I am about a month into the blogging experiment. My main purpose is to get some thoughts organized around a few developments in impact investing for myself, and doing it in a (barely) public forum makes me slightly more accountable. My hope was to write three times a week for no more than an hour, and to set a relatively low bar in terms of prose quality. While I haven’t been able to write quite that often, and the prose has been as dismal as predicted, it has been a useful exercise for me and hopefully somewhat informative to the four of you who are reading. So, I’m going to keep going.
One of the downsides of semi-stream of consciousness blogging is that I will sometimes write things out of order. Last time I did an overview of the so-far-missed opportunity for impact investing through P2P and direct lending portals. What I didn’t do was say why any of us should care. Maybe it’s obvious to all four of you (hell, two of you know more about this than me), but allow me to give a few reasons:
By and large, banks aren’t lending - Of course, this is a blanket statement, but in general banks have retreated from small business lending, and with good reason. In the wake of the Basel II and the 2008 financial crisis, banks are increasingly careful how they allocate their risk capital and for many there are more profitable places to spend risk capital than small business lending. As a result, many small and medium businesses are starved for capital that would otherwise allow them to grow and add jobs. (Side note: Many CDFIs do great work in this space, but my general impression is that the problem/opportunity is much much larger than the capital they have to deploy. Find ways to support you local CDFIs!)
When they are lending, they are sticking to what and who they know - When banks are lending, they are keeping their underwriting standards high and rigid (again, for good reason - the less risky the loans are, the less risk capital they have to hold against the loans). They are sticking to individual businesses and sectors with which they have significant history, which means new businesses and emerging sectors go wanting. Businesses that don’t conform to these high underwriting standards are out of luck. I recently had an employee of a committed social lender tell me, “We’re in this business explicitly to make a business, and the loans we make are good loans. But as a bank, our underwriting standards are so high, if someone can get a loan from us, they have offers from 2 or 3 other banks as well. So what’s our real impact?”
Individuals have access to access to some credit but it’s really expensive - Even unbanked and underbanked individuals and families often have access to credit through credit cards or payday lenders, but this money is so expensive, its uncommon that their financial situation is improved by access to this type of credit.
For personal credit, the use of funds matters - I was talking to someone who understands the unbanked and underbanked markets better than I, and he told me that there is almost no evidence that providing people access to lower cost credit has any measurable positive impact in the medium to long term. Give someone with 25% credit card debt access to a 12% loan, and usually they’ll just be carrying a correspondingly larger debt load when you check back in a year. On the other hand, loans that are used to make an investment, starting a business for example, or to weather a one time trauma, like emergency medical expenses, or a fixing a broken down car you use to get to work, can have a lasting positive impact on the borrower. One unfortunate (and totally predictable) element of the Indian commercial microfinance scandal of a few years back is that impact investors told ourselves lovely anecdotes about loans being used for the latter purposes (investments and one time shocks) when most loans were being used for the former (consumption smoothing at best, unsustainable spending at worst.)
Non-profits and social ventures are developing innovative lending programs, but lending has a lot of moving parts and, therefore, scaling can be difficult (and sometimes dangerous) - Confronted by a lack of reasonably structured commercial sources of capital, both non-profit social service agencies and for-profit social ventures have ventured into the lending world to fill some of these gaps. Programs run the gamut from medical debt to auto repair to small business loans in traditionally underserved demographic groups. Many have identified group of borrowers and corresponding loan products that pencil out, both in terms of returns to investors. A few, like Progresso Financiero, have found ways to go to significant scale. But for most, scale is elusive. Why is this? Well, to answer the question, I have tried to write out the simplest diagram I can of how a person who needs a loan can get one:
I am probably missing a few steps, but the point is, it's a lot, and there is very little margin for error. Talk to any foundation program officer about the fantastic $20,000 revolving loan facility at a local non-profit that expanded to a $1 million and promptly collapsed under the weight of the operational demands of running a "professional" lending practice, and they'll give you a knowing grimace. I personally know of two very innovative non-profits in my home state of Oregon, both of whom were working with large pools of potential borrowers for loans that appear to have strong financial and impact characteristics. One raised a sizable ($10m+) fund based on the performance of a small test portfolio, but it eventually collapsed due to structural and administrative reasons despite the fact that the loans themselves were still performing. The other non-profit raised $5m of lending capital to invest into small businesses in a remote community, but eventually returned it unused because they couldn't find a reasonable plan to be able to process, underwrite, and service loans at that scale.
So you have banks that are fairly limited to who they will lend to, individuals who have access to a lot of credit that isn't good for them, and non-profits and social ventures that are innovating to solve these problems but have a hard time executing at scale. Now, remember from last time, P2P platforms (which from here on I'll call online lending platforms since most of their capital is coming from institutions now) are showing up on the scene. They have spent the last 9 years building the infrastructure and regulatory buy in to underwrite, process and service loans at massive scale. They are fundamentally different from banks in terms of their motivations and limitations. But so far, there hasn't been a big positive social impact in the way we were hoping back in Part 1. Today, if you are the sort of person who could get a loan already, online lending platforms offer you a much more convenient process to get a loan on somewhat similar terms to what you could get from a bank. It seems reasonable in the future that certain small business segments that should have had access to credit all along will be better served by some of these platforms than by banks. But if you are someone on the fringes of traditional finance, or an impact investor who has watched your traditional partners struggle to scale to serve all those people on the fringes, the massive efficiency gains promised by online lending have not yet been realized, either in terms of access to funds or the interest rate at which they are available.
But I think there is a lot to be hopeful for. That will be next.
Patrick Maloney lives in Portland, OR where he helps nice people working on cool stuff. He tries to limit his blogging to things about which he knows something.