The Role of Secured Credit in Small-Business Lending

Ronald J. Mann, Columbia Law School


The traditional perspective holds that large firms in our economy use unsecured credit and small firms use secured credit. Existing scholarship has not done much, however, to explain that pattern. In a recent article, I attributed the use of unsecured credit by large firms to the limited ability of secured credit to lower the lending costs of creditworthy companies. This paper builds on data from a series of interviews with small-business bankers to explain the small-business half of the pattern. I argue that the only significant benefit of secured credit for small-business borrowers is that it allows them to give a credible commitment that they will refrain from excessive future borrowing. It 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 thing by taking a guaranty from the borrower's principal. I then have to explain why so much small-business borrowing is unsecured. I identify four separate effects that support the use of unsecured credit in small-business lending: 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 reduce lending costs and risks considerably. 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 traditional 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 are more important to the pattern than the ability to externalize risk that is the focal point of the traditional perspective.