It’s high time fintech small-business lenders should be regulated.
5 min read
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A recent lawsuit against fintech small-business lender Kabbage Inc., charging that it partnered with a bank in order to offer interest rates that exceeded the legal limit, highlights the need for more regulatory oversight of the growing number of online lenders signing deals with small businesses.
U.S. banks are licensed by either their state’s banking commission or the U.S. Treasury Department’s Office of the Comptroller of the Currency (OCC) and are federally regulated by either the OCC, the U.S. Federal Reserve System (Fed) or the Federal Deposit Insurance Corporation (FDIC).
Once a bank has a charter, it serves an important community purpose: It takes deposits and lends that cash to keep money moving through the economy — a dynamic economists call the multiplier effect.
Done correctly, the economy grows sustainably; done incorrectly, it can cause a recession. If banks take deposits and hoard cash, the economy could contract, and if banks lend without regard for the borrower’s ability to repay, high defaults could cause credit to seize up. Bank regulator oversight tries to ensure that nothing in this delicate balance goes amiss.
Online lenders are getting more scrutiny.
The recent Massachusetts federal case brought by a small business against Kabbage (and its partner Celtic Bank) highlights why non-bank fintech lenders should be regulated. The suit alleges that Kabbage used its relationship with Celtic — which “rented” its balance sheet to Kabbage — as a basis to charge interest rates that violated usury laws. Usury laws differ from state to state, but in the majority of states it’s illegal for a non-bank lender to charge more than 29 percent interest annually on a loan.
The case against Kabbage is just one of many alleging that online lenders charge interest rates that burden their clients with unsustainable loan repayments. The state of New York is considering regulating online lenders after lawmakers found that there was “significant potential for unscrupulous online lenders to exploit consumers through predatory practices such as unusually high interest rates, lack of disclosure of hidden fees, and unclear loan terms.”
The state of New York is not alone with those concerns: A research paper prepared for the Fed’s Board of Governors, writes that 20 percent of small businesses seek financing from a fintech or online lender, compared to 52 percent from small banks and 42 percent from large banks. Small companies with less than $100,000 in revenues applied for loans from online lenders 30 percent of the time.
The report concludes that most of those taking online loans do not meet underwriting criteria for traditional loans and that these lenders are not disclosing important loan terms like APR or clearly identifying terms as basic as the frequency of payments.
When a borrower does not have sufficient cash flow and accepts loan terms they don’t understand with interest rates that far exceed the usury limit, business failure becomes a likely outcome.
But online lenders are not the only option.
For many of these businesses, there are two alternative and much more responsible options: micro loans and U.S. Small Business Administration (SBA) loans.
Micro loans are offered through non-bank, mission-based, non-profit lenders, that receive funding from private foundations, the SBA and local banks as part of their Community Reinvestment Act efforts. They offer loans to the very smallest of businesses that are not yet ready for bank financing, either because their needs are just too small, or they have risk characteristics that are outside of the banks’ risk profile.
The loans range from $500 up to $350,000 or more, with interest rates that are slightly higher than bank rates and terms that are in line with conventional loans. And in addition to loans, these non-profits typically offer ongoing technical assistance to help businesses assess business plans, and understand ways to better manage their finances.
The other option is SBA-guaranteed loans, which come in two forms: the 7(a) program and the 504 program. The 7(a) loans are offered through banks and SBA-regulated lenders and are partially government guaranteed, in amounts up to $5 million for most business purposes. The 504 loans, which can be used to purchase owner-occupied real estate or capital equipment, have part of the financing coming from a conventional bank loan in a senior position and part coming from a 100 percent SBA-guaranteed bond in a second position.
To get an SBA loan from a bank, a company goes through an underwriting process that examines the 5 C’s of credit — capital, collateral, conditions, creditworthiness and cash flow. While banks typically demand strength in all five Cs to qualify for their conventional loans, an SBA loan provides greater flexibility.
SBA loans allow banks to approve a loan with less collateral or a lower down payment (if cash flow supports repayment), offer a borrower a longer term to repay resulting in lower payments that fit the business’ cash flow, or in some cases, underwrite the company’s projections for repayment. And in most cases banks cannot, by law, charge more than Prime + 2.75 percent on loans over $50,000.
Some businesses complain that the bank underwriting process is frustratingly slow, especially when compared to the yes/no decision that an online lender can make in just minutes. However, the No. 1 goal of any traditional small-business lender is to ensure that a loan never harms the client. A loan must benefit the health of the firm, so making sure that’s the case requires careful analysis and scrutiny.
While a traditional bank underwriting process may be frustrating for small companies, the extra speed that online lenders provide may come at a real cost to the business — and even your life’s savings. So beware!