The credit pipeline for small business has been slow to unclog since the recession. Business owners are turning to alternative sources to cope with curtailed lending from traditional banks. An October report released by the Federal Reserve Bank of Cleveland found nonbank online lenders are a growing source of financing for small firms across the U.S.; in 2015, as many as one-in-five small businesses sought financing from an online alternative lender.
More firms are opting for these lenders on the basis of a perceived greater chance of approval. The widespread perception among small business owners is that alternative lenders have looser underwriting criteria than traditional banks. That perception is proving to be greater than reality. Online lender applicants reported lower approval rates than traditional bank applicants. While more than half (56 percent) of the traditional lender applicants were approved for all the funding for which they applied, just 20 percent of the online lender applicants were approved for all the funding they sought
These outcomes parallel longstanding challenges in capital accessibility. The characteristics of small businesses that struggle to gain credit online mimic firms who have traditionally faced limited success in obtaining financing from mainstream lenders: smaller, younger, and more likely to be minority-owned.
That the struggles for these firms to access capital persists is of little surprise. As banking practices have tilted towards transactional-based lending, decisions have become predominantly based on a firm's balance sheet, the available collateral, and an industry risk evaluation. Online lenders, in particular, rely overwhelmingly on transactional-based lending, using data-driven processes and technology for underwriting, pricing, services, and delivery of funds. For these banks, the calculus is simple; it is all about the return on the risk:reward ratio. Their business model mirrors that of a fastfood restaurant: pull a high volume of profitable (if low margin) customers through the door as quickly as possible without anyone getting sick (defaulting).
Easing the small business credit crunch hinges more substantially on a shift towards relationship-based lending than diversifying funding sources. Relationship lending is critical for small businesses whose finances and prospects may be relatively less transparent than larger firms. It uses financial analysis as a guide to credit decision but is complemented by factors related to a firm's management, organizational strengths and proposed business plan. This strategy assumes that knowing your customer and being involved as an advisor helps to reduce the risk.
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From the SBN Policy Desk:
Is Online Lending Easing the Small Business Credit Crunch?
D