4 ways alternative lenders are changing the game July 23, 2015 by Sean Albert
Traditional banks cut back on lending in the aftermath of the economic crisis, which hampered small businesses' abilities to grow. To fill this void, the alternative lending sector emerged and has since established itself as an option for SMBs seeking to expedite the approval process and gain quick access to necessary capital.
But to ensure the long term viability of this industry, its constituents have had to take approaches that greatly differ from those of traditional banks. Below are some trends within the alternative lending market.
1. Encourage better decision-making among prospective borrowers
Industry expert Ken Rees wrote in an article for American Banker that lenders should hold themselves accountable for educating loan-seeking companies or individuals. While the main attraction of applying for loans from alternative sources is perhaps the simplicity and lack of hidden fees, Rees noted that, at times, the language can be confusing for consumers. This lack of transparency contributed to banks providing funding to unqualified applicants, and is something that alternative lenders need to avoid. By providing financial literacy tools to borrowers, providers can create a more intelligent lending environment and minimize risks.
2. Alternate sources use different models to assess applicants New lenders have taken a stark departure from banks in terms of the methods they use to analyze borrowers' qualifications, according to The Huffington Post's Gina Harman. She pointed to software that analyzes a range of data without the interference of human bias as a major breakthrough for the industry. Some of the factors included in these programs are cash flow, payment history, customer transactions, industry trends and even social media engagement, Harman said. The application, approval and decision-making process can be streamlined for those who need capital immediately, and sometimes the entire operation can take place within a day.
3 . Online lending has added options and increased efficiency Harman also noted that one of the most prominent developments among alternative lenders has been the ability to apply for and receive a loan online. In addition, the Internet has given birth to a variety of different lending services, which has given applicants more chances to be approved, even if they are rejected by traditional lenders. Technology investments have allowed online providers to offer more user-friendly and faster application processes.
Rees chimed in on the subject, remarking that small business owners have benefited from the plethora of options. Instead of being at the mercy of a select few banks, these organizations can choose from a variety of different lenders, many of whom are eager to provide capital to burgeoning businesses.
4. Alternative lenders have increased the amount of funding distributed The sheer volume of cash being lent to SMBs and individuals has increased dramatically in recent years. Harman asserted that a vibrant and healthy marketplace has contributed to lending growth by alternative sources of 175 percent each year, according to Forbes, and, in contrast, the traditional banking sector has seen a lending decrease of 3 percent. This large spike in capital loans has opened up new doors for small businesses that may have struggled to meet the banks' requirements.
It’s no secret that bank lending to small businesses is on a steady decline. If you’re reading this, you may be a part of the 80% of merchants who have applied for a bank loan and got rejected. Since 2005, the percentage of business loans issued by banks to small businesses has dropped from 33% to a mere 24%.
Before President Obama had been elected to his second term, he vowed to “tailor his second term policies to the needs of small business owners and entrepreneurs, promising to improve their access to capital, limit their tax burden and alleviate their regulatory headaches to encourage job creation and business expansion” (Harrison, The Washington Post). Entrepreneurs across the nation would argue that no such change has been in effect. The million dollar question that everyone wants to know the answer to is: Why?
Small businesses felt the brunt of the recession crisis, accounting for over 40% of job losses. Without access to capital, small firms were a lot slower to recover than larger firms. Since 2008, the number of struggling entrepreneurs has increased drastically because of the result of declining sales, banks tightening their loan standards, along with weakened housing and stock market collateral.
In fact, more than 80% of banks have admittedly reported tightening their standards after the 2008 economic crisis. Small businesses that would have been approved for loans 10+ years ago are simply being denied day in and day out.
Their reasons for tightening their standards are because they believe smaller loans are a whole lot more “time consuming”.
When lending capital, it is important to develop close relationships, and banks feel smaller firms are too costly/time consuming. While merchants of smaller firms are very optimistic about the talent and ability of their business, they remain concerned about what they can in fact control.
Furthermore, the main argument banks have is that small businesses represent a higher risk. They have higher failure rates, fewer assets, and/or bad credit. Moreover, these smaller firms are harder to underwrite. They tend to have tax liens, history of bankruptcies, or inadequate financial statements.
Traditional banks have simply tailored their protocol in ways that owners of small businesses do not fit. They require a strong cash flow, some sort of collateral, and a detailed look of the owner’s credit. Most merchants lack one, if not all, of these guidelines.
While community banks are the answer for some, they definitely aren’t the final solution. While small business loan approval rates are triple the amount of approval at big banks, the number of “local banks” have been steadily declining since the 80’s. The big banks keep getting bigger, and the number of community banks are on pace to diminish completely.
According to Financial Times, the state of bank lending to small firms remains a big problem. Of the 27 million small businesses, 10 million do not require financing. However, 14 million do not get the businessfunding that was requested, whether it was because they simply were denied, or that they were discouraged by the long process and gave up.
That leaves a remarkable number of only 3 million business owners who get the financing they requested. The void that these banks have left upon us all has opened the door for a new wave of financing: Alternative lending.