Why banks are closing their doors to small business borrowers

Feeling excluded?

More than six years have passed since the height of the 2008 financial crisis, yet America’s biggest banks still have an image problem. From continued reports about the less-than-savory business practices that contributed to the recession, to consumers’ not-distant-enough memories of dreams and investments lost, it’s no wonder these banks are desperate to appear Main Street friendly.

“For political reasons, for marketing reasons, big banks clearly want to represent that they’re very friendly to small business,” Ami Kassar, founder and CEO of MultiFunding, told The Huffington Post.

Banks today hold onto the claim they are increasing lending to small business, even while entrepreneur experiences and hard data tell a different story.

Rhetoric vs. reality

Talk to any small business owner who has applied for a loan lately, and you’ll hear a very different tune when it comes to the state of lending recovery. The majority sentiment among entrepreneurs is that if you need a loan, going to a traditional bank is mostly a waste of time. A recent working paper from the Harvard Business School gives a more objective picture:

“In an absolute sense, small business loans on the balance sheets of banks are down about 20 percent since the financial crisis, while loans to larger businesses have risen by about 4 percent over the same period.”

So what exactly has led banks to close their doors to small business lending, and is there any hope for a reversal of the trend? Let’s take a look at the biggest factors contributing to the small business credit gap.

The decline of community banks

There was a time when small business owners had personal relationships with managers at their local community banks. The opportunity to know and trust a local entrepreneur’s reputation offered community bankers solid qualitative data when credit histories and other quantitative records didn’t tell the whole story.

Texas real estate developer Joy McKenzie-Smith attributes the success of her business to such a community bank experience:

“I remember walking into the local bank wearing my best suit and just about every piece of good jewelry I owned. I knew I needed the loan officer to believe in me personally and in the project so he would advocate for us before the loan committee. There’s no way we would have been eligible on paperwork alone. It took relationship building along with every bit of collateral I had, which wasn’t much, to finally be approved.”

But a decades-long trend toward consolidation of community banks by national corporations means such an opportunity is rare for today’s small business owners.

According to Karen Mills, former administrator of the U.S. Small Business Administration and primary author of the Harvard Business School’s recent working paper, the number of local community banks has dwindled by 50 percent since the mid-1980s — from more than 14,000 nationwide to fewer than 7,000 independent community banks today.

That spells trouble for modern entrepreneurs, who present inherently risky business models more reliant on the grit of the business owner than on any quantitative factors to succeed. McKenzie-Smith knows how lucky she is. “I had to pledge everything except my two daughters to acquire that first loan,” she said. “But a successful project and an ongoing relationship with my local banker helped to build a very lucrative family business that endured for over 20 years.”

Regulatory challenges

Government regulators are another popular scapegoat for the lending freeze. Some in the financial industry have claimed that standards for business loans became more stringent after the 2008 financial crisis. On paper, that’s not exactly true. The majority of the regulations haven’t changed. For example, standards for business loans secured by accounts receivables have remained unchanged since March 2000.

What has changed since the recession, however, is government regulators’ involvement with enforcing these standards. Prior to the financial crisis, banks were mostly left to their own self-regulatory devices to interpret and enforce lending rules. Now that government entities have become more involved, regulatory compliance for collateral-based commercial loans has become too expensive for most banks to find them worthwhile — especially for smaller loans, which individually bring in smaller revenues.

Size matters

Loan amounts are cited as yet another strike against small business borrowers in the current climate. Since regulatory and transactional fees for banks don’t change proportionate to the size of the loan, bigger loans mean bigger profit margins. And because the average small business is seeking less than $100,000 in funding, that depreciated profit margin means driving available capital toward small businesses can ultimately hurt the bank’s bottom line.

As a result, according to Mills’ working paper, “some banks, particularly larger banks, have significantly reduced or eliminated loans below a certain threshold.” Others, she says, have simply cut out small business lending altogether.

The eligibility issue

Regulatory costs, small profit margins, the disappearance of personal community relationships — with so many challenges stacked against small business lending, it’s easy to see how the banks’ standards for approving small business loans have become nearly prohibitive.

When the cost of doing business becomes so high, banks have little incentive for betting on anything less than a sure thing.

And in the world of small business lending, does a sure thing even exist? Sure, the banks say they’re willing to take the leap when the right opportunity comes along — but they’ll likely be waiting a long time.

Yet every day, as banks continue waiting for their golden ticket, a growing crop of would-be entrepreneurs waits to make their small business dreams come true.

Like McKenzie-Smith, these folks aren’t what traditional banks would call the perfect candidate, but they are willing to put everything they have on the line just for a chance at success. If the banks are unwilling or unable to meet the needs of these less than ideal borrowers, it might be up to the emerging alternative lending markets to satisfy demand.

Image by: Kecko via Compfight cc

Meredith Wood
Meredith Wood is the Editor-in-Chief at Fundera, an online marketplace for small business loans that matches business owners with the best funding providers for their business. Prior to Fundera, Meredith was the CCO at Funding Gates. She is a resident Finance Advisor on American Express OPEN Forum and an avid business writer. Her advice consistently appears on such sites as Yahoo!, Fox Business, Amex OPEN, AllBusiness, and many more. Meredith is also the Senior Financial and B2B Correspondent for AlleyWire.