In the decade following the financial crisis and recession of 2007-09, lending to small businesses from nonbank lenders grew rapidly, often faster in terms of annual originations than depository institutions. In 2019, the last full year before the COVID-19 pandemic, nonbank lenders held an estimated $550 billion in outstanding loans to American small businesses.1 Today, nonbank lenders account for around half of new credit extended to small businesses.
Nonbank, or non-depository, lenders have long been a feature of the small business financing landscape. In the late 1980s and early 1990s, one-quarter of small businesses reported using a nonbank for credit, compared to 48% using a commercial bank.2
Diverse Set of Lenders
The term “nonbank” refers to a variety of lenders and lending models that differ in structure, market focus, and financing activity. The largest are finance companies, also referred to as asset-based lenders.3 “Factors” are companies that purchase invoices from small businesses; leasing companies give small businesses use of equipment or vehicles. Fintechs, or online lenders, are the newest entrant into the space and operate according to several different business models. Merchant cash advance, said to originate in the late 1990s, offers upfront money in return for repayment in the form of a fixed percentage of sales. Trade credit has also been used by small businesses for years, with suppliers deferring payment for delivered goods or services. Commercial mortgage companies specialize in providing credit for residential dwellings with more than five units. Non-depository community development financial institutions (CDFIs) occupy a smaller niche.
The estimates in Figure 1 from the Consumer Financial Protection Bureau do not include other nonbank sources such as cooperatives (which engage in agricultural lending) and private credit sources such as business development companies (BDCs). These investment companies provide loans, equity financing, and assistance, specializing in larger small businesses or “middle market” companies. The assets and activities of BDCs have, like other nonbank lenders, grown rapidly in the last decade.4
Recession and Regulation Drive Rapid Growth
In the years after the recession and financial crisis of 2007-09, lending to small businesses from banks dropped sharply and was slow to recover. This was a consequence of new regulatory constraints (e.g., stress tests) and the hangover from the collapse in asset values during the recession. Small business lending from banks did not fully recover until nearly a decade after the recession.5
Meanwhile, amidst low interest rates together with new advances in financial technology, non-bank lending grew rapidly on almost all fronts. This growth meant that aggregate small business credit did not decline as different forms of nonbank lending substituted for depository lending.
By the 2010s, there was “ferment” in the nonbank lending sector, with new online lenders (what many refer to as fintechs) entering the market: “the space changed so rapidly that it didn’t even have a fixed name.”6
Many nonbank lenders also entered partnerships with banks, helping with origination and selling. The share of small businesses that applied for credit at nonbank lenders rose steadily each year. According to some researchers, small business loan originations from nonbanks grew 69.5% per year from 2010-16 compared to 44% from banks and credit unions.7 As banks wrestled with recovery from the financial crisis and new regulations that narrowed their risk appetite, nonbank lenders—especially finance companies—filled the gap.
The dynamic landscape of small business financing is not shaped exclusively by the supply side of lenders and credit products. Demand from small businesses is just as important and shifts according to macro trends and the individual decisions of millions of business owners.
Serving Different Market Segments
It is widely thought that these “alternative” sources of credit are more likely to serve small business borrowers deemed to be higher credit risks. Survey results are mixed. On one hand, “low credit risk” small business owners are much more likely to seek credit from banks. On the other hand, application rates from “medium/high credit risk” small business borrowers have been roughly the same at banks and online lenders.8 (See box.)
Depository institutions and nonbank lenders may also differ in the types of small businesses they serve or the amounts they provide. There is some evidence for such differentiation, though the lines are not necessarily clear. Banks and finance companies, according to some estimates, provide credit to small businesses in similar industry sectors while fintechs tend to concentrate their lending activities in retail and services. On average, fintechs lend more to smaller firms in terms of employment and sales, with loans that are smaller and shorter in duration.9
Nonbank lenders also vary in the extent to which they require collateral in return for credit as well as the types of collateral they lend against. Many nonbank lenders, such as finance companies, extend credit against tangible collateral such as equipment. Depository institutions, oriented more toward cash-flow-based lending, lend against a broader variety of collateral. Many fintech lenders will require a personal guarantee but, at lower amounts, not collateral.10
Small businesses also appear to utilize the diversity of credit options that meet their changing needs. There is evidence, for example, of “loan bridging,” wherein borrowers obtain unsecured credit from a fintech lender and use it to obtain collateral that they subsequently use to secure a loan from a depository institution.11
Nonbank Benefits—and Costs
According to the Small Business Credit Survey, small businesses say they turn to nonbank lenders for two main reasons: speed of decision, and chance of being funded.12 Prior to COVID-19, approval rates at online lenders and finance companies were around 70 to 80%.13 (Approval rates fell in 2021.) Other benefits of nonbank lenders include “flexible repayment options” and access to credit for those “who might not qualify for more traditional loans.”14
Black business owners, for example, have historically been more likely to apply for credit at online lenders.15 In 2020, excluding forgivable loans such as government assistance, 29% of Black business owners applied for credit at either a fintech or finance company compared to 23% of White and 17% of Asian business owners.16 Such results must be treated with caution as Black business owners tend to have higher credit application rates at other sources, too, including large banks and credit unions. Evidence of application incidence is not necessarily evidence of credit access.
Credit provision from a nonbank lender also comes with costs. A recent report from the Treasury Department17 found that, while nonbank lenders bring market diversification and competition to lending, they also “pose risks” around safety, soundness, and borrower protection. In the Small Business Credit Survey, small business respondents consistently cite “unfavorable repayment terms” as a reason for dissatisfaction with online lenders and “high interest rates” as cause for dissatisfaction at both online lenders and finance companies.18 Concerns have also been raised about “wide variation in disclosures” regarding financing terms from nonbank lenders and aggressive collection tactics such as confessions of judgment.19
1 Bureau of Consumer Financial Protection, “Small Business Lending Data Collection Under the Equal Credit Opportunity Act (Regulation B),” Proposed Rule, October 8, 2021.
2 Gregory E. Elliehausen and John D. Wolken, “Banking Markets and the Use of Financial Services by Small and Medium-Sized Businesses,” Federal Reserve Bulletin, October 1990; Rebel A. Cole and John D. Wolken, “Financial Services Used by Small Businesses: Evidence from the 1993 National Survey of Small Business Finances,” Federal Reserve Bulletin, July 1995; Traci L. Mach and John D. Wolken, “Financial Services Used by Small Businesses: Evidence from the 2003 Survey of Small Business Finances,” Federal Reserve Bulletin, October 2006.
3 There are both “independent” and “captive” finance companies. The latter are owned by a larger company, such as an equipment manufacturer. Other finance companies are owned by banks. The remainder are independent.
4 Tetiana Davydiuk, Tatyana Marchuk, and Samuel Rosen, “Direct Lenders in the U.S. Middle Market,” SSRN Working Paper, April 2022.
5 See, e.g., Ann Marie Wiersch and Scott Shane, “Why Small Business Lending Isn’t What It Used to Be,” Economic Commentary, Federal Reserve Bank of Cleveland, August 2013; Rebel A. Cole, “How Did Bank Lending to Small Businesses in the United States Fare After the Financial Crisis?” U.S. Small Business Administration, Office of Advocacy, January 2018.
6 Karen Mills, Fintech, Small Business & the American Dream (Palgrave Macmillan, 2018).
7 Manana Gopal and Philipp Schnabl, “The Rise of Finance Companies and FinTech Lenders in Small Business Lending,” Review of Financial Studies, 2022
8 Federal Reserve Banks, Small Business Credit Survey, various years.
9 Manana Gopal and Philipp Schnabl, “The Rise of Finance Companies and FinTech Lenders in Small Business Lending,” Review of Financial Studies, 2022
10 Manana Gopal and Philipp Schnabl, “The Rise of Finance Companies and FinTech Lenders in Small Business Lending,” Review of Financial Studies, 2022
11 Paul Beaumont, Huan Tang, and Eric Vansteenberghe, “The Role of FinTech in Small Business Lending,” SSRN Working Paper, 2021.
12 Federal Reserve Banks, Small Business Credit Survey, various years. The survey results reported here are for both online lenders and finance companies. By contrast, small businesses that apply for credit at banks cite existing relationships, chance of being funded, and cost or interest rate as principal reasons.
13 Federal Reserve Banks, Small Business Credit Survey, various years.
14 Federal Trade Commission, “‘Strictly Business’: An FTC Forum on Small Business Financing,” Staff Perspective, February 2020.
15 See, e.g., Ann Marie Wiersch, Scott Lieberman, and Barbara J. Lipman, “Click, Submit 2.0: An Update on Online Lender Applicants from the Small Business Credit Survey,” Federal Reserve Bank of Cleveland, December 2019; Ann Marie Wiersch, Barbara J. Lipman, Kim Wilson, and Lucas Misera, “Clicking for Credit: Experiences of Online Lender Applicants from the Small Business Credit Survey,” Federal Reserve Bank of Cleveland, August 2022.
16 U.S. Census Bureau, 2021 Annual Business Survey.
17 U.S. Department of the Treasury “Assessing the Impact of New Entrant Non-bank Firms on Competition in Consumer Finance Markets” Report to the White House Competition Council, November 2022.
18 Federal Reserve Banks, Small Business Credit Survey, various years.
19 Federal Trade Commission, “‘Strictly Business’: An FTC Forum on Small Business Financing,” Staff Perspective, February 2020.
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