The UK has it right on SME finance, and we in America need to emulate. After a recent public consultation with the business lobbies and the financial services industry, UK government has decided to enact a law that requires large lenders to share information with alternative lenders and smaller banks about SMEs whose credit applications these banks have turned down. The sharing of such information, UK has decided, should occur via online referral portals that display the rejected companies and help match SMEs to alternative lenders.
In addition to loans, the new initiative covers invoice discounting/factoring, asset-based finance, and trade finance.
This law hits a market failure between the eyes: good, credit-worthy companies unable to access capital due to lack of information about best-fit lenders, and vice versa. It matters: the largest four UK banks (Lloyds Banking Group, the Royal Bank of Scotland, HSBC and Barclays) account for over 80 percent of UK SMEs’ main banking relationships. Most UK SMEs only approach their main bank for finance; 37 percent give up completely if they are turned down, and only 28 percent approached different providers – and 12 percent used an existing form of borrowing, such as credit cards.
Meanwhile, the UK, just like the United States, has seen the rise of alternative credit providers – small banks and peer-to-peer lending and crowdfunding platforms. The UK government reasons, when one door closes, another one opens; SMEs now only need to be handheld from the former to the latter.
The United States needs to follow suit. We have a similar problem as the Brits do. Pressed by regulatory heat, U.S. banks are increasingly uninterested in small business loans, and will be even more reticent as Basel III capital requirements go into effect in 2015. SMEs are feeling the pain. When asked to name the most severe obstacles to growth in a May 2013 survey by Federal Reserve Board of New York, 49 percent of 670 surveyed SMEs (of up to 499 employees) listed access to capital as the leading challenge. Many SMEs that are nowadays turned down by banks are viable businesses; they just don’t fit banks’ underwriting criteria – yet have limited contacts to turn to.
Across the U.S., small-business lending disappoints. At the end of the second quarter of 2014, banks held $659 billion in loans to small businesses, up 1 percent from June 2013, but still 16 percent less than the peak of $711 billion in 2008 (figure 1).
Figure 1 – Small Business and All Loans Held by Banks, 2006-June 2014
The number of loans for $1 million or less held by banks is down about 14 percent to 24.6 million since 2008. Paynet estimates that nearly one-third of all U.S. counties, small business lending remains below 2005 levels.
This financing gap is a big deal. It hampers our companies’ growth – and that hampers our economy. SMEs make up 99 percent of all 28 million companies, employ over 50 percent of private sector employees, generate 65 percent of net new private sector jobs, and account for over half of U.S. non-farm GDP. If our economy is to grow, this giant segment needs oxygen.
The financing gap also hurts U.S. exports, a major growth driver. Empirically, a company’s export prospects are critically shaped by access to financing. Exporters need various instruments, such as export working capital loans to fulfill large foreign orders, accounts receivable finance to get paid in a timely fashion, and growth capital to expand production capacities at home to scale and serve international markets. But exporter SMEs cite lack of capital as the main obstacle to trade. And increasingly, American exporter is a micro-business selling products on eBay around the world, yet with scant prospects for bank loans.
The timing for a referral law is right. In our white paper earlier this year, we showed that the United States has a vibrant, growing market of alternatives to banks, first and foremost online lending and financing platforms. Platforms like OnDeck and Dealstruck offer small business loans of up to $250,000. Biz2Credit and Boefly seek to match small businesses to lenders across the nation. Kabbage helps companies secure credit lines of $500-$100,000. These platforms offer speed and higher odds of success than traditional lenders, approving an estimated two-thirds of the loan applications they receive within minutes or a few days. In exchange for the speed and convenience, borrowers typically pay a premium in the form of higher interest rates. There are also countless crowdfunding platforms that match lenders and investors to companies typically seeking equity.
How would such a law work? The UK law offers a blueprint, with the following components:
- Only large lenders are required to forward on details of SMEs they reject for finance; smaller lenders can be too burdened.
- SMEs will be in charge of the process: their information will be shared on alternative lending portals only at their consent.
- The information on SMEs will be limited to key business information, such as name, amount and type of financing sought, and legal structure.
- The referral portals need to meet certain standards to access the information.
- The referral portals will need to protect SMEs’ data and offer fair access to all SME lenders.
Here in the United States we need to think even bigger. Many companies are too nascent for lenders, or need too much capital to fuel their growth than any online lender could lend. Venture capital funds are not the answer: they are like banks, looking for more mature companies. Angels are a better bet, but only a fifth of deals considered by angels are financed. The many equity crowdfunding platforms are a good place to refer deals: they are an efficient means for investors find growth companies, but should also, like lenders and lending platforms, get access to deals rejected by banks.
Why not leave referrals to the market? Because market won’t do it alone: there is little in it for big banks to refer companies to other lenders, unless of course they believe the company will remember the good deed and one day return as a client. In our equity crowdfunding business TradeUp, we have found that referrals are all about relationships, and they are personality-driven: some bankers love to do it; many don’t bother. With a legal mandate in place, everyone would have to bother.
In the UK, larger lenders worry about forwarding on non-viable businesses: this serves no-one and costs banks credibility and relationship capital. But this is not hard to manage: best for everyone is for the referral platforms to categorize the SMEs by key ratios and credit scores – risk-loving lenders could then pick riskier deals, risk-averse ones the safer ones.
The UK has recognized non-bank and online lending as a legitimate and powerful source of financing. Why shouldn’t we? American SMEs win, and so will the economy.