Through our unique experiences as both a direct small business lender and process optimization consultant, we’re often asked to provide our perspective on the challenges today’s small business borrowers face when attempting to access capital. Over time, we have observed and documented six common threads we’ve come across and are sharing the first three in this month’s newsletter.
Race / Ethnicity
As we know, many members of our society are not served by the finance system – traditional, alternative, online and non-profit lenders do not reach everyone. Further, home ownership has historically provided the foundation for wealth and accumulation of equity in our country, with homes making up as much as 60% of the average American household’s wealth. When we look at home ownership rates, the breakdown is as follows:
- Whites: 72%
- Hispanics: 45%
- African Americans: 42%
Without the ability to build equity in the home, many minority and low-income borrowers lack that initial asset often used or leveraged in the creation or collateralization of their business. Without collateral, many minority borrowers often turn to unsecured lending in the form of expensive online products or, even worse, payday loans.
In addition, basic trust in the finance and banking system is often lacking in many of the low-income and underbanked communities in which we operate. This is in large part due to historical and well-documented banking practices around redlining, discrimination in hiring and lending, pushing low-income borrowers into predatory products, charging higher rates and fees to minority clients as compared to their white counterparts, even going so far as to defer basic required maintenance on real estate owned (REO) properties in low-income neighborhoods.
Past Credit Performance
While the capital stack and balance sheet many CDFIs use varies in size and complexity, patterns do exist. As CDFIs are required to meet capital and covenant requirements, we are often not able to look beyond traditional methods of judging an applicant’s past credit performance (traditionally FICO score-driven approaches to lending), especially if we desire to scale and pay back investors. This means we often can’t look past a very explainable and understandable credit blip, say a prior bankruptcy for example, and our tolerance for risk is artificially lowered.
Borrowers are limited by their past credit performance and FICO score in today’s finance system. We are continuously looking at ways to combine alternative sources of data (telecom, Lexis Nexus, social, etc.) with traditional sources of payment data in ways that are more predictive of a business’s ability, as well as, INTENT to repay. This helps dispel the notion that what a borrower did seven years ago affects their ability to secure needed financing to take advantage of growth opportunities today.
The graphic below from Foundation Capital shows the expected effect of combining alternative data (the dotted and bowed line) with traditional data (the flat line), resulting in “a better model” and a better predictor of default:
Geographic Location
Many of the poorest communities have been left behind. Income inequality and income segregation are inter-related and can’t be ignored. As income inequality has measurably and dramatically risen over the past 5 decades, the rich and poor have started to cluster away from each other. As a result, richer neighborhoods begin to accumulate and dedicate more resources toward improving themselves and their communities while poorer neighborhoods fall further behind, leading to an increasing gap between the two. Without public policy changes that address zoning, business incentives and numerous housing issues (housing stock, estimated value, mortgage availability, equity erosion, etc.), the “free market” alone will not lift these poorer neighborhoods up.
In the August blog, I will talk about how education, general understanding of the lending process and borrower preparedness impact our customers. I would love to hear about how these challenges, and others, impact your small business borrowers. Please feel free to reach out to me at nick@crfusa.com.
Interested in how you can improve your small business loan origination processes? Talk to us about a JumpStart Assessment!
