Digitization of small business lending, arising from advances in technology, data, and analytics, combined with open banking, fintech innovation, streamlined regulation, and new capital pools, is transforming small business lending.

Banks have long placed limitations on their lending to small and medium-sized businesses for a variety of reasons: business strategy focused on larger loans, staffing levels ill-suited to administer a high volume of small-sized loans, process inefficiency, regulatory compliance; and an overall industry mindset that tends to deprioritize SMB lending.

While many regional and community banks prioritize small business lending, businesses owners have often found it difficult to secure the funding efficiently from big banks. In fact, the Federal Reserve assesses that almost 50% of small businesses in the U.S. do not receive all or part of the financing they seek. Further, some estimates of the global funding gap for SMBs exceed $5 trillion.

This funding gap hinders small business expansion, especially when one considers the huge role of small businesses in the overall U.S. economy. Indeed, small businesses account for an estimated 40% of the $29 trillion gross domestic product (GDP) in the U.S. Thus, the gap represents a major obstacle to the country’s economic growth.

Fortunately, small businesses lending is undergoing a technological transformation that is helping to expand access to capital while significantly improving the digital experience in the process. Advances in technology, data analytics, combined with embedded financing, and new, non-bank sources of credit have set the stage for an unprecedented shift. Access to capital is expanding, while lender exposure to risk has improved dramatically. Biz2Credit recently partnered with the Boston Consulting Group (BCG) on a white paper to examine the revolution in small business finance.

Funding challenges confront small business

To confront today’s economic challenges and support growth, small businesses need funding. Research has found that they are not receiving funding at the levels they need, and that they are frustrated by the slow approval process. The speed of funding is especially critical to SMBs, who generally lack the organization and human resources to anticipate needs into the more distant future. They are often willing to accept slightly higher rates in return for the swift provision of funding. Meanwhile, many small businesses have found that lenders are unwilling to extend credit at acceptable terms.

Some firms are deterred from pursuing funding at all, inhibited by the prospect of a time-consuming onboarding process or by previous rejections. Others receive some funding, but not to the extent required. These frustrations are prompting many small businesses to diversify their financial relationships.

For their part, many banks need to improve their technology, SMB-specific policies, risk-based pricing methods, and process automation in order to better serve the needs of small business borrowers. Although 82% of small business in the survey rely heavily on digital channels for account management, only one in three feels that their bank’s digital offerings meet their expectations

For small business owners, digital experience is another area in which banking often falls short, accelerating this diversification of their financial relationships. Dissatisfaction with the process has led nearly 40% of small businesses to consider alternative financial platforms. Many are interested in embedded financial services within their business software. For banks and other lenders that are willing to invest in digital enhancements and expanded offerings, there is a clear opportunity to capture more of the share of revenue from small businesses and build stronger client relationships.

Complexities of small business lending

Lending to small businesses has historically presented significant challenges for traditional banks. Among the reasons:

• Perception of higher risk: A generally conservative risk appetite, reduces the scope for financing for the SMB segment. Since the U.S. Bureau of Labor Statistics reports that 20% of small businesses fail within their first year and 50% within the first five, it is not surprising that banks perceive the segment to be higher risk. Additionally, banks have been cautious in lending to small businesses because many SMBs have limited operating histories and volatile patterns of cash flow.
• Reliance on outdated assessments: Insufficient technology, data, and analytics capabilities lead to higher costs and inefficiencies throughout the underwriting and loan management processes. Much focus has been put on personal credit scores, rather than factors such as monthly cash flow.
• Lack of digitization in the lending process: Even as the world has shifted toward digital some institutions are lagging in the investment in the digital experience for SMB lending.
• Banking regulations: Tighter regulations since the Global Financial Crisis stifled bank lending to small businesses. Commercial loans of under $1 million (a proxy for small business lending) declined from a pre-2008 approval rate average of around 23% to approximately 18% today. It is important to note that in the business-friendly Trump administration, regulations are likely to ease.

Related: Why Digitization Will Transform The Small Business Economy Under Trump

When the banks pulled back, fintechs and other forms of lending (such as Merchant Cash Advance) filled some of the void. Additionally, key public-private funding initiatives, including increased SBA lending (loans made by pre-approved banks that receive a federal government backing in case of default), helped put millions of dollars into the hands of small business owners. Yet, small businesses still struggle to get the funding they need.

Digitization of Small Business Lending: The Revolution Is Now

Advances in data analytics and technology, along with the entry of new forms of capital providers, are fundamentally expanding SMB access capital while reducing lender risk. A concurrent generational shift has occurred; the digital-savvy generation of younger business owners have embraced digital finance much more so that previous generations.

Fintech has enabled effective integration and cross-validation of high-quality data on small businesses and resulted in advanced analysis and monitoring. At the same time, small businesses continue to show appetite for integrated solutions that will cater to their needs.

Another benefit of technology is that it has increased efficiency via more effective utilization of advanced data and analytics techniques that are replacing labor-intensive processes. According to BCG, a total cost saving of between 30% and 40% is typically registered within the end-to-end credit process through implementing advanced analytical credit decisioning and ongoing monitoring systems.

APIs enable small businesses and third-party data providers to share information instantly with potential lenders, offering deeper insight into financial performance. Many banks already have valuable client data at their disposal when they possess a primary relationship or transaction account. As data and decisioning engines continue to improve, a broader scope of loans and loan sizes can be efficiently addressed through digitization. Meanwhile, SMBs are taking advantage of the opportunities created by digitization and now expect faster service and financial solutions that address their needs.

Changes in the lending landscape

New and broad sources of institutional capital to fund SMB lending are key to expanding credit access, which is reducing both the funding gap and the borrowing cost for SMB owners. Private capital is seeking attractive risk and yield in new and existing asset classes. Thus, private credit continues to grow, with assets under management expanding by approximately 20% per year over the last five years. Meanwhile, although the market for securitizing small business loans is in its infancy, it is showing significant promise.

Greater emphasis is being placed on cash flow underwriting today. Increased visibility into small business performance and data sharing has paved the way for higher-quality and more consistent underwriting of small business loans. Enhanced tracking of performance throughout a number of credit cycles now presents credit investors with extensive historical data, and the expanded dataset makes SMB performance more predictable and enables lender to identify performance risks more easily.

Related: 7 Ways Businesses Can Cut Costs While Maintaining Quality And Service

Lenders will need to accelerate the digitization and deployment of new data, technologies, and analytical methods. Past stagnation and conservatism in this area have hindered the servicing of the critical SMB segment. And while a transformation is now underway, it remains slow. They need to make their lending profiles more consistent and better structured.

Likewise, small business owners must be ready for this lending for this revolution by increasing their willingness to share financial and business data with lenders and service provider and embrace the digitization of small business lending processes.

In general, a greater number of more active market participants will be required across the entire lending value chain as SMB funding grows. These participants will include banks to securitize loans, government agencies to facilitate securitization, and ratings agencies to assess issuances.

The digitization of small business lending has benefited small business owners by expanding access to capital, providing more customized products, and improving customer experience. If they want to be successful, traditional banks will have to change, forge new partnerships with fintech companies to improve their processes, and rethink their approach to this vital segment in order to remain competitive.

New players, including fintechs and non-traditional direct lenders such as insurance companies and pension funds, will get into the direct lending game increasingly. Digitization of small business lending is enabling them to better navigate the challenges of risk management and build customer trust that many banks took for granted. We can expect private credit providers to play a greater role, adding both depth and flexibility to the small business lending landscape.