“Online business lending is a very exciting new area to foster high-growth . . . businesses,” said Usman Ahmed of PayPal Inc., as he explained the results of an in-house study of PayPal Working Capital loans on businesses and communities.
Though small relative to traditional banking, the dynamic online market is growing at a fast pace and disrupting the small business lending industry. Online lenders are utilizing big data analysis to assess credit risks allowing them to provide businesses with targeted funding often without requiring collateral.
PayPal Working Capital (PPWC) is a unique product in this space and the basis of the study by Ahmed, Thorsten Beck, Christine McDaniel, and Simon Schropp. It is detailed in the latest issue of innovations. In February, Ahmed presented his findings to GERN members. The consequences for entrepreneurship could be substantial, as most of the online loans went to startups – i.e., business that were less than five years old.
“Small- and medium-sized enterprises (SMEs) account for more than one-half of the world’s GDP and employ two-thirds of the global workforce," Ahmed and coauthors wrote. Therefore, anything that helps these businesses thrive has large benefits to communities and countries.
“The number one barrier to growth faced by SMEs around the globe is access to financing,” they authors added.
The 2008 financial crisis exacerbated the problem as many bank branches closed their doors. A 2010 study by the International Finance Corporation (IFC) estimates that the global unmet credit needs are upwards of $3.1 trillion.
The original motivation for the study, Ahmed explained, was a hypothesis put forth by Karen Mills and Brayden McCarthy of the Harvard Business School, who wrote about the U.S. financing gap following the 2008 financial crisis. They noted troubling signs that bank credit for small businesses has been hit hard during the crisis and continued to decline during the recovery as banks decided making small business loans were too risky given the relatively low returns. In a 2014 study, Mills and McCarthy documented the emergence of new online lenders and suggested that these may be stepping in to fill the financing gap.
In absence of publicly accessible data on online loan transactions, however, it has been difficult to evaluate the impact of online business lending. Ahmed and his coauthors took the opportunity to look at PayPal’s proprietary data. “We thought we would analyze PayPal Working Capital loans and see whether we can actually show that,” Ahmed said.
The way that the product works, business owners are able to apply and receive funding in just a few minutes, Ahmed explained. There’s no credit check because PayPal has access to the applicant’s PayPal payment history (in addition to social interaction data and back-end financial data widely used in this space), which makes the Working Capital service unique. “We can look at the payment history and get a sense of receivables and the outgoing flows, and make a very accurate credit assessment.”
According to Ahmed, the most innovative part of PayPal Working Capital is its repayment mechanism, which is triggered by future sales. Instead of a traditional fixed-loan repayment period, Working Capital repayment terms are flexible, and change with the sales. In strong periods, entrepreneurs pay more, and on slow ones, they pay less. This has led to incredibly low default rates and very high ratings, as entrepreneurs appreciate the flexibility and ease of repayment. “They don't have to constantly search under the bed to pay off the loan,” Ahmed added. It also reduces repeat loans and the likelihood of a debt cycle descent. Since Working Capital was launched in September 2013, it has originated well over a billion dollars in loans.
To study the effect of online technologies on the business lending space, Ahmed and coauthors analyzed 60,000 U.S. loans. They also analyzed U.S. data from Kiva Zip, a person-to-person lending platform with zero interest rate. “A very unique product, zero percentage interest and [the loan] goes directly to the borrower,” Ahmed said about Kiva Zip.
Looking at how Working Capital loans were distributed across the country, they found a strong association between banks deserting certain areas and business leaders turning to PayPal for financial services. “A take away was that 25% of the loans were disbursed in 3% of counties that lost 10 or more banks since the financial crisis,” Ahmed said. The strong relationship turned out to be consistent with the type of banks that left these areas, he added, as the banks that shut down tended to be community banks, the primary providers of SME debt financing.
The findings point to online credit filling a void left by the closure of retail bank branches, suggesting the critical importance of new technologies in filling financing gaps. Significantly, however, Ahmed and his team went beyond this hypothesis to seek answers to questions about which types of businesses benefited most and the impact of online loans.
With the ever-rising focus on economic inequality, the implications of these technologies for income and wealth distribution are perhaps even more interesting. “When you look at traditional banking data, low and moderate income businesses tend not to get retail bank loans,” Ahmed said. “Only 20% of retail bank loans across the U.S. go to low-to-moderate income businesses.”
In comparison, Working Capital was granted to businesses of similar size at almost double the rate for traditional banks, with 35% of loans granted to low-to-moderate income businesses.
Business age and history are taken heavily into account by traditional financial institutions, which has resulted in low approval rates for young businesses. A question Ahmed and his team asked was whether online lending has improved access to capital for young businesses. The results were remarkable. 61% of Working Capital loans and 84% of Kiva Zip loans were made to businesses less than five years old. “Younger firms that don't have the history for a traditional loan are able to secure loans in the online environment.” Usman said.
Looking at the loans granted by Kiva Zip, they discovered an interesting finding regarding women and minority owned businesses. Both women and minorities are the majority in Kiva Zip loans, with 52% going to women-owned businesses and 63% to minority-owned, both much higher than traditional retail loans.
But, perhaps their most striking finding was the impressive growth in PayPal sales in those U.S. counties where 10 or more banks deserted: one year later PayPal sales had grown by almost 23%. Taken at face value, this figure is higher than online business growth statistics, and substantially higher than retail business growth during the period.
“When compared to a traditional loan,” Ahmed emphasized, “these tend to be small and targeted, with easy repayment terms.” These features could potentially explain the astounding 23% growth rate, as the loans are small-business tailored products, which businesses put to good use.
Many questions remain for future study. For example, how much do different factors, such as the customized nature of loans and the extent of credit constraints, drive the result? Nevertheless, PayPal, and others, have discovered that utilizing big data and digital platforms create new business opportunities, where traditional business models fail. Ahmed’s study is a remarkable start and a strong motivation for future research of online business lending. Because of the consequences for entrepreneurs, gaining an understanding of the underlying reasons behind the findings and how much the results generalize to other situations, including emerging markets, could impact all those who seek to support the development of entrepreneurial ecosystems across the globe.
Photo credit: eBay