As 2015 has come to an end, the Federal Reserve has finally raised interest rates, but they will still remain near zero. Zero also approximates the number of credit options that have been available to small businesses in the post-financial crisis and post-Dodd-Frank era of the past few years.
“Small business lending continues to fall, while large business lending rises” since the 2008 financial crisis and the 2010 Dodd-Frank so-called financial reform, concludes a 2014 Harvard Business School study. Specifically, lending to small firms has declined by 20% since 2008, while loans to large firms have actually increased by 4%.
Small businesses’ diminished access to credit should be a much greater concern than a minuscule rise in interest rates, given small businesses’ big economic impact. As the Harvard study notes, small firms create two out of three net new jobs; other studies have come to similar conclusions.
A beating dealt to small banks
Overregulation has already stifled traditional bank lending to small businesses, which, as the Harvard study confirms, borrow overwhelmingly from smaller banks. Moreover, startup or “de novo” banks, those that have been in operation for five years or less, are the ones most likely to lend to small firms, a 2012 study from the Small Business Administration’s Office of Advocacy found.
Yet, small banks have been hammered by Dodd-Frank rules. Dodd-Frank’s stringent rules on everything from mortgages to debit cards forced many banks to double their compliance staff, according to a Mercatus Center study.
Increased costs and less revenue due to Dodd-Frank translate into more bank mergers, and fewer resources at existing small banks to make small business loans. The Harvard study also found that post-crisis capital rules–and their inconsistent application by various bank examiners–have led small banks to “confusion and an aversion to taking on more risk,” including the risk of lending to small businesses.
The number of banks with assets of less than $1 billion has fallen by 20% in the years since Dodd-Frank passed in 2010, according to an American Banker article by scholar Richard J. Parsons. And startup banks less than five years old? Might as well forget them. Federal regulators have only allowed one new bank to open in the five years since Dodd-Frank passed in 2010, as I noted in a recent Competitive Enterprise Institute paper.
Non-bank funding for small businesses
Luckily for entrepreneurs, banks aren’t the only game in town. While there have always been nonbank lenders, 2015 saw the continued rise of marketplace lending, an outgrowth of crowdfunding and peer-to-peer lending that is starting to pick up some of the slack in small business lending. It is changing the game with technology that enables the creation of loans tailored to the needs of all parties involved. Though it is far from filling the void, it shows promise—if regulators allow it to achieve its potential.
I got a good glimpse of that vast potential at the 2015 FinTech Global Expo, which I attended as a keynote speaker, and where I met some of the entrepreneurs behind marketplace lending. Produced by Coastal Shows, the conference was held in May at the sprawling San Diego Convention Center and had its share of prominent venture capitalists and angel investors, both in the audience and on stage. There were glasses clinking at receptions and deals beginning to be made.
These investors still believe that despite everything Washington throws at them, small businesses have the potential to achieve steady, sometimes phenomenal, growth, and therefore make good prospects to invest in or lend to.
The number one topic of discussion was innovation in how to fund smaller firms. Carlsbad, Calif.-based Dealstruck, for instance, has created an online platform that analyzes the credit risk of small business borrowers and offers them various types of loans to fit their needs, in amounts ranging from $50,000 to $500,000. Dealstruck’s CEO and co-founder, Ethan Senturia, says Dealstruck has processed loans through its online platform for small businesses ranging from wholesale beverage distributors to food trucks. Dealstruck used to sell such loans to investors after they were processed, but now mostly holds them on its own books.
Senturia says options for entrepreneurs seeking credit are exploding. “If you’re a small business today, you now have lots of places to go to get money outside the banking system,” he told me. “And a number of those places are going to give you a better product and a better overall experience than you ever had access to in the banking system or otherwise.” Dealstruck competes in marketplace lending to small business with larger firms like OnDeck, which went public late last year, and Kabbage.
A job market created by non-bank lending
With so many new online venues popping up for small business lending, a Utah-based company called Lendio has created an Orbitz-type aggregating website to compare the terms of loans for small-business borrowers. Lendio also gives input to lenders on designing loans for various small business niches that most banks no longer serve.
In his speech at the FinTech Global Expo, Lendio CEO and co-founder Brock Blake expressed optimism about the future of small business lending. “Lenders that we work with on a very regular basis come to us and say, ‘Hey can we work with you to create a new loan product. Let’s find a new niche of customers that are underserved.’”
Yet Blake acknowledged there is still a long way to go. In an interview, he noted a big impediment to the growth of non-bank small business lending: decades-old securities laws that effectively outlaw peer-to-peer business lending by making it exceedingly difficult for ordinary folks to invest in small-business loans.
Too many shackles on promising new ventures
The U.S. Securities and Exchange Commission classifies most peer-to-peer loans bought and sold on an online platform, and virtually all online business loans facilitated this way, as “securities.” That means they must go through a cumbersome registration process similar to that for large companies’ stock offerings, unless they are offered to wealthy “accredited investors” exempt from SEC rules. These restrictions limit online opportunities for small businesses, as mom-and-pop investors are effectively locked out of most marketplace lending platforms.
These middle-class folks are the very investors who, dizzy from the wild ride their portfolios have taken in the past few years, might just find a loan to a stable neighborhood business a bit more attractive. “Retail investors are more likely to withstand credit cycles with lower yields,” Blake told me.
Various state usury caps also may trip up marketplace lenders as they grow. Brian Knight of the Milken Institute has proposed changes to federal law to allow marketplace lenders to “export” interest rates from their states of origin in the same manner banks can under current law.
The good news is there are not just new entrepreneurs, but new lenders and investors with new ideas for funding new businesses. But Dodd-Frank, as well as antiquated securities regulations, put too many shackles on these promising new ventures.
As long as this is the case, too many small entrepreneurs and investors will continue to face volatility and lag behind. To allow small business to fuel job growth once again, lawmakers need to abolish Dodd-Frank’s provisions burdening small banks and knock down barriers to new methods of lending to startups.
Originally posted at Forbes.