‘Entrepreneurial talent is not the prerogative of the wealthy, but is broadly distributed throughout the population as a whole. Without reasonable access to financing, many of our countries’ most talented and aggressive entrepreneurs will be cut out of the economic system. Innovation and business development will become a luxury reserved for the wealthy, and the economy as a whole will suffer.’ Hanson (83)
Today, starting a business often requires getting a loan. Yet more often than not, getting a loan requires some form of collateral as security. As traditional types of security like the family home become further out of reach for the incoming generation of entrepreneurs, how will our traditional approach to lending need to change?
To answer this question, let us revisit the significance of collateral in tradition lending. Today, when asymmetries in information exist between two parties, security in the form of property has been a handy neutraliser, negating the need for lenders to spend a lengthy period of time assessing complex business models.
From relationships to algorithms
This has led banking away from a deeply relationship based approach to one that embraces a much more efficient model-based methodology, where credit is offered based on credit scores, cash flow, security and stability. And while the idea of having a close relationship with your business banker has all but vanished for most, in return we have broadly benefitted from faster application turn around times, online servicing and a broader range of lending products.
Yet it is a widely acknowledged fact that an entrepreneur or first time small business owner cannot compete on such factors against a more established business. With little to no credit history, no revenue to show and debts incurred during set-up, quite simply they are ‘credit outclassed’. Given both businesses new and old are often competing for the same credit, it is not unreasonable to see why preferential treatment towards more long standing businesses occurs. Of course any type of bias like this will, over time, lead to distortions in the way credit is distributed throughout the economy, with potentially wider ramifications.
Applying a commercial lens verses a fairness lens to this situation allows us to see two very different outcomes . Firstly, it is evident that lending to borrowers with demonstrated financial stability, good income and security is the best decision for a lender, and the wider lending institution’s financial health and stability.
But when we look through the fairness lens, and place ourselves in the borrowers shoes, (or, might I add, society’s), we may very well come to an opposing conclusion. Have we, by limiting our willingness to step outside of traditional credit assessment models for new businesses, stifled innovation and growth for the community as a whole? And what repercussions does this have for the fabric of the business sector at large?
The British Business Bank
In the UK, a government led initiative known as the British Business Bank is addressing this challenge head on. By partnering with local financial institutions, both new and old, and by applying a mixture of funding strategies – including government backed guarantees for small business owners – they are facilitating the flow of capital from finance providers to small business owners. Programs under the bank’s banner now support over 40,000 local businesses, with $2.9 billion in finance having been provided through its network of over 80 lenders.
Leverage technology to build a better borrower picture
Other ways to address this challenge could be via reducing information asymmetries between borrowers and lenders. One method in this vein is the ability for lenders to tap into financial data stored in cloud accounting systems to assess a company’s health. Many fintech startups and a few cutting edge banks have started taking tentative steps in this direction.
Another could be to leverage other data sources, like benchmarking tools, to more quickly build a picture of where a business should be aiming for. In Australia, the Australian Tax Office (ATO) uses data from over 1.3 million small businesses to provide a set of benchmarks across a number of ratios. If lenders were to work with borrowers, and set targets against benchmarks, good performance could be rewarded with a drop in rates. In fact, a graduated approach could lead to more traditional lenders getting comfortable in lending to startups.
Lending needs to adapt to a changing world
Whatever the future model is that we employ, the key word must be flexibility. We must build more dynamism into lending products that rewards good financial behaviour and outcomes and discourages poor ones. And rather than punish when poor behaviour does occur – of course, unless it is absolutely necessary – we must also acknowledge that the finance sector has a role to play in building better financial literacy amongst small business owners, to reduce the incidence of financial mismanagement.
The economy is changing rapidly. Some estimate in 10-15 years many of the jobs we have taken for granted for decades will no longer exist. Millennials face an uncertain future, driven more and more by technology, devices and automation. We must help encourage them to adapt to this new knowledge driven economy by branching out of the old and into the new. Business as we know it has changed and continues to evolve rapidly – therefore so too must our lending practices.
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