Fintech, Small Business & the American Dream

by Karen G Mills

  Data Ownership, Privacy, and Transparency

  Data is a key ingredient of many of the new innovations that will transform small business lending. This leads to a series of challenging questions facing not just financial services regulators, but multiple actors responsible for government oversight and protection. These issues are particularly acute when it comes to sensitive financial data. Policymakers will need to decide who owns different kinds of data, including transaction information, and a small business’s credit score. Significant concerns arise around whether a business should have the right to know what is driving their credit score and what they can do to improve it.

  Most small business advocates believe that more transparency is better, and that where possible, small businesses should own their own data. Innovators who have developed proprietary credit scoring or other algorithms, however, are concerned that too much transparency will undermine their competitive advantage and lead to less innovation. The right answer should be a balanced approach—with the weight on small business disclosure.

  On the question of data ownership, many lessons can be taken from PSD2 and, in the United Kingdom, from the 2018 implementation of Open Banking. This new approach to data regulation has two key components: First, customers and small businesses own their data that resides in banks. Second, they can also release that data seamlessly through APIs to be used by other entities. The intent is to both protect data privacy and allow greater innovation in the use of data for the benefit of consumers and small businesses. Although the results are not yet known, U.S. regulators need to watch the European experience closely, and strongly consider whether a form of Open Banking framework would benefit the American market.

  Principle 2: Look Out for Small Businesses

  Current regulations need to be adjusted to make sure that small businesses have greater protections, particularly as new innovative products and services emerge in the market.

  Require Appropriate Disclosures in Small Business Lending

  If a person applies for a loan to buy a pickup truck for themselves, they are protected by numerous consumer laws and regulations, including standardized price and term disclosures. But if that same person applies for a loan to buy a pickup truck to expand their small lawn care business, many of those same protections do not apply. Given that small business borrowers are often hard to distinguish from consumer borrowers, this dichotomy makes little sense. And, at a more fundamental level, all borrowers should be able to easily understand and compare their credit options.

  A 2007 Federal Trade Commission (FTC) study found that disclosures that enabled cross-comparisons dramatically increased borrowers’ ability to understand mortgage options.30 Loan disclosures already exist for consumers in formats that work, so lenders can begin by using these as examples. And as we have seen, small business owners want to be aware of the cost, fees, and terms of loans in order to make good credit decisions. Simply extending the Truth in Lending Act (TILA) provisions to small businesses might be the easiest solution.31 However, given that consumer and small business loan products may have increasingly different characteristics, a more tailored set of protections will likely be required.32

  Collect Small Business Lending Data

  The first task for policymakers should be to improve the quality of data available on small business lending in a way that is minimally burdensome for regulators and financial firms. It is the critical step that will make every other action on small business policy easier. The most important data to collect is information about small business loan originations. This should include information on the type and purpose of the credit being applied for, the amount of credit applied for and provided (if any), whether the application was approved or denied, and demographic and location information on the applicant.

  These metrics are already required by Dodd-Frank Section 1071. In Chapter 10, we suggested ways to phase in their collection, and mitigate industry concerns about implementation of the provision. Regulating complex financial markets is a demanding job. A lack of good data about the transactions in those markets raises the degree of difficulty in identifying and stopping bad actors, and in designing good small business policy.

  Protect Small Businesses from Discrimination

  With the influx of large of amounts of data in the underwriting process comes new responsibilities. As lenders increasingly rely on personal information and transaction data as part of their standardized algorithms, it will be imperative to adapt oversight to avoid adverse discriminatory effects. Our story in Chapter 8 about predicting a driver’s accidents based on whether or not they buy frozen pizza may have seemed like an innocuous example. But, it foreshadows real dangers about how artificial intelligence will be used and its potential to marginalize certain populations. These are not imaginary concerns—troubling examples of applied artificial intelligence are emerging in social media and other platforms, and financial services will not be far behind.

  Building a smart oversight environment in a financial services world driven by big data will be complicated. Financial firms that use AI or other algorithms to guide how they engage with customers will need to share the inner workings of their models with regulatory agencies. Regulators will need the expertise to assess these complex activities, and the data to see if discriminatory outcomes are occurring. One useful parallel is the process that regulators have used to build expertise on how to oversee banks’ internal risk models since the financial crisis. A priority for financial regulators should be to develop transparent and secure communication with lenders about the algorithms and machine learning tools they are using, and the outcomes from those algorithms on protected classes.

  Principle 3: Streamline the Financial Regulatory System

  The often-conflicting authorities of individual regulatory agencies make compliance needlessly difficult for industry participants. Even before online lending came into the picture, many small banks expressed frustration and anxiety about conflicting directives received from different agencies about the same loan. In addition, each agency has its own examination process, which results in duplicative requests for information, and other inefficiencies.

  Numerous proposals have been made over the years to reduce the fragmentation and overlap in the U.S. financial regulatory system. A 2014 report from the Bipartisan Policy Center recommended a comprehensive overhaul that would include consolidating the bank prudential regulatory functions of the Federal Reserve (Fed), the Federal Deposit Insurance Corporation (FDIC), and the OCC into a single agency with a unified federal charter, merging the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) into a single agency to oversee capital markets, and creating a federal insurance regulator. The proposed structure could clarify regulatory responsibility and reduce complexity and inefficiency.33 More recently, the 2018 Treasury report on fintech and innovation included recommendations on agile regulation, regulatory sandboxes, and improving the clarity and efficiency of regulatory frameworks.34

  In general, reducing fragmentation, overlapping jurisdiction, and duplicative regulatory functions would make U.S. financial regulation both more effective and more efficient. Fintech provides an opportunity, and in fact, an imperative, to streamline the system. The decisions on how to revise and improve regulation should be based on clear factual evidence, not as a reaction to industry pressure or ideological views. And regulatory review and improvement should be a continuous practice, just as it is in the United Kingdom.

  Develop Broad Principles Instead of Restrictive Rules

  No matter how well developed a policy or law is, the world does not stand still. Good policymakers have the judgment to consistently adapt to changing circumstances by updating their approach and regulations. This is especially important when technology is changing as quickly as it is today.

  One good way to ensure adaptability is, when possible, to rely on broad principles of conduct, rather than restrictive rules, for regulation. One suc
h principle would be to supervise like activity in like ways. This would mean that an entity making a small business loan would fall under the same guidelines for disclosure or conduct of its business, whether it is a bank or a nonbank lender. Basic tenets like those embodied in the Small Business Borrowers’ Bill of Rights could be important foundational principles for more specific legislative or regulatory actions. One overarching principle might be to promote clear product disclosure in ways that customers find easy to understand and compare. A principles-based approach would also provide more consistency—and avoid conflicting or confusing guidance as different agencies make their own rules around data ownership and privacy.

  Ensure Constructive Communication and Coordination Among Regulators

  At a minimum, regulators should share relevant information with each other and coordinate their efforts whenever possible. Following the 2008 crisis, Congress recognized that fragmentation and lack of coordination were problems. They responded by creating the Financial Stability Oversight Council (FSOC) in the Dodd-Frank Act as a forum for its member agencies to regularly meet to discuss issues of mutual concern. Another interagency body, the Federal Financial Institutions Examination Council (FFIEC), was established in 1979 with the goal of prescribing “uniform principles, standards and report forms for the federal examination of financial institutions.” FSOC and FFIEC have been helpful, but coordination should be enhanced in other ways.

  A 2014 Bipartisan Policy Center report recommended creating a consolidated task force made up of examiners from the OCC, the Fed, and the FDIC, who would jointly conduct their bank examinations. The relevant state bank regulatory agency would also have the option of joining the task force. The task force would submit a single set of questions to the entity being examined and publish a joint examination report that would be immediately available to each of the agencies involved.35 Ideas such as this one would be excellent candidates for a pilot program—perhaps coordinated by FFIEC—to test them in practice.

  There could also be better coordination on third-party vendors, as we have discussed in Chapter 10. If the agencies coordinated their guidance as much as possible and provided financial firms with single agency points of contact to streamline communication about third-party arrangements, they could ensure that the compliance burden is no greater than it needs to be. FFIEC could, for example, conduct regular trainings of examiners that are coordinated across all the regulatory agencies, so that examiners have the same criteria by which they administer third-party rules.

  Use Innovation to Improve Regulation

  Innovation is also important in regulatory compliance, where the use of regulatory technology, or “regtech,” is growing. Regtech applications help in two ways. First, firms can increasingly use technology to ensure that they are complying with rules and other requirements. And regulators can use innovation to find more effective and less costly ways to audit compliance, find anomalies, and identify potential bad actors for further review. Some countries have even used regulatory sandboxes, and “sprints” and “hackathons,” to solve specific compliance problems. In general, more data, more transparency, and more streamlining of activities are good watchwords in order for both regulators and policymakers to make continuous improvement in regulatory processes and outcomes.

  * * *

  Getting regulation right is difficult, as it requires balancing appropriate oversight with promoting innovation. Too little oversight could lead to the emergence of bad actors or another financial crisis that would hurt small businesses, while too much regulation could stifle new products and innovations that would make life easier for small businesses.

  Unfortunately, while other countries have proactively sought out solutions to this dilemma, the United States must make up ground. But it is not too late for regulators to step up to the task. Indeed, how regulators respond to the challenges before them will determine whether the United States takes advantage of the enormous opportunity to lead in financial technology and innovation—and to help the nation’s small businesses.

  Conclusion

  © The Author(s) 2018

  Karen G. MillsFintech, Small Business & the American Dreamhttps://doi.org/10.1007/978-3-030-03620-1_12

  12. The Future of Fintech and the American Dream

  Karen G. Mills1

  (1)Harvard Business School, Harvard University, Boston, MA, USA

  Karen G. Mills

  Email: kmills@hbs.edu

  Small businesses have been around since the time of early civilizations, and lending to small businesses is almost that old. The roots of traditional lending can be traced back to 3,000-year-old written loan contracts from Mesopotamia, which show the development of a credit system and include the concept of interest.

  These ancient records include a loan to one Dumuzi-gamil, a bread distributor in the Mesopotamian city of Ur. He and his partner borrowed 500 grams of silver from the businessman Shumi-abum, who appeared to be acting as a banker. Dumuzi-gamil became a prominent bread distributor within the region by operating institutional bakeries that supplied the temple. In fact, one tablet describes him as the “grain supplier to the King.” This early businessman paid an annual rate of 3.78 percent. Some of his colleagues were not as lucky. Other loans of silver to fisherman and farmers were documented at rates as high as 20 percent interest for a single month.1

  Even 3,000 years ago, the structure of commercial activities required capital that the merchant could use to fund the business, and the owner of the capital required a return for the use of those resources. Remarkably, this initial contractual relationship still forms the foundation for the arrangements between small businesses and their lenders.

  Small business lending has been so consistent over time because the basic math of small business operations has remained constant. A business sells a good or service for some margin over the cost of providing the product. Even in a high-margin business, the profits from each transaction are a small percentage of the sale. This makes it hard to accumulate the large amounts of capital that investments in land, animals, or supplies can require.

  Enter the small business lender, and the resulting arrangements of loan contracts, interest, and repayment over time. Over the centuries, many facets of these arrangements have evolved, with the establishment of money, banks, and traditional loan products such as term loans and lines of credit. But at their core, the needs of small businesses for capital have not changed.

  Until recently, the modern market for small business capital had been operating adequately, though not optimally. Large and small banks in the United States provided various loan products and relationship activities designed to address the needs of small businesses for working capital and expansion investments. For most of the twentieth century, small business lending saw little innovation and only incrementally used technology to automate existing processes. The customer experience was slow and paper-intensive, but the market felt little pressure to change.

  Not anymore. As we have seen, the financial crisis of 2008 and the entrance of new fintech competitors was a one-two punch that galvanized a new cycle of innovation in small business lending. The frozen credit markets showed the importance of small business lending to the economy and the slow recovery highlighted the market gaps. Entrepreneurs demonstrated that technology could change the built-in frictions in the traditional small business lending process, and a new era of innovation was born.

  In this new era, we ask a final set of questions: what will the small business lending environment of the future look like? How will technology enable new products and activities to emerge? Will credit be more widely available? Will more small businesses be better off, or will many be taken advantage of by bad actors? Given the fundamentals of small business needs and the changes in the lending markets we have explored, what exactly will be different in the future—and what will stay the same?

  Truths of Small Business Lending

  Change is flourishing in small business lending because th
e innovators are finding new ways to address some of the fundamental barriers or frictions in the marketplace. These frictions have been there for a long time and have been hard to ameliorate. They have been so constant that we call them the “truths” of small business lending.

  The first truth is that not all businesses succeed. In fact, small businesses fail at an alarming rate. Over 50 percent of businesses started in the United States over the last 10 years failed before they reached the fifth year. Providing a loan to most of these businesses would not have been a good idea because they failed for some reason other than lack of credit. Often, their product or idea was something that customers did not want, or something that they could not deliver profitably.

  Even in the most robust economic times, when credit is relatively easy to obtain, an estimated 50 percent of loan applications are denied because the small business is not creditworthy. If such a business were to get a loan and fail, that loan would turn into an additional burden the owner would be desperately trying to pay off. Thus, the goal is not to get loans to every small business, but to those who are creditworthy, meaning that they will be able to effectively use the capital to help themselves succeed. A related objective is to pair each creditworthy owner with a loan that fits their business: one that is the right amount, duration, and cost, with terms that the borrower can successfully handle and repay.

  The second truth is that it is difficult to know who is creditworthy. Many small business owners do not understand their cash flows well and, as a result, can suffer unexpected cash shortages. Businesses sometimes need cash to bridge a slow period, and sometimes they need funds because they are doing better than expected. One of the least understood realities of growth in a business is that it usually requires cash to fund increases in working capital or fixed assets. Thus, a fast-growing business can run out of cash, and even fail, if it does not plan ahead for a way to access the credit it will need.