Small Business Lending: Partnering Your Way to the Top

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small-business-loans-4-25-16.pngSmall 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.

How Community Banks Can Grow Loans by Partnering With Competitors

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bank-capital-8-5-15.pngWhat many bankers have seen as the industry’s greatest peril is suddenly becoming their most powerful possibility: shadow banking. Shadow banking is frequently the term used to describe nonbanks who offer services and products that are similar to what banks offer. A new business model for community banks is transforming shadow banks from rivals to partners, enabling the two worlds to partner to compete with the biggest banks in ways community banks standing alone never could.

How could shadow banks that often compete directly with banks instead enable something entirely different? Imagine a world in which community banks—currently limited by their smaller scale in the array of products and services they can deliver to their customers—combine their acclaimed community focus, service and customer experience with the reach, depth, technology and convenience of direct nonbank lenders.

That sounds, but isn’t, almost too good to be true. The explanation lies in both what community banks already know—what separates them from the largest banks—and in what they may not: the ways in which shadow banking has evolved, offering products that can complement and empower rather than compete and threaten.

The biggest institutional banks—the five to 10 largest—are often inefficient, stodgy and misaligned. They resist innovation. Their legacy burdens include bad systems, faceless and painful customer experiences, and regulatory issues. Yet they have the capital and reach to provide consumer loans, often at interest rates that can top 20 percent (think credit cards) in a less competitive environment because community banks lack the scale to go up against them.

The more than 5,000 community banks in the country are innovative, agile and acclaimed for customer service. By definition, they can never be too big to fail. Together, they hold $2.3 trillion in assets—14 percent of the economy.

Yet as many types of lending have shifted from relationships to technology, community banks have lacked, first, the expertise, resources and scale to offer these services themselves, and, second, the technology to connect their own platforms with those that can. It’s little surprise that their share of the consumer lending market has collapsed from more than 80 percent to less than 10 in the last 25 years.

Recently, new nonbank lenders like Lending Club have exploited the inefficiency of the big banks by providing direct loans with best-in-class customer experiences. They offer better returns to investors and better rates to customers. But these new nonbank lenders have come to recognize they lack existing relationships with customers and low-cost, stable capital—exactly what community banks have in abundance.

A new model holds out the promise of combining the ideals of community banking—trust, service, relationships, low cost capital—with the best of these new nonbank lenders: scale, efficiency, technology and superior customer experience. The idea is to bind community banks together into alliances with nonbank lenders. This blends the service of the former with the lending platforms of the latter and allows each to do what it is uniquely good at—all while providing the customer with the best possible product and experience. The only losers: the biggest banks.

My organization, for example—BancAlliance—has gathered more than 200 bank members across 41 states into a collaborative pool with the scale and expertise to compete with the largest banks. We’ve assembled an innovative partnership between this group and Lending Club to offer community banks a consumer lending platform so they no longer have to turn away customers looking for consumer loans—and so they can focus on what they do and know best, which is serving individuals face-to-face. The first bank went live with offering loans through this partnership via its website just this summer.

Surely other models will emerge, and there will be enormous opportunities to replicate this approach to other products, such as unsecured small-business loans, that make sense (but are challenging) for community banks. Some trends are clear. One is that the big banks no longer own an exclusive title to this space. Another is that community banking remains as competitive—and crucial—as ever. Finally, and every bit as important, shadow banking is no longer solely competition for community banks. For community banks, the opportunities it presents are suddenly compelling and potentially transformative.