Online lenders complement small business bank loans
Recent initial public offerings from Lending Club and OnDeck Capital have led some observers to argue that online lending platforms will soon replace banks as the major source of credit for small businesses. I do not agree.
Rather than replacing bank loans, online lenders fill a niche, providing capital primarily to small businesses that had previously been unable to borrow. Where they have replaced other lenders, online lenders have replaced expensive alternatives to traditional bank loans, such as credit card debt and merchant cash advances.
Theoretically, online lenders could replace bank loans to small businesses. Companies such as Funding Circle, OnDeck Capital, Lending Club, DealStruck and Kabbage, allow those with capital to lend it directly to businesses, removing banks as middlemen. Getting rid of a middleman benefits both borrowers, who can pay less for funds, and lenders, who can get higher returns on their money.
But we are a long way from the point where online lenders will replace banks as the major source of credit for small businesses. Online direct lending to small businesses has grown from zero to around $10 billion since the mid-2000s. But, at current levels, this form of lending still represents a tiny slice of all small business lending, whether the Small Business Administration estimates over $1 trillion.
Online lenders are not replacing banks as a source of credit for small businesses because their main benefits for borrowers – faster loan decisions and better chances of getting credit – come at a cost – interest rates much higher. Estimates from Federal Reserve researchers show that the interest rate on the average online small business loan is more than double that of the average traditional bank loan.
The higher cost of borrowing from online lenders means that few borrowers are looking to replace their traditional bank loans with credit from online lenders. Those using online lenders tend to be small businesses that were previously unable to obtain credit or had taken out high interest loans from alternative lenders and credit card companies. .
Also, online loans are not a substitute for secured small business loans. Since online lenders primarily provide unsecured credit, their loans do not replace debt backed by small business assets, such as equipment or property.
Few banks currently see online lenders as competitors, and many see them as partners, building referral relationships with them. For example, in the UK, Banco Santander outsourced small loan applications and loan applications from less creditworthy small businesses to online lender Funding Circle, but kept larger loan applications and more creditworthy small business loans. In the United States, several banks have agreements in place to refer borrowers who do not meet their criteria to online lenders, such as OnDeck and QuarterSpot. If banks believed that online lenders were substitutes for their existing, profitable small business lending business, they would not partner with new types of lenders.
Online loans represent a new source of small business credit that is expected to grow significantly in the coming years. However, it is more likely to add a new source of financing for small businesses unable to obtain bank loans or to replace credit card borrowing or other alternative loans than to replace traditional bank loans.