Are Alternative Small-Business Lenders Headed for the Mainstream?

Online small business lenders frequently bill themselves as speedboats running circles around banks' lumbering cargo ships.

Because they're less encumbered by regulation, the theory goes, they can use creative, automated underwriting models to make faster lending decisions and extend credit to a broader range of borrowers.

But as the industry gains popularity, more alternative lenders have been forging partnerships with banks — prompting the question of whether these digital disruptors could join the mainstream financial system.

At American Banker's Small Business Banking conference in Miami last week, a community banker in the audience asked a panel of online small business lenders whether their firms would ever consider becoming an insured institution. The panelists gave different answers.

"I don't think we should take deposits or be bought by a bank," said James Hobson, chief operating officer at OnDeck. "That would kill the role we have to play. We should be the innovators trying new things first, and we should be doing that on our dime."

Sam Graziano, chief executive and co-founder of Fundation, sounded more amenable to the idea of alternative lenders joining the ranks of the banking system. But he said that day, should it come, remains a ways off.

"To get comfortable with the way we predict risk and the risks we're willing to take is outside the tolerance many regulators have," Graziano said. Online lenders pride themselves on harnessing a wide range of data to pluck out creditworthy applicants rather than relying solely on more conventional indicators like FICO scores and tax returns.

However, Graziano predicted that as online lenders "get more cost-efficient and smarter," the industry will be primed to commingle with banks.

"That could be more tightly integrated partnerships, or it could mean becoming part of the banking system because of the proven way that models can work," Graziano said.

The unconventional nature of alternative lenders' underwriting models emerged as another hot topic at the panel. CAN Capital's vice president of product management, Krystl Black, explained her company's practice of incorporating small business owners' social media profiles into lending decisions.

"If you look at a nail salon's Yelp reviews or Facebook page, you can confirm that they're one that people enjoy visiting and that they'll be a good credit-quality customer," Black said.

That data, used alongside more traditional credit-risk indicators, "helps us make decisions when we don't have all the financial facts," she said.

But Graziano disputed social media's usefulness as a tool for evaluating loan applicants, arguing that the people who post Yelp reviews are frequently friends of the store owner.

"It's not adding predictive power to predict the likelihood of default," he said.

Moreover, Graziano pointed out that reliably profitable businesses like doctor's and dentist's offices often "don't have digital footprints to the same degree that consumer [businesses] do."

OnDeck's Hobson acknowledged the limitations of using stores' online presence to determine credit risk, but pointed out that traditional measures like FICO scores can also fall short.

"We're taking a long time to develop models, and the only way to develop them is to have bad ones," he said. "That means you have to lose money and move at a responsible rate in terms of how you should grow. If you invest and build now, you can understand what the presence or absence of data means to a credit profile."