How Banks Can Raise Their Game in Small Business Lending

An interesting phenomenon is occurring in business funding in the US. Although the demand for small business credit remains high, banks - the traditional providers of financing for this segment - have continued a long and steady decline in their position in lending to small businesses. Small loans to businesses are down about 15% at banks since the financial crisis. Small business loans represented just 20% of business loan balances in 2015, continuing a consistent downward trend from 34% in 1995 (Figure 1). That's despite an uptick in 2015 that almost brought loan balances back to the level they were a decade ago.

Figure 1. Business lending at US banks, 1995-2015

Source: FDIC

Meanwhile, small businesses report persistent financing shortfalls, with only half indicating in a recent survey that all of their credit needs were met.¹ Prospective small business borrowers cite onerous processes, lack of transparency, and high search costs among the challenges of obtaining credit. Research from the Federal Reserve found that small business borrowers spend an average of 24 hours on paperwork for bank loans and approach multiple banks during the application process.² Banks and borrowers routinely cite small business loan processing times of weeks or months from completed application to approval, not including the time to collect application information or fund an approved loan.

These factors have contributed to the rapid growth of online and alternative "marketplace" lending to small businesses. Marketplace lenders focus on using technology to improve the customer experience and "time-to-money," often offering turnaround times for credit decisions in less than a day. A recent Morgan Stanley report estimated that online lenders granted nearly $8 billion in credit to small businesses in 2015, reflecting year-on-year growth of 68%.³ At the current rate, they estimate online lending could claim as much as 20% of the small business loan market in the next five years.

Marketplace players have the advantage of being unencumbered by legacy systems and old technology. They are scaling up quickly to tap into the unmet demand, and they are doing so profitably. While this may start to raise alarm bells among community banks and large banks whose mainstay has been lending to the small business segment, alternative lenders will face some headwinds that make it an opportune time for traditional lenders to shore up their capabilities to remain competitive in the small business space.

First, alternative lender portfolios have scaled up over the past five years and remain unchallenged by a down credit cycle. Delinquency rates and net charge-offs for business loans at banks are the lowest they've been in more than three decades. Some online lenders are using new techniques and information, like social data and educational backgrounds of borrowers, that are contributing to approval rates well above those at banks and credit unions (Figure 2).

Figure 2. Small business loan approval rates by type of lender, February 2016

Source: Biz2Credit Small Business Lending Index

While these new approaches are driving valuable innovation in the industry, they are yet unproven in challenging credit conditions. More than a few industry observers have expressed fear that the rapid proliferation of online lenders, the application of new lending standards based on non-traditional data, and the origination-for-sale dynamics of this market are akin to the causes of the mortgage crisis. Although many alternative lenders are basing their decisions on strong credit management techniques, the next credit cycle is likely to expose gaps in credit modeling and lending expertise among some of the online players.

Second, while regulators have given alternative lenders some freedom for the past few years in an effort to allow innovation, the period of regulatory arbitrage for non-bank lenders may be ending. The online lending industry has made concerted and visible efforts to self-regulate, such as by creating a Small Business Borrower's Bill of Rights and committing to practices that promote fairness and transparency in lending. Despite these activities, regulators and advocacy groups are starting to put increased scrutiny on alternative lenders as loan volume has increased. A recent paper by the Consumer Financial Protection Bureau considers expanding the scope of consumer protection to small business loans,⁴ and the Treasury Department closed a comment period on marketplace lending in September 2015. More regulation is likely to follow, particularly in the areas of disclosure, predatory lending, and sales tactics.

Third, while small business borrowers clearly respond to the ease of getting credit quickly from marketplace lenders, banks and credit unions far outperform online lenders when it comes to satisfaction after a loan is approved. According to the 2015 Small Business Credit Survey, between half and three-quarters of approved applicants said they were satisfied with their bank or credit union, while only 15% said the same of their online lender. The biggest reasons for dissatisfaction with online lenders were rates and payment terms (Figure 3).

Figure 3. Lender satisfaction rates, and reasons for dissatisfaction

Source: 2015 Small Business Credit Survey

A number of banks have recognized the opportunity to leverage the technology model of marketplace lenders in combination with their traditional strengths in credit and risk management to better serve small businesses. Some have begun developing similar process capabilities or partnering with online providers for prospecting, onboarding, and information-gathering, but these activities are still in their infancy. Traditional lenders that act now to streamline and improve their small business lending practices will be best equipped to address the funding needs of their small business customers and remain competitive and profitable as new players emerge.

For the tier of small business borrowers above branch-based microbusinesses, credit decisioning and monitoring in many banks are characterized by highly manual processes. Such manual processes are better suited to middle-market and larger corporate lending, where exposures (and revenue per loan) are much larger and volumes are lower.

Banks often collect customer and third-party information on paper or through static files that require data to be manually keyed into bank systems. Compounding the problem, data often has to be re-keyed multiple times because systems used in different parts of the origination and back-office processes are not integrated. In smaller organizations, these "systems" sometimes include spreadsheets and word processing programs for analysis and credit write-ups. In larger ones, elaborate legacy systems are often so deeply entrenched and entangled that it can be nearly impossible to adopt new technologies that could dramatically streamline workflows. Together, these approaches contribute to labor-intensive and time-consuming processing, incomplete process tracking, and increased probability of errors. These challenges extend to small business borrowers as well. While a consumer can secure a five- or six-figure car loan on the spot at a dealership, a small business borrower seeking the same amount of funding will have to go through time-consuming document-gathering; have back-and-forth communications with their lender in person and by phone, email, and fax; and endure weeks of waiting time while their application makes its way through the black box of the bank's process. In contrast, the always-available, fully automated, and fast-response customer experience of online lenders seems appealing, even at potentially higher interest rates and less attractive payment terms.

Many banks have focused on ways to increase lending efficiency with origination platforms and system integrations to reduce rework. According to a survey by the American Banker, nearly 30% of bank CIOs plan to increase their technology spending on lending platforms in 2016.⁵ So far, that spending has focused mostly on banks' internal processes, and often it is invested in rebuilding or replacing in-house proprietary systems with similarly customized internal platforms that will face obsolescence in only a few years. Meanwhile, banks often continue to overlook the customer-facing systems and tools on which marketplace lenders win.

There is an opportunity to do a lot more. Streamlining banks' internal processes and offering customer tools that match the experience provided by online lenders will require active divestment in legacy systems, not just the introduction of new tools overlaid on dysfunctional or inefficient processes. To avoid legacy problems, banks must design new, modular systems and processes that leverage cloud technology, APIs, and web tools, and require less customization and implementation to prevent them from becoming obsolete and weighing down lenders as new technologies continue to emerge.

Lenders of all sizes report a lack of good credit decisioning tools for small business lending above the retail level. The market for external models is highly fragmented, and many rely primarily or entirely on behavioral data that is backward-looking, heavily weighted toward the financial position of the proprietor rather than of the business, or focused on the business's propensity rather than capacity to repay. Banks are left to piece together different models' outputs to make decisions, or rely on judgmental analysis for decisioning and approval, resulting in inefficiencies and inconsistent outcomes.

The emergence of marketplace lenders as significant competitors makes this a more urgent problem. Some are starting to do auto-decisioning on loans to small businesses and moving up the size scale quickly, granting and funding six-figure loans in days.

Banks can address this challenge by standardizing their credit analyses of small businesses through adoption of automated spreading and quantitative scoring models for larger loan sizes. These models should heavily weight the fundamental financial information for the business that has proven to be most predictive of future default, while incorporating basic behavioral elements that are indicative of small business credit risk.

Our research has found that complementing financial data with limited, relatively easy-to-provide information on the prospective borrower's relationship with the bank, available credit line utilization, and past delinquency substantially increases accuracy while preserving the efficiency of model-based decisioning. Incorporating these elements leads to higher predictive power among small businesses than existing financial-only or behavioral-only models based on 30 years of historical data. Scoring tools that utilize this information can also be used more proactively for early warning and loan monitoring, helping lenders prioritize credits warranting more scrutiny based on changes in scores.

The 2015 Small Business Credit Survey shows that one-sixth of employer firms that didn't apply for credit were discouraged either because they felt they would not qualify or because they thought the process would be too arduous to justify the time commitment. At the same time, banks continue to be the primary and most trusted sources of information for small business borrowers - 73% of applicants asked their bankers for financing advice according to the Fed's research.

Banks have an opportunity to solidify their position as trusted advisors to their business customers and prospects by providing education and tools that help the borrower understand their credit standing before they apply for a loan. Resources that provide a credit score and simple, accessible information to help the user understand what is driving it would go a long way toward addressing this untapped market. Consumer tools abound in this area, but there are few that equip businesses to better understand and manage their credit positions. Banks that provide such tools in ways that are adapted to when, where, and how their customers do business can become more valuable partners to their customers and create new lending opportunities in this segment.

Strong demand for small business credit is expected to continue unabated. Online and marketplace lenders will continue to disrupt the small business lending industry by changing customer expectations with highspeed, technology-facilitated loan decisions, more accessible credit information, and vastly improved customer experiences. At the same time, alternative sources of funding will continue to expand the population of the "bankable" beyond businesses and individuals with traditional scores, making new types of data and new approaches to modeling increasingly important. Across the industry, the rapid evolution of technology and new sources of data will shorten the time to obsolescence of in-house, customized, non-modular platforms and of existing decisioning models.

It is critical for banks to modernize the small business lending process now to remain competitive. This means divesting of heavy, obsolete, customized systems and adopting modular cloud-based technologies for rapid deployment and agility. It means automating processes that are typically done manually and leveraging workflow solutions that speed the process. It means buying into automated scoring solutions and innovative use of data to inform rapid and consistent decisioning, while maintaining a position of strength in traditional credit and risk management. And most of all, it means investing in the customer experience to make it easy, fast, transparent, and adapted to the way small businesses operate.