FinTech Firms: Revolutionizing Lending
Ever since the financial crisis of 2008, small- and medium-sized businesses have seen a sharp cut back in financing from the mainstream banking sector, which has adversely impacted their ability to grow and create additional jobs. Data from FDIC-insured institutions shows that the proportion of commercial and industrial loans under $1 million (used to measure small business lending) has fallen to 21% of all commercial loans from a peak of 34% before the "credit crunch."
A new breed of alternative lenders, such as Lending Club, On Deck, Biz2Credit, Kabbage and recently, Goldman Sachs, have emerged to address the gap between small business needs for financing and the willingness and capacity of banks to serve these needs effectively. Collectively known as “FinTech firms,” they are pioneering a distinctive online and digital-based approach that promises to greatly enhance small businesses access and efficiency to funding for growth. The new FinTech disrupters are benefiting from the fact that small businesses are increasingly turning online to search for financing, especially through mobile devices.
Like other disrupters, these firms are growing fast and attracted $12 billion of investments in 2014, an increase of $4 billion from 2013. Further, nearly one in five credit-seeking small businesses surveyed in the first half of 2014 applied for funding through an online lender, according to a Federal Reserve Bank of New York survey.
Your cash belongs to you, not your bank. Fintech startups are challenging the big banks—and already saving people thousands.
The Information Challenge
Traditionally, mainstream lenders who underwrite small business loans have been challenged by the fact that the required information for the loan decision is both asynchronous and asymmetric. In essence, every small business is its own unique entity, with distinctive needs that vary with time and are different from other small businesses even within the same industry. Additionally, their cash flows are much more variable than large corporations. Thus, it is both hard and expensive to monitor such businesses on a day-to-day basis to ensure their ongoing viability and hence the ability to repay the loan.
In contrast, cutting-edge FinTech companies are asking prospective small business borrowers to opt-in to share information and data about themselves, both at the time of initial application and on an ongoing basis. Such data includes their funding priorities for the business, as well as bank statements, tax records and authorizations to review credit and public records. Moreover, the behavior of such small businesses through digital loan applications is creating a wealth of data that can be harnessed effectively to better serve their financial needs while also increasing the likelihood that the risks associated with lending to such businesses are better understood for improved loan decisions.
By systematically combining this information with other local, regional and national economic data and also with that of thousands of other small business applicants, they are able to quickly respond to the funding needs of applicants and provide a rigorous and analytically-based approach to evaluate the risk of such lending.
The BizAnalyzer score developed by Biz2Credit offers an interesting example of the evolution of this approach. It assigns a score from 0 to 100 after collating 2,200+ variables broadly bucketed by industry to which the small business belongs, time in business, cash flows, debt to income ratios, personal credit score and repayment record. As new information comes in, the score is dynamically updated over time as well.
Additionally, the BizAnalyzer score along with the applicant’s ratings on each dimension is readily available at any time free of charge to the prospective business borrower, along with specific guidance about how they can improve their score to obtain better lending terms. This is a big departure from how mainstream lenders have kept their decision approach proprietary and hidden from the applicant, adding to the latter’s frustration and uncertainty associated with their loan request. The open sharing of business creditworthiness provides a powerful incentive for the small business to consent to share their information, since they know it can potentially help them attain a better outcome.
In turn, the willingness of thousands of small businesses to share their business data on an ongoing basis along with their repayment history enables increasingly sharper assessments of lending risks that even at very early stages of the evolution of FinTech are proving to be significantly better than traditional methods of assessing business risk, such as the personal credit score. The following chart, known as a Lorenz curve, provides a comparison of the FICO score with the BizAnalyzer in predicting loan impairment.
Figure 1: BizAnalyzer Score vs. FICO Score: Indicative ability to predict default
The greater the area under the curve in the accompanying chart, the greater the predictability of the model. As can be seen from the chart, where the BizAnalyzer curve lies entirely above the other, the performance difference persists at every level of the borrower’s score.
Reshaping Finance as we know it
As the FinTech approach to small business lending increases in popularity, banks are asking themselves the question of whether they will be disintermediated from the entire process. While this is unlikely, FinTech firms like Biz2Credit are certainly reshaping the industry through their data driven lending. Banks can choose to stick to their current approach or to join the FinTech revolution, either through their own digital efforts or by partnering with FinTech players. If they do, they will provide their relationship managers and underwriters with much richer sources of data and analytics that help their customers and lead to better lending decisions.
In the long run, Fitch's behavioral data approach offers a large promise to improve small businesses' access to capital while also serving their needs better. Small businesses will have more lenders competing for their business as well as a transparent understanding of how to improve their business creditworthiness to obtain the best lending terms for themselves.
