By most accounts, the economy is improving. Unemployment is subsiding, retail sales are increasing and reportedly, the lending market is more receptive to new loan applications than it’s been in years — unless you happen to be a small business.
According to a May 13 report from American Banker, mid-size and larger banks approved less than 17% of small business loan requests between $25,000 and $3 million in April 2013. Small business loans fared somewhat better at smaller banks, where roughly half were given the go-ahead during the same period. Approximately 70% were approved by specialty finance firms prior to the economic collapse.
The opportunities presented by this obvious double standard haven’t gone unnoticed.
The New Alternatives for Funding
A fresh crop of venture-capital-backed alternative lending companies has sprouted in the small-business financing marketplace. Many take an algorithmic approach to the credit underwriting process. Some are even forgoing collateralization because of the high confidence they have in their formula-driven, automated systems.
The question is: are small businesses better or worse off as a result?
Some Internet-based finance companies don’t charge interest for a period of time, instead expressing the financing costs in terms of a whole-dollar percentage of a total amount borrowed, a system that payday lenders should be familiar with. Why? It may make the financing appear less costly. (There may also be a regulatory advantage as nonbanks hope to skirt statutory usury limits by minimizing or avoiding any mention of interest.)
I read about one that charges a $1,000 fee for a $10,000 advance (10% of the amount borrowed), $720 for a $7,200 advance (10% again), $280 for a $2,000 advance (14%) and $90 for a $500 advance (18%).
All things considered—no collateral, quick turnaround—these charges seem pretty reasonable, that is, until you calculate their equivalent annual percentage rates.
APRs mathematically combine interest rates, fees and the timing of the individual payments into a singular metric that can be more easily assessed and compared. In the aforementioned examples, the APRs work out to be 34.26% each for the $10,000 and $7,200 advances, 48.6% for the $2,000 advance and 63.3% for the $500 transaction — clearly, a very different story.
Where are the Big Banks?
As a former lender, I can understand the need to charge higher rates for micro-dollar loans. Not only does it take a whole lot of these things to pay the rent, there are also per-transaction costs that need to be covered regardless of the size of the underlying deal. But as a borrower, rates of this magnitude would give me pause—so much so that I’d be inclined to use a high-limit credit card instead (because the interest rate is less) while arranging to pay off the debt within the same six-month period.
What perplexes me, though, is the apparent willingness of the banks to cede small business lending to these higher-priced, formula-driven, venture-capital-backed startups.
Arguably, institutional lenders have access to the lowest-cost funds in the U.S. — lower than for the federal government when you take into account how little (if at all) they pay for the demand (checking) and short-term-time (savings) deposits that fuel their lending activities.
Moreover, according to the Federal Reserve’s most recent Senior Loan Officer Opinion Survey on Bank Lending Practices, underwriting standards have been easing, as have interest rate-spreads over institutional cost of funds.
So what are we missing here? If banks have good access to low-priced funds — which they seem quite willing to lend at favorable rates and terms — then why aren’t they putting these same resources to work in an area that has the potential to yield superior returns?
How a Small Business is Different
Perhaps it’s because banks actually prefer to do the larger deals.
Big companies are in a position to present the full complement of background financial information — audited balance sheets, P&L’s, statements of cash flows, projections and so forth — that are easier for the banks to analyze.
Small businesses are small potatoes by comparison.
The deals are smaller; financial statements are internally prepared à la QuickBooks; owner tax returns are more complicated; and quite often, there’s a sob story or two to tell. Also, smaller operations often blur the line between the personal and the professional via their ownership constructs, which has the potential to introduce certain regulatory wrinkles that the banks would prefer to avoid.
But are the same institutions that drove the economy off the cliff not long ago once again throwing prudence under the profitability bus by concentrating their best efforts and pricing at the larger end of the lending spectrum?
There’s no question that small business applications can be tricky to underwrite. However, loan pricing is more elastic and cumulative credit risks can be spread over the larger population of transactions — outcomes that would help to mitigate concerns the banking regulators are voicing at this time.
So for now, how can small businesses that are in decent financial shape negotiate for more reasonably-priced debt capital? By knowing their worth.
Many banks assess customer profitability holistically — the income the institution earns by lending out the average daily cash balances the customer maintains on deposit, the interest the company pays on its outstanding term loans and lines of credit, plus the fees the business remits for the various products and services it uses during the course of a given year.
It therefore makes sense for small business owners to leverage their aggregate economics for the deals they deserve. Otherwise, they should move it all to a community bank or credit union that values the relationship the way it should.
This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.
Image: Jupiterimages
You Might Also Like
With two stimulus checks under our belts, planning is curren... Read More
March 11, 2021
Personal Finance
The COVID-19 pandemic has taken a financial toll on nearly all of... Read More
March 1, 2021
Personal Finance
The following is a guest post by Orion Talmay, of Orion’s M... Read More
February 18, 2021
Personal Finance