Fintech, Small Business & the American Dream

by Karen G Mills

  Lenders have a hard time determining whether a small business owner is creditworthy for two reasons that we have discussed earlier. The first is their information opacity. It is hard to know if a small business is profitable, especially given that they often don’t know themselves. The second issue is their heterogeneity, the fact that all small businesses are different. Because of this heterogeneity, it is hard to generate that “truth file”—the formula that can automatically give a credit approval to a loan applicant. In traditional small business lending, a banker might spend weeks with a small business, understanding their operations, only to ask at the end for a personal guarantee. A corollary to the second truth is that bankers seek collateral whenever possible, especially when the prospects of a business are opaque.

  These two truths are the foundations for the story we have told in this book. Despite the importance of small business to the economy, lending to small businesses hasn’t changed much because this lending is risky, and the information issues make the loan process costly and difficult to automate. Bankers have compensated by viewing the business as an extension of the business owner, and making personal guarantees the standard for anyone but the most creditworthy.

  These longstanding frictions in the small business lending market have been the most difficult for newer or smaller businesses, because these businesses are the hardest to understand, have the least collateral, and are the most likely to fail. But most of the 30 million U.S. small businesses are indeed small and, if they seek capital, are likely to want small loans. The result is gaps and inefficiencies in the marketplace, and creditworthy borrowers who are either rejected or discouraged from getting the capital they need.

  The Future of Small Business Lending

  The technology that is available today has the power to create information and intelligence to which small business owners and their lenders have never before had access. This should improve the small business lending market in fundamental ways.

  What Will Change in the Future?

  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?

  Better Matching

  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.

  Reduced Gaps

  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, particularly those seeking small-dollar loans. Square’s average loan size of $6,000 has meant that many retailers who 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 the business’s 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 who are turning over new ground in finding data that has predictive ability. Recall the story of Tala from Chapter 8. Operating in the developing world, the company uses data gleaned from Android phones to predict the creditworthiness of shop owners who have no formal credit history or banking relationship. They successfully make loans as low as $100, opening the door to more economic opportunity for those business owners.

  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.2 At the margin, technology is likely to help lenders find more creditworthy borrowers, and the reduction in frictions 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 who 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 one investor puts it, “Would a rational consumer armed with perfect information choose your product?”3

  Risk-Based Pricing

  In a perfectly functioning market, every small business who wanted a loan could get one—if three conditions were true:1.Business owners were sophisticated and well-informed enough to understand the full costs of the loan, both the monetary costs and the “life” costs. That would mean borrowers were able to rationally assess the consequences of failure, as well as success for themselves and their families.

  2.Lenders were incentivized both economically and by regulation to create full disclosure about all loan fees and costs.4

  3.Lenders were able to perfectly match the price of credit with the risk of the credit offered.

  If these three principles were operating, then theoretically, the market would match the risk of each loan with a price. If the borrower was willing to pay that price, the loan would be made. It would be the personal choice and responsibility of each small business owner to decide if the cost was too high.

  This marketplace may be where we are heading. Certain fintech innovators are offering higher-priced loans than banks are comfortable making. Some borrowers, such as Linda Pagan of The Hat Shop NYC in Chapter 5, are happy to take those loans, as they meet their needs.

  But risk-based pricing and a free market solution for small business lending comes with several concerns. Behavioral economists have demonstrated that humans are wired to downplay long-term negative consequences and overemphasize short-term wins. Entrepreneurs and small business owners are even more likely than most to have an optimistic view of the potential future outcomes. If small business owners were not generally optimistic, far fewer wou
ld take the risk of starting a business in the first place. Will these entrepreneurs be able to rationally assess the future risks of loan defaults, or will they just take the money and believe it will all work out well?

  The high costs of some loans in the fintech market raise another question: what level of pricing are we willing to tolerate in the market? Should there be caps, or should we allow the levels to be set by the market and let borrowers use their own judgment in taking on loans? Although there are sharp disagreements on these questions, logic says that at some point, the costs will simply be too much for the small business owner to ever repay.

  The risk of debt traps has long been recognized by usury laws and more recent efforts to regulate payday lenders. Yet, some argue that a fast short-term cash option can be a necessary lifeline for a business, even if it is costly. Leaning on the side of a cap on rates, and living with the market inefficiencies, is perhaps a better solution than allowing too many small businesses to fall prey to overly optimistic forecasts, and end up losing their businesses and maybe more. An interest rate cap or limit is particularly appropriate in an environment without full transparency of loan terms and small business borrower protections.

  The Perfect Information Platform

  The Small Business Utopia described in Chapter 8 includes an information platform for small businesses that gives them better insights into the financial side of their businesses. In particular, we imagined this dashboard integrating information flows from bank statements, payment activities, past sales, and expense patterns to predict cash flows and potential shortfalls. With a more fluid lending market in operation, different credit options would also be available at the push of a button, and an automated “bot” would dispense financial advice. In the ideal world, this system would be augmented by human advisors who would build a relationship with the small business owner and provide timely counsel and insight on a more personal basis.

  Anyone who has run a small business or interacted with small business owners knows that, despite their abilities and talents, it is hard to carry an integrated financial picture of the business in one’s head. QuickBooks, Xero, and other accounting software have helped, but many entrepreneurs operate by instinct, supplemented by scraps of paper. The frictions and inefficiencies of this less than perfect manual process would be transformed by a solution that includes the three elements described above: a dashboard that integrates financial information streams, simple access to loan products, and personal and automated advice. With these tools, it is likely that fewer businesses would fail, at least from unexpected cash surprises or mismanagement of their cash positions.

  The Voice of Small Business

  Small businesses don’t go unnoticed, but sometimes they do go unheard. As we noted at the beginning of Chapter 2, small businesses have a special place in the hearts of Americans, and are one of the few areas where there is bipartisan agreement. But the voice of small business is sometimes missing at the table. Small business owners are an independent, diverse group, and are busy running their companies, so they rarely convene and express their priorities. We saw this in the slowness of the banks’ response to the pain points of their customers in the traditional lending experience.

  There are signs, however, that more attention is being paid to the voices of small businesses. In 2009, Jack Dorsey founded Square, based largely on a desire to make life work better for small businesses. Each day in San Francisco, he would walk to work by a different route so he could observe small business owners opening their doors and going about their daily tasks.5 His focus translated into Square, a device that allowed them to easily process credit card payments, and then Square Capital. Other new entrants like the payroll and benefits operator Gusto, and the accounting software provider Xero, see small businesses as important customers, and innovate every day to more effectively meet their needs.

  Technology is also enabling small businesses to be a more connected community. A new Boston-based company, Alignable, has built a series of online networks for small business owners. In over 30,000 locations, the Alignable platform lets 3 million small businesses advise each other, sharing issues they face and solutions they find helpful.6 Often, they refer businesses to each other, or just brainstorm answers to questions posed on the community forum. Perhaps this kind of vibrant small business online community is one of the new alternative sources of relationship advice. It will certainly have an impact on the spread of good ideas, products, or companies that provide solutions for small business problems.

  The Dark Side of the Black Box

  The use of big data and algorithms will bring new products and services, but also bring some new concerns. It is not yet clear what impact the changes we anticipate from technology will have on access to capital for traditionally underserved markets. In the past, women and minorities have struggled to find willing lenders. The hope is that with more efficient markets and new data sources, more creditworthy borrowers from underserved segments of the market will get loans. However, “black box” algorithms, where the formulas are not open to review, could lead to an outcome of more discrimination, not less.

  One way to get ahead of these concerns is to collect the actual data on access to capital in the small business market. The most relevant metrics would be loan origination data by size of loan and by type of small business owner. As we have discussed, the law requiring this data collection was passed after the financial crisis, but has yet to be implemented.7 More innovation can take place if there is a way to track potential poor market outcomes. Collecting this information and using it to identify and correct market gaps is a critical foundational element of a highly functioning small business credit market, as artificial intelligence becomes an integral part of lending decisions.

  The Role of Government

  With the insights from better information in hand, government can play a more effective role in intervening when there are market gaps. Programs such as Community Development Financial Institutions (CDFIs), the Small Business Administration (SBA), and many state and local initiatives already play this role, often with great impact. In the future, banks could use Community Reinvestment Act (CRA) funds more effectively to target market failures in small business lending and improve access.

  The government must also ensure that small businesses are not taken advantage of by bad actors amidst the new opportunities. The early days of fintech saw the emergence of high cost products with hidden fees and brokers with misaligned incentives. As we have argued earlier, Washington needs to take steps through a more effective regulatory environment to protect small business owners with the same vigor as they do consumers.

  Predictions for the Future of Fintech and Small Business Lending

  What is going to happen next? Of course, we don’t know for sure. But based on the narrative described in the preceding chapters, it is possible to make some predictions:

  Prediction #1: Data Ownership Will Determine the Level of Innovation in Small Business Platforms

  We have described a new state of Small Business Utopia, where information streams come together to provide a more transparent, helpful, and predictive view of a small business’s cash and financial needs. This data integration will improve how small businesses decide what capital they need, how lenders assess whether they want to lend, and how efficiently the marketplace matches the parties. At the margin, this enhanced information will increase the success rates of small business owners, who will be able to plan for and manage unexpected cash fluctuations.

  Who will provide the integrated platform?

  The answer will depend on an unlikely source—regulation of data ownership. If banks, or even large tech companies, control customer financial data, then they will likely be the central facilitators of an integrated data platform. Some view this as a big mistake. Brad Kitschke, the CEO of FinTech Australia, said, “Allowing the big banks to control or restrict access is not in the interests of consumers. Without access to this data, consumers will continue
to be forced to accept the off-the-shelf generic products on offer from the big banks that don’t meet their needs.”8

  In Europe and the United Kingdom, recent legislation has given control of data to the customer. We believe this structure will drive more innovation. As the fintech, Plaid, has demonstrated, new infrastructure can be created behind the scenes to integrate data streams into useful formats. This will allow innovators to access relevant data with customers’ permission, and create platforms that fundamentally change the way small businesses operate financially. Banks and other financial firms could then use these solutions, or create their own, but would not control the data at the source. We should carefully watch the countries who have already adopted Open Banking, as their experiences will undoubtedly provide useful lessons on what decisions to make and what mistakes to avoid.

  It is not at all certain that the United States will ever implement Open Banking regulation. Banks and large tech companies have vested interests in controlling data, and there is no momentum for new data privacy legislation in the current environment. This may change if powerful innovation occurs, such as the dashboards and other tools we have described, or if other pressures build on the side of data security. As we navigate these waters, it is worth remembering that the theories of markets and competition support the prediction that more control of data in the hands of customers rather than large institutions is likely to lead to more experimentation and opportunity for products and services that transform small businesses’ lives.