Small Business Lending is dead (Or at least on life support)

by Larry Baker

It is no secret that banks are having an awful time lending to small business. After all, they are extremely risky and are typically hit hardest by economic down cycles. But is it a question of risk or is it a larger fundamental flaw in the way traditional brick and mortar financial institutions are structured? 


The traditional banking method of originating a small business loan is broken. Lending institutions are forced to rely on imperfect barometers of the health of a business (i.e. the FICO score of the business owner). The FICO score is merely a datapoint that in some cases may shed some light on how financially responsible an individual is with their money (i.e. can I trust that you won’t screw me if I loan you this money). But the business owners FICO score has no baring on whether that business has a good product, strong sales, a growing customer base, or is an overall healthy business.  How did we get here? Over time bankers have lost sight of one of the C's in the 5 C's of lending, Character. A significant amount of time and diligence is necessary to get a good bead on an individuals character. Because small business loans are inherently low in volume, the cost of originating a small business loan often does not justify the economics on the loan. Thus, banks have defaulted to relying on a small business owners credit score.

So where does this leave us? Without government subsidies (i.e. SBA loan guarantees), the traditional lending model for small businesses falls flat on its face. Late last year SBA Administrator, Karen Mills, said:

"We were able to raise the guarantee on SBA loans to 90%, and reduce or eliminate the fees. It worked. SBA lending roared back. We were able to bring 1,200 lenders back to SBA lending who had not made a loan since 2007. SBA lending quickly went back up to pre-recession levels as we helped to fill the gap in the marketplace."

This is a staggering statement that demonstrates the fundmental flaw that has evolved. The fact that the traditional small business lender has to rely on near risk-free subsidies to exist, spells trouble for the future of small business lending. It is clear that reform is needed, and alternative funding vehicles are going to become increasingly important.