Why do traditional banks hate lending to small businesses?

By: First Union | Date:


Why do traditional banks hate lending to small businesses?

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Once upon a time, small businesses could approach their local banks for a business loan. The process was much easier, less paperwork involved, less time to wait for a decision (and for funding/), and the interaction itself was more personal interaction. Today, unfortunately that is just not the case. In fact, some might say that banks actually hate lending to small businesses, at least this seems to be the issue with larger, more traditional banks.

There is a growing divide between the needs of small business owner and what banks are consequently willing to do to help these small businesses. As the smoke of the pandemic clears, we are seeing more and more small businesses struggle. And yet, when going to their local bank for a loan, increasingly these smaller companies are meeting with rejection.

Not only that but think about the traditional bank landscape in general. Once there were community banks, smaller lenders with actual ties to the neighborhood in which they were located. What we see daily however, is these types of local banks being swallowed up by national conglomerates. And the large national banks don’t have the time nor the interest in bailing out small companies with business loans. Just think about it…today’s small business owner has only a twenty percent chance of having their loan application accepted by a larger traditional bank. The odds are definitely not in their favor.

Small business lending has been declining

Small business lending was first dealt a blow back in 2008 after the Great Recession. Skeptical banks and wary lenders significantly decreased the amount of business loans they were issuing to smaller firms and organizations. Following the bubble bursting and as recovery ensued, many thought that small business lending would pick back up again, especially where traditional banks were concerned; this, however did not prove to be the case—at least not completely. And the way back for small businesses was very gradual, in some cases nonexistent. As noted, many experts are prone to deduce that traditional banks hate lending to small businesses particularly in this current climate.

The downward trend therefore continues despite efforts made during the pandemic to bail out small businesses. Overall, there is still extreme hesitance on the part of banks to issue commercial loans to smaller companies. Why? There are a number of reasons why business loans for small businesses are not forthcoming from traditional banks. Below are just a few of the top reasons why small companies are having a difficult time procuring the funding they need from banks.

A dramatic uptick in regulations. Following the 2008 recession and now in light of what the pandemic has done to the financial world, banks have had to to reevaluate their criteria and regulations where business lending was concerned. Think about the nature of bank loans—the money they are issuing comes from that of other customers. They thus have to have a strong risk assessment program in place. And by nature, small businesses do carry greater risk as far as loan repayment goes. Whether or not to extend a small business credit is going to be based on a number of key factors and criteria—such that can be very hard for many companies to meet. This is one reason why the number of business loans issued to small companies does tend to be much lower than those given to larger corporations.

Dwindling number of community banks. As noted earlier, larger banks are quickly buying out small community banks. The small local bank used to be a mainstay when it came to issuing small business loans. However, as their number continues to dwindle, it is becoming harder and harder for small companies to find community banks, what’s more, find those community banks willing to lend them money. It stands to reason that with less community banks in existence, opportunities for small companies to get loans from traditional banks are also dwindling.

Banks want to see a strong chain of command. The structure of a company’s management team is very important to most traditional banks that are considering whether or not to lend a company money. They look for an expansive well-organized management team, leadership with accolades to show for themselves and a sizeable chain of command. This, in their eyes, equates to less risk. A small business, especially a newer one, probably will not have a chain of command of the magnitude for which traditional banks look. And thus, their loan application gets rejected.

Banks tend to prioritize collateral. This to many small businesses seems a catch 22 of sorts. A larger conventional bank wants to see collateral before they will approve a loan application—most of the time this is indeed the case. The small business owner in need of money likely may not have enough collateral. They are therefore stuck in a type of vicious cycle. Same goes with the idea of a down payment. The frustrated business owner doesn’t have the money to put down on a loan, which is very often why they are applying for a loan to begin with.

The small business client base isn’t expansive enough. As can be the case with many small businesses, the client base tends to be somewhat narrow. Many small businesses are niche businesses and so of course their customers are not going to represent a comprehensive cross section. Think of a local community restaurant. Their clients are largely coming from one neighborhood. This, for the traditional bank, is simply not enough to justify issuing a loan to that establishment.

Lack of an operating history. Beyond insufficient credit score, perhaps one of the main reasons why traditional banks hate loaning money to small businesses is because the businesses just don’t have a long enough track record. By the same token, they may not be bringing in enough revenue. Conventional banks like to deal with companies that are larger, have been in business for five plus years and have a healthy annual revenue to show for it.

Small businesses generally require smaller loans. And this means that many traditional banks are simply not interested. There is less money in issuing smaller loan amounts—it’s a matter of simple mathematics. The average loan size for many small businesses is under fifty thousand. For large traditional banks, loaning this much money (considering the risk involved with smaller companies/) just doesn’t make financial sense for them. There is not enough of a reward given the risk you might say. They are going to be far better off focusing their time and effort on landing those big loans for big companies. Why devote attention to a loan that is less than 100k when you can potentially underwrite a loan that is upwards of two million? The bigger profit comes with the million dollar loans.

Exploring other options for small business loans

If, as seems to be the case, small businesses are having a difficult time finding the money they need with traditional banks, then what options are open to them? Especially given the current economic climate, when things seem to be somewhat topsy turvy in the business and financial worlds, are small businesses simply doomed to have to fend for themselves?

This is where alternative and online lenders have been increasingly filling a gap—that left by traditional banks where smaller companies’ lending needs are concerned. What exactly constitutes an alternative lender? Basically, they are nonbank lenders that tend not to have a physical brick and mortar location per se but rather transact most business and loan dealings online.

Numerous small business owners across the US have found great success when working with alternative lenders versus more traditional banks, who are otherwise all too quick to close the door on their lending needs. What are some of the advantages of working specifically with alternative/online lenders given the climate we now face and the needs of small business owners looking for available funding?

Less stringent approval criteria. This is perhaps one of the biggest reasons why we’ve seen such a notable rise in the popularity of alternative lenders being used by small businesses. Someone with a less than ideal credit score stands a zero chance of being approved for a commercial loan from a traditional bank. On the other hand, that same applicant faces a totally different scenario when applying for funding through an online lender. Perhaps the main reason is because alternative lenders take a big picture approach. That is to say, they are not solely fixated on one number but rather strive to gain a sense of the business as a whole. Their risk evaluation policies are a bit different and because of this, small businesses stand a much better chance of approval.

Easier application process involved. What we saw post 2008 and also now as we emerge from the pandemic is that traditional banks are making the lending process increasingly difficult—some might say downright impossible. The sheer amount of paperwork alone is enough to deter even the most desperate small business owner from applying. With alternative lending solutions however, the picture looks quite different. Everything is done online. And versus pages and pages of paperwork, the applications are fairly fast and easy. Granted, they still do generally ask for certain documents standard to a loan application of this nature—tax returns, bank statements and financial statements, among others. But they also make it a priority to issue decisions quickly and get their clients funded within a matter of days, not weeks.

Funding time is quick. It bears repeating: the amount of time from application submission to actual funding is incredibly fast when dealing with online lenders versus what you get when working with traditional banks. In fact, depending on the lender you choose to work with, the money could be in your account in as little as 1-2 days. Alternative lenders work under the assumption that their clients do in fact need money quickly—why else would they be applying for a business loan in the first place? This mindset is what they base their policies and practices on.

There are a variety of loan programs. From secure merchant cash advances to unsecured short term loans and everything in between, the great thing about working with online lenders is that they do offer a number of business loan programs such that can be tailored to meet an individual company’s needs. In other words, a business is not relegated to one specific loan type or one set of loan terms. There is a great deal of flexibility when working with alternative lenders that just isn’t there when working with more conventional banks.

They will work with newer companies. One of the biggest check marks against a business applying for a traditional bank loan will be if they do not have enough years in business. At least two years, sometimes (depending on loan size/) five or more years. This leaves startups and newer firms out completely. Their loan application is dead before it even hits the water. But with online lenders, this isn’t necessarily the case. Some online lenders will to loan to startups or companies that have been in business for less than two years. It’s a matter of finding the alternative lender willing to work with you in your given situation.

The choice of whether or not to apply for a business loan through an alternative lender versus first going to a traditional bank is one every company must weigh carefully. Yes, with traditional banks there are some advantages, however, increasingly the trend seems to be that conventional lending institutions are just not approving the loan applications of smaller companies. Meanwhile, alternative lenders are most definitely picking up the slack in that department.

First Union works with all sorts of small businesses from across the US. We want to see our clients thrive and grow which is why we offer a variety of fast and flexible loan program all custom tailored to fit the individual client’s needs. Call today!

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First Union Lending LLC is a dually licensed Lender/Broker with its main offices located at 4900 Millenia Blvd First Floor Orlando, FL 32839. First Union Lending LLC and its ads are meant for continental United States, including Alaska and Hawaii small business owners. Business Loans offered by First Union Lending LLC have varying rates and terms that can range from 30 - 120 payments and all rates and terms are based on eligibility of the business and its owners. The actual terms are based on credit, business history, industry, amount and terms. As an example, a $5,000 loan paid over 5 years at 8% would have a total repayment of $6,082.92 over the life of the loan. We use the latest encryption to protect sensitive information transmitted online, as well as run our own secure server network to ensure your information is protected offline as well.

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