Why do deserving borrowers have a hard time getting bank loans?

You know something is wrong with bank lending practices when Ben Bernanke* gets rejected. Bernanke, former chairman of the Federal Reserve, was trying to refinance his Washington, D.C. home last year but his bank rejected his application.

The deciding factor clearly wasn’t income, but in how his income was earned. Most of Bernanke’s income, primarily speeches at $200,000 an appearance, came from 1099 sources, not W-2s. The banks’ formulaic approval processes cannot underwrite such applications effectively.

This irony highlights the rigid nature with which banks apply lending standards to all Americans in the wake of the recession. Remember the lax standards banks and other institutions applied to borrowers at the height of the housing bubble? The robo signers? The faked data?

Those chickens have come home to roost in a big way. Traditional lenders are being held to higher standards by regulators tasked with making sure another housing bubble does not form, though it remains to be seen how much tighter those standards will be over the long term.

The average borrower is typically worried about the following factors:

  1. Hard & Inconvenient: Post-2008 crisis, strict lending guidelines require a significant time commitment to comply with manual paperwork and application requirements. The long and arduous decision-making cycle can take months.
  2. Banking Gaps: Historically, specialty finance deals have not been able to secure bank financing as nontraditional asset classes are generally turned down by traditional banks and institutions. Many of these investments do not fit into the banks’ formulaic underwriting and analysis processes.
  3. High : Specialty finance companies have taken advantage of the supply-demand capital inefficiency for these companies.

Banks are in business to make as much money as possible as fast as they possibly can. Expect them to follow the path of least resistance in that quest.

The combination of historically-low interest rates and tighter lending standards has made many mortgages and small business loans more trouble than they are worth for most traditional lenders. Why risk default and incur underwriting costs when for a negligible difference, when you can put your money in Treasuries?

Lenders incur similar costs whether they underwrite a $40,000 loan, which is around the average sought by a small business in the United States, or a $400,000 loan. If you could loan $400,000 to one borrower and incur one set of underwriting costs or go through the process 10 times at 10 times the cost to loan the same $400,000, which one would you choose?

Yes, the national economy would enjoy many benefits from increased lending. Small businesses, the main drivers of job creation, could expand and create more opportunities. More people could also buy houses, which leads to increased consumer spending.

But until rates rise or banks’ profit mandates change, do not expect them to alter their behavior. They will tell you it is not their problem.
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* Source: Widely reported in the press by CNBC, CNN, Bloomberg etc.

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