How can U.S. boost small business financing?

Getting a small business off the ground is no easy feat. Even the most dedicated entrepreneurs contend with an array of challenges in turning their businesses into going concerns.

Chief among those challenges: getting the money needed to start and run the enterprise. Financing can be the make or break proposition between a new business rising to the next level — or falling short of its promise.

A recent study from a team of economic researchers at George Mason University’s Mercatus Center takes a closer look at the realities of small business — and identifies potential threats that policymakers and regulators should heed.

In “Small Business Financing after the Financial Crisis: Lessons from the Literature,” Stephen Matteo, Adam Hoffer and David Wille survey recent research to develop a clearer picture of how entrepreneurs are funding their enterprises.

It’s a pertinent question, they note, since small businesses (defined here as companies with fewer than 500 employees and/or less than $7.5 million in annual revenue) employ about half the nation’s workforce and pay about half of all wages.

Conventional wisdom is that small enterprises are more likely to be financed via owner equity — funding provided by the founder, or borrowed from family and friends — used to steer the business through its early stages.

Indeed, the Mercatus researchers found that owner equity remains the most common financing option for most small businesses — but that the financial services industry plays an underappreciated role in capitalizing entrepreneurial ventures. As they note:

• Owner capital is not the only source of financing for new businesses. This statement runs contrary to standard theories of small-business financing, which predict that the owners of new firms are limited in their access to traditional loans, forcing them to rely on their own capital and financing from their family and friends.
• New business owners obtain credit from banks. But while owner equity is indeed an important source of capital for these small firms, especially at the time of startup, research shows that small-business owners are able to obtain credit from the traditional banking industry in the form of both consumer financial products (like credit cards) and business loans.

One area of concern, the study notes, is that while external financing is more available today than in the immediate aftermath of the 2007–2009 recession, access to that financing remains a challenge for many small businesses. While there are various reasons for this dynamic, the studies surveyed in the Mercatus study suggest that in addition to the low interest rate environment, financial regulations enacted after the financial crisis may be adversely affecting the supply of credit these businesses need to expand and thrive.

The authors detail a few of the unintended consequences that burdensome regulation has brought to bear on lenders, particularly at smaller community banks:

• There are higher compliance costs at banks. Increased scrutiny, mandatory changes to banks’ capital structure, and regulatory uncertainty, among other factors, may be affecting the profitability of small-business lending relative to other types of lending. According to a 2015 Federal Reserve Board and the Conference of State Bank Supervisors survey of small banks, nearly 50 percent of respondents reported that compliance costs increased 10–30 percent in the past three years.
• There is a disproportionate impact on small banks. While small banks were supposed to be shielded from certain aspects of new financial regulations, smaller banks are still spending more on compliance. This is a concern because banks with under $10 billion in assets issue about half of all small-business loans in the United States.
• There are increased costs of credit. There is evidence that new regulatory burdens are increasing the costs of credit for the small-business owners who do obtain it, particularly the costs of the consumer financial products that many small firms rely on like personal loans and credit cards.

The authors go on to look at how financial technology innovations like peer-to-peer lending and crowdfunding platforms may help to fill the gap by connecting investors and entrepreneurs. While these platforms are limited in their depth and breadth right now, they show promise for the future.

The Mercatus researchers conclude that the financial services industry plays a key role in financing small business and that policymakers should take into account that impact on small businesses in formulating or reforming financial sector regulations. Similarly, SIFMA leaders John Rogers and Kenneth Bentsen made the case for a more balanced regulatory approach in a December 2015 discussion.

Solving the puzzle of small business lending won’t be easy, but making more funding available to small enterprises through a variety of mechanisms is critical, given the important role these companies play in driving economic growth. Taking the needed steps to ensure that the small business sector is vital and growing is essential.