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.