Report Summary

Small business policy makers desire to make more capital available to entrepreneurs by increasing the flow of capital through the development of a secondary market for small business loans.

The ultimate conclusion of this paper is that due to the increased use of credit scoring combined with the emergence of multibillion-dollar bank holding companies in the U.S. banking sector, the development of a secondary market for conventional small business loans is more likely.

Key Findings

Despite the passing of the Riegle Community Development Act in 1994, the growth of a secondary market for conventional small business loans has shown little growth. This lack of growth of a secondary market is a point of concern for small business credit policy makers.

The paper concludes that a secondary market has not emerged due to the fact that there is an abundant supply of capital in the banking sector without the need for a secondary market. Furthermore, and probably the most important aspect of this study is the assumption that the lack of standardized loan underwriting practices makes it difficult to determine actual value of these loans for a secondary market.

The two conditions mentioned may be changing, due to the increased used of "Credit Scoring" in conventional small business lending and due to the emergence of giant interstate bank holding companies, or quite simply, the consolidation of the banking industry. The thought process revolves around the fact that due to the consolidation of the industry, there will be fewer originators of the loans creating the emergence of larger pools of loans. As these larger pools emerge, they will be easier to scrutinize in terms of their risk because more standard criteria will be used such as credit scoring.

A key finding in the paper is the fact that while the larger banks' share of the small business lending pool is growing, the growing pool consists of smaller loans - less than $100,000. These loans are more easily predicted through standardized models such as credit scoring. A large portion of the loan pool, on the other hand, consists of the larger loans, greater than $100,000, and many of these loans are made by smaller banks that use "Relationship" underwriting to scrutinize loan applications. These larger loans are difficult to pool and possibly hinder the emergence of the secondary market while serving the true financial needs of the entrepreneurs.

Field Faculty Findings and Business Development Implications

A major concern is that there is, at present, no apparent need for a secondary market under current economic conditions. In an effort to create a secondary market, regulators may actually develop policies that may hinder the growth of capital available to entrepreneurs by attempting to standardize the lending decisions. While standardization may be appropriate for other types of "asset based" lending, small business lending typically does not always fit into a standardized model.

Conventional loans are less expensive than SBA Loans for existing businesses, and the availability of conventional loans is key. Small businesses seek capital because of a "change" in their situation. This change may be related to the growth of the business, changing markets, or to expand the business. In other words, there is no actual relationship between the need for the capital and the historical credit score of the owner.

When a small business owner determines that he/she should seek financing their credit score may have already suffered a bit, limiting their conventional lending options if standard scores are used in place of the relationship lending. Entrepreneurs, as a rule, may not be finance/lending professionals and their credit score, in all likelihood, does not provide enough information for a lender to make a decision for the business. The overall relationship and a complete understanding of the entrepreneur and the business are vital.

Few business deals appear attractive to a lender when illustrated simply through a credit score or through financial statements. A relationship that allows a complete understanding by the lender of where the entrepreneur is taking the business is always more credible.

One final point related to the consolidation of the industry, pertains to the quality of the loans. Recent experience in the field has shown that the large banks are monopolizing the higher quality, small loans to the detriment of the smaller banks that are risking more to assist the entrepreneurs. As portfolios begin to mature, the quality of the loans for the secondary pool for the smaller banks may decline. The real benefactors in this process will be the large banks and only the most secure entrepreneurs possibly ignoring the needs of the more aggressive, higher growth entrepreneurs and penalizing the smaller banks for serving the community.

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