The origins of modern banking can be traced to early Renaissance Italy, and the architecture of older bank branches still reflects that neoclassical idealism. We still romanticize banks today.
As a society, we take comfort in the (literal) pillars of strength and statehood that banks represent. Take the American classic film It’s a Wonderful Life as an example. Every holiday season we gather around the TV to watch George Bailey save the Bailey Building and Loan from the evil takeover plans of Mr. Potter. Did it ever occur to you that many of the financial industry issues that George Bailey faced in 1940s’ Bedford Falls are the very same issues we are struggling with today?
The truth is, the banking industry has changed very little over the last century. The state regulation that prohibited Bailey Building and Loan from maintaining its own cash deposits remained on the books until the end of the 20th century. Small business owners looking for a business loan are still required to go down to their local branch and apply for the money in person. The fact that most major banks are currently closing branches in underserved communities makes accessing capital via traditional means increasingly difficult for business owners.
The Great Recession
The financial collapse of 2008 sparked major changes to the small business financing industry as we knew it—much to the chagrin of the small business community. And while our acceptance of those changes has been painful at times, the innovation emerging from the transition is both exciting and long overdue.
The innovative disruption of the industry began with a return to extreme conservatism by the banks. After the financial collapse, banks tightened their lending standards and started removing small business loans from their balance sheets. Customers who had been doing business with the same branch for years had their lines of credit severed with no warning. By June 2012, small business loans were down $56 billion from their June 2008 peak of $336.4 billion.
According to the Small Business Administration (SBA), small business accounts for over half of non-farm private gross domestic profit (GDP) and originates 75 percent of the net new jobs in our society. Without reliable access to capital, small business owners were forced to cut back on expenses, halt plans for expansion and delay hiring. The effect on the American economy was catastrophic.
Enter the alternative lender
One enterprising group was quick to step up to fill the capital void left by the banks: the alternative lenders. Many alternative financing companies that had long been out-priced by banks were given the chance to show off their financial products on a large scale for the first time. The results were impressive not just in terms of the companies they were willing to finance, but also in the ways that they were doing it.
The industry is now full of companies that are leveraging technology to offer extremely creative funding products to all facets of the small business community. Former bank darlings like manufacturers are finding that alternative lenders are able to fund them faster and with more flexible terms than banks ever could.
Most alternative lenders know that they still can’t compete with banks on cost of capital (though increasing competition has driven down interest rates exponentially over the last six years). The secret to their success lies with their ability to use datadriven analytical platforms to efficiently assess applicants. While banks are still relying heavily upon manual review of credit scores, personal financial history, bank statements and balance sheets that can take weeks to evaluate risk, alternative lenders are quickly working outside the box. Some companies are even using factors like social media, payroll and data from the Better Business Bureau to determine creditworthiness.
What is the future of small business lending?
The umbrella term “alternative lender” is used to describe an incredibly diverse group of companies that offer very different financial products. Merchant cash advance companies that issue loans based upon future earnings are categorized in that group. So are factoring companies that finance unpaid accounts receivable and asset-based lenders that allow small business owners to borrow money using assets as collateral. What nearly all of these companies have in common is an Internet-based technology platform that allows them to finance companies from all over the country and in nearly every industry. Many alternative financing products are short term with higher interest rates. Others are designed to resemble a traditional loan: long term, low cost.
There is, of course, a trade off. Small business owners are sacrificing the familiarity of seeing their loan officer face to face when they complete a loan application. They can no longer take comfort in the false sense of financial security that those impressive old bank buildings provide. What they are gaining is the ability to manage their business finances from anywhere. The diversity of products available to entrepreneurs and small business owners is growing every day. There is no longer a one-size-fits-all solution to small business financing.
Banks will inevitably return to the small business lending marketplace— it’s happening already. The Biz2Credit Small Business Lending Index from April 2013 reported the highest approval rates from both big banks ($10 billion+ in assets) and small banks since the index was created three years ago. As of right now, there are still too few banks eager to adopt the progressive technology of their competitors. However, their return to the market should result in increased competition among lenders and a lower cost of capital for business owners.
The last five years have been challenging for small business owners, but the exposure they received to new financing products and technology was undeniably positive. What’s more, there’s no such thing as one-size-fits-all financing. In fact, some businesses benefit most from a hybrid traditional/alternative combination. The return of the banks doesn’t mean the departure of innovative alternative financing. It just means more choices for small business. And that’s a good thing.