The State of Small Business Lending - Harvard Business School

The State of Small Business Lending: Innovation and Technology and the Implications for Regulation

Karen Gordon Mills Brayden McCarthy

Working Paper 17-042

The State of Small Business Lending: Innovation and Technology and the Implications for Regulation

Karen Gordon Mills

Harvard Business School

Brayden McCarthy

Fundera, Inc.

Working Paper 17-042

Copyright ? 2016 by Karen Gordon Mills and Brayden McCarthy Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author.

THE STATE OF SMALL BUSINESS LENDING:

INNOVATION AND TECHNOLOGY AND THE IMPLICATIONS FOR REGULATION

Karen Gordon Mills Brayden McCarthy

Karen Gordon Mills is a Senior Fellow at Harvard Business School focusing on U.S. competitiveness, entrepreneurship and innovation. From 2009 until 2013, she was Administrator of the U.S. Small Business Administration, and a member of President Barack Obama's Cabinet. Brayden McCarthy is Vice President of Strategy at Fundera, an online small business credit marketplace, and was formerly Senior Policy Advisor at the White House National Economic Council and the U.S. Small Business Administration.

Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder.

STATE OF SMALL BUSINESS LENDING: INNOVATION AND TECHNOLOGY AND THE IMPLICATIONS FOR REGULATION

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TABLE OF CONTENTS

EXECUTIVE SUMMARY ................................................................................................................................................. 3 INTRODUCTION .......................................................................................................................................................... 10 CHAPTER 1: THE STATE OF THE SMALL BUSINESS ECONOMY: PRESSURES CONTINUE ..................................... 14 CHAPTER 2: THE GAP IN SMALL BUSINESS CREDIT: SMALL DOLLAR LOANS ....................................................... 24 CHAPTER 3: HOW TECHNOLOGY HAS CHANGED THE GAME: NEW ENTRANTS AND THEIR INNOVATIONS ......... 45 CHAPTER 4: WHO WILL BE THE WINNERS AND THE LOSERS: STRATEGIC ADVANTAGES OF INCUMBENTS VERSUS NEW PLAYERS ............................................................................................................................................. 59 CHAPTER 5: THE CURRENT U.S. REGULATORY ENVIRONMENT: SPAGHETTI SOUP .............................................. 86 CHAPTER 6: RECOMMENDED REGULATORY ACTION PLAN .................................................................................... 96 APPENDIX A: FEDERAL GOVERNMENT EFFORTS TO RESTORE CREDIT ACCESS FOLOWING THE `08 CRISIS...119 APPENDIX B: U.K. POLICY AND REGULATORY FRAMEWORK ................................................................................123

STATE OF SMALL BUSINESS LENDING: INNOVATION AND TECHNOLOGY AND THE IMPLICATIONS FOR REGULATION

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EXECUTIVE SUMMARY

Small businesses are core to America's economic competitiveness. Not only do they employ half of the nation's private sector workforce ? about 62 million people ? but since 1995 they have created approximately 60 percent of the net new jobs in our country. Small businesses were hit especially hard by the Great Recession, accounting for over 60 percent of the total jobs lost, in part because the crisis was centered on the banking sector. Credit oriented crises are known to have a disproportionate effect on credit dependent entities such as small businesses.

In 2014, small businesses were still struggling to recover, prompting our first HBS Working Paper: "The State of Small Business Lending: Access to Credit During the Recovery and How Technology May Change the Game," which focused on a then controversial question: "Is there a credit gap in small business lending?" 1

One answer became clear: a gap in access to credit for small businesses did exist and was

particularly persistent in small dollar loans-- those defined as under $250,000. This finding is noteworthy, as this is the level of loan that most small businesses want; more than 70 percent of small businesses seek loans in amounts under $250,000, and more than 60 percent want loans under $100,000.

Not surprisingly, this was exactly the market targeted by a new set of lenders. Entrepreneurs and innovators saw the opportunity, and over the last several years have created an emerging, dynamic market of online lenders that use technology to disrupt the small business lending market. Though still small relative to the traditional bank market, these new competitors provide fast turnaround and online accessibility for customers, and use new data and credit scoring algorithms.

Over the past several years, the online lending market has exploded with rapid growth both in the proliferation of new companies and new product offerings and in terms of market

1 Mills, Karen G., and Brayden McCarthy. "The State of Small Business Lending: Credit Access During the Recovery and How Technology May Change the Game." Harvard Business School

Working Paper No. 15-004. July 2014.

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