Does the Marketplace Lending Model Make the SME Lending Challenge Worse?

This is an interesting discussion.

Todd H. Baker and Kathryn Judge, both from the Columbia Law School, posted an article earlier this month on banks and Fintechs in the time of the COVID-19 pandemic. As most people recall, during the last big financial crisis, policymakers fumbled and caused credit to SMEs to dry up thus exacerbating the situation. The US government learned a valuable lesson during that recession, it appears, as it rushes to backstop an economy crushed by a health issue.

Entitled, “How Banks and Fintechs Can Help Small Businesses Survive COVID-19,” the article addresses the US government programs that have been enacted to support SMEs during the crisis. Programs under the CARES Act, like the Paycheck Protection Program (PPP), are designed to assist struggling SMEs with funding being funneled from both banks and non-bank lenders. Judge and Baker believe that more can and should be done. But the duo also addresses the efficacy of non-bank lenders.

To quote the two authors:

“The situation with online small-business lenders is significantly more complicated.  They have become the main source of credit for many, highly vulnerable small businesses. In 2018, nearly one-third of small businesses that applied for credit sought it from an online lender. For less traditionally credit-worthy businesses, the number was closer to one-half. But online lenders are paralyzed because they can’t access the capital markets funding on which their business depends.  As a result, they are scaling back – just when their services are most needed.

If you peel back the skin of an online lender, what you find underneath is a finance company. Finance companies borrow in the capital markets and lend that money to customers. In good times, this model works well. But when funding in the capital markets is unavailable or prohibitively expensive, a finance company quickly hits the wall and can’t provide new credit to its customers. The “marketplace lending” business model of many online lenders –  they need loan sales to generate revenue – only exacerbates the crisis funding problem of traditional finance companies. That means online small-business lenders need the federal government to help them, in the short and medium-term, rescue their customers and then to play a meaningful role in any small business credit and economic recovery.”

The entire article is available here.

So is the marketplace lending model broken? Well, not so fast.

Brian Knight, a Fintech advocate and policy expert who is Director, Program on Innovation and Governance and Senior Research Fellow at the Mercatus Institute, makes an important point. Banks are effectively subsidized by the government with insured deposits and during the last crisis were bailed out in bulk. In a comment posted on LinkedIn, Knight had this to say regarding the Baker and Judge article:

“… I am left with some questions on some of their ancillary conclusions: 1. How much should we read into the fragility of the non-bank lender business model given the severity of the crisis? Yes, they hit a wall, but the economy was largely shut down by law. That seems a lot more disruptive than a typical crisis. If I drop a bomb on a car I can’t say the car is unsafe because it blew apart, no car can be expected to survive this. Is this crisis similar? 2. I’m not convinced the banking system is safer per se so much as government bailouts are built in. Yes, banks have access to deposits (at government subsidized prices) but in the last crisis (which was less severe in many ways than this one) over 700 banks required government support, some banks required extraordinary support, and many banks failed anyway. Banks also enjoy the Fed as a lender of last resort as a matter of course.”

Knight compliments the article as a fascinating read that is “well worth your time.”

But credit where credit is due, Knight makes an important point. Most Fintech lenders operate on a different basis than traditional banks minus the explicit government subsidy. Fintechs drive value with a better service at a lower cost and, sometimes, lower rates. This value is mostly delivered without insured deposits – a difference that is slowly changing with the advent of digital-only banks like LendingClub and its “Marketplace Bank” concept.

Baker and Judge believe it is “hard to justify rescuing lenders that could have designed their businesses to be more resilient to liquidity and credit shocks.” They advocate bringing in non-bank lenders inside the federal bank system to lessen the potential for systemic risk. Something some Fintechs have been trying to do for quite some time.

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