Small businesses are the root of the US economy, driving over 60% of new job creation and accounting for over 50% of all US sales.1 However, a negative impact on this sector – traditional banks being slow to bridge the capital access gaps resulting from the Great Recession – continues to stunt growth.
Historically, established banks were the backbone small businesses relied upon to access the capital necessary for growth. With the advent of fintech and the emergence of online lending less than a decade ago, innovators disrupted traditional lending models by offering those in need alternative options to easily secure financing. The demand for capital remains high, and with the economy trending positively, both traditional and alternative lenders must revisit strategies to maximize their market share. Fintech players have leveraged investor capital and are at a pivotal moment where they must prove their sustainability. Banks, on the other hand, are embracing the changing environment and are looking to prioritize a segment that has been overlooked in the last decade. By evaluating and acting upon current industry trends, traditional lenders will themselves succeed by taking advantage of the opportunity to provide funding to businesses of all sizes.
Just over 15 years ago, little-know startup Netflix was offered up for sale to movie rental mainstay Blockbuster, which opted to pass.2 The concept of acquiring a subscription network for movie rentals, offering at-home delivery, may have seemed far-fetched. Why alter a flourishing system in which customers would willingly head out to their local branch to pick up the same copy?
Venerable photography company Kodak finally saw the digital age coming and tried to get ahead in organizing for the change.3 However, poor execution at a time when innovators were picking up traction resulted in Kodak falling behind and, eventually, becoming obsolete.
Whether they never saw the change coming, or because innovators leapt too far ahead, history shows that time and time again industry leaders fail because of their inability to see or adapt to the change that is sprinting their way.
Watching the booming fintech alternative lending space gain more and more momentum, it is safe to assume the banking industry is poised for similar change. And, without the application of strategic measures to reestablish the commercial lending industry as a whole, it is likely that leading financial technology firms will surpass the incumbents’ ability to fully serve their clients.
There are almost 30 million small businesses in the US, which make up over 99% of all firms in the country. As the primary source of job creation, these businesses play a pivotal role in the economy. According to the US Small Business Administration Office of Advocacy, small businesses accounted for over 60% of net new jobs since 1993.4
Post-2008, capital access available to these small businesses diminished for a number of reasons. Many banks did not survive the economic downturn, and those that did took a variety of measures to prevent any potential recurrence. Credit standards were fine-tuned, with even the most solvent companies struggling to secure capital for both survival and growth. Banks had to contend with increased regulatory oversight, which resulted in higher operational costs and significantly reduced margins. This perfect storm affected funding for small businesses, and only recently has the tide begun to turn for this critical segment of our economy.
As the economy has been steadily getting back on track, small and medium-sized enterprises (SMEs) are today able to secure financing more freely, but there is still much room for improvement. According to the “2015 Small Business Credit Survey: Report on Employer Firms” produced by several Federal Reserve Banks, 55% of businesses surveyed in 2015 were declined or received less than the requested capital amount.5 Although roughly one in two small business owners could not secure the requested amount of capital, this was actually an improvement from 62% in 2014. Figure 1 shows the full breakdown.
In addition, the Federal Reserve Banks’ “2015 Small Business Credit Survey: Report on Nonemployer Firms” revealed that 71% of those surveyed were declined or received less than their requested amount, as shown in Figure 2.6 Microbusinesses (non-employer and employer firms with under $100,000 in annual revenue) appear to show the greatest unmet need for capital.
The biggest underlying problem is that traditional banks employ the same workflow processes and staffing resources toward analyzing applications regardless of loan size, making the pursuit of small business lending a high-maintenance and less profitable endeavor. In a 2013 New York Fed Small Business Credit Survey, more than 50% of SMEs reported applying for a loan or line of credit of less than $100,000.7 This statistic accentuates the fact that the capital access gap remains unfulfilled, even though the potential profit in servicing these smaller loans is substantial – if progressive process improvements are implemented.
Knowing what small businesses mean for our economy, as well as the potential lending market that banks are barely tapping into, how do banks start more meaningfully serving this segment again? An important step in approaching this marketplace is to consider the definition of the SMEs in question.
The Small Business Administration (SBA) Office of Advocacy defines a small business as an independent business having fewer than 500 employees.8 There is more to the equation, however. According to a Harvard Business Review study conducted by former SBA Administrator Karen Mills, four main types of small businesses exist, and if all categorized business types are treated the same, a disparity in the ability to serve them effectively ensues.9
It is apparent that of the roughly 30 million small businesses, fewer than 5% will come anywhere near the “high growth” threshold. In other words, the majority of small businesses that experience capital access restrictions are the sole proprietors and local “Main Street” operations. These firms should not be ignored, as they generate countless jobs and are the backbones of many cities and towns across the nation.
Banks need to understand that when they are servicing an SME, they are working with a customer that often has a more immediate, and smaller, capital need. This is in comparison to “larger” businesses that may command more substantial funding requirements. As the commercial lending landscape evolves, leveraging and augmenting multiple sources of information can result in more expansive credit models that impact a number of variables, including the time needed to generate a decision. With proper credit risk measures applied, the effort level to underwrite a small business loan can be streamlined, and pursuing these loans can become more efficient and desirable.
Where banks let down small businesses, alternative lending – a key component of the fintech industry – stepped in to fill the void. That perfect storm led to a tremendous opportunity for new entrants looking to bridge the capital access gap and provide uncomplicated funding where it was needed most.
This industry that barely existed a few years ago has been rapidly expanding. Fintech startups have excelled by making computerized process improvements to the application and credit analysis workflow, and minimizing overhead by automating as many steps as possible. In 2015, Morgan Stanley forecast that these alternative lenders would reach $47 billion, or 16% of total SME loan issuance in the US, by 2020.10 Similar findings have been shared by Business Insider Intelligence, which further measured the impact to the small business lending market as it relates to loan originations below $250,000 (see Figure 4).11 The 2015 Fed Small Business Credit Surveys reported that 20% of employer firms and 28% of non-employer firms applied to an online lender. Looking ahead, the primary catalyst for growth in the sector will be credit expansion, yet both Morgan Stanley and Business Insider expect there to be a noticeable market share shift from traditional banks to fintech players.
With constant improvements in technology and banks’ competition growing faster and smarter, traditional banks need to adapt and take advantage of today’s tools. Finding solutions that can be tactically integrated into existing systems and processes is the key to competing with the fintech players.
Many incumbents have been slow to act, potentially waiting to see how new entrants would fare once the credit environment began to shift. Others took the opportunistic approach and found ways to partner with innovators early. Major players such as OnDeck and Fundation have established partnerships with JPMorgan Chase Bank, Regions Bank, and Citizens Bank. These collaborations have allowed the traditional banks to access the technological innovations proven successful by the startups. By expanding the horizons of growth potential while retaining valued depository relationships and allowing for various cross-sell opportunities, the banks can improve upon their innate advantages. It’s important to remember that banks retain the trust factor that is inherent in maintaining a high level of customer service, which is difficult for innovators to replicate. Banking services also go beyond just lending, and SMEs may welcome the opportunity to work with familiar institutions that can fulfill the broad range of their financial needs. Identifying the right partner is crucial, but outsourcing the ability to satisfy existing and prospective customers is imperative as the space continues to evolve.
For banks to remain relevant, they must expand product lines to include innovative solutions that cater to clients. CIT Bank acquired Direct Capital, an SME commercial leasing firm, in 2014. Direct Capital soon expanded its suite to meet customer needs, offering a three- to 18-month working capital loan product that mirrors those of fintech players such as OnDeck and CAN Capital. By providing six months of recent bank statements, a driver’s license photo, and a voided check, an SME can secure up to $150,000 in under 24 hours. The terms are simple to understand: a fixed daily payback structure and full cost of capital disclosed up front, with no undefined fees. This product can compete with many of the “alternative lenders” that are offering similar loans, often with unfavorable terms. This is just one example of evolving a product suite to meet SME demand while supporting healthy growth and customer retention.
As the economy strengthens, there is great lending opportunity, with many avenues for SMEs and banks to consider. Those that have already engaged in partnerships with new entrants are ahead of the curve – but there are costs involved with these collaborations, and there are ways banks can accomplish similar goals in-house. In a 2016 working paper, Karen Mills and Brayden McCarthy identify four broad strategies for incumbents to consider:12
- Strategic partnership strategy: Mills and McCarthy note that by pursuing strategic partnerships, banks are able to offer their SME product lines to existing and prospective clients through an online credit marketplace. This opportunity to leverage innovative products can be incorporated into an existing SME product suite.
- Arms-length partnership strategy: This risky dual strategy calls for banks to buy loans originated by alternative lenders, while also establishing a referral partner for marginal or non-creditworthy applicants when a bank declines an application. Customer satisfaction is imperative for repeat business; finding the right partner to refer a declined existing or prospective client to can preserve the trust factor that banks continue to maintain. Purchasing SME loans originated on alternative platforms can broaden existing loan portfolios without applying costly resources.
- Long-tail incubation strategy: In an effort to hedge the risk of disruption, banks can take the approach of investing in and incubating new or existing fintech players. This strategy has unknown variables and may require a greater capital investment; however, there is an opportunity to diversify the banks’ balance sheets while expanding future earnings potential. Research and development efforts require continuous attention, so leveraging excess capital and/or resources to enhance existing processes and offerings, while retaining full control, may be considered a safer option.
- Build or buy: The final strategy Mills and McCarthy put forth is to develop new technology and/or product lines to compete with new entrants, or to purchase existing players offering competitive solutions. Banks have survived through good and bad times by adapting to changing environments. The fintech threats are present, but there is still time for banks to build solutions by applying tactical strategies that have worked in the past.
Traditional lenders now have the opportunity to embrace the changes Blockbuster and Kodak did not. Banks need to not only preserve their current market share, but also seize the opportunity to expand their lending base and improve their involvement with the important SME segment. Automated underwriting, expanded acquisition channels, and new credit products are becoming the new standard in SME lending. Banks should consider leveraging existing relationships by expanding access to capital in a practical way, enabling convenience, and applying progressive risk management practices. The time to internalize the fintech movement’s innovations and plan for a more successful future is now.
1 US Small Business Administration. "Small Business Trends." 2017.
2 Chong, Celena. “Blockbuster's CEO once passed up a chance to buy Netflix for only $50 million.” Business Insider. July 17, 2015.
3 Jones, Milo and Philippe Silberzahn. "Do You Have A Digital Strategy? Kodak Had One Too." Forbes. May 30, 2016.
4 Small Business Administration Office of Advocacy. "Frequently Asked Questions." March 2014.
5 Federal Reserve Banks of New York, Atlanta, Boston, Cleveland, Philadelphia, Richmond, & St. Louis. “2015 Small Business Credit Survey: Report on Employer Firms.” March 2016.
6 Federal Reserve Banks of New York, Atlanta, Boston, Cleveland, Philadelphia, Richmond, & St. Louis. “2015 Small Business Credit Survey: Report on Nonemployer Firms.” December 2016.
7 Federal Reserve Bank of New York. “Fall 2013 Small Business Credit Survey.” September 2013.
8 US Small Business Administration Office of Advocacy. “Frequently Asked Questions.” June 2016.
9 Mills, Karen. “The 4 Types of Small Businesses, and Why Each One Matters.” Harvard Business Review. April 30, 2015.
10 Srethapramote, Smittipon, et al. “Global Marketplace Lending: Disruptive Innovation in Financials.” Morgan Stanley blue paper. May 19, 2015.
11 Bakker, Evan. “Small Business Alternative Lending: Alternative roads to capital will add billions to the small business lending market.” Business Insider. April 29, 2016.
12 Mills, Karen and Brayden McCarthy. “The State of Small Business Lending: Innovation and Technology and the Implications for Regulation.” Harvard Business School working paper. 2016.
Across 15 years as a consultant and practitioner, Chris worked on a range of strategy, risk management and operational transformation initiatives with leading financial institutions throughout North America. From this collection of abstract, “what now?” challenges, he has developed specialties in credit optimization, business combinations and system implementations. Chris joined Moody’s in 2020 after leading CECL implementation and dual risk rating expansion at a $50 billion bank.
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