FinTech to Reshape the Way Entrepreneurs Look for Loans
Small businesses have been around since the days of the earliest civilizations, and small business loans are almost as old.
The roots of traditional loans can be traced back to 3000-year-old written loan agreements in Mesopotamia, which show the development of a credit system and include the concept of interest.
These ancient documents include a loan to a certain Dumuzi-gamil, a bread distributor in the Mesopotamian town 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 money from businessman Shumi-abum, who appeared to be acting as a banker. Dumuzi-gamil became a major bread distributor in the region by operating institutional bakeries that supplied the temple. In fact, one tablet describes him as “the king’s grain supplier”.
This first businessman paid an annual rate of 3.78%. Some of his colleagues were not so lucky. Other money lending to fishermen and farmers has been documented at interest rates of up to 20% for a single month.
Until 3,000 years ago, the structure of trading activities required capital that the trader could use to finance the business, and the owner of the capital demanded a return for the use of those resources. Remarkably, this initial contractual relationship still forms the basis of agreements between small businesses and their lenders.
Small business loans have been so constant over time because the basic calculations of small business operations have remained constant. A business sells a good or service for a certain mark-up 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 difficult to accumulate the large amounts of capital that may be required for investments in land, animals or supplies.
Enter the small business lender and the resulting loan, interest and repayment arrangements over time. Over the centuries, many facets of these arrangements have evolved, with the establishment of currency, banking, and traditional lending products such as term loans and lines of credit. But fundamentally, the capital needs of small businesses have not changed.
Until recently, the modern small business capital market worked well, but not optimally.
Large and small banks in the United States have provided a variety of loan products and relationship activities designed to meet the needs of small businesses for working capital and expansion investments. For most of the 20th century, small business loans saw little innovation and only gradually used technology to automate existing processes.
The customer experience was slow and paper-intensive, but the market felt no pressure to change.
As we have seen, the financial crisis of 2008 and the arrival of new fintech competitors was a punch that galvanized a new round of innovation in small business lending. the frozen credit markets has shown the importance of small business loans to the economy and the slow recovery has highlighted the market failures.
Entrepreneurs have shown that technology can change the frictions inherent in the traditional small business lending process, and a new era of innovation has been born. In this new era, we ask one final set of questions:
What will the small business lending environment of the future look like? How will technology allow the emergence of new products and activities? Will credit be more widely available? Will more small businesses be better off, or will many be exploited by bad actors? Given the fundamentals of small business needs and the changes in credit markets that we’ve explored, what exactly will be different in the future – and what will stay the same?
Imagine a future state in which lenders and borrowers have much better and more transparent and there is an active and fluid market matching loan supply and demand. What would be the benefits of a more perfect market for small business loans, and what risks and uncertainties could interfere with 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 be successful. If technology can dramatically improve the ability to differentiate between creditworthy and non-creditworthy borrowers, everyone will benefit.
Lenders who know more clearly which borrowers have low credit risk would avoid accumulating more debt on those who will not be able to repay them, allowing 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 meeting the credit criteria. The result: more solvent companies would be financed; in particular, those looking for a small amount who have never had access to capital before can purchase the equipment they need to operate. The lower costs of automated transactions would allow even these small loans to be profitable.
Of course, in reality, perfect or complete information is unlikely to exist. No single data source will capture the entrepreneurial talent of the small business owner, which can be a critical factor in the success of the business.
It may not be possible to fully replicate the contribution of a relationship banker who knows the borrower personally. But the market is now crowded with fintech innovators, big tech companies and traditional banks opening up new horizons to find data with predictive power.
In the United States, no one knows how big the gap in access to credit is 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 reducing user experience frictions should lower borrower search costs and make it easier for borrowers to find a loan.
Reduced research costs
The perfect small business loan market will provide a better customer experience. We’ve seen applications that are short and easy to complete before, supported by automated access to data through application programming interfaces (APIs).
Small businesses that spent 25 hours on an app now have a fully digital experience and a near immediate response. For small businesses that have been discouraged by the time and length of the process, the new lending markets of the future will be more open, transparent and usable.
This should involve more borrowers in the process and improve their ability to obtain a loan if they meet the loan criteria.
Transparency and choice
Comparative shopping with transparency and choice will be part of the future market for small business loans. Borrowers will be able to understand the costs, benefits and risks of loan options and will be able to compare these options on an apple-to-apple basis.
We are already seeing this story unfold in the personal credit card space. In the 1990s, almost all credit card offers were mailed to consumers 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 provide aggregation services that allow consumers to compare prices and buy online on a bank-to-bank basis. Consumers have comprehensive information written in plain English on all available products, prices and probabilities of approval in one central location.
Although small business loan products are more complicated, comparison markets like Fundera and Lendio already exist and their functionality will improve. The question that credit providers face in this new environment will be, as Frank Rotman of QED Investors puts it: “Would a rational consumer with perfect information choose your product?” “
Extract from “Fintech, Small Business & the American Dream”, Palgrave Macmillan, March 2019.