Surviving the Winter

The Small Business Administration can help small firms get the funds they need by cutting red tape and encouraging technical innovation in lending

By Jeanette Quick

Small businesses are a critical component of a thriving economy: they employ 60.6 million people and make up half the workforce. But many small businesses are just barely hanging on, and it’s about to get worse. One in five small businesses have already closed (roughly 60 percent of them permanently) during the pandemic, and cold weather, coupled with new increases in the daily number of COVID-19 cases, will likely force many more businesses to close, potentially leading to millions of additional lost jobs.

Many businesses have stayed afloat because of the Paycheck Protection Program (PPP), which offered funds to incentivize small businesses to keep their workers employed and stay in business. But between winter approaching and the remaining PPP funds already being spent, the next six months will be rough for small businesses. With congressional negotiations over a new stimulus package stalled, it’s time to think much bigger than the PPP. We should seize the opportunity to create a better system, including modernizing the Small Business Administration (SBA) to better serve small businesses.

Small Businesses Struggled to Access Capital Even Before the Pandemic

Small businesses have never been able to access sufficient capital. The SBA doesn’t meet all of their needs, and neither does the private market. More than half of small businesses couldn’t access enough capital before the pandemic, according to the Federal Reserve (Fed), and two-thirds of them experienced financial challenges in 2019. Further, access to capital varied widely by race: Black-owned businesses were half as likely as White-owned businesses to secure bank funds, and Latinx-owned businesses fared only slightly better. And, according to the Fed, the problem is not just due to SBA shortcomings: inefficiencies in markets also have hindered effective pricing or pooling of risk.

Traditional banks, meanwhile, have exited the small business market, and financial technology (fintech) lenders have only partially filled the gap. The FDIC has reported that nearly 20 percent of banks offering business loans have closed over the past five years, while many of those still operating have stopped serving small businesses. As the SBA notes, the declining participation of banks means that “SBA’s guaranty products [are] even more critical for growing small businesses that may be denied credit in the private loan market.”

Small Business Financing Can Use a “SmallBizTech” Revolution

The SBA can and should reduce barriers to becoming an approved SBA lender and thereby increase access to capital for small businesses in the federally guaranteed market. Further, the SBA’s modeling the use of technology in its programs may encourage innovation in the private lending market.

The PPP was unprecedented in its impact on small businesses. In all of 2019, the SBA approved roughly 60,000 loans, or $28 billion, to small businesses. By contrast, in 2020, through the PPP alone, the SBA approved 5.2 million loans, or $525 billion, through 5,500 private lenders. The PPP had its challenges, to be sure, but overall we can learn significant lessons from the program—such as the importance of using private lenders, particularly those that focus on serving underserved businesses, such as community development financial institutions (CDFIs).

Tech-enabled lending can remove systemic barriers and leverage the SBA’s small but critical resources to create a broader impact. Proven programs—like the SBA’s microloan and CDFI programs—get capital out to those that need it most. The SBA should expand microloans—loans of under $50,000—as they are unattractive to large lenders but critical to millions of entrepreneurs, particularly those who have recently started businesses. Additionally, the SBA can apply the lessons of financial regulators—who have spent the last decade adapting to fintech, machine learning, and alternative underwriting—to small businesses.

Many SBA programs, such as the 7(a) program (which offers flexible, long-term loans of between $100,000 and $5 million), are administered by private lenders. But the vast majority of commercial banks have no interest in offering SBA loans. Less than 30 percent of banks offer 7(a) loans, and the number is declining: between 2012 and 2019, 32 percent of 7(a) lenders exited the market, and the loans that are still being made increasingly go to large businesses. According to the Office of the Comptroller of the Currency, this decline in the number of 7(a) loans is driven in part by rigid eligibility, underwriting, and servicing guidelines.

SBA Programs Are Too Complicated and Underinclusive

So, what can be done? Congress—and the SBA—should incentivize private lenders to reenter the small business lending market, including by reducing barriers to SBA lender entry and by simplifying requirements once approved. To become an SBA lender currently requires multiple stages of application, a relationship with a regional office, and the ability to navigate the challenging ETRAN system. Further, the SBA and private lenders alike should consider the many sources of alternative data and technology to better price a business’s credit risk. Payroll companies, for example, could evaluate a small business’s propensity to be late in meeting payroll and its employee turnover, both of which could help better assess a company’s credit risk.

The SBA has an opportunity to create a better system for small businesses. Although it has loan programs beyond its 7(a) program, they are opaque and not user friendly. Simplifying these programs could make them more accessible and make the SBA more effective at spending taxpayer money and reaching the neediest small businesses.

Some of the SBA’s programs are high effort, low reward. For example, the Express Bridge program requires an existing relationship with an SBA Express lender (which requires separate SBA approval), with limited visibility into qualifying lenders, to obtain a maximum $25,000 at 10 percent interest. Many other programs require collateral, no previous criminal convictions, strong personal credit, significant documentation, and two verifications of no credit elsewhere. These criteria make financing less available to many small businesses.

The SBA should consider the effect of such requirements on small business financing, especially to historically underserved populations—including female, Black and Latinx business owners—and modify them to reduce those impacts. This is particularly important now because Black-owned businesses have been closing at a faster rate than White-owned businesses during the pandemic. And while a lawsuit forced the SBA to extend PPP loans to those with previous convictions, in practice most SBA programs continue to bar small business owners with convictions, which disproportionately excludes many Black- and Latinx-owned businesses. Systematic reliance on personal credit scores from small business owners has a similar disparate impact.

This should be of interest to the SBA, as the annual number of SBA loans to Black-owned businesses has decreased by 84 percent since 2008, resulting in only 3 percent of all SBA loans in 2019 going to Black-owned businesses. Further, in the private market, only 9.9 percent of conventional small business loans go to minority-owned small businesses and 16 percent to women-owned businesses. The SBA should evaluate whether its programs are available to all populations on an equal basis and adjust accordingly, and it should encourage the private market to evaluate its fair lending practices.

The small business financing market is not serving all businesses equally, through either the SBA or the private sector. Now more than ever, small businesses need capital to survive, and many are willing to take out loans to do so. The agency has an opportunity to lead with innovative methods of putting capital in their hands, and the fate of half of the nation’s workers may depend on it rising to the challenge.

This is the seventh in a series of articles that will examine ways to help entrepreneurs who are seeking to start small businesses in the wake of the pandemic to access the capital they need. The first article in this series provides an overview of the challenges facing would-be entrepreneurs in the coronavirus economy. The second article concerns offering small businesses guaranteed access to credit. The third article examines the rules governing investors in startups. The fourth article concerns easing restrictions on lending by small banks. The fifth article proposes easing restrictions on the sale of securities by small startups. The sixth article argues that Congress should ease restrictions on peer-to-peer lending. The eighth and final article urges governments to create a better environment for small businesses by reducing uncertainty and reopening the economy.