Small businesses have been slow to recover from the recession and credit crisis that hit them especially hard. Banks, even community banks, have been subject to regulatory and structural changes that continue to cast doubt on whether or not traditional bank credit will ever recover for small loans, according to Harvard Business School (HBS) professor (and former SBA administrator) Karen Mills.

In an HBS “working paper” by Mills and research associate Brayden McCarthy, they suggest the difficulty many small businesses have had in securing traditional bank debt has led to non-bank, internet-enabled lending alternatives that will change the landscape of small business lending well into the future.

The disincentives traditional banks have to lend to small businesses

According to Mills, bankers say they are lending to small businesses, but have trouble finding creditworthy borrowers. “In addition, bankers note the dampening effect of increased regulatory oversight on the availability of small business credit. Not only is there more regulation and higher compliance costs, there is uncertainty about how regulators view the credit characteristics of loans in their portfolios, making them less likely to make a loan based on “softer” underwriting criteria such as knowledge of the borrower from a long term relationship.

The share of small business loans of total bank loans was about 50 percent in 1995, but only about 30 percent in 2012. Moreover, small business owners report that competition among banks for their business peaked in the 2001 to 2006 period, and has sharply declined from 2006 to the present. Reasons are varied, but include the reduced value of collateral experienced during the recession and the cost to banks of administering small business loans.

Writes Mills: “Transaction costs to process a $100,000 loan are comparable to a $1 million loan, but with less profit. As a result, banks are less likely to engage in lending at the smallest dollar level. Some banks, particularly larger banks, have significantly reduced or eliminated loans below a certain threshold, typically $100,000 or $250,000, or simply will not lend to small businesses with revenue of less than $2 million, as a way to limit time‐consuming applications from small businesses. This is problematic as over half of small businesses surveyed are seeking loans of under $100,000, leaving a critical gap in the small business loan market. Often times, the biggest banks refer small businesses below such revenue thresholds or seeking such low dollar loans to their small business credit card products, which earn higher yields.

The emergence of new types of online lenders

In response to the downward trend in traditional bank loans to small businesses, there is an emergence of three new models of online lenders that are using technology to disrupt the small business lending market:

• Players such as OnDeck and Kabbage are using their own balance sheet; they are raising capital from institutional investors, including hedge funds, and using proprietary risk scoring models that include non‐traditional data to decision loans for small business owners.
• Peer‐to‐peer platforms such as Lending Club, Prosper and Funding Circle are connecting capital from institutional and retail investors with prime and sub‐prime quality borrowers.
• Lender‐agnostic marketplaces such as Fundera and Biz2Credit provide online marketplaces which connect borrowers with a range of traditional and alternative lenders.

According to Mills, existing players such as large banks and credit card companies are eying the space, and some have already begun to partner with or acquire these new entrants.

What does the future hold?

With banks, due to various factors, loaning less to small businesses, will the new players fill the gap? Perhaps now, says Mills. “There is already disagreement over the appropriate level of regulation,” she writes. “One side of the debate cautions against regulating online small business lending too early for fear of cutting off innovation that could provide valuable products to small business owners. However, there is concern that if left unchecked, online small business lending could become the next sub‐prime lending crisis.

On one thing all parties–small businesses, bankers and lawmakers–agree. Small businesses play a critical role in job creation and the overall economy. Without access to debt, the ability of small businesses to invest in growth will be stymied and will undermine the prospects for longterm economic health.