People are worried this could be the next US 'subprime' crisis
Harvard Business School's Karen Mills said regulators are "very anxious" about the fact that loan brokers are now referring leads to online small business lending platforms in the US.
Mills said these are the same brokers whose "predatory practices led to the financial crisis" and said: "They are under watch."
Mills told the LendIt Europe online lending conference in London on Tuesday: "We have the emergence of the loan brokers [in online small business lending] so the questions is, 'Is this the next subprime mortgage market?' This has many people very anxious."
Mills was the head of the US Small Business Administration from 2009 to 2013 and a member of President Obama's cabinet, so she knows what's going on.
She says the fear among regulators is that loan brokers could be referring low-quality borrowers who may default and create another subprime debt crisis like the 2008 mortgage meltdown in the US.
But she was keen to stress that not everyone is so worried about online small business lending. The alternative view among regulators is that online lending platforms should regulate themselves. Mills said her view is somewhere in the middle of both positions.
She said: "On the other hand, and I subscribe to both of these, we have people who say this is a nascent market that is serving the need of small businesses, good for them. They're filling it in a cost effective way. We should have the industry get together and begin to self-regulated."
Online lending has exploded around the world since the financial crisis as traditional bank loans for both consumers and small businesses have dried up. The sector ranges from on-balance sheet lending to peer-to-peer marketplaces that fund loans.
In the US, the most high-profile online small business lenders are Lending Club, Kabbage, and Funding Circle.
The big problem is America doesn't actually have anyone looking at the sector right now, even in a hands-off way, as there's no clear body who would have oversight. Mills said: "There is no designated regulator. We have a spaghetti soup of regulators."
By contrast, online lenders here in the UK are currently in the process of being regulated by the Financial Conduct Authority.
The worry is that while US regulators are trying figure out who should look after online small business lending, unscrupulous loan brokers could take advantage.
Mills says the problem is compounded by a lack of transparency from online lenders about how much businesses actually have to pay for loans.
Mills said: "There's a concern that the lack of transparency on costs could disadvantage small businesses. They don't know how much they're paying. Some of these costs are really, really high."
In short, regulators are worried that a lethal combination of subprime lenders and high hidden costs could lead to a wave of defaults further down the line.
Aaron Vermut, the CEO of US peer-to-peer consumer loans platform Prosper, said his wife has had direct experience of how confusing it can be for a small business to borrow.
Vermut told Business Insider: "Small business lending definitely carries some distinct risks. My wife is a business owner and she took an OnDeck loan and you definitely have to do a little bit of math to figure out the true APR [annual percentage rate, a measure of interest].
"She ended up taking it and having a good experience. I'm not saying it's a bad loan, it's just the disclosure requires are a little tricky."
Vermut said the online small business lending sector was more like the "wild west," adding "They can charge much higher rates over a short period of time so it's a little bit like payday lending was for consumers."