By Karen Mills
Aug. 11, 2014
Harvard Business Review
Ever since the early days of the recovery, it’s been a common refrain that Wall Street was able to emerge from the Great Recession while Main Street was left behind. It’s more than just rhetoric.
Main Street has in fact been slower to recover from the recession, and much-needed capital on which small businesses rely has been in shorter supply. Factors ranging from weak demand to bank consolidation have combined to hobble many small businesses – and if these factors aren’t addressed, they could continue to impede U.S. job growth and economic security.
In short, the health of American small businesses depends significantly on credit. And as we describe in a recent HBS Working Paper, gaps remain in traditional bank credit supply.
It’s worth remembering why small business matters in the first place: small firms employ half of the private sector workforce—about 120 million people. Since 1995, small employers have created about two out of every three net new jobs—65%of total net job creation. Small businesses are also instrumental to our innovation economy; small firms produce 13 times more patents per employee than larger firms and employ more than 40% of high technology workers in America.
Moreover, small firms are core to America’s middle class and part of the fabric of Main Streets across our country. Even though we cannot say for certain the extent to which new businesses generate middle class jobs, we do know that company founders come from the middle class themselves. According to a Kauffman Foundation study, 72% of entrepreneurs surveyed come from self-described middle class backgrounds, and another 22% reported being from “upper lower class” backgrounds.
But the strength of small business is dependent on the availability of bank loans, and the evidence suggests this critical funding may be drying up.
The majority of small businesses rely on such loans, and in the fall of 2013 alone, 37% of small businesses applied for credit. (Another 20% might have, but were discouraged from doing so because they believed they wouldn’t get the loan, or because the process was too arduous.)
Yet small business lending has declined steadily since the recession.
In contrast, loans to larger firms have risen every year since hitting bottom in 2011, and are now up about 4% since that low point.
The reasons for this decrease in small business lending are many, and in our research we discovered plenty of disagreement over the causes. Bankers, for their part, allege that they are anxious to do more small businesses loans but are finding a shortage of credit-worthy candidates.
The most useful way to sort through the various causes is to distinguish between the cyclical and the structural. Small business sales were hit hard during the crisis and may still be soft, undermining firms’ demand for loan capital. Financial crises hit sources of collateral like real estate particularly hard, and this has negatively impacted smaller firms’ credit scores. Banks remain relatively risk-averse amid the tepid recovery. And increased banking regulation may be forcing banks to be more risk adverse and to conserve capital that might otherwise have gone toward small business loans.
These are all cyclical factors that we might expect to improve with the economy over time. In contrast, several longer-term structural factors are contributing to the dearth of small business lending.
In comparison to larger firms, small businesses are less well equipped to efficiently navigate the loan process – in economic parlance, their search costs are higher. And for banks, the transaction costs of a loan tend to be the same regardless of the loan’s size, such that larger loans are a more efficient use of time and resources.
Finally, the number of community banks – the most likely institutions to lend to small firms – appears to be in decline. Most of the banks shuttered during the recession were community banks, and new ones have not materialized to take their place.
Taken together, these trends are cause for concern, as they may threaten the viability of U.S. small businesses. But there is also reason for optimism.
Since the onset of the financial crisis, and particularly during the economic recovery, there has been significant growth in innovative alternative sources of loan capital to small businesses, driven by technology. Emerging online players like Funding Circle, LendingClub, and Fundera are stepping into the void left by the consolidation and retrenchment of the banks, and pushing innovation within the banking sector just as Amazon changed retail and Square changed the small business payments business.
The growth of these alternative lenders is driven by more than just a greater appetite for risk. Alternative lenders are innovating in small business lending, particularly in terms of simplicity and convenience of the application process, speed of delivery of capital, and a greater focus on customer service.
For example, all of the biggest players emerging in the alternative lending space offer online and mobile applications, many of which can be completed in under 30 minutes. These are not just inquiries; these are actual loan applications, which compares to the average of about 25 hours that small businesses spend on filling out paperwork at an average of three conventional banks before securing some form of credit. Upon filling out an online application, borrowers can be approved in hours and have the money in their account in just days, whereas in the conventional banking model small business owners may not have their loans approved for several weeks. Some of these services are also relying on broader sources of data, combined with new methods of predictive modeling, to better assess creditworthiness.
These lenders vary along several dimensions – you can read more about them in our full report – but together they offer hope that the small business credit market may be being reinvented. These entrants may also push traditional lenders such as large banks and credit card companies to adopt new innovations, and use their large stores of borrower data and existing relationships with small businesses as a competitive advantage.
These developments, while promising, are not without risks. Although the online small business lending market is in its infancy, there is already disagreement over the appropriate level of regulation. On one side, many view the new entrants as disruptors of an old and inefficient marketplace, and caution against regulating too early or aggressively for fear of cutting off innovation that could provide valuable products to small businesses and fill market gaps.
But, on the other side, there is already concern that, if left unchecked, small business lending could become the next subprime lending crisis, as was recently pointed out by Bloomberg BusinessWeek in an article that has garnered significant attention in the industry. Traditional players, including community banks, are weighing into the debate as well, fearing that stronger regulatory oversight in the wake of the recession is leaving them less competitive relative to new entrants that have to date operated in largely unregulated markets.
The diversity of models in alternative lending cautions against a one-size-fits-all approach to policy; different approaches must be treated differently. Still, the need for transparency and oversight is clear.
The policy challenge is to ensure that these new marketplaces have sufficient oversight to prevent abuse, but not so much oversight that the innovation is dampened or delayed.
In the wake of the worst recession since the Great Depression, the state of American small businesses is precarious. Neither sales nor employment have fully recovered, and credit seems harder to come by. The potential of new technology to fill the gaps in small business lending is high. In fact, we may be seeing a technology disruption in small business lending along the lines of what we’ve seen over the last few decades in industries like travel and media. If it’s successful, small businesses will have more opportunity to what they do best—grow the American economy and create jobs.