With a High Loan Approval Rate, Alternative Lenders Are Easing the Credit Burden on Small Businesses

July 1, 2021

Small/medium-scale enterprises (SMEs) are a vital cog in a country’s economy. In the US, SME lending has been growing strong over the years. US small-business lending is a $700-billion business, serving more than 29 million small businesses. In the last two years, strong economic growth, rising interest rates, and growing digitization in the lending space by the emergence of alternative lenders have been key drivers of growth in SME lending.

Banks have traditionally been a custodian of customer relationships in the SME lending space. However, there has been a significant reduction in their risk appetite after the global financial crisis. As a result, they have been increasingly cautious about lending to small businesses, especially newer businesses that lack a strong credit history.

Also, banks are primarily more inclined towards large, multi-billion corporate loans as the share of SME loans as part of their total business loans has continued to decrease for a few years now. Thus they tend to reject three out of every four loan applications that they receive from small businesses, highlighting a clear apprehension towards financing thin-file businesses.

Small banks, on the other hand, show a different side of the coin. The approval rates of smaller community banks and credit unions are 48%-53% and 40%-45%, respectively. The local, community banks and credit unions are a step ahead of the other lenders in their relationship-based lending. Their credit decisioning and loan approval is characterized by local ownership, control, and decision-making. They can make lending decisions based on personally knowing the borrower’s character, the collateral, and the community’s needs. This substantiates a significantly high level of approval rates on the side of these smaller banks and credit unions. However, these small banks have their fair share of challenges, including limited capital, the higher impact of regulatory scrutiny, etc.

Alternative lenders emerged on the scene with a promise to bring thin-file and high-risk businesses under the credit spectrum with their innovative, non-traditional credit decisioning frameworks. In addition, these online lenders have a relatively better view of a small business’ creditworthiness with these alternative data sources.

Amazon, for example, has a clear view of a merchant’s performance since it is listed with its platform. Therefore, by understanding the merchant’s transactional and behavioral risk patterns, Amazon can better understand its risk profile. This way, these alternative lenders can afford to consider newer, thin-file businesses, enabling them to have the highest range of approval rates among all lenders (55%–60%).

Also, most of the high-quality borrowers are approaching banks, pushing alternative lenders to take on more risk. According to the Federal Reserve’s study, ~37% of medium & high-credit risk firms often seek funding from alternative lenders online.

The most popular financing products for which small businesses apply include lines of credit, business loans, credit cards, and SBA loans. Also, there has been a more robust demand for smaller loans. According to the Federal Reserve’s 2016 survey, more than 55% of small businesses sought less than $100,000 in loans; only 26% sought more than $250,000 in 2016.

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