The Future of Small Business Lending: CREDIT ACCESS DURING THE RECOVERY AND HOW TECHNOLOGY IS CHANGING THE GAME

Karen Gordon Mills Senior Fellow, Harvard Business School & Harvard Kennedy School Former Administrator of the U.S. Small Business Administration

April 15th, 2015

LendIt USA

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WHY WORRY ABOUT ACCESS TO CREDIT FOR SMALL BUSINESSES?

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Source: U.S. Census Bureau; *remaining 500,000 business are Non-Supplier Businesses in the Traded Sector

28  Million  Small  Businesses

High-­‐Growth(~200K)

Suppliers(~1M)

Main  Street(~4M)

Non-­‐Employer(~23M)

Employer*  (5.7M)

§ Small businesses account for half of U.S. jobs:

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WORKED FOR PRESIDENT OBAMA AS HEAD OF THE SMALL BUSINESS ADMINISTRATION (2009-2013)

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SMALL FIRMS HIT HARDER IN CRISIS, ACCOUNTING FOR 60% OF JOB LOSSES

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Source: Bureau of Labor Statistics, Business Dynamics Statistics (latest as of 3Q13). Chart shows the change in the number of charges by firm size, specifically “small businesses (firms with fewer than 500 employees) and large businesses (firms with more than 500 employees).

Quar

terly

Net

Job

Chan

ge (‘

000)

-2,000

-1,500

-1,000

-500

0

500

1,000

1,500

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13

Small (<500 Employees) Medium (500 to 999 Employees) Large (1,000+ Employees)

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THE WHITE HOUSE ECONOMIC TEAM DURING THE HEIGHT OF THE GREAT RECESSION

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TURNAROUND IN SBA LENDING

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Source: Small Business Administration. 7(a) and 504 loan volume since Fiscal Year 2008. As of May 2014.

§ Swift action to spur SBA lending, resulted in record years in ‘11, ‘12 and ‘13

$25.0

$18.0

$22.0

$30.5 $30.3 $30.1

$15

$20

$25

$30

$35

FY08 FY09 FY10 FY11 FY12 FY13

SBA LENDING UP TWO-THIRDS FROM THE CRISIS, BRINGING BACK 1,000 LENDERS, HELPED BY NEW LEGISLATION AND AN AGENCY-WIDE INITIATIVE TO CUT PAPERWORK

Loan

Vol

ume

($ b

illio

ns)

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CREDIT FROZE DURING CRISIS, SLOW TO RECOVER FOR SMALL BUSINESSES

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Source: Federal Reserve, “Senior Loan Officer Survey” as of April 2014.

Net

Tig

hten

ing

Net

Loo

seni

ng

PERCENTAGE OF BANKERS REPORTING NET TIGHTENING OR LOOSENING OF LOAN CONDITIONS

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

2007 2008 2009 2010 2011 2012 2013 2014

Tightening Standards (Large Businesses) Tightening Standards (Small Businesses)

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CYCLICAL AND STRUCTURAL PROBLEMS PLAGUE THE SMALL LOAN MARKET

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Source: Federal Deposit Insurance Corporation, Call Report Data. As of January 2014* Per reports from the FDIC Acting Chairman Martin Gruenberg and a December 2012 survey of small business finances conducted by the Federal Reserve Bank of Atlanta

Small Business loan assets fell by 18% in the recession and have not trended back up

0

100

200

300

400

500

600

700

800

02 03 04 05 06 07 08 09 10 11 12 13 14

Smal

l Firm

s Lo

an B

alan

ces

at B

anks

($

Bill

ions

)

Small Business Loan Assets on Bank Balance Sheets

1412

98

7 7

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

0

2

4

6

8

10

12

14

16

1985 1990 1995 2000 2005 2010

Number  of  Community  Banks Average  Bank  Assets

Community Banks supply close to 40%* of loans to small businesses, but are being consolidated

Com

mun

ity B

anks

(‘00

0)

Aver

age

Bank

Ass

ets

($ b

illio

ns)

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FIRMS WANT SMALL LOANS, WHICH AREN’T PROFITABLE FOR BANKS

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Source: Federal Reserve (New York), “Small Business Credit Survey”, Fall 2013.

% S

mal

l Firm

s Th

at A

pply

for L

oan

Size

s

ABOUT 70% OF SMALL BUSINESSES WANT LOANS BELOW $250K

39%

12%17%

14%18%

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

<50K $50-100K $100-250K $250-500K >$500K

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$0

$100

$200

$300

$400

$500

$600

Bank Loans Business Credit Cards

Equipment Leasing

SBA Factoring MCA Online Alternatives

HOW TECHNOLOGY IS CHANGING THE GAME

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Source: Bank loans data taken from FDIC Call Reports; SBA data sourced from SBA publicly available information; Credit card data sourced from creditcards.com; remainder sourced from interviews with industry experts, and authors’ analysis.

TOTAL DEBT CAPITAL OUTSTANDING AS OF 4Q13FOR SMALL BUSINESSES ($ BILLIONS)

-3.1% +1.% +2% <-1% N/A N/A +175%Portfolio Balance% Year-Over-YearGrowth

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ONLINE LENDERS GAINING TRACTION WITH SMALL BUSINESSES

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§ 2014 Joint Small Business Credit Survey by Federal Reserve banks of New York,

Atlanta, Cleveland and Philadelphia

§ 18% of small businesses say they applied for credit from online lenders

Credit Sources Application Rate Approval Rate

Large national bank 35% 31%

Large regional bank 41% 45%

Small regional or community bank 34% 59%

Online lender 18% 38%

Source: Joint Small Business Credit Survey Report, 2014. Federal Reserve Banks of New York, Atlanta, Cleveland and Philadelphia.

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THREE INITIAL ONLINE MODELS DEVELOPED – BUT LINES ARE NOW BLURRING

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Source: Authors’ analysis

Online Balance Sheet Lenders

Use balance sheet capital from institutional investors and decisions loans via proprietary risk scoring algorithms that rely largely on cash flow data, credit scores, social data, industry, geographic and other firmographic information

Lenders Agnostic Marketplaces

Connect small business borrowers to a series of lenders that are part of their online marketplaces; most work with conventional lenders like big and small banks, SBA lenders as well as alternatives like OnDeck and Kabbage

Peer to Peer (P2P) Platforms

Peer to peer, initially consumer-focused. Now, greater emphasis on small businesses. New funding sources from institutional investors.

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ONLINE MARKETPLACE IS EVOLVING RAPIDLY

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Sources of Customers Product Sources of Capital

Small business customer does not always know what product will best

meet their needs

All aspects of the business models are changing:

§ Partnerships

§ Consortiums

§ Traditional Banks

§ Loan Brokers

§ Direct Online

Customer Acquisition

§ Account Receivable/

Invoice Lending

§ Term Loans

§ Short-term Cash

Advances

§ Individuals

§ Institutional Lenders

§ Hedge Funds

§ Traditional Banks

§ Syndication Markets

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WHO HAS COMPETITIVE ADVANTAGE?

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Traditional Banks & Other Lenders Online Lenders

Capital• Low cost capital from deposits• Federally insured

• Higher cost capital from institutional and other sources looking for yields• At risk in a downturn

Customer Service

• Small business spends an average of 26 hours on loan paperwork• Response comes within weeks or

months

• Streamlined online application• Response within minutes or days

CreditAssessment

• Costly personal underwriting or reliance on FICO scores

• New credit algorithms (unproven)

Source of Customers

• Large pool of existing customers (on which extensive data is available)

• Customer acquisition costs can be 15 percentage points (without sourcing alliances)

Regulation• Heavily regulated • Largely unregulated except at state level

and by SEC

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WHAT IS THE APPROPRIATE LEVEL OF REGULATION FOR THE ONLINE SMALLBUSINESS LENDING MARKET?

NEED FOR REGULATION

§ No current designated federal regulator§ Should there be one?

§ CFPB? Other?

§ Lack of transparency on costs to small business owners

§ Concern that this might be the next ‘subprime market’§ Emergence of loan brokers

§ High costs

IMPROVE EXISTING REGULATION/ ENCOURAGE MARKET MECHANISMS

§ Clarify existing state and SEC regulatory oversight

§ Let nascent market develop§ Current industry move to improve

transparency§ Consistent disclosure of cost metrics

§ Borrower ‘Bill of Rights’

§ Internal industry oversight increasing on loan brokers

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Two views:

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HBS WORKING PAPER

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