How Banks and Online Lenders are Rethinking Small Business Loans

Can online lenders meet the credit needs of small business borrowers in a tight credit market? A number of innovative start-ups and established financial institutions are stepping up with new loan services to address shortfalls in small business lending.

Financing a small business or a start-up is one of the perennial challenges entrepreneurs face, as we noted in our recent article on crowdfunding. And in the wake of the 2007–2009 economic slowdown, that challenge continues, as many potential borrowers report difficulty in securing loans and lines of credit, owing to a variety of factors.

The decline in small business lending

The Cleveland Federal Reserve sought out explanations for “Why Small Business Lending Isn’t What It Used to Be” in a 2013 study. The Fed researchers found several factors weighing heavily on [small?] business lending (which they define as commercial and industrial loans of less than $1 million). Among those factors:

· Reduced demand for credit from small business owners post-recession, and fewer creditworthy applicants

· Tightened lending standards, in part due to government regulators’ heightened scrutiny of loan practices

· Industry consolidation reducing the number of small banks, which traditionally are the backbone of small business lending

· Higher costs for administering small loans, and higher default risk

The study also notes that while the recession exacerbated the decline, the trend actually predates the downturn: small business lending had been slowing since the 1990s.

Diminished lending doesn’t only hamper small business, the Fed authors note: it can also have a damaging effect on the overall economy, given the vital role that small business plays in fueling job growth.

“Small businesses employ roughly half of the private sector labor force and provide more than 40% of the private sector’s contribution to gross domestic product,” the study notes. “If small businesses have been unable to access the credit they need, they may be underperforming, slowing economic growth and employment.”

While approval rates for small business loans have improved since that study was published three years ago, it (the study) still captures the essential dynamics of small business lending today.

According to the Federal Reserve’s 2015 Small Business Credit Survey published in March, while more small firms are meeting with success in getting financing, there remain significant shortfalls:

Both firm performance and financing success rates have improved [from 2014 to 2015]. Still half of applicant firms reported financing shortfalls between Q3 2014 and Q3 2015, meaning they were approved for less than the amount requested. Microbusinesses and start-ups had the largest unmet financing needs with 63% and 58%, respectively, reporting a financing shortfall.

New solutions for lending

Recognizing an underserved market, a number of providers have stepped into the breach to offer alternative lending services. On the one hand, financial tech start-ups like Square Capital, On Deck Capital and Lending Club — all non-bank marketplace lenders that connect borrowers to capital — have moved to expand loan offerings to small businesses.

According to the Department of Treasury, the top online alternative lenders “originated about $1.9 billion in small business loans last year, up nearly 60% from 2014,” the Wall Street Journal reports. That’s still a relatively small part of the overall small business lending market, but it’s shown substantial growth in recent years.

Meanwhile, larger financial institutions are also sensing an opportunity to provide higher levels of service to the small business sector:

· American Express is also preparing to launch an online lending platform for existing business card holders, Working Capital Terms. Loan amounts range from $1,000 to $750,000 with relatively low fees. As with Wells Fargo’s FastFlex, the AmEx program touts its speed: loans can be approved quickly (some in minutes) and funds can be deposited into vendors’ accounts in as little as two days.

· JPMorgan Chase has also ventured into online lending, but with a twist: the Chase program launched last year is a collaboration with online lending start-up On Deck Capital. Under the arrangement, Chase uses its lending experience coupled with On Deck technology to approve loans in minutes and fund them within one business day.

A potential downside to alternate small business loans is that borrowers in many cases may pay more for this rapid access to operating capital. While traditional small business loans may carry interest rates in the 5–6% range, many online lenders often charge higher rates.

For many entrepreneurs, the convenience and rapid access to credit may be worth paying more in order to meet customer needs, boost revenues, hire and retain staff, and expand production on a timely basis. And with more entrants to the online borrowing space, greater competition may help reduce borrowing costs as the sector matures.

The growth of online lending is also likely to lead to new oversight of the industry. Concern about less scrupulous lenders charging exorbitant interest rates has caught the attention of federal regulators, who have signaled their intent to bring greater supervision to online lending, in order to enhance transparency and to protect borrowers.

Given the challenges to small business lending, it’s healthy to have a variety of players competing to provide services, from community banks to large banks to alternative lenders. That’s the argument that economist Lael Brainard, a member of the Federal Reserve Board of Governors, made in a 2015 speech to a banking audience:

Some view the growth of online platforms as a challenge to community banks in their traditional core businesses.

But it is also possible that the very different strengths of community banks and online lenders could lead to complementarity and collaboration in the provision of credit to small business while recognizing there are important risks that must be managed by banks and borrowers.

By working together, lenders, borrowers, and regulators can help support an outcome whereby credit channels are strengthened and the possible risks are being proactively managed.

It’s too soon to predict exactly how online lending platforms will rewrite the rules on small business lending — but the trend toward experimentation and innovation looks promising.