Small and medium-sized enterprises (SME’s), or firms with less than 500 employees, make up 99% of the US economy. Although they are a core component of the US economy, these entities often have a harder time securing access to financing due to their size and the credit risk they represent to lenders. In the wake of the recession, lending from traditional banks to SME’s has been subdued due to their deteriorated credit conditions, and as of today, SME lending has yet to return to its pre-recession levels (See chart below). But because these entities make up such a large portion of the US economy, positive correlations between improved economic conditions and increased lending to SME’s certainly exist.
Exhibit – Loans to Small Businesses from 2000-2014 by loan size ($millions)
Fortunately, technology may be paving the way for improved SME lending conditions. Although bank credit has traditionally been the main source of raising capital for SME’s, alternative lenders like credit unions, merchant cash advances, and online payment technologies have been emerging and taking banks’ place as the SME’s preferred source of funding.
The introduction of online payment companies such as PayPal has given rise to online lenders like Lending Club and Square, and these alternative lenders are shifting the current state of banking in two ways.
Re-targeting Subprime Lending
Although online lending is not necessarily specific to the subprime class, online lenders (or fintech) typically target these types of borrowers. Despite what we’ve learned from the 2007-2009 recession, subprime lending, if unchecked, can be disastrous. However, it is still a necessary cog to the economy, and because over 92 million credit active Americans fall within the subprime category, this is certainly a significant class that cannot be left unserviced by lenders. In recent years, the rise of fintech platforms has attracted a diverse array of investors including hedge funds, venture capital firms, private equity firms, mutual funds, and angel-investors.
From the perspective of the investors and lenders, targeting SMEs is attractive because of the relatively high rates of return that this demographic offers. To lend to a subprime borrower and assume the associated credit risk means that lenders will demand higher premiums, which equate to higher interest rates for the borrowers.
Figure 1 – Source: TransUnion
As a result, fintechs have grown tremendously over the last five years through the subprime lending segment. According to a 2016 TransUnion survey (highlighted in the graph above), loans made by fintechs to subprime borrowers have far outstripped those made by all other lending classes since 2010. Of course, this is not without risk and complications; companies like Lending Club have fallen under regulatory scrutiny after dishonestly packaging subprime loans and selling them to investors (this may ring some bells), which has led to industry slowdown as a result of heightened investor scrutiny.
Exhibit – Credit Risk among Alternate Lenders – Loan Approval Rate by Lender Type
Despite the current slowdown in the fintech industry, continued growth in banking via online SME lending still remains optimistic. At the end of the day, these companies are able to achieve greater efficiencies and economies of scale due to the nature of their operations as compared to traditional lenders, as they are not tied down by bricks-and-mortar locations and can rely on web-advertising to expand consumer outreach. Furthermore, the technological flexibility and versatility that online lenders provide simply cannot be overstated, and more and more borrowers today are showing a preference for the convenience and availability of fintech platforms. In an increasingly digital and mobile society, the appeal of online lenders lies in the speed and simplicity of their services
With online lenders, borrowers have been able to secure financing more easily than they have with traditional banks, which is a key draw to these businesses. Many fintech loan applications can be finished in under 30 minutes and the money delivered within days, compared to the days that traditional banks spend on just processing and filling out paperwork for loan approvals, which then translate to weeks before the money is actually delivered. To small and medium sized borrowers, the opportunity costs in these days and weeks can represent a world of difference.
At the end of the day, there is a large SME population that needs access to capital. Although there are appropriate discussions taking place about the lending practices of some online lenders and certain regulatory hurdles that clearly need to be addressed, the convenience and necessity of online lending shows that it has the potential to significantly change the face of banking going forward.