The pandemic has raised questions about where small businesses might seek credit.

Even during an existential crisis, small businesses will go to great lengths to avoid taking on debt. According to the latest Small Business Credit Survey (SBCS), fielded and published by 12 Federal Reserve Banks, the most common actions taken by small businesses in response to financial challenges from autumn 2020 to autumn 2021 were:

• Obtaining funds that do not have to be repaid: 71%
• Using personal funds: 61%
• Using cash reserves: 56%
• Obtaining funds that must be repaid: 52%

In any given year, of course, according to the SBCS, fewer than half of small businesses seek external financing. The last two years forced most small businesses to seek external assistance from financial institutions, particularly through the Paycheck Protection Program (PPP). For most borrowers, a PPP loan ended up being a grant. As of a few days ago, 89% of the total value of PPP loans had been forgiven.

As the survey results above show, small business owners sought forgivable PPP funds as well as grants from public and private sources. Then, before seeking credit, they used whatever they had in the bank, including their personal accounts. In the 2016 SBCS, 71% of small businesses said they carried outstanding debt. In 2021, 74% did.

We hear about small business resilience all the time—part of being resilient in a crisis means going to great lengths to sustain your business without endangering its long-term viability. Many small businesses have evidently been able to survive the pandemic without loading up on debt. (The situation is slightly different for many of those who received Economic Injury Disaster Loans.)

The experience during COVID-19, for small business borrowers and lenders alike, raises several questions about the future of small business financing. Some may have used an online lender or other alternative. Some might even have used a bank for the first time. Many turned to the Small Business Administration (SBA) for the first time.

Will Financing Gaps Close—or Widen?

It’s well known that the Covid-19 pandemic had a disproportionately negative impact on people of color. Prior to the Omicron surge over the winter, the SBCS data indicate that firms owned by people of color “were most likely to be in fair or poor financial condition.” Three-quarters (76%) of Black-owned businesses, for example, described themselves this way compared to 55% of White-owned businesses.

The pandemic’s uneven racial and ethnic impact came on top of racial gaps in small business and startup financing that have persisted for many years. Black and Hispanic business owners have historically been more likely to seek smaller amounts of credit. That type of financing gap only widens over time as businesses grow and mature.

Black and Hispanic small businesses are more likely to seek smaller amounts of financing than White and Asian small businesses.

That chart is from a recent report from the Bipartisan Policy Center, in collaboration with Goldman Sachs 10,000 Small Businesses Voices. The report looks at these disparities and how public policy might help close them. Tracking small business financing gaps should be a top priority for policymakers in the months ahead.

Will More Small Businesses Seek SBA Loan Guarantees?

Excluding PPP and EIDL, more small businesses turned to SBA loan guarantees in 2021 than in prior years. Many small businesses were either previously unaware of SBA lending support programs or declined to utilize them. SBA programs such as its 7(a) loan guarantee are generally designed to help small businesses that cannot find “credit elsewhere.”

From 2016 through 2019, according to the SBCS, less than one-quarter of small business respondents applied for credit through the SBA. In 2020 and 2021, that share was over 40%. The 7(a) secret is out. Again, this excludes PPP and EIDL.

High utilization is evident in SBA data. The number of 7(a) loans in fiscal year 2021 rose by 22.5% compared to FY20, back to nearly the same volume as in FY19. The amount of financing provided through 7(a) loan guarantees grew enormously, from $22.7 billion in FY20 to $36 billion in FY21. Last year’s amount was the largest ever provided through the 7(a) program (unadjusted for inflation). According to the SBA, through the first five months of FY22, 7(a) lending is already running ahead of 2021.

Lending dollars supported through the 7(a) program reached its highest level in FY21.

A major question facing the SBA and its lenders is to what extent the last two years—and the increased awareness among small businesses of the agency and its support—represent a new trajectory or a pandemic aberration.

Whither Financing Innovations?

The BPC report cited above also highlights research finding that inclusion of online lenders in PPP helped close those disparities that characterized the early phase of the program. Prior to 2020, online and alternative lenders could not directly participate in government-backed lending programs.

Beyond government guarantee programs, of course, the small business financing market had boomed in the decade prior to Covid. Rapid growth in marketplace lending options was a significant driver of that. According to the SBCS, while application rates at online lenders (excluding pandemic-related assistance) fell in 2020, they rebounded in 2021. By contrast, there was a decline from 2020 to 2021 in the share of small businesses applying for credit at small banks.

Online lenders are now an important part of the small business lending landscape. The tradeoffs for small businesses at different types of lenders are clear in the SBCS data. They face difficult application processes and long waits for credit decisions at banks, especially large ones. And they face high interest rates and sometimes unfavorable repayment terms at online lenders (and finance companies).

Beyond marketplace lenders, there is consistent innovation in capital structures and growth in areas such as revenue-based financing. As small businesses look to recover and grow—and as new business creation booms—policymakers will need to make adjustments to accommodate innovation even as they seek to close longstanding gaps.