Banking for small and medium-sized enterprises (SMEs) has been astonishingly unaffected by the rise of the Internet. Small businesses are starting to demand banking services that have engaging web and mobile user experiences, on par with the technologies they use in their personal lives. New digital entrants have spotted the market opportunity created by these dynamics, and the result is an explosion in online lending to SMEs from fintech startups. There are four broad strategies that traditional banks could pursue to compete or collaborate with emerging online players — and in some cases do both simultaneously. The choice of strategy depends on how much investment of time and money the bank is willing to make to enter the new marketplace, and the level of integration the bank wants between the new digital activities and their traditional operations. Two of the four options are low-integration strategies in which banks contract for new digital activities in arms-length agreements, or pursue long-term corporate investments in separate emerging companies. On the other end of the spectrum, banks choose higher-integration strategies, like investing in partnership arrangements, where the new technologies are integrated into the bank’s loan application and decision-making apparatus, sometimes in the form of a “white label” arrangement.

It’s been more than 25 years since Bill Gates dismissed retail banks as “dinosaurs,” but the statement may be as true today as it was then. Banking for small and medium-sized enterprises (SMEs) has been astonishingly unaffected by the rise of the Internet. To the extent that banks have digitized, they have focused on the most routine customer transactions, like online access to bank accounts and remote deposits. The marketing, underwriting, and servicing of SME loans have largely taken a backseat. Other sectors of retail lending have not fared much better. Recent analysis by Bain and SAP found that only 7% of bank credit products could be handled digitally from end to end.

The glacial pace at which banks have moved SME lending online has left them vulnerable. Gates’ original quote contended that the dinosaurs can be ”bypassed.” That hasn’t happened yet, but our research suggests the threat to retail banks from online lending is very real. If U.S. banks are going to survive the coming wave in financial technology (fintech), they’ll need to finally take digital transformation seriously. And our analysis suggests there are strategies that they can use to compete successfully online.

Lending to small and medium-sized businesses is ready to move online

Small businesses are starting to demand banking services that have engaging web and mobile user experiences, on par with the technologies they use in their personal lives. In a recent survey from Javelin Research, 56% of SMEs indicated a desire for better digital banking tools. In a separate, forthcoming survey conducted by Oliver Wyman and Fundera (where one of us works), over 60% of small business owners indicated that they would prefer to apply for loans entirely online.

In addition to improving the experience for business owners, digitization has the potential to substantially reduce the cost of lending at every stage of the process, making SME customers more profitable for lenders, and creating opportunities to serve a broader swath of SMEs. This is important because transaction costs in SME lending can be formidable and, as our research in a recent HBS Working Paper indicates, some small businesses are not being served. Transaction costs associated with making a $100,000 loan are roughly the same as making a $1,000,000 loan, but with less profit to the bank, which has led to banks prioritizing SMEs seeking higher loan amounts. The problem is that about 60% of small businesses want loans below $100,000. If digitization can decrease costs, it could help more of these small businesses get funded.

New digital entrants have spotted the market opportunity created by these dynamics, and the result is an explosion in online lending to SMEs from fintech startups. Last year, less than $10 billion in small-business loans was funded by online lenders, a fraction compared to the $300 billion in SME loans outstanding at U.S. banks. However, the current meager market share held by online lenders masks immense potential: Morgan Stanley estimates the total addressable market for online SME lenders is $280 billion and predicts the industry will grow at a 47% annualized rate through 2020. They estimate that online lenders will constitute nearly a fifth of the total SME lending market by then. This finding confirms what bankers fear: digitization upends business models, enabling greater competition that puts pressure on incumbents. Sometimes David can triumph over Goliath. As JPMorgan Chase’s CEO, Jamie Dimon, warned in a June 2015 letter to the bank’s shareholders, “Silicon Valley is coming.”

Can banks out-compete the disruptors?

Established banks have real advantages in serving the SME lending market, which should not be underestimated. Banks’ cost of capital is typically 50 basis points or less. These low-cost and reliable sources of funds are from taxpayer-insured deposits and the Federal Reserve’s discount window. By comparison, online lenders face capital costs that can be higher than 10%, sourced from potentially fickle institutional investors like hedge funds. Banks also have a built-in customer base, and access to proprietary data on depositors that can be used to find eligible borrowers who already have a relationship with the bank. Comparatively, online lenders have limited brand recognition, and acquiring small business customers online is expensive and competitive.

But banks’ ability to use these strengths to build real competitive advantage is not a forgone conclusion. The new online lenders have made the loan application process much more customer-friendly. Instead of walking into a branch on Main Street and spending hours filling out paperwork, borrowers can complete online applications with lenders like Lending Club and Kabbage in minutes and from their laptop or phone at any hour of the day. Approval times are cut to days or, in some cases, a few minutes, fueled by data-driven algorithms that quickly pre-qualify borrowers based on a handful of data points such as personal credit scores, Demand Deposit Account (DDA) data, tax returns, and three months of bank statements. Moreover, in instances where borrowers want to shop and compare myriad options in one place, they turn to online credit brokers like Fundera or Intuit’s QuickBooks Financing for a one-stop shopping experience. By contrast, banks — particularly regional and smaller banks — have traditionally relied on manual, paper-intensive underwriting processes, which draw out approval times to as much as 20 days.

The questions banks should ask themselves

We see four broad strategies that traditional banks could pursue to compete or collaborate with emerging online players—and in some cases do both simultaneously. The choice of strategy depends on how much investment of time and money the bank is willing to make to enter the new marketplace, and the level of integration the bank wants between the new digital activities and their traditional operations.

Two of the four options are low-integration strategies in which banks contract for new digital activities in arms-length agreements, or pursue long-term corporate investments in separate emerging companies. This amounts to putting a toe in the water, while keeping current operations relatively separate and pristine.

On the other end of the spectrum, banks choose higher-integration strategies, like investing in partnership arrangements, where the new technologies are integrated into the bank’s loan application and decision making apparatus, sometimes in the form of a “white label” arrangement. The recent partnership between OnDeck and JPMorgan Chase is such an example. Some large and even regional banks have made even more significant investment to build their own digital front ends (e.g. Eastern Bank). And as more of the new fintech companies become possible acquisition targets, banks may look to a “build or buy” strategy to gain these new digital capabilities.

For banks that choose to develop their own systems to compete head-on with new players, significant investment is required to automate routine aspects of underwriting, to better integrate their own proprietary account data, and to create a better customer experience through truly customer-friendly design. The design and user experience aspect is especially out of sync with bank culture, and many banks struggle with internal resistance.

Alternatively, banks can partner with online lenders in a range ways – from having an online lender power the bank’s online loan application, to using an online lender’s credit model to better underwrite and service bank loan applications. In these options, the critical question is whether the bank wants to keep its own underwriting criteria or use new algorithms developed by its digital partner. Though the new underwriting is fast and uses intriguing new data, such as current bank transaction and cash flows, it’s still early days for these new credit scoring methods, and they have largely not been tested through an economic downturn.

Another large downside of partnering with online lenders is the significant level of resources required for compliance with federal “third party” oversight, which makes banks responsible for the activities of their vendors and partners. In the U.S., at least three federal regulators have overlapping requirements in this area, creating a dampening effect that regulatory reform in Washington could serve to mitigate.

Banks that prefer a more “arm’s-length” arrangement have the option to buy loans originated on an alternative lender’s platform. This allows a bank to increase their exposure to SME loans and pick the credits they wish to hold, while freeing up capital for online lenders. This type of partnership is among the most prolific in the online small business lending world, with banks such as JPMorgan Chase, Bank of America, and SunTrust buying assets from leading online lenders.

The familiar David vs. Goliath script of the scrappy, internet-fueled startup vanquishing the clunky, brick-and-mortar-laden incumbent is repeated so often in startup circles that it is sometimes treated as inevitable. But in the real world, sometimes David wins, other times Goliath wins, and sometimes the right solution involves a combination of both. SME lending can remain a big business for banks, but only with deliberate choices about where to play and how to win. Banks must focus on areas where they can build a distinct competitive advantage, and find ways to partner with or learn from the new innovators.