Early last week, we stumbled upon this fascinating article, published by the Asian Development Bank Institute, that highlights a dichotomy in the adoption of artificial intelligence (AI) and advanced data analytics in banking and small business finance. While these technologies significantly facilitate long-term credit growth for small and medium-sized enterprises (SMEs) by reducing information asymmetry and enhancing decision-making processes, they simultaneously lead to an increase in the cost of borrowing. This dual impact presents a complex landscape for SMEs, offering improved access to credit but at a higher price.
The study utilized a dataset of approximately 179,921 European SME-bank lending relationships between 2009 and 2019. Interestingly, the study’s authors found that “bank technological advancement is positively correlated with all forms of SME credit growth.” Perhaps unsurprisingly, the findings indicated that such innovation appears to drive long-term credit products rather than short-term credit. Notably, the authors conclude that “[t]he results [also] indicate that relaxing the requirements for SMEs to access bank credit may challenge banks to increase the risk premium due to a potentially looser relationship or a relaxed attitude toward the collateral.”
The study’s authors in our opinion correctly conclude that “regulators should incentivize the adoption of” new technological solutions that ease the friction of SME finance transactions. Unfortunately, at least for creditors and borrowers in the United States, regulatory bodies such as the Consumer Financial Protection Bureau (CFPB) and the prudential banking agencies are intensifying their scrutiny of AI and machine learning technologies, which suggests that financial institutions may face increased regulatory costs.
AI, data analytics, and the alternative commercial finance industry
The use of emerging technologies by the alternative commercial finance industry represents a key opportunity to expand SME access to products, make better underwriting decisions (for instance, through the use of machine learning and alternative data in the decision-making process), and perform more effective due diligence and fraud prevention. As noted by Todd Ehrlich at FactorCloud in a fantastic IFA article on the subject, “[t]he rapid decision-making of AI and machine learning will create huge improvements in profitability and efficiency [and will lead to] lower costs, increase[d] speed, and reduce[d] risk.”
Technologies such as Generative AI are also well positioned to add value to commercial finance companies’ marketing and customer relations processes. Natalie Hogg at Method Q and Sarah Woodward at AI Growth Ops, in another interesting IFA Commercial Factor E-Magazine article, discuss how the use of generative AI can be leveraged for content creation, as well as hyper-personalized targeted campaigns through predictive analytics and everyday customer engagement through chatbots. Indeed, as Hogg and Woodward state, “AI is not just a tool for the big players; it’s a transformational technology accessible to entrepreneurial factors.”
The risk of overly burdensome regulators stifling innovation
While this technology is poised to transform many aspects of the industry, there is a substantial and imminent risk of stifling regulation in the space. Indeed, last week, the Federal Trade Commission and the Department of Justice, along with the European Commission and the Competition and Markets Authority, issued a Joint Statement on Competition in Generative AI Foundation Models and AI Products. While the primary bulk of the statement relates to risks to competition, the release notes the risk of practices such as price fixing, data security, and price discrimination. Moreover, the release notes that the use of AI can “turbocharge deceptive and unfair practices…” These concerns are consistent with regulatory concerns about the risk of discrimination and bias in the use of AI technology. For instance, last year, the FTC, CFPB, DOJ, and EEOC released a joint statement regarding discrimination and bias in automated systems. The agencies note that while AI systems “can be useful, they also have the potential to produce outcomes that result in unlawful discrimination.” The joint statement states that the agencies “pledge to vigorously use our collective authorities to protect individuals’ rights regardless of whether legal violations occur through traditional means or advanced technologies.”
And this doesn’t even begin to scratch the surface of what might be on the horizon. For instance, the CFPB is set to substantially expand the definition of “credit reporting agency” under the Fair Credit Reporting Act in a way that threatens to envelop any entity that collects and transmits data that could be construed as consumer report data.
How can you prepare?
- Discuss the current regulatory landscape with your outside counsel. We can’t count the number of conversations we have had with clients and contacts about the future of regulatory scrutiny, only to realize that there is risk under current regulatory regimes. Make sure your outside counsel understand the finance products that your company is offering so that your business operations are aligned with your risk appetite.
- Pay attention to emerging regulations related to emerging technologies and data markets. Regulators at the state and federal level are homing in on these issues, and they tend to perform their regulatory “surgery” with an axe rather than a scalpel. Put differently, new regulatory regimes that might appear to only affect one industry or sector often have direct and indirect down-stream effects. Regulatory changes don’t just affect your products. They can affect your vendor relationships as well. It’s critical to approach the regulatory landscape holistically, and with your entire business in mind.
- Let regulators and lawmakers know your position. Trade groups do a great job of representing the industry, but you can also let your voice be heard. On the regulatory side, federal agencies require public comment during the rulemaking process. It’s worth carefully considering filing a statement during the comment period, or participating in the comment drafting process along with your respective trade association.
- Don’t be afraid of using this technology. Yes – onerous regulations threaten to slow the adoption of helpful technologies. But this doesn’t mean that companies shouldn’t aggressively lean into tools that will help enhance their respective businesses. Carefully consider the actual risks and your company’s risk appetite, and then make a reasoned decision based on that analysis. After all, plenty of companies in the alternative commercial finance space are already utilizing these products and services with great success.
News and views
Alex Johnson, Fintech Takes, "The Ideal Small Business Lender"
We are big fans of Alex Johnson’s blog Fintech Takes, so it was a pleasant surprise to see him do a deep dive into the SME finance space. In particular, Johnson takes a stab at describing an “ideal” small business lender – which he states is a lender that:
- Delivers a fast and convenient borrower experience;
- Has useful first-party data;
- Specializes in a specific niche; and
- Has a balanced and sustainable business model.
This reflects many companies in the alternative commercial finance space. Factoring, a time-honored model dating back to the Middle Ages, may not be “innovative,” but it, along with models like supply chain financing, provides businesses with rapid access to capital on equitable terms that benefit all parties. The ongoing evolution of alternative finance sources, coupled with technological advancements, promises to enhance customer outcomes, increase access to fast credit, and, we hope, contribute positively to the broader health of the American economy.
ABF Journal, Delivering Yield Without Compromising Credit Quality
René Canezin and Ryan Dregney discuss the important role of junior capital in the ABF Journal. In particular, Canezin and Dregney describe how savvy credit investors are seeking yield in a market with lower interest rates. It highlights junior capital as a compelling option, encompassing instruments like subordinated debt, mezzanine debt, and preferred equity. Junior capital allows investors to enhance yields by moving down the capital structure without compromising on credit quality. For borrowers, junior capital offers benefits like preservation of control, customization, and strategic credit enhancement. This blend of debt and equity features provides flexibility and growth-oriented capital, appealing to both investors and borrowers.
Details on New Missouri Commercial Financial Disclosure Law
As we discussed last week, Missouri has enacted a new commercial finance disclosure law. Your authors put together a detailed legal update describing the requirements under the law, including new requirements that brokers obtain a registration. We hope you find it helpful!
Law360, CFPB Sued Over its Probe of Lease-To-Own Fintech Co
The Consumer Financial Protection Bureau (CFPB), the agency which has issued rules affecting commercial finance companies – such as Dodd-Frank 1071 – has been subject to intense legal challenges lately by trade groups. Most recently, the CFPB survived a close call in CFSA v. CFPB when the United States Supreme Court held that the agency’s funding structure passed constitutional muster. Well, the CFPB shouldn’t breathe too easily. Earlier this week, Acima, a lease-to-own company, sued the CFPB over the agency’s investigation into the company. Of interest, the plaintiff is levying a novel argument that challenges the CFPB’s funding structure. Specifically, the plaintiff argues that Congress funded the CFPB out of the Federal Reserve’s “earnings” and, since the Federal Reserve has operated at a deficit since 2022, there were no “earnings” with which to fund the bureau. Thus, any action taken by the CFPB since 2022 fell outside of the scope of the Constitution’s appropriations clause, and therefore was illegitimate. We will see where this argument goes.
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