The Role of Secured Credit in Small-Business Lending

The traditional perspective holds that large firms in our economy use unsecured credit and small firms use secured credit. Existing scholarship, however, has provided little explanation of that pattern. In a recent article, I attributed the use of unsecured credit by large firms to the limited capacity of secured credit to lower the lending costs of creditworthy companies. This article uses data from a dozen interviews with small-business bankers to explain the small-business half of that lending pattern. To the extent small-business lenders require secured credit, they do so largely for one significant benefit: secured credit allows small-business lenders to obtain a credible commitment that borrowers will refrain from excessive future borrowing. Secured credit provides little in the way of liquidation value, because the assets of small businesses tend to have low liquidation values. Similarly, it does little to improve the borrower's incentives, because the lender can accomplish the same goal by taking a guaranty from the borrower's principal. As it happens, however, much small-business borrowing is unsecured. I identify four circumstances that explain that fact: the relatively high transaction costs of secured debt; the declining enforceability of constraints on future lending (brought on by the ready availability of credit-card debt); the ambiguous value of constraints on future lending; and technological developments in credit-scoring and early-warning systems that dramatically reduce lending costs and risks. I argue that those developments presage a marked shift of small-business lending from secured debt to unsecured debt. Finally, I argue that those developments cast doubt on the dominant academic view that businesses use secured debt as a device for externalizing risk to third parties. The decline of secured debt at a time when legal liability risks appear to be increasing suggests that the transaction costs I discuss provide greater insight into the pattern of secured and unsecured lending to small businesses than the ability of small businesses to externalize risk.