Is Small Business Lending Facing a ‘Moment of Reckoning?’

Financial institutions that want to play in the small business lending sandbox need to bring their digital toys.

In a recent American Banker article, former Small Business Administration administrator Karen Mills said community banks with strong small business customer bases that don’t find new ways to serve them digitally are going to face a “reckoning.” But how can community banks successfully compete with big banks and fintechs that are spending billions on their digital lending capabilities?

Recent trends paint a scary picture for community banks as well as credit unions that offer member business loans (MBLs):

• Small business loan dollars closed per loan officer per month dropped 23%, and loans closed per branch per month declined by 9% according to the most recent data in the Cornerstone Performance Report for Banks.
• While online lenders Kabbage and OnDeck lent $2 billion and $2.5 billion, respectively, to small businesses in 2018, PayPal is now the largest online small business lender in the United States, with over $4 billion funded in 2018. (Source: DeBanked)
• Square Capital lent about $1.6 billion to small businesses in 2018, up nearly 36% over 2017 and double that of 2016. Amazon lent over $1 billion to small businesses in 2018, and small and medium-size businesses selling in Amazon’s stores now account for 58% of its sales, up from 30% 10 years ago. (Source: DeBanked)

When it comes to their digital lending capabilities, community banks and credit unions are coming up short in three key areas:

1. Technology Utilization

Based on Cornerstone Advisors’ experience, many banks and credit unions aren’t leveraging available technology to make the borrowing experience easier, faster and more transparent—despite small business borrower willingness to pay exorbitantly for speed as is evidenced in the interest rates obtained by the high growth fintechs.

• Institutions are still using Word and Excel in some fashion in their small business credit application, underwriting or closing processes.
• Institutions are “spreading” financial statements for electronically provided tax returns or financial statements.

2. Distinguishing Between Small Business and Commercial Loans

Many financial institutions handle small business loan requests, data gathering, underwriting analysis, documenting and closing largely the same as they do for their commercial loans.

• Many institutions don’t offer expedited processing or streamlined, score-based underwriting criteria for smaller applications/exposure.
• Small business loans are sometimes underwritten to include financial covenants, require periodic financial statements vs. “exception managing,” and they are not consistently priced relative to their risk. 

3. Opportunity Identification/Training

Many financial institutions don’t provide their client-facing staff with the tools to identify potential small business loan or other relationship opportunities—from existing small business customers as well as local businesses that fit the institutions’ desired profile/footprint. 

• Many institutions still rely on identifying business loan opportunities largely via maturing loan reports, or one-off internal or center of influence (COI) external referrals.
• Too many institutions don’t provide small business lenders the data to identify small businesses in the lender’s footprint that have loans with another creditor—including non-borrowing existing business depositors.

Taking Stock

In the face of rapidly evolving technology and the growing competition posed by fintechs, it’s alarming to see how many community banks and credit unions do not conduct periodic assessments of their lending processes and adjust their small business digital planning accordingly.

Here are five areas community banks and credit unions should be evaluating annually to ensure their digital lending roadmap meets increasing borrower expectations:

1. Eliminate paper applications and utilize an online portal.

This applies to myriad capabilities including online applications, website messaging of loan promotions, AI-identified existing customers that have prospective borrowing needs, real-time loan status borrower updates, secure information file uploads, automated financial spreading capabilities and digital signatures. Institutions should have internal and, ideally, external service level agreements that enable borrowers to know how quickly their completed applications will be approved and funded. 

2. Define distinct “cradle to grave” micro vs. traditional small business loan processes.

Requiring borrower and guarantor tax returns/financial statements and personal financial statements on “micro” (typically $50,000-$100,000) business loans is inefficient and often unprofitable—even if there were an accurate way to measure it. It is imperative that institutions define efficient processes and due diligence for micro vs. traditional small/business banking loans vs. commercial loans. Otherwise, the experience is more cumbersome, less transparent and significantly less timely for micro business borrowers. 

Small business lenders need data in order to be able to identify and call on local small businesses and COIs—existing business depositors, those with loans with other creditors, and those in desirable/targeted industries or other demographics that make them prime calling candidates. Institutions have a wealth of data on existing customers and can easily purchase it for prospects (Google “Small Business Calling Lists” for over 200 million hits). Lenders need the tools to proactively identify these potential borrowers and should be held accountable for doing so.

3.  Define consistent small business risk-based pricing metrics; track and collect 95%+ of third-party vendor costs.

The institution’s pricing methodology should ensure its best pricing is only offered to the strongest borrowers—that is, it consistently applies pricing commensurate with defined risk parameters such as debt service coverage, credit scores, loan-to-value ratio and guarantor liquidity. A top 10 list of the institution’s desired risk-based pricing criteria will quickly confirm how configurable pricing “engines” can incorporate the criteria and how quick the payback is.  

The third-party vendor costs (search/recording/collateral evaluation, etc.) that an institution incurs to make a loan must be clearly defined and fully integrated into all processes beginning with the initial loan application. Upfront disclosure of projected closing costs at application, collection of these costs at time of approval acceptance, and strong tracking/governance processes from application to loan closing are essential.

4. Target auto-debit at 90%+ in all small business digital lending processes.

An “early and often” approach in setting borrower and lender expectations on requiring auto-debit for monthly loan payments will flow to the bottom line via lower costs and higher loan margins. Standard risk-based pricing should assume auto-debit of monthly loan payments, requiring a 25-50bp premium over standard pricing if not agreed to by the borrower. This pricing differential should be explicit at time of application, approval, documentation and closing, with automated processes defined to identify when/if auto-debit ceases after closing.

5. Track the number of times borrower, loan and credit data information are entered and in what media/system.

Financial institutions should identify 40-50 data points in evaluating a small business loan application and record how many times each data point is entered and where. This exercise will reveal not only the number of times the same element is rekeyed in disparate systems, but also the number of times these elements may actually increase year over year when manual processes are not addressed.

. . .

Yes, “moment of reckoning” sounds melodramatic, but with so many institutions without any semblance of a small business digital strategy or impetus to change hugely inefficient processes, it’s a realistic summation of the current situation. Bankers are overdue to face this reckoning head on, while there’s still calm before the next inevitable storm.

-jg

Ready to compete against big banks, fintechs and non-bank lenders?

A digitally optimized lending operation means an enhanced borrower experience, improved efficiencies and increased profitability.

Cornerstone Advisors can provide you with insights and direction to get your institution’s lending operations up to speed in a digital world.

Contact us today to learn more.