The Small Business Administration’s Direct Lending Proposal is Well-Meaning but Flawed

Small businesses are one of the most important pillars of the U.S. economy. They employ 47% of Americans and contribute $5.9 trillion to overall GDP. The nearby convenience store, the auto repair shop around the corner or pizza parlor down the street are constants in our lives — and at the heart of local communities across the country. But times are tough and the future less certain than normal. The pandemic has exacerbated an already existing challenge of being a small business: access to credit.  

This issue has been on the radar since after the global financial crisis, when traditional lenders tightened their credit requirements, leaving small businesses in the cold. In recent years, fintech lenders have stepped in to fill the gap, bringing updated underwriting and credit assessment practises to the table, but a small business lending gap has persisted. And the pandemic pushed the issue further. The government took immediate action to ensure credit flow, launching initiatives including The Paycheck Protection and Economic Injury and Disaster Loan and Programs. A current proposal, included in the Build Back Better Act, includes a $1.9 billion direct loan program to be managed by the Small Business Administration (SBA). It would sit under the current 7(a) program and be distributed over the next 10 years, meeting a need for smaller loans below $150,000.

The proposal pinpoints a key issue that needs attention: If small businesses do not recover from the coronavirus pandemic, the rest of the economy won’t either. However, it is flawed in that it underplays the importance of addressing the root causes of small businesses having poor access to credit, in particular for smaller loans. It’s not about the pools of creditors and credit being inadequate. It’s about the ability of existing creditors to accurately assess the creditworthiness of applicants. Moreover, lenders struggle to profitably process smaller loans. Because of the SMB’s thin file, the cost to process and risk compared to the amount they earn from these loans doesn't stack up. Faced with a flooded demand side of the market, they have stuck to the same processes. Instead, they need to automate the data exchange and underwriting.

The last time the government discussed a direct lending program (yes, it’s been on the agenda before – back in 2010). Karen Mills, the Administrator of the SBA, now a Senior Fellow at Harvard Business School, supported the notion of the key issue being the ability of small businesses to provide sufficient financial data for a loan. “We can get them bankable by helping them with their package.”  

In other words, the problem of small business credit lies with small businesses being unable to provide a satisfactory loan package of data that the bank can understand and lend against. For example, take a four-month old business set up to sell home improvement supplies online. They now need $40,000 for marketing and online advertising. While their business may be thriving, it's unlikely that they would be able to secure funding via traditional methods due to their limited time trading. However, by accessing their accounting, banking, and commerce data, banks would be more confident in their ability to fund the business while sensibly managing risk and minimizing costs. In addition, given small businesses can't provide enough data for lenders to check their existing process boxes, solutions that allow for richer real-time data benefit all parties, giving a more accurate picture of creditworthiness.

There are other reasons why a direct lending program isn’t the best idea. For one, it would face practical challenges. Given that they have not historically offered loans directly, the SBA naturally does not have the necessary infrastructure (systems, trained lenders, computer systems) readily available. The current proposal involves the SBA partnering with community development financial institutions (CDFIs) to process the loans and earn a fee, while the SBA holds the loan and does the rest. To manage all this an online loan portal would be created. It is not unreasonable to assume it could take at least a year to staff, train and set up back-end computer systems for the program. But time is of the essence. As we all know small businesses owners are time poor. They need smooth and efficient access to capital. Especially after the various PPP program delays and hiccups earlier this year. 

Proponents of the SBA direct lending program have been arguing that banks and existing creditors are no longer equipped to support small businesses. They seem unaware that over 24,000 lenders  have been participating in the PPP and hundreds in the 7(a) loan program. Lenders today are well capitalized and committed to championing small business. However, what they do need is better digitized data that allows them to automate underwriting for smaller loans and access real-time insight. This would speed up the process and reduce manual error while providing a richer data picture. It’s the main thing that is going to help existing lenders meet the needs for smaller loans.

A public small business lending program might make sense at some point in the future, if the free market fails. But the demand for credit is urgent. Small businesses are trying to build back better today. They need the credit application process to be as clear, efficient and as quick as possible. In other words, it is not the time to roll out a new direct lending scheme. Instead, our collective energy and efforts—private industry, The SBA and publicly elected officials—should go toward making today’s system function better.