Alert: Online Small Business Lenders’ Customers Musn’t be Ignored in the COVID Crisis
Small businesses are a key driver of the U.S. economy. They support the growth and vitality of our neighborhoods, spark innovation, and provide a proven pathway for many people — particularly women and minorities — to achieve financial success and independence. And they are in trouble — big, big, trouble — as the COVID crisis shuts down business activity across the country. It seems clear that solving the small business crisis will be the most important part of any rescue package Congress enacts.
Credit has always been an essential part of the small business ecosystem. Around three jobs are created or sustained for every loan to a very small business. As policy makers consider how to save these jobs and address the plight of small businesses, they must be clear-eyed about how the small business credit market has changed. Banks aren’t the only source of credit for true small businesses anymore. I’m not talking about the 500-employee light manufacturing and distribution “small businesses” that fill the nation’s industrial parks and are counted as SMEs in government statistics. I’m talking about the Mom & Pop corner stores, laundromats, beauty salons, coffee and sandwich shops we all rely on.
Although precise data is hard to come by, my best estimate is that somewhere between one quarter and one-third of the credit extended to truly small enterprises (with revenues under $750,000) comes from nonbank online lenders.
Amidst the market crisis triggered by COVID, many of those lenders are about to be forced out of the market just when the liquidity they provide is needed most. While weak business models are ultimately to blame for this failure, it’s irrelevant to what has to be done. We can’t abandon the small businesses that rely on these lenders. Alternative funding for their customers needs to be part of any government solution to protect small businesses and avoid accelerating the credit squeeze.
Who are these lenders? They include the new breed of standalone non-bank “fintech” small business lenders like FundingCircle, OnDeck, Fundation, Kabbage, BlueVine, Can Capital, Lendio, and Biz2Credit as well as more established tech and fintech companies like Square, PayPal, Stripe, Intuit and Amazon which include lending as part of their service. They make term loans and extend lines of credit to many small businesses that wouldn’t qualify for a bank loans because of a short track record or an owner with a limited personal credit history (almost all these loans are personally guaranteed). Online lenders extended more than $20 billion in loans to small businesses in 2019, overwhelmingly to very small enterprises. If you add to that approximately $12–15 billion in aggregate merchant cash advances that were made to small retail businesses in 2019, nonbank lenders provided somewhere between a quarter and a third of all credit to the smallest businesses.
Online small business lending volume was growing fast until the crisis. The most recent Federal Reserve Banks’ Small Business Credit Survey indicated that, in 2018, nearly one-third (32 percent) of small businesses that applied for credit sought it from an online lender, up from 19 percent and 24 percent in 2016 and 2017, respectively. Based on the way applications appear to be surging at these lenders today we should expect that the current number is far larger.
So what is it about online small business lending which makes it a particular problem in the COVID crisis? Almost 5 years ago I made the following prediction in an article in the American Banker:
“The impact of [online marketplace lending] disruption on the real economy is likely to be much more severe than is commonly recognized. Imagine the consequences…[if] small business borrowers can’t find replacement loans quickly from traditional lenders in an MPL liquidity squeeze, especially borrowers who may not meet traditional bank credit standards…The rapid withdrawal of credit to so many Main Street…businesses could be devastating to the U.S. economy.”
That prediction is coming true today for everyone in the sector except the larger, diversified BigTech companies (more recent entrants into the space) for which lending is a sideline like Amazon, Paypal, Intuit, Stripe and Square. Those companies probably have the wherewithal to survive elevated credit losses, although not without some damage and not without pulling in their lending horns significantly. [Just yesterday, the trade group for the BigTech lenders, Financial Innovation Now, sent a letter to Congress asking it to direct Treasury to 1) provide conditional capital to alternative online lenders; 2) permit these non-bank lenders to disburse loans, including via partnership with financial institutions; and 3) allocate a portion of funds for distribution via these lenders. The author has no connection with this organization.] It’s a different matter for the standalone lenders. Online small business lending by fintechs is likely to come screeching to a halt as the debt capital markets — anticipating sharply increased losses from outstanding loans — start to demand a significantly higher risk premium to fund new loans.
This shouldn’t surprise anyone. The lifeblood of a lender is access to funding — repeated funding crises were the reason finance companies of the past all ultimately were forced or went voluntarily into the banking system to get access to the stable deposit funding they needed to survive and prosper through business cycles. The new breed of online small business lenders shares all the liquidity risks of those traditional finance companies, with an added characteristic that makes things worse in a crisis. Today’s marketplace-focused online lender has to keep issuing loans to survive. It can’t slow down lending and slash operating costs to stay afloat while collecting cash from existing loans, like a traditional finance company, because it typically doesn’t own many loans and relies on transaction fees or “gains on sale” for its main source of revenue. If the market stops buying its loans and securitizations, the music stops.
The equity markets have come to understand this and value these companies accordingly. FundingCircle and OnDeck trade today at a tiny fraction of their IPO prices. The debt capital markets are now having their say. Reported spreads on A-rated asset-backed securities issued by online business lenders are now so wide that none of these lenders can generate a positive gain on sale, let alone cover other operating costs. The hedge funds and financial institutions that typically acquire these companies’ loans and securitizations are starting to close off market access. Unless online small business lenders have enough capital to hold the loans they make, they will either shut down new originations and rollovers or go out of business, leaving borrowers to fend for themselves in a world without credit. Unfortunately, few have the needed balance sheet capacity. That’s certain to cause thousands of their small business customers to fail when credit is withdrawn.
Bad business models or not, we can’t abandon the small businesses that rely on online finance. Fintech online small business lenders are the main source of credit for a big part of the small business ecosystem that the banks can’t or won’t serve effectively. That means that whatever emergency solution comes out of Washington, D.C. needs to protect small businesses from the consequences of their failure to be effective in a crisis. That may mean using appropriated funds to deliver alternative funding solutions through these lenders to more than a quarter of all small business borrowers. It’s a big task but it is vital to the success of any small business rescue effort.
Todd H. Baker is a senior fellow at the Richman Center for Business, Law & Public Policy at Columbia University and Managing Principal at Broadmoor Consulting LLC
[For a collection of essays on FinTech, consumer financial health, banking and related topics, go to Medium.] [For papers on FinTech alternatives to short-term, small-dollar credit, go to Here and Here.][For videos of my public programs at Columbia Business School go Here.]