While small businesses are reeling from mandatory closings, many homeowners are scrambling for other options. The federal small business loan program has stalled, and even if Congress provides more funding, it will remain too small. A route carries the risk of more harm than help – unregulated online lenders offering easy money, but often at a high and sometimes hidden cost.
FinTech companies, known as ‘fintechs’ and including Lending Club and Prosper, have grown in popularity over the past decade as community banking has contracted and the ease of the application process made their loans more popular online. Although masked as an innovative development, the rise of fintech in the face of lax financial regulation is troubling for small businesses, and our economy more broadly, especially in the age of Covid-19.
Even before the crisis, financially troubled businesses were more likely to approach lenders online. The recent Federal Reserve Small Business Credit Survey showed that 51% of medium and high risk small businesses used an online lender in 2019, compared to 21% of low risk businesses, who preferred traditional bank loans. With the collapse in consumption in 2020, the demand for small business loans will increase by orders of magnitude.
The danger right now is that many applicants do not realize that the consumer protections that cover them when applying for a personal loan online do not apply if the loan is for small business purposes. . (I write about this in detail in a recent legal journal article.) Consumer protection laws such as the Truth in Lending Act and Fair Debt Protection Practices Act cover loans granted to households by non-banking institutions. Fintechs are required to adhere to many of the same disclosure standards as traditional banks so that personal borrowers can reasonably compare products.
However, small business borrowing from fintechs is not covered by these laws, possibly because the owners are more financially sophisticated. But small businesses don’t have the teams of accountants and lawyers who advise large companies. These owners need the same protections owed to consumers. Pressed to keep their businesses alive, they could take out predatory loans that could eventually bankrupt them.
a investigation by US representative Emanuel Cleaver (D., Mo.) discovered that loans can carry deceptively high interest rates and are based on a “black box” of credit rating information that the borrower cannot see. Smaller businesses, with disproportionately black and Latinx business owners, many of whom are in areas without community banks, are potentially the most at risk. According to the Federal Reserve’s credit survey, business owners of color were more likely to use online lenders and their businesses were more likely to be at high risk financially.
Fintech companies are also not covered by mandatory disclosure requirements, making data about them difficult to obtain. This is one of the reasons why small businesses defenders have been asking the Consumer Financial Protection Bureau for years to implement section 1071 of the Dodd-Frank Act. This would make small business loan data readily available to the public so that it can be monitored for disparate impacts on business owners who are people of color and women.
In my own research, I used the dataset that Lending Club, one of the largest lenders, makes available to the public. I have found that small business loans are more likely to default after controlling for other observable differences among borrowers, which suggests that small business owners are taking excessively high levels of risk. When comparing financially similar borrowers, small business owners pay interest rates between five and eight percentage points higher than loans from traditional banking institutions.
The last few years have seen a lot of back and forth between state and federal decision makers to determine who would regulate the growing fintech market, and states should reasonably continue to substantially regulate much of the small business market (as well as mortgages and other non-bank financial products). But the federal government must intervene. Policymakers should go beyond just collecting data – they should change consumer protection laws to include non-bank loans to small business owners. This would ensure that lenders must transparently provide information on the real interest rate on loans and the payments that the borrower will face.
In this time of crisis, fintechs are probably an important lifeline for many small businesses, and some fintech companies have been access granted the paycheque protection program. Ease of use and speed can be a plus. To stay alive, small business owners will look beyond P3s just to get to the other side of the crisis. But the rules of the game should ensure that the loans are offered in a manner comparable to traditional bank loans so that small business owners who are excluded from federal programs don’t find themselves struggling with unpayable debts down the road. This would only worsen the inequalities of the current economic crisis.
Lenore Palladino is an assistant professor of economics and public policy at the University of Massachusetts Amherst. She is a fellow of the Roosevelt Institute and a research associate at the Political Economy Research Institute.