Small business (SB) lending is a large and yet still underserved market in which community banks are generally well positioned to compete. The SB commercial loan market represents approximately $1 trillion in outstanding loans, of which banks hold over $500 billion. Approximately one-third of these assets are currently held by community banks. Despite those impressive figures, the existing small business market is smaller than it could be as large numbers of creditworthy small businesses needing smaller loans are not able to access the credit for which they likely could qualify, largely due to the costs of accessing and underwriting those loans.
Critically, it is the smaller SB loans—i.e. those below $250,000—that constitute the majority of the potential market of borrowers: a recent Federal Reserve survey suggests that applicants seeking less than $250,000 represent approximately 70 percent of total small business applicants. But most banks struggle to make such loans profitable, due to the fixed costs of traditional underwriting and processing relative to the smaller revenue opportunities.
On the other side of the equation, the lending market is undergoing a transformation driven by technology and new competition that is rapidly increasing the investment and scale necessary to compete. This technology is designed to reduce underwriting costs, shorten approval timelines and provide a more user-friendly customer experience. Larger banks and new, nonbank lenders are aggressively using this technology to expand share in SB lending, especially in the underserved smaller balance loan space that is so important to community banks.
Community banks are already gradually ceding SB market share—first to the larger banks and more recently to new technology-enabled nonbank lenders, commonly referred to as fintech lenders. Unfortunately, each community bank alone typically lacks the individual scale required to invest in technology that is now required to compete.
Banks, and particularly the largest banks, appropriately see the emergence of fintech lenders as a potential threat. But, since many community banks lack the resources to build or buy a technology platform on their own, the emergence of fintech lenders who can partner with community banks provides a new and attractive option for community banks to serve these important SB customers and to gain market share.
Federal Reserve Governor Lael Brainard summed up the opportunity for community banks as follows:
“Some view the growth of online platforms as a challenge to community banks in their traditional core businesses. But it is also possible that the very different strengths of community banks and online lenders could lead to complementarity and collaboration in the provision of credit to small business….”
… By working together, lenders, borrowers, and regulators can help support an outcome whereby credit channels are strengthened and possible risks are being proactively managed.”
Fintech partnerships designed to empower community banks should demonstrate the following characteristics:
- Enable banks to offer a product that is otherwise not widely available through that bank and/or to replace a costlier or inefficient product with a better solution;
- Enable banks to provide a “yes” to more of their customers, facilitating access to credit even if the customer is not yet able to meet bank credit standards;
- Ensure banks retain control of the customer relationship and the customer’s experience;
- Increase fee income and earning assets; and
- Ensure banks are able to meet regulatory expectations and best practices.
In its January 2015 paper on collaboration by community banks, the Office of the Comptroller of the Currency (OCC) states: “As a group of like-minded institutions, community banks may find the benefits of collaboration outweigh competitive challenges and could strengthen the future viability of community banks. The OCC supports community banks in exploring opportunities to achieve economies of scale and the other potential benefits of collaboration.” The OCC goes on to note that community banks that collaborate must manage the risks inherent in such a collaborative arrangement but states “there are risks to collaborative relationships, but there are also risks to doing something alone without the proper expertise or in an inefficient or ineffective manner.”
I couldn’t say it any better. In connection with SB lending, therefore, community banks should assess the extent to which a collaborative approach may offer benefits of collective scale, expertise and efficiency in a controlled and compliant manner. They may just find that the benefits readily outweigh the risks, and that fintech offers a powerful opportunity for community banks to regain share in a number of product lines that have come to be dominated by the largest banks.
Regulators can’t afford to wait any longer in developing a framework for their oversight of the fast-rising fintech sector. The number of fintech companies, and the amount of investment in them, is growing too rapidly for regulators to hope that they can supervise the sector by applying existing regulations for banks to fintech companies on an ad-hoc basis. That will only create gaps in regulators’ monitoring of the sector, and confusion among fintech companies trying to grasp the complexities of financial regulation in the U.S. Such gaps and confusion are already evident: Many fintech companies are failing to implement best practices in securing customer data, and many of them are also unaware of how existing regulations apply to them.
When looking at the new competition arising from fintech companies, many bankers understandably feel that they are at an unfair disadvantage. Banks must deal with a constricting regulatory environment, but regulators don’t always apply the same standards to fintech companies. So bankers have lobbied regulators to take a more aggressive stance towards their new competitors. [Editor’s note: