To benefit both the borrower and the lender, we must improve transparency and the loan process to protect and ascertain the true value of small businesses. In the United States, there are nearly 28.8 million small businesses, including franchises, which account for 48 percent of the private sector. While they serve as a backbone to the U.S. economy, small businesses have been singled out when it comes to receiving commercial lending from banks due to a lack of modernizing of the commercial lending construction. To benefit both the borrower and lender, we must improve transparency and the loan process to protect and ascertain the true value of small businesses.
Credit Vs Commercial Lending
In 1970, the Fair Credit Reporting Act ushered in a new digital structure made up of statistics, data and rights of consumers to guarantee the successful growth of the consumer finance industry and the consumer motivated economy. Profits for credit card companies grew exponentially, and the “Big Five”credit and rating agencies were established.
Like many established markets, regulation helped to create a market where a superhighway of financial products could grow. This provided consumers a new credit, or FICO, score, which dictates whether individuals are able to get a mortgage, credit card or auto loan. FICO typically gives the best rating to those individuals who pay on time, have no negative collections activity and limited credit card debt and no negative collections recorded, judgments or past bankruptcy filing. However, this fortuitous outcome of the credit score was that it eventually became the standard by which consumers, and specifically their businesses, are judged by financial institutions for being eligible for investment and capital.
Following the crash in 2008, banks, and especially smaller community banks who were more likely to lend to not so big firms, were hit hard, directing them to become even more risk adverse. Regulatory overhauling responded to the crisis by forcing banks to convert capital and make less risky loans. In the report on small business lending, Harvard Business School revealed that this forced less than 6,000 local banks throughout the U.S. to place a greater focus on the borrower’s own profile, including personal income, higher personal credit thresholds and higher collateral requirements.
Typically, when initiating the commercial lending process with a financial institution, business owners and entrepreneurs are asked two questions – What is your credit score and what is your current income? – the same questions that individuals are asked when they are seeking a personal loan, highlighting a benchmarking process that works to disadvantage small business owners.
These two questions hold the key for the bank to begin looking at financing options for small businesses yet are not truly indicative of how their business is progressing or what the business owner has built. These scoring methods must be updated beyond the variables that are included in a FICO score for commercial lenders to make improved commercial lending decisions.
Luckily, advances in big data technology have begun to force commercial lenders into holistic adaptation – incorporating new data insights to new small business owner demands in efforts to make commercial lending faster and more efficient. Big data provides information to be studied by both borrowers and lenders, giving borrowers more information on the terms other businesses are receiving, while lenders are able to weigh out the risk by having a thorough understanding of the businesses’ revenue, valuation, capital and collateral. Overall, it will be beneficial for both parties if loans are better able to reflect not just the primary shareholders’ credit worthiness but the businesses’ value and worth.
If the economy and the banking sector can find a way to better marry the supply of available funds to the demand for commercial lending from the business owners this would usher in a full-scale revolution in commercial lending. Most modern firms believe that in order for this to occur there needs to be a new, fair and open lending act and data infrastructure established for the small and midsize business. For in the end, modeling credit based solely on risk and not the potential capacity for growth will forever short wire the business and the commercial lending industry.