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Why Small Businesses Have Trouble Getting Credit

Only one third of small business owners were able to obtain all of the credit that their businesses need, a recent National Federation of Independent Business (NFIB) survey [1] shows.

The survey’s finding is not surprising. Many economists, policy makers and small business advocacy groups have long explained that small businesses have a harder time obtaining credit than their larger counterparts. When it comes to accessing capital, size definitely matters.

Even among small businesses, the smaller the company, the lower the odds that it has a loan (see figure below) or a line of credit. Only 15.7 percent of businesses with one or fewer employees have a business loan and only 33.7 percent have a line of credit, the NFIB survey shows. By contrast, 56.8 percent of businesses with between 50 and 250 workers has a business loan and 65.4 percent has a line of credit.

Source: National Federation of Independent Business, 2011 finance survey [2] Source: National Federation of Independent Business, 2011 finance survey

Rather than reveal some sinister motives among bankers, however, these patterns simply reflect the economics of business credit. Fewer small businesses have access to credit than larger companies because lending to them is riskier and more expensive than extending credit to larger companies.

Default risk is higher in the small business loan market. Small businesses fail at higher rates than big businesses and changes in the business cycle have a larger impact on their profits. Because lenders cannot always charge interest rates that are commensurate with a borrower’s default risk, the most risky small business borrowers are often unable to get credit.

Lending to small businesses is more expensive than lending to big companies. Part of the problem is the fixed cost of making a loan. Some costs are the same whether you make a $50,000 loan or a $5 million loan. Therefore, profit margins are higher on bigger loans. Of course, larger companies are more likely to need bigger loans than their smaller counterparts, which leads lenders to focus on larger customers.

Additionally, evaluating small business loan applications is often expensive. Little publicly available information on the financial condition of small companies exists, and small businesses’ financial statements are not always very detailed. Small business owners’ personal finances are sometimes intermingled with those of their businesses. The very large variety of small businesses and the way they use borrowed funds make it tough to apply general lending standards. Finally, monitoring the financial condition of small businesses often requires lenders to build personal relationships with small business owners.

These economic principles have important implications for those seeking to boost small businesses’ access to credit. Encouraging more lending will require policies that take into account the greater cost and risk of lending to small companies — and why small businesses have trouble getting credit.