James “Chip” Mahan has a colorful past as a banker who turned himself into a tech entrepreneur. He went from a failed attempt at a hostile takeover of his hometown community bank at the age of 31 to launching the first internet bank in the 1990s, Security First Network Bank, as well as developing a successful technology company that sold internet applications to banks called SQ Corp. Later, he founded what is now one of the largest Small Business Administration lenders in the country, Live Oak Bank, and used it as a jumping off point for a technology platform that is sold to other banks, nCino, which speeds up loan processing.
He speaks here with Naomi Snyder, editor of Bank Director digital magazine on the following topics:
Small businesses are an important segment for banks and credit unions with aggressive growth goals. In the United States, small businesses make up 99.7 percent of employer firms, according to the SBA FAQ Sheet. The top concern for these firms is managing their cash flow needs, which creates a great lending opportunity for banks and credit unions. Unfortunately, it can be a difficult opportunity for them to take advantage of because of their antiquated processes.
As Steven Martin, vice president of strategy at Sageworks, discussed during a recent webinar, the demographic composition of small business owners is shifting away from baby boomers and towards Gen X’ers and millennials. These younger business owners are more tech-savvy than their parents. They are more used to shopping online, including for credit and financing solutions. Additionally, many small business owners are too busy running their businesses to leave to visit a branch to begin the application process. When these small business owners go online looking for loans, they find that over 80 percent of banks and credit unions do not offer a way to apply for a loan online. This causes many small business owners to turn to alternative lenders for credit. These “alt lenders” can provide the funds faster and offer an end-to-end online experience. The number of small business owners who turn to alt lenders instead of banks and credit unions is growing. If financial institutions want to preserve and grow their SMB lending business, they will need to revisit two aspects of their loan origination strategy.
Small business borrowers deserve a better experience
Slow and complex loan application processes at many financial institutions frustrate small business borrowers. On average, an application for a small business loan takes two to four weeks. By the time borrowers submit an application, they have already spent an average of 26 hours researching capital options. Once borrowers decide they are ready to apply for a loan, they do not want to spend weeks waiting to receive their funding.
Many of the alternative online lenders charge much higher interest rates than banks and credit unions, yet, business borrowers short on time are increasingly willing to pay more in fees or interest rates to fix their cash flow problem.
Additionally, the difficulties of traveling to a branch and chasing hard copies of documents make the application process even more tedious. Improving the borrower experience is critical for banks and credit unions that want to grow their SMB portfolios.
Costly origination of SMB loans
A second challenge to growing the SMB portfolio is the cost of originating small loans. On average, the cost to originate a small business loan is almost as high as the cost to originate a much larger loan. The lower profits on smaller loans means that many banks and credit unions struggle with achieving sufficient profitability on SMB loans.
However, simply ignoring the SMB market narrows the institution’s opportunity to grow. Also, banks that already have a depository relationship with a small business may risk the entire relationship if they can’t provide a loan.
How then to increase profitability of small business lending?
First, the institution can reduce costs by making the job easier for lenders. Leveraging tools such as an online loan application, which allows borrowers to enter their information and submit documents online, saves loan officers the time of tracking down all the necessary documentation. Institutions can also reduce the time analysts spend entering data by utilizing a tool such as the Sageworks Electronic Tax Return Reader. The ETRR reads and imports data from the borrower’s tax return into the spreading software.
Another major cost of loan origination is the time spent analyzing and decisioning a loan, and automated tools can help here as well. For example, a bank that specializes in agricultural lending may be very familiar with equipment loans. This bank could see significant time savings by implementing loan decisioning software that can be tailored to its risk appetite for ag loans. The bank sets the required metrics and approval criteria, and the software provides a recommendation on the loan. This allows analysts to enter less information and make a faster decision while maintaining pre-existing credit standards.
Small business lending is an important segment for growth-minded banks and credit unions. However, frustrating borrower experiences and expensive application processes make it difficult for many institutions to build profitable SMB lending programs. By leveraging technology to improve the borrower experience and increase profitability for the institution, banks and credit unions can build a path to growth with business lending.
There are a million reasons for leveraging fintech to enhance a financial institution’s small business lending experience. To name a few, there’s better efficiency, customer convenience, profitability, speed to decision, speed to capital, cost reductions and a much-improved overall customer experience. However, one that often gets lost in the fray is the impact technology will have on the day- to-day productivity, motivation and morale of the bankers who work so hard to source and sell small business loans. This “banker experience” as it is known, plays a huge role in sales performance, retention, revenue generation and employee satisfaction.
The reality of a day in the life of a small business lender is that a surprisingly small amount of time is spent on sourcing new opportunities or even cross-solving to sell deeper into an existing relationship. Because they are shackled with the responsibility of shepherding deals through the multiple steps in the lending process, the more loan deals a banker has, the less time he or she is able to spend growing the book of business. So how are they spending their time?
As many as 80 percent of applications come in either incomplete or with an error on them, delaying the decisioning process and requiring the banker to go back to the client again and again.
Unique borrowing situations prompt the back office to request additional information requiring the banker to reach out and coordinate the collection of the information.
The collection of documents in the “docs and due diligence” phase of the approval process is tedious and time consuming. Bankers spend a great deal of time reaching out to applicants asking for things like: entity docs, insurance certificates, tax returns and so on.
Multiple teams and individuals touch each deal and as a result, things get lost, forcing the banker to invest a great deal of time and energy babysitting deals and checking on their progress from application to closing.
Much of the processing time is dependent upon the borrower’s promptness in getting requested information back to the bank. Bankers spend countless hours making multiple calls to collect information from clients.
I ran small business sales for a $150 billion asset institution, and our data proved that whenever a banker had as little as two loan deals in the workflow process, their new business acquisition productivity was reduced by 50 percent. Bankers with five deals in the process had their acquisition productivity diminished by 75 to 80 percent. That’s because they expend all their time and energy shepherding deals through the various stages of the process, gathering additional documentation, or monitoring the progress of each deal.
All of this is challenging for one person to do… but simple for technology to handle automatically, accurately and consistently. Technology can ensure an application is complete before it is submitted. It can ping the client for any-and-all documentation or data required. It can communicate progress and monitor a deal at every step in the lending process. Technology can also facilitate the collection of more and better data and translate that data into information that enables the banker to add value by asking great questions that help solve more problems for the customer.
When technology is used end-to-end, from application to closing, bankers are able to focus on the important things like:
Sourcing new opportunities.
Cross-solving for existing customers.
Preparing for sales calls and follow-up activities to advance the sales process.
Providing clients and prospects the value that earns trust and feeds future revenue.
Growing their loan book, and their portfolio revenue.
Technology makes the banker’s life simpler. When bankers are able to do what they do best, which is sell, job satisfaction, performance, job retention and morale go through the roof. And that positivity translates into improvements in the customer experience, and increases in revenues for the institution.
With reports touting the health of the economy and the officials at the Federal Reserve talking about raising interest rates again, the lending environment must be good for small business owners, right? Wrong.
According to Babson’s 2016 State of Small Business in America report, obtaining capital is a challenge that frustrated SMB owners continue to face. Even those receiving a loan from a traditional lender obtain less than half the amount they applied for. What’s standing in the way of entrepreneurs borrowing from a traditional bank?
Lingering fear from the Great Recession: From 2008 to 2013, small businesses benefited from loosened lending restrictions. But in the past couple of years, fears about SMB lending has shifted thinking and brought about a tightening of standards–leading banks to provide available loan opportunities only to bigger businesses, which they view as less risky.
Fallout from Dodd-Frank: Post-2008 recession, new regulations created paperwork headaches for large lenders and small community banks alike. But the annoyances aren’t just isolated to a potential borrower being required to fill out a couple of additional forms. Compliance increased the cost of originating loans, so much so that it’s no longer fiscally responsible for lenders to issue lots of small loans.
In fact, Oliver Wyman research (PDF) indicates underwriting these loans costs a marginal $1,600 to $3,200 per loan. Compare these costs to the annual revenue smaller loans generate—$700 to $3,500 on average—and they’re clearly unprofitable.
Fewer lending options: It has also become very expensive to raise capital to open new community banks due to heightened regulatory requirements since the financial crisis. These local financial institutions are a great lending option for small business owners when big banks tighten their lending requirements. But with fewer local banks, SMB owners are left with fewer borrowing options than ever.
The stimulus encouraged banks to stockpile reserves: Prior to 2008, the U.S. economic structure encouraged financial institutions with large amounts of cash to lend it to other banks in need of liquidity. The federal stimulus pact reduced this cash flow, and large banks began sitting on their significant reserves–reducing the amount of available capital to smaller lenders, which in turn would be passed on to small business owners in their form of much needed credit.
Despite these obstacles, traditional lenders can and should break the SMB lending logjam. According to Barlow Research’s 2016 Small Business Annual Report, SMB loan demand is trending down slightly in a year-over-year comparison—off 9 percent between 2010 and 2016. However, this downward trend applies only to the traditional-lender space. New digital marketplace lenders are helping SMB borrowers to get around this credit logjam–and capturing more and more SMB lending business that used to go to banks.
According to one report by Morgan Stanley, loan origination at alternative lenders has doubled every year since 2010, reaching $12 billion in 2014. While banks are still the dominate credit source for small businesses, last year SMBs sought 22 percent of their financing from alternative lenders. That’s hardly a trend that benefits small businesses. Marketplace lenders do offer SMB borrowers fast, convenient loans–but that speed and convenience comes at a steep price, with expensive and often opaque lending terms that have attracted increasing scrutiny from regulators.
How can traditional lenders reverse this trend and break the SMB lending logjam? Simply put, banks need to harness the power of financial technology, machine learning and big data to bring small business lending online. By streamlining the origination process, banks can reduce operational costs dramatically for these loans while offering the speed and convenience SMB borrowers demand–and get–from alternative lenders. Reducing loan origination costs improves their profitability and introduces a virtuous circle of increased lending that expands lending options for borrowers at more competitive pricing.
The innovations don’t stop there. New machine learning algorithms can supplement the traditional, narrowly defined credit score criteria with enhanced, real-time data like shipping trends, social media reviews and other information relevant to a small business’ financial health. Thus armed, banks can identify an expanded field of highly qualified borrowers without increasing risk. They can pilot risk-based pricing models based on a borrower’s creditworthiness, ending the all-or-nothing style of flat pricing for approved loans. The possibilities are exciting and enormous. But traditional lenders will need the right financial technology to break this lending logjam and unleash the SBM market’s full potential.
A version of this article originally appeared on the Mirador blog.
Cash4truckers.com* sounds like something you’d see on a roadside billboard, not a message coming from a community bank. In fact, the domain name is owned by Triumph Business Capital, a subsidiary of a $1.7 billion asset community banking company named Triumph Bancorp in Dallas, Texas.
“You’d have no idea it was a bank,’’ Triumph Bancorp Vice Chairman and CEO Aaron Graft said about the web site at a recent Bank Director conference. “We don’t wait for a customer to show up in one of our primary markets.”
Triumph Business Capital, then known as Advance Business Capital, was founded in 2004 and sold to a group of Dallas area investors in 2012 led by Graft. Triumph has very little presence in the Dallas market where it is headquartered but has 40 percent of its loan portfolio in specialty finance nationwide. It is doing something unusual for a community bank. It’s trying to compete in the realm of factoring and asset-based lending for small businesses, including construction, transportation and trucking businesses as small as one guy with his one truck. Triumph will buy an invoice from a trucker, for example, charging 1.5 or 2 percent of the size of the invoice. That has helped the bank achieve an adjusted net interest margin of 5.61 percent, 203 basis points higher than the average for banks $1 billion to $10 billion in asset size, according to data from the Federal Deposit Insurance Corp.
The trucker gets the cash and Triumph pursues collection from the customer who received the shipment. So the credit risk is analyzing whether or not the customer, not the trucker, will pay the bill. The trucker also gets additional services including discount fuel cards as well as having someone else manage invoices while they’re on the road.
Not a lot of banks want to get into this business. Larger companies are able to finance their working capital needs through the likes of big banks such as CIT Group. Small businesses take just as much work as the big companies to finance, but the loans are smaller. Many small banks don’t want to invest in that type of lending because it requires so much expertise to manage and keep track of the loans.
This is where Triumph comes in. “We are willing to serve the smaller end of the market because we think they need it more and because we think that’s where the opportunity is,” says Graft.
It’s a strategy born in an age of slow growth and low interest rates, where banks are scrambling to grow loan portfolios and profits. The Office of the Comptroller of the Currency recently warned in its semi-annual risk report that growing competitive pressures have led to lowering underwriting quality and increased credit risk.
Graft says he’s dealing with the risk inherent in his strategy by bulking up his specialty finance staffing and expertise. As an example, more than 100 people work in factoring with a loan book of about $150 million. The bank reviews invoices for fraud, hoping to catch people submitting false invoices. Graft says he’s dealing with regulatory risk by communicating the bank’s strategy to regulators, to serve both as a community bank and as a national specialty finance company. The bank’s subsidiaries offer business-related services such as treasury management and insurance, as well as branch banking through Triumph Community Bank in the Chicago area. Triumph also announced plans in March to purchase a bank based in Lamar, Colorado, with $759 million in assets and 17 branches, which will make Triumph a $2.5 billion asset holding company.
“It’s a little outside the box,’’ says stock analyst Brad Milsaps of Sandler O’Neill + Partners, who covers the bank. He says Triumph is growing by buying community banks to acquire deposits and use those deposits to lend nationally. The bank’s return on assets was 1.20 percent in the first quarter, up from 1.10 percent in the same quarter a year ago, but some of that was the impact of bargain purchase gains from acquisitions, Milsaps says. “They’ve got the operational controls and experience in that business to hopefully mitigate the risk,’’ he says. “If you don’t have the systems and people in place in that space, you’ll get burned very, very quickly.”
*Note: Triumph owns cash4ftruckers.com but has begun redirecting viewers to invoicefactoring.com. Cashfortruckers.com has a similar name but is owned by a different company.
In today’s challenging banking market, community banks are always looking for ways to increase profits, minimize expenses and diversify their loan portfolios. One solution many banks are utilizing is to add an SBA lending department into their mix of loan products.
The primary SBA lending program is the SBA 7(a) loan program, which allows the bank to make small business loans and receive a 75 percent guarantee from the U.S. government. The guaranteed portions of these loans can be sold in a secondary market, with current gain on sale premiums of 13.5 percent net to the bank.
SBA lending is not only a great way to increase the number of business clients that your bank can serve, but can also be very profitable.
Profitability Model Let’s assume that you hire your underwriting and processing staff and the lending staff brings in $10 million in SBA loans. If the bank sells the 75 percent portion of the loans that is guaranteed, or $7.5 million, it should earn at least a 12 percent premium in today’s market, or $900,000. For simplicity sake, we will exclude interest and servicing income from this analysis. If you can generate the $10 million with an internal lending staff, the bank will generally have the $200,000 processing and underwriting expense, and therefore generate $700,000 in profit.
Impact on Stock Price Let’s say your bank currently makes $1.5 million per year in income from its current activities and has 3 million shares outstanding, or an earnings per share (EPS) of 50 cents. At a typical price/earnings ratio of 10, the bank’s stock should be trading at around $10 per share. If the bank were to create an SBA department and generate the additional $700,000 in pre-tax profits, the after tax affect would be an increase in income of $455,000 or $1.96 million in total profit. This would boost the banks EPS to 65 cents and should move the stock price up to $6.50, which will certainly make your board and shareholders happy.
Other Benefits of SBA Lending Beyond enhancing profitability and mitigating risk, many banks use SBA lending as a tool to provide better loan structuring for their loan clients. So what are some common ways to utilize the SBA 7(a) guaranty?
Some loans may be better suited to being structured as SBA loans and they may be eligible for refinancing. Converting existing conventional loans or lines of credit by refinancing them into SBA guaranteed loans is one way to improve your portfolio and generate fee income. Banks are allowed to refinance their own debt, but it is important to note that the loan needs to have stayed current within 30 days for the last 36 months. If not, SBA would consider the lender to be putting itself in a preferential position.
We recently had a client refinance a mini-storage loan they had on their books that was coming up for renewal. Their regulator had criticized the bank for having a concentration in mini-storage loans. We completed the refinance of this mini-storage loan for approximately $1.6 million and sold the $1.2 million guaranteed portion for a premium in excess of $133,000.
Many times banks have good clients that need financing for equipment the bank doesn’t feel comfortable relying on as collateral. Some examples of this might be food processing and bottling equipment, car washes, MRI machines or unique manufacturing equipment. However, the SBA guaranty can mitigate the risk of taking unique assets as a form of collateral.
Smaller banks can also use the SBA 7(a) guaranty program as a way to provide funding beyond their legal lending limit. Since the guaranteed portion of an SBA loan is excluded from calculating this limit, it frees up the ability to make more loans to a quality customer.
Conclusion It is clear that creating an SBA lending group can increase your bank’s profitability and provides some significant advantages. All community banks are looking for new ways to better serve their clients and increase profits. SBA lending provides an opportunity to accomplish both of those objectives and potentially improve the bank’s stock price at the same time.
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.
Calvin Coolidge once observed that “the business of America is business,” and if the 30th president of the United States were alive today, he would probably amend his statement to says “the business of America is small business.”
Indeed, small businesses—or companies with fewer than 500 employees—are the engine of the U.S. economy, accounting for 99.7 percent of all U.S. employee firms, 64 percent of net new private sector jobs and 49 percent of private company employment, according the the Small Business Administration’s Office of Advocacy. However, banking a small business can be an entirely different matter because as borrowers, they tend to fall into a high risk category. Only about half of all new businesses are still around after five years, according to the SBA, and only about a third survive 10 years or more. Most banks tend to be put off by markets where the likelihood of success or failure could be predicted by the flip of the coin.
Enter the SBA’s various loan guarantee programs, particularly its highly popular 7(a) program (named after a section of the Small Business Act passed by Congress in July 1953), which has been very successful in bringing much needed bank financing to the small business sector. In its 2015 fiscal year, which ran through September 30, the SBA approved 63,000 7(a) loans for a record $23.6 billion. In FY2014, the SBA approved 52,044 7(a) loans totaling $19.19 billion. While the 7(a) program’s annual loan totals are still well off their peak in 2007, when they approached 100,000, volume has been increasing since 2009, when demand dropped off sharply as the financial crisis and Great Recession caused many banks to pull back from most lending markets.
There are several SBA loan guarantee programs, including disaster recovery loans, microloans and financing loans for fixed assets like real estate and equipment. But the 7(a) program is the big daddy of them all, and can be used for a variety of purposes, including acquisitions, business expansion, working capital and debt refinancing. A regular 7(a) loan can be for as much as $5 million. Loans up to $150,000 can be guaranteed by the government up to 85 percent. For loans over $150,000, the guarantee limit is 75 percent. These are term loans with one monthly payment of principal and interest, with a maximum maturity of 10 years except for real estate. Real estate can be financed for a maximum term of 25 years.
The leading SBA 7(a) lender in FY2015 based on loan volume was San Francisco-based Wells Fargo & Co., which originated $1.9 billion in loans, followed by Live Oak Banking Co., U.S. Bancorp, JPMorgan Chase & Co. and Huntington Bancshares. Wells Fargo also originated the greatest number of loans in FY2015, at 7,254, followed somewhat surprisingly by Huntington, at 4,337. Wells Fargo—which is the third largest bank in the country with $1.78 trillion in assets—sources much of its 7(a) loan production through a coast-to-coast retail branch network, while $71 billion asset Huntington relies on a much smaller network of 750 branches in six upper Midwestern states, with additional loan production offices in Chicago, Wisconsin and Florida.
Top SBA Lenders in FY 2015
Wells Fargo & Co.
Live Oak Banking Co.
JPMorgan Chase & Co.
Celtic Bank Corp.
Newtek Small Business Finance
Seacoast Commerce Banc Holdings
Regions Financial Corp.
Stearns Financial Services
*Dollar amounts are in millions Source: Small Business Administration
The top five 7(a) lenders in FY2015 carried their rankings through the first quarter of the SBA’s 2016 fiscal year as well, which ended December 31. Wells Fargo lead the group with 2,379 loans for total volume of $437 million.
Huntington SBA Group Manager Margaret Ference is a big proponent of the agency’s various loan guaranty initiatives, particularly the 7(a) program. “It allows us to invest in our communities and say yes” to small business borrowers who otherwise might be deemed too risky for a conventional commercial loan, she says. Whether the problem is a collateral shortfall, too much leverage or the need for a longer loan term than Huntington would normally provide, the SBA’s backing makes it possible for many small business borrowers to qualify for bank funding who probably wouldn’t be approved for a conventional business loan. “The SBA guaranty is used to mitigate risk, not to make a risky loan,” Ference says.
The 7(a) program is in fact Huntington’s primary small business loan, and the bank views it as an entry level product. The ultimate goal is to engage the borrower in a broader relationship that would include commercial deposit accounts, merchant services and cash management services. “That’s the start of a relationship,” she says.
If the economy’s backbone is small business, then small business’ backbone is community banking. Unfortunately, both economic and policy developments have dealt community banks a sustained blow from which they can only recover together. The challenge is for community banks to leverage the scale they lack as individual institutions but jointly possess.
The indications of stress are stark. It was just a generation ago that community banks accounted for nearly 80 percent of consumer loans. The number today is less than 10 percent. The largest banks are simply driving community banks out of the lending business.
The irony is that some of the difficulty community banks face actually results from policies intended to help them. Regulations that were supposed to limit the largest banks instead created impossible compliance burdens for small ones. The lifting of limits on interstate banking gave the big players a further leg up. But the biggest challenge has come from the shift of many types of lending away from relationship-based, customized lending (at which local banks excel) towards process-based, standardized lending (which requires scale to afford the systems, people, models, marketing and processes that are required).
This evolution from handshakes in a local bank to anonymous clicks in online applications required massive investments in technological platforms that community banks were unable to make. Yet despite the pressures, community banks retain advantages with which no large bank can compete: the trust and genuine loyalty of local customers, a personal understanding of their needs and the willingness and ability to customize their offering to the specific needs of customers when appropriate.
But if they are to survive, personal service alone will not be enough. If these banks lose the ability to offer the broad array of products and services that have become process-intensive (consumer lending, small business lending, wealth management, etc.), they will lose their connection to their customers who are forced to look elsewhere. Community banks must combine what they are uniquely good at with the scale necessary to go toe-to-toe with the largest banks. The good news is that these banks, collectively, already have that scale. Taken together, community banks command $2.3 trillion in assets—14 percent of the economy and more than enough to compete with any of the largest banks.
“Together” is key. The imperative for community banks is to find ways to take advantage of their combined scale while retaining the local focus and service for which they are legendary.
One such model is BancAlliance—a collaboration, as the name suggests, of more than 200 community banks with more than $300 billion in assets in 40 states. That $300 billion would be enough to rank these institutions together as one of the 10 largest banks in the country. The network is managed by Alliance Partners.
Among other benefits, partnerships like BancAlliance can help community banks seize the opportunities in the financial markets that new technologies enable. New players like Lending Club are using high-end online platforms to provide first-in-class customer experiences that are taking ever larger swaths of the consumer lending business away from the largest mega banks.
The platforms are so sophisticated, though, that no single community bank has the resources to figure out how to forge a partnership with them. By partnering through collaborations like BancAlliance with lenders like Lending Club, community banks can combine their knowledge of their customers with the new lenders’ unmatched customer experience platforms. BancAlliance, for example, is allowing its members to achieve those benefits through a partnership under which the Lending Club platform is offered through community banks.
BancAlliance is a promising model for collaboration, but only one. Regulators are recognizing and encouraging the value of these efforts, even as tiered requirements and limits on consolidation are also improving the policy environment. The key to these collaborative efforts now is that community banks realize the value of their combined scale.
Community banks still have the best advantages in a business that ultimately distills to relationships and trust. But the detriments of smaller individual size have begun to erode those assets and, absent action, could threaten the sustainability of the community banking model. By joining forces—collaborating with each other and partnering with institutions that can give them access to the advantages of technology and reach—community banks can convert a serious problem into a compelling opportunity. And history tells us that when they are able to compete on a level playing field, community banks prevail.
One way to look at Kabbage is that it’s a company of mostly millennials who are helping to recreate finance in their own image. Formed in February 2009 during the waning months of the Great Recession, when many commercial banks had curtailed their lending and some were taking capital from the federal government to strengthen their balance sheets, Kabbage provides unsecured consumer and small business loans through its online platform. It is one of the leading players in the emerging fintech sector, and to date has made over $550 million in loans.
Neither Chief Executive Officer Rob Frohwein nor the rest of his leadership team are millennials (the company does have a sense of humor, playfully describing the team on its website as the “heads of Kabbage”), but there are plenty of them working at the company. And if you’re going to hire millennials to work at a fintech company, you’ve got to offer them cool stuff like daily catered lunches and snacks, on-site yoga, top-of-the-line Macs and 27” Thunderbolt displays. And of course, you need to give them stock options for the day when the privately-held company either goes public or is acquired. The irony of the company’s name is that many millennials probably wouldn’t know, unless it was pointed out to them by their baby boomer parents, that “cabbage” is slang for money.
The financial services industry is experiencing a wave of innovation where several upstarts like Kabbage are taking an old product—money lending in some form has been around for more than two millennia—and using technology to create a 21st Century delivery and customer experience.The company provides small business lines of credit from $2,000 to $100,000, and more recently began offering consumer loans from $5,000 to $35,000, with repayment terms of either three or five years. Unlike most banks, which base their underwriting decisions primarily on the credit scores of the borrower, Kabbage takes a diverse range of information into consideration, and because the process is fully automated, the applicant receives an immediate decision.
Although conventional wisdom would argue that Kabbage is a threat to traditional banks, particularly in the consumer lending space where much of its activity is focused on consolidation of credit card-related debt, Frohwein says that he wants to work with banks and would rather be seen as collaborator than a competitor. Kabbage’s principal offering is an unsecured business line of credit. Most banks won’t provide that kind of funding without some form of collateral, and they can take weeks to make a decision. Prior to this issue going to press, the company was expected to announce agreements to work with two international banks, and Frohwein was hopeful that similar conversations with U.S. banks would also bear fruit.
Like all fintech companies, Kabbage has benefited from growing consumer comfort with doing financial transactions online. According to Frohwein, 95 percent of Kabbage’s customers never interact with a human at any point in the process. And many of them seem to like it that way. Kabbage might be a company with a culture that has been influenced by the many millennials who work there, but it has created a product that is finding acceptance among borrowers of all generations, and that adds up to a lot of cabbage. Frohwein spoke recently with Bank Director Editor Jack Milligan
Let’s talk about why there is a Kabbage.
There is a Kabbage because you can actually access data from online sources on a real-time basis allowing you to do a couple of different things.
First, you can permit a customer to have a very elegant online experience. The customer lands on the Kabbage website, which provides access to information relating to their entire business, and receives a decision within just a handful of minutes.
Because Kabbage gains access to these data sources through the customer’s authorization, we have ongoing access to data. As a result, we understand how that small business operates, not just today—at the time of qualification—but how they’re operating today and any point in between. It gives us a very rich understanding of that small business.
When we started the company, we believed this information would better reflect how a business was going to perform as a customer rather than relying on the personal credit score of the small business owner. The whole premise of the company was based on data access and technology. Our DNA is technology and data access and how that access can provide us with unique insights and customers with better experiences. I think that’s probably what separates us from some of the other players that are in this space who continue to have a lot of manual processes residing within their customer experience even though most have adopted the “data and technology” marketing speak.
When the company formed, did you feel as though you were stepping in and filling a void that was out there for small business borrowers? In 2009, obviously, we were just coming out of the financial crisis. The banking industry had closed up like a clam in terms of lending, and there was a real credit crunch, especially for smaller companies.
For sure. Despite being responsible for most of the growth in our economy, small businesses have historically been treated as the redheaded stepchild of the financial services industry. They’ve been largely ignored over the years. Though we serve all small businesses now, when we started, we focused on online retailers. Traditional lenders are reluctant to provide an online retailer with a loan. It’s not that they’re not good customers, but they’re hard-to-reach and they often have limited operating histories. They don’t have a physical presence so you can’t walk into the store and hear the cash register ringing, and see the smiles on the customers’ faces. If you can serve that audience as Kabbage has, then you can serve all small businesses, because you start with the most challenging segment of businesses.
Explain the products that you provide.
We provide a working capital line credit for small businesses. In the fourth quarter of last year we also launched a personal loan product. We have both a small business direct product and a consumer direct product.
We also started licensing our platform to third parties, which allows them to start lending in the small business and personal consumer lending space. We announced the first deal with Kikka Capital, out of Australia, a couple months ago.
Have you also had conversations with domestic banks about the possibility of working with you under a licensing arrangement?
Yes. In the U.S., we are working currently with two banks. Those discussions are in a slightly earlier stage, but we believe we will execute agreements with both of them. One relationship will center on a small business product and the other is on the consumer side.
The reaction from U.S. banks has been very positive, but it’s a difficult regulatory environment, and there’s a lot of caution that goes into that decision. It’s a process of working with the financial institution and getting them to the point where they really understand how we operate, how this compares favorably to their existing approach and how this grows their core business.
Do you see banks as competitors, or do you see them as potential partners? Or both?
I don’t think I see them as competitors, I actually see them as partners. I try to help them recognize that this is a market they can serve, it’s not a market they should ignore, and there’s a legitimate partnership opportunity here. They don’t need to take a competitive stance with us. We think we can actually work with all the banks.
How about in the consumer space? Or do banks not really focus on the size of personal loans you provide?
In the consumer space, our loans average about $15,000 and many of our customers are consolidating credit card debt so this is a segment in which banks are interested. Although banks may or may not see that as competitive, they should see what we are doing as important and core to them. However, again, banks do not need to look at us as competitive. We are working with a large U.S. bank right now to help them enter this space directly.
Though very focused on the consumer lending space for many years, small business lending has been another story for them. It’s been traditionally difficult for banks to make profitable, and that’s because there’s typically high acquisition costs, and also there’s a lot of operational inefficiencies. Banks apply the same requirements and invest the same resources for a $30,000 loan as they do for a $3 million loan. It’s just not reasonable to expect small business owners to go through that hassle for that amount of money.
Explain a little bit more about your underwriting process. It sounds like it’s a very sophisticated approach, and one that’s a little bit different than what most banks employ.
When a bank underwrites a small business loan they will have a checklist of many items they need to collect: three years of financial statements, FICO score, an asset list, whatever it might be. A bank would expect every small business lending applicant to come to the table with the exact same set of documents and information. We take a different approach.
Kabbage must meet the small business owner where that small business owner is. That means if they have a specific set of relationships with accounting companies, or credit card transaction processing systems, or social networks, or shipping companies or whatever it might be, that’s the data we need to collect and decision on. The data helps us determine the capacity, character and consistency of small and medium-sized businesses, or SMBs, just as the items the bank collects attempt to determine.
We’ve had to figure out a way to basically say, “Give us access to any number of data sources.” Without getting too technical, it’s an API, or application programming interface, approach where we’re given automated access on these electronic accounts for specified information. We don’t have the ability to write to the account, so we can’t manipulate anything within it. It does give us the right to read the information that’s contained within the accounts.
As you would imagine, it also provides us with a lot of historical information. It doesn’t just relate to the most recent period, it oftentimes goes back many months or many years in the past so we can see how these customers have performed over time.
The real key to what we do is a couple of different things. One is we are able to take all that information and make it relatable. If somebody gives us access to their credit card transaction processing information and shipping information, and another person gives us access to their marketplace information, personal credit score and social data, we’ve got to figure out, “Okay, how do I make a decision on both of those customers, and make a decision that is consistent and fair across the board?” We have developed that capability over time, and we did that through a lot of trial and error, to be frank, where we made educated decisions as to how we were going to view information. Until you get repayment information back and see the customer’s actual behavior, you really don’t know how well correlated that information is to actual performance. We’ve gone through that process over the last several years.
The nice thing about the way our product works is once somebody takes cash from our line, they pay it back within, on average, less than four months. Therefore, we are able to determine how effective our models are very rapidly.
How do you find your customers?
SMB owners do not congregate in a single place. There’s not a hall where SMB owners meet each evening and you can advertise there. They’re everywhere the population is. Therefore, we have had to become experts at locating them.
We have a blended approach. We do both traditional and digital marketing. If you log on to Kabbage.com, we’ll probably follow you for a long time online, and you’ll see more ads from us in the future. On the traditional side, we do radio and direct mail. If you watch TV, you’ll be seeing ads in the fall.
We also have a pretty robust business development arm where we enter into relationships with other businesses that have a lot of small business customers. It can be those that are offering phone systems to small businesses, or packaging for small businesses, or selling accounting software to them or whatever it might be. We try to work with the folks that work closely with small business owners.
When you look at the personal demographics of who your customers are, is there anything that’s distinctive from a generational perspective? What do you find interesting about your customer base?
We work with SMB owners that are super young and we work with folks who are much older. However, they all embrace technology at least in some manner. Although we started with online retailers, over the last couple of years, we’ve grown to include all small businesses, so you get your restaurants, your dry cleaners and your professional service firms, and everybody in-between. We see a much broader demographic than we did in the past in terms of their technology savviness.
You’d be amazed, 95 percent of our customers have a 100 percent fully automated experience. Not only do they not have to interact with anybody specifically at Kabbage, we don’t have a person on the backend specifically reviewing that file. It’s all done through our system. You’d be amazed at how many of our customers are comfortable just interacting with our system. That didn’t happen overnight; we had to figure that out the hard way. We made a lot of mistakes, and we created some bad experiences, and we worked hard to make it as comprehensible as possible. That’s what we’ve really focused on over the last five years. Now it seems easy, but we had many sleepless nights on the road to getting there.