Karen Mills, former SBA Administrator, recently published a series of articles based on her report with Brayden McCarthy entitled: “State of Small Business Lending: Credit Access During the Recovery and How Technology May Change the Game.” The paper discusses the tight, post-recession credit market currently facing small business borrowers and how alternative online lending platforms are beginning to bridge this economic gap.
The Post-Recession Credit Market
The recent recession undoubtedly hit small businesses the hardest. From the employment peak pre-recession to the highest unemployment rate in March 2009, small firms (less than 50 employees) declined 14 percent in employment while medium and large firms (ranging from 50 to 500+ employees) declined only 8.4 percent and 7 percent, respectively. It is generally expected that small businesses will suffer disproportionately during tough economic times; however, the aftermath is still hurting these small firms despite the current economic upswing. Prior to the fiscal crisis, the rate of small business loans was on the rise each year. Since 2008, this type of financing has decreased 21 percent. This is particularly striking when compared to their larger loan counterparts, the rate of which is up 4 percent. Given that small businesses are strongly reliant on institutional loans for growth these figures are highly problematic.
Lenders use a potential borrower’s personal credit history to help evaluate creditworthiness, but these aggregated values may not always paint the full picture and have proven an uneven predictor of performance. Lots of credit scores took a serious hit during the recession, some of which were inevitable casualties of the economic climate instead of real a reflection on the individual’s fiscal responsibility. Entrepreneurs of small firms were especially vulnerable in this respect – the income of a typical household supported by a self-employed individual declined 19 percent between 2007 and 2010. Collateral is another key factor when assessing a loan request and it is estimated that two-thirds of a typical small business’s assets are tied to property ownership. The collapse of real estate market hurt both credit scores and the value of these assets, causing many entrepreneurs affected by the crisis to remain relatively undesirable lending prospects.
Despite economic upturn in recent quarters, lenders remain extremely cautious and far less willing to take on high risk. This credit tightening does not fare well for ‘mom and pop’ borrowers. Small business loans are considered more risky: small firms are more sensitive to economic swings, have fewer assets to collateralize the loan, and generally have a higher rate of default. Plus, information asymmetry and a highly heterogeneous market make it more difficult and more costly to assess a small business candidate. The underwriting costs for a $100,000 loan and a $1 million loan are essentially equal, even though the latter will likely be more profitable for the lender. Seeing as 39 percent of small business loans are reported as less than $50,000, the lender’s potential return on risk is simply stacked against the small dollar loans. In addition, the lack of a solid secondary market greatly limits their liquidity as an investment.
Another piece of the puzzle is the regulatory overhang that continues to limit lender activity. With the memory of recession still fresh, banks are under extreme scrutiny and subject to much tighter standards. In response many have raised excess capital levels to appease bank examiners and other regulators. Bank consolidation – another product of the recession – has further exacerbated the issue. 48 percent of small business loans are secured by community banks. However, many community banks struggling during the tough economic climate were absorbed by larger banks and their growth has yet to recover. 2013 was the first time in 80 years that no new bank charters were reported by the FDIC.
The Emerging Alternative Market
Evidently there is a troubling gap in the credit market for small business entrepreneurs. Alternative lenders have existed for decades, but innovative online lending platforms are only recently emerging. The tough economic climate and modern technological developments have created an excellent position for their necessity and entry. The industry is currently responsible for $10 billion in outstanding loan capital – a very small share of the total market with traditional players (an industry 70 times that size), but one that is rapidly doubling each year. These online platforms aim to address the numerous inefficiencies and struggles faced by small businesses borrowers, as detailed above. Through use of high-tech software and data-driven algorithms, alternative solutions have simplified the application process and fast-tracked the timeline. With the extensive amount of data available, these companies have also created their own proprietary scoring models that to provide a more comprehensive report and increase transparency.
The expanding market for online lending platforms appeals to both borrower and lender. There is extremely high demand among borrowers for these opportunities, from which they would otherwise be excluded or face major obstacles to acquire. The process is simpler and faster, there is greater emphasis on client service, and there are simply more lenders with access to each request. All these qualities help to explain why more and more borrowers are turning to these alternatives. On the other side of the industry, lenders also greatly benefit from these developments. Although banks may be taking on higher risk with smaller loans, this risk is mitigated by greater transparency and expansive data usage. Moreover, the search and underwriting costs are significantly lower while the pool of applicants is immediately amplified.
It should be noted that these emerging online alternatives come in various shapes and sizes. Online marketplaces such as BoeFly, denoted by Mills and McCarthy as “lender-agnostic” platforms, are equipped with their own loan package software and algorithms to enable this efficiency and user-accessibility. They have moreover created a “true” marketplace for small business loans, wherein borrowers have access to numerous institutional and alternative lenders across the country and thus can find the best terms for their deal. On the other hand, many online lenders have simply transferred an existing alternative model to an online platform – categorized as online balance sheet lenders. The rates and terms offered by these lenders vary greatly (sometimes to exorbitant levels) and generally have little room for negotiation. Another form is peer-to-peer lending, which connects borrowers with consumers and investors. However, these models often cater to super-prime applicants and ignore the credit gap issue. Given this variety under the umbrella of alternative online lending, borrowers should properly assess these different options before taking the plunge.
The Big Picture
The problem is clear – the traditional credit market has yet to recover and small businesses are struggling as a result. The solution is in motion – online, data-driven lending platforms are growing rapidly and consistently using new technology to develop. It is important to note these innovations are not only for the sake of small businesses and their constituents, but are also crucial to the stability and growth of the entire U.S. economy. Since 1995, small firms (defined by the SBA as less than 500 employees) have created 64 percent of new jobs and generated 44 percent of total revenue. These firms currently employ half of the private sector workforce, 120 million people. Furthermore, small businesses have proven to be the driving force behind innovation, producing 13 times more patents per employee than their larger business counterparts. They pay taxes to support the surrounding community and advance growth of local regions. Small businesses – as well as the credit market that supports them –fill an essential role that must not be overlooked.
Cole, Rebel A. “How Did the Financial Crisis Affect Small Business Lending in the United States?” SBA Office of Advocacy. November 2012.
Mills, Karen and Brayden McCarthy. “State of Small Business Lending: Credit Access During the Recovery and How Technology May Change the Game.” Harvard Business School. July 2014.