Today, starting a business often requires getting a loan. Yet more often than not, getting a loan requires some form of collateral as security. As traditional types of security like the family home become further out of reach for the incoming generation of entrepreneurs, how will our traditional approach to lending need to change?
The answer to this questions hinges on the significance of collateral in its ability to neutralise risk. Today, when asymmetries in information exist between two parties, security in the form of property can negate the need for lenders to spend a lengthy period of time assessing complex business models. However if there were simple, cost effective and dynamic ways to assess risk throughout the duration of the loan, would traditional forms of security still be required?
Secured loans out of reach for millennials
Today traditional credit assessments and loan approvals are naturally biased towards businesses that have a healthy credit score, good cash flow and the ability to offer security. For a first time business owner or entrepreneur, competing on the same factors against a more established business can, more often than not, leave them ‘credit outclassed’.
‘Entrepreneurial talent is not the prerogative of the wealthy, but is broadly distributed throughout the population as a whole. Without reasonable access to financing, many of our countries’ most talented and aggressive entrepreneurs will be cut out of the economic system. Innovation and business development will become a luxury reserved for the wealthy, and the economy as a whole will suffer.’ Hanson (83)
Given both businesses new and old are competing for the same credit, it is not unreasonable to see why preferential treatment by banks towards more long standing and stable businesses occurs. Yet as we move into an era where security becomes less common for the incoming millennial generation, it is highly possible this type of bias could lead to distortions in the way credit is distributed throughout the economy, with both ethical and social implications. We may very well find ourselves in a situation where only the rich or those with inherited wealth can start a business from scratch.
Leverage technology to build a better borrower picture
It strikes me that there is a need for new credit assessment models to be created, so as to not stifle innovation or growth in this changing landscape. The online lending space and developments in peer-to-peer lending have certainly sought to plug this gap, with a multitude of unsecured offerings now available for would be borrowers.
The smartest players in this space are now looking beyond traditional credit scoring and finding other methods to evaluate borrowers. Some are tapping into financial data stored in cloud accounting platforms, or using holistic questionnaires to build a more robust picture of a new business’s prospects. For many it heralds the return of a more relationship style banking model that has been replaced for the most part by automated customer service desks and disengaged bank staff.
Connecting private investors directly to small business owners through marketplace vehicles has also allowed for an increased range of ‘risk appetites’ to be catered for, simultaneously enabling greater experimentation with alternative underwriting models. While in principle this has been seen as a broadly positive move, the long term impacts of these unorthodox markets have yet to be fully understood. There is also a question mark around how sophisticated many of the investors are who are participating in these marketplaces. Do they themselves have the skills required to assess the risk involved?
The ethics of online lending
When companies do decide to move out of the bounds of traditional credit assessment, the waters can become murky. Recent media reports out this week relating to LendingClub, one of the larger P2P lending platforms suggest write offs
in the marketplace lending sector may be on the rise. While LendingClub predominantly lends to consumers, rather than businesses, many suggest the news indicates its data driven underwriting models may not be as robust as initially thought.
Compounding LendingClub’s woes are issues around disclosure at senior management level regarding a number of high profile deals. And on Monday, one of the first high profile casualties of the emerging fintech small business lending market came in the form of LendingClub’s CEO, Renauld Laplanche.
Reports suggest Laplanche crossed ethical lines on two fronts – firstly by failing to disclose a personal interest in Cirrix Capital, a fund he was advising the company’s board to invest in, and secondly, via his involvement in overseeing a securitisation deal that saw loans being put up for sale to a private bank that did not meet the firm’s investment criteria.
Investors and analysts may well be wondering if LendingClub is the canary in the coal mine for marketplace lending, with the desire to write new business leading to slipping credit and ethical standards. The ‘default domino effect’ that P2P platforms could be responsible for initiating is eerily similar to that of 2008 and raises questions more widely about the P2P sector as a whole. While P2P has been mainly driven by consumer lending, the small business market is being increasingly targeted, as lenders seek to expand and compete in an increasingly crowded market.
Lending needs to adapt to a changing world
While online players are making great strides in servicing the underserved end of the market, there is no doubt the greater good is catered for more broadly when traditional forms of lending adapt. We should not let outdated ideas of loan origination stifle entrepreneurial talent. Whatever the future model is that we employ, the key word must be flexibility. We must build more dynamism into lending products and ensure we reward good financial behaviour and outcomes and discourage poor ones. And rather than punish when poor behaviour does occur - of course, unless it is absolutely necessary - we must also acknowledge that the finance sector has a role to play in building better financial literacy amongst small business owners, to reduce the incidence of financial mismanagement.
Banks and online lenders are both part of the future solution – it is not a case of one or the other. Let us hope we build the framework that keeps both honest, ethical and agile, in order to adapt and flourish in our increasingly changing world.
Jessica Ellerm is a Partner Development Manager at Tyro Payments, working on the launch of Tyro’s deposit and lending solutions for small businesses. She is an active fintech commentator via her blog, jessicaellerm.com and writes weekly for global fintech powerhouse Daily Fintech. Jessica also presents the Monday and Friday share market outlook for Finance News Network.