Big banks continue to overlook lending opportunities to small and mid-size businesses. Lower profits, high underwriting expenses, and a desire to lower risk to depositors means there’s just not much upside for them. Though this would seem to indicate a less than robust market for loans, this is hardly the truth.
In fact, neglect by big banks – loans sized $1 million or below fell between 2010-2014 as both GDP and $1 million-plus loans rose – is serving as a catalyst for online lenders. Platforms such as Biz2Credit, Funding Circle, and Lending Club are filling the void and experiencing growth by providing small businesses with loans ranging between $25,000 and $500,000.
These loans, which carry one to five-year terms and are priced based on a borrower’s risk profile, continue to evolve. Increasingly, commercial banks are finding they can capture larger profits by partnering with online lenders in revenue sharing agreements. In 2016, for example, JP Morgan announced it would partner with online lender On Deck Capital to offer small business loans, while Kabbage joined forces with Santander UK.
Unsecured Loans Draw Institutional Investors
The appeal is very strong when it comes to the market for unsecured loans. Banks are funding loans as institutional investors – their objective is to select loans that meet the portfolio manager’s investment objectives. In contrast, peer-to-peer platforms underwrite the loans and generate revenue by maxing out lending – so long as they meet certain criteria. They make money by collecting a one-time origination fee on funded loans and by assessing a servicing fee to over the life of the loan.
The market for small business loans will remain strong for the foreseeable future, providing opportunities for investors to enter the market. Despite speculation that bank de-regulation may ensue under the Trump Administration, fund of funds, pensions, and endowments are poised to seize on the steady cash flows SME loans produce.
To do so will require them to separate fact from fiction. Regulatory change, even in the form of a repeal of Dodd-Frank, will not produce a rush of banks entering the small to mid-size market. And, defaults and late payments ebb and flow like all asset classes.
Lending and underwriting remain the lifeblood of economic growth and business expansion. P2P lenders are the new conduit for delivering these loans. Still, with any lending, appropriate risk-based pricing is needed to retain institutional capital.
Drawn by the prospect of strong cash flows while avoiding the costs required to underwrite and service these loans, traditional banks will increasingly seek to enter this market. Even with deregulation, trends point to increased partnerships between commercial banks and online lenders. Still, big banks will not take away market share; nonbank lenders will still have the edge in the near- and medium-term.
 FDIC: Loans to Small Businesses and Farms, FDIC-Insured Institutions, 1995-2014.