Online Lenders Complement Bank Lending to Small Businesses

The recent initial public offerings of the Lending Club and OnDeck Capital, have some observers claiming that online lending platforms will soon replace banks as a major source of small business credit. I disagree.

Rather than substituting for bank loans, online lenders are filling a niche, providing capital primarily to small companies that previously had been unable to borrow. Where they have been substituting for other lenders, online lenders have been replacing high cost alternatives to traditional bank loans, like credit card debt and merchant cash advances.

Theoretically, online lenders could replace bank lending to small businesses. Companies such as Funding Circle, OnDeck Capital, Lending Club, DealStruck and Kabbage, allow those with capital to lend it directly to businesses, removing the banks as middlemen. Getting rid of an intermediary benefits both borrowers, who can pay less for funds, and lenders, who can receive higher returns on their money.

But we are far from the point where online lenders will replace banks as a major source of small business credit. Online direct lending to small businesses has grown from effectively zero to approximately $10 billion since the mid-2000s. But, at current levels, this form of lending still represents a miniscule slice of all small business credit, which the the Small Business Administration estimates to be more than $1 trillion.

Online lenders aren’t replacing banks as a source of small business credit because their main advantages to borrowers – faster loan decisions and greater odds of getting credit – come at a cost – much higher rates of interest. Estimates by Federal Reserve researchers show that the interest rate on the average online small business loan is more than twice that of the average traditional bank loan.

The higher cost of borrowing from online lenders means that few borrowers are seeking to replace their traditional bank loans with credit from online lenders. Those tapping online lenders have tended to be small companies that were previously unable to obtain credit or who had been tapping high interest rate loans from alternative lenders and credit card companies.

Moreover, online loans aren’t replacing collateralized small business loans. Because online lenders provide primarily unsecured credit, their loans are not a replacement for debt backed by small business assets, such as equipment or property.

Few banks currently see online lenders as competitors, and several see them as partners, setting up referral relationships with them. For instance, in the United Kingdom, Banco Santander has been outsourcing smaller loan inquiries and borrowing requests from less creditworthy small business borrowers to online lender Funding Circle, but has been keeping inquiries for larger loans and loans from more creditworthy small business borrowers for themselves. In the United States, several banks have set up deals to refer borrowers that don’t meet their criteria to online lenders, such as OnDeck and QuarterSpot. If the banks thought that online lenders were substitutes for their existing, profitable, small business loan business, they would not be partnering with the new types of lenders.

Online lending represents a new source of small business credit that is likely to grow substantially in future years. However, it is more likely to add a new source of funding for small businesses unable to get bank loans or substitute for credit card borrowing or other alternative lending than it is to replace traditional bank loans.


Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

2 Reactions
  1. I agree that banks won’t be replaced by online lending but I do have to say online lending is here to stay. Not only are we allowing companies that usually wouldn’t be able to get cash the capital they need but we’re able to do it at light speed compared to the banks.

    Most people still look at online lending as a high cost but it’s because they don’t understand the value. Costs seem low to people when the value out weights the cost. My clients in the East Coast have seen huge value by having a variable pay back based on their sales during this crazy winter they’ve gone through.

    I broker for OnDeck, Rapid advance and over 25 different online lenders because in this industry it’s all about having options. Every lenders have different niches they go after so having these options can change your deal for good. Call me if you have any questions on navigating these waters.

    Drew Walker