Bridging the Gap between Lenders’ Capital Supply and Small Business Demand

For the last few years, entrepreneurs have been struggling to access needed capital to either start a business or grow their companies. This diminishing flow of capital to small businesses could be attributed to a variety of factors. First, there was the financial and housing crisis which locked up capital reducing market and funding liquidity.  Then, the recession hit, and banks became increasingly reluctant to relinquish government stimulus funds due in part to economic uncertainty and higher regulations among other reasons.  Now, banks claim they are ready to extend credit but see a lack of qualified borrowers; while small businesses who are in need of capital are unwilling to apply for credit for fear of loan rejection as a result of banks’ more stringent lending requirements.  So, what gives? With the economy teetering between another recession and a slow recovery, determining how to bridge the gap between supply of capital and its demand will be vital for economic growth and general prosperity.

Despite the perception to the contrary, banks claim they are in fact lending to small businesses. According to the FDIC, the last quarter of 2011 saw the highest increase in small business lending since 2007.  Wells Fargo declared that they have increased small business loans by 27 % from 2010.  So, why is this happening now? There are a number of possible reasons.  Many larger banks have more cash on hand as a result of receiving TARP (Troubled Asset Relief Program) funds, cash hoarding, and interest made on government required cash reserves.  Additionally, many larger banks have been able to clear some bad loans off their balance sheets making them stronger and more willing to lend again while smaller and local banks, to a lesser degree, are stabilizing.  With the 2012 election just around the corner, there is also added pressure from Washington to increase new lending to small businesses.  This direction is good news for small businesses…but lending is still considered low relative to where it needs to be.

According to the Pepperdine University’s Private Capital Markets Project-Economic Forecast 2012, 53% of small business owners claim access to capital is still an issue.  Although many small businesses successfully weathered the Great Recession and are now poised for growth, recent tightening of lending standards have made it extremely difficult for them to qualify for a loan.  In the current economy, banks view lending to small businesses and, in particular, to new ventures, as high-risk as so many businesses have folded in the last few years.  To mitigate the risks in lending to small businesses, the criteria for a loan has become much more stringent.  These stricter qualifications are actually deterring small businesses from applying for credit.  Many entrepreneurs are unwilling to take the time and effort to go through the complex, lengthy and costly loan application process if the result is a probable rejection. Unfortunately, banks may have mistaken the lack of loan applications as a decline in demand for capital when in fact, businesses greatly need financing for their expansion. Ironically, banks claim these much stricter lending requirements have been imposed upon them in part by government regulators seeking to curb risky loans that were made prior to the recession. Yet, elected officials are simultaneously urging banks to increase small business lending.

Barriers to capital access have remained a major obstacle to business growth for entrepreneurs since the financial crisis of 2008.  A number of factors at that time have actually created strong incentives against lending.   Some experts cite the virtual halt of interbank trading, a process where banks lend to other banks, as a major contributor to capital depletion. After the financial and housing crisis, low interest rates combined with government incentives imposed on banks to maintain minimum cash reserves made it more profitable for banks to sit on their money rather than lend to businesses or other banks.  This slowdown in interbank lending particularly hurt smaller banks that depended on this avenue of capital to fund their own lending to small businesses.  Today, larger banks have tremendous excess of cash reserves but, unfortunately, at the expense of small business growth.

The housing crisis also put a major dent in capital availability. To limit the risk on their business loans, banks have required small businesses to offer personal collateral.  Typically, small business owners borrowed against their homes or some sort of real estate.  But since the housing crisis, which saw home values plummet, this avenue of collateral collapsed as well.

To some experts, however, this may not have been a bad thing.  By basing small business loans on home values, many banks became complacent in their lending standards and did not pay careful enough attention to the fundamentals of the businesses they were lending to.  This “shortcut” approach lulled the banks into a false belief in the stability and security of their loans.  Once the recession hit and the real estate market collapsed, banks found themselves with bad investments and insufficient collateral to cover their losses.

Although personal collateral still matters, in the current economic climate banks are digging deeper into small companies’ financials and overall management.  For the most part, banks now rely more on detailed company metrics such as sturdy cash flows, healthy balance sheet and good credit scores.

So how can we bridge the gap between supply and demand?

Many small businesses would like to see enhanced transparency in the loan application process and approval criteria.  This would allow small business owners to better target their efforts on loans that are more appropriate for their specific business or financial needs.  Knowing specific information on what banks and lenders are using to decide who gets a loan could also help applicants be better prepared and increase their chances of securing credit.  As it stands right now, many small business owners are confused, mystified and even intimidated by the incredibly lengthy lending process. Professor John Paglia, of the Pepperdine Private Capital Markets Project, has said, “Many business owners see raising capital as a very opaque, black-box kind of process. They don’t know frequently what leads to a ‘yes’ decision, what leads to a ‘no’ decision…to the extent that we can start to be more transparent as capital providers, I think that will help business owners tremendously on the upfront process.”

Additionally, business owners need to be more knowledgeable about their own businesses.  As Jeff Moore, Vice President of Relationship Manager, First California Bank said in the Access to Capital for Everyday Small Business presentation, “it’s not enough to know how to make money.”  Banks are looking for business owners who understand their business financials, primarily cash flows and balance sheet, and possess solid business acumen.  Banks want to be reassured that small business owners will be making smart decisions in the future to ensure profitability and be able repay their loans.

Equally important is maintaining healthy business credit scores.  At a time when revenues are down and personal collateral is hard to attain, business scores are more important than ever.  Paying one’s business bills on schedule, and maintaining healthy business credit scores is crucial when seeking business capital or credit.

The government could also help bridge the gap of supply and demand by enacting policies that will encourage banks to lend to small businesses.  Policies that will help financial institutions provide more capital to small business owners will allow the small business community to once again be on a growth trajectory which could only advance the nation’s overall economic recovery.

Recently President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law, to encourage investment into new companies and small businesses.  This new law includes a provision that allows new companies to seek investments through “crowdfunding” and a provision that removes certain regulations allowing startups to solicit funds from the public.  Although the controversial JOBS act is not without critics, its passage signifies the need for increasing  access to capital for small businesses.Time will tell whether the JOBS Act will truly increase the flow of capital to small business.

It is clear small businesses are not getting access to capital they need to grow and it is clear that banks have the capital to lend.   The schism between supply and demand must be alleviated in order to see small businesses grow, new businesses emerge, job creation accelerate and the nation’s economy recover and expand once again.

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