How To Lend More to Small Businesses

Small business owners face a credit crisis—and the problem is even worse for minorities. There is a solution—and it doesn’t require regulatory changes.

The Small Business Credit Crisis

If you search online for “small business challenges,” the list that Google returns is nearly endless. The U.S. Chamber of Commerce boils the list down to the top 5 of which #2 is “access to credit.”

Of small business owners who applied for a business loan in early 2023, 6 in 10 found it difficult to find affordable financing, and overall, 77% are concerned about their access to capital according to a survey from Goldman Sachs.

The problem is even worse in 2024.

According to Patrick Reily, co-founder of Uplinq, a technology firm that helps small business owners gain access to fair and ethical credit, “Using the FDIC’s definition, 80% of the small businesses in the U.S. are ‘underserved.’”

Small Businesses’ Credit Challenges

The challenge isn’t simply access to credit—it’s access to affordable credit. According to Randi Zeller, senior advisor to Community Reinvestment Fund, USA: “There is no lack of capital. If you’re willing to borrow at predatory rates, you can get capital. What we need is access to affordable capital.”

It’s a global problem. Syed Abdul Momen, deputy managing director and head of SME, BRAC Bank Limited in Bangladesh, said, “Small businesses need timely access to the funds and that’s more important to them than the interest rate because if they don’t get money, they can’t make money.”

Lack of access to affordable capital from mainstream sources like banks causes small businesses to get higher rate capital from non-mainstream sources, which artificially—and needlessly—pushes delinquency rates up.

Small business financial stress nearly reached a 10-year high in December 2023, as Equifax’s Small Business Delinquency Index nearly doubled, rising 95 basis points over the course of last year.

The Challenge Isn’t Evenly Distributed

The issue of affordable credit access is more pronounced for small business owners who are women or persons of color. According to the Federal Reserve:

“Black- and Hispanic-owned businesses have a harder time accessing credit from traditional sources because they’re evaluated as higher credit risks. These risks are determined in part by lower owner wealth, lower business revenue, and insufficient credit histories.”

Women have a harder time accessing credit through traditional bank loans because of:

• Business size. Women-owned small businesses tend to be smaller—in terms of revenue, number of employees, profit and capital—than men-owned businesses, making them less attractive borrowers to banks.
• Risk profile. Women may be less likely to take on major financial risks than men. This affects the rate at which women start new businesses, limits their use of credit and, ultimately, negatively impacts their creditworthiness.
• Financial knowledge. Analyses from the Organization for Economic Cooperation and Development show that across 16 countries, men have higher financial knowledge scores than women.

According to the Consumer Financial Protection Bureau, “Minority small business owners are often treated differently in person than on the phone or online, discouraged from applying for credit, encouraged to apply for a type of loan that has less favorable terms, or refused credit even though they qualify for it based on advertised requirements.”

Ayodele Olojede, divisional head, retail and SME at Wema Bank in Nigeria, said that in Africa, “women don’t have the opportunity to network or engage in business the same way that male-owned businesses are able to do.”

Minority small business owners need ‘fair and accessible’ lending. Sounds great, right? But what is it?

To the U.S. Department of Housing and Urban Development, fair lending “guarantees the same lending opportunities to everyone” by “prohibiting lenders from considering race, color, national origin, religion, sex, familial status or disability when applying for loans.”

Accessibility, however, is a harder term to define and measure. When amending Regulation B of the Equal Credit Opportunity Act, the CFPB wrote:

“There is limited data on small businesses’ access to credit. Small business lending data will give investors and lenders more insights to identify new opportunities that support economic growth, help policymakers measure the effectiveness of government programs, and provide a data-driven approach to detect potential discrimination.”

Technology and Data—Not Regulations—Is the Answer

The CFPB’s comment holds the clue to the solution (and it isn’t more regulation from the CFPB and other regulatory bodies).

At the heart of the small business fair and accessible solution is data—which is often incorrect, missing or misleading.

According to an analysis from Uplinq, relying strictly on FICO scores for small business loan underwriting can unfairly impact protected class business owners. The data and technology firm’s analysis found that expanding the set of data inputs used to evaluate protected class small businesses—including data from accounting systems, payment and e-commerce systems, core banking platforms and other sources—could increase the number of good (i.e., non-loss) loans accepted by 215%.

The expanded use of data is happening in some parts of the globe—but in a limited way. Wema Bank’s Olojede said that “there has been more use of alternative data in driving loans in Nigeria, but it’s happening largely with fintechs—banks are only slowly adopting the use of alternative data.”

AI Reduces—Not Increases—Biases in Lending

Joe Decosmo, chief analytics and technology officer at Enova, writes:

“Bias—a systematic distortion of a statistical result—is a common concern about using machine learning and other artificial intelligence (AI) solutions in financial services as critics worry that algorithms can embed historically discriminatory lending practices into automated credit decisions.”

A new study from Cornerstone Advisors, titled Fair and Accessible Credit for Small Businesses: A Guidebook for Financial Institutions, finds that leveraging machine learning models that use an expanded set of data attributes provides benefits for lenders and borrowers, including:

• Improved credit risk assessment. By incorporating alternative data sources and nonlinear relationships, these models can generate more accurate and comprehensive credit risk assessments, enabling lenders to make more informed lending decisions and better manage risk.
• Efficient collections and loss mitigation. Machine learning models can analyze borrower behavior, payment patterns and external factors to identify early warning signals of potential delinquency or default. Using machine learning to identify the optimal treatment and contact strategy can reduce their net charge-off losses by 4% to 5% according to McKinsey & Co.

The Path to Fair and Accessible Lending

How should banks move down the path to fair and accessible—and more profitable—lending? The road map includes three phased, overlapping steps:

• Education. Banks need to educate small businesses, regulators and themselves. They need to understand the new models, but also need the ability to explain them to regulators.
• Data. Banks can accelerate the process to operationalize new data types and sources by participating in innovation labs like the SME Lending Innovation Lab created by Equifax and Uplinq.
• Business case. Building the business case for a “fair and accessible” small business lending approach is needed to convince senior lending executives—and the rest of the bank—that this new approach to small business lending is more than just the “right” thing to do.

Small business owners’ access to affordable credit can’t be solved by regulatory change. It will improve when the lenders—banks, fintech and other non-bank lenders—see improved profitability from the use of AI and expanded data sources.

For a complimentary copy of the Fair and Accessible Credit for Small Businesses: A Guidebook for Financial Institutions study, click here.

To register for a free webinar on Fair and Accessible Credit for Small Business, and the Impact of AI, click here.

Ron Shevlin is chief research officer at Cornerstone Advisors. Tune in to Ron’s What’s Going On In Banking podcast and follow him on LinkedIn and X.