Small Business Alternative Lenders

With lending to small business by traditional lenders still well below pre-recession levels (see Good News and Bad News about Small Business Lending), where are small businesses turning for access to capital? The Fed’s 2014 Small Business Credit Survey, which tallied input from some 2,000 small business owners in 10 states, revealed that nearly 20 percent of respondents have applied for credit with an online lender.  Since other previous surveys, while not altogether comparable, have indicated very little activity with online lenders, our findings could indicate that small business owners’ awareness of these alternative lenders is now rising and that they are increasingly open to new sources of credit.

Certainly, the level of interest in online alternative lenders has risen.  Every time I’m out talking to folks in our District about small business credit, the conversation inevitably turns to this new financing option available to small business owners.

So, just what do I mean by “alternative lenders”?  Historically, an alternative lender could be any non-bank lender.  But today, alternative lenders -- sometimes referred to as “online alternative lenders” -- are generally understood to be lenders operating online platforms through which they offer faster, easier, and often more expensive credit products.

The alternative lending industry is relatively new and continually evolving.  Some lenders focus on consumer credit, but for purposes of this posting, let’s look at the small business lenders:

1. Merchant Cash Advance (MCA) Providers:  An MCA allows businesses to convert future credit card receivables into capital. For example, a business can obtain $40,000 in capital in exchange for $52,000 in future revenues, repaid with swipes of around 10 percent of their daily credit card receipts.
2. Online Direct Lenders:  Sometimes called cash-flow lenders, these are direct credit providers who evaluate a combination of borrower characteristics - - cash flow, credit scores, and even social media feedback -- and offer a variety of loan products, many of which are structured similarly to MCAs. 
3. Payment Processors:  These firms have recently entered into the field, offering businesses loans or cash advances in exchange for a percentage of future receipts collected through the payment processor’s platform.  
4. Peer-to-peer Lending Platforms:  In this case, the platform evaluates borrower creditworthiness using its proprietary model and connects borrowers with capital from investors.  These firms facilitate lending primarily in the consumer space, but have recently become more active in small business lending.
5. Marketplaces:  While not lenders themselves, these online marketplaces connect borrowers with loans from both traditional and alternative lenders, and as such, are sometimes called “lender-agnostic” marketplaces.   

The alternative lending market has grown rapidly; industry analysts estimate it has doubled in size every year since the end of the recession.  The growth has been driven by both borrowers and investors.

In recent years small business owners, some discouraged by tight credit at financial institutions that they’ve either heard reports of or experienced firsthand, have sought new sources of funding. They found that alternative lenders offer quick and easy credit, even to borrowers with low credit scores.  The credit products are generally unsecured and lenders require minimal documentation.  Applications can usually be completed in just minutes, and borrowers can receive funds in as little as a few hours.  They pay for the convenience, however, as these loans and cash advances can carry effective interest rates—often undisclosed—of 25 to 150 percent.

And investors, seeking better returns in the low-interest-rate environment, are drawn to the high yields and are actively investing in the alternative lending sector, fueling more growth.

This growth, coupled with the minimal regulation and oversight of this industry, raises new questions from the standpoint of both protecting the interests of borrowers and investors and ensuring stability in the industry as it grows.  Small business advocates have called for greater transparency and uniform disclosures.  Industry observers have raised concern about the uncertain future flow of investor capital and lenders that target subprime borrowers, as well as the rising securitization activity.

Here at the Cleveland Fed, we’ll remain focused on the changing role of these lenders, working with industry leaders, small businesses, and bankers to understand the developments and any risks that emerge.