Community banks like to portray themselves as a friendly neighborhood resource, including a source of support for entrepreneurs. Visit any small bank’s website and you’ll typically find their business services prominently displayed, often with a few quotes from satisfied small business owners they’ve assisted.
Unfortunately, the influence of community banks in small business lending has dwindled over the years. They may be harder to find as they shutter branches or merge with larger institutions. As we mentioned earlier this week, the perceived higher risk presented by small businesses has also constrained capital access for entrepreneurs seeking bank loans.
Out of frustration, many small businesses have started to turn to online fintech lenders for their financing needs. The share of bank loans to small businesses as a percentage of their total loans fell from 40 percent in 1995 to 21 percent in 2016; meanwhile, fintech’s share exploded from 5 percent in 2013 to 38 percent in 2018. Online lenders gained further prominence during the COVID-19 pandemic, becoming partners in the effort to distribute Paycheck Protection Program loans to businesses.
Online lenders generally offer lower loan amounts, but this might not necessarily be a major concern for small business owners. As bank lending trends toward larger, established businesses, a Fundera survey found that the average small business bank loan last year was $633,000. The average loan backed by the U.S. Small Business Administration was $107,000, a more modest figure but still quite substantial considering what most entrepreneurs need. The report determined that 57 percent of small businesses were seeking financing of $100,000 or less, with another 20 percent needing only up to $20,000.
Borrowers considered to pose a higher credit risk are also more likely to go to online lenders for business financing. The Federal Reserve’s most recent Small Business Credit Survey found that 35 percent of business owners considered to be a medium or high credit risk applied to an online lender, compared to just 11 percent of those considered to be a low credit risk.
As entrepreneurs face greater challenges in accessing capital, they’ll be more likely to consider online lenders for their financing needs. However, the short-term benefit can easily turn into a long-term nightmare due to the higher rates charged by fintechs. While the average interest rate on a small business bank loan has varied from 2.58 percent to 7.16 percent, the rate for online lenders can skyrocket as high as 99 percent.
Fintech companies charging interest between 10 percent and 99 percent are often accused of being predatory lenders. It is easy to understand why. Fintech is largely unregulated. Federal banking deregulation has arguably been a major factor that fostered the creation of fintech.
It’s not surprising, then, that borrowers have often been dissatisfied with online lenders. The Federal Reserve’s study found that just 18 percent of borrowers who had taken out a loan through an online lender were satisfied with the result. By contrast, 61 percent of small bank borrowers were satisfied, second only to community development financial institutions.
When robust community banking options are available, entrepreneurs will use them. A Federal Reserve report from 2017 found that when community banks made up a greater share of a state’s bank branches, the share of small business lending increased – up to 83.5 percent in states where community banks accounted for at least half of all branches.
At one point, noting the growing influence of large banks in small business lending, the report declares that “several studies have shown that community banks still have an advantage in providing appropriate credit products for small businesses.”
The same idea holds true today when considering online lenders. Community banks can play an important role in supporting small businesses, especially as they recover from the COVID-19 pandemic, but they need to scrutinize their services and lending practices to see where they might improve.
Small businesses employ approximately half of the U.S. workforce. Small business is arguably the foundation of the U.S. economy, and certainly the innovation proving ground. Some form of regulation is necessary to rein in fintech. We need to help restore a banking system that supports the rebuilding of our small businesses and their ability to employ more people.