Preventing a Subprime Small Business Bubble

According to recent estimates, the subprime business loan market has grown to over $3 billion a year. This growth has been driven by increases in both the demand for subprime business loans and in the number of new alternative lenders willing to supply these loans. Some worry that the growth of subprime business loans, which often carry interest rates above 100%, could portend another financial crisis. If enough small business borrowers take out costly loans they cannot afford to repay, the consequences could be dire for entrepreneurs, lenders and the economy.

Subprime business loans can indeed be risky. The problem is that alternative loans are a crucial resource for many entrepreneurs—particularly startups. Many startups cannot obtain funding through the Small Business Administration's 7(a) loan program. The time and paperwork involved in securing a loan may be too much for startups experiencing rapid growth to handle, or they might not yet qualify for traditional loans from banks. The solution, therefore, is not for alternative lenders to stop financing subprime borrowers but to ensure that borrowers are able to access loans at competitive rates. 

Small businesses need access to capital in order to succeed. Startups that receive subprime loans are much more likely to survive, generate higher revenue and create more jobs than startups that do not receive funding, according to a forthcoming study of data from the San Antonio microfinance institution Accion. Loans are even more important for survival among subprime business owners with more education and less managerial experience, according to the study. These new small business owners are sometimes middle-aged individuals who, having lost their longtime employment, must acquire new skills in order to earn income. Entrepreneurship can be an attractive alternative to low-paying jobs.

These borrowers shouldn't have to take on exorbitant costs in order to receive credit. The hefty interest rates and fees currently charged by some alternative lenders may reflect a lack of competition from other creditors rather than the riskiness of the borrower. Some alternative lenders also charge expensive interest rates in order to hedge against risk because they lack information about the creditworthiness of the borrowers. However, given that alternative lenders including OnDeck and Kabbage can estimate the likelihood that borrowers will repay their loans by pulling information from their bank accounts, accounting programs and other online resources, there is less justification for charging excessive rates.

A few measures could protect both small business borrowers and lenders from taking on too much risk. One option is greater regulation at the federal and state level, along the lines of the government crackdown against payday lending. But the problem with greater regulation is that it imposes costs on borrowers and lenders that may adversely affect the use of this lending alternative and ultimately hurt the overall economy.

A better option is to encourage financial innovation that will allow lenders to provide credit to growing businesses at competitive rates. Square's recently announced cash advance program for small businesses, Square Capital, offers one helpful model. Rather than requiring a small business to make repayments each month, Square takes a certain percentage from the business's credit and debit card sales, along with an added fixed cost, until the advance is paid off.  This new program is a contemporary version of factoring—an ancient method of selling accounts receivable to finance the production of goods. While factoring has been historically associated with the clothing industry, it has become available to many other types of business in the in the internet age. 

Because alternative loans are important for new businesses, financial innovation should be encouraged through regulatory restraint. Regulators should take a wait-and-see approach and avoid setting interest rate caps in order to see how profit incentives can improve the market.

Small businesses and entrepreneurship have been an essential element of the success story of the U.S. economy. Providing adequate financing is necessary to continue this success. The solution, as is typically the case, will come either through government actions or the operation of market forces and incentives. Though markets are not always perfect and government action is sometimes required, caution should be exercised in order to allow potentially beneficial financial innovation to occur.

Ronnie J. Phillips is professor emeritus of economics at Colorado State University and recently edited a six-volume series on the history of credit and payments in the U.S. for Pickering & Chatto.