State of the Industry – Small Business Lending

State of the Industry – Small Business Lending

Current challenges and outlook for Small Business Lending. Will FinTech really help?

Introduction

My goal for this article is to bring together a number of arguments that are being made in disparate venues regarding issues with the small business lending market and try to visualize a path forward, giving hope to those small businesses who might be struggling or whom are looking for help and guidance.
There is some very strong research that the Federal Reserve Board (FRB) and others have done underlying these arguments as well as other authors and presenters who have made similar arguments.  However, while going through the details again may seem redundant, it is worth doing because the message is consistent from the most recent presentation about small business lending all the way back to surveys done in the first few years of this decade.  Additionally, our economy needs to make adjustments if we are going to see more than just the tepid economic growth since the popping of the dot-com bubble in 2000.

 “You may have to fight a battle more than once to win it”
Margaret Thatcher
 

The Gap

A recurring theme of small business surveys is a lack of available capital or funding to grow and run their businesses.  As expected, this problem gets worse during downturns but improves, returning to the norm, in recoveries.  Small business funding is a hidden but vital cog in our economic machinery because small businesses employ 50% of all the workers in the U.S. and are both generators of 50% of the country’s GDP as well as generator of 65% of all new jobs.  However, the recent downturn in ’08-’09 and subsequent recovery hasn’t seen the improvements in small business funding previously seen.
We will look at this persistent funding gap from the perspective of today’s entrepreneurs who see this as an opportunity as well as from the classical funding side, the banks, which see this as a risk management issue.  We will then turn back to the entrepreneurial perspective to understand how much these new firms can help now and where things might go in the future.
Over the past three or four years there has been quite a lot of press about FinTech and the companies that are in this developing industry.  One of the major areas of focus of FinTech companies is the commercial lending space and for our purposes, the small business portion. Globally, the FinTech space accepted $12B in venture funding in 2014 with the commercial space garnering 16% of that funding.  So why is there so much interest in this space and what is the need to be met or the gap in what is being provided today?  As mentioned the gaps can be seen in Small Business survey data regarding how our current banking institutions lend to small businesses.
Commercial loans outstanding by size
Figure 1
Share of small business lending by size of bank
Figure 2
We see in Figure 1 above, from a presentation given by Traci Mach, a Federal Reserve Board economist, since the 2008-2009 recession banking institutions have been making a greater percentage of larger loans (>$1M.) This makes business sense for them since it cost about same amount to originate a small loan as it does a large loan, but the income to be made from a larger loan, and to cover the origination costs, is greater.  Additionally, from a risk perspective, the larger loans can be more readily monitored than multiple smaller loans.  However, that doesn’t make the loans less risky.  In fact, larger loans actually concentrate the risk where a loss on one loan has a bigger impact.  But the regulatory agencies in the finance space are pushing banks to know their customers and borrowers better and that is easier if there are fewer.  So banks have made the choice to ‘go big’ and deal with the concentration risk but have more information about their borrowers and manage them more tightly.
If we make the assumption that larger loans are being requested by larger companies as Figure 2 suggests, this leads us to the conclusion that fewer and fewer loans are being made to the smaller companies that make up the majority of the SBA population.  This conclusion is borne out in small business surveys taken by the New York FRB.
Credit application outcomes by size of small business
Table 1
The table above comes from the 2014 small business survey and shows that 50% of the small businesses that are turned down for loans have less than $1MM in revenue and almost 2/3 of those same size businesses don’t get all of the credit that they request.  Additionally, the 2010 survey noted that successful applications were strongly correlated with firms that were in business for more than 5 years.  So there clearly is both a need and a gap, especially at the smallest end of the small business market.  But is there anything to bridge that gap?

The Bridge

The answer is yes, alternative sources of finance including alternative lenders.  These can be inventory factoring firms and equipment financing firms as well as the newer companies in the marketplace lending arena.  Inventory factoring and equipment financing companies have been sources for small business funding for some time and have provided a consistent 15-25% of all business funding.  However, for the remainder of this post, we will focus on alternate funding and the companies that are changing the way small business borrowers and lenders are connected, which is where we are likely to see the most change for the better, in the small business lending space.

There are many variations in the alternate funding space.  But we are going to focus on three distinct models.  The first are startups and young companies are are leading the way, starting by changing the approach that small businesses take towards funding.  Both anecdotally and statistically, the market is seeing significant loan volume growth within these companies and they claim to be processing loans in hours as opposed to days or weeks as in a typical bank.  The graph below is from a presentation given by Charles Moldow of Foundation Capital.  They have invested in both Lending Club and OnDeck Capital and had estimated that in 2014 almost $9B in these loans were made growing by 130% annually from 2009.

Size of marketplace lending space in dollars of loans originated
Figure 4
 Their term for this market subsegment is marketplace lending which is also known as peer-to-peer (P2P) lending.  The source of the funds lent by these companies span individual investors up to large institutions who are looking for better returns than what they can get from the stock market.
In addition to P2P lending, there are companies that have partnerships with smaller banks and provide referrals to the banks that make the loans.  However, they often do more than just provide a source of loan referrals, they also vet prospective borrowers and can use alternate, sometimes proprietary credit risk management procedures to screen prospective small businesses.
Finally, there are options for crowdfunding small business capital needs.  Typically, business crowdfunding is used for new product development where the funders get one of the first products made or maybe just pride in sponsorship.  However, related to small business lending a few startups have engaged in community crowdfunding small businesses to help those businesses connect with their customers and other people in their community to help them invest in equipment and facilities and thereby further developing that local community.
There is a concern, specifically regarding alternative funding and how a rising rate environment will affect the marketplace lenders as all they’ve ever seen is very low interest rate.  But for now, these are excellent options for small businesses in need of capital.

The Future

This space has been growing significantly in the past 5 years and obviously it can not continue to grow at this rate indefinitely.  If it did continue at a rate of 130% per year it would overtake the current market in…13 years…ok so maybe it does have some room to grow.  However, there is a little bit of a dark lining to the silver cloud. First, many of the alternate lenders highlighted in the graph above report very high returns in their prospectuses, which directly stems from charging higher rates than what would be charged in a traditional loans.  Also, their borrower profiles are not very different from that of current banks.  Again this makes sense because they desire to be profitable (read larger loans to the larger companies) just like banks.  So they aren’t necessarily solving the lending gap issue, but are taking more risks so they are helping.
There are also some risks to this marketplace.  The current low interest rate environment has increased available capital which some lenders have heavily relied on to fund their loans.  If that capital dries up when rates rise those companies that depend on it may dry up as well.  Additionally, the current lenders and their business models haven’t seen a down market to test their alternative approaches to risk management.  Even if a moderate down market could cause a shake-out in the marketplace lending space as investor losses rise.  Third, the current marketplace lenders, while not large relative to their traditional competitors still have to manage risk.  Like their established cousins, they are required to obtain and protect key borrower data along with many other requirements and will likely become the focus of regulators at some point soon as noted in this KPMG paper which makes the case for compliance.  So we can expect that the current cost efficiencies marketplace lenders enjoy will be reduced in at some time in the not-too-distant future.  If we happen to see rates rise and then the moderate downturn it’s possible all three of these risks will be realized and the landscape we’ve been discussing could change drastically.
But I’m actually an optimist and believe FinTech and marketplace lending are going to redefine banking in general and lending specifically.  What is needed to continue to bridge the funding gap is more investment and innovation to reduce the cost to originate a loan and to better gauge and manage the risks of those loans and the portfolios.  We are seeing new technologies that are doing just that like alternate credit scoring and automated loan origination, allowing more loans to be made in smaller amounts more profitably.  So the trend is a very good one.
Please note that this article was written to help others, as well as myself, better understand the small business lending market and the FinTech future within that market.  There are quite a number of data sources I borrowed from and people, much smarter than I, who have graciously made their material available and indirectly helped me outline the ideas above.  Please see their presentations and papers for more rigorous analyses and additional details.  And please also feel free to comment back on these thoughts as well as offer some of your own.  Finally, if I’ve gotten anything wrong it was due to my mistake, not any of the references or people I highlighted.  Please also let me know if and when you find those.

Woody

The author does not intend for this to be an analysis of either the Banking or FinTech markets from an investment perspective.  Additionally none of the companies or research organizations mentioned in this article are personally connected to the author.

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