We are current writing a report for the Equipment Leasing and Finance Foundation on the topic of alternative financing. Our focus centers on what comprises alternative financing, why it is gaining in importance, and how banks and equipment finance companies should respond to these new players. As part of our work we wanted to size the market, both where it is today and its potential.

The best estimate (a rough one) is that today alternative financing is no more than a $10 Billion market, probably between 1/50th and 1/70th of the entire small business loan opportunity. However, while small today it is also growing at about a 100% rate as its products become more mainstream and its visibility increases. Therefore, we were more interested in the size potential for alternative financing going forward rather than its current numbers.

We asked Ray Greenhill, the President of Oxxford Information Technology, our data analytics partner, to quantify the opportunity available to nontraditional players. Oxxford can access over 200 databases in developing its analysis and is an acknowledged leader in working with its clients (and ours) to quantify market opportunities and develop product priorities. Given their 25+ years focusing on small business, they can offer very valuable insights that our clients have used to increase productivity and results by better target marketing.

As a starting point, Oxxford determined that in total 36.1 million businesses operate in the U.S. Obviously, most of those are very small, home-based entities (SOHOs) with little revenue. In order to determine which companies are traditionally bankable and which need to find funding from alternative companies, Oxxford screened the 36 million using three criteria often applied by bank lenders:

• The company’s sales volume ranges from $250,000 to $10 million.
• The small business has been in operation for more than three years.
• Its credit history shows that the company has an average or above average credit rating.

Many lenders have stricter criteria than this, adding screens based on industry, owner credit scores, etc., but even this minimal screen results in an important story. As Ray noted, “Based on generally accepted bank lending guidelines, only about 10% of small businesses would qualify for traditional bank lending. ” While this number excludes credit cards, it does offer a clear sense of how limited banks are in the number of those they serve. “Qualifying” businesses total 3.7 million. Those that do not qualify total 32.4 million companies, almost 90% of the total.

How does this translate into loan dollars? The 3. 7 million customers generate $544 Billion in loans. However, the 32 million provide a potential loan value of $1.746 Trillion in outstandings. Traditional lenders capture 24% of the total, leaving the majority for others.

For alternative lenders, these numbers suggest an enormous opportunity given to them by the banking industry. That is one reason why investment dollars have been flowing into the alternative space and companies like Lending Club and OnDeck are able now to launch IPOs with valuations in the billions of dollars.

Since the downturn of 2007 and beyond, banks have been operating inside a narrowed credit box, reminiscent of the classic cliché about closing the barn door after the horse has escaped. Arguably, many banks remain too conservative in their lending practices but that is a difficult argument to make, given past history. Further, in many cases the way banks operate – their often-convoluted internal processes, their inability or unwillingness to standardize how they operate, and for some their distrust of increasing reliance on data analytics – all these elements are in conflict with profitable small business lending. Instead of adapting to the realities of the market, many banks continue to go down the same track, blaming the small business segment rather than themselves for their profit problems.

Our client work with alternative finance companies as well as recent research demonstrates that these companies design themselves with the customer’s requirements and not their internal bureaucracy in mind. Unfortunately, too many “Dr. No’s” operate within banks, people whose job seems to be raising red flags and stopping innovation rather than determining how to let innovation flourish within appropriate regulatory requirements. That is one of the reasons that banks are unlikely to expand beyond the 10% customer number, even though there must be some opportunity or growth in a $1.7 Trillion dollar market.

We are big advocates of segmentation and the role it plays in increasing profitability and productivity. Nevertheless, few businesses exist in which it would be acceptable to focus on just 10% of the customer base. What should banks do? Should they broaden their current credit appetite? In fact, many should. However, the alternative finance experts we know are unanimous in their belief that banks will not enter this segment directly even though it is large, and many banks have the market power and access to information required to do so successfully. In their view bank culture creates the biggest impediment blocking this initiative.

A more likely path is to team up with others. Opportunities include:

• Buying portfolios of pre-screened loans from Lending Club and others.
• Becoming a lender to the industry.
• Using the processing/risk management platform developed by OnDeck, SmartBiz, or others in order to reduce costs, lever proprietary risk management capabilities, and profitably expand a bank’s lending universe.
• Providing turndowns to a specific provider like RapidAdvance or a loan marketplace such as Fundera. This allows banks to maintain control over the small business relationship and generate cross-sell opportunities while providing lending alternatives to customers who fail a bank’s criteria.

Banks should not ignore the alternative space. It is too vibrant and offers too many opportunities (related to origination, risk management, processing, and other areas) to ignore. Unfortunately, most will use the excuse of too many other activities, compliance, regulatory issues, or some other reason for not engaging with his group. Meanwhile, alternative lending moves on.

The head of one alternative lending company remarked that he thought that in a five to ten years alternative lenders will the main funders of small businesses. Given how established players have narrowed their focus, their disinterest in changing, and the amount of opportunity, his view seems reasonable. But what a shame that the bank industry is in the process of losing a core franchise that they can ill afford to lose.