The small-business credit market is crowded with unprofitable providers that are under strong pressure to increase originations — a pressure that can drive the upstarts into riskier channels or products and push their credit models beyond their limits.
In the second half of 2016, the fintech-credit bubble began to show signs of losing air when investors and funders signaled declining confidence in fintechs by withdrawing their investments — triggering some fintech closures. In trying to scale up, some providers went outside their core markets and struggled as their credit models failed (e.g., CAN Capital). Some faltered in attempting to diversify into different loan types, while others — which are now retrenching (e.g., LendingClub) — struggled with costs far outrunning revenues.
The market is ripe for consolidation and beneficial partnerships. Indeed, the remainder of 2017 and 2018 will see more partnerships between the banks and fintechs for the following three reasons.
The whole is greater than the parts
“Build it and they will come” does not apply to small businesses. While the fintechs are pacesetters in user experience and underwriting analytics, the fact remains that a majority of small businesses have not sought financing from these newer entrants.
Banks, which benefit from an omnichannel footprint to serve small businesses however they prefer, continue to have the strongest gravitational pull on small businesses. Banks have the infrastructure to handle millions of small-business loans. For example, Bank of America, Citigroup, JPMorgan Chase, U.S. Bank and Wells Fargo, combined, manage nearly 10 million small-business loans under $100,000 (including credit cards), according to data from second-quarter call reports.
Cost-effective growth is banks’ biggest challenge: In June 2017, year-over-year growth in the value of these loans amounted to $2.4 billion, which is at most only a third greater than growth at the top fintechs and digital giants such as Amazon, PayPal and Square. There is strong potential for a bank-fintech combination to expand originations in a mutually beneficial way, as JPMorgan Chase has recognized by recently extending its partnership with OnDeck Capital.
Credit portfolios and models need adjustment
Another potential benefit in banks and fintechs partnering is found in underwriting. Fintech’s short-term credit models work with 12-month to 24-month loss curves. As the economic environment shifts, marketplace lenders can be challenged to predict how performance will change. Partnerships with banks, which have several cycles of performance data, allow fintechs to do more robust scenario analyses — which could yield refinements to their credit models.
Fintechs as well as digital giants also have an advantage over banks: portfolio nimbleness. Those focused on originating credit with under six months of repayment terms and/or credit lines can make real-time adjustments in their model to materially change the characteristics of their credit portfolio relatively fast. The small-business market is heterogeneous, and an economic downturn has varying impact on different industries and geographies. Banks that partner with fintechs or build their own platform will be able to take advantage of the agility of a digital-origination platform. For instance, they could focus on industries and geographies less vulnerable to economic downturns and/or focus on low-risk Small Business Administration loan candidates.
Revenue and liquidity cushions are needed
Moral hazard remains in numerous origination models (i.e., separation of risk-taking from risk exposure, such as when cash advance providers rely on third-party brokers or funding advisers to acquire borrowers). The models that stand the test of time will assure that all origination sources have incentives to care about whether the small business can pay back its loan or cash advance. The models will have incentives and guardrails driving positive behavior of the entities that acquire borrowers — that call the risk, and ultimately, take the risk.
To be sure, the fintech bubble will burst as a market correction occurs and an economic downturn begins within five years. Combined, these factors will eliminate a majority of the credit fintechs existing today — just as similar factors thinned out e-merchants during the dot-bomb period. But what does not kill you makes you stronger. The few survivors will have effectively adapted their underwriting platforms as the climate changed, and equally important, will either have had sufficient support from their partners or will have been acquired by a bank, digital giant or bank technology provider.
However, revenue diversification will not save them, and none will be spared a liquidity crisis. Further, the digital standouts at banks will have retrenched but not shut down their operations, and a few of them will have enhanced their operations by acquiring fintechs. The digital giants will have proven to be resilient competitors.
Sufficient diversification will not happen in time for the fintechs, though some of them are already undertaking initiatives, such as selling insurance. The tech giants and banks, however, already have a revenue cushion built in: revenue streams that are significantly less cyclical than credit revenues. For example, payment processing revenue will drop, but the decline will be counteracted by the steady increase in cards’ share of payments. In addition, banks have other fee-based revenues that are less cyclical than credit and slow-performance deterioration.
The greatest danger to even the most nimble, sustainable players during a downturn will be severely limited funding. Deposit-taking institutions, naturally, have a built-in liquidity cushion; however, that cushion does not translate into an appetite to use this liquidity to underwrite small loans. As experienced during past economic downturns and financial crises, credit dries up for entire segments of the market regardless of creditworthiness. Those providers relying on third-party funding sources (credit and warehouse lines, peer-to-peer networks) and/or the capital markets for securitization will find the funding spigot turned off. Mitigating this risk is likely one of the factors driving Square to apply for an industrial loan company charter, which would enable it to accept deposits.
Stronger, more sustainable small-business credit models will emerge amid the shake-up, and advancements will continue to be made in the digital application process. The digital giants will rev up their origination machines and form bank partnerships to extend their credit scope to larger and longer-term loans. At least one marketplace lender will spring back with affordable credit. A few banks will have sufficient confidence in their partner’s or their own digital platform to begin experimenting underwriting loans above $250,000 and loans with terms of two years or more. Leading accounting software providers will increasingly be a source of customer acquisition. Providers will vie to embed themselves in not only accounting software but also partner with other small-business software providers that, say, provide scheduling and billing software for specific verticals. In other words, progress will have been made.