“If you build the website, they will come – but they might be a little confused”
As my Accion colleague Lauren reminds us, and as many politicians (whether New York hotel magnates or northeastern socialists) often emphasize, small and medium-sized businesses (SMEs) help ensure economic growth and spur job creation. The challenges they face accessing credit are an element of the U.S.’s financial inclusion story and important to anyone who cares about innovation, economic growth, equality, and employment. When given the chance to express preferences and discuss their perceptions of the lending landscape, small businesses say that online lending improves their access to credit, as in this recent study by the Federal Reserve. But they also say that in order to enable small business owners to continue to grow their businesses and operate sustainably, these evolving online models must pay better attention to user preferences and actively embrace consumer protection standards such as transparency. As one car dealership owner noted in the Fed’s focus groups, online lenders present their loans “in the most confusing way possible.” The websites are full of bright colors and testimonials from nice people, the owner added, but they don’t give applicants all the information they need.
There is no doubt that the rapid growth of online lending reflects its ability to address the huge credit gap for small and medium-sized enterprises. Recent Federal Reserve data shows that even as the economy continues to grow, small businesses in the United States struggle to find lenders. In fact, just over half of small businesses are denied a loan when they apply to banks, and microbusinesses and startups struggle the most. As Ty Kiisel of Forbes notes, “In an absolute sense small business loans on the balance sheets of banks are down about 20 percent since the financial crisis, while loans to larger businesses have risen by about 4 percent over the same period.” Even the companies that did receive funding noted that they received less than half of their requested.
SMEs struggle because they are viewed as riskier and less predictable that mainstream businesses. They have higher failure rates, less cash flow, a hard time finding and retaining qualified staff, fewer assets for collateral, are sensitive to economic and personal swings, and are not required to report as much information. Limited public information can make it difficult to assess their credit worthiness and check for red flags. Even growth stage firms reported that the main reason for not receiving a loan was insufficient credit history or collateral. SME heterogeneity also makes it difficult for lenders to develop standards for evaluating repayment capacity and harder to standardize or bundle products. After all, how easy is it to compare a dog walker and a phone app or a nail salon and a microbrewery?
The struggle to raise capital can cause clients to take risks with their personal finances in order to meet operating expenses or expand the business. In the recent Federal Reserve study, 63 percent of respondents reported holding debt in small amounts secured with personal assets and one in five growing firms used personal finances to finance their business.
Interestingly, as confirmed in the Federal Reserve’s research, a small but growing number of small businesses unable to obtain adequate traditional bank financing are turning to online lenders. New entrants such as peer-to-peer platforms, cultivators of non-traditional data for loan decision making, or lender-agnostic marketplaces (e.g. Biz2Credit) are shaking up markets, and larger banks and their clients are paying attention. These new firms use advances in technology to achieve a competitive edge in terms of access (it is quick and easy to apply online wherever you are and whenever you want), fast turnaround (timing improves when your application goes through an algorithm), and data proxies to improve credit scoring for thin envelop clients (no more finding all your old tax returns). While the majority of larger businesses still seek traditional loans or lines of credit from banks, it is telling that, given the short period of time that they’ve existed, almost a third of microbusinesses and small firms now apply to online lenders.
However this migration to online lenders doesn’t necessarily reflect satisfaction. The Federal Reserve’s study found that while small businesses like the simplicity of the online application process, they struggle with these providers. Seventy-five percent of businesses approved for a traditional bank loan report satisfaction, but only 15 percent of those using an online lending platform do. Complaints include lack of transparency, unfavorable repayment terms, and high interest rates. In recent focus groups convened by the Federal Reserve Bank of Cleveland and the Federal Reserve Board small business owners commented on how modern, visually pleasing websites containing what initially appeared to be clear terms actually hid the real, often high, cost of doing business, with hidden late fees and repayment penalties, poor communication on features and costs, and lenders demanding a cut of daily sales until repayment. They also voiced data privacy concerns and confusion over the actual loan amount. Meanwhile, regulators and others have noted that while in theory, expanding credit access is a good thing, it should not mean lowering underwriting criteria or accepting proxy data points. After all, not all small businesses SHOULD get loans, and these critics are not convinced that these lenders harnessing fintech are effectively improving the imperfect science of defining which businesses are credit worthy.
Of course, traditional banks are still absolutely seen as important for SMEs. The same Federal Reserve study found that, along with being a potential source of financing, small businesses go to bankers or lenders for advice (almost 75 percent of them) and the majority of those that borrow from banks report high satisfaction. While banks can reassure themselves that they have satisfied clients, it is likely that the new players will challenge traditional banks to make changes and seek to build out their own similar services in the space.
How should regulators respond? Regulations have to balance quality of services with access to services and accommodation for innovation. For instance, some reports note that regulation related to the capital levels banks are required to maintain has deterred banks from underwriting SME loans. Similarly, community banks, often the likely option for a local small business, say they are burdened by staff time focused on compliance and oversight enforcement, which has hurt their return on assets.
At the same time, small business loans are not covered under consumer protection legislation or the Consumer Financial Protection Bureau. In that circumstance, as the Smart Campaign often asks, what about self-regulation and consumer advocacy? A number of socially-motivated alternative lenders – including the Accion U.S. Network – have joined together to promote the Borrowers Bill of Rights, a set of principles for responsible small business lending that closely mirror the Client Protection Principles promoted by the Smart Campaign. As the Borrowers Bill of Rights gains traction, perhaps it will begin to influence online lenders.
We look forward to hearing your thoughts. Over all, as we saw in our own Client Voice study, efforts like those from the Federal Reserve and others that allow small businesses to voice their views in their own words can reveal the full picture of the impact of financial services. Perhaps, in our upcoming presidential debates, we will be surprised to see server discussions turn from Benghazi to online lending risks? Ok, that’s unlikely….
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