How to Boost U.S. Small Business Lending? Look to the UK

The following piece by me ran today in Ideas Lab: http://www.ideaslaboratory.com/post/104665004574/boosting-small-business-lending-look-to-the-u-k

After a recent public consultation with the business community and financial services industry, the U.K. government has decided to enact a law that requires large lenders to share information with alternative and smaller lenders about small and mid-size enterprises (SMEs) whose credit applications have been rejected. The sharing of such information — which, in addition to loans, would cover factoring, asset-based lending and trade finance — would occur via online referral portals that help match the rejected SMEs to alternative lenders.

The legislation hits a market failure between the eyes: good, credit-worthy companies unable to access capital due to lack of information about best-fit alternative lenders. It matters: the largest four U.K. banks (Lloyds Banking Group, the Royal Bank of Scotland, HSBC and Barclays) account for more 80 percent of U.K. SMEs’ main banking relationships. In the wake of the financial crisis, banks have typically tightened their underwriting criteria — yet most U.K. SMEs only approach their main bank for finance. An estimated 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 U.K., just like the United States, has seen the rise of alternative lenders, such as peer-to-peer lending and crowdfunding platforms. The U.K. government reasons that 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. Pressed by regulatory heat, U.S. banks too are less interested in small business loans, and will be even more reticent as Basel III capital requirements go into effect in 2015. When asked to name the most severe obstacles to growth in a May 2013 survey by the Federal Reserve Board of New York, 49 percent of 670 surveyed SMEs listed access to capital as the leading challenge.

Across the United States, 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. The number of loans of $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.

Financing gaps are a big deal. Access to capital is key to companies’ growth, which is key to economic growth. SMEs make up 99 percent of all 28 million companies, employ more than 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. They also fuel innovation and competition. 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 working capital loans to fulfill large foreign orders, accounts receivable financing to fuel their cash flow and growth capital to scale internationally. American SME manufacturers cite lack of capital as the number one hurdle to trade. This problem will intensify as the exporter shrinks: increasingly, U.S. exporters will be micro-businesses selling products on eBay around the world, and with scant prospects to access bank loans.

Savvy lenders and investors would counter that many companies just aren’t credit-worthy even under the most lax underwriting criteria. That is certainly the case: some companies just won’t pay back their loans. But if U.S. small businesses are anything like the U.K.’s, they too are underserved by banks — and they too could still secure loan from a non-bank alternative, if they just knew where to go and had time to sort through alternatives.

The timing for a referral law is right. The United States has a vibrant, growing market of alternatives to banks, such as online lending and financing platforms. Platforms like OnDeck andDealstruck offer small business loans of up to $250,000; Biz2Creditand BoeFly seek to match small businesses to lenders across the nation; and Kabbage helps companies secure credit lines of $500 to $100,000. While the effectiveness of these platforms needs to be better analyzed, they do 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, borrowers typically pay a premium in the form of higher interest rates.

There are also countless crowdfunding platforms that match companies to lenders and investors, typically for larger capital raises.

How would a “referral law” similar to the U.K. legislation work in the United States? The U.K. bill offers a blueprint:

  • Only large lenders are required to forward details of SMEs they reject for finance; smaller lenders with less bandwidth can do it voluntarily.
  • SMEs will be in charge — their information will be shared on alternative lending portals only at their consent.
  • 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.

Of course, in the United States, a referral law could be more about carrots than sticks. For example, banks that refer small businesses they reject could be rewarded with tax deductions and breaks.

Why not leave referrals to the market? Because the market won’t do it alone: there is little in it for banks, unless of course they believe the company will remember the good deed and one day return as a client. Referrals are personality-driven: some bankers love to do it, many don’t bother. And even if it is done, a banker’s network may not include lenders that would be the best match for the small business. With a mandate, everyone would have to bother.

In the U.K., larger lenders worry about referring non-viable businesses: this serves no one and costs banks credibility and relationship capital. But this is not hard to manage — it would be best for everyone if the referral platforms categorize the SMEs by financial ratios and credit scores. Risk-loving lenders could then pick riskier deals, risk-averse ones the safer ones. Some deals will just remain unfunded.

The U.K. has recognized non-bank and online lending as a legitimate and powerful source of financing. Why shouldn’t we? American SMEs win, and so would the economy.

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