To many observers in the retail financial industry, it would appear that digital lenders have simply outflanked traditional institutions. These alternative credit sources have been making steady inroads in many key credit areas, notably small business lending. Banks and credit unions may not even know about the loans they lost. Borrowers frequently go straight to the internet for credit, seeking the ease and speed of the internet when shopping for money.
Kabbage, for instance, brags that it has provided over $5 billion in credit to small business people — $1 billion of that applied for during non-banking hours.
“We built Kabbage to allow business owners to access funds on schedules convenient to them, not us,” says CEO Rob Frohwein.
New research from the Federal Reserve and other sources measures the impact these nontraditional lenders are building in the small business market, but tellingly also suggest five ways that traditional lenders can gain back lost ground.
Small business credit straddles the line between consumer and business borrowing. Business owners frequently start off using their own personal credit for their company. This means that the “consumer” conducting personal banking with your institution may actually represent much more potential if they own a business. For many banks and credit unions, however, such customers typically are only seen face-to-face in a branch.
While a growing number of traditional players have ventured into online lending — with some smaller ones even buying their own specialized lending platforms — many traditional lenders have held back. In its annual Performance Against Customer Expectations (PACE) study, FIS makes the point that smaller institutions that don’t offer digital self-service for small business “are missing conquest opportunities.” FIS found that lack of self-service options is the top reason customers switch among big-bank providers.
The Federal Reserve says that industry estimates for total alternative online business lending come to roughly $12 billion currently, but that relatively small amount is expected to increase significantly each year.
How can banks and credit unions counter the appeal that online lenders — often promising instant credit decisions — bring to the table?
One key step is “knowing your enemy” — understanding how these new competitors operate. Another is learning how small business owners view the online lending option. Two pieces of research from the Federal Reserve provide competitive intelligence about digital lenders.
More Small Firms Explore Online Offerings
One out of four small business borrowers have applied to alternative online lenders, according to the Federal Reserve’s latest Small Business Credit Survey. The online lenders rank third among sources that small businesses apply to for credit. At 24%, they came behind large banks (48%) and small banks (47%), and ahead of credit unions (9%).
The same survey found that applicants tend to choose a lender based on their perception of how likely they’ll be approved. Up front, they aren’t worrying about price. Online lenders’ websites stress willingness to lend — and speed — and these factors weighed heavily in the responses to the Fed’s survey. The research found that applicants representing medium and high credit risks are more likely to apply to an online lender than are lower-risk applicants.
When asked what frustrated them most about various types of lenders, applicants to traditional sources top-ranked long waiting times for decisions. Applicants to online lenders complained the most about the high rates charged.
The difference in rate between borrowing from a traditional lender funded by insured deposits versus a digital lender funded by venture capital or other pricy sources can be exploited by local lenders who ask the right questions.
How Entrepreneurs Feel About Digital Lenders
In another study from the Federal Reserve, researchers found that these firms’ awareness of alternative online lenders has grown stronger. But that awareness is not frequently positive. Here’s a sampling of the many negative comments the study’s participants offered in focus group sessions:
“Negative impressions of websites reinforce mistrust, especially when small business borrowers suspect hidden fees and costs.”
- “higher interest rate”
- “scam, identity theft”
- “loan shark”
- “business payday loans”
- “red flags”
- “not trustworthy”
- “fly by night”
- “barrage of calls and snail mail”
The last item came up frequently, particularly among those who had applied for online credit but were then subjected to aggressive and annoying calls from credit brokers once they had provided their contact information.
“Negative impressions of the websites tended to reinforce mistrust, especially when participants suspected fees and costs were ‘hidden’ or that the advertised ‘as low as’ rates were not what they actually would be offered,” according to the focus group report.
“I wish I had been more diligent to look at the fine print on the loan,” said one online borrower. “The fee was astronomical.”
However, these negative feelings weren’t unanimous. Among positive comments: “faster loan approval turnaround,” “more willing to deal with business loans,” “competitive rates because they have less overhead,” and “easy, quick and painless.”
Among participants who have applied for financing from traditional lenders, terms and rates generally pleased them… but not the process. Borrowers expressed concerns about “stringent qualifications, time-consuming paperwork, and long waits until approval and funding,” according to the Fed report. Several focus group members said that good relationships with front-line lending officers also eased the application process.
Armed with these points, traditional lenders have an opportunity to speak to their own institutions’ strengths and advantages. Here are five approaches distilled from the two Fed reports and other sources.
1. Sell Accuracy: How Instant Is ‘Instant Gratification’?
Speed of approval is often a selling point for online lenders. The appeal of it goes beyond simply modern impatience, however. “Some decisions may be rushed because the owner has an urgent need to quickly acquire inventory or to make payroll,” the report states. At a workshop on online lending, a representative of Square Capital, an online lender associated with the payments company Square, noted that in the case of businesses like coffee shops and hair salons, “if their equipment breaks, they don’t have a business.”
In a few cases online lenders even offer apps, for “in the moment” credit applications. That said, online lenders don’t always live up to the popular image of instant decisions. Sometimes preapprovals are what’s promised — and those aren’t always final.
While Kabbage promotes speed on its site, a footnote on the site’s homepage states:
“Kabbage can approve you in minutes for up to $150,000 when we are able to automatically obtain your business data and verify your bank account. Lines of credit over $150,000 require a manual review. In some situations, errors may occur during the sign up process, or we may need to send micro-deposits to confirm your bank account for security purposes. If this is the case, it may take up to several days to provide you access to funding.”
And this highlights a key point traditional lenders can stress among business borrowers: sometimes an online lender’s “fast answer” is “no.”
Read More: How To Win The Small Business Banking Market
2. Clarify Cost: What Is The Borrower’s Real Rate?
What entrepreneurs know about borrowing comes mostly from their experience on the consumer lending side. But not all forms of online credit behave exactly like consumer credit nor traditional business loans. One variation called a “cash advance” may be paid off by the online lender taking a piece of every customer credit card swipe, for example.
The Fed focus group report demonstrates the potential for confusion among borrowers. Because shorter-term loans and credit lines may behave differently from bank and credit union products, “equivalent APRs can range from 25% to 80%, and funds are often repaid in six to 18 months.”
In one exercise, participants were given a hypothetical deal from an online lender and asked to guess the rate if the loan were repaid in a year. The answers ranged from 10% to 53% — plus “I have no idea.”
Focus group participants told the Fed that they would prefer to see sample disclosure tables containing rates, payment amounts, fees, and other key product terms — before they formally apply or enter information about their business.
Read More: Small Business, Big Opportunity
3. Emphasize Trust: How Much Do Online Lenders Tell Applicants?
“Sticking with a proven lender saves time and trouble,” said the owner of a writing service based in Oregon who preferred his usual bank to an online lender. “Everything was transparent.”
Fed research indicates that for many small business owners, doing business with an institution they know and trust outweighs other factors. During a focus group exercise where researchers watched owners’ behavior while exploring online lender websites, “quite a few participants sought out user reviews and third-party endorsements in order to ascertain the trustworthiness of the sites they visited.”
Some sites left participants with skepticism about the lender because they could obtain little solid information about their offerings without surrendering contact information and data about their business. This stymied business owners who wanted to shop around and led to reduced trust in online lenders.
“All these sites are a lot of clicking around and not getting very far without providing information that I’m not ready to provide,” commented a stone fabrication company owner in the focus group. “I don’t want to be solicited for the rest of my life just because I was looking for some information.”
4. Raise Concerns: Are Online Lenders Lending Responsibly?
While a common complaint among small businesses in the survey was that traditional lenders aren’t always willing to lend when they need money, at the other extreme are tsome alternative lenders who will lend to small business customers until it hurts.
While not blackening all online and alternative lenders, a report by Opportunity Fund, a California nonprofit microlender, recounted the unfortunate experiences of business borrowers who came to the fund for assistance when they have borrowed too much from online and other alternative lenders. Of a group of 104 businesses that received 150 alternative loans from 54 different lenders, the fund could only extend refinancing loans to barely half of them.
“Most of the other applicants had borrowed so much money that we did not believe they could repay the debt, even if it was refinanced over a longer term at a much lower rate,” the fund’s report says.
5. Go Digital: Build Your Online Lending Platform
The most precious commodity for small business owners is time. Owners appreciate the ability to apply online 24/7. The argument frequently made is that small business owners do their financial planning and banking in the wee small hours.
Technology permitting banks and credit unions to expand into digital lending platforms is already available from the financial institutions vendor community and has been or is being implemented. Business customers will be looking for it.
For many banks and credit unions, that may be just over the horizon. But in the meantime, make the most of the relationships your institution has with internet borrowers. It’s not unusual for firms borrowing from online lenders to have additional business banking relationships — even other loans — with traditional players.
Some smaller banking institutions have made a niche business of refinancing online borrowers with good credit out of their more-expensive internet loans. Banks and especially credit unions, typically can offer rates substantially below what the online borrowers are paying — and that’s something those owners will appreciate.