| Robyn Fadden – host: | For small and medium sized enterprises such as restaurants and retail stores or publishing companies and construction businesses, getting a bank loan is the first step to getting off the ground or a vital part of expanding and diversifying. Without collateral and credit, securing bank funding is difficult. In recent years, another form of business lending has popped up: FinTech companies. FinTech lending relies on algorithms to determine whether a business is worth the risk. |
| Robyn Fadden – host: | Desautels Professor Paul Beaumont recently researched the role of FinTech funding for small and medium sized businesses – he and he co-authors found that firms served by FinTech platforms have less in tangible assets than bank borrowers, but relative to similar firms that take out bank loans or were denied FinTech credit, FinTech borrowers experience a long-term 20% increase in bank credit after receiving their FinTech loan. |
| Robyn Fadden – host: | I spoke to Professor Beaumont about why this change in bank lending appeal happens, what businesses are most likely to experience it, and what the longer-term outlook of FinTech financing on small and medium sized businesses might look like, such as whether we’ll see an increase in successful businesses or certain kinds of businesses thanks to this alternative form of financing – and whether banks might change their tune about what businesses they fund in the first place. |
| Robyn Fadden – host: | Welcome to the Delve podcast, Professor Beaumont. The term FinTech is really an umbrella term and many types of companies fall under that, including companies related to blockchain and new technologies. Could you outline the kind of FinTech platforms you’re looking at in this particular research? |
| Paul Beaumont: | What we mean by FinTech here is like FinTech platforms that lend to small firms. So it’s, we are talking about the p2p lending business. So like peer p2p, meaning peer to peer, so, individual lending directly to firms. The p2p corporate lending business model is the second one in terms of size in the FinTech lending market. So, first there is like the consumer lending market. So like FinTech that lend to individuals, so on various lending to from lending to small and small and medium firms. So this is the second one in terms of size. And we’re not talking about like blockchain or this kind of thing. It’s really like it’s simple financing process, which is, I lend to a firm. |
| Robyn Fadden – host: | What are the small and medium sized businesses that FinTech companies would lend to and what are the typical ways that they would apply for and receive loans? |
| Paul Beaumont: | One thing that I want to be clear from the outset is that we’re not talking about startups here. Here we are talking about like, your everyday mom and pop stores – we’re talking about restaurants, we’re talking about small manufacturing firms, we’re talking about construction firms. Startups, it’s a whole different game – the goal of startups is to become super large, to become the next Google or Apple or anything. The research I’m talking about today is about how do small firms get funded, but there is a consensus in the literature that banks play a super big role, and it’s the reason why there have been many research papers written about the role of banks in in small business and lending since the 1990s. |
| Paul Beaumont: | The question then is, how do small firms obtain financing from banks? What is necessary for them to obtain financing from things from banks? And here, the classical problem that small firms face when they try to obtain financing from banks is that there is information asymmetry. So what do we mean by information asymmetry, it’s super simple: it’s very hard for a bank to know whether the small firm that wants to borrow money is, good on it, whether like, in two or three years, the firm will actually default or whether it would be not profitable from the outset, there is no way to know whether the firm is good or not. One thing that is important is that this kind of problem like information asymmetry is this kind of problem is like particularly acute for small firms. Why is that? Because we are talking about new firms, for instance, firms for which is not like no credit history for instance. The other reason is also like just more films, since they are smaller. They are more exposed to shocks, like if there is a recession, a small film will be more exposed to attend in the business cycle. So it’s just super simple reason that makes small business lending super complicated. There are structural reasons why it’s complicated for bank to lend to lend to a small firm. |
| Robyn Fadden – host: | Information asymmetry has caused major friction in bank lending since the 1980s, with more unreliable firms applying for loans and defaulting on them – these high default rates caused banks to increase interest rates, which caused reliable, non-defaulting or “good” firms to not even apply for loans. Society loses as well, as qualifying firms who don’t apply for financing aren’t able to bring their products and services to market. Information asymmetry still causes friction today in finance, but one way that banks have tried to overcome it is with more information, like credit history and accepted credible signals that indicate that an entrepreneur or a firm won’t default, such as collateral, including machines, equipment, real estate and other property. So we know that FinTech lending is clearly different than bank lending, but still subject to risk, defaults, and to certain regulations. In the introduction to your research paper, you talk about the 2008 financial crisis, which in some ways we saw an altered reflection of during the COVID crisis in 2020, with many small and medium sized businesses closing. Why did financial crises help FinTech firms grow and play a larger part in SME lending? |
| Paul Beaumont: | Banks are crucial for SMEs to get financed. And it’s important to understand that after 2008 crisis, everything changed for banks and hence everything changed for firms – it’s a very important period for banks. One important factor contributing to the 2008 crisis is the fact that banks leant to risky borrowers, what we call subprime borrowers. We realized two things. Thanks to the 2008 crisis, policymakers realized two things: first, banks take risks, and they have an incentive to take risks, and have more incentive to take risks than we thought. So it’s very difficult for policymakers to monitor the risk taken by banks. Policymakers had two major goals after the 2008 crisis: they wanted first to limit the incentives of banks to take risks and also be better able to anticipate episodes such as the 2008 crisis. |
| Robyn Fadden – host: | After the 2008 financial crisis, bank regulations became tighter and banks took fewer risks. That meant that with smaller businesses already being quite risky, banks began to loan less to those small and medium sized businesses. Limiting the incentives of banks to take risks results in costs to both businesses and society. In a sense, says Paul Beaumont, this is where FinTech companies come into play. |
| Paul Beaumont: | One thing that is important to understand is like the difference between banks and FinTech, they do not operate the same way. And actually, it’s important to understand how FinTechs work, but let me start with banks, mainly on how banks work. I am a depositor, so I’m a regular individual like you and me, I will put my money in my deposits in my bank. And the bank will use that money to lend to like for instance, fund small business firms. It’s not the same business model at all for FinTech. For FinTechs, we’re talking about individuals, like you and me, lending directly to small and business firms. So my name is Paul, I am on my web browser now. I will like have access to many firm profiles on the webpage of a FinTech. I can see whether it’s a restaurant, whether it’s manufacturing firm, and so on. I can see which type of projects the firm will want to undertake. I have access to some information on the firm such as balance sheet ratio, like some form of scores that the FinTech will attribute to and so on. So I will have information on the firm. And based on the information that I get, I will decide or not to lend to that firm. I lend directly to that firm. And this makes a huge difference. Because it means that here it’s my money directly that is that is given to the firm, that is lent to the firm. |
| Robyn Fadden – host: | That’s some serious incentive to avoid fraud, of course, so FinTech has to be regulated somewhat because of that, let alone other factors. |
| Paul Beaumont: | It’s normal that FinTechs are regulated somehow, but the main goal of regulation is to prevent fraud. As long as people are allowed to invest in the stock market, there is no clear reason why they should not be allowed also to lend directly to small and medium firms – you just want to avoid fraud essentially. It’s not the same thing at all for banks, because here banks are by definition, using other people’s money to lend to firms. |
| Paul Beaumont: | So, this is a super important difference, because it means that as regulators, as policymakers, we want that banks take the exact amount of risk so that they make profits because we want them to make profits after all, without putting the money of depositors at risk – you want to be sure that the one on the dollar which you put in your deposit is still very ungenerous. So, this is the reason why banks are, mechanically, more regulated than FinTechs. So, this gives FinTechs in a sense an advantage because like we just said that banks got more regulated at 2008, FinTechs are less regulated, so they face lower regulatory costs. And what we observed is that in a sense, FinTechs, they fill the void left by banks. So, banks lend less to small and medium businesses — FinTechs are less regulated, so they fill that void. |
| Robyn Fadden – host: | Is it possible to know whether FinTech is filling a void right now that banks have left where they haven’t funded small and medium sized enterprises as much as they used to? And whether FinTech is actually helping the economy, at least where these businesses are concerned? |
| Paul Beaumont: | We know that in France, it’s not the case. Based on the data that we use, just to give you an idea, the FinTech market is still small, like less than 1% of new loan are actually issued by FinTechs. So it’s still a very small market. But one thing that I want say is that it’s true that the FinTech market is still small compared to banks. But one thing that we have to realize is that the small business lending market is not innovative, we have been lending the same way to Small and Medium Enterprises now, for decades. There is research showing that in the finance industry, whereas, like productivity gains have been actually like quite low, meaning that the finance industry is claiming to be super innovative, but it does not show up in the data. And FinTechs it’s true are small compared to banks, but one thing that is for sure true is that they constitute an innovation in the way we lend to firms and this as scholars as researchers, this is something that is super exciting, because it means that finally at last, we have invented a new business model to provide funds to small and medium-sized firms. So this is one reason to care about FinTechs. |
| Paul Beaumont: | Let me give you another reason why to care about FinTechs. Small and medium firms, they do matter. Sure we’re not talking about startups, but like in terms of job creation. We know that like small and medium, small and medium firms, they matter a lot. They represent a large chunk of the job creation rates in the economy. And also we know that new firms are responding to growth opportunities to demand opportunities when we’re all like, new developments in the same in the industry, and when we are like new markets, like the way in the economy respond to those new opportunities is by the creation of new firms. it’s very important from the society perspective, and to make sure that we allocate the right amount of financing to those firms. So every type of innovation in that market is important from the society perspective. One major thing that FinTechs did is to show to the world is that you can have a different business model and still be profitable. And you can actually lend money towards from the various new way of lending to small firms – from the society perspective, it’s super important to know that, but it’s possible to innovate in that market. |
| Robyn Fadden – host: | Because FinTechs are small businesses in themselves, they take on the full cost of any business defaulting on the loan. To limit the amount of risk that they take, they diversify and expand the pool of firms in which they invest and limit the amount of financing they could provide to a single firm. So it’s unlikely that a FinTech will give 5 million dollars to one firm. Is this level of risk, with higher interest rates on top of that, an incentive or deterrent for a firm to go to FinTech companies for funding rather than a bank? |
| Paul Beaumont: | It’s a very important question, in a sense it’s at the heart of our paper. The premise of our paper is that we can see that FinTechs have a very different business model than banks. Individuals are lending directly to firms – it’s not at all the same setting, so FinTechs are not subject to the same regulations. Another thing about FinTechs do is that they rely a lot on new technologies — they screen firms using algorithms. So they also use very streamlined processes. When you go on with online FinTech websites, it’s surprisingly efficient in the sense that you just have to give some financial information on your firm, you have to give to describe the project that you want to finance you have to do some give some information. But like, after you hit sent, you will receive a response within like a day, or it can be within hours, actually. So compared to a bank, it’s like not at all the same process. |
| Paul Beaumont: | The question that we wanted to take here and in our research paper is: Are FinTechs just substituting for banks, so are they just replacing banks, filling the void? Or are they actually also expanding the set of products available to SMEs, available to small firms? And this is super important from society’s perspective, because it’s not the same at all. If they widen the range of products available to SMEs, it means that SMEs in a sense will be able to do more things to finance more diverse projects. |
| Robyn Fadden – host: | What did you find in your research data about whether FinTech is filling a void? |
| Paul Beaumont: | First, we saw that like, the prices of FinTech loans – FinTech loans are much more expensive. We are talking about loans that were issued, like before 2020, it seems like a whole different period. The average interest rate for a corporate loan issued by a bank, the interest rate would be about 2%. For a FinTech, it would be about 7.5. So we are talking about a huge difference, a huge gap. So it’s not just a matter. So it relates to your question, why are why would small firms be interested in paying more? |
| Paul Beaumont: | The second thing that we noticed is that it’s not the same firms that borrow from FinTechs. Typically, the firms that borrow from FinTechs are smaller, and have less tangible assets. What do we mean by tangible assets? We talked about collateral. Collateral, you pledge tangible assets to a bank, you will say, you can have my machine if I default. So this is what I mean by tangible assets, it’s something that you pay rent, you can pledge. So we have less tangible assets, which kind of suggests, when we suggests that this firm will have a harder time getting bank financing, because we have less collateral to pitch for the, it’s harder to simulate real times. |
| Paul Beaumont: | We see two things: the prices are not the same, and the identity of the firms are not the same. So it kind of suggests that banks and FinTechs are not competing exactly on the same market – if they were competing on the same market, they should more or less deal with the same firms and prices should be comparable, because otherwise, they would be priced out. It kind of hints at this idea that FinTechs are providing a different product or different service to firms. So the question then is, what is this service? So this is what we this is the research question that we wanted to address in the paper. |
| Robyn Fadden – host: | So FinTech firms can’t substitute for banks, especially for certain types of SMEs. What kinds of firms are going to FinTech today? Are these novel firms that are on the cutting edge of something new in the market or are they more typical small businesses? |
| Paul Beaumont: | So, first of all, I want to emphasize that we’re using French data, the French ecosystem, but we have no reason to believe that things would be super different in Canada, for instance, or the US. In terms of differences, we find that, for instance, in terms of industry FinTech borrowers will be located more in the service industry or the manufacturing industry. The main difference that we found between like bank borrowers and FinTech borrowers, is really about whether they have like tangible assets on their balance sheets. |
| Paul Beaumont: | FinTech borrowers can first be new firms. You want to start your restaurant, you want to start your, I don’t know, bakery or a temp agency, this kind of thing. But here we have like a chicken and egg problem, because you need tangible assets to finance the acquisition of let’s say, your restaurant, the premises of your restaurant. But if you don’t already have collateral, it will be harder for you to get that loan. So if, as an entrepreneur, you own a house, it will be easier for you to launch your own company, because it will be easier for you to get a bank loan. But sometimes you don’t have like, you don’t have you don’t own a house or like the house is not like the price of the house is not high enough for you to get that bank loan or so on. For new firms, especially, it’s hard to like get financing, because sometimes you just lack that collateral. And this is where a plan to get a FinTech loan can be advantageous because one important thing with FinTechs is that we already said that they are subject to less stringent regulations. And in particular, it’s less costly for FinTechs to issue unsecured loans. Like, since 2008, we tighten bank regulations, and the idea being that we want them to take less risks. |
| Paul Beaumont: | For a bank, it’s relatively costly to issue an unsecured loan — that is not the case with FinTechs. And, again, this is where FinTechs enter the stage like it’s – for them, like, they can in a sense fill the gap between banks and firms in a sense, but they can provide the funding that is necessary for film to let’s say, buy a house or buy by the premises of the restaurant or this kind of thing. By providing financing towards film to those newly created films FinTechs kind of solve the chicken and egg problem – they allow firms to purchase tangible assets. Typically, as I said like machines. And what is great is that those machines since we are not seen as, since the FinTech loans and secure, firms can then pledge those machines to get bank loans. So like, again, it’s sort of the chicken and egg problem, because like at first you had to film with no collateral, and therefore no bank loan. FinTechs arrive, they provide financing to those firms, those firms can invest in tangible assets, those tangible assets now appear on their balance sheet, banks are happy because it means that they can ask for collateral, which means that finally those newly created firms can get access to a bank loans. FinTechs, in a sense they fill that void in the market. |
| Robyn Fadden – host: | So in that way, FinTech allows them to grow, because they can go to a bank and show their collateral thanks to the loan they received from the FinTech company. |
| Paul Beaumont: | And this is exactly what we observe in the data. This is actually a very robust phenomenon. If we plot the amount of bank financing that a firm gets, we observe a super sharp 20% increase in the six months that follows the grant of a FinTech loan. Our goal in that paper was to understand why it was the case. So there was this collateral channel that we just talked about. So this idea that if you get a FinTech loan, you will invest in tangible assets, you will then pledge them to get a bank loan. So there was this mechanism, but there were also other mechanisms that could explain this phenomenon. |
| Paul Beaumont: | When such mechanism is, for instance, the information channel. So what do we mean by this? We talked about information asymmetry before and we know that FinTech or they rely on the algorithms, like data, big data, machine learning. this kind of stuff. It’s possible that FinTechs are actually better at extracting information on firms or at least they are able to observe different signals – banks are good at observing, let’s say certain forms of signals and perhaps FinTechs are better at observing other forms of signals. In any case, what could happen is that banks interpret the grant of a FinTech loan, as a positive signal on the quality of banks could tell themselves Okay, with this firm got a loan from FinTech A, this must mean since FinTechs are good at their job, that this firm is actually better than we thought. |
| Paul Beaumont: | We find that firms invest more after getting a FinTech loan, they invest more in tangible assets. And the increase in bank credit is stronger when firms invest in tangible assets. Which supports this collateral mechanism. So it’s consistent with this idea that FinTech lending is, in a sense, like, complimentary with bank lending. Why is that? Because thanks to the collateral channel, FinTech provide the funding that’s necessary to invest in tangible assets, which is necessary to obtain bank financing. So like the two forms of lending in a sense complement each other. |
| Robyn Fadden – host: | The effects of FinTech are being measured – we’ll see the outcomes soon enough. I’d like to know what small and medium sized enterprises can learn from your research findings? |
| Paul Beaumont: | So I think the main thing that entrepreneurs could learn from the paper is the existence of FinTechs. So to be honest, not all firms are aware of this, far from it. So just knowing that this kind of solution exists, that they are an alternative to banks can be helpful for some firms. |
| Robyn Fadden – host: | Could banks learn something from FinTech as well? |
| Paul Beaumont: | If there is one thing that we could learn from the business model from FinTechs is the way FinTechs streamline their funding process. In a sense, it suggests that banks could automate some processes, rely on the algorithms that FinTechs use to process loans faster. I don’t know when not which extent they will go that way. But it’s one way we could do, productivity gains. |
| Robyn Fadden – host: | Of course, this research is also something that could help policy makers understand the value of FinTech to SMEs. |
| Paul Beaumont: | I think policymakers could learn from our paper. What our research suggests is that this business model so far seems to be sustainable. And I mentioned that there is a cap on loans in the French market, so you’re not allowed to issue loans larger than the five millions, if I’m not mistaken. Is this gap legitimate or not? This is debatable. I completely understand the reason why our policymakers want to like limit the amount of risk taken by individuals, but there are also costs on imposing those kind of caps. What our research suggests is that it would make sense for policymakers to foster the growth of the FinTech market – that it seems that the business model not only seems to be sustainable, but also seem to like favor the access to credit of small firms and this is something that is desirable from the society’s perspective. Like the fact that obtaining a FinTech loan favours access to bank credit is something that speaks really in favor of the FinTech industry. So we hope that policymakers will hear that message and we hope that it will inform the debates surrounding the FinTech industry. |
| Robyn Fadden – host: | As the FinTech industry grows in popularity among a larger variety of businesses and evolves alongside changing economies and technologies, what can we expect in the coming years from both FinTech and the many businesses these companies finance? We’ll have to pay attention to both the economy and the research. |
| Robyn Fadden – host: | Our guest today on the Delve podcast was Desautels Faculty of Management Professor Paul Beaumont, discussing his recent research on FinTech lending and small and medium sized enterprises. You can find out more about this research in an article at delve.mcgill.ca. Thank you for listening to the Delve podcast, produced by Delve, the thought leadership platform of the Desautels Faculty of Management at McGill University. You can follow DelveMcGill on Facebook, LinkedIn, Twitter and Instagram. And subscribe to the DelveMcGill podcast on your favourite podcasting app. |
