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E-commerce growth and decline of cash may usher in new small business lending competition

Each swipe on those little plastic Square devices does more than make a payment. They build data sets that Square can use to build appeal to the small business lending market. Each swipe on those little plastic Square devices does more than make a payment. They build data sets that Square can use to build appeal to the small business lending market.

The growth in alternative lending over the last few years has been driven by data. Alternative lenders are using new types of data for determining creditworthiness to target borrower segments that have been underserved by banks, including small businesses.

Banks started pulling back on small business lending during the financial crisis, and bank loans of less than $1 million to small businesses have yet to recover to pre-recession volumes. Alternative lending startups like Kabbage and OnDeck Capital have been filling that void using new data sources like social media and proprietary algorithms for credit risk and terms. Kabbage announced in October of last year that it was lending more than $5 million per day to small businesses, and OnDeck issued more than $1.9 billion in loans to small businesses last year.

Challenge of entering mainstream

However, the commonly identified alternative lending startups in the small business space face the same hurdle that alternative lenders face across the board: They can’t grow beyond their niche market segments to attract mainstream borrowers.

Alternative lenders are attracting borrowers that many banks don’t want to lend to, such as very small businesses, and unbanked or underbanked consumers. But the most valuable borrowers, like larger small businesses, corporates, and mass affluent consumers, have still been turning to banks for credit.

This means that alternative lending startups like OnDeck and Kabbage, as well as peer-to-peer lenders—now typically called “marketplace lenders”—like Prosper and Lending Club, pose little threat to banks’ lending business long term.

That’s the good news, but it’s not the only news.

The growth of e-commerce and non-cash payments over the coming years will fuel the rise of a different group of alternative small business lenders that pose a more serious threat to banks. These are the digital commerce and payments providers Square, PayPal, and Amazon.

Digitals enjoy brand recognition

The reason these providers are well-positioned in small business lending is two-fold.

The first reason: These companies already have high brand recognition among small businesses and online retailers. Without such brand recognition, lending startups have had to partner with banks to help expand their businesses. For example, OnDeck agreed last year to license its online lending platform to JP Morgan Chase to help the bank speed up its application process for small business loans.

By contrast, Amazon, Square, and PayPal have name recognition that will allow them to grow their small business lending operations by simply growing and nurturing their existing base of small business clients. And their customer bases will likely expand as digital commerce continues to grow and cash transactions continue to decline, pushing more small businesses to use the services of these digital commerce and payments providers.

For Amazon and PayPal, the rapid growth of e-commerce will push more small businesses to use Amazon’s marketplace and PayPal’s online payments services. Forrester projects that the U.S. e-commerce market will grow to $523 billion in sales by 2020, up from $335 billion last year. Forrester also predicts that 270 million Americans will be shopping online by 2020.

That large audience—and the cheaper startup costs of an e-commerce business compared to a brick-and-mortar one—will drive more small businesses online.

The growth of card transactions and mobile payments will also drive more small businesses to adopt Square’s card reader and other services.

Total card purchase volumes in the U.S. reached nearly $5 trillion in 2014 (the latest year for which data is available), up more than 8% from the previous year, according to The Nilson Report. And in-store mobile payments volume in the U.S. will grow from $7.5 billion last year to nearly $500 billion by 2020, Aite Group projects.

The growth of these non-cash payments will lead to rapid adoption of mobile point-of-sale terminals: The global number of mobile point-of-sale terminals installed will hit 54 million in 2019, up from 13 million last year, according to 451 Research. This will give Square an increasingly large footprint among U.S. small businesses.

Valuable data with every transaction

The second reason that Square, PayPal, and Amazon have the most long-term potential among alternative small business lenders is the data they collect about their merchant clients.

Banks have access to incredible data about their clients, even though they struggle sometimes to make use of it. The vast majority of alternative lenders can’t match the account data, spending data, and market risk data (like delinquencies and write-offs) that banks have access to. 

However, Square, PayPal, and Amazon also have a great deal transactional data about their small business clients. Other alternative lenders like Kabbage actually use transactional data from Amazon, PayPal, and Square to help determine risk and terms for the loans they offer.

But PayPal, Amazon, and Square can gain even more data about small businesses that use their add-on services. For instance, Square provides services for managing payroll and invoices that can provide additional data for credit decisions. Square claims it can see more than 2,000 data points on its small business clients.

Amazon can also use data about its merchants’ inventories and customer satisfaction ratings.

While alternative lenders in general have struggled in 2016, this wealth of data means that Square, PayPal, and Amazon have more stable businesses than other alternative lenders. Square Capital, Square’s lending arm, boasts a 4% default rate, which is low for small business loans, thanks to the data it uses to determine risk. So although Square Capital had delays earlier this year getting investment, it actually has a stable lending business that should have little trouble attracting investors going forward. 

Additionally, Square, Amazon, and PayPal have very valuable data about how shoppers spend their money online and at small businesses, and they will have even more of this data as digital commerce and payments grow more popular.

PayPal’s and Amazon’s transaction data can give them insights into trends in the general e-commerce market, as well as valuable insights into the shopping behaviors of their consumer clients, who tend to be the most avid online shoppers.

And there’s more. These firms can also aggregate data from other services they offer—like the Pay with Amazon digital wallet and PayPal-owned Braintree’s payments gateway—to gain market insights.

As Square readers—those little plastic slide-through gadgets and more-advanced devices—become more popular, Square will also be able to gain an increasingly broad view of how consumers shop at small businesses.

Find a partner

All of this data will help these companies better understand the markets and individual clients they serve, which will allow them to better determine credit worthiness and grow their small business lending operations.

And these companies—like other alternative lenders—can crunch all of this data and issue credit much faster than banks. This will force banks to overhaul their own customer experience and streamline their small business loan processes.

Fortunately, there are partners that can easily help banks accomplish that goal: alternative lending startups. Other banks should follow the example of JP Morgan Chase and look to partner with alternative lending startups that provide platforms that simplify credit application and approval for small businesses.

Square, PayPal, and Amazon will look like increasingly enticing credit providers to small businesses if banks don’t take advantage of the opportunity to partner with alternative lending platforms.

Paul Schaus

Paul Schaus is CEO & President at CCG Catalyst. Follow CCG Catalyst on Twitter and LinkedIn.

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