Asking the Right Questions in Small Business Banking
The small business lending market is one of the few bright spots in banking and can have a significant impact on a bank’s bottom line. But it’s also not a business to approach haphazardly. The banks that are most successful in this area have a clear strategy for the types of loans they are willing to write, have done the hard work of cost allocation to analyze profitability and have considered how to best organize their operations to underwrite and process those loans.
During the recent economic crisis, many institutions switched from mortgage lending to making small business loans. But it’s important to remember that small business lending is entirely different from consumer mortgage lending and requires a different set of strategies. Unlike consumer lending that is based on collateral, usually a home that isn’t going anywhere, small business assets such as accounts receivables and inventory can – and do – evaporate.
The asset-based assessment typically used for small business lending requires analyzing accounts receivables or inventory. More so than for mortgage lending, asset-based lending requires a disciplined approach to tracking and monitoring, since the value of the asset ebbs and flows with the health of the business.
Small business lending is a unique market that requires its own strategy tied to the bank’s overall strategy. Here are three questions to consider about small business lending as you create a strategy that makes sense for your bank.
Are you writing consumer loans disguised as small business lending? For the smallest of small businesses, the owner is the business. In these cases, the bank often makes lending decisions based on the credit worthiness of the individual rather than the assets of the business yet calls it small business lending. That’s fine, but it’s important to understand whether you are lending to the company or to the owner and document the loan accordingly.
The types of small business lending you do determine the skills your lenders need as well. If you chose to use scoring models similar to those used in consumer lending to underwrite small business loans, you can use less-experienced lenders. If you are doing asset-based lending, you’ll need lenders with more experience.
Is your lending business profitable? Small business lending can be lucrative not only for the loan income but also because small business customers often rely on deposit and cash management products from the same bank. And small businesses are willing to pay for services such as payroll, Automated Clearing House (ACH), concentration accounts and positive pay.
But not all small business lending is lucrative and since many banks don’t measure profitability, they don’t know which type of loans make money and which don’t. One bank we worked with was writing a large volume of indirect automobile loans and touted that business unit as one of the most profitable for the bank. They were buying dealer paper worth an impressive millions of dollars each month. However, when we performed a business unit profitability study that included allocating costs, we found that they were not earning enough yield to actually make a reasonable profit. The cost allocation process was detailed and time-consuming but critical in determining that the bank’s lending and collections processes were not efficient enough to support this particular lending business.
According to the old Kenny Rogers song, “You got to know when to hold ‘em, know when to fold ‘em.” Rogers may have been referencing gambling in this song but the advice holds true in lending as well. The challenge for banks is to be able to identify a loan that is not profitable and then be able to walk away from that loan if necessary. The banks least likely to know when to fold ‘em are those who chase loans without a lending strategy based on actual lending costs.
Should you centralize or decentralize? The experience of your lenders is critical in the choice of whether to centralize credit decisions at headquarters or provide more authority to the lenders. With rookie lenders it becomes almost impossible to decentralize lending since they simply don’t have the experience to make solid decisions out in the field. However, with more experienced lenders, a decentralized model can work since it gives the lending team leeway to engage in relationship-based lending rather than rely on automated and inflexible underwriting.
Another factor to consider is whether or not your small business lending strategy is focused on quantity or quality. Typically a centralized lending operation is most concerned with quantity, whereas a decentralized operation is most focused on quality. Some community banks insist on pushing loan pricing decision making into the field. Although that can work for some loans, risk-based pricing is best centralized, since it’s important to have a consistent and disciplined approach to managing risk.
For the majority of community banks a hybrid-lending model works best – centralizing underwriting and/or credit decisioning while leaving lenders responsible for sales and customer relationship building. Banks can also choose to centralize or decentralize depending on the type of lending, perhaps decentralizing commercial real estate lending but centralizing commercial and industrial (C&I) lending.