December 8, 2017
Imagine you are a small-business owner running a profitable family restaurant for several years and looking to expand to another location. To do this, you need a $70,000 loan, but your bank has declined your request. Rather than go to a different bank and complete another three-inch-thick loan application, you may decide to skip this time-consuming, manual application process and instead apply for a loan online through an alternative lender, which only takes a few minutes.
Perhaps you are a millennial that wants to start a business. You would like to obtain a small business loan to accomplish this, but obtaining approval for a loan seems like a complex endeavor. Instead, you choose to rely on your personal credit to launch and grow your company.
Small-business lending is touted as a core component of the community banking business, but community banks often miss opportunities like those above, losing to alternative lenders and larger banks. With interest rates to continue rising in 2018, community banks cannot afford to bypass these revenue-generating opportunities.
According to a survey by the Federal Reserve and the Conference of State Bank Supervisors, small business lending at community banks fell by 2.2% in 2016, while small business lending at banks with more than $10 billion in assets grew by 5.1%. Additionally, 26% of small businesses that sought funding in 2016 turned to alternative lenders, according to the Federal Reserve’s 2016 Small Business Credit Survey. In short, today’s community banks are challenged with increased competition, from both banks and their non-bank counterparts, coupled with increasing customer demands.
Despite this, community banks are positioned to succeed in the small-business lending space if they can address their areas of weakness and build on their unique strengths.
As an example, banks have multiple cycles of performance data, which can support more powerful scenario analysis and comprehensive credit models. As economic conditions change, banks can more accurately predict how loan portfolio performance may shift. This is a considerable advantage in the lending space. Conversely, alternative lenders typically use credit models with a 12-month to 24-month loss curve, making it difficult for these lenders to predict how market fluctuations may affect portfolio performance. However, banks do not possess the same portfolio agility that alternative lenders do. Alternative lenders have the ability to make real-time adjustments to their credit model and quickly change their portfolios.
Another strength that community banks and other deposit-accepting institutions possess is stable access to liquidity, which serves as a cheap source of funding for small-business loans. Alternative lenders are challenged by limited access to funding, often relying on third-party funding sources. This may prove problematic if and when the economy slows. To combat this and gain access to liquidity, alternative lenders are more frequently seeking bank charters or partnerships with financial institutions.
While collaboration between FinTech companies and banks is largely hailed as a good thing, it recently came to light that FinTech companies find it incredibly difficult to work with large, tier-one banks. Complaints include claims that banks string these companies along, fail to communicate, and often do not pay in a timely fashion. Some FinTech companies even reported that large banks have stolen intellectual property. Such issues could prove beneficial for community banks as alternative lenders may move downstream and choose to partner with smaller, community financial institutions. Community banks can partner with alternative lenders in a way that complements the bank’s current business model. This could include investing in alternative lenders or buying loans originated on an alternative lender’s platform.
As a starting point, community banks should begin to think about ways to revamp their small business lending processes and make the customer experience a priority. Alternative lending, despite the previously mentioned weaknesses, has grown popular in recent years, largely due to its more convenient customer experience. Rather than taking several hours to complete that three-inch thick loan application, applying for a loan through an alternative lender can take mere minutes and be accomplished online or via mobile. Moreover, the approval time takes hours or days, not months.
Community banks can mirror alternative lenders’ lending processes by using technology to support online loan applications and power the underwriting and servicing of loans. This enables banks to significantly streamline the small-business loan application process and thus minimize the amount of information that applicants must supply. Banks can modernize the underwriting process by leveraging electronic data sources, including real-time business payment history, along with other technologies such as business intelligence and analytics. These support faster decisioning times and stronger risk mitigation.
As interest rates rise, community banks should identify ways to automate lending processes and fully leverage digital technologies to meet their customers’ heightened expectations for a better application experience and faster turnaround times. Community banks must also recognize and leverage their strengths, including their strong ties to local communities and access to liquidity and performance data that will help them better capitalize on small-business lending opportunities.
Alternative lenders may have an advantage in some areas. Community banks would be wise to learn from these lenders and identify how to close the gaps in their own traditionally cumbersome and rigid lending processes. Doing so will enable community banks to meet market expectations for convenience and speed, positioning themselves for future loan growth and increased profitability.