Alternative Lenders Brace for More Oversight
Banks are transforming branches, rolling out new products and experimenting with alternative data, in an effort to bring more people into the financial mainstream. Such initiatives might have been a footnote in the past, but they have grown into a serious business strategy lately.February 24
Loan demand, which bankers say remained weak well after the recession, is picking up, and the industry is adjusting business models to meet it. But banks may want to act fast.February 16
Marketplace lenders are seizing on current investor enthusiasm after the December public listing of LendingClub. SoFi and Funding Circle have set new origination targets, and new capital markets deals may help replace bank credit lines for Blue Elephant Capital Management and perhaps others.January 28
Critics of online alternative lenders argue that their underwriting models are unproven and that a financial crisis could bring the whole industry crashing down. But while Lending Club and other startups may be relatively new to the scene, they're no greenhorns.January 28
In the struggle to book small-business loans, alternative lenders say one of the big advantages they have over banks is not having to deal with the same burdensome regulations.
"It's harder than ever to obtain small amounts of capital especially debt capital," says Mark Rockefeller, founder of Street Shares, a social-lending auction website.
The reason is largely that regulation imposes an expense on banks that makes smaller loans less attractive,
according to Rockefeller, who spoke at a small-business investment conference the Federal Communications Commission sponsored in January. "It costs banks as much to make a small loan as a big one, so banks stick to the bigger loans."
This helps explain the rapid rise to prominence of so many nonbank small-business lenders. Funding Circle will not celebrate its fifth anniversary until August, but co-founder Sam Hodges predicts it will flirt with $1 billion of originations this year. PayPal Working Capital, which launched in September 2013, is growing fast too, having recently passed the $150 million mark for total funding provided.
These nimbler, unregulated upstarts are shaking up small-business finance by using data-driven scoring to make loan decisions and promising borrowers quicker turnaround times. But even as they emerge as a legitimate threat to banks, they face growing pains that could, conceivably, cancel out any advantages they may have. The lenders say that fraud is becoming an increasing concern and many believe it's only a matter of time before they come under the scrutiny of state and federal regulators.
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Their heavy reliance on data leaves the online lenders vulnerable to fraud. Hodges, who calls fraud "a major concern," says he has been shocked at how sophisticated some of the scam attempts directed at Funding Circle have been.
His company has made a significant investment in safeguards for each step in its application process. Those safeguards have kept fraud-related losses to a minimum, but the attempt rate remains high, Hodges says.
Ryan Sullivan, a partner at CapFusion, a Kansas City, Mo.-based small-business lender, agrees that companies relying on an all-tech model are inherently more vulnerable to scams. One common scheme he's seeing is an employee of a company posing as an officer and applying for a loan in the company's name. Policing such scams is an ongoing challenge, Sullivan says.
Many involved in small-business lending believe that regulation of the newcomers is inevitable, whether it comes from banking agencies or other regulatory bodies. Alternative lenders "are kidding themselves if they think they stay out from under the regulatory umbrella indefinitely," says David Lucht, chief risk officer at the $565 million-asset Live Oak Bank in Wilmington, N.C. Live Oak focuses exclusively on Small Business Administration lending, and sometimes competes with alternative lenders.
Lucht says most alternative lenders are so new that regulators haven't had time to study their operations, but he expects the situation to change. The lack of regulation should be viewed as "a temporary advantage," he says.
Though Lucht may be biased, even CapFusion's Sullivan says he is bracing for some sort of regulatory oversight eventually. "The niche is growing so quick," says Sullivan, who expects the three-year-old CapFusion to fund more than $25 million of loans in 2015. "Bad actors are beginning to come into the space. We're going to have to start policing ourselves, or the government will do it for us."