Business Loans: How Banks Decide on Lending to Small Businesses Today

Why loan talks have become more difficult

A business has full order books, needs a new machine, and goes to its main bank. Instead of an approval come questions: about the three-year plan, the result of the current year, collateral, succession. In the end, there is an offer for less money than hoped, with a personal guarantee. Many owners experience this as distrust. For the bank, it is a regulated process.

The figures confirm that access has become tighter. KfW, Germany's state-owned development bank, measures quarterly together with the ifo Institute how SMEs experience their loan talks.

The central question, then: How do banks decide on loans to small businesses today, and what can an owner do to make the decision turn out better? To answer it, we first look at why banks prefer to say no rather than lend at a higher price, then at what they look at specifically, and then weigh two ways of lending. At the end comes a preparation for your own conversation.

The thinking model: credit rationing according to Stiglitz and Weiss

Why does a bank not simply raise the interest rate for uncertain customers? In 1981, the economists Joseph Stiglitz and Andrew Weiss gave an answer that still shapes research on lending today. Their starting point is information asymmetry: the borrower knows more about his project and intentions than the bank.

If the bank raises the interest rate in this situation, two things happen. Cautious borrowers with solid but less profitable projects drop out, because the loan no longer pays off for them. Those who remain are more likely to pursue risky projects and accept high interest, because they gain a lot if successful and would not repay anyway in case of failure. This is called adverse selection. In addition, a high interest rate can lead borrowers to act more riskily. Beyond a certain point, the bank's expected return therefore falls even though the interest rate rises.

The result is credit rationing: at a given interest rate, banks grant fewer loans than are demanded and select instead of steering through the price. An analogy makes this tangible. A landlord with a sought-after apartment does not give it to whoever offers the highest rent, but to the person he trusts to pay the rent over time and treat the apartment with care. He looks at pay slips, manner, and references.

A bank does not sell a loan to whoever pays the most, but to the one whose repayment it understands.

For an owner, this yields an important insight. The lever lies less in negotiating the interest rate than in closing the information gap. If you show the bank how your business works and where repayment will come from, you move from the group of the unclear to the group of the understandable. Interest rates and investment observes the same from the customer's perspective: access to credit is the real bottleneck, not the level of interest rates.

What banks look at specifically

Banks in the EU must assess the risk of their loans according to fixed rules and back them with capital. Most use an internal rating for this, a classification that estimates the probability that a borrower defaults within one year. The worse the rating, the more capital the bank must hold and the more expensive or rarer the loan becomes.

In addition, there is data the bank already has: how the account is run, whether overdrafts are frequent, whether payments come in on time. For total loans of more than 750,000 euros, the German Banking Act also requires the bank to have the borrower's financial circumstances disclosed regularly. Increasingly, the bank also asks about sustainability: according to a special KfW analysis, the topic came up in loan talks for 15 percent of SMEs in 2024, as Sustainability as a selling point describes.

Debt service capacity in an example

The most important building block is often the least conspicuous. The bank wants to see that, after taxes and owner withdrawals, enough remains to service all loans, with a buffer for weaker years.

In the example, the business can carry the new loan, but not by a wide margin. If earnings fall by a third, things get tight. This is exactly the question the bank asks, and if you answer it yourself before it is asked, you come across as prepared. Growth and cash flow explains why growth further increases financing needs.

What research shows about soft factors

The financial statements of small businesses are often not very informative for banks. They look backward, are shaped by tax planning, and sometimes mix business and private matters. Moro, Fink, and Kautonen (2014) therefore examined the role of information beyond the balance sheet. Their data cover 433 relationships between banks and small and medium-sized enterprises in northern Italy, combined with public financial data and a survey.

Their finding has two parts. First, information that the entrepreneur gives voluntarily shapes the loan manager's view of his competence, in addition to the hard figures and to what the bank learns anyway over the course of the relationship. Second, higher perceived competence lowers the interest rate. The authors conclude that entrepreneurs should actively demonstrate their competence to the bank and that banks should give local loan managers more decision-making authority.

Beltrame, Grassetti, Bertinetti, and colleagues (2023) arrive at a similar picture with a survey of small and medium-sized enterprises in Austria and Italy. Traits such as proactiveness and competitive orientation improved access to bank loans, especially when a relationship bank was involved. For innovative firms, the close bank relationship was particularly important to avoid rejections. Ferri, Minetti, and Murro (2019) show for European manufacturers that exports fell less sharply in the 2009 crisis when the bank had up-to-date soft information on export prospects.

Main bank or scoring? Two ways of lending

Both ways have their justification. For small amounts, such as a working capital loan or a vehicle, standardized procedures are fast and often sufficient. For investments, acquisitions, or phases with fluctuating figures, the studies mentioned show the value of a bank that knows the business.

I consider the main bank relationship the more important lever, but only if it is maintained. A relationship in which the owner only gets in touch when he needs money contains hardly any soft information. A second bank relationship also makes sense, because it allows comparison and limits dependence. If you know no alternative, you negotiate from weakness.

The five-part loan file

From the thinking model and the findings, I derive a preparation that I call the loan file. It is meant to close the information gap before the bank asks, and it can be reused for every conversation.

1. Figures for the last three years

   Annual financial statements, current management accounts, and a short explanation of outliers: a one-off loss, a large order, an investment. Unexplained fluctuations are read as risk.

2. Plan for two to three years

   Revenue, earnings, and liquidity, with traceable assumptions. Show where the revenue is to come from, for example from existing framework agreements or the pipeline. Planning sales targets describes how to derive sales targets properly.

3. Calculate debt service yourself

   Compile all financing and show that the business can carry it, even in a weaker year. This answers the bank's most important question in advance.

4. Clarify collateral and subsidies

   List what you can offer and check whether development loans or guarantees from development banks are an option. They are usually applied for through the main bank.

5. Name risks openly

   Dependence on large customers, open succession, staff bottlenecks. If you raise risks yourself and say what you are doing about them, you gain credibility. If you conceal them, you lose it as soon as the bank finds them.

Financing growth discusses which financing routes besides a bank loan are worth considering. A one-page KPI dashboard shows which figures are suitable for a regular review.

What follows beyond the individual case, and where the limits lie

Lending decisions follow the same logic as any decision under incomplete information. If you want trust, you must provide evidence, in a form the other side can check. The reverse also applies to your own business: if you grant customers payment terms, you are a small lender yourself. Reading a customer's balance sheet describes how to read a customer's figures before accepting a large order.

The limits of this analysis are clear. The studies on soft factors come from Italy and Austria and show correlations, not guarantees. Banks do not publish in detail how strongly soft factors enter German rating procedures. The KfW figures describe companies' perceptions, the Bundesbank survey the view of 33 banks. Both point in the same direction but measure different things.

Conclusion: how banks decide and what you can influence

To the guiding question: banks decide on loans to small businesses on the basis of rating, debt service capacity, collateral, and an impression of management. Because under uncertainty they prefer to say no rather than raise the interest rate, access to credit is often a bigger problem than its price. Research shows that voluntarily shared information and a well-maintained bank relationship can improve the bank's view of the entrepreneur and lower the interest rate.

For owners, this means: you can hardly negotiate the interest rate, but you can close the information gap. A loan conversation is won by the one who prepared it before needing the money.

• Set up the loan file with figures, plan, debt service, collateral, and risks.
• Calculate the debt service of all financing for a normal and a weak year.
• Send your main bank one page with current figures twice a year.
• Consider a second bank relationship so you can compare.
• Ask about development loans and guarantees before major investments.