Re-thinking lending – why we must learn from the lessons of the past

By Ian Johnson, Head of Europe, Marqeta

We are living in unprecedented times, with the COVID-19 pandemic heaping huge financial pressures on businesses, who are reeling from the effects – particularly SMEs. While extraordinary measures are being put in place through the government at present, when the dust starts to settle and some normality has returned to the economy, most will be looking to banks and lenders for access to funding to help them get back on their feet. When this time comes, we will need a completely different approach to lending, to ensure smaller businesses can access the financial support they need.

However, since the financial crash of 2008, many lenders in the UK have grown risk averse. The volume and value of lending to businesses has been decreasing since 2016. As a result, SMEs have struggled to access much-needed funds, through no fault of their own. Yet SMEs are the lifeblood of the UK economy, accounting for 99.9% of the business population, according to the Federation of Small Businesses (FSB). As and when the recovery from this current pandemic begins, it is vital that we do not strangle SMEs as we did after the previous financial crisis. Instead, we must ensure that help is there when needed.

Within this context, a new generation of data-driven alternative lenders in the fintech space are stepping up to fill the void.

Challenges in access to funding for SMEs

Over the past decade, traditional lenders have introduced tighter restrictions on lending. After getting their fingers burnt during the 2008 financial crisis, many traditional lenders have been turning viable businesses away – with 3.3 per cent more businesses labelled ‘high risk’ for lending in 2009 than in 2004. Yet these assessments are often based on outdated criteria and antiquated risk modelling, which does not give lenders the full picture in terms of a business’ viability. As a result, money doesn’t make it to the businesses that need it, stifling the economy.

This is in part because of the loan process itself, which involves a high degree of self-reporting and lengthy credit checks. This process can take months to complete, with lending criteria often favouring larger businesses over SMEs. This is then compounded with long response times, meaning funding is not accessible to smaller businesses when it is needed. Yet it is also due to a lack of visibility and control once the funds have been issued. Once a loan is approved, it is issued directly to the borrower’s account; the lender has no way of knowing what that money is then spent on. This heightens concerns about delinquency rates, as it’s impossible to know whether the business is spending wisely, or if they are likely to default.

All of this is particularly hard on SMEs – with just 36 per cent now using external finance, compared to 44 percent in 2012 – a factor that may have contributed to the fact that, in 2019, the number of UK companies going into administration hit a five year peak. Sadly, this trend is likely to accelerate in  2020, given the current turmoil; we will need to see a more inclusive approach to lending if we are to weather the upcoming storm.

Disrupting the current lending models

It is against this backdrop that we are seeing a new breed of fintechs, like Capital on Tap, entering the lending space. These companies differ from traditional lenders as they are technology companies at heart, so are more likely to naturally rely on data to inform their decision making. Offering SMEs an alternative approach to lending, these companies are able to bypass rigid lending criteria without significantly increasing their risk for several key reasons: they are able to make faster and more accurate data-driven decisions on loan applications, lend to more people, while still lowering delinquency and they can maintain control using virtual cards.

Open banking has opened up new possibilities for alternative lenders, firstly by allowing access to financial data from other providers – like previous lending requests and repayments. Secondly, as they are data-driven, these lenders are also starting to look at the abundance of additional data they have available to make these better, faster decisions. For example, using real-time location data to check where a business card is being used makes it possible to know if the loan is likely to be spent as expected, letting them release the funding as it is needed.

These technology-driven lenders also have much more visibility into how loans are being used. As we start moving towards Lending 3.0, more companies will have the capacity to distribute funds directly onto the borrower’s card. This gives the lender an overview of how any loan is being spent – from the geolocation, to the exact time of purchase and the specific amount. But more than this, it also provides the opportunity for the lender to set specific lending controls – anything from blocking spending in certain shops or websites, to putting a stop on the card at any time.

The ability to dispense funds directly onto a card offers another opportunity for funding providers – just in time lending. Instead of paying a loan which sits in the business bank account for days or weeks, lenders can provide funding exactly where and when it is needed, using the same visibility and controls as before. Ultimately, in relying on technology to make better decisions and retain some oversight throughout the entire financing process, alternative lenders are able to reduce their risk and counter high delinquency rates.

The future of lending is data-driven

We are facing a lot of uncertainty in the market, yet what is certain is that SMEs are going to need a lot of help to recover from the events of 2020. To meet these needs, lending in the UK needs an overhaul. We have begun to see more alternative lenders enter the market, empowered by data-driven decision making, as well as greater visibility and control. Although their role may be limited at present, in the longer term, these providers will be perfectly placed to support the underserved SME market. And as the finance industry begins to recover, we should begin to see the economic benefit in the years to come as SMEs are enabled to grow and flourish.