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B207 Reading 17: Small Business Lending & Technology …
B207 Reading 17: Small Business Lending & Technology
Small Business Credit Access (The Credit Gap)
1. Context and The Problem
Importance of Small Businesses (SBs)
: Core to economic competitiveness. Employ half of the nation's private sector workforce (120 million people) and create approximately two-thirds of the net new jobs since 1995 (approx 65%).
Vulnerability:
SBs were hit harder than larger businesses during the 2008 financial crisis and have been slower to recover. They are more dependent on bank capital (a 'financial accelerator') to fund growth.
The Gap:
Small business loans on bank balance sheets are down about 20% since the crisis, while loans to larger businesses have risen by about 4%. The share of small business loans of total bank loans fell from 50% in 1995 to 30% in 20128.
2. Constraints on Traditional Bank Lending
Cyclical Factors (Lingering effects of the 2008 Crisis)
Weakened Borrowers:
SB sales were hit hard , collateral was weakened , and average SB credit scores (PAYDEX) are lower now than before the recession.
Bank Risk Aversion
: Measures of tightening on loan terms increased at double-digit rates and have loosened at just single-digit rates for SBs. Banks are less likely to lend based on 'softer' underwriting criteria (like knowledge of the borrower from a long-term relationship).
Community Bank Failures:
Failures consisted mostly of community banks, which are the institutions most likely to lend to small firms.
Regulatory Overhang:
Increased regulatory oversight forces banks to raise capital levels , undermining their ability to underwrite inherently riskier small business loans.
Structural Barriers (Long-term issues)
Banking Consolidation
: A decades-long trend eliminating a key source of capital, as consolidated big banks are less focused on small business lending.
High Search Costs
: Difficult for qualified borrowers to find willing lenders, and vice versa. Borrowers often spend almost 25 hours on paperwork.
Transaction Costs:
Small business loans (below $1 million) are considerably less profitable than large business loans20. Transaction costs to process a $100,000 loan are comparable to those of a $1 million loan.
Thresholds:
Some larger banks have reduced or eliminated loans below a threshold (typically $100,000 to $250,000), leaving a critical gap.
Information Asymmetry:
Difficult to assess SB creditworthiness due to lack of publicly traded securities, detailed balance sheets, and inadequate income statements.
3. Technology and Disruption
New Online Marketplaces
: A number of new online lenders and marketplaces are emerging to disrupt the traditional market.
Competitive Advantages:
Provide easy-to-use online applications, rapid loan decisioning, fast turnaround, and use data-driven algorithms with non-traditional data to accurately screen creditworthy borrowers.
Three Emerging Models
Balance Sheet Lenders:
Use their own balance sheet (capital raised from institutional investors) and proprietary risk scoring models (e.g., OnDeck, Kabbage).
Peer-to-Peer Platforms
: Connect capital from institutional and retail investors with borrowers (e.g., Lending Club, Funding Circle).
Lender-Agnostic Marketplaces
: Connect borrowers with a range of traditional and alternative lenders (e.g., Fundera, Biz2Credit)
4. Regulatory Challenges
Disagreement:
Disagreement exists over the appropriate level of regulation; regulating too early risks cutting off innovation.
The Risk
: Concern that if left unchecked, online small business lending could become the next sub-prime lending crisis.
Regulatory Gap:
The current online marketplace falls between the cracks for Federal regulators