Small firms and startups are often referred to as the “engine” of the U.S. economy because of their ability to create new jobs. For example, firms with fewer than 500 employees accounted for 63% of net new U.S. jobs created between 1992 and 2013.
Yet despite their importance to the economy, small firms often face difficulties accessing bank financing. These firms are typically opaque — that is, they don’t attract media or analyst attention, or produce lengthy financial reports. As a result, banks cannot rely on public information to assess loan applications from small firms. Instead, the firms must provide the bank with information demonstrating their creditworthiness. This process can be cumbersome and expensive for small firms.
In many cases, a bank can avoid imposing onerous reporting requirements on a firm by relying on its experience lending to similar firms from the industry or community to make loan approval decisions. In theory, this arrangement can make it easier for small firms to get credit.
Yet regulators pressure banks to collect more documentation from their largest exposures — precisely those areas where the bank has the greatest experience — a policy that can work to the disadvantage of small firms.
For example, a bank that has expertise in lending to small manufacturing companies might be the best able to access lending risk, and therefore make the soundest lending decisions on new businesses in this sector. But the bank’s expertise works against it since regulators require banks with heavy concentrations of loans in certain industries to collect even more documentation.
There is an historical reason for regulators to be cautious. Banks with the largest concentration of housing loans in the early 2000s were most likely to encounter losses and closures during the 2008 financial crisis. Many of the banks facing these problems were not documenting the income or assets of their borrowers. Prior bank failures, such as Continental Bank of Illinois, have also been traced to inadequate due diligence of borrowers in the most concentrated exposures.
For this reason, regulators expect banks to closely monitor their largest positions, and to demonstrate sufficient hard information collection from borrowers in these positions. This, in turn, can create a reporting burden for small firms. Bank requests for audited financial statements can be onerous if the firm isn’t already producing them — audits can cost upwards of $100,000 for firms with revenues of $25 million.
Read the full post at MarketWatch.
Andrew Sutherland is an Assistant Professor of Accounting at the MIT Sloan School of Management.