No. 229

 May 2003

SMALL BUSINESS

RESEARCH

SUMMARY

Assessing the Profitability and Riskiness 

of Small Business Lenders in the Banking Industry

James W. Kolari 

Mays Business School, Texas A&M University

College Station, Texas 77843-4218

under contract no. SBAHQ-01-R-0005 

This Small Business Research Summary (ISSN 1076-8904) summarizes one of a series of research papers prepared under contracts

issued by the U.S. Small Business Administration’s Office of Advocacy. The opinions and recommendations of the authors of this study do

not necessarily reflect official policies of the SBA or other agencies of the U.S. government. For more information, write to the Office of

Advocacy at 409 Third Street S.W., Washington, DC 20416, or visit the office’s Internet site at www.sba.gov/advo.

Purpose

Small banks have traditionally been one of the major

suppliers of credit to small firms in the United

States. In recent years, there has been concern that

deregulation and consolidation in the industry, by

reducing the number of small banks lending to small

businesses, will reduce bank lending to small businesses overall.

This research looks more closely at the reasons

for the availability of bank credit to small business

by asking how profitable small business lending is.

The research suggests two possible hypotheses:

• If the “specialization hypothesis” is verified,

banks will be more profitable as they specialize in

small business lending. 

• If, on the other hand, the “diversification

hypothesis” prevails, banks will be less profitable as

they specialize in small business lending.

Overall Findings

Small business lending can help banks, especially

large banks, diversify and reduce the risk of failure.

The specific findings depend on which of two definitions of profit are used:

• The rate of return on assets (ROA) relates a

bank’s profits to its resources—in other words, it

measures the “bottom line”—how profitably a bank

has used each dollar of assets under its control. The

study finds generally that small business lending neither reduces nor increases a bank’s profitability

measured as return on assets—that is, neither of the

two hypotheses is accepted.

• The rate of return on equity (ROE) relates a

bank’s profits to its shareholder equity—and is relevant to shareholders who are concerned about the

profitability of their investment. Using this measure

the study finds that banks can benefit from specializing in small business lending, especially by reducing

the risk of failure.

If larger, more diversified banks are the future of

the industry, small business lending can play a positive role by contributing to diversification and reducing the risk of bank failure.

Highlights

The determination of whether small business lenders

are more profitable than other banks hinges on the

definition of profits used.

Using Return on Assets as the Measure 

of Profit

• For four of the five bank size groups, small business lending had no effect on the bank’s profitability.

• An exception is that small business lending did

lower the profits of very small banks with assets

under $100 million over the period studied.
• Also, there was weak evidence that small business lending lowered the profitability of larger banks

in recent years. This decline is probably related to

the economic slowdown.

Using Return on Equity as the Measure 

of Profit

• Small banks specializing in small business lending are well diversified and have relatively low risk

compared with banks specializing in other kinds of

lending as well as those with a balanced portfolio.

• Large banks (with assets over $500 million) that

specialized in small business loans had the lowest

risk and high levels of diversification compared with

banks specializing in other loan areas.

• The study concludes that while small business

lending tends to lower bank profitability to some

degree, bank risk is commensurately reduced, not

only for small banks but also for large banks. 

• The results therefore support the specialization

hypothesis—small business lenders had higher return

on equity compared to other banks.

Scope and Methodology

To assess the profitability and riskiness of small

business lending, the researchers conducted various

tests on data from banks’ annual Call Reports of

Condition and Income for 1994-2001. Small business loans are defined as loans of less than $250,000

To compare the performance of small and large

banks, five asset size categories of banks are

defined: those with assets of less than $100 million,

$100 million to $300 million, $300 million to $500

million, $500 million to $3 billion, and more than $3

billion. Analyses were divided into two parts: 

(1) univariate and multivariate tests that focused

on how small business lending affects banks’ rate of

return on assets (ROA) and 

(2) “efficient frontier” analyses that focused on

how small business lending affects banks’ rate of

return on equity (ROE) and associated capital risk.

Ordering Information

The full text of this report and summaries of other

studies performed under contract to the U.S. Small

Business Administration’s Office of Advocacy are

available on the Internet at www.sba.gov/advo/research.

Printed copies are available for purchase from:

National Technical Information Service

5285 Port Royal Road

Springfield, VA 22161

Tel. (800) 553-6847

TDD: (703) 487-4639

www.ntis.gov

Order number: PB2003-102400

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