Armed with cost and process efficiency, greater transparency, and innovative underwriting processes, alternative lenders are determined to take the lending space by storm. Alternative small business lenders only originated $5 billion and had a 4.3 percent share of the small business lending market in the U.S. in 2015. By 2020, the market share of alternative lenders in small business lending in the U.S. is expected to reach 20.7 percent, according to Business Insider Intelligence, a research arm of the business publication.
Being able to understand customer-associated risk by relying on alternative data and sophisticated algorithms allowed alternative lenders to expand the borders of eligibility, whether for private clients or small businesses. In fact, a Federal Reserve survey of banks in 2015 suggests that online lenders approved a little over 70 percent of loan applications they received from small-business borrowers—the second-highest rate after small banks, which approved 76 percent, and much higher than the 58 percent approved by big banks.
Coming so close in approval rates to banks and having lent billions employing a different, more efficient business model inevitably created an interest from banks. Some of the largest institutions have been taking advantage of the online lenders’ technology, but community and regional banks are still in the early stages of exploring partnership opportunities. While concerns over those types of partnerships are understandable, there are also important positive implications, which we will explore further.
Cost-Efficient Capital Distribution Channel
Online marketplaces represent an additional, cost-efficient channel for capital distribution, expanding the potential customer base. An opportunity to grow loan portfolios with minimal overhead and without the need for adoption or development of resource-consuming technology, led to a partnership between Lending Club and BancAlliance, a nationwide network of about 200 community banks. The partnership allowed banks to have a chance at purchasing the loans originated by Lending Club, and, in case those loans did not meet the requirements, they were offered to a larger pool of investors. Banks also have an opportunity to finance loans from a wider Lending Club portfolio.
Examples of partnerships also include Prosper and the Western Independent Bankers. These partnerships give more banks an opportunity to offer credit to their customers, and more consumers access to affordable loans.
Portfolio Diversification and Customer Base Expansion
Alternatives lenders can offer an easy application process, a quick decision and rapid availability of funds due to an alternative approach to the underwriting process. Use of alternative data to assess creditworthiness is an inclusive approach to loan distribution. In 2015, in the U.S., there were 26 million credit invisible consumers. Moreover, the Consumer Financial Protection Bureau suggests that 8 percent of the adult population has credit records that you can’t score using a widely-used credit scoring model. Those records are almost evenly split between the 9.9 million that have an insufficient credit history and the 9.6 million that lack a recent credit history.
Paul Christensen, a clinical professor of finance at Northwestern University’s Kellogg School of Management, believes there are positive implications for companies leveraging alternative data to make a credit decision.
“For companies, alternative credit rating is about reducing transaction costs. It’s about figuring out how to make profitable loans that are also affordable for most people—not just business owners,” he said in a September 2015 article.
For community banks, as regulated institutions, partnerships with alternative lenders that extend credit to parts of the population perceived as not creditworthy is an opportunity to reach new consumer segments and contribute to inclusive growth and resilience of disadvantaged households.
Two Federal Reserve researchers noted in a 2015 paper that community banks can increase customer loyalty by referring customers to alternative lenders when banks cannot offer a product that meets the customer’s needs. “By providing customers with viable alternatives? it is more likely that these customers will maintain deposit and other banking relationships with the bank and return to the bank for future lending needs,” the researchers emphasized.
Access to Knowledge, Expertise and Technology
While the extent of integration may vary, one of the most important elements of partnerships that carry long-term organizational and industry benefits is mutual access to knowledge, expertise and technology. The combination of banks’ and alternative lenders’ different business models with an understanding of mutual strengths allows the whole industry to transform and provide the most efficient, consumer-facing model.