ByAmy B. Simpkins
The traditional model of small business lending relies heavily on banks, credit card companies and other intermediary institutions to find and underwrite borrowers based on standardized processes and risk modeling as a primary basis for giving out credit. Analyzing a borrower's creditworthiness is streamlined, so that transaction costs are lowered, and risk is limited.
Many market segments, however, experience either real or perceived barriers to access with traditional lending. Further, relying on standardized underwriting may make credit unaffordable or unattainable if borrowers have weak credit history.
Nontraditional service providers are attempting to respond to what they see as increasing market demand that is not being met by commercial banks and the traditional model of small business lending. Fueled by changes in technology that allow for advances in online loan transactions and payment services, nontraditional financial service providers claim to increase access to credit for small businesses worldwide. Two new business models for small business lending are emerging—one relying on interpersonal relationships to allocate credit, and another based on unique partnerships between lenders and retailers.
The hallmark of peer-to-peer (P2P) lending is that borrowers and lenders are directly connected and negotiate credit terms favorable to both parties. On Internet-based P2P sites, borrowers share personal and financial information about themselves, and individual lenders decide whether to contribute to borrowers' loan requests. The online format of these products means that anyone who has a computer and the Internet can apply for, or invest in, P2P loans.
Popular P2P sites include Kiva, MicroPlace, Lending Club, Prosper, Zopa, Loanio and others. According to an interview conducted with Prosper CEO Chris Larsen by staff at the Federal Reserve Bank of San Francisco, P2P was a $647 million industry in 2009, expected to reach $5.8 billion by this year.
P2P lending typically falls into one of two categories: consumer lending or international microfinance. Consumer loans, such as those offered by Lending Club and Prosper, can be used as sources of credit to small and microbusiness owners to finance their operations. Kiva and MicroPlace focus on international microfinance, where investments are directed to low-income entrepreneurs across the globe. Both consumer lending sites and international microfinance sites emphasize the double bottom-line return for such investments, either as an economic driver for our nation's economy or a poverty-alleviation strategy for developing countries.
In both categories, loans are usually underwritten by multiple individual lenders until the loan is fully funded. Once originated, lenders receive a pro rata share of principal and interest payments until the loan reaches maturity or the borrower defaults. Structures of these loans vary greatly across sites, with online platforms typically serving as brokers of the loans or originators of the loans.
For a comprehensive explanation of P2P lending, read the working paper on this subject created by the Center for Community Development Investments at the Federal Reserve Bank of San Francisco.
As the economy begins to recover, small businesses have started to look for sources of credit to fund expansion. Unfortunately for the smallest businesses—five employees or less and revenues less than $500,000—credit is often unavailable through traditional lending models used by commercial banks. Sam's Club, a division of Wal-Mart Inc., recognized that most of its customers fall into this category. In light of growing demand, Sam's began examining alternatives that would increase credit availability for its small business members.
Sam's Club developed a pilot program to offer loans to qualifying small business members.
The result is a pilot program to offer loans of up to $25,000 to qualifying Sam's Club small business members. These loans are offered through a partnership with Superior Financial Group (Superior), a nonbank Small Business Lending Company (SBLC) authorized by the Small Business Administration (SBA). The program will primarily rely on the Community Express program to originate loans targeting minority-owned, women-owned and veteran-owned small businesses, as well as micro-entrepreneurs.
Superior's offering of the SBA Community Express product is similar to an unsecured credit card. Superior has developed an online application, which is user-friendly and provides information and tools to educate applicants on different types of loans, overall creditworthiness, and how to improve their chances of loan approval. Normally, the application can be approved in minutes, and the borrower is contacted within days to set up loan closing. While the applications are prequalified through an automated underwriting process, some discretion is applied during the review process.
Superior Financial Group reports that approximately 45 percent of applications have been approved for an average loan amount of $9,500. The pilot status of these programs is important because that statute limits the total number of loans made under all SBA pilot programs. For example, if 70,000 SBA loans were made nationally this year, no more than 7,000 pilot program loans (including Community Express, Export Express and Patriot Express) can be made this year. In order to ensure that the SBA does not exceed this statutory limitation, each lender originating loans in the pilot programs cannot close more than 200 loans a month.
Representatives from Sam's Club and Superior Financial Group report that demand for these loans is far exceeding expectations. Where initially 100 applications were expected a month, in July 2010 alone more than 2,500 applications had been received.
Nontraditional lending to small businesses has implications for a host of diverse stakeholders—federal state and local policymakers, financial regulators, community development groups, consumer advocates, and financial institutions alike.
Policymakers and regulators must ensure that alternative products and services do not include high fees and other predatory practices. Borrowers and investors need to be fully aware of the risks involved with such products and pay careful attention to disclosure statements and prospectus information. Some things to note may be whether FDIC insurance applies or which, if any, industry or bank guarantees may or may not be applicable.
In particular, when considering P2P sites, borrowers applying for consumer loans need to be mindful of the cost of credit, just as with any other form of unsecured debt. Ian Galloway, investment associate with the Federal Reserve Bank of San Francisco, explains. "This (P2P lending) expands consumer credit access but it can be an expensive option, with interest rates as high as 36 percent in some cases."
Allen North, vice president in the Banking Supervision and Regulation Division at the Federal Reserve Bank of St. Louis, notes that, "demand for small dollar credit is evident." But "the risk-return tradeoff may be one reason why more banks and other SBA lenders do not participate significantly in programs or partnerships like that of Sam's and Superior." But he offers that if expansion of programs like this is deemed a desirable policy option, more intermediaries like Superior need to be at the table. "This would reduce the risk of administration of the program should one intermediary become unable to continue participating for any reason."
At the same time changes the nontraditional market occur, the Federal Reserve is actively engaged in efforts to ensure that traditional financial institutions are able to meet the credit needs of small businesses in a responsible way that add to the range of borrowing opportunities available to business owners. (See articles Understanding the Small Business "Credit Crunch" and In this Issue for summarizing key findings from the Federal Reserve's local small business meetings and national capstone event held earlier this year). Overall, the evolution of this market indicates there is continuing need for industry-based solutions that model new ways to match supply and demand. Whether through traditional or nontraditional lenders, innovation appears to be the new norm for small business lending.