Where Credit’s Due Ep. 2: How PayPal and Square use data and speed to drive growth in SMB lending

Securing loans from traditional banks is very tough for SMBs – it’s a long and complicated process and it’s not that likely they’ll get the cash they need – only 15% of small business applications get approved at big banks, for example.

This is another reason why digital players like Square and PayPal were able to grow to be some of the largest SMB lenders in the US, underwriting billions of dollars in loans to the small business sector in 2021.

And that is the reason why the two companies are my guests today - I talk to Luke Voiles, general manager at Square Banking, and Bernardo Martinez, vice president of Global Merchant Lending at PayPal - to hear their thoughts on small business lending.

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The following excerpts were edited for clarity.

What drives small businesses to get financing from digital lenders rather than go to traditional banks?

Bernardo Martinez: SMBs have been hit very hard by the pandemic. I think that the ultimate issues that have been understood for a while by the traditional banking industry is that lenders like PayPal have been at the forefront of using data, to really overcome some of the fears that they have when they go when they apply for a loan. Traditional banks typically have not invested in this process.

The customers want you to talk to them – they don't really know how to start with a bank, what data they need in order to apply. PayPal is really trying to come up with tools and solutions that deliver lending in a fair and transparent manner. I think that's why they have looked to companies like us – it's a true evolution that we have been able to come and help those SMBs and solve their needs.

Luke Voiles: There's some pretty great data from the Federal Reserve about what's happened to small businesses through the cycle. I think 82% tried to get PPP loans, they needed help coming through the cycle. And now that we're coming out the other side, this is where we're seeing the market start to stabilize, which is great for the SMB customers that we serve.

The banks just don't serve these populations – they're just too small and don't have credit scores, so it's just really tough for them to get access, and the process is very time consuming. It's just a prioritization of time and resources, and if they can get a loan quickly from a digital lender, then they'll do it. The thought process of trying to put together the paper package of documents and get that loan, it's just overwhelming for the small businesses that are just trying to kind of start and grow.

What makes it easier now for fintechs to underwrite to SMBs? What role does alternative data play here?

Bernardo Martinez: Pay Pal is really using the payment information that we have available, and really predict their ability to repay. I do think that some of that data may have been available to banks as well, they just haven't invested in the infrastructure. I think the ultimate goal here is that as the economy continues to digitize, we are going to be able to use more information that was probably not scalable in a traditional underwriting process. And now we can scale, when you look at payment data as it is now you can go to a deep level of granularity.

Luke Voiles: At a traditional bank, you have to get a validated long timeframe view to see trends on what's going on with the data. The way the banks would do it is get like two years of audited financial statements, and two years of tax returns, right, so that to them, somebody else's double check that they filed it with the government, there's some validation there. And you can see at least a trend over a two year timeframe and maybe six months old, because they filed these things six months ago, but at least it is some snapshot of a validated trend in view.

What's different about the customers that we serve is that they're super small, they might even have an LLC, like they're going to be a sole prop that just started their business. But the data set that we both use is like a credit card transaction. So you can see every single transaction with a customer's permission to offer them a loan, because you can see that last year, or even the last three months, they processed $100,000 in credit card transactions. With machine learning models, you're able to predict what the next 12 months look like. And you can pretty safely give them 10% or 15% of that amount. It is just a different mindset of underwriting as well – you don't need that holistic view, you just need to very accurately predict one thing with very unbelievable validation. What that fundamentally allows us to actually make financial services fair, accessible and inclusive, so we're serving these micro businesses that have under $100,000 in revenue, and they likely have no FICO score.

What do you make of banks pushing into small business lending by acquiring fintechs? As we've seen with Kabbage and Ondeck, for example.

Luke Voiles: I think it's interesting. If you look at the Kabbage-Amex deal, it's more of a data play – they're trying to figure out how to get access to larger alternative datasets that they can then underwrite and then sell the same product to their traditional customer base. With fintech lending, you have to have a cheap way to acquire customers, so embedded finance just makes it easier. The banks have broad swaths of customers and try to cross sell, but they just can't figure out the whole fintech part, right, which is how do you get the data in? How do you create a credit model that's going to work for this population? And how do you serve that population and convince your credit committee that it's a good idea to go make it happen? Within the banks, they need to get approval from 10 different people to actually make anything happen. It's almost like they can't get out of their own way.

Bernardo Martinez: It's a mindset and legacy issue in the sense that most of the banks’ data and infrastructure is not set for mining to take advantage of that data in a simplistic way. They may actually be able to use a third party company and accelerate that, but at the end of the day, as Luke mentioned, they have to go through multiple committees to really get this approved, and get the resources and investment that are required to take advantage of this. Sometimes banks have other opportunities, and that's why they have not been at the top of the list, and that's the reason why you don't see them acting as fast as they have probably had done in other segments.

What are the main drivers that have been behind the recent post pandemic growth that we've seen in small business lending?

Bernardo Martinez: I'll start with in our case. I think coming back to some of the initial conversations I had with SMBs after their pandemic, they know that there are new opportunities to grow their business today that were not present before. So they're rethinking about opportunity, how they grow and evolve their business. And some of those alternatives are new. Some new opportunities require capital, so they're seeing loans as a way to provide capital for their growth initiative. So I think that there's a little bit of a shift in mindset, if you will. In addition, we all have started to see a little bit more inflation and supply chain issues, and they're trying to serve issue areas from a higher cost of labor, but also potential different suppliers that require additional capital.

Luke Voiles: Business confidence was broken for a minute. But now, business is back to normal. A lot of the stimulus has been driving excess demand - customers are back buying, which increases business confidence, so they think it's time to grow. It's nice to see these businesses feel confident enough to take the capital and to expand. In Q4 2021, we helped 100,000 small businesses get loans.

One of the biggest trends in the industry at the moment is embedded finance - how do you see small businesses interact with embedded lending in the future?

Luke Voiles: The journey of the small business customers is the easiest way to describe all the pain points that we've been solving for our customers over time. As a small business gets started as a sole prop, they want to accept credit cards. But the whole payment setup causes a two or three day delay in getting the money from those credit card transactions, so we added instant transfer, where the customer can immediately and instantly get the money deposited in their outside bank account and then use their debit card instantly to shop with the next Square seller. That's all well and good for customers that actually have an outside bank account. But if you don't, what do you do? Well, okay, we'll give them a debit card, we'll push the limit, like start working on KYC and KYB to open up to more and more of these businesses that may not have a FICO score or credit score or any credit profile at all.

The table stakes features are just based on the uniqueness of our micro business customers -- we continue to solve those problems one at a time, and continue to build out a broader kind of embedded full suite of financial services. It's not just embedded lending -- it's embedded financial services for these small business customers. And we're going to do it globally. We want to launch these suite of financial services products to help customers in other countries and larger customers get access to these financial services in a way that it's just easier for them to use and an automated like simple fashion, you don't have to go into the banks anymore.

Bernardo Martinez: It's similar in our case. We have multiple products in multiple countries that we serve. We will continue to build our solutions according to the requirements of our customers. The lending and financial services we can come up with have the ultimate goal to offer a very simple approach to fulfill all their needs in a very simple, transparent and easy way compared to traditional players that may have not been able to accommodate these needs because of the way they grew up in their in their ecosystems and the technology they use.