Karen Mills is currently perched as a Senior Fellow at the Harvard Business School and at the Mossavar-Rahmani Center for Business and Government at the Harvard Kennedy School. She spends her time focusing on competitiveness, entrepreneurship and innovation – all extremely important areas of economic policy. Prior to returning to Cambridge, Mass., Mills was the 23rd Administrator of the Small Business Administration from 2009 to 2013. Selected by President Obama to lead the SBA, Mills was engaged with small business during a challenging time in the country’s history: the Great Recession.
After transitioning from public sector to academia, Mills put her first-hand experience to work. She co-authored a white paper entitled “The State of Small Business Lending: Credit Access during the Recovery and How Technology May Change the Game“. This was an early, comprehensive look as to whether or not there was a credit gap in small business lending. Her answer? A resounding yes.
The marketplace lending industry has boomed in recent years. The industry started out slowly (as many do) but advancements in technology and institutional interest have fueled vertical growth. Online lending has capitalized on the fact that mainstream finance is ensconced in traditional, brick and mortar operations. Meanwhile finance is rapidly moving online. Legacy costs, varying and convoluted regulatory environments and a culture that is too tied to the past, have hurt the old banks. Online lending has the power to provide better service, at a lower cost, while generating higher returns for investors. But, according to Mills, don’t count the banks out quite yet.
Recently Crowdfund Insider had the opportunity to speak with Mills at the LendIt conference in London. I spoke with Mills about her frontline experience. Where we are now and, in her opinion, where online lending is heading.
Mills noted that we get a small business loan pretty much the same way we did 50 years ago. You walk down the street to your local bank, you have a relationship, you bring them a mountain of paperwork and somewhere between three weeks and three months you get an answer. This new set of models, at the very least, deliver a transformative customer service experience.
Mills explained the lightbulb moment while she was managing the SBA;
“…Until this point the banks had been saying we are lending to every credit worthy borrower that is out there. Small businesses were saying, I still can’t get a loan.”
The enigma was that SMEs were being denied access to capital. It is these same SMEs that are the engines of economic growth. Now Mills accomplished some impressive tasks while at the SBA. By raising the guarantee rate during the crisis, the SBA was able to improve small business lending. But even while delivering record amounts of capital, there was still something that was not happening. “I was traveling across the country and there were credit worthy borrowers who were really still struggling”. Mills investigated the problem.
“I had the banks take me through the economics of $50,000 to $100,000 loans. They couldn’t make money with individual, personal underwriting. Unfortunately, that’s the size loan that most small businesses want. I think that 70% of the loans small business want are under $250,000 – 40/50% are under $50,000.”
For banks, the equation simply did not work. Too much effort and cost. Not enough money. In the end, we all lose.
About the same time, online lenders were starting to ramp up. Platforms like Prosper, Lending Club and soon after Funding Circle, were providing a needed alternative for loans. These new lending products filled the market gap. Mills was surprised as to how much interest the industry received from early investors. In a low-interest rate environment, the hunt for investor yield heats up.
Innovative financial entrepreneurs saw opportunity where traditional finance saw a loss. Asked if internet finance is transformative? Mills states;
“Absolutely. It is transformative, but I would not count the established players out yet … Because they have a lot of assets. They have customers. They have low-cost deposits. They have underwriting expertise.”
The future of traditional banking is a good topic of discussion at a gathering like LendIt where young financial entrepreneurs and disaffected banking executives convene to discuss the future of finance.
Mills is not completely convinced that in another downturn that marketplace lenders will fare quite as well. The banks still have a lot of customers and Federally insured deposits.
“It is very difficult for these new entrants to find borrowers who are ready to take on a loan and the first place they actually come is the bank. That said, the traditional bankers I have spoken with have said they have sat up and taken notice of the customer service transformation. One way or another they need to increase and improve customer service. That might be creating a faster turnaround cycle, that is definitely on the minds of some of the larger banks I have spoken with. Creating a more online process where you do not have to xerox your tax returns and drive them around…”
Some banks have decided to move into the new territory. Others have determined a partnership makes sense. Most continue to watch on the sidelines as strategies are formulated in board rooms – waiting to act.
Asked about the regulatory environment for online lending, while the US Department of Treasury reviews the nascent marketplace lending market, Mills believes US policy makers have a tall task. They are paying attention but there are overlapping agencies and much work to do. She contrasts the regulatory process in the UK with that of the States;
“I actually think they are trying to solve two different problems. In the UK, the problem they have to solve is they basically have [only] 5 banks. When the crisis hit those banks were not able to respond in a way that small businesses needed. In the US we had the SBA.”
“I was over here at the time and they [the UK] very much wanted to duplicate the SBA but they don’t have 7000 community banks with whom to partner with on any type of guarantee scheme. The creative alternative was to develop the British Business Bank, designed to facilitate other distribution channels of credit to the SME market. I think they are doing quite a remarkable job in the 18 months they have been doing it.”
The US is a far more complicated beast. US regulators are thinking about how to protect the market from bad actors. About borrower and investor protection. The US situation is further complicated by the fact that nobody has explicit oversight mandate for this sector – because it, online lending, didn’t really exist. Direct lenders are not banks so they do not fall under banking regulation completely. There are state laws. The SEC oversees part of the sector.
The UK has been lauded for its regulatory approach on disruptive finance. The Financial Conduct Authority (FCA), gained oversight on the industry. But their mission of rule-making and enforcement is balanced with a need to foster competition – something missing in the US.
“One of the things we see here [in the UK] is principles-based regulation and in the US we have rules based regulation. I think this is something the US market is looking at. I think one of the big principles for the borrowers is transparency. You have to give this [marketplace lending] industry credit because many of the leaders of the industry have fully embraced transparency. That is setting the tone for the industry. It is good for us. It is good for the borrower. It is good for the customer.”
Of course, regulatory uncertainty creates risk for the young industry. A recent initiative that Mills is part of is the Small Business Borrowers Bill of Rights. Mills was asked to join by Lending Club CEO and founder Renaud Laplanche. Mills wants to help lay the framework for the industry;
“I think the BBOR and the Treasury RFI and all the discussions going on behind the scene are all helpful. I think what they are all trying to understand is a complicated question: How do you provide the appropriate level of oversight but not dampen the growth in creativity and innovation in a marketplace that is clearly transforming and innovating in a sector where there is a gap? Many businesses will benefit to access to credit and these small loans. But it needs to be transparent. It needs to be easy for small business to understand how much they are borrowing and how much it’s going to cost and what the exact terms are. And one wants to make sure that the marketplace evolves in a positive way without burdening anyone.”
For the moment, Mills believes the regulators are doing their homework. Treasury truly just wants to better understand the fast moving industry. Morgan Stanley sees the industry becoming 60% of the market by 2020 – clearly relevant for policy makers. Mills is of the opinion that we are at a very early stage in the transformation but, the disruption is clear.
“I think this is good way for Treasury to get a sense of the products and the potential for this market,” says Mills. “They need to try and create enough understanding so that a regulatory framework, written by whomever, makes sense and it doesn’t dampen the positive aspects of this market but still provides investor protection and borrower protection.”
This is not insignificant for the US economy. The rate of small business startups remains tepid at best. Creating good, transparent and efficient access to capital for small dollar loans will be a plus for that segment. The question is can proper rules be balanced with light enough approach so innovation can evolve?
Asked about the big picture and Mills states;
“I do not think the winners and losers are clear. I do not think the product innovations are completely clear. I hope we will continue the transparency and adherence to the industry standards we put together in the Borrowers Bill of Rights. If this is the case this is very positive for small business owners.”
This is part of a series of articles where Crowdfund Insider will be interviewing the many women changing the profession of finance today. In FinTech, crowdfunding and peer to peer lending, there are many female entrepreneurs leading or assisting innovative firms that are altering the process of capital formation around the globe.