Commentary

To Boost Small Business Credit, Think Small (Banks)


The Denhart Baking Co. located in an old bank building on the town square in Washington, Ill.

Photograph by Bruce Leighty

The Denhart Baking Co. located in an old bank building on the town square in Washington, Ill.

In the years preceding the financial crisis, big banks controlled a growing share of the small business loan market, rising from just over 31 percent in 2005 to nearly 39 percent in 2009, according to Small Business Administration data. Over the last two years, that trend reversed, dropping to just under 38 percent in 2011.

While it’s too early to tell whether this is just a blip or a shift back to the way things used to be, the decline in market share is actually good news for small business owners. That’s because their access to bank credit improves when the market isn’t dominated by behemoths, as this Journal of Banking and Finance article points out.

Bank credit, as you probably know, is crucial to small businesses seeking to grow. Roughly one-third of entrepreneurs borrow from banks when they need expansion capital, according to the most recent Census data. That’s more than any other source of external capital. Yes, small business owners have increased their reliance on credit cards, but the average bank loan is much larger than the average credit-card loan.

With the value of small business bank loans declining 19 percent in inflation-adjusted terms between 2008 and 2011, small banks need to recoup market share if lending to small companies is to rebound. It’s easier for small businesses to borrow from small banks compared with big banks, for a few big reasons.

To start, small lenders are less likely than their bigger counterparts to focus solely on credit scores and financial statements during the evaluation process, and more likely to rely on small business owners’ character and relationships, according to this 2004 Journal of Financial and Quantitative Analysis study (PDF). The tendency to rely on soft factors helps small business owners whose creditworthiness is often better than it looks on paper. Relying on measures less affected by macroeconomic trends helps over the long haul, too: A recent Federal Reserve Bank of Boston study (PDF) shows smaller institutions’ lending to small businesses stayed stable while that of big banks dropped during the Great Recession.

Small financial institutions can afford to pay more attention to small businesses than large institutions do, despite all the lip service sparked by politicians. In 2010, the latest year data are available, lenders with less than $100 million in assets lent 87 percent of their total loan value to small businesses, as compared with only 26 percent for banks with more than $50 billion in assets. Given their size, giant banks must make large loans to big companies or they cannot operate efficiently. And should the big banks’ bets in Greece or Italy misfire, small borrowers who are performing fine could find themselves affected, as this Federal Reserve Bank of St. Louis article explains.

Yes, big banks have several advantages in lending money to small businesses. Their scope allows them to more easily offer cash management services, letters of credit for exporting, and other ancillary products. And their scale allows them to invest in the fixed costs necessary to make asset-based loans or loans against accounts receivable. Despite these advantages, the main reason for small business owners to choose small banks in their communities is obvious. They’re more likely to lend them the money they need, just like George Bailey’s building and loan did in the Jimmy Stewart classic It’s a Wonderful Life.

Scott_shane
Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

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