I recently read “Fintech, Small Business & The American Dream” by Karen Mills, HBS faculty and former Administrator of the U.S. Small Business Administration (SBA). The book was rather academic but very insightful in explaining how fintech firms disrupted small business lending in the U.S. and the evolving challenges facing the fintechs, incumbent banks, and regulators. I also took notes (available here) as I read the book. An absolute page-turner for me!
Small business, or small and medium enterprise (SME), lending is a topic of interest to me. Financing is the lifeline for businesses, but the SME lending space is filled with gaps. These gaps are largely universal across countries and include:
· Lack of reliable data to assess the borrower’s creditworthiness. For instance, SMEs may not have audited financials[1]. Traditional lenders, therefore, often require a personal guarantee from the business owner and/or other fixed asset collaterals to mitigate risk.
· Lack of operating track record (for relatively new SMEs) and/or lack of credit history, i.e., have not sought external financing. According to a Deloitte study on SME financing in 2015, less than 60% of SMEs in Indonesia, Malaysia, Philippines, Singapore, and Thailand used bank loans as a means of funding. In particular, in Indonesia, only 6% of SMEs cited using bank loans as a source of financing.
· High cost of acquisition and underwriting of SME loans for banks. Revenues per client are typically lower for SMEs compared to that of larger corporate clients.
· Tedious paperwork submissions with long turnaround times.
Recognizing the prevalent gaps, fintechs have sprung up and used innovative ways to ease the frictions in SME lending. For instance, some have leveraged alternative data and innovative underwriting formulas to assess the borrower’s repayment risk. Kabbage, a U.S. fintech company, lent to merchants on eBay and Amazon by analyzing their data on sales, customer traffic, and buyer feedback. In Singapore, fintech lender Validus collaborates with corporates to assess the vendors’ and distributors’ trade data to determine lending decisions. Using such unconventional data, fintechs can derive new insights into customers’ behavior as a proxy for their creditworthiness.
In addition, fintechs are often more agile and can adopt new technologies quickly, unlike banks that may be constrained by their legacy IT systems. Some fintechs have also managed to access new sources of capital to open up more lending opportunities for SMEs. For example, U.S. fintech lender Lending Club is widely regarded as the pioneer of peer-to-peer lending.
Despite the value of fintechs in facilitating SMEs’ access to credit, governments did not, for the longest time, recognize fintechs as official lenders on government’s loan guarantee or risk-sharing schemes. The following reasons could be some concerns of governments.
· Track record of fintechs. After all, fintechs only sprung up within the last two decades and gained prominence in the previous decade or so. Their track record pales in comparison to that of traditional banks. Related to this point is that the relatively short track record may mean that loan data, such as non-performing loans (NPL), may not be comprehensive enough for governments to assess the robustness of the fintechs’ underwriting and risk assessment models.
· Reach of customers. Fintechs generally have less capital/funding than banks. How many SMEs can they realistically support with their funding pool?
· Technology risk. Are the fintechs’ platforms stable? Do they have robust mechanisms to prevent and withstand cyber attacks?
Governments were adopting a “wait and see” approach cautiously, understandably so because they had to be accountable in using taxpayers’ monies. However, COVID-19 changed the equation and accelerated the decision-making by governments.
When COVID-19 struck, one of governments’ top concerns was saving livelihoods. There was a strong urgency to roll out support measures quickly. Hence, governments relied on lenders, including fintechs, to channel financing to a wide audience of businesses, especially SMEs. Some governments also approved fintechs as direct lenders on the government’s loan assistance programs to catalyze lending to SMEs. Some examples are listed in Figure 1 below.
The pandemic created an opportunity for fintechs to demonstrate their value. Fintechs were able to channel loans to SMEs quickly. For instance, Singapore’s alternative lender Goldbell Financial Services could disburse funds in three days upon completing the paperwork, whereas banks could take up to months.
In the U.S., fintechs also originated loans of smaller quantum, indicating that they served smaller businesses. For instance, an NYU study showed that fintechs made 757,137 PPP loans with a medium value of $15,000, less than the median value of $22,880 across all lender types.
A study by Liberty Street Economics on PPP loans also found that only one in three applicants that applied to a fintech lender had worked with that lender before (Figure 2). These borrowers had fewer employees, lower credit scores, and greater difficulty in accessing PPP credit. Hence, fintechs likely served borrowers who would otherwise not have received loans.
After more fintechs were approved as lenders on PPP in wave 2, their share of lending also increased to more than 10% of loan amounts and 20% by number of loans (Figure 3).
The COVID-19 government-backed loans serve as an interesting experiment to examine the efficacy of fintech lenders. It will be critical to monitor the NPL and fraud rates and compare them to the average rates across all lenders to assess the robustness of fintechs’ underwriting approaches.
Governments may also analyze the characteristics of the loans disbursed by fintech lenders to understand the profile of the borrowers. For example, review the demographics of the business owners, the borrowers’ revenues, years of operating history, and industry classification to understand if fintech lenders are serving niche and/or underserved groups. Such data will help governments assess the reliability and suitability of the fintechs to remain as direct lenders on government support schemes even post-COVID.
For the fintech lenders, COVID-19 presents an opportunity for them to gain new customers and accumulate more data on these SMEs, but the challenge will be in retaining these customers post-COVID.
Anyhow, COVID-19 and the government-backed loans by fintechs are set to leave long-lasting impacts on the future of SME lending. This will be an exciting space to watch!
[1] For example in Singapore, the Companies Act exempts a “small company” from audit requirements. A company is considered to be a small company if it fulfills at least two out of three conditions: (a) the total annual revenue of the company must not exceed S$10 million; (b) the total assets of the company for the financial year-end must not exceed S$10 million; (c) the number of full-time employees at the end of the financial year must not exceed 50.
