How Nonbank Lenders’ Small Business Encroachment Threatens Community Banks

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A new trend has emerged as small businesses across the U.S. seek capital to ensure their survival through the Covid-19 pandemic: a significantly more crowded and competitive market for small business lending. 

Community banks are best-equipped to meet the capital needs of small businesses due to existing relationships and the ability to offer lower interest rates. However, many banks lack the ability to deliver that capital efficiently, meaning:

  • Application approval rates are low; 
  • Customer satisfaction suffers;  
  • Both the bank and small business waste time and resources; 
  • Small businesses seek capital elsewhere — often at higher rates. 

When community banks do approve small credit requests, they almost always lose money due to the high cost of underwriting and servicing them. But the real risk to community banks is that large players like Amazon.com and Goldman Sachs Group are threatening to edge them out of the market for small business lending. At stake is nothing less than their entire small business relationships.

Over the past few years, nonbank fintechs have infiltrated both consumer and business banking, bringing convenience and digital delivery to the forefront. Owners of small businesses can easily apply for capital online and manage their finances digitally.

Yet in 2018, only 11% of small banks had a digital origination channel for small business lending. In an age of smartphones, community banks still heavily rely on manual, paper-based processes for originating, underwriting and servicing small business loans. 

It was no surprise, then, when Amazon and Goldman Sachs announced a lending partnership geared toward third-party merchants using the retail giant’s platform. Soon, invited businesses can apply for a revolving line of credit with a fixed APR. Other major companies like Apple and Alphabet’s Google have also debuted innovative fintech products for consumers —it’s only a matter of time before they make headway into the small business space.

A 2016 Well Fargo survey found that small business owners are willing to pay more for products and services that make their lives easier. It makes sense that an independent retailer that already sells on Amazon would be more inclined to work with a lender that integrates directly into the platform. If your small business lending program isn’t fully online, customers will take the path of least resistance and work with institutions that make the process easier and more seamless.

Serving small business borrowers better
The issue isn’t that small businesses lack creditworthiness as prospective customers. Rather, it’s that the process is stacked against them. Small businesses aren’t large corporations, but many banks apply the same process and requirements for small credit requests as they do for commercial loans, including collecting and reviewing sophisticated financials. This eliminates any chance of profit on small credit requests. The problem is with the bank’s process — not its borrowers.

The solution is clear cut:

  • Digitize the lending process so customers don’t have to take time out of their busy day to visit a branch or speak with a loan officer. Note that this includes more than just an online application. The ability to collect/manage documents, present loans offers, provide e-contracts and manage payments are all part of a digitally-enabled lending process.
  • Incorporate SMB-specific credit criteria that accurately assess creditworthiness more effectively, like real-time cash flow and consumer sentiment.
  • Take advantage of automation without giving up control or increasing risk. For example, client notifications, scoring and application workflow management are all easy ways to save time and cut costs.
  • Free up lending officers to spend more time with your most-profitable commercial customers.

These changes can help turn small business customers into an important, profitable part of your bank. After all, 99% of all U.S. businesses are considered “small” — so the ability to turn a profit on small business lending represents significant upside for your bank. 

With better technology and data, along with a more flexible process, community banks can sufficiently reduce the cost of extending capital to small businesses and turn a profit on every loan funded. Next, banks can market their small business loan products to existing business customers in the form of pre-approved loan offers, and even gain new business customers from competitors that push small business borrowers away. 

Think about it: small business customers already have a deposit relationship at your bank. Community banks have this advantage over the likes of Amazon, Goldman Sachs, Apple and others. But when time is limited, small businesses won’t see it that way. By rethinking your small business lending process, it’s a win for your bank’s bottom line as well as a win in customer loyalty.

Does the Future of Community Banking Rest on Technology?

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technology-9-2-16.pngIn Bank Director’s 2016 Technology Survey, the participants identified the following as the greatest business concerns in terms of the growth and profitability of their banks: regulatory compliance (59 percent), becoming more efficient (38 percent), competition from other banks (30 percent), regulations from the Consumer Financial Protection Bureau (28 percent), weak economic growth in their market (28 percent) and the ability to implement new technology (27 percent).

It’s hardly a surprise that regulatory compliance was the top concern of the 199 survey participants, a group that included bank CEOs, board chairs, independent directors, chief financial officers and senior technology executives. Fifty-eight percent of the respondents represent banks with $1 billion in assets or less, and this group has been disproportionately impacted by the significant increase in regulations that has occurred since the 2008 to 2009 financial crisis. In many respects, this is actually a money problem—hence the respondents’ concern about the impact of regulation on their profitability. While banks of all sizes have seen their compliance costs go up, small banks lack the scale or revenue base to absorb those higher costs as efficiently as large ones can.

Most of these issues are actually interrelated. The increased regulatory burden is one of several reasons why banks need to become more efficient, since this would help ease the pressure on their profitability from higher compliance costs. And one of the ways in which they will become more efficient will be through the implementation of new technology. For example, as banks place greater emphasis on digital distribution, in response to customer demand, they will be able to reduce the number of branches they have—which will lead to significant cost savings. Weak economic demand is one reason why banks worry about competition from other banks. Banking has become a zero sum game in the current economy, with everyone scratching and clawing to get what they can.

Another possible answer to this question was competition from nonbank entities, and only 22 percent of the respondents chose this as one of their top three concerns. However, when we asked later in the survey to identify the nonbank competitors that worried them the most, online marketplace lenders received the most votes, at 48 percent. And when we asked them how they felt about competition from these online lenders, 60 percent said they should be more highly regulated and 41 percent worried that these lenders could siphon off loans from their banks.

There is a definite theme that emerges from these questions. The survey participants are worried about the higher cost of regulation and its impact on the profitability of their banks. A majority of them also believe it’s unfair that banks are more heavily regulated than marketplace lenders, which are hardly regulated at all and yet compete with banks for business. Of course, banks are also experiencing lots of competition from other banks, as well as their old nemesis the credit unions. But the rise of marketplace lenders as a competitive threat is especially troublesome because it’s been enabled by advances in technology that banks are scrambling to keep pace with.

I am one who believes that marketplace lenders are here to stay. Individual companies will wax and wane, but the underlying dynamic that supports them—data driven loan underwriting technology—is growing in usage. And it’s beginning to go mainstream. Goldman Sachs, the gold-plated investment bank, has launched a marketplace lending operation called Marcus that will compete with the likes of Lending Club and SoFi for unsecured consumer loans. And JP Morgan Chase & Co., the country’s largest bank, has teamed up with On Deck Capital to target the small business loan market.

My sense is that most community banks under $1 billion in assets have yet to feel the full effects of competition from marketplace lenders because they are tightly focused on commercial real estate and C&I lending opportunities in their local markets, while marketplace lenders have focused mostly on unsecured personal and small business loans. But for how long? I’d be very surprised if data-driven underwriting technology doesn’t begin to find a place in the CRE and C&I loan markets as well because the efficiency advantages are too great to ignore.

There is some talk that marketplace lenders should be regulated just like the banks, and the Office of the Comptroller of the Currency has even raised the possibility of a federal charter for nonbank marketplace lenders. That might create more of a level playing field when it comes to the regulatory burden issue, but financial reform moves slowly in Washington, so I wouldn’t expect the feds to ride to the industry’s rescue anytime soon. I think community banks will have to solve this problem on their own, primarily through the implementation of new technology that will significantly improve their efficiency.

Only 27 percent of the survey respondents included technology as one of their three greatest business concerns, but it should have been at the top of the list.