Fintech will reshape how entrepreneurs seek loans
Small businesses have been around since the time of early civilizations, and lending to small businesses is almost that old.
The roots of traditional lending can be traced back to 3,000-year-old written loan contracts from Mesopotamia, which show the development of a credit system and include the concept of interest.
These ancient records include a loan to one Dumuzi-gamil, a bread distributor in the Mesopotamian city of Ur, according to William Goetzmann in his book "Money Changes Everything: How Finance Made Civilization Possible."
Dumuzi-gamil and his partner borrowed 500 grams of silver from the businessman Shumi-abum, who appeared to be acting as a banker. Dumuzi-gamil became a prominent bread distributor within the region by operating institutional bakeries that supplied the temple. In fact, one tablet describes him as the "grain supplier to the King."
This early businessman paid an annual rate of 3.78%. Some of his colleagues were not as lucky. Other loans of silver to fisherman and farmers were documented at rates as high as 20% interest for a single month.
Even 3,000 years ago, the structure of commercial activities required capital that the merchant could use to fund the business, and the owner of the capital required a return for the use of those resources. Remarkably, this initial contractual relationship still forms the foundation for the arrangements between small businesses and their lenders.
Small-business lending has been so consistent over time because the basic math of small-business operations has remained constant. A business sells a good or service for some margin over the cost of providing the product.
Even in a high-margin business, the profits from each transaction are a small percentage of the sale. This makes it hard to accumulate the large amounts of capital that investments in land, animals or supplies can require.
Enter the small-business lender, and the resulting arrangements of loan contracts, interest and repayment over time. Over the centuries, many facets of these arrangements have evolved, with the establishment of money, banks and traditional loan products such as term loans and lines of credit. But at their core, the needs of small businesses for capital have not changed.
Until recently, the modern market for small-business capital had been operating adequately, though not optimally.
Large and small banks in the United States provided various loan products and relationship activities designed to address the needs of small businesses for working capital and expansion investments. For most of the 20th century, small-business lending saw little innovation and only incrementally used technology to automate existing processes.
The customer experience was slow and paper-intensive, but the market felt little pressure to change.
As we have seen, the financial crisis of 2008 and the entrance of new fintech competitors was a one-two punch that galvanized a new cycle of innovation in small-business lending. The frozen credit markets showed the importance of small-business lending to the economy and the slow recovery highlighted the market gaps.
Entrepreneurs demonstrated that technology could change the built-in frictions in the traditional small-business lending process, and a new era of innovation was born. In this new era, we ask a final set of questions:
What will the small-business lending environment of the future look like? How will technology enable new products and activities to emerge? Will credit be more widely available? Will more small businesses be better off, or will many be taken advantage of by bad actors? Given the fundamentals of small-business needs and the changes in the lending markets we have explored, what exactly will be different in the future — and what will stay the same?
Let's imagine a future state in which lenders and borrowers have much better and more transparent information, and there is an active and fluid market matching supply and demand for loans. What would be the benefits of a more perfect market for small-business lending, and what risks and uncertainties could undermine its functioning?
In this market, big data and artificial intelligence would play a central role, helping lenders determine whether a small-business borrower is going to succeed. If technology can significantly improve the ability to differentiate creditworthy from noncreditworthy borrowers, everyone will benefit.
Lenders who have greater clarity on which borrowers are poor credit risks would avoid piling more debt onto those who will be unable to pay it back, which in turn would allow them to lend to creditworthy borrowers at lower cost.
In a market with perfect information, there would be no gap in access to credit for any borrower who met the credit criteria. The result: More creditworthy businesses would be funded; in particular those seeking a small-dollar amount that never before had access to capital can buy the piece of equipment they need to operate. The lower costs of automated transactions would allow even these small loans to be made profitably.
Of course, in reality, perfect or complete information is unlikely to exist. No data source will capture the entrepreneurial talent of the small-business owner, which may be a critical factor in business success.
It may be impossible to fully replicate the input of a relationship banker who knows the borrower personally. But the marketplace is now crowded with fintech innovators, large technology companies and traditional banks that are turning over new ground in finding data that has predictive ability.
In the United States, no one knows the size of the gap in access to credit or what the improvement would look like if technology made markets work optimally. But even with small improvements, tens of thousands of small businesses could be affected.
At the margin, technology is likely to help lenders find more creditworthy borrowers, and the reduction in friction in the user experience should make borrowers' search costs lower, and make it easier for them to find a loan.
Lower search costs
The perfect small-business lending market will offer a better customer experience. We have already seen applications that are short and easy to fill out, supported by automated data access through application programming interfaces (APIs).
Small businesses that used to spend 25 hours on an application now have a fully digital experience and a near immediate response. For small businesses that have been deterred by the time commitment and length of the process, new lending marketplaces of the future will be more open, transparent and usable.
This should bring more borrowers into the process and improve their ability to get matched with a loan if they meet the lending criteria.
Transparency and choice
Comparison shopping with full transparency and choice will be part of the future small-business loan market. Borrowers will be able to understand the costs, benefits and risks of loan options, and be able to compare those options on an apples-to-apples basis.
We are already seeing this story play out in the personal credit card space. In the 1990s, almost all credit card offers came to consumers in the mail or could be found at bank branches. Then, in the early 2000s, banks began offering products online, which allowed consumers to shop and compare from the comfort of their own homes.
Now, shopping sites like CreditCards.com, Credit Karma and NerdWallet are providing aggregation services that enable consumers to compare prices and shop bank-by-bank online. Consumers have complete information written in plain English about all available products, pricing and approval odds in a central location.
Although small-business loan products are more complicated, comparison marketplaces such as Fundera and Lendio already exist, and their functionality will improve. The question facing credit providers in this new environment will be, as Frank Rotman of QED Investors puts it, "Would a rational consumer armed with perfect information choose your product?"
Excerpt from "Fintech, Small Business & the American Dream," Palgrave Macmillan, March 2019.