Small Businesses Matter: Increasing Small Business Access to Capital in the Digital Age

In early 2023, a series of bank runs among small and midsize lenders caused havoc in the financial system, jeopardizing lending to small businesses because smaller lenders are more likely than larger ones to approve loans for these owners. Between interest rate hikes by the Federal Reserve, inflation, and new regulation in response to those bank runs, it is as difficult as ever for small businesses to access the capital they need.

Entrepreneurs need financing to start and grow a business. They have various options, from traditional business loans to Small Business Administration (SBA)-backed loans to credit cards. They can receive financing from traditional sources such as banks or credit unions, and from newer sources such as online lenders, also called fintechs.

One trend shaping small business financing is the digitization of lending. Digitization is twofold, bringing existing processes online and incorporating new technologies and data into operations. Digitization can make lending to small businesses more accessible, efficient, and faster by decreasing manual processes for both the lender and the borrower. When incorporated with risk-based pricing and other lending strategies, it can increase access to financing, including for historically underserved business owners. However, with novel technology comes novel problems: Digitization carries potential privacy and security risks, as well as diminishing returns.

Understanding how digitization, fintech lending, and lending strategies like risk-based pricing are reshaping small business lending will help lawmakers craft policy that meets the capital needs of more small businesses. This paper explores what digitization and fintech companies are, how digitization and fintech lenders affect small business lending, and how incorporating risk-based pricing and technologies like artificial intelligence can help close lending gaps for entrepreneurs and small businesses.

Small Business Lending: Sources and Challenges

Gaining access to capital is one of the biggest barriers to small business growth. A 2024 Goldman Sachs 10,000 Small Businesses Voices survey found that 77% of small businesses were concerned about their ability to access capital, and an OnDeck survey reported that 70% of small businesses had less than four months of operating cash on hand. In response to financial challenges in 2023, a majority of small business owners had to tap into their personal funds (53%) and/or use cash reserves (51%) to maintain operations.

Early in a small business’s inception, it commonly operates with money from the owner’s personal savings or with financial support from friends and family. As businesses mature, they often reach a stage in which accessing additional funding becomes necessary to expand their operations or manage day-to-day business expenses. Unlike large corporations that have access to public markets and high growth startups that can more easily attract equity investment, small businesses have fewer financing options available. Consequently, debt financing through loans emerges as their optimal choice for obtaining needed capital.

Owners face many barriers in obtaining financing, such as having the proper credit history, a lack of collateral, and complexity of applications. Rural and minority entrepreneurs and business owners face a unique set of additional challenges.

In 2022, Black and Hispanic small business owners had less liquid wealth compared with their white counterparts. This creates a large barrier for those wanting to start and build a business, especially since 75% of small business owners invest their own funds to start their business. With less capital of their own, minority entrepreneurs must turn to other sources of financing. The lending landscape is no easier for this group. In 2023, Black (32%), Asian (34%), and Hispanic (32%) business owners were less likely to receive all the financing they applied for than their white counterparts (56%).

According to U.S. Census Bureau data, small businesses are important employers in rural areas: Small firms employ 62% of workers in rural communities. Banks, especially small banks, are the primary source of financing for rural small businesses. According to Goldman Sachs, “60% of loans to small businesses are made by banks within 10 miles of the borrower and around 75% of loans are made by banks within 25 miles of the borrower.” The ongoing decline in the number of small banks, as well as reduced competition among credit providers, means rural small businesses can face acute financing challenges.

Applying for a business loan from a large bank was the most common form of financing application before the COVID-19 pandemic and still is today, with 44% of small business owners who applied for financing saying they sought a loan from a large bank in 2023. Among other sources of credit small businesses applied to, small banks were the second most popular (28%), followed by online lenders (23%). Fintech lending boomed during the pandemic, as minority entrepreneurs and business owners found they were better able to access loans from these providers.

Small Business and Personal-Loan Underwriting: An Overview

Several similarities exist between personal and business lending, with “risk” at the center of it all. Lenders aim to assess the risk involved in lending money to an applicant, which includes analyzing a potential borrower’s creditworthiness—the individual’s or business’ ability to repay the loan in full and on time. Establishing that information on the application is true and that the evidence supports the likelihood of repaying is the process known as underwriting.

The underwriting process involves a thorough assessment of various factors to determine whether the applicant qualifies for a loan and, if so, the terms of that loan. In both cases lenders conduct the following:

• Financial review: Lenders seek to understand the applicant’s cash flows and assets. For individuals, this could mean looking at the income-to-debt payment ratio and equity. For businesses, this involves examining financial statements, which assess the company’s revenue, expenses, liabilities, and assets.
• Credit analysis: Lenders seek to understand the applicant’s credit score and their historical use of credit, as reflected in their credit report. Similarly, for businesses, this process entails evaluating the same factors but for the entity rather than the owner(s)—although the owners might be included if they are personally guaranteeing the loan.
• Collateral and guarantees assessment: To aid in the risk assessment, lenders might consider an applicant’s collateral—an asset that the lender can claim if the borrower defaults. However, this practice is much more common in business lending than for loans to individuals. In other instances, lenders might consider the role of a co-signer to help reduce their risk.

These core assessments are used to determine the applicant’s risk level. If the risk level is deemed acceptable, the applicant then receives the set loan terms. A SBA program designed to offset lender risk is the 7(a) lending program. The SBA guarantees between 75%-85% of a qualifying loan based on the loan amount. Until 2023, traditional lenders were the only ones licensed by the SBA to make 7(a) loans; a single fintech has been licensed to make 7(a) loans opening up the possibility for others to be licensed as well.

Business lending differs in several ways due to the nature of small business financing and their unique needs. Business lending generally involves considerably larger sums of money than personal loans, necessitating a higher minimum credit score and offering extended repayment terms often accompanied by lower interest rates. Moreover, due to the substantial funds involved, the underwriting process typically includes a closer review of more information.

Traditional and Nontraditional Small Business Lenders

Small business lenders can be divided into two types: traditional lenders, consisting of banks and credit unions; and nontraditional lenders, such as finance and fintech companies. Fintech companies are nonbanks that operate primarily online. They are part of an industry that is relatively new to the financial system and that has been expanding rapidly in recent years. Data from the Fed Small Business Credit Surveys (SBCS) reveals a notable trend: In 2019, 20% of employer firms sought funding from online lenders. This figure rose to 22% in 2022 and 23% in 2023.

Banks and online lenders cater to different types of small businesses. There is some evidence for this, but the distinctions are not always clear. Banks generally lend to small businesses in similar industries, while fintechs often focus on retail and service sectors. Fintechs also tend to lend smaller amounts to smaller businesses for shorter periods.

 

This variation is key for small businesses, which need capital across the full business life cycle. Small businesses often use a mix of lending options to meet their needs. They get a loan from an online lender to secure collateral, which they then can use to get a loan from a traditional bank.

A notable difference between traditional lenders and online lenders is their ability to participate in SBA lending. Banks and credit unions can participate in SBA’s 7(a) loan guaranty program, but online lenders could not until recently. In 2023, SBA changed its lending rules to allow fintechs to apply for Small Business Lending Company licenses. They have since approved one license for a fintech company. This change follows pandemic-era lending in which fintechs were brought into the process to help administer PPP loans. SBA’s move to allow fintechs to apply to become a 7(a) lender has been contentious. Widespread fraud was found in PPP lending, much of which originated with fintechs – specifically two banks classified as fintechs due to the prevalence of technology in their lending processes. Lawmakers on both sides of the aisle question SBA’s ability to prevent fraud from happening again with the well-established 7(a) program. SBA is confident in its ability to bring fintechs into the fold to reach more underserved business owners. Despite the differences between bank and fintechs, many banks and fintech companies already partner on lending and payments, whether as a subsidiary or by jointly offering a product.

Fintechs: A Growing Type of Nontraditional Lender

Financial technology, or fintech, is the integration of technology into financial services. A part of digitization, fintech has boomed as more banking and financial services are done online. Around 73% of the world’s interactions with banks occur through digital channels. Although traditional banks have adopted financial technology, fintech has turned into its own industry by offering some products that can compete with banks and some in cooperation. Fintechs can often process loan applications faster and cheaper than banks, allowing them to serve market segments and loan sizes that are not economically feasible for banks. This evolution has contributed to a surge of financial applications and online platforms in the past decade.

These new companies operate exclusively online as alternative lending companies and are known for their innovative use of technology and fully digital presence. Banks have been integrating new technologies and expanding to online channels, but they often operate on legacy systems—outdated, older systems—that can hinder their ability to integrate new technologies rapidly.

Fintechs are also recognized for their increased use of robust data and the nontraditional aspects of their underwriting processes. A key difference between fintechs and banks is that banks are often viewed as “cash-flow” lenders, focusing more on the projected cash flow of the borrower’s business operations. In contrast, fintechs are seen as “asset-based lenders,” considering the inclusion of assets as securities for payment options.

Fintech companies serving small businesses include LendingClub, SoFi, Biz2Credit, OnDeck, and Funding Circle. These companies offer products or services that are meant to be more accessible than products from traditional financial institutions. Research has found that fintech lenders increase access to capital for underserved businesses and small businesses overall.

In 2023, Black- and Hispanic-owned firms were more likely to have a medium or high credit risk and were more likely to be approved by an online lender. Because of the better odds or the speed of decision, Black and Hispanic business owners were also more likely to pursue financing at an online lender. Rural small business owners were also more likely to turn to online lenders due to the greater chance of receiving a loan or speed of decision.

Although fintechs have demonstrated an ability to increase borrowers’ access to financing, they also tend to charge higher interest rates and have lower borrower satisfaction. On average, fintech companies charge low-scoring borrowers an interest rate that was 3% higher than high-scoring borrowers. This difference could be attributed to the use of risk-based pricing. Twenty-five percent of small business owners were dissatisfied with their experience at an online lender, more than double the dissatisfaction rate with banks or credit unions.

Lending Innovations Can Enhance Small Business Lending

Digitization, alternative datasets, risk-based pricing, and artificial intelligence (AI) are all interconnected. Digitization enables the use of AI and alternative datasets, while AI allows lenders to leverage alternative datasets in risk assessment and risk-based pricing.

Digitization

The rise of digitization and alternative data, central to the fintech industry, has opened new avenues for small businesses and consumers to access capital. Digitization involves employing technology to convert physical information into digital formats, facilitating the sharing, storage, and analysis of data. In small business lending, where lenders require detailed scrutiny of large amounts of data, digitization streamlines the process. The traditional underwriting process, which is tedious and lengthy, can be enhanced through digitization.

Alternative Datasets

Alternative data encompasses nontraditional sources of information, such as business location or industry trends, that lenders can use to gain valuable insights into an applicant’s risk profile. By integrating alternative data into the underwriting process, lenders can develop a more holistic understanding of a small business’s financial health and performance. Although the fundamental principles and criteria for lending remain similar across institutions, the methods, processes, and considerations in assessing a borrower’s creditworthiness can differ significantly between lenders.

Over the past decade, the increasing use of technology has profoundly affected small business financing, particularly in credit risk assessment.

The traditional underwriting process in small business lending can be time-consuming. It has long adhered to a standardized approach in assessing creditworthiness. The digital transformation in lending equips traditional and nontraditional lenders with new tools to leverage vast amounts of data faster, creating a more personalized and streamlined approach to credit risk assessment. This change increases access to credit for small business owners, bridging lending gaps for younger small businesses and to those in underserved communities who often most lack access.

Underwriters need more comprehensive data to improve access to capital for borrowers from underserved groups. Current processes hinder lenders from seeing a holistic view of borrowers. Digitization and alternative data can help improve financial access by providing a clearer picture of a borrower’s risk. New technology can speed up the process for small businesses that need capital quickly and bolster pattern recognition to decrease human error.

Although alternative data and datasets hold promise for raising lending to underserved groups, increased lending could come with increased risk of defaults. Using more data in the lending process can also increase concerns about fraud, privacy, and data security. Ensuring that proper infrastructure and processes are in place can mitigate some of these concerns.

Risk-based pricing

Risk-based pricing is a lending strategy that has become more popular in the past few decades alongside alternative data and digitization. In contrast to traditional underwriting methods used by lenders, risk-based pricing does not rely solely on a set of standardized data and predetermined thresholds to assess risk. Used by traditional lenders and fintechs alike, this method considers more-individualized data points for each borrower to create a specific “risk profile.” Models vary by industry and institution but include considerations beyond the standard credit score and ability to repay, such as debt-to-income ratio, employment/occupation, assets, loan-to-value ratio, education, location, and prior lending history.

More than 26 million American adults did not have a credit history in 2021, creating a challenge for lenders regardless of lending strategy. Risk-based pricing can address this by incorporating and relying on alternative data and datasets. Lenders can then offer products, interest rates, and other loan terms tailored to a borrower’s risk profile.

Proponents of risk-based pricing highlight the strategy’s customized approach, which allows lenders to manage their risk accordingly, allocate resources to borrowers more likely to repay, increase access to credit for underserved groups, and mitigate risk. These benefits ultimately make the market more efficient, foster competition between lenders, and increase profits for lenders.

On the other hand, critics note that risk-based pricing has a point of diminishing return. The more data lenders have access to, the increased chance for perceived unfairness and discrimination. While risk-based pricing can increase accessibility, it can conversely make lending more inaccessible by pricing borrowers out. Because loan terms are tailored to an individual’s unique risk profile, high-risk borrowers face interest rates that make the terms of the loan unreasonable. This idea applies to risk management as well. Risk-based pricing can incentivize risk mitigation, but making riskier loans can also increase profits for lenders. This incentivizes risk-taking behaviors that could lead to less stable markets. Addressing these nuances will be crucial for policymakers to expand access to capital for disadvantaged business owners and entrepreneurs. Striking the right balance will allow more people to reap the benefits of digitization.

An alternative lending strategy to risk-based pricing is cross-subsidization, in which one group of borrowers funds another through different lending terms. For example, the lender charges higher interest rates to one group to offset lower interest rates offered to another, or sets a uniform interest rate for a certain type of loan regardless of the determined risk of the borrower. Supporters of this method emphasize the financial-inclusion benefits. Cross-subsidization can offer consistent and affordable pricing to a broader customer base.

Where risk-based pricing aims to provide fairness by aligning cost with a borrower’s risk, cross-subsidization focuses on simplification and transparent pricing. Cross-subsidization can be perceived as providing more access and affordability, but in practice it might not expand financial inclusion by making lending less fair for certain groups. Advanced analytics and AI further complicate matters.

AI

AI and machine learning present a growth opportunity for lenders. AI can help make lending decisions faster and more efficient by improving the lender’s ability to quickly analyzing data to create risk profiles and identify patterns. Machine learning can help predict answers to frequently asked customer questions, assisting both live agents and chatbots. If programmed appropriately, AI could also decrease bias in lending decisions. Beyond automating processes to streamline decisions, AI can help underwriting be more consistent for borrowers with similar risk profiles, as it identifies patterns and tailors experiences. In addition to assisting with lending decisions, AI can help prevent fraud and identify security threats.

AI in lending, as in most uses, is only as capable and effective as human input makes it. AI use for lending decisions is still novel and not widespread, and caution is necessary to avoid instability in the markets. AI is most successful when it is used to enhance or work alongside human processes rather than replace them. As more advanced models and better security measures are developed, AI integration can help modernize the lending process.

Leveraging Innovation to Benefit Small Businesses
As lenders increasingly digitize and integrate alternative data into their decisions, the gap between banks and alternative lending companies’ use of financial technology will close. Their capabilities will also accelerate as they incorporate AI tools into lending processes. The intersection of lending and technology presents a complex landscape. Policymakers need to be ready to leverage digitization’s benefits to expand access to capital and foster innovation within the industry to support small businesses. We propose the following guiding principles for consideration when developing policies to achieve that goal:

Establish guidelines and best practices for the use of alternative data. Lenders and regulators should work together to develop standards to ensure that new lending strategies are transparent, equitable, and aligned with current regulations.

Ensure small business owners understand their lending options and how decisions are made. Lenders and policymakers should invest in education initiatives for small businesses to understand the process behind lending decisions, what factors go into a decision, and how lending strategies and companies differ. Disclosures should be consistent for all lenders and all financial products.

Encourage responsible innovation lending. Lenders face regulations at the local, state, and federal levels, which makes it difficult for statutes and regulators to keep up with changes in the marketplace. For fintech lenders, a regulatory sandbox, where companies can test the market and develop products and services in an accelerated trial period within in existing regulatory frameworks, is one way to guide financial service innovation.

Monitor the inclusion of fintech lenders into government-guaranteed lending and incorporate new technologies with existing lenders. With appropriate oversight and regulatory safeguards to prevent fraud, long-term participation of fintech lenders in programs like 7(a) could help more small businesses access financing and increase competition in government-guaranteed lending by encouraging additional collaboration between traditional lenders and fintechs. Although traditional lending institutions have begun to adopt new financial technologies to some extent, there is still ample opportunity for further expansion and integration.

Acknowledgments

We are grateful for the support and assistance from the team at Enova. Thank you to our colleagues at the Bipartisan Policy Center, including John Soroushian, who provided feedback and assistance. And thank you to our colleagues at BPC Action for their insights and input.