Karen Mills is someone who has a unique perspective on small business. She was a venture capitalist for 25 years before moving to Washington in late 2008 when she was appointed by President Obama to head the Small Business Administration, right in the thick of the financial crisis. For five years, until late 2013, she spent all of her time trying to help American small businesses and a big part of that was improving access to capital. Today, she is a senior fellow at Harvard Business School and is still very much focused on helping small business.
In this podcast you will learn:
- Karen’s background in venture capital.
- How she first got involved in the public sector.
- What it was like to start as head of the Small Business Administration in December 2008.
- Her first major step taken as head of the SBA that helped stimulate small business lending.
- The problem with the lack of data on small business lending.
- Why there is a gap in what small business want and what banks want to lend.
- Why Karen was so happy to see innovation from the online lending platforms.
- What banks are trying to do to compete with these new platforms.
- How the SBA views smaller dollar loans and their attitude towards non-bank lenders.
- What the loss rate was for SBA-backed loans during the recession.
- When the online lenders first got on the radar for Karen and the SBA.
- Why institutional capital has been so important to growth of online lending.
- What is most important when considering potential new regulation.
- Why it is difficult for small business owners to know the best loan product for them.
- Why it is important to have a self-regulatory body for this industry.
- A word of warning for the online small business but why Karen thinks the best is yet to come.
You can watch Karen Mills special presentation on The Future of Small Business Lending from LendIt USA 2015.
Click to Read Podcast Transcription (Full Text Version) Below
Peter Renton: Welcome the Lend Academy Podcast, session number 41. This is your host, Peter Renton, founder of Lend Academy.
Peter: We have a very special guest on today’s program. Karen Mills is someone who has been a champion for small business her entire career. She is most well known as the Head of the Small Business Administration from 2009 through 2013 and she was appointed by President Obama during what must be seen as one of the most challenging times for small business in many decades and she really did a lot to really help small business lending, help small businesses in general as the Head of the SBA. So I wanted to get her on the program to talk about the role of government, the role of regulation and where she sees small business lending when it comes to the online platforms, where she sees this going and what are some of the opportunities and risks for the sector. I hope you enjoy the show.
Peter: Welcome to the podcast, Karen
Karen Mills: Delightful to be talking to you today.
Peter: Okay, right, so I wanted to get started by getting a little background about yourself. Can you tell us a little bit about your career before you joined the Obama administration in the Small Business Administration and what you did before then.
Karen: Well before I went to Washington, I actually had a long career in the private sector in leveraged buyouts, in venture capital about 25 years starting in 1983, before there really even was leveraged buyouts. At that point, we bought a number of manufacturing companies; big injection molders, automotive suppliers, makers of electronics and sub-fractional motors all across the country and that gave me a real sense for how the American economy works and what it was like to sit in the control seat of a manufacturing company, particularly in terms of getting the right financing for that company, whether it be bank debt or equity and how to navigate the ups and downs of the economy. I actually run a number of those companies through the recession in 1989-91. That really gave me a sense for how we create jobs in this country and the role that small and medium sized businesses play.
Peter: So then was it your choice or ambition to join the public sector or did it just kind of fall into your lap?
Karen: I never thought at all about becoming part of the public sector, but in the early 2001, my husband took a job as the President of Bowdoin College and we moved to Maine and I got very involved with the governor of Maine in redeveloping the Brunswick Naval Air Station which had gone on the base closure list. The base was closing, it was right in my town and the governor said, well, you’re a venture capitalist, you probably can create some jobs and start some companies and we’re going to need them. This is your community, you have to help.
So I got involved with that and we created a cluster of the Maine boat builders and the composite technology sector. It turns out that there were tremendous innovation in faster and lighter composite boat hulls and we created an opportunity for all the small and medium sized independent boat makers to come together and that was really a lesson I took with me into Washington and into the Small Business Administration that as you grow an economy and create jobs in this next century, we can’t rely on big companies, especially in rural states like Maine, to come in and really be the generators. We have to look for innovation and then we have to create mechanisms for the small and medium sized companies to come together and get the scale that they need to get skilled workers, to get capital.
When I was doing that I ended up writing a paper for Brookings and ended up on the transition team for the Obama administration and then somebody said to me, well, how would you like to do this job and I said, well, I’d like to do it so we have to have an interview. I had an interview with the President, we got along and I was able to have the great honor of serving for about five years in his cabinet as Head of the SBA.
Peter: And so let’s talk about that for a bit because…I mean, you arrived at the SBA in probably the most difficult circumstances of the last 75 years, since the SBA was founded, I imagine, so you came in at a time when banks weren’t lending, layoffs were happening left, right and center, can you just talk a little bit about that time and what some of the things that you sort of did immediately to try and help small businesses.
Karen: The President appointed me in December 2008 and I think we forget today how difficult it was in that period of time for the whole economy, but particularly for small businesses. The credit markets were absolutely frozen, banks were not lending at all and I realized that we had to do something quite bold so I was able to persuade the rest of the White House economic team that we should raise our SBA guarantees to 90% and eliminate all of the fees on SBA loans. I call it the “hockey stick” that did happen because it really worked, but it took some persuading because people were concerned that we would get all the bad loans.
As it turns out, we got better and better credit because the marketplace was just unavailable to small businesses and great small businesses were having their credit lines pulled so we were really able to turn that around. We ended up having record years, $30 Billion of loans were facilitated by SBA guarantees into the hands of small businesses in those years and Congress came back and replenished our funds for doing this five different times, even in that difficult environment.
So it proved to me that if you were tenacious and you understood the facts behind the problem and you could prove that this was going to be critical to an important part of the economy, you could really get something done.
Peter: Yeah, for sure, so I’m sure that many of the stories of that time were…..people with multi-decade relationships with their banks with their credit lines that have been established for a long time and successfully been….payments being made and suddenly the rug was pulled out from under them and it certainly it did need some bold action.
I actually went back and watched your LendIt presentation a few days ago and one of the things you said there which struck me is that you talked about the amount of small business loans being held on bank balance sheets. You talked about they’ve fallen by 18% since the high, which was in 2008 and they really haven’t recovered. What are the reasons that it has remained flat or even declined while we’re having this recovery.
Karen: After I left the Obama administration, I came to Harvard Business School and had the opportunity to step back and really take a look at the data and analyzed the situation on small business credit. There was and perhaps still is a big argument going on in the recovery as to whether there is a gap in small business credit. The reason that there’s a big argument is that we actually don’t have the right data. In Dodd-Frank there is a provision for banks to collect that data, but it has not been implemented.
The data you would want is loan originations by size; by size of loan or by size of company so all we have now are the assets of loans under $1 Million that are on bank balance sheets and it’s a proxy for whether or not there are lots of small business loans out there. In fact, that number shows the deserving trend, which is that it peaked and then in 2007ish and then the client abruptly, of course, during the recession by 18% and has not recovered. So it was up around $700 Billion, it’s down to about $600 Billion and it has been flat even as things have been improving in the credit environment and in small business optimism. So that is one indication that the volume is not out there on small business loans that might have been out there in the past.
Peter: Yeah, that makes sense, and also along with that there’s a disconnect it seems with what banks want to provide and what small businesses want. It was talked about in many sessions at LendIt and you mentioned it in your presentation and you actually gave this great graphic about the $250,000 loan market and below. It’s what small business want and it’s the exact opposite of what banks want to provide so do you think the banks are basically giving up on that market and they’re going to cede it to these more innovative online lenders or do you think there really is a drive in some banks to keep lending small amounts to small businesses?
Karen: As you mentioned, there really, it turns out, is a gap in the small dollar loans. We looked at all kinds of data about the credit gap and found that under $250,000, maybe $150,000, that is a very difficult area for banks to lend. Why? Because they would much prefer to do a million dollar loan. It costs the same amount to do the underwriting as for a $100,00 loan and there’s much more profit in it. I actually went through the economics with a number of banks who showed me that it was unprofitable for them to make those smaller loans.
That was one of the reasons why I was so delighted to see innovation come from entrepreneurs in the form of online lending. Now there’s lots of evolution in that market place, but, initially, one of the things you could say is that there is a gap. It was not clear that traditional lenders with their cost structure were going to be able to fill it and that this is the area, as you pointed out, that most small businesses want. They want a loan say under $250,000 and many of them want a loan under $50,000 so having a different model with a lower cost structure, a more automated front end, a fast turnaround was really a welcome innovation for small business owners.
That said, it remains to be seen, in terms of the market evolution, how this is going to play out, but on the whole, showing a gap in the small dollar loans using technology is a positive.
Peter: In the paper that you…..your Harvard paper you talked about the status of business lending and it’s a very really detailed paper, in there you said that technology is one of the ways that the small business lending problem is going to be resolved. The thing is you talked with a lot of bankers in your time, why, the question that I’m not sure….obviously, the cost structures of banks are…there’s a legacy cost structures from the branch network and what have you, but why can’t or why won’t banks adapt and redo underwriting in a similar way to the online lending platforms?
Karen: Well, there’s a number of ways that banks are now entering the game. One way is that some of the larger banks are looking to just plain reduce their turnaround time and that is a real positive. Small businesses are getting loans the same way they did 30, 50, maybe even a hundred years ago. They walk into the bank, they create a mountain of paperwork, they leave it with the bank or they come back weeks sometimes even months later, maybe they get rejected, maybe they get a loan and that whole process is too long for the small business owner.
So the CEO of one of the major banks told me within the last month that they have completely revised their turnaround time and their objective is to get things turned around in days and weeks as opposed to weeks and months. That is all for the benefit of small business owners.
Some banks are changing their credit models to look at more automation, others are saying, you know, I would rather partner with one of the new entrants and if I want loans on my book, I could buy those loans from one of the online platforms and get my exposure to small loans that way. So there’s a whole range of reactions from banks and I think we are only at the beginning of the story and we will see it play out over the next six to eight to twelve months or maybe over the next several years.
Peter: That, certainly, I think……there’s going to be a combination. There will be some banks partnering, there’ll be some banks that will innovate.
Karen: They’re all waking up.
Peter: Yes, yes.
Karen: They’re all waking up and taking notice.
Peter: They’re all and it’s a good thing, it’s a good thing for small business, it’s a good thing for the economy as a whole.
Karen: And it’s a good thing for the banks because maybe they’ll find a way to access this market that they couldn’t before and they’ll be able to help in their communities and they’ll be able to help borrowers that they were turning away and when those borrowers want a larger loan, they’ll have a relationship with them.
Peter: So one thing that’s also been on my mind…you’re less than two years out from your SBA job, wondering would the SBA ever consider working with the online lenders or some of the more established lenders non-bank, alternative lenders or what you want to call them in creating like a guarantee program like there is with the banks? Or, is there some sort of regulatory hurdle or structural hurdle that will prevent that because it seems like that would be a great thing to help…..you know, you look at the small businesses that all want sub $250K loans and it seems like the online lenders could really help small businesses…and also, business owners want a government-backed loan or the lenders would make their funds more readily available if they know there’s a government guarantee. Is that something you ever looked at or is that even a possibility?
Karen: Well, even back when I was running the SBA, the SBA was a leader in looking at small loans processing and we did something called Small Loan Advantage where we actually automated quite a bit of the process of getting loans in the smaller amounts and that trend, I think, the openness to that trend continues. The SBA is governed by the existing regulations, but as different kinds of authorized lenders go out and enable small businesses to get loans and have good track records, I think there is certainly an openness among the legislators that I’ve spoken with to make sure that SBA continues to be able to provide support for the underserved markets, for those sizes where you need extra credit support.
One of the things, I think, that I’m very pleased that happened to the SBA in my tenure is that people really understood why it was important to have an agency ready to support a gap when the marketplace fails. We had a real failure in the marketplace in the credit crisis. Good businesses couldn’t get loans and even in good days there are pockets, underserved pockets. There are women, minority owned businesses have much more trouble accessing capital, but they are great businesses. One of the reasons we know is that the SBA did this $30 Billion worth of lending and the loss rate was under 5%. So these are good loans out there and we need all of those entrepreneurs that have access to capital so they can do what they do best which is create jobs and grow the economy.
Peter: Yeah, that makes sense to me. So I wanted to just switch gears a little bit and talk about the online lending industry per se which really has been around for a while. It was around before you started the SBA and companies like OnDeck, I think it was about 2007 they started, obviously Lending Club and Prosper have been around for a while, CAN Capital has been around longer than anybody, were these companies on your radar while you were with the SBA?
Karen: Well, I had conversations with several of them as early as 2010, I believe, because we did a number of forums on innovation and they were engaged with us, telling us about what they were doing, talking to us about how we could sort of try to innovate the marketplace for small dollar loans so we have had a long time…..I’ve had a long history of watching them grow, but I will say that even two and half years ago, the industry was in a really natal stage. When we wrote the paper last year, it was just beginning to emerge with some structure and as you know at LendIt, this past year it just exploded in terms of vibrancy in interest and capital. And I think one of the things that made the change is that institutional capital has found this market. I
In the early days, players had very, very little capital to offer in their lending portfolios and they had very, very high cost to access that capital. In the last year, institutional money has come in the form of hedge funds and other folks looking for yield and that money if it stays available creates quite a bit of energy and excitement around the industry and really has changed its profile.
Peter: Yeah, there’s no question that….you know, when we had our first LendIt which was in 2013, all of the small business lenders…..the platforms they were all like six months old or less pretty much. It was amazing how young they were and not all of them made it, but some of them will probably continue to struggle, but there’s a lot of entrepreneurial energy in this industry because ….I mean, let’s face it, in small business… everyone wants to help small business, I mean, it seems like it’s one of the few bipartisan issues that people believe that small business should have access to capital and everyone wants to help them.
Karen: On that point, I will say that’s one of the things I am most pleased about because I don’t think that small business was viewed as a bipartisan issue until my time in the administration and I give President Obama a lot of credit because he had the backs of small business owners from day one and that’s one of the reasons I was able to as effective as I was. He clearly made this a bipartisan issue and we were able to get the small business legislation passed that made some of the most important changes in over ten years.
This, now, I think is……now it’s understood that small businesses is an engine of growth in the economy, but when I began I had a lot of convincing to do on Capitol Hill and everywhere in order to make sure people understood the facts to help the people who work in this country own or work for small business and they really are the critical piece of creating new jobs.
Peter: I didn’t realize that’s…. it’s a relatively recent development. Interesting. I want to talk about regulation because this has been talked about a lot. There’s really no federal regulator that is overseeing the small business lending industry when it comes to online lenders and people talk about…these platforms, they have a regulatory arbitrage advantage because of that…I guess what I would like your opinion on is if you were in charge of regulating this new industry, keeping in mind that there’s a lot of innovation happening, how would you regulate it? What changes would you make from the existing structure?
Karen: I’m having a number of conversations in these weeks and months with existing regulators to discuss this issue. What should be the regulatory framework for this new segment of the market? And the core idea that I think is important is transparency.
Small business owners need to know how much they are paying, they need to understand the terms and conditions and they need to have visibility into the different options in some kind of comparable basis. It turns out that many in the industry feel that this is also important and will give them, in fact, competitive advantage and help the industry grow.
There’s a movement in the industry for self-regulation for even what they call a borrowers’ bill of rights. That is very important activity because at the moment there are no regulators stepping up and saying, this is my area to regulate. I’ve spoken with the Fed, the CFPB, many of the other folks and at this time there’s no concrete regulatory framework being discussed, but this could change quickly, particularly if there are some bad actors and small businesses end up paying the price.
So I think a move for industry self-regulation and an effort for transparency in the form that business owners can quickly and easily access and understand. Those would be major pluses in whatever regulatory environment comes forward.
Peter: Okay, that makes sense. I know that your partner on your paper, Brayden McCarthy, he was on this podcast a few months ago and he’s very focused on this borrower bill of rights and transparency. I think that’s one of the things that came up and I think you even mentioned it in your presentation. It’s one of the biggest challenges you say is that small business owners are not finance experts typically. They’re expert in whatever their particular niche is, but whether you go for ….there are so many options for small business.
One of the things you say is holding back the industry is the fact that it is not clear what the best decision is, what is going to be the right form of financing for a business. Do you think that this needs to be part of this kind of transparency, sort of a uniform way of presenting this information to a small business owner?
Karen: Well, we started this program talking about my history as an owner and operator of small businesses of all types and I could tell you from experience that it is very difficult for small business owners to know exactly what type of loan is right for them. I visited small business owners all across the country every week for five years listening to their stories about why they needed access to capital and it is something that a small business owner doesn’t always have visibility into.
When a small business owner wants to grow or wants capital they have to think very carefully about how much cash do they need and what are they going to do with it and how is it going to generate enough future profits to pay both the interest and the principal on that loan, how long do they need the money for? Is it going to be to buy a piece of equipment that should pay off over two or three or five years? Well then maybe they need a term loan. Is it to buy inventory that they are going to sell at Christmas or the holiday season? Maybe they need six months working capital loan.
So a small business owner needs some help thinking through their cash needs. This used to be the role of the in-person banker. An online lender has to think very carefully about how it is they are going to help small business owners get to the right loan for them. If they get a loan that’s too expensive or too short, it is quite possible that they won’t be able to handle that loan as well as they would if they had the right loan for them and that’s a bad outcome for the lender as well because what’s really going to happen is that the default rates will differentiate what the costs are for the different players and those who are better able to get a small business owner into the right kind of product are going to have a better outcome.
Peter: What you’re saying is that this really should be part of the self-regulation of the industry in a way where we have…..like in the UK they have the Peer-to-Peer Finance Association. They have a small business and consumer in that association. I’ve heard a lot of talk and Sam Hodges from Funding Circle has talked about it in front of Congress where we need to have a self-regulatory body that really polices all of the players or the main players in the industry. Now is that sort of …I guess, we’re talking about lobbying or even providing a unified force towards the regulators. I mean, this is sort of a no brainer, we have to have some sort of association.
Karen: The industry players that I have spoken to appear to be quite interested in being open in forming this kind of association for a whole set of reasons which are positive. In addition, though, individually in their own activities there’s lots of room for some of the different online companies to improve their transparency and to improve the way they help small business borrowers understand the product that’s right for them. As I said, I think it will help them get better credit and it will really differentiate the winners and losers in the competitive game if they can find a way to engage with small businesses in a low cost, online manner that actually helps the small business make better decision so that would be a winning strategy.
Peter: Sure, it’s like when we take out a loan….a consumer loan we have this Truth in Lending statement that is a mandated by the regulators but there is no equivalent of that with the small business loan and I think that’s maybe the reason we have to come up with our own. Maybe companies themselves can start doing it, but I think having a uniform approach because everyone of these…it’s challenging because there are different kinds of companies and different kinds of products as far as loan products go. We have a long way to go there and I totally agree with that. I hope we do get some movement on that. I’ve heard a lot of people talking about an industry association happening this year even so that would be good.
Before I let you go, I want to ask one last question about the industry and the future. We had Larry Summers at LendIt just before your presentation say that 70% of non-bank guaranteed, small business loans could easily end up in the online lending sector. Would you subscribe to that statement? Are you more bullish or less bullish than Larry Summers?
Karen: I think that there’s no question that online lending is filling the gap in the market place and it has some advantages that will cause banks to likely partner with them and imitate them in order to create products and services that have much quicker turnaround and much more cost effective cost than a traditional bank underwritten loan.
That said, I think that there are some things that we need to be a little bit thoughtful about when we look at how the growth of this market and that is that small businesses are very, very different. A lot of heterogeneity in the marketplace, every single one has a different kind of outcome and the algorithms that we are using now to test credit worthiness are in very early stages. They haven’t gone through the sessions, they haven’t really found exactly the secret sauce to differentiate good credit from bad credit. There’s a lot of innovation going on in these algorithms.
I think it’s fascinating and positive, but until we get that right, it’s hard to see the online lending not having a bumpy road so it will rise, it might have a bump and then it might move back to some of the pools of capital then it might rise again because it’s filling a very important need and the algorithms get better so I foresee a……I mentioned pretty good at looking around the corner and like everything that involves a small business, it’s never a straight line, but overall the trajectory will be that this will be here to stay and it will be an important component of small business lending. I believe that we are in the early stage of the game and we have yet to see the full evolution of the partnerships and the players in the industry. So think the best is yet to come and overall, it will be the good of small business owners.
Peter: Okay, great. On that note, I think we will leave it. I really appreciate your time today, Karen.
Karen: Thank you so much. I enjoyed it.
Peter: Okay, thank you.
That piece that Karen was talking about, about transparency and about having small business owners really understand what they are getting in for, I feel strongly about that. I think it really should be the cornerstone of what we’re doing. The platforms should be doing it. Certainly, any trade association it forms will….sounds like we’ll make it a very important part of being in that group.
To me, it’s just the right way to do business because we want to be able to make sure that every single transaction is a win-win. We want this to be a win for the small business and a win for the platform. Now some of the time I think of this high interest advances that companies take out. Sometimes it’s a win because it’s just filling a short term need, other times it’s not a win and other times the small business owner does not really understand their different options so anything we can do to make this more standardized and help the borrower make a more informed decision, I think, it can only to be a good thing.
Anyway on that note, I will sign off. I very much appreciate your listening and we’ll catch you next time. Bye.