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September 30, 2015

Community Banks, Small Business Credit, and Online Lending

Remarks by
Lael Brainard
Board of Governors of the Federal Reserve System
“Community Banking in the 21st Century”
The Third Annual Community Banking Research and Policy Conference
Cosponsored by the Federal Reserve System and Conference of State Bank Supervisors
Federal Reserve Bank of St. Louis
St. Louis, Missouri

September 30, 2015

I would like to thank the event organizers for inviting me to participate in this
year’s Community Banking Research and Policy Conference. Supporting the health and
vitality of America’s community banks is an important priority for me. Community
banks have long been a central provider of finance to Main Street America. Despite the
challenging environment of the past several years, community banks have continued to
play a significant role in a number of key market segments.
Today I want to focus on one of the most important of those segments--the
provision of credit to small businesses--and to explore how the traditional role of
community banks may be affected by the growing role of online lenders. Some view the
growth of online platforms as a challenge to community banks in their traditional core
businesses. But it is also possible that the very different strengths of community banks
and online lenders could lead to complementarity and collaboration in the provision of
credit to small business while recognizing there are important risks that must be managed
by banks and borrowers. By working together, lenders, borrowers, and regulators can
help support an outcome whereby credit channels are strengthened and the possible risks
are being proactively managed.
Small Businesses, Small Business Credit, and the U.S. Economy
Small businesses make up a large and vitally important segment of the U.S.
economy. And their vitality hinges centrally on their access to credit.
More than three-fourths of American businesses have fewer than 10 employees
and another nearly one-fourth have between 10 and 500 employees. 1 In addition to
constituting the vast majority of firms in the United States, small businesses account for


See Bureau of Labor Statistics, “Table G, Distribution of Private Sector Firms by Size Class: 1993/Q1
through 2014/Q1, Not Seasonally Adjusted,”

-2 about one-half of private-sector employment. 2 And small firms, especially new small
firms, are an even greater source of net new jobs in our economy. 3 Thus, ensuring that
creditworthy small businesses have access to credit is vitally important.
Discussions of small businesses, along with their credit needs, often fail to
appreciate the tremendous heterogeneity that exists among these firms and, consequently,
the variation in their credit needs. Small businesses include plumbers and electricians,
medical and dental offices, dry cleaners and hair salons, restaurants and bodegas, as well
as growth-oriented tech start-ups and small manufacturers. They range in size from
having zero employees--which accounts for a very large share of small businesses--to the
much smaller share of small businesses with a few hundred employees. Although some
small businesses aspire to grow quickly, many others are unlikely to grow much at all.
While some have audited financial statements, most small businesses do not. Some have
assets that can be pledged as collateral, but many do not. Some have a long history of
solid, profitable performance, while others have short histories or a mixed track record
with regard to profitability.
Not surprisingly, there is also considerable variation in the credit needs of small
businesses. Some small businesses, particularly very small firms in knowledge or service
industries, may have little or no need for credit. Larger small businesses, and those that
require a substantial amount of equipment or need to hold sizeable inventories, tend to
have greater credit needs. Among small businesses that do need credit, funds may be
required for managing cash flow, for purchasing or maintaining property or equipment,


See Bureau of Labor Statistics, “Table F, Distribution of Private Sector Employment by Firm Size Class:
1993/Q1 through 2014/Q1, Not Seasonally Adjusted,”
For more on small firms and net new jobs, see Haltiwanger (2013).

-3 for building inventory, or for expanding operations. Depending on the needs, firms may
be interested in term loans, capital leases, lines of credit, or credit card loans. The
characteristics of a small business and the nature of its credit needs influence the type of
lender that is best suited to meeting those needs.
Community Banks and Small Business Lending
Community banks have long been a primary source of credit for small businesses
and today may continue to have the best business model for fulfilling many small
business credit needs. 4 But changing technology has led to increased competition in this
product space from both larger banks and, in recent years, alternative lenders.
Large banking organizations ramped up their small business lending between
2003 and 2008. Although they pulled back from this market segment in the wake of the
financial crisis, their small loans to businesses have been gradually rising since 2011.
Meanwhile, community banks experienced very modest growth in small loans to
businesses during the pre-crisis period, followed by a decline from 2009 through 2013
and a subsequent leveling-off. Consequently, community banks’ share of the dollar
volume of outstanding small loans to businesses at commercial banks has declined over
the past decade. 5 Despite this decline, community banks continue to hold about
50 percent of outstanding small business loans at commercial banks, far in excess of
their 20 percent share of commercial banking assets and deposits. 6


For purposes of this talk, I define a community bank as a bank with less than $10 billion in assets, which
is either independent or part of a banking organization that also has less than $10 billion in assets.
Small loans to businesses are loans to businesses with initial principal amounts of less than $1 million.
Data on bank assets, deposits, and small loans to businesses were compiled from Consolidated Reports of
Condition and Income, also known as Call Reports, that banks file with the Federal Financial Institutions
Examination Council. Data on banks’ small loans to businesses are widely used to proxy for bank loans to
small businesses because data on the latter are not collected.

-4 To understand the continued strong role played by community banks, it is helpful
to look at the differences in small business lending between large and small banks.
Although large banks and small banks now provide about equal dollar volumes of small
loans to businesses, they tend to provide different types of loans to different types of
borrowers, using different underwriting methods. On the one hand, large banks generally
have some advantages in the provision of transaction-based lending--that is, lending that
relies on hard or quantitative information such as financial ratios, collateral, or credit
scores. Small banks, on the other hand, have advantages in the provision of relationshipbased lending--lending based on context-specific or qualitative information, such as the
owner’s character and reliability and the needs of the community.
When we use Call Report data to break down commercial banks’ loans to
businesses by loan size, it is striking that most of the erosion in community banks’ share
over the past decade has been concentrated among the very smallest loans--those with
initial principal amounts less than $100,000. Among these so-called micro loans, the
share held by large banks grew from 42 percent in 2005 to 67 percent in 2015. In
contrast, large banks’ share of larger outstanding small loans to businesses--those with
initial principal amounts between $100,000 and $1 million--grew much more modestly,
from 39 percent to 43 percent, over the same time period. Business micro loans are
typically underwritten based, primarily or exclusively, on credit scores because the small
loan size makes it unprofitable to produce such loans using more costly traditional
underwriting methods. Thus, the growth in large banks’ share of micro business loans is
likely attributable to their ability to benefit from economies of scale in credit-score-based

-5 Business loans with principal amounts between $100,000 and $1 million are
generally not underwritten solely on the basis of credit scores--probably because lenders
are not willing to incur the risk associated with larger loan amounts without the benefit of
a traditional underwriting approach. For these larger loans--and for smaller loans where
the borrower does not qualify based on credit score alone--community banks are often the
lender of choice. Their local knowledge and close ties to the communities they serve
enable community bankers to establish a deep understanding of local businesses that
allows them to prudently provide credit to borrowers who might not otherwise be
considered creditworthy. A number of empirical studies confirm that relationships are
important factors influencing both the availability and the terms of loans to small
businesses. 7
Similarly, when we slice the Call Report data to separate commercial and
industrial (C&I) loans from commercial real estate loans, we see that while community
banks’ share of outstanding small C&I loans dwindled from about 54 percent in 2005 to
40 percent in 2015, their share of small commercial real estate loans has remained
relatively stable, moving marginally from 66 percent to 63 percent. Community bankers’
intimate knowledge of their communities and their familiarity with local economic
conditions provide an advantage relative to large, geographically dispersed banks in
underwriting commercial real estate loans.


Examples of such studies include Petersen and Rajan (1994), Berger and Udell (1995), Cole (1998),
Berger and others (2005), and Cole and others (2004).

-6 Since large banks are unlikely to become as knowledgeable about local economic
conditions or as adept at small business relationship lending as community banks, there
may be some limits to their expansion in this segment of lending.
Online Alternative Lenders
In recent years, online alternative lenders have also made inroads into small
business lending. There has been a lot of speculation about the effect of this sector on
traditional banks: Will it disrupt their activities, broaden their reach, or maybe a little of
Focusing specifically on nonbank alternative online lenders or online marketplace
lenders, it is important to underscore that the online space is highly dynamic, with a
number of business models emerging and evolving. I will touch on two business models
in particular, recognizing that as these business models are tested, it is likely that some
will prove more successful than others, and that some may adapt in ways that will cause
us to revise our segmentation of online alternative lending. 8 First, online balance sheet
lenders generally use their own capital to fund small business credit products that are
originated either directly on their platforms or indirectly through brokers or referral


As the industry has evolved, alternative online lenders have increasingly been referred to as marketplace
lenders, a term that helps emphasize the growing institutional investor base of the sector. So while peer-topeer lenders initially allowed individual borrowers to connect with individual lenders, individual lenders
increasingly are being replaced by institutional investors who are turning to online marketplace lenders for
investment opportunities. Because some balance sheet lenders are now originating small business loans for
institutional investors to purchase, balance sheet lenders are also often referred to as marketplace lenders.
In the Treasury Department’s recent Request for Information, they defined online marketplace lending as
“the segment of the financial services industry that uses investment capital and data-driven online platforms
to lend either directly or indirectly to small businesses and consumers.” (See U.S. Treasury, 2015, p. 6.)

-7 partnerships. 9 Credit products offered by these lenders are usually short term and include
loans, lines of credit, or cash advances. 10
Second, peer-to-peer lending platforms, by contrast, act as intermediaries to
connect borrowers with lenders and to assist investors in identifying and purchasing loans
that meet their investment criteria. These lenders can be individuals, banks, or
institutional investors. 11
Although data are limited on this sector, the data that are available suggest that
the various types of online alternative lenders have captured a small but rapidly growing
share of lending since the financial crisis. In aggregate, the outstanding portfolio
balances of these lenders have doubled every year since the mid-2000s. 12 It is estimated
that online alternative lenders originated $12 billion in 2014, with unsecured consumer
loans representing $7 billion and small business loans accounting for approximately
$5 billion. 13 While this amount represents only a small fraction of U.S. unsecured
consumer and small business lending overall, the rate of growth is notable.
Much of the growth in online alternative lending has been supported by
innovative uses of technology that allow lending platforms to streamline and automate
loan applications, expedite underwriting and quickly price risk, and provide loan
applicants with quick loan decisions and access to funds. Online alternative lenders use
algorithms to provide rapid decisions on loan applications, often taking into account


Online balance sheet lenders include companies such as OnDeck, Square Capital, Fundation,
CAN Capital, Kabbage, and PayPal Credit.
Cash advances, sometimes known as merchant cash advances, capital advances, or business cash
advances, are credit products that allow businesses to convert future credit card or payment account
receivables into capital (Lipman and Wiersch, 2015).
Peer-to-peer lending platforms include companies such as Prosper, Lending Club, and Funding Circle.
See Mills and McCarthy (2014, p. 42).
For information on online alternative lenders, see U.S. Treasury (2015, p. 6); for more on unsecured
consumer loans and small business loans, see Morgan Stanley Research (2015).

-8 information from a wide range of sources that are not typically involved in bank
underwriting of loans. For example, aggregated information for small business
underwriting may include data on online banking, accounting, bookkeeping, credit card,
shipping, supplier, and social media. So, while traditional banks often focus on personal
credit scores for underwriting consumer loans and the majority of small dollar, small
business loans, online alternative lenders may analyze a broader variety of data to
develop different metrics to measure and price loan risk. Currently, the largest platforms
typically offer online or mobile applications that allow consumers and small business
owners to easily submit information and aggregate vast amounts of data to complete loan
Although rates vary by platform and borrower characteristics, when taking into
account origination fees and repayment periods, the average annual cost of borrowing,
or APR, associated with loans and credit products offered by online alternative small
business lenders tend to be higher than those associated with traditional bank products. 14
Reports suggest that some borrowers are willing to pay a higher price in exchange for an
easy application process, a quick decision, and rapid availability of funds. 15
While some see online alternative lenders as a disruptive threat to traditional
lenders, banks increasingly are finding ways to partner with online alternative lenders,
including through loan purchases and referral agreements. Loan purchases by
community banks of loans originated by online alternative lenders have been focused on


For example, Mills and McCarthy (2014, p. 44) note that many alternative lending platforms charge
yields ranging from 30 to 120 percent of the loan value, depending on the size, term duration, and risk
profile of the loan. Several alternative online lenders advertise lower rates, but industry sources note that
lending is rarely done at those rates.
For example, see Clark (2014), Cortese (2014), Crowley (2015), and Mills and McCarthy (2014, p. 46).

-9 unsecured consumer debt. As the percentage of unsecured consumer debt outstanding
held by community banks has been declining in recent years, several banks have
partnered with online alternative lenders to grow and diversify their portfolios of
unsecured consumer debt. 16
In contrast to the consumer loan activity, the small business partnerships that have
developed so far are largely fee-based referral partnerships. In these partnerships, banks
refer to online alternative lenders some of their small business customers who are usually
seeking loan amounts that the referring banks may see as too costly to underwrite and
service, particularly in the size range below $100,000.17 For example, in 2014, OnDeck
announced small business loan referral partnerships with BBVA Compass and with the
ProfitStars Lending Network, part of the Independent Community Bankers of America
Preferred Service Provider program.
Another type of partnership that has been announced recently involves alternative
online lenders and Community Development Financial Institutions (CDFIs) that seek to
provide loans to low-income and underserved borrowers and neighborhoods. These
partnerships may enable the CDFI to use the online lender’s technology platform at no

In 1994, banks and thrifts with less than $10 billion in assets held about 69 percent of U.S. consumer
loans, according to an analysis of regulatory filings by SNL Financial. That share dropped to 19 percent in
2004 and 9 percent in 2014 (Tracy, 2015). Recently, BancAlliance, a consortium of approximately 200
community banks, has partnered with Lending Club to purchase consumer loans originated on Lending
Club’s platform and the Western Independent Bankers, a consortium of more than 160 independent and
community banks, have entered into a partnership with Prosper to encourage member banks to use
Prosper’s platform to facilitate consumer loans for their customers. Also, Lending Club and Citi
Community Capital, the community development lending and investing division of CitiGroup, recently
announced a partnership to facilitate up to $150 million in consumer loans designed to provide more
affordable credit to underserved, lower-income borrowers in low- and moderate-income communities.
As an indication of the demand for small dollar loans on the part of small businesses, the Joint Small
Business Credit Survey conducted in 2014 by the Federal Reserve Banks of New York, Atlanta, Cleveland,
and Philadelphia found that more than one-half of small business loan applicants sought $100,000 or less in
credit. (For more information, the survey report is available at

- 10 cost or for a reduced cost in order to make underwriting decisions faster and more cost
effective. 18 These partnerships are still in the early stages.
Risks and Opportunities
Across the Federal Reserve System, we are actively following developments in
the alternative online lending space and have engaged with several alternative online
lenders over the past few years to learn more about the industry, the technology, and the
business models as well as engaging with bankers to understand how these developments
are affecting their markets. 19 Most recently, several alternative lenders have participated
in events where we have joined with community development finance experts to discuss
ways to adopt platform lending technology to better serve low- and moderate-income
borrowers and small business owners. 20
We want to better understand the opportunities presented by technological
advances that may bring new data to bear and help lenders make available credit to a


For example, in June 2015, Lending Club and the Opportunity Fund, a California-based CDFI
microenterprise lender, announced a partnership intended to provide $10 million in loans over a period of
five months to 400 small businesses in underserved areas of California (for more information, see In 2012, the Association for Enterprise Opportunities (AEO) launched the TILT Forward
platform, an online lending platform that is powered by OnDeck’s technology and can be used by AEO’s
network of nonprofit community lenders and other community-based organizations to reach underserved
entrepreneurs (more information is available at
In April 2014, the Federal Reserve Bank of New York hosted “Filling the Gaps: Summit on Small
Business Credit Innovations.” and the Federal Reserve Bank of San Francisco will be hosting the
Consumer Financial Services Revolution in November 2015.
For example, in March 2014, the Board and the Federal Reserve Banks of New York and San Francisco
convened a small group of thought leaders for a discussion on the challenges and opportunities presented
by crowdfunding investments as a significant source of capital for the community development industry;
and in March 2015, we cohosted the Financial Innovations Roundtable with the University of New
Hampshire’s Carsey School of Public Policy and brought together representatives from banks, CDFIs,
mission-driven lenders, and small business online alternative lenders to talk about opportunities for
collaboration, the challenges of scaling up small business lending, and potential consumer and safety and
soundness regulatory issues facing partnerships between regulated financial institutions and alternative
online lenders. As the sector grows and evolves, we will continue to monitor the development of online
alternative lenders and the risks and opportunities that they may have for a range of stakeholders.

- 11 more diverse set of small business borrowers. In some cases, partnerships between
community banks and online platforms may help expand access to credit for consumers
and small businesses, and help banks retain and grow their customer base.
As regulators, we also want to help the various stakeholders anticipate and
carefully manage the associated risks. Of course, third-party and vendor risks are factors
that banks should always take into account when introducing new products and services.
Taking the time to identify and mitigate risks is a prudent step that banks can take to
avoid unintended consequences when entering into partnership agreements with
alternative online lenders. In addition, banks should consider whether the partnerships
provide new opportunities to diversify their portfolios if they are purchasing loans, and
whether the partnerships provide opportunities to offer new products that are a good
strategic fit for their bank and their customers. 21
It is also important for banks to carefully consider regulatory compliance. When
purchasing consumer loans originated by online alternative lenders, banks should
examine whether fair lending or unfair or deceptive acts or practices issues result from
the origination and underwriting methods used by online alternative lenders. 22 To the
extent that the underlying algorithms used for credit decisionmaking use nontraditional

If a bank is considering a referral partnership, the following questions could help identify potential risks:
Do existing customers have a need for the product or are there less expensive products that would better
serve borrower’s needs? Are the features, risks, and terms of the products offered through the referral
program explained clearly and conspicuously, or are they buried in a lengthy document full of “legalese”
that makes it difficult for borrowers to make a truly informed choice? Finally, are the products offered
through the referral partnership consistent with what would be recommended to a family member? (See
Curran, 2013.)
There are several regulatory compliance-related questions that banks should consider. For example, have
the loans offered or the lending platform to be partnered with been reviewed for compliance with
applicable federal and state laws? Have the loans originated by the partnering lending platform been
reviewed from a consumer fairness standpoint? When assessing referral partnerships, have any issues been
identified that would lead to disparate treatment of customers if banks selectively refer customers to online
alternative lending partners? (See Federal Reserve System Community Banking Connections Advisory
Board, 2014).

- 12 data sources, it will be important to ensure that this does not lead to disparate treatment or
have a disparate impact on a prohibited basis.
Aside from these risks, banks should consider a variety of others, including the
implications of credit risk stemming from the purchase of loans and reputational risk if
referrals to online alternative lending platforms end badly.
The risks I have described so far have primarily been from the perspective of
banks considering partnerships with online alternative lenders. Another important set of
concerns are focused on the small business borrowers who may be considering online
alternative loans. Some have raised concerns about the high APRs associated with some
online alternative lending products. Others have raised concerns about the risk that some
small business borrowers may have difficulty fully understanding the terms of the various
loan products or the risk of becoming trapped in layered debt that poses risks to the
survival of their businesses. Some industry participants have recently proposed that
online lenders follow a voluntary set of guidelines designed to standardize best practices
and mitigate these risks. 23 It is too soon to determine whether such efforts of industry
participants to self-police will be sufficient. Even with these efforts, some have
suggested a need for regulators to take a more active role in defining and enforcing
standards that apply more broadly in this sector.
No doubt, ongoing technological advances and the evolving competitive lending
landscape will continue to present both challenges and opportunities for community
bankers who are deeply committed to the provision of credit to small businesses. I
remain confident that community bankers will continue to play a vital role in the small


For example, see

- 13 business lending landscape as the respective business models of online platforms and
community banks evolve. The advantage that comes from close relationships with their
customers and intimate knowledge of their communities that lie at the heart of
community banking will continue to provide a powerful advantage in serving the vital
banking needs of small businesses, even as the use of nontraditional sources of data and
electronic processing platforms may permit faster loan decisions, especially for smaller
loan amounts, to a broader set of borrowers.
Thank you, again, to the conference organizers for inviting me to this important
event and for the opportunity to speak to you today.

- 14 References
Berger, Allen N., and Gregory F. Udell (1995). “Relationship Lending and Lines of
Credit in Small Firm Finance,” Journal of Business, vol. 68 (July), pp. 351-81.
Berger, Allen N., Nathan H. Miller, Mitchell A. Petersen, Raghuram G. Rajan, and
Jeremy C. Stein (2005). “Does Function Follow Organizational Form? Evidence
from the Lending Practices of Large and Small Banks,” Journal of Financial
Economics, vol. 76 (May), pp. 237-69.
Clark, Patrick (2014). “How Much Is Too Much to Pay for a Small Business Loan?”

Bloomberg Businessweek, May 16,
Cole, Rebel A. (1998). “The Importance of Relationships to the Availability of Credit,”
Journal of Banking and Finance, vol. 22 (August), pp. 959-77.
Cole, Rebel A., Lawrence G. Goldberg, and Lawrence J. White (2004). “Cookie Cutter
Versus Character: The Micro Structure of Small Business Lending by Large and
Small Banks,” Journal of Financial and Quantitative Analysis, vol. 39 (June),
pp. 227-51.
Cortese, Amy (2014). “Can’t Get a Bank Loan? The Alternatives Are Expanding,” New
York Times, March 5.
Cowley, Stacy (2015). “Online Lenders Offer a Faster Lifeline for Small Businesses,”
New York Times, April 8.
Curran, Teresa (2013). “Consideration When Introducing a New Product or Service at a
Community Bank,” Community Banking Connections, First Quarter,
Federal Reserve System Community Banking Connections Advisory Board (2014).
“Introducing a New Product or Service,” FedLinks, September,
Haltiwanger, John, Ron S. Jarmin, and Javier Miranda (2013). “Who Creates Jobs?
Small Versus Large Versus Young,” The Review of Economics and Statistics,
vol. 95 (May), pp. 347-61.
Lipman, Barbara J., and Ann Marie Wiersch (2015). Alternative Lending through the
Eyes of “Mom-and-Pop” Small-Business Owners: Findings from Online Focus
Groups. Cleveland: Federal Reserve Bank of Cleveland, August,

- 15 Mills, Karen G., and Brayden McCarthy (2014). “The State of Small Business Lending:
Credit Access During the Recovery and How Technology May Change the
Game,” Working paper 15-004. Cambridge, Mass.: Harvard Business School,
Morgan Stanley Research (2015). Global Marketplace Lending: Disruptive Innovation
in Financials. Morgan Stanley, Global Research, May.
Petersen, Mitchell A., and Raghuram G. Rajan (1994). “The Benefits of Lending
Relationships: Evidence from Small Business Data,” Journal of Finance, vol. 49
(March), pp. 3-37.
Tracy, Ryan (2015). “Lending Club, Small U.S. Banks Plan New Consumer-Loan
Program,” Wall Street Journal, February 9.
U.S. Department of Treasury (2015). “Public Input on Expanding Access to Credit
through Online Marketplace Lending,” notice submitted to the Office of the
Federal Register. Washington: Department of Treasury,