The Future of Small Business Lending: CREDIT ACCESS DURING THE RECOVERY AND HOW TECHNOLOGY IS CHANGING THE GAME

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1 The Future of Small Business Lending: CREDIT ACCESS DURING THE RECOVERY AND HOW TECHNOLOGY IS CHANGING THE GAME LendIt USA Karen Gordon Mills Senior Fellow, Harvard Business School & Harvard Kennedy School Former Administrator of the U.S. Small Business Administration April 15 th, 2015

Senior Fellow, Harvard Business School & Harvard Kennedy School Former

2 WHY WORRY ABOUT ACCESS TO CREDIT FOR SMALL BUSINESSES? Small businesses account for half of U.S. jobs: 28 Million Small Businesses Non- Employer (~23M) Employer* (5.7M) High- Growth (~200K) Suppliers (~1M) Main Street (~4M) Source: U.S. Census Bureau; *remaining 500,000 business are Non-Supplier Businesses in the Traded Sector 2

3 WORKED FOR RESIDENT OBAMA AS HEAD OF THE SMALL BUSINESS ADMINISTRATION ( ) 3

4 SMALL FIRMS HIT HARDER IN CRISIS, ACCOUNTING FOR 60% OF JOB LOSSES 1,500 1,000 Quarterly Net Job Change ( 000) ,000-1,500-2, Small (<500 Employees) Medium (500 to 999 Employees) Large (1,000+ Employees) Source: Bureau of Labor Statistics, Business Dynamics Statistics (latest as of 3Q13). Chart shows the change in the number of charges by firm size, specifically small businesses (firms with fewer than 500 employees) and large businesses (firms with more than 500 employees). 4

Employees) Source: Bureau of Labor Statistics, Business Dynamics Statistics (latest as of 3Q13).

5 THE WHITE HOUSE ECONOMIC TEAM DURING THE HEIGHT OF THE GREAT RECESSION 5

6 TURNAROUND IN SBA LENDING Swift action to spur SBA lending, resulted in record years in 11, 12 and 13 $35 SBA LENDING U TWO-THIRDS FROM THE CRISIS, BRINGING BACK 1,000 LENDERS, HELED BY NEW LEGISLATION AND AN AGENCY-WIDE INITIATIVE TO CUT AERWORK Loan Volume ($ billions) $30 $25 $30.5 $30.3 $30.1 $20 $25.0 $22.0 $18.0 $15 FY08 FY09 FY10 FY11 FY12 FY13 Source: Small Business Administration. 7(a) and 504 loan volume since Fiscal Year As of May

INITIATIVE TO CUT AERWORK Loan Volume ($ billions) $30 $25 $30.5 $30.3 $30.1 $20 $25.0 $22.0 $18.

7 CREDIT FROZE DURING CRISIS, SLOW TO RECOVER FOR SMALL BUSINESSES ERCENTAGE OF BANKERS REORTING NET TIGHTENING OR LOOSENING OF LOAN CONDITIONS 80% 70% 60% Net Tightening 50% 40% 30% 20% 10% 0% Net Loosening -10% -20% Tightening Standards (Large Businesses) Tightening Standards (Small Businesses) Source: Federal Reserve, Senior Loan Officer Survey as of April

Loosening -10% -20% 2007 2008 2009 2010 2011 2012 2013 2014 Tightening Standards (Large Businesses)

8 CYCLICAL AND STRUCTURAL ROBLEMS LAGUE THE SMALL LOAN MARKET Small Business loan assets fell by 18% in the recession and have not trended back up Community Banks supply close to 40%* of loans to small businesses, but are being consolidated , Small Firms Loan Balances at Banks ($ Billions) Community Banks ( 000) ,800 1,600 1,400 1,200 1, Average Bank Assets ($ billions) Small Business Loan Assets on Bank Balance Sheets Number of Community Banks Average Bank Assets Source: Federal Deposit Insurance Corporation, Call Report Data. As of January 2014 * er reports from the FDIC Acting Chairman Martin Gruenberg and a December 2012 survey of small business finances conducted by the Federal Reserve Bank of Atlanta 8

1,200 1,000 800 600 400 200 Average Bank Assets ($ billions) 0 0 0 02 03 04 05 06 07 08 09 10 11 12 13 14 1985 1990 1995 2000 2005 2010 Small Business Loan Assets on Bank Balance Sheets Number of

9 FIRMS WANT SMALL LOANS, WHICH AREN T ROFITABLE FOR BANKS ABOUT 70% OF SMALL BUSINESSES WANT LOANS BELOW $250K 45% % Small Firms That Apply for Loan Sizes 40% 35% 30% 25% 20% 15% 10% 39% 17% 18% 5% 12% 14% 0% <50K $50-100K $ K $ K >$500K Source: Federal Reserve (New York), Small Business Credit Survey, Fall

35% 30% 25% 20% 15% 10% 39% 17% 18% 5% 12% 14% 0% <50K $50-100K $100-250K

10 HOW TECHNOLOGY IS CHANGING THE GAME TOTAL DEBT CAITAL OUTSTANDING AS OF 4Q13 FOR SMALL BUSINESSES ($ BILLIONS) $600 $500 $400 $300 $200 $100 $0 Bank Loans Business Credit Equipment SBA Factoring MCA Online Cards Leasing Alternatives ortfolio Balance % Year-Over-Year -3.1% +1.% +2% <-1% N/A N/A +175% Growth Source: Bank loans data taken from FDIC Call Reports; SBA data sourced from SBA publicly available information; Credit card data sourced from creditcards.com; remainder sourced from interviews with industry experts, and authors analysis. 10

11 ONLINE LENDERS GAINING TRACTION WITH SMALL BUSINESSES 2014 Joint Small Business Credit Survey by Federal Reserve banks of New York, Atlanta, Cleveland and hiladelphia 18% of small businesses say they applied for credit from online lenders Credit Sources Application Rate Approval Rate Large national bank 35% 31% Large regional bank 41% 45% Small regional or community bank 34% 59% Online lender 18% 38% Source: Joint Small Business Credit Survey Report, Federal Reserve Banks of New York, Atlanta, Cleveland and hiladelphia. 11

Rate Approval Rate Large national bank 35% 31% Large regional bank 41% 45% Small regional or community bank 34% 59% Online lender 18%

12 THREE INITIAL ONLINE MODELS DEVELOED BUT LINES ARE NOW BLURRING Online Balance Sheet Lenders Lenders Agnostic Marketplaces eer to eer (2) latforms Use balance sheet capital from institutional investors and decisions loans via proprietary risk scoring algorithms that rely largely on cash flow data, credit scores, social data, industry, geographic and other firmographic information Connect small business borrowers to a series of lenders that are part of their online marketplaces; most work with conventional lenders like big and small banks, SBA lenders as well as alternatives like OnDeck and Kabbage eer to peer, initially consumer-focused. Now, greater emphasis on small businesses. New funding sources from institutional investors. Source: Authors analysis 12

Connect small business borrowers to a series of lenders that are part of their online marketplaces; most work with conventional lenders like big and small banks, SBA lenders as well as

13 ONLINE MARKETLACE IS EVOLVING RAIDLY All aspects of the business models are changing: Sources of Customers roduct Sources of Capital artnerships Account Receivable/ Individuals Consortiums Invoice Lending Institutional Lenders Traditional Banks Term Loans Hedge Funds Loan Brokers Short-term Cash Traditional Banks Direct Online Advances Syndication Markets Customer Acquisition Small business customer does not always know what product will best meet their needs 13

Traditional Banks Term Loans Hedge Funds Loan Brokers Short-term Cash Traditional Banks Direct Online Advances

14 WHO HAS COMETITIVE ADVANTAGE? Traditional Banks & Other Lenders Online Lenders Capital Low cost capital from deposits Federally insured Higher cost capital from institutional and other sources looking for yields At risk in a downturn Customer Service Small business spends an average of 26 hours on loan paperwork Response comes within weeks or months Streamlined online application Response within minutes or days Credit Assessment Costly personal underwriting or reliance on FICO scores New credit algorithms (unproven) Source of Customers Large pool of existing customers (on which extensive data is available) Customer acquisition costs can be 15 percentage points (without sourcing alliances) Regulation Heavily regulated Largely unregulated except at state level and by SEC 14

downturn Customer Service Small business spends an average of 26 hours on loan paperwork Response comes within weeks or months Streamlined online application Response within minutes or days

15 WHAT IS THE ARORIATE LEVEL OF REGULATION FOR THE ONLINE SMALL BUSINESS LENDING MARKET? Two views: NEED FOR REGULATION IMROVE EXISTING REGULATION/ ENCOURAGE MARKET MECHANISMS No current designated federal regulator Clarify existing state and SEC regulatory oversight Should there be one? CFB? Other? Let nascent market develop Current industry move to improve Lack of transparency on costs to transparency small business owners Concern that this might be the next Consistent disclosure of cost metrics Borrower Bill of Rights subprime market Internal industry oversight Emergence of loan brokers High costs increasing on loan brokers 15

regulatory oversight Should there be one? CFB? Other?

16 HBS WORKING AER 16

State of Small Business Lending: US and UK

State of Small Business Lending: US and UK Karen Gordon Mills Senior Fellow, Harvard Business School & Harvard Kennedy School Former Administrator of the U.S. Small Business Administration and Member of