Impacts of Fintech-Issued Loans on MSMEs
By Kati Suominen, Founder and CEO, Nextrade Group and Techical Director, eTrade Alliance
A leading constraint to MSMEs to engage in trade and ecommerce is access to finance – for example, access to growth capital to set up an omnichannel business; working capital to fulfill export orders; accounts receivable finance to get cash against receivables; trade finance to ensure they get paid for exports; and import finance credit to purchase parts, components, and products from overseas providers. The financing challenges became more acute as banks tightened their know your customer and anti-money laundering processes in the wake of the 2008-09 financial crisis. Online lending by Fintechs has emerged as a powerful alternative to bank financing, to fill these SME financing gaps. What do we know by now about its impacts?
The experience of the United States with online lenders is quite well studied and instructive for developing countries seeking to leverage FinTechs to lend to MSMEs. The consolidation of the U.S. banking sector and regulatory challenges that complicated SME financing after the 2008-09 financial crisis helped propel the rise of alternative lenders. Fintechs such as Fundation, Funding Circle, Dealstruck, PayPal’s working capital arm, OnDeck, and Lending Club provide working capital loans of $16,000-$130,000, using fast and creative credit scoring methods and algorithm-driven automated underwriting; Kabbage offers receivables financing.
Online lenders have diverse business models and funding sources. Some platforms are matchmakers for peer-to-peer lending; others are “balance sheet lenders” that have their own capital provided by major banks or Wall Street investment banks that diversify their portfolios to include these higher-interest small business loans. Still others have created symbiotic relationships with banks. For example, in 2015, Lending Club partnered with BancAlliance, a nationwide network of some 200 American community banks. In the arrangement, banks direct their customers who need small loans to Lending Club, and in exchange get an opportunity to purchase the loans made to their customers. Banks can also purchase loans from the Lending Club portfolio, allowing them to add loans outside their area to their portfolio.
Online lenders have filled financing gaps especially of small firms with less than $1 million in revenue. Even after the financial crisis in 2016, the New York Federal Reserve found that 61 percent of small businesses faced financial challenges, such as availability of credit for expansion (44 percent), operating expenses (36 percent), making payments on debt (25 percent), and purchasing inventory or supplies to fulfill contracts (17 percent). Of firms that did get financing form banks, one-half got less than requested. A third were unable to grow their businesses as a result and 13 percent had to lay off employees. Applying to online lenders, a small business borrower can get a loan with a low credit score, minimal paperwork, and within a day to two, compared to 1-2 months it takes to negotiate with banks, but pays a higher interest.
Loans provided by these lenders are still a small share, about 10 percent, of all MSME lending in the United States, but the online lending market has grown about ten times faster than bank lending to MSMEs. Every day more SMEs are turning to online lenders; in 2018, 32 percent of applicants turned to online lenders, up from 24 percent in 2017, and 19 percent in 2016. Meanwhile, 49 percent applied with a large banks and 44 percent with a small banks in 2018. Of medium-risk and high-risk firms, 54 percent applied to online lenders. The typical loan size requested on online platforms was $10,000-$50,000 (42 percent of loans), while 29 percent were below $10,000 and 29 percent above $50,000.
Also mid-cap borrowers have significantly increased their borrowing from alternative, non-bank sources. In a random sample of publicly-traded middle-market firms during 2010-15, some 32 percent of all loans being extended by nonbank lenders such as private equity and venture capital firms, hedge funds, bank-affiliated finance companies, investment banks, insurance companies, business development companies, and investment managers.
SME loan additionality. OnDeck found that 90 percent of its borrowers had “some type of borrowing constraint that precluded them from pursuing loans from other financing sources, whether due to time, credit, or budget constraints.” The Federal Reserve Bank of Cleveland similarly found that online borrowers are likely businesses that were denied credit in banks, and finding that the impact of the small loans on the businesses seemed positive. In the case of the publicly trade mid-caps, almost one-half had negative EBITDA, versus only 14 percent of those that obtained a loan form a bank. Mid-cap nonbank borrowers are less profitable, more levered, and more volatile than bank borrowers.
Lending opened to SMEs in remote areas deserted by banks. PayPal’s working capital loan product, underwritten with PayPal’s own data on transactions the borrower has conducted, has enabled companies in remote areas to access credit. As the Dodd-Frank regulations induced banks to consolidate and local and community banks, the primary providers of SME debt financing, shut down in places like rural Idaho, Nebraska, or Montana, PayPal and other online lenders have filled the gap. A quarter of PayPal loans were disbursed in the three percent of counties that have lost 10 or more banks since the financial crisis. Online payments and lending appears to have enabled rural businesses in America access financing.
Faster lending – for firms with little collateral. In a survey, the main reason for American SMEs to apply with online lenders as speed of decisions on credit, chance of being funded, and the fact that no collateral was required. 82 percent of applicants to online loans were approved, while only 58 percent of applicants to loans from large banks were approved. Only 12 percent of online borrowers felt the wait times for decision were long, as opposed to 26 percent of borrower with large banks. the same time, 53 percent cited high interest rates and 32 percent unfavorable payment terms as complicating factors with online lenders, while fewer than a fifth had these challenges with bank loans. For the mid-caps, controlling for firm and loan characteristics, nonbank loans carry 190 basis points higher interest rates. In short, SMEs use online lenders to access capital quickly (or at all) and without heavy collateral requirements, but are not as happy with them as with banks.
Greater sales and output. In one study sponsored by industry associations and covering five major online lenders (such as leading platforms OnDeck, Kabbage and Lendio) that funded nearly $10 billion to approximately 180,000 small businesses in urban and rural communities across America in 2015-17, these loans directly generated $23 billion in sales for the business borrowers. The additional sales of these small businesses in turn generated $38 billion in gross output and created 358,911 jobs with $12.6 billion wages in the local economies of the small business borrowers. The economic benefits of online lending vary across industries and states. For every dollar in lending to small businesses, sales of small business borrowers increased between $1.05 and $2.84 (with an average of $2.31). That one dollar in lending created between $2.01 and $5.59 (with an average of $3.79) in gross output in the local communities of the small business borrowers.
Help small firms in deposit and lending booms that favor large firms. Several studies suggest that credit expansion, for example government emergency credit or spending, can generate unintended consequences on the real economy: banks exposed to deposit booms expand credit disproportionately more to larger businesses to the detriment of small borrowers. The financial solvency of micro firms falls sharply in deposit booms, whereas the solvency of larger firms improves. Meanwhile, instruments aimed at small businesses, such as online loans, can ameliorate these negative shocks and level the playing field between firms of varying sizes.
These results suggest that there is certain specialization and market segmentation in the commercial loan market, where bank and nonbank lenders utilize different lending techniques and cater to different types of borrowers.
Granted, there have been some concerns that online lenders could be “too many to fail” and precipitate the next financial crisis if their borrowers were to default. In general, Fintech markets are viewed as less visible to regulators and vulnerable to shocks. This concern is still more limited in online SME business loans, as they tend to make up a small part of all business loans in many countries (with the exception of China). However, mass defaults in consumer online lending market and across segments such as real estate, healthcare, and so on, could be more challenging.
By Kati Suominen, Founder and CEO, Nextrade Group and Techical Director, eTrade Alliance