Imagine being a small business owner in a low-income neighborhood in America today. Trying to achieve the “American Dream,” you have worked your hardest to start and grow your business, and you’ve largely been successful. You’ve invested hundreds of dollars of your own money into your business over the years. You’ve borrowed money from friends and family. And for many years, you barely took a paycheck in order to ensure that every dollar you earned went back into growing the business. Now, your business model is working.
Then, something financially devastating happens – it might be a personal issue like an uninsured family member getting sick, an economic recession, or (to use a recent example), a government shutdown. Strapped for cash and desperate to pay your next month’s rent for your business, you do a Google search for “small business loans.” You click on the first ad that comes up and are directed to a website that asks you to fill out a simple application, which you do. Then, within minutes, you are approved for a short-term three-month loan. The next day, the money is in your account. You use it to pay the rent for the business, planning to pay it back once your business is back in full swing. Your profit margins are thin, but you saw the interest rate of 4% per month and you thought it was a pretty good deal for a short-term loan. You set aside enough in proceeds from your business to pay the entire loan within one month, which you figure will help you save money on interest.
But when you go to pay off the loan, you realize that there’s a catch. You’re going to be charged a prepayment penalty (a fee for paying off your loan early). As you look into your business’s online checking account, you realize that the loan company has already charged you a processing fee and an origination fee. You didn’t account for these payments, and to add insult to injury, your bank is now charging you an overdraft fee. You have no idea what these loan fees are, or why they are so high. And none of this information was disclosed to you when you took out the loan. If you’re lucky, you will find friends and family from whom to borrow this additional money. If you’re not, you may find yourself taking out another loan to pay for the first one, or putting off paying your other bills and hoping you can keep your business afloat.
How Did We Get Here?
This is not an uncommon experience for small business owners in America today, particularly those who – because of income or race – have limited options for obtaining financing. Now, financial technology (“fintech”) players have entered the market. The mission of these new lenders is generally good. They are responding to gaps in the market for small business financing. In recent years, a number of factors have made it difficult for the smallest businesses and those seeking the smallest loans to access capital. (See Chapter 2 of this report.) Moreover, for a long time, the process of obtaining a small business loan has been slow and tedious. These fintech lenders are making smaller, faster loans that respond to these needs.
The issue, however, is that these rapidly growing start-ups have gone largely unregulated, and a burgeoning set of bad actors are simply taking advantage of a lack of federal and state small business borrower protection laws to offer predatory loans to small businesses in need. Perhaps that is why nearly 80% of small business owners think predatory lending that targets small businesses is a problem.
Why are lenders still able to do this? After the 2008 financial crisis, borrower protection became a hot-button issue. In response, the Dodd-Frank Act of 2010 took major steps to protect consumers from the worst abuses in the financial lending market, including forming the Consumer Financial Protection Bureau. As transformative as this legislation was, small business borrower protections were not included. This was based on an idea, however unfounded, that small business borrowers were more sophisticated than consumer borrowers, and therefore did not need the same protections. But as shown in multiple studies by the Federal Reserve Bank of Cleveland, small business owners are often no more knowledgeable than ordinary consumers when it comes to understanding lending terms.
Now, instead of having robust small business borrower protection laws, former U.S. Small Business Administrator Karen Mills points out that we have been left with a patchwork of federal and state regulation that is duplicative, conflicting, and perhaps most importantly, incomplete. (See Chapter 5 of this report.) Despite a range of federal and state regulators responsible for overseeing small business lending, there is no federal agency (nor is there one in most states) tasked with ensuring that small business lenders give accurate and clear information to borrowers about the cost of their loans.
Why Does It Matter?
Why does this matter from the standpoint of civil rights and economic justice? Perhaps the most troubling aspect of small business predatory lending is that it takes advantage of a lack of financing options created, at least in part, by the past practices of the financial industry itself. There is a long and sordid history of financial exclusion (e.g., using redlining to avoid lending to people of color) and predatory mortgage practices (e.g., subprime lending targeted at low-income communities) that have contributed significantly to the racial wealth gap and made it more difficult for black and Latino borrowers to access the loans they need at affordable rates. For example, it is no secret that in the run up to the financial crisis of 2008, minority borrowers were specifically targeted by lenders peddling predatory mortgage products. As the housing bubble collapsed, many low-income and minority borrowers lost everything. The fact that black and Latino households held a disproportionate share of their family wealth in housing as opposed to other assets made this even worse. As a result, many black and Latino small business owners have lost any home equity they once had, limiting their ability to access new and cheaper financing options for their businesses. Instead, they are often stuck borrowing from shady lenders whose products are all too reminiscent of those that fueled the housing crisis – loans that are seemingly low-interest but turn out to be filled with hidden penalties and fees.
What Can We Do?
What can we do about this problem? To start, it is important to note that many civil rights legal organizations are working directly with small businesses in historically disadvantaged communities. For example, from Boston to San Francisco, local affiliates of the Lawyers’ Committee for Civil Rights Under Law are working to provide legal services to local small business owners. A clinic at George Washington School of Law is doing the same. Simply having a lawyer to help navigate the process of obtaining the financing to start and grow a business can be of significant help. But, of course, there are not enough legal aid lawyers or student attorneys to serve every small business in need. Thus, we must turn to policy solutions that can help stem the tide of small business predatory lending.
Some have suggested that usury laws, which put a hard cap on the interest rates that lenders can charge, would be the most effective solution. While this seems like a simple fix in theory, in practice it would be difficult to calibrate the interest rate caps effectively, particularly for short-term loans. If the cap was too high, it would have no impact. If the cap was too low, it would stifle the ability of lenders to make the short-term loans that many small businesses need. Even if the caps were accurately calibrated, it would be difficult to enforce, as lenders could shift around their fees structures to skirt the regulations. As a result, it is possible that such usury laws would have unintended consequences for the very people they are intended to protect.
What Should We Do Right Now?
I would argue that the best policy option, at least in the short term, is simply requiring disclosure. There has been much debate in the financial services industry and in policy circles about what lending terms should be disclosed and who should have to disclose them. (See pages 22 and 34 of this report.) However, responsible players in the industry have made a variety of proposals to advance borrower protection. These ideas range from a SMARTBox, in which key lending metrics are clearly disclosed, to a Borrowers’ Bill of Rights, which lays out a broad set of protections to which all small businesses should be entitled.
Moreover, at least one state has taken comprehensive legislative action on this issue. In September 2018, former California Governor Jerry Brown signed into law SB 1235, the nation’s first statewide small business truth in lending act. The law requires lenders to disclose the following terms for loans of under $500,000: the total amount of financing, the total cost of financing, loan term length, the frequency and amount of payments, any pre-payment policies, and the annualized interest rate. Together, these disclosures give small businesses a clear sense of what they need to pay and when they need to pay it, before they take out the loan. What makes the California law so exciting is that it empowers small businesses with all of the information they need to make a decision, and applies to all non-federally chartered lenders operating in the state. It also has support from both small business advocates and responsible industry players. This is a positive development, and other states should follow suit. In addition, given the national reach of many lenders and the fact that state law cannot reach federally-chartered financial institutions, Congress must act to fill the gaps.
Some in the lending industry argue that even basic disclosure laws will make them think twice before making small business loans, or will create compliance costs so high that they will raise their interest rates or stop making loans to low-income borrowers altogether. But this argument has become a trojan horse for shady lenders who know that they would lose market share to more responsible lenders if they were required to disclose their lending terms up front. After all, most major financial institutions are already disclosing this type of information (although not always in language that borrowers can easily understand). Many fintech players are doing the same. For responsible lenders, the increased compliance costs will be minimal. Moreover, without such disclosures, even responsible lenders will be forced into a “race to the bottom” when it comes to disclosure. If they disclose everything up front, they will lose out to lenders who offer seemingly lower prices but who do not disclose that their products are ripe with hidden costs. Instead of competing based upon the price of loans, responsible lenders will have to minimize the amount they disclose in order to stay in the market. Finally, while it is true that any new regulation serves as a barrier to entry for smaller startups, we should be wary of the notion that the market competition they bring is worth the negative impact on some of our nation’s most vulnerable small businesses.
As bad actors continue to provide loans that take advantage of low-income and minority borrowers, we must recognize that small business lending policy is social justice policy. The last financial crisis made the effects of predatory lending to communities of color and low-income communities abundantly clear. Those same practices may have taken a different form, but if we once again fail to protect the most vulnerable, the outcome may very well be the same.