Small and medium enterprises (SMEs) in any country routinely face hurdles in securing bank loans for the usual reasons: They can’t provide collateral to secure loans; they appear to be riskier borrowers than larger firms; or regulators have stricter norms for bank lending to them. But there is a sweet spot where SMEs and banks can work together, with fintech lenders playing a matchmaker, according to a new paper by experts at Wharton and elsewhere titled, “Collateral Effects: The Role of FinTech in Small Business Lending.”

In its study focused on France, the paper found that fintech borrowers, or small businesses, experience an immediate increase in bank credit, plateauing at 20% in six months after the fintech loan origination. That 20% translated into an additional 15,000 euros ($15,770) on average for an SME in France. The study covered some 2,000 fintech borrowers and 10 fintech platforms, which made up 80% of the market, between 2014 and 2019.

Such credit expansion, or an increase in the borrowing capacity of fintech borrowers, holds true for the U.S. market as well, said Wharton finance professor Huan Tang, who co-authored the paper with Paul Beaumont, finance professor at McGill University in Canada, and Eric Vansteenberghe, a doctoral student at the Paris School of Economics in France, who is also a research economist at Banque de France.

The Market Niche for Fintech Lending

Banks have limited presence in the market for unsecured loans because it is unattractive for them: Regulations require them to provide for unsecured loans double the capital adequacy buffer required for secured loans, the paper explained. But fintech lenders are happy to extend to SMEs unsecured loans to buy assets, which the SMEs can pledge as collateral to raise more money from banks.

“It’s a win-win situation for the fintech firms, their investors, and the SMEs.”— Huan Tang

Tang pointed to a few other reasons why fintech lenders make their market in unsecured loans. “Most of these fintech lenders are purely online-based, which means they don’t have the necessary resources to go after the firms that default,” she said. “It’s also a marketplace based on crowdfunding, where for each loan extended to a firm, there are thousands of individual investors backing that loan, or providing the funding for it. Even if the fintech lenders acquire the assets of defaulting borrowers, it will be very tricky to distribute that collateral or those assets among thousands of investors.”

How Everybody Benefits in the Fintech Market

“It’s a win-win situation for the fintech firms, their investors, and the SMEs,” said Tang. As in most countries, fintech lenders in France are not authorized to accept deposits from the public, and therefore are not regulated like banks are. In that setting, they have a market opportunity where they can raise capital from private investors, which they can use to provide so-called “junior unsecured loans” to SMEs.

To compensate for the risk they take on with such loans without collateral, or assets as security, fintech lenders in France charge interest rates averaging 8% annually, compared to bank interest rates that average 2%. The investors in the fintech firms take home annual realized returns averaging 5%, while the platforms on which they operate collect fees for their role as intermediaries between the fintech firms and the investors.

The paper noted that despite the “low creditor protection” associated with fintech loans, investors who back those loans find it profitable. “Overall, our findings suggest that fostering the supply of junior unsecured loans in the small business lending market has the potential to alleviate SMEs’ financing constraints, which reduce aggregate output and productivity.”

How SMEs Use Their Fintech and Bank Loans

The study identified some interesting traits of fintech borrowers who go on to tap bank loans. One, averaging at 150,000 euros ($157,000), the most popular use of the fintech loan is to buy assets, as opposed to commercial growth or to finance business development expenses. Two, while most of them used the fintech loans to buy assets, they did not seem to use the bank credit they could then raise to invest in additional assets. Instead, those borrowers use most of the additional bank funding “to substitute away from expensive sources of short-term financing (i.e., supplier trade credit), suggesting that firms actively consolidate debt to limit the risk of default,” the paper stated. Suppliers’ credit, or trade financing where firms get short-term payment facilities against supplies of raw materials or other intermediate products, can be as expensive as 40% annually, Tang pointed out.

“There has been no systematic default on the fintech platforms that would expose thousands of investors to financial losses.”— Huan Tang

Another trend the study found is that changes in default rates of fintech borrowers after the credit expansion depend on their financial health. If a fintech borrower had a low credit risk (compared to the median credit risk among all borrowers) before raising a bank loan, it did not become riskier than a comparable firm taking out a similarly sized bank loan, despite facing a higher repayment obligation. The converse also held true, where fintech borrowers with higher credit risk defaulted more than a comparable firm taking out a bank loan.

Fintech platforms arrived in France only as late as 2014 after regulatory relaxations allowed non-bank entities to carry out lending activities, the paper noted. Together, the 14 active fintech platforms collectively issued loans totaling some 530 million euros ($557 million) between 2016 and 2019. The platforms are allowed to put through corporate loans of less than one million euros each. Fintech borrowers in France are relatively small in number, accounting for only 0.5% of the borrowing base of banks.

Takeaways for Policymakers

According to Tang, one big takeaway from the study for the French central bank is that it does not have to start regulating fintech lending immediately. “What they worry about is financial stability — whether this model of unsecured junior loans is sustainable or not. There is no systematic default on the fintech platforms that would expose thousands of investors to financial losses, as of now,” she said.

According to the paper, its findings showed that “instead of replacing bank credit, junior unsecured loans enable firms to acquire assets that can be pledged to banks, thus complementing the range of financial products offered by traditional financial institutions.”