The big business of small business: Fostering a digital lending revolution
Small businesses constitute the civic backbone of our communities and largest drivers of job creation and economic growth. The U.S. Small Business Administration estimates that 28 million small businesses in America account for 54 percent of all U.S. sales and provide 55 percent of all jobs. Yet, small businesses today face a range of challenges, including numerous workforce and regulatory barriers, and frequently require access to capital to grow and hire.
Unfortunately, the traditional lending processes have underserved Main Street, compelling a need for new approaches to finance delivery.
One problem is that small businesses typically seek small loans that aren’t as economically viable for traditional banks. Indeed, the vast majority of small businesses (more than 70 percent) need $250,000 in financing at most, with 60 percent of small businesses needing $100,000 in financing or less.
Additionally, the costs of manually underwriting a $100,000 loan compare to a $1 million loan: The result is that traditional institutions favor large companies with greater financing needs. It should not surprise anyone, then, that two decades ago the share of small business loans out of bank loans total equaled about 50 percent—and by 2012, had fallen to 30 percent.
Fortunately, financial services innovations driven by technological advancement and the rising internet of finance carry the potential to address the credit gap small businesses face.
Promise of the platform: FinTech, lending and internet innovation
Financial technology or FinTech platforms provide access to capital more efficiently by using credit, data, and technology-driven innovation—and as a result can fund Main Street small businesses in as little as 24 hours. This innovative new approach to financial services transactions shares much in common with the emergence of e-commerce platforms in the late 1990s—Including Amazon, eBay, and PayPal. This trio revolutionized how we shop by creating more efficient and scalable internet-based models that increased customer access, decreased transaction costs and focused on customer experience.
Leveraging the scale, along with the lower marginal costs of internet-based credit models to provide capital, has yielded promising early results. Beyond the effects of loan originations, platforms are also expanding access to capital for communities where traditional financial institutions have contracted. Roughly one-quarter of PayPal’s Working Capital portfolio has been disbursed in the three percent of counties that have lost more than 10 banks since the most recent financial crisis.
And contrary to the notion that incumbents would reject the models of new competitors, leading banks now recognize the potential efficiencies of such platforms—and are joining forces through new partnerships. OnDeck has partnered with JP Morgan Chase; Fundation has partnered with Regions Bank; Kabbage has partnered with Santander; and in the U.K., Funding Circle has partnered with RBS.
In marrying leading technology, automation and data analytics with traditional financial institution customer networks and data, financial services firms can offer efficient internet or mobile-based services to their small business customers, while digital lenders solve for otherwise large customer acquisition costs.
To scale and recognize the benefits of these new lending models, however, requires time, determination and constant iteration. As it was for the e-commerce platforms, creating an internet-based platform—while attracting funders to fund you and customers to find you—is not easy. There will be winners and losers.
As the old adage goes, the key to being a good lender is getting paid back: a critical principle when lending in a dynamic economy with many small business starts and closures each year. The goal must be to build efficient and sustainable lending models that can serve small businesses through various economic cycles.
That said, meeting the challenge requires a consistent commitment to test, learn, adapt and innovate. When lenders validate lending models, focus on customer service and invest in leading technology, it can allow a platform to scale. This makes it possible to pass cost-savings on to customers.
But validation goes beyond technology. Sustainability rests on offering customers fair and transparent products that serve their needs. This will emerge as especially important to an industry looking to prove itself to policymakers. And in turn, policymakers must remain cognizant of the diversity of actors and models in the FinTech space, and recognize industry-led efforts to develop best practices. To the extent that tailored regulation is required to balance innovation with protection, it should embrace real-world outcomes and data, and remain flexible in the face of a fast evolving sector.
Prudent policy framework: Regulation observations
Indeed, as the digital lending industry continues to evolve, policymakers should remember the observations offered by the Clinton Administration in the late ’90s regarding e-commerce platforms. Back then, a senior official stated that given “the breakneck speed of change in technology . . . government attempts to regulate [the internet] are likely to be outmoded by the time they are finally enacted.” The administration thus opted for a prudent regulatory approach that focused on high-level guiding principles and carefully tailored policies.
That same general mindset should apply today as regulators and policymakers approach FinTech. Rather than box-in, officials should strive to create more coherent, efficient and harmonized policy frameworks that facilitate responsible innovation as they capture the reality of an internet-driven economy.
In its final days, the Obama Administration published a white paper called “A Framework for FinTech” that reflected this need. It noted that “innovations in financial technology have the potential to fundamentally change the financial services industry and the wider economy. While still early in its evolution, FinTech can, for example, promote financial inclusion, expand access to capital for individuals and small businesses, and more broadly reshape how society interacts with financial services.”
Small businesses need efficient capital access and deserve a digital experience as rewarding as the one we consumers now enjoy—for what they contribute, in the final analysis, is large.
Daniel Gorfine is vice president, external affairs and associate general counsel at OnDeck and a Senior Advisor at the Milken Institute. His work focuses on law and public policy, strategic initiatives, and government and regulatory affairs in the context of FinTech and financial services innovation.
Jackson Mueller is associate director, Center for Financial Markets at the Milken Institute. He focuses on FinTech, capital formation policy and financial markets education initiatives.