Half of the people who work in America own or work for a small business. They account for half of this countryâs jobs. There are more than 30 million small businesses in the United States today, underpinning our economy and the fabric of our society. These businesses operate in every corner of every state, and exist in every industry, from retail shops to oil and gas exploration. The story of the small business owner is often one of the community-minded citizen who supports the local Little League or the immigrant entrepreneur who builds a life of opportunity.
All of these small businesses are different, but they face a common challenge: it is often difficult for them to get access to the capital they need to operate and succeed. Until recently, lending to small businesses hadnât changed much over the past century. A small business owner would compile a stack of paperwork, go to their local banker, and often wait weeks for a response. If the answer was âno,â they would go down the street to the next bank and try again.
While this might sound like a frustrating process, there are many who say that it is not a serious problem. They argue that many of the small businesses that have trouble accessing capital should not actually get it because they are not creditworthy, and that most small businesses donât want to grow, so have no need for external financing. They also argue that todayâs banks are fully meeting the needs of the creditworthy borrowers in the marketplace. These statements have some truth to them. Not every business who wants a loan should get one and many businesses donât want to grow. The lending environment is also much improved from the dark days of the Great Recession. However, these views are blind to market failures in small business lending, which have only worsened over recent decades.
Small business lending is hard. In this book, we will meet small business ownersâfrom Miami to Manhattan to Maineâwho are struggling to get the right loan in the right amount at the right cost. We will meet lendersâfrom New England to Texas to Silicon Valleyâwho are trying to figure out which small businesses are creditworthy and how to lend to them profitably. These are not just isolated anecdotes, but rather, they represent the experiences of small business borrowers and lenders in a market filled with frictions . Using the best available research and data, we will show a picture of the gaps in access to capital for creditworthy small businesses, and the barriers that have made many traditional lenders less willing or able to meet their needs. And we will track how innovations in fintech have begun to address some of these problems.
Transforming Small Business Lending
Many industries, from music to telecommunications, have been transformed by technology, but small business banking has been slow to evolve. That is changing. Financial technology, or âfintech,â is a broad category that includes innovation across the banking, insurance, and financial services sectors, as well as new activities in areas like cryptocurrencies and blockchain . This book uses a narrower fintech lens, focusing on the way technology will affect lendingâspecifically, small business lending.
Lending does not happen in isolation. Other fintech innovations , particularly in payments, will have a related impact as they evolve. But, for the purposes of this narrative, the innovations in lending, and in data and intelligence related to lending, provide a rich environment to explore the ways in which technology will bring changes to the market. The cycle of fintech innovation in small business lending is not yet complete, but it has ushered in promising changes.
Today, all that is visible are the âgreen shootsââideas that early fintech entrepreneurs brought to the market beginning around 2010, and the nascent activities of larger banks and technology companies. Based on analysis of the foundational elements of small business needs and current lending markets, this book describes the ways that technology can be truly transformative, opening up better prospects for both small businesses and the lenders who serve them. Such a positive future for small businesses may sound overly optimistic. But newly available and soon-to-be discovered ways that data and intelligence can change decision-making promise to alter even areas as âold schoolâ as small business loans.
As technology opens the doors to vast troves of data, opportunities are emerging to create new insights on a small businessâs health and prospects. Insights from this data have the potential to resolve two defining issues that have faced lenders and borrowers in the sector: heterogeneity âthe fact that all small businesses are different, making it difficult to extrapolate from one example to the nextâand information opacity, the fact that it is hard to know what is really going on inside a small business.
From a lenderâs point of view, the smaller the business, the more difficult it is to know if the business is actually profitable and what its prospects might be. Many small business owners do not have a great sense of their cash flow, the sales they might make, when customers will pay, or what cash needs they could have based on the season or the new contract. Small businesses have low cash buffers and a miscalculation, a late payment, or even fast growth could cause a life-threatening cash crunch.
But what if technology had the power to make a small business owner significantly wiser about their cash flow, and a lender wiser as well? What if new loan products and services made it easier to create what one investor calls a âtruth fileââa set of information that could quickly and accurately predict the creditworthiness of a small business, much like a consumerâs personal credit score helps banks predict creditworthiness for personal loans , credit cards, and mortgages?1 What if a small business owner had a dashboard of their business activities, including cash projections and insights on sales and cost trends that helped them weave an end-to-end picture of their businessâs financial health? What if this dashboard helped them understand all credit options they qualified for today and which actions they could take to improve their credit rating over time? And better yet, what if the dashboard , marshalling the predictive power of machine learning amassed from data on thousands of business owners in similar industries, could help a business owner head off perilous trends or dangers?
This future is appealing because it responds to the fundamental need of small business owners to be able to see and more clearly interpret the information that already exists, helping them navigate the uncertain world of their businesses on their own terms and plan accordingly. And it provides an opportunity for lenders to better understand the creditworthiness of their potential customers and lower lending costs as a result. We call this future state âSmall Business Utopia.â
It may be that this name overpromises the outcome. Small businesses are perhaps too varied to be predictable and entrepreneurs run their businesses with so much ingenuity and peculiarity that their insights cannot be replaced or even augmented by artificial intelligence. Small business owners have a reputation for being set in their ways, and might be resistant to technology. But they are also pragmatic. If new intelligence is developed that will help them succeed, they will find a way to adopt it. Small businesses are hungry for new solutions. They responded so positively to the early fintechsâ quick turnaround times on loans and the ease of the online applications that they spurred traditional lenders to action.
In this book, we trace the progress of the fintech innovation cycle and explore what will be next and who will provide it. We build these predictions for the future on a fundamental foundation of elements we can understand today: the needs of small businesses as they access the capital they require, the challenges their current lenders face in meeting these needs, and the opportunities that technology is providing for new solutions.
Three Myths of Small Business Lending
In the course of this journey, this book takes on three commonly held misconceptions about small businesses and small business lending. There are often good reasons why countervailing narratives exist. Sometimes, they are partly true. Often, there is not enough data to know definitively what the actual situation is or to prove causality. This is often an issue with small business, as data sources are scarce. Fortunately, since the Great Recession, more research and analysis has been conducted on the importance of small business to the economy , the role of access to capital to small business, and the gaps that exist in the market. We take advantage of this new research as we explore three myths of small business lending.
The first myth is the view that small businesses arenât that important to the economy , and that most small businesses fail and probably shouldnât be financed. This narrative argues that the small businesses that succeed largely donât need external financing, and those that should get financing are already well served by the market. In contrast to this narrative, the early chapters of this book pull together the best evidence of the barriers which are preventing small businesses from getting the financing they need, and describe the underlying market gaps in small business lending.
The second myth is that traditional lenders were âdinosaursâ that fintech start-ups would soon replace. Subsequent events have shown that this initial expectation about fintech disruption was too simplistic. However, the potential remains for technology to revolutionize small business lending. The contribution of this book is to separate hype from realityâto pull apart where the disruption will occur and where it will have the most impact, both on the health and wellbeing of small businesses and their finances, and on small business lenders. Based on an understanding of the kinds of products that will best serve small businesses and their needs, this book predicts what will determine the winners in the future small business lending environment.
The third myth is that the primary culprit for the decline in small business lending is post-crisis financial services regulations , particularly the Dodd-Frank reforms.2 Some argue or imply that if these regulations were reduced or eliminated, community banks would return to their former role as the critical providers of small business loans , particularly through relationship lending.
There is truth to the claim that small banks have suffered disproportionately from the burdens of post-crisis regulation and that changes must be made to ease the regulatory burdens, particularly on small banks . But deeper analysis shows that the morass of competing and overlapping regulation is not the only problem. Structural issues that have existed for decades are largely responsible for the decline in community banking. Innovation , particularly in the use of data, is creating changes that can improve the marketplace, but will bring new regulatory questions. The answer is not simply less regulation ; rather, it is the right regulation that considers and anticipates the new challenges that a technology-enabled small business lending world will face.
Taking on these three arguments requires an ambitious journey, because it means delving into the data and evidence in three distinct areas of economic work. First is the macroeconomic and microeconomic debate over the importance and role of small business, and the gaps in small business lending. Second is the innovation literature, which helps us to understand how cycles of innovation work and what outcomes we can predict for the fintech revolution. Third is the policy and regulatory arena, which requires an understanding of both the current state of financial regulation and th...