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Special Report Businesses Are Poised for Growth
Good News: Small Business Confidence Surges Small businesses are on an upward trajectory: · Anticipated small business loan demand is at its highest level since 2012, with 48 percent planning to take out a loan in the next 12 months
·
Nearly two-thirds of small businesses (65 percent) anticipate an
increase in sales, compared to just 5 percent that expect a decrease
·
Small
business economic confidence ratings outpace those of consumers by more
than two times (43 percent vs. 21 percent)
SOURCE: PayNet / Raddon 2018
Small
businesses are in full-on growth mode. They’re looking to banking
partners for reasonable capital infusions, but are discouraged by slow
reviews, impersonal processes and denials. This creates a huge
opportunity for nimble alternative and fintech lenders to fill the void.
Downside: A Small Business Credit Gap
Following the 2008 financial crisis, a combination of regulatory and
risk factors lowered credit volume among larger financial institutions,
hampering the pace of recovery. The lingering effects of these factors
continue to hamper small business growth today.
Closing the Gap in Small
Business Lending
U.S. small businesses employ almost half (48 percent) of the civilian
population. These 5.9 million non-sole-proprietorships also are
responsible for 41 cents of every dollar earned by American workers. In
essence, 40 percent of consumer spending power is a function of small
business employment.
However, with the Great Recession now a decade past, recent findings
show that small businesses’ lack of access to credit – their lifeblood
for investment – played a notable role in the modesty of the economic
recovery. As Figure 1 shows, annual GDP growth averaged 2.1
percent through 2017 versus 3.0 percent over the three previous decades.
Figure 1: Annual GDP growth has been modest during the recovery
To wit, a 2017 study from Harvard University, The Decline of Big-Bank
Lending to Small Business: Dynamic Impacts on Local Credit and Labor
Markets, found a significant contraction in the supply of credit to
small businesses during and following the recession. That development,
by many indications, persists today. The study found that, although all
banks have reduced their small business lending activity since 2006, the
major banks pulled back the most. (See Figure 2 below.) Even though this
dynamic opened the door for fintech lenders, these firms did not have
the market presence or capacity to amply fill this “credit gap.”
Ultimately, the reduced flow of small business credit contributed
significantly to lower employment, wages and economic activity as the
recession ended. In fact, Harvard’s report found that 14 percent of the
rise in unemployment from 2006 to 2010 was a result of the small
business credit gap, which equates to over 1 million jobs lost during
that period!
Figure 2: Major banks have pulled back on small business lending and
remain on the sidelines
While a variety of factors – including high charge-off rates, increased
capital requirements, heightened regulation – influenced the larger
banks to decrease small business lending, the central challenge remains
the inability of financial institutions to profitably extend loans with
terms and conditions that are attractive to small business borrowers.
Our joint research finds that a key factor preventing community
institutions from closing this gap is the loan process itself. A
time-series analysis by PayNet of the traditional loan process – a
largely human-intensive process still deployed by many lenders today –
exposed two critical issues with these outmoded processes.
The first is cost: High costs to underwrite and review loans make it
financially prohibitive for lenders to meet the needs of small business
borrowers. Consider that 95 percent of small businesses seek loans of
less than $250,000; the average loan amount sought is only $75,000.
Using PayNet’s process costs and applying some standard cost assumptions
for funding, a net-present-value analysis by Raddon shows that a
financial institution would need to charge an interest rate of 9.49
percent just to break even on a five-year loan for this average loan
amount. Would a small business borrower view an interest rate north of
10 percent as competitive today? Likewise, charging a 5.00 percent
interest rate on a five-year loan with the same process and funding
costs would entail a breakeven balance of over $860,000 – substantially
higher than $75,000.
The second issue is a combination of time and effort: Inefficiencies
result in a challenging application process and long duration – 30 days
or more in too many instances – to adjudication. These are untenable for
potential borrowers (especially those requesting a modest loan amount).
Indeed, according to the Federal Reserve Bank’s 2015 Small Business
Credit Survey, 52 percent of small businesses cited the difficult
application process and 43 percent cited the long wait for a credit
decision as sources of dissatisfaction when they sought to borrow from
small banks. And the 2018 Small Business Survey from Raddon revealed
that 47 percent of small businesses agreed with the statement, “Getting
a business loan is a long and difficult process.”
These economics and sentiments demonstrate a key source of the credit
gap. They also illuminate the need for small business lenders to examine
and streamline (i.e., modernize) their loan processes to compete
effectively in this space. Certainly, technology (think APIs, data
analysis) plays an important role here, but institutions should also
assess resource allocation, asking themselves if they are spending the
same time and effort on a loan that is one-third the size or risk of
another loan. They need to explore additional data investment that can
better inform and advance credit decisions as well.
Ultimately, a vibrant small business arena helps the economy thrive. But
the research shows that a broken credit system is inhibiting the full
potential of this space. Institutions that can close the gap in their
own loan processes (the aforementioned fintechs should be emulated
rather than feared) will be better equipped to capitalize on the clear
opportunity at hand. And perhaps faster, simpler, safer credit for main
street America will enable a stronger recovery from the inevitable next
recession.
Small
Business Reports
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