Invoice and fintech's hold on small biz lending pushes banks to modernize

Fintechs and payment startups are creating a wide range of solutions to SME financing, from crowdlending and invoice-backed factoring to digitalization and formalization of business processes.

These new companies are targeting pain points facing small-business banking, competing with banks that previously controlled the market, and pushing these institutions to modernize.

In many cases, banks are choosing to develop partnerships with fintechs, rather than try to compete. For example, Funding Circle partnered with Kansas INTRUST Bank to provide small- business loans in the U.S.

While Funding Circle, which is based in the U.K., has already financed over $5 billion in loans worldwide, this kind of partnership provides legitimacy and further funding opportunities for the startup. In these partnerships, the startup provides the technical expertise and business experience while the bank can offer deeper capital channels and credibility. This natural partnership aligns previous competitors to lend the best possible service to underfinanced small businesses across the globe.

Small-business credit around the world dried up after the 2008 financial crisis and has only started to open up again in the past few years. When banks became incapable of rating and financing SME credit, governments and the private sector took over the challenge.

However, while governments have become involved in backing small-business lending, this kind of funding can sometimes be politically contentious, making it an unstable solution. That's why SMEs now often look to financial technology startups that offer agile, customer-focused financing systems designed explicitly for small-business needs.

Providing credit to SMEs is a notoriously challenging task. Depending on the size and formality of the company, the business may lack the invoices, credit ratings, significant assets or track record to qualify for a loan at a traditional banking institution.

Many banks require two years of official invoicing to back a loan. When banks cannot verify the creditworthiness of a business, they cannot provide credit. The credit line is too risky for their investors, and the bank runs a risk of incurring a loss.

While small businesses struggle to get credit in economies of all sizes, SMEs in developing markets face a particularly steep struggle. In markets with high levels of informality and bureaucratic banking systems, it can be next to impossible for a small business to apply for a formal loan. Looking at the problem from the demand side as well, many small-business owners have low levels of financial literacy, meaning they are not aware of alternative financing methods or do not know how to get a business loan. This credit crunch puts a cap on economic growth in every economy that depends on small businesses.

In the U.S., Europe, Latin America and Asia, fintech startups stepped up when banks could not, or would not, take the risk of lending to small businesses. Not only do these startups occasionally provide peer-to-peer loans, but they also have radically new ways to analyze the creditworthiness of companies that fall outside the traditional banking system.

At first, these startups preferred to compete directly with banks, providing financing where banks fell short. Most banks were unconcerned. When companies like Funding Circle, LendingClub and OnDeck were starting out, they were nowhere close to disrupting traditional banking. But over time, as these startups began raising more capital, partnering with financial institutions and providing thousands of loans, banks started to pay attention.

Fintech startups were better placed to understand and resolve the complex problems that small-business owners were facing, and banks began to realize the size of the market opportunity they were missing. However, banks still lack many of the tools to properly analyze and provide loans to small businesses, and fintech startups lack the capital to finance SMEs at scale.