Over the last few years online business lending has exploded. Dozens of “financial technology” (fintech) players such as OnDeck, Kabbage and Funding Circle have emerged. Instead of spending hours filling out paperwork, borrowers complete applications in minutes, with approval times cut to days, or even just a few minutes. And, in instances where borrowers want to shop and compare myriad options in one place, they can turn to marketplaces like Fundera or Intuit’s QuickBooks Financing for a one-stop shop experience.
Not to be outdone, incumbents like JPMorgan Chase and Wells Fargo are also moving into online lending, in some cases partnering with emergent fintech players. Taken together, Morgan Stanley estimates online lending to small businesses will grow 50 percent annually through 2020, with an addressable market of $280 billion.
That’s music to the ears of small businesses. Indeed, our research shows a sizeable credit gap exists for small businesses, particularly for loans under $100,000, which is the size that over 60 percent of small businesses want, and is precisely the loan size fintech players tend to offer.
The problem is that lending to small businesses falls through the regulatory cracks, specifically on borrower protections. As a case in point, safeguards such as the Truth in Lending Act afford consumers standardized disclosure of loan prices, but when those same consumers apply for a business loan they’re left in the dark. Lack of universal disclosure in business lending is particularly worrisome amidst the rise of online lending as loans originated online can bear high price tags, with annual percentage rates running above 50 percent.
But, that’s not the whole story.
Our regulatory system has also been an unnecessary albatross on the growth of fintech players and on banks who try to partner with them. No single federal regulator has authority to oversee business lending. Instead, there is a spaghetti soup of at least seven agencies with overlapping jurisdictions and purviews. This leaves online small business lenders to be governed by an expensive and time-consuming patchwork of state oversight, often with inconsistent rules that can confine online lending to state-by-state silos, undermining what is an otherwise national market for credit.
As Congress and the new president take aim at streamlining financial regulation, they should consider our six point Regulatory Action Plan, outlined in our Harvard Business School working paper released today, Small Business Lending: Innovation and Technology and the Implications for Regulation, which seeks to provide first principles for a regulatory framework that enables the sustainable growth of small business lending.
1. Create a national non-bank charter option for online lenders
The Office of the Comptroller of the Currency (OCC) should allow online lenders to apply for a special purpose non-bank charter permitting preemption of state law. The Internet is not bound by any one state, and the market for loans online is no exception—regulation must reflect this new reality. However, regulators should not simply mandate all federal laws associated with a national bank charter must now apply to non-bank lenders. Rather, regulators should carefully consider which aspects of bank charters should apply to online lenders with an eye to ensuring soundness of the activities, and recognition of the vital innovation new entrants are bringing to small business lending. Most existing banking laws were written at a time when online lending was nonexistent, let alone the fastest growing segment of the market.
2. Set universal rules and guidelines to strengthen borrower protections
An important precondition of a national charter should be the creation of new rules, universally applied, that create borrower protections for small businesses. If offering a national regulation option to fintech players is the proverbial carrot, compliance with commonsense borrower protections could be the stick. This is important as the lack of rules requiring universal disclosure allows lenders, including traditional banks, to display loan terms and costs, inconsistently. Regulators should require disclosures that are clear and concise, and let borrowers decide what is best for them. Model disclosures being developed within the online small business lending industry, including Fundera’s model for credit marketplaces and the SMART Box for term loans, are steps in the right direction, and could provide a useful basis for federally-mandated disclosure boxes.
3. Develop joint guidance on bank-fintech partnerships
Partnerships between banks and new entrants are likely to grow provided that regulators allow it. This can be a win-win for online lenders, banks and the borrowers that both lenders seek to serve.
As a case in point, when large banks decline small business applicants, they leave them to sort through complicated loan options from other banks or online lenders entirely on their own. Another alternative could be joint partnerships in which banks fund the small businesses they wish to, and direct those that they are unable to fund to a vetted third-party fintech partner.
While this is practice has become the law in the United Kingdom, on this side of the pond recent guidance coming out of the OCC and Federal Deposit Insurance Corporation (FDIC) would make such partnerships expensive and complicated to implement. Enabling these partnerships to flourish requires clear, consistent, and non-overlapping rules from the multiple agencies that already govern third-party relationships. No-action letters could be helpful tools, as they would allow regulators to assure lenders that new products, or partnerships, are legal and that no enforcement action will be needed.
4. Shine a light on bad actors with better data on borrower outcomes
We lack market-wide data on small business lending trends. Survey data, data from the Small Business Administration, and anecdotal information exist, but these are blunt tools, offering a limited snapshot of supply and demand, often with years of delay. Lack of quality data means that policy makers and regulators are flying blind as they try to assess the depth of problems in small business lending, and find and measure solutions. In the advent of another credit crisis this could prove disastrous.
The Consumer Financial Protection Bureau (CFPB) is empowered within Section 1071 of Dodd-Frank to collect basic data on small business loans, including originations, rejections, and “any additional data that the Bureau determines would aid in fulfilling the purposes of this section.” We believe that CFPB should use this authority to shine a light on bad actors in small business lending, whether originated online or offline, including by mandating disclosure of product outcomes, such as average APRs and default rates. Requiring disclosure of such data would empower watchdogs and the market itself to evaluate bad actors.
5. Respect fiduciary duties
Small business loan brokers have generally fallen through regulators’ grips, and aside from fair lending laws, they are not subject to federal oversight. Only a handful of states require brokers to obtain licenses. The problem is that brokers can add extensive costs to the loan and have no obligation to disclose their fees or any conflicts. And brokers originate as much as three-quarters of all loans at some of the larger online small business lenders, in part because finding creditworthy borrowers can be tough.
The subprime crisis illuminated the dangers of letting loan brokers go unchecked. As with mortgage brokers in many states, and more recently with investment brokers at the federal level, small business loan brokers should act in borrowers' best interest, respecting fiduciary duties of disclosure, loyalty and prudence. Most importantly, brokers should endeavor to reduce or eliminate biases where possible, disclose conflicts that compromise their impartiality, and clearly break out the fees they add to loans.
6. Create a National Advisory Board on Responsible Financial Innovation
We are aware that all too often, the creation of a national advisory board is a substitute for real action. But in this case, it would be a means to a broader end, and a vital precursor to a more coordinated regulatory approach to oversight of financial services. Industry should be included and at the table to ensure that they have a consistent mechanism to provide feedback and advice on how any new regulation will hurt or harm innovation.
Fintech will benefit from focused regulation
The debate in Washington may have shifted, and the “r” word—regulation, that is—may well become be a nonstarter, but that knee-jerk view misses important issues. After all, the financial crisis made it blindingly obvious that regulatory vigilance and financial innovation should exist in tandem and in dialogue. Those same lessons apply to the rise of online lending. Focused regulation is needed both to better protect small business borrowers from predation, and to make it easier for emerging fintech players to grow responsibly.
Our Regulatory Action Plan seeks to lay out first principles that regulators should pursue to meet these ends, and ultimately achieve a more efficient market in small business lending. Doing so will help small businesses focus more of their time doing what they do best: growing their business, creating jobs, and continuing to be a vital catalyst in the US economy.
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