Fintech, Small Business & the American Dream

by Karen G Mills

  These innovation cycles create economic progress. Joseph Schumpeter, one of the most influential economists of the twentieth century, was known for his work on innovation and business cycle theory. Schumpeter did not see economic growth as a gradual, steady climb like many economists did. Instead, he believed growth came from innovation, which was, in his words, “more like a series of explosions” than a gentle, continual transformation.2 These discontinuous innovations overturned old ways of doing things and destroyed incumbent firms, and even entire industries.

  Schumpeter cast the entrepreneur as the hero of his economic story, leading what he described as a “process of industrial mutation … that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism.”3 For Schumpeter, innovation was not invention per se, but rather the application of inventions in economically useful ways. Innovation could mean a new product, a new process of production, opening up a new market, securing a new source of supply for production, or designing a new market structure for an industry, such as by creating or breaking up a monopoly.4

  Later in the twentieth century, several scholars built on Schumpeter’s work, including Everett Rogers, who popularized the innovation S-curve in his 1962 book on the diffusion of innovations. Others have since adapted Rogers’ S-curve to include a four-stage life cycle for innovations: Ferment, Takeoff, Maturity, and Discontinuity.5 Ferment describes the early stages of an innovation when the products and uses are not fully understood, and new avenues are being explored. Takeoff is the growth phase in which new companies, new products, and new customers fuel a rapid increase in adoption and usage. Eventually, sometimes after many years, a market reaches the maturity phase. Finally, discontinuity occurs when the market is overtaken by another innovation.

  Our story of the transistor was just one example of how innovation follows the S-curve pattern, but there are plenty of other cases as well. Think, for example, about videocassette recorders (VCRs ). The forerunners of VCRs were massive and expensive magnetic tape recorders, first invented in the 1950s. It was not until the 1970s that the VCR format was standardized and made affordable enough for mass consumer adoption. By the 1980s, two major formats had shaped the market: JVC’s VHS and Sony’s Betamax. VHS won the format war largely because its cassettes allowed for longer recording times—a major selling point for consumers. By the late 1980s, the VCR was maturing, growing primarily from movie rentals and making VCR ownership widespread.6 Finally, in 1995, DVDs were introduced, disrupting the market quickly due to the smaller size and superior capabilities of the disks.

  Financial Services and the Innovation Life Cycle

  In banking, the automated teller machine (ATM) was a visible example of the innovation cycle. First introduced in the late 1960s purely to dispense cash, it caught on in the 1970s as banks added functionality that allowed customers to conduct other banking services such as deposits. By 1980, shared networks proliferated and banks began to view ATMs as necessities, and finally, as replacements for branches. From the late 1990s to the present, ATMs have remained common, but new innovations have moved customers toward Internet and mobile banking, and debit cards have made cash less important for payment transactions.

  The evolution of banking services reflects the changes that have occurred in payment technologies, beginning over four centuries ago. This evolution can be envisioned as a series of S-curves (Figure 6.1). In Europe, physical money and checks were gradually accepted as payment starting in the 1600s. They were disrupted by a series of innovations—credit and debit cards, electronic payments, and ATMs in the 1960s to 1980s—which caused the number of checks written to peak in 1995 and decline ever since. In more recent years, e-payments have begun giving way to online banking and mobile money, such as Venmo and ApplePay. Contemporary innovations such as cryptocurrencies and distributed ledger technology may fail to take hold, or they may represent the next innovation discontinuity in payments.

  Figure 6.1 The Evolution of Payment Technologies

  Source: Jarunee Wonglimpiyarat, “S-curve Trajectories of Electronic Money,” The Journal of High Technology Management Research 27, no. 1 (2016).

  However, with the exception of changes in payments, the banking sector has generally been slower to adopt innovation than many other industries. When innovation has occurred, small business products have often been the last ones affected. Until the small business fintech innovation cycle began in about 2010, small business lending was still a tedious process and decisions about whether to extend credit were generally made slowly, using personal underwriting and methods of assessment that had not changed in many decades. Small business lending was long overdue for innovation.

  Why Did Innovation Lag in Small Business Lending?

  With the advent of the Internet, entrepreneurs began challenging old-line industries in earnest. The technology to move lending completely online existed before 2005. Why had marketing, underwriting, and servicing of loans—particularly small business loans—largely taken a back seat?

  There are several possible explanations for the slow pace of innovation in lending, and in small business lending in particular. First, the banking sector is heavily regulated. With so many industries and markets ripe for innovation in the age of the Internet, many entrepreneurs may have seen the financial sector, with its heavy overlay of rules, as an unappealing market. Second, the high level of regulation and supervision engendered a risk-avoidance culture at many banks. Banks employ armies of people whose job it is to ensure that they accurately assess and manage their risks. It can be difficult for an organization with a risk-averse culture to accomplish innovative internal change.

  An example of the regulatory overhang on innovation in banking is the ability to deposit and handle checks electronically. Traditionally, banks were required to transfer original paper checks among themselves to make payments, and depositors received their paper checks in their monthly bank statements. In 2003, Congress passed a law known as Check 21, which allowed deposits to be made with electronic photos of checks, and for banks to transfer checks electronically as well.7 Although the technology to do this existed well before, it required a new law to provide the convenience and cost reduction of electronic check deposits that we now expect.

  A third barrier to innovation is the fact that the small business loan market is more heterogeneous than the consumer market. Mortgages, for example, are largely standardized and simple for the market to understand and securitize. Small business loans involve more risk in part because each business is different and their needs vary according to their industry, age, financial history, and other factors.

  A final possibility is the relative size of the small business lending market. According to the Federal Deposit Insurance Corporation (FDIC), U.S. banks held $352 billion in Commercial and Industrial (C&I) loans of less than $1 million—a good proxy for the stock of small business loans.8 In addition, there was $493 billion in spending on small business credit cards in 2017.9 These numbers add up to just over $845 billion in small business credit, which is large in absolute terms, but small relative to the consumer market. Banks held about $1.7 trillion in consumer loans on their balance sheets in mid-2018.10 In addition, the Federal Reserve Bank of St. Louis estimated the total consumer credit owned and securitized as more than twice as large, or about $3.9 trillion, plus another $2.2 trillion in residential real estate loans.11,12

  Although small business lending was clearly an important segment for many banks, it was not the largest source of activity or profit, and not the priority for innovation. For JPMorgan Chase, although small business has been mentioned often in the CEO’s speeches and in the company’s annual report, the small business lending segment constituted just $22 billion out of a lending portfolio of $688 billion in 2017.13 The voices of small business customers were not loud enough to demand more convenience and better service. Until fa
ced with a real threat of disruption by fintech innovators, the traditional industry players felt little pressure to change the way they provided services to small businesses.

  The Small Business Lending Innovation Curve

  The first phase of innovation in small business lending emerged as the recovery from the 2008 credit crisis took hold. Fintech lenders had been around before then, most notably CAN Capital, which was founded in 1998 and pioneered the merchant cash advance (MCA).14 But OnDeck really provided the first noteworthy small business focused innovative lending approach. Why not, asked OnDeck founder Mitch Jacobs, use the actual data from a business’s bank account—including the record of what bills they had recently paid—to help determine their creditworthiness? This information was more current than the traditional measures used in small business credit, primarily the business owner’s personal FICO (Fair Isaac Corporation) score. As Jacobs put it, “The time is right, the adoption of software by businesses is high, and there’s an opportunity for businesses to quickly create a full data profile that minimizes risk for lenders and opens up a vast sum of capital for the small business owner.”15

  In the Great Recession, FICO scores had indeed proven unreliable predictors of default risk, and many like Bank of America, which had relied on them extensively in 2005 to 2007 to make automated loans, had withdrawn from the small business lending market with heavy losses.16 And, as we discussed in Chapter 3, banks’ slow return to small business lending in the aftermath of the recession, particularly to the less profitable small-dollar loan segment, left a gap in the market that innovators like Jacobs began to fill.

  Ferment

  The first, or ferment, phase of the online small business lending innovation cycle relied on available technology to rethink two longstanding frictions in the small business lending market: the speed and ease of the customer experience and the visibility of small business finances to lenders for credit underwriting. These pain points were not new, and the technology being used was not groundbreaking, but early fintechs such as OnDeck, Lending Club, and Kabbage gained momentum by creating experiences that were simpler and faster for small business customers. The applications were easy to complete, taking about half an hour at the time, and money could be in the business’s bank account within days.

  For small businesses, this time frame was unheard of, and for many it was the decision driver. Despite higher pricing, borrowers flocked to the new offerings, drawn by this superior and attractive customer experience. The first concrete analysis of the appeal of the new online products came in the 2015 Federal Reserve (Fed) Small Business Credit Survey. A shocking 20 percent of small business applicants reported applying for online loans, even more than were applying to credit unions (Figure 6.2). While the initial belief was that these respondents were applying to fintech companies, it later became clear that many were actually using their bank’s online application, so the number applying to fintechs was likely lower. Nonetheless, the real or perceived speed of adoption put fintech lenders on the radar of venture capitalists and other early stage investors, and spurred competition.

  Figure 6.2 20 Percent of Applicants Applied to Online Lenders in 2015

  Credit sources applied to (percentage of loan/line of credit applicants)

  Source: “2015 Small Business Credit Survey,” Federal Reserve Banks, March 2016.

  At the time, we dubbed this period the “wild west,” as literally hundreds of new firms—including online lenders, online loan marketplaces, and data analysis firms—entered the market. From 2013 to 2015, many argued that online lending would fundamentally disrupt the marketplace and push traditional banks out of business. Data that already existed, from Yelp reviews to a small business’s bank and credit card files to utility bill payment histories, could now be accessed through application programming interfaces (APIs ), a major development in computer software that allowed for easier and more efficient data sharing. Automated underwriting algorithms offered a lower cost (and potentially higher quality) innovative replacement for expensive personal underwriting activities. The combination of access to new data and novel underwriting formulas enabled online lenders to start taking market share. In Schumpeterian terms, it appeared that creative destruction would occur as the “takeoff” phase gained steam.

  “Takeoff ” Aborted

  Despite this momentum, the small business lending innovation cycle took a surprise blow in the summer of 2016. An internal probe at Lending Club, one of the leading online lenders, revealed that the company had failed to disclose information to an investor regarding a loan pool. The Lending Club board responded by firing the charismatic CEO and founder, Renaud Laplanche.17 OnDeck, which had gone public with a valuation of over $1 billion and a share price of $20, saw its stock price plummet by 42 percent between December 2015 and July 2016.18 Concerned industry observers also began to question whether the new entrants had truly brought disruptive innovation to the market, or had simply made the application experience faster and more pleasant for borrowers. Were online lenders offering new products or were they just offering the same loans and lines of credit processed more quickly and at a higher cost to the borrower?

  In the 2015 Fed credit survey, some troubling information about the price of those online loans also emerged. While borrowers generally expressed satisfaction with the ease of the online lending experience, they complained about the high costs and hidden fees (Figure 6.3).

  Figure 6.3 Borrowers’ Reasons for Dissatisfaction by Lender Type

  Percentage of employer firms dissatisfied with lender in 2015

  Source: “2015 Small Business Credit Survey,” Federal Reserve Banks, March 2016.

  Anecdotes about small businesses falling into debt traps began to appear in the media, and concerns about “bad actors” found their way into the halls of Congress and the offices of regulators. More questions arose: were the new algorithms actually better predictors of small business credit than the bank underwriting models? Were they even as good? And, if the innovation was just in the customer experience, why couldn’t banks replicate these processes? Were they just a bunch of “dinosaurs,” unable to adapt to change? Most importantly, who held the competitive advantage?

  Ferment—Part II

  Thus began a second phase of the small business innovation cycle, or perhaps a mini-cycle of further fermentation. The original development of a technology and Internet-enabled front-end application process was so appealing to the small business owner that it jolted the industry into a new era. But, at this point, there was little innovation in the loan products that were delivered. In fact, the products were arguably worse—at least in terms of their cost to borrowers—primarily due to the competitive disadvantages of the new players.

  For one, the new online lenders had trouble finding customers. Small business owners are busy and, despite the appeal of a faster experience, online lenders found that placing targeted ads on Google was not enough to reach this fragmented customer base. Beyond just reaching small businesses, the online lenders also needed to get their ads in front of the borrower at almost exactly the moment when they were ready to borrow. As a result, acquiring customers was like finding a needle in a haystack. Customer acquisition costs reached about 15 percent of revenue, some of which was passed back to borrowers in the cost of the loans.

  In addition, the new fintech entrants had little track record of performance and no access to the cheap capital that banks held in the form of deposits. Many were using high-cost money from hedge funds to finance their loans. Peer-to-peer lenders played matchmaker, for a fee, between eager borrowers and the individuals and institutions that wanted returns. The unit economics of the innovators, that is, their ability to make profit on a per loan basis, were proving to be a challenge.

  At the same time as the early players were stumbling, the dinosaurs were waking up. The established banks and other lenders saw their customers enjoying the ease of the faster and friendlier customer experience, and decided they needed to resp
ond. At first, many just tightened their timelines for responding to loan applications. Turnaround times went from weeks or even months to 10 to 14 days. Processes were still partly manual, but the banks worked on incremental improvements to create fewer burdens for the applicant. This alone made a difference to many small businesses, who finally found more responsive loan officers with a sense of urgency at the other end of the phone. In the months that followed, many banks, even some of those least prone to embracing change, came to realize that they too could use technology to automate small business lending, either by partnering with the new fintech challengers or by beating them at their own game.

  Each bank had its own strategy for testing the fintech waters. JPMorgan Chase took early action, partnering with OnDeck in 2015 to deliver an automated small business loan product “white-labeled” under the Chase brand. Wells Fargo developed its own product, called FastFlex, an online fast-decisioned option for small business loans under $100,000 launched in May 2016. Between 2012 and 2017, Citibank invested in more than 20 fintechs to keep an eye on the developing sector and see what innovations might prove worth incorporating. Even community banks engaged, defying the initial view that they would be too small and too technologically backward to explore the new frontiers. Eastern Bank in New England hired a team of fintech entrepreneurs to create Eastern Labs and develop their own in-house small business lending product. After successfully launching Eastern Labs internally, they spun out the technology into its own company, with the purpose of selling the software to other community banks. (Chapter 9 explores the different strategic options available to banks in more detail.)