One of the first effects you might feel in a recession as a small business owner is the tightening of credit conditions. While larger businesses have access to varied forms of financing, smaller businesses more often depend on credit that can be obtained through intermediaries such as banks.
During an economic downturn, intermediaries may tighten their underwriting or credit standards, making it more difficult for businesses to get approved for a loan.
Why is it Harder to Get a Business Loan in an Economic Downturn?
During a recession or other “credit-tightening” cycle, accessing these kinds of capital can become more difficult. A study from the Federal Reserve Bank of New York’s Research and Statistics Group after the 2008 financial crisis put it this way:
“Theory suggests that when credit declines in the banking system, ‘flight-to-quality’ phenomena likely emerge. That is, banks become more selective and risk-averse when extending loans and they curtail lending to riskier borrowers. Hence, small firms, which rely more on external financing and tend to be riskier, are more likely to be affected by a credit crunch.”
The data from that downturn illustrates this idea. Bank loans declined significantly during the Great Recession, with commercial and industrial loans falling approximately 20% from March 2008 to June 2010. As you can see in this chart from the Consumer Finance Protection Bureau, loan volume was also slow to recover after the recession had ended.
Source: Small Business Lending and the Great Recession, January 2020
While some of this loss may have been due to businesses not seeking credit and being more averse to taking on new debt, there’s no doubt that obtaining capital during an economic downturn becomes more difficult.
Small firms may have a hard time obtaining loans during a credit-tightening cycle because they are young and have limited credit history. Lenders may also be reluctant to lend to small firms with innovative products because it might be difficult to collect enough reliable information to correctly estimate the risk for such products.
So, what can small businesses do to obtain a business loan if they need one during a credit-tightening cycle?
The SBA 7(a) Loan Program
Small businesses can obtain business loans through the SBA 7(a) program when they cannot obtain funding through traditional lenders due to underwriting or credit standards becoming more risk-averse.
The 7(a) loan program can be a great capital option for small businesses, especially since the Paycheck Protection Program (PPP) has ended and there aren’t any current forgivable loan or grant programs. At NEWITY, we offer loans up to $250,000 through our Smart Portal. The SBA 7(a) working capital loan terms are as follows:
*Please note: the estimated monthly payment is using the WSJ prime rate at time of publication, monthly payments will vary based on multiple factors including, but not limited to: loan size and current WSJ prime rates.
The SBA 7(a) loans are originated by a lender – for instance, NEWITY – and are meant to provide capital to US small businesses who might otherwise have challenges in obtaining a loan. The benefit of 7(a) is that the eligibility and documentation requirements stay the same even with volatile economic conditions.
Eligibility for SBA 7(a) Loans
The SBA’s 7(a) program encourages lenders like NEWITY to provide loans to small businesses that might not otherwise obtain financing on reasonable terms and conditions. This is where something called the “credit elsewhere requirement” comes in: The 7(a) loan process requires that lenders verify that borrowers were unable to secure part or all of the desired loan amount from sources outside the SBA without causing undue burden.
The rest of the 7(a) eligibility requirements for $25k or less working capital loans are as follows:
Documentation for SBA 7(a) Loans
The documentation requirements for businesses also stay the same regardless of when the 7(a) loan is obtained. Borrowers are not required to provide additional projections of business in order for a credit decision to be made based on the credit environment.