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The math behind small business lending: Problems & possibilities for banks & credit unions

Mary Ellen Biery
April 22, 2024
Read Time: 0 min

Recent dynamics of the small business lending market

A deep understanding of the small business lending landscape and potential efficiencies can help banks and credit unions grow their portfolios. 

You might also like this guide for smarter, faster small business lending.

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Takeaway 1

Financing plays a crucial role in small business survival and success. It's also a prominent line of business that many financial institutions are targeting for growth.

Takeaway 2

Several small business lending processes can tax both borrowers and staff. They lead to inefficiencies and roadblocks to small business lending. 

Takeaway 3

Depository lenders are enhancing their lending procedures and technologies to meet institution risk and return requirements as they grow.

Dynamic market

Small business lending by banks & credit unions

Small businesses are a pillar of the U.S. economy, and access to financing often plays a crucial role in their survival and success. Small business lending is also a prominent line of business for many financial institutions, especially those driven by a mission to help their communities thrive.

However, small business lending can be costly and time-consuming for banks and credit unions. Some of the factors that can make small business lending a lower-return venture than other types of lending are the same ones that lead to costly and frustrating experiences for small business owners. This article outlines some of the math behind small business lending and its profitability and suggests ways for banks and credit unions to better serve this important market while earning appropriate returns.

The piece covers:

  • The small business lending market and its role in communities and the economy
  • Traditional depository institutions’ changing market share in small business lending
  • The challenges (financial and operational) of small business lending for banks, credit unions, and borrowers.
  • Options that create lending economies of scale and better borrower encounters.

 

Role of business loans

The market and impact of small business lending

Small business lending is a large and growing market, and many banks and credit unions want more of it. Record new business formation and a wider gap between U.S. establishments' birth and death rates compared to the last business cycle have some financial institutions eager to meet the credit needs tied to this small-business boom.

While data on the small business lending market is fragmented and incomplete, the Consumer Financial Protection Bureau’s (CFPB) last detailed review estimates it grew 21% to $1.7 trillion between 2019 and 2022. The market surged to as high as $2.4 trillion in 2020 as a result of COVID-19 relief programs.

Demand for small business financing is driven by many factors, not least of which is small businesses' vital, ongoing role in the U.S. economy.

Consider the following small business facts:

  • Nearly all American businesses (99.9%) are small, generally defined as having fewer than 500 employees.

  • The 33.2 million small businesses in the U.S. employ roughly half of all Americans in the labor force and drive nearly 44% of GDP.

  • Small businesses created nearly two-thirds of net jobs in the last 30 years
  •  Small businesses represent 97% of exporting firms.

Despite their essential economic role, small businesses are notoriously risky. The U.S. Census Bureau says a fifth of small businesses fail within the first year. Between 1994 and 2020, nearly a third of new employer establishments didn’t last more than two years, and the 15-year survival rate was 26%.

Indeed, most small businesses require external financing to survive and grow. The Fed’s latest Small Business Credit Survey, conducted in 2023 and released in 2024, found that nearly 60% of employer firms had sought financing in the previous 12 months. Almost half sought credit to grow their businesses, and 28% applied to make repairs or replace capital assets. At the same time, 59% pursued credit to meet operating expenses. A majority of applicants sought less than $100,000.

While small business loans inherently benefit business owners, they also benefit communities, according to 2021 research for the SBA. Small business loans “have large and significant effects on employment growth and job creation, particularly for firms with less than 100 employees.” Loans of less than $100,000 showed the strongest impact.

"[H]igher shares of small business loans ... are associated with higher asset growth rates."

Lending to small businesses can help financial institutions, too. The research for the SBA found that higher shares of small business loans in the portfolio are associated with higher asset growth rates. The strongest effects are seen among banks with less than $10 billion in assets.

Major players in SMB loans

The role of banks and credit unions in small business lending

Financial institutions are major players in small business lending, but their roles are shifting.

The CFPB is implementing new small business lending data collection rules in part to improve the data on this fragmented and complex market. Meanwhile, the agency says banks, credit unions, and other depository institutions accounted for 80% of the 8,200 financial institutions active in small business financing in 2019.  With $580 billion in private-term loans and lines of credit and $62 billion in credit cards, they accounted for 56% of the small business financing market.

As a share of their total assets, community banks have more business loans below $1 million than larger banks, according to the St. Louis Fed:

[S]mall-business loans—i.e., loans less than $1 million—accounted for 12.6%, 11.1% and 7.9% of total assets at three different sizes of community banks (those with $250 million or less in assets, those with more than $250 million to $1 billion in assets, and those with more than $1 billion to $10 billion in assets, respectively.) Larger banks, those with assets of more than $10 billion, held just 3.6% of their total assets in small-business loans.

However, big banks are increasingly where small businesses apply for credit. Fed survey data show that lower percentages have said they applied at small banks in each of the last three years.

Online fintech lenders and merchant cash advance providers are also making up ground. The CFPB estimates 2019 small business financing was as much as $19 billion by merchant cash advance providers and about $25 billion by online fintech lenders.

As smaller banks seek to win more small business loans and credit unions expand more into member business lending, it's important to consider some of the complexities they'll face. It also helps to understand how those issues affect borrowers. As a St. Louis Fed economist noted, small businesses “frequently encounter obstacles to accessing capital because banks face challenges in lending to them.”

See how Dover FCU speeds up its lending processes. 

READ STORY

Business lending complexities

Challenges for small business lenders and borrowers

As noted earlier, small businesses bring inherently higher risk, so lenders have unique considerations during underwriting. Among additional challenges that complicate the small business financing process:

  1. Small businesses often have shorter track records of operating, making it harder to assess their creditworthiness.
  2. Evaluating smaller loans is also complicated by how little public information exists about the performance of most small businesses and by the fact that many lack detailed balance sheets and other financial information often used by lenders in underwriting small business loans.
  3. Each small business has a distinctive business strategy, customer base, and mode of operation —factors that make small business loans harder to monitor than those for large corporations.
  4. Small businesses often lack substantial collateral.

CFIs can navigate the complexity, but...

Community financial institutions’ insight, experience with local economic conditions, and strong relationship banking with small businesses in their service areas help them navigate the complexity. However, lenders can spend as much time processing a $50,000 loan as a $5 million loan, which limits their ability to take advantage of operational efficiencies from volume increases.

Lending processes at many banks and credit unions impair their growth efforts. A 2022 report by industry research firm Datos, formerly Aite-Novarica, said lenders have limited levels of automation in a market that requires scale, speed, and loan application volume for success. It found that 47% of examined lenders have highly manual operations, with just 16% describing their operations as highly automated with reasonable digitalization.

As former SBA Administrator and Senior Harvard Business Fellow Karen Mills has noted, lenders’ processes are also taxing on their borrowers:

For loans, most small businesses still go from bank to bank, filling out applications and submitting significant amounts of paperwork in a process that takes 24 to 34 hours according to a recent Federal Reserve survey. The personal underwriting process is largely paper-intensive and manual, often done with the aid of [E]xcel spreadsheets, and there is a reliance on personal credit scores, particularly in the larger banks. The response times are slow, often several weeks and even months until borrowers are approved or denied.

The large number of lenders, the absence of standard application requirements, and substantial differences in credit costs among lenders result in business owners spending time navigating the market. They’d rather invest that time in growing their revenues and profits.

Innovation

How to create growing, profitable small business lending

Banks and credit unions looking to grow small business lending in a way that fits their customer or members' needs along with the institution’s risk, return, and strategic goals are increasingly revamping their processes and systems.

Fundamental inefficiencies they address with automated workflows configured to their needs and market demands include:

  • Duplicate data entry, where staff have to enter the same data into multiple systems
  • Returning to the borrower multiple times to collect necessary documents
  • Storing borrower documents in various systems so it’s unclear what information has and hasn’t been collected
  • Difficulty tracking the loan stage due to multiple people working on a single credit
  • Re-spreading financials for a borrower when new information is collected
  • Manually aggregating data needed for loan committee presentations
  • Manually adjusting loan proposals if the loan committee recommends changes

Small business loan origination software that allows automation from origination through closing but is flexible enough for a lender to step in when needed allows financial institutions to offer faster decisions and funding. Here are a few additional benefits of effective lending software tailored for small businesses:

  • A user-friendly online application that can be completed by the borrower or with a lender’s assistance means the small business owner can apply when and where they want, and staff can avoid repeated data entry. When a small business owner can upload supporting documents securely anytime from anywhere, the bank or credit union spends less time chasing documents. Analysts can begin analyzing the borrower more quickly when financial spreads are automated and when an AI-powered decisioning engine provides a loan score in seconds.
  • Loan proposals and loan committee presentations are prepared more quickly and are easier to review with workflows and templates that align with your loan policy.
  • Small business borrowers are offered faster decisions and streamlined processes for all types of credit. They expect them from their primary financial services provide.

Financial institutions can grow their small business lending portfolio while managing risk if they capitalize on automation, which allows them to offer better loans and customer or member experiences.

Conclusion

Ever-changing market & opportunities

Given the role of banks and credit unions in business lending, the interplay between small businesses and financial institutions is critical for the U.S. economic ecosystem.

Despite the complexity and risks, small business lending has immense potential rewards—both economic and social. Banks and credit unions that harness innovation, improve efficiencies, and foster a deeper understanding of the small business lending landscape can better serve this crucial sector and ensure their own growth and stability.  

As the market dynamics evolve and new data becomes available, institutions that adapt and refine their strategies will secure their role as pivotal players in community development and economic vitality.

 

Win more small business deals and grow market share.

abrigo small business lending
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About the Author

Mary Ellen Biery

Senior Strategist & Content Manager
Mary Ellen Biery is Senior Strategist & Content Manager at Abrigo, where she works with advisors and other experts to develop whitepapers, original research, and other resources that help financial institutions drive growth and manage risk. A former equities reporter for Dow Jones Newswires whose work has been published in

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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