Small businesses are one of the most important pillars of the US economy. They employ 47% of Americans and contribute $5.9 trillion to total GDP. The nearby grocery store, the corner auto repair shop, or the pizzeria down the street are constants in our lives—and at the heart of local communities across the country. But times are tough and the future less certain than usual. The pandemic has exacerbated an already existing challenge for small businesses: access to credit.
This problem has been on the radar since the global financial crisis, when traditional lenders tightened their credit requirements and abandoned small businesses. In recent years, fintech lenders have stepped in to bridge the gap by bringing updated underwriting and credit rating practices to the table, but a gap in small business lending remained. And the pandemic has pushed the issue further. The government took immediate action to ensure the flow of credit, launching initiatives such as The Paycheck Protection and Economic Injury and Disaster Loan and Programs. A recent proposal included in the Build Back Better Act includes a $1.9 billion direct loan program to be administered by the Small Business Administration (SBA). It would fall under the current 7(a) program and be spread over the next 10 years to meet smaller loan needs below $150,000.
The proposal highlights a key issue that needs attention: if small businesses don’t recover from the coronavirus pandemic, the rest of the economy won’t recover either. However, it is flawed in that it underestimates the importance of tackling the root causes of small business’ poor access to credit, particularly for smaller loans. It’s not that creditor pools and creditworthiness are inadequate. It is about the ability of existing creditors to accurately assess the creditworthiness of applicants. In addition, lenders have difficulty processing smaller loans profitably. Due to the thin files of SMEs, the processing and risk costs are not high compared to the amount they earn on these loans. Faced with a flooded demand side of the market, they have followed the same processes. Instead, they need to automate data sharing and underwriting.
The last time the government discussed a direct lending program (yes, it was on the agenda before – back in 2010). Karen Mills, the administrator of the SBA and now a senior fellow at Harvard Business School, supported the notion that the key problem was the ability of small businesses to provide sufficient financial data for a loan. “We can make them bankable by helping them with their package.”
In other words, the problem with small business lending is that small businesses cannot provide a satisfactory loan package with data that the bank can understand and lend against. Take, for example, a four-month-old company that was founded to sell home improvement supplies online. You now need $40,000 for marketing and online advertising. Although their business is thriving, it is unlikely that they would be able to secure funding through traditional methods due to their limited time trading. However, by having access to their accounting, banking and trading data, banks would have more confidence in their ability to fund the business while judiciously managing risk and minimizing costs. Given that small businesses cannot provide lenders with enough data to validate their existing process boxes, all parties benefit from solutions that enable richer, real-time data and provide a more accurate picture of creditworthiness.
There are other reasons why a direct lending program isn’t the best idea. For one, it would face practical challenges. Since it has not offered any loans directly in the past, the SBA naturally does not have the necessary infrastructure (systems, trained lenders, computer systems) readily available. The current proposal would have the SBA work with Community Development Financial Institutions (CDFIs) to process the loans and earn a fee while the SBA holds the loan and handles the rest. To manage all this, an online loan portal would be created. It is not unreasonable to assume that staffing, training and setting up back-end computer systems for the program could take at least a year. But time is pressing. As we all know, small business owners are time-poor. You need smooth and efficient access to capital. Especially after the delays and hiccups in various PPP programs earlier this year.
Supporters of the SBA direct lending program have argued that banks and existing creditors are no longer able to support small businesses. They don’t seem to know that over 24,000 lenders have participated in the PPP and hundreds in the 7(a) loan program. Lenders today are well capitalized and committed to small businesses. What they need, however, is better digitized data that allows them to automate underwriting for smaller loans and access real-time insights. This would speed up the process and reduce manual errors while providing a richer data picture. It is the main thing that will help existing lenders meet the need for smaller loans.
A small business public lending program could make sense sometime in the future when the free market fails. But the credit demand is urgent. Small businesses today are trying to rebuild better. You need a loan application process that is as clear, efficient and fast as possible. In other words, it is not the time to introduce a new direct lending system. Instead, our collective energy and efforts — private industry, the SBA, and publicly elected officials — should help make today’s system work better.