How Fintech Is Disrupting Small Business Loans
The rise of fintech ranks among the small business ecosystem’s biggest game-changing developments of the past few years. While fintech products aren’t ready to replace traditional banking just yet, it’s no secret that they have been disrupting traditional banking channels for a long time now.
One of the areas where fintech has had the largest impact is small business lending. This has been a haven for traditional and smaller community banks, but today they face increasingly stiff competition from a wide range of fintech companies. Small businesses typically issue credit to their customers, and this places stress on their working capital. Without a line of credit, it’s harder to find a good credit card processor to work with, and it’s impossible to pay ongoing expenses like rent and payroll before revenues start flowing — a “chicken and egg” problem. A loan helps to alleviate these issues and helps businesses avoid any disruptions.
Banks have been caught napping by fintech companies thanks to the consequences of the credit crisis of 2007 to 2009. The Dodd-Frank Act of 2010 aimed to curb the risk that banks could carry on their balance sheets. This resulted in banks tightening their lending criteria and requiring small businesses to clear stricter hurdles to obtain financing. While this reduced the risk from a bank’s perspective, it also hampered small business’ ability to access capital.
According to a working paper authored by the Minneapolis Federal Reserve Bank, fintech firms originated over $41 billion in loans in 2017 with this number only increasing over the next two years. This number includes consumer loans as well. When it comes to small business loans, fintech lenders originated over $6.5 billion.
While traditional and small community banks still hold the advantage when it comes to small business loan origination, fintech is rapidly closing the gap. This is evidenced by the increasing number of loans that fintech firms provided under the Payment Protection Program (PPP) that was initiated to combat the effects of the COVID-19 pandemic.
Let’s take a deeper look at why small businesses are turning to tech companies instead of local banks for loans.
Why Banks Are Lagging on Lending
Tightened credit conditions have opened to door for alternative lenders, and traditional banks have been unable to keep up. Here are some of the requirements that traditional lenders impose on prospective borrowers that complicate the lending process.
The typical bank wants to see a track record that stretches several years. They’re particularly interested in your business’s credit history. If a business has been operating for many years successfully but has never borrowed money, loan officers will hesitate signing off on credit.
Startups and early-stage businesses simply don’t have enough of a track record to qualify for such terms. Compare this to fintech lenders such as OnDeck, which typically require just a year’s worth of business transactions to consider a credit application, and it’s easy to see why small businesses are gravitating towards them.
Demonstrating Cash Flow to Pay Interest
The reason banks focus on a business’s credit history is because they’re concerned with its ability to service debt. One of the key criteria according to which loan officers evaluate a business on is its ability to generate enough cash flow to service its debt. Revenue and free cash flow figures are of extreme importance.
Requirements for revenues are typically in the region of $1 million annually. This barrier is simply too large for the majority of small businesses to overcome. Each bank has its own criteria for free cash flow evaluations, and many businesses struggle to pass them. Online lenders, in contrast, are typically comfortable with $100,000 in revenues and accommodate a much larger number of small businesses.
An increasing number of small businesses are turning to alternative financing sources such as crowdfunding to finance new product launches through pre-orders and to raise funds for product enhancements. While crowdfunding is a natural choice for startups without venture backing, established businesses are using it to boost cash flow as well.
The typical small business loan application with a traditional bank requires owners to file mountains of paperwork. Then, processing time lasts for around a month to three months, depending on the size of the bank and the business’s relationship with it. Even after all of this, there’s no guarantee that the loan will be approved.
Contrast this with fintech lenders, which usually take between one to three days to approve loans. In the United Kingdom, a partnership between the fintech firm Kabbage and the bank ING allows clients to borrow as much as EUR 100,000 within a few minutes. Crowdfunding campaigns can potentially raise money in whatever time frame the business needs it, with the average campaign lasting a little over a month.
Processes Making Fintech Loans More Accessible
So how do fintech firms manage to deliver such massive benefits while big banks can’t? A closer look at their work processes helps to explain.
The fintech advantage can be distilled into four categories. All of these areas have witnessed investment from traditional banks but their execution leaves a lot to be desired.
Traditional banks have faced challenges integrating legacy systems with new technology that identifies customer behavior. Technology-driven startups have built their business models from the ground up around analytics and data gathering.
Therefore, it’s a lot easier for a fintech firm to make quick and accurate decisions regarding customer credit worthiness.
Efficient Credit Scoring
The traditional credit scoring model is outdated. The FICO score model develops conclusions by looking at historical data and predicting credit worthiness. This leads to consumers without lengthy credit histories, such as students, startups and small businesses with limited borrowing history, underserved. It also fails to evaluate non-linear relationships between data points that are a part of a borrower’s history.
Fintech companies have improved the existing model thanks to insights into customer behavior. In addition to this, the analytics-driven focus of these businesses allows them to interpret the vast amount of data they collect in better ways. This results in better credit decisions.
Consumers today demand faster and more efficient online experiences. Traditional bank approvals still require multiple in-person interactions that haven’t fully adopted the online business model.
By emphasizing digital interactions, fintech firms offer consumers the ability to file applications digitally and to instantly receive decisions or receive them at a far quicker pace than what a traditional bank can manage.
Very few banks have executed enterprise-wide IT transformations. As a result, most banks’ technology platforms are a mess of discontinuous processes that don’t talk to one another. Legacy systems are patched with the latest improvements, and as a result, inefficiency rises. The typical fintech firm’s architecture, on the other hand, creates a single hub for all transactions.
A good example of this can be seen in P2P lending platforms that provide a single marketplace for borrowers and investors to interact with one another directly. This benefits all parties involved and drives further engagement. Smart portfolio management is a natural result of all this, and it allows fintech firms to make faster credit decisions.
The Future Is Calling
Big banks still have major advantages over fintech firms, thanks to their immense balance sheets and prior consumer relationships. This capital advantage will determine how the industry evolves moving forward. A more collaborative approach between both sides of the market is inevitable, too, as traditional banks will integrate fintech service providers into their offerings.
A good example of this is the fintech firm nCino. This company provides SaaS analytics solutions to big banks that removes the need for legacy systems or costly IT infrastructure. Expect more collaborations such as the one between Kabbage and ING as highlighted previously.
From a small business owner’s perspective, all of this is welcome news, too, since the loan origination process is on a solid trajectory to become far more efficient and accessible.