United States Small Business Administration
Office of Advocacy
RS 160
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Purpose

Finance companies encompass a broad range of lenders, extending from companies such as General Motors Acceptance Corporation (GMAC) to those owned by individuals. The industry has evolved as a significant participant in the financial capital market over the past couple of decades. Redirecting their portfolios toward business and real estate credit and away from the traditional source of customers, consumer loans, finance companies increased their total business lending from just under $86 billion in 1980 to nearly $300 billion in 1992. Although little information is available about finance companies' lending to small business in the United States, there does exist a popular notion that finance companies are the "pawn shops of the financial services industry" -- insignificant and isolated participants in the financial services market, attracting primarily high risk borrowers and charging these borrowers relatively high loan prices. This study explores the "pawn shop" notion, profiling finance company borrowers, examining their demands for financial services and assessing whether they pay higher loan prices than borrowers of bank loans.

Scope and Methodology

In this study, finance companies are separated into two groups, captive and non-captive. Captive finance companies, such as GMAC, use the financial strength of their parent company to raise low cost capital and their product knowledge to efficiently resell assets acquired in loan defaults, hence decreasing their total cost of capital. Non-captive finance companies supply finance products marketed by other companies, and typically have no comparative advantage in raising capital or disposing of products acquired in a loan default. Non-captive finance firms depend on offering other financial services (such as consulting, sales financing, and accounts receivable factoring) to survive.

The data source for this study is the 1988 National Survey of Small Business Finances (NSSBF). The NSSBF provides for the first time information on small business borrowing from different types of lenders, such as banks and finance companies. The NSSBF sampled the population of non-financial, non-agricultural businesses with fewer than 500 employees. The information requested was for the year 1987. A probability sample was designed to select a sample from the Dun's Market Identifier file. Of 5,190 eligible firms, 3,404 businesses completed the survey instrument, yielding a 65.6 percent response rate. Because interest rate information was to be used to assess the loan prices, only firms with loans since 1978 were retained in the sample for the pricing analysis (1,786 firms). In addition, a study verification survey was conducted to discuss and verify the results of the statistical analysis with knowledgeable individuals who either own or work for a finance company.

The study employed a conceptual model depicting loan pricing behavior for two lenders (commercial banks and finance companies) who evaluate borrowers based on their credit riskiness and relationship with the lender. Based on the conceptual model, hypotheses tested included: (1) borrowers with close lender relationships will have a higher probability of being attracted to commercial banks than finance companies (and conversely, borrowers without close lender relationships will have a higher probability of being attracted to finance companies than commercial banks); (2) high risk borrowers will pay higher loan prices than low risk borrowers; and (3) finance company borrowers will pay lower loan prices (that is, face lower interest rates and lower collateral requirements) than other borrowers.

Highlights

• The results of this study portray both captive and non-captive finance companies as mainstream lenders, attracting a mix of borrowers similar to other lenders and charging these borrowers competitive loan prices.
• Borrowers who acquire leases or loans from finance companies are typically larger small businesses with some previous lending experience with a commercial bank.
• Captive and non-captive finance companies are significant lenders in the financial market for small businesses, especially as vehicle and equipment lenders. Captive finance companies supply 3.9 percent of all lease funds and 4.8 percent of all loan funds to small businesses. Non-captive finance companies supply 11.5 percent of all lease funds and 3.9 percent of all loan funds. When all institutional sources of capital are considered, finance companies rank as the third most important source of financial capital, following commercial banks and thrifts.
• Finance companies are not the "pawn shops" of the financial services industry. They charge lower prices in the vehicle loan market than other lenders. In other loan and lease markets, finance companies were shown to offer competitive prices, based on the risk of the borrower and the transaction costs associated with initiating and monitoring each type of loan.
• Finance companies do not appear to be a better conduit for SBA loans or loan guarantees than other lenders. When captive and non­captive finance companies are compared, captive finance companies have a higher probability of attracting borrowers in high concentration financial markets. However, when all finance companies are considered as a group, they have a higher probability of attracting low risk borrowers who reside in low financial concentration markets than any other group of borrowers.

Ordering Information

The complete report is available from:

National Technical Information Service
5285 Port Royal Road
Springfield, Virginia 22161
(703) 487-4650
(703) 487-4639 (TDD)

Order Number: PB96 146485

Cost: A06/$27.00; A02/$12.50 Microf.

*Last Modified 6-11-01