Small Banks, Big Impact: Community Banks and Their Role in Small Business Lending

The U.S. economy depends on small businesses, and small banks play a key role in providing access to credit for small firms. The U.S. Small Business Administration (SBA) defines a small business as a firm with fewer than 500 employees. Using this widely accepted measure, the SBA estimates that there are 33.2 million small businesses in the U.S. and that roughly half of all Americans in the labor force are employed by a small business or running one.See this March 2023 frequently asked questions document (PDF) from the SBA’s Office of Advocacy. Small banks, often called community banks, are those with less than $10 billion in total assets.Banks in the U.S. are often grouped into three categories: community banks (those with less than $10 billion in total assets), regional banks (those with total assets between $10 billion and $100 billion) and large financial institutions (those with total assets of $100 billion or more). According to data from the Federal Deposit Insurance Corp., the number of U.S. community banks dropped by 46% over the last two decades, falling from 7,620 in 2003 to 4,129 in 2023. In contrast, the number of regional banks grew almost 50% over the same period. As of 2023, there were more than 30 large financial institutions with about 30,000 branches. Community banks had over 27,000 branches. A vast majority of the banks in the U.S. are community banks.

Challenges to Small Business Lending

Even though small businesses play a critical role in their communities, they frequently encounter obstacles to accessing capital because banks face challenges in lending to them.

For instance, small businesses are inherently riskier. The failure rates for small businesses in the early stages of development are high. Small business failure rates are also elevated compared with those for larger firms. Early access to credit is crucial for businesses, and its availability may determine whether a firm can expand and hire more employees. The U.S. Census Bureau compiles statistics that provide annual measures of firm startups and shutdowns. These data indicate that a fifth of small businesses fail within the first year.See the U.S. Census Bureau’s Business Dynamics Statistics.

Moreover, small businesses are often younger than larger companies, making it more difficult to assess their creditworthiness. It is also more difficult to evaluate and monitor smaller loans, and the costs associated with processing smaller loans are higher. Each small business has a distinctive business strategy, customer base and mode of operation—factors that make them harder to monitor than large corporations. A final challenge that banks may face in extending capital to small businesses is a lack of collateral.

The Community Bank and Small Business Relationship

Community banks are uniquely positioned to meet the challenges of lending to small businesses, as they have deep insight into local economic conditions and business opportunities. Community bankers claim, and research appears to confirm, that by operating local branches, small banks leverage their physical proximity in making loan decisions.See Nguyen T. H. Nguyen and James R. Barth’s July 2020 Atlantic Economic Journal article, “Community Banks vs. Non-Community Banks: Where Is the Advantage in Local Small Business Funding?” Community banks tend to form stronger relationships with small businesses, which helps overcome “informational opacity,” i.e., a lack of information about a small business needed to determine its creditworthiness.See Allen N. Berger, William Goulding and Tara Rice’s December 2013 paper, “Do Small Businesses Still Prefer Community Banks?” (Board of Governors of the Federal Reserve System International Finance Discussion Paper No. 1096).

Small businesses that work with small banks report higher rates of loan approvals. In 2022, 82% of small-business applicants were at least partially approved for loans from small banks. At larger banks, just 68% of small-business applicants received at least partial loan approval. Small-business owners who applied and got approved for loans from small banks also reported being much more satisfied with their banking experience than those who worked with larger banks, finance companies or online lenders.See the Federal Reserve’s 2023 Report on Employer Firms: Findings from the 2022 Small Business Credit Survey.

Moreover, small businesses applying for a loan, a line of credit or a cash advance reported fewer challenges when working with small banks. Over 60% of small businesses applying for a loan from a fintech lender, for example, said that they ran into an issue. Exactly half of firms that applied for financing from a larger bank reported encountering a problem, compared with just 40% of entrepreneurs who applied for a loan from a small bank.

There are, however, differences in banking relationships between white-owned small businesses and small firms owned by people of color. For example, in 2022, minority entrepreneurs applied for loans from small banks at a lower rate (10%) than did white business owners (27%).See the Federal Reserve’s 2023 Report on Startup Firms Owned by People of Color: Findings from the 2022 Small Business Credit Survey. A subset of community banks—minority depository institutions (MDIs)—promote financial inclusion in traditionally underserved communities. MDIs have become instrumental in increasing access to credit in minority communities and are filling gaps left by larger institutions.See Maude Toussaint-Comeau and Robin Newberger’s May 2017 article, “Minority-Owned Banks and Their Primary Local Market Areas,” in the Federal Reserve Bank of Chicago’s Economic Perspectives. For a discussion of Black-owned MDIs, see my February 2021 Regional Economist article, “Black-Owned Banks and the Communities They Serve.”

Community Banks and Nonemployer Firms

A relationship with a small bank is even more important for nonemployer firms, i.e., businesses with no employees other than the owner. Approximately 4 in 5 small businesses are nonemployer firms. In 2022, 58% of nonemployer firms reported that at least a portion of their loan applications were approved by small banks, compared with about a third of nonemployer firms reporting the same level of success in applying for loans from larger banks.See the Federal Reserve’s 2023 Report on Nonemployer Firms: Findings from the 2022 Small Business Credit Survey.

Community Banks’ Focus on Small Business Lending

The ratio of small-business loans to total assets demonstrates the importance of community banks in the small-business space. An analysis of June 2023 call report data shows that community banks have larger shares of small-business loans relative to their total assets than do bigger institutions. As the following figure illustrates, small-business loans—i.e., loans less than $1 million—accounted for 12.6%, 11.1% and 7.9% of total assets at three different sizes of community banks (those with $250 million or less in assets, those with more than $250 million to $1 billion in assets, and those with more than $1 billion to $10 billion in assets, respectively.) Larger banks, those with assets of more than $10 billion, held just 3.6% of their total assets in small-business loans.

The differences in lending patterns between larger banks and small banks are even more evident when comparing banks’ microloan portfolios. Microloans are business loans of at most $100,000. As the above figure also shows, microloans make up larger shares of total assets at smaller banks. Community banks are much more likely to provide microloans to small businesses, which makes economic sense: Community banks build more diversified loan portfolios by extending many microloans rather than fewer big loans. This difference further underscores the focus of small banks on meeting the credit needs of small businesses in their communities.

Notes

1. See this March 2023 frequently asked questions document (PDF) from the SBA’s Office of Advocacy.
2. Banks in the U.S. are often grouped into three categories: community banks (those with less than $10 billion in total assets), regional banks (those with total assets between $10 billion and $100 billion) and large financial institutions (those with total assets of $100 billion or more). According to data from the Federal Deposit Insurance Corp., the number of U.S. community banks dropped by 46% over the last two decades, falling from 7,620 in 2003 to 4,129 in 2023. In contrast, the number of regional banks grew almost 50% over the same period. As of 2023, there were more than 30 large financial institutions with about 30,000 branches. Community banks had over 27,000 branches.
3. See the U.S. Census Bureau’s Business Dynamics Statistics.
4. See Nguyen T. H. Nguyen and James R. Barth’s July 2020 Atlantic Economic Journal article, “Community Banks vs. Non-Community Banks: Where Is the Advantage in Local Small Business Funding?”
5. See Allen N. Berger, William Goulding and Tara Rice’s December 2013 paper, “Do Small Businesses Still Prefer Community Banks?” (Board of Governors of the Federal Reserve System International Finance Discussion Paper No. 1096).
6. See the Federal Reserve’s 2023 Report on Employer Firms: Findings from the 2022 Small Business Credit Survey.
7. See the Federal Reserve’s 2023 Report on Startup Firms Owned by People of Color: Findings from the 2022 Small Business Credit Survey.
8. See Maude Toussaint-Comeau and Robin Newberger’s May 2017 article, “Minority-Owned Banks and Their Primary Local Market Areas,” in the Federal Reserve Bank of Chicago’s Economic Perspectives. For a discussion of Black-owned MDIs, see my February 2021 Regional Economist article, “Black-Owned Banks and the Communities They Serve.”
9. See the Federal Reserve’s 2023 Report on Nonemployer Firms: Findings from the 2022 Small Business Credit Survey.