opportunity for small business owners for a few reasons. They don’t require the same type of collateral and guidelines as big banks who are operating under the hand of the government, the funding amounts are often more manageable, and the application process is simpler.
It’s true that over the past decade, there has been a large decline in banks lending to small businesses. There have been several factors that have contributed to this result with some of those reasons being mentioned above. While it is still possible to seek out small business funding from banks (provided you have excellent credit and a history with the bank), there are a large variety of alternative funding options available to borrowers that do not meet banking standards.