Making small business loans profitably
Many banks are losing money with every small business loan they make. High origination costs and increased processing and infrastructure requirements often mean that loans of less than $100,000 end up being value destroyers for a bank’s bottom line. High costs have also opened the door to alternative lenders, both as competitors to banks and as bank partners. Every bank needs to fully understand its loan costs and determine how best to improve loan returns either directly or by leveraging the capabilities of a partner.
As expected, banks differ in their cost structures and internal economics. The handful of banks that have invested millions in streamlining operational and risk management processes can generate positive loan returns from day one. So too for the alternative lenders, with their emphasis on process streamlining, higher interest rates and risk-based pricing. But those lenders are the exceptions. Too often we find that banks do not know their loan economics, relying on anecdotes over rigorous quantification of key costs. When banks understand their costs, more times than not, they will find a disturbing story, one that requires immediate action.
Costs of a $100,000 Loan
Banks need to quantify at least six key components as part of determining the cost of a small business loan: origination, underwriting, loan review, operations, monitoring and collections, and compliance.
With input from Bill Phelan, president and co-founder of PayNet, and after review by several banker colleagues, we estimate that it costs between $3,000 and $4,000 to obtain, set up, and monitor a small business loan of $100,000 or less. These are mainly fixed costs that, depending upon the bank, can apply to loans as small as $25,000. Key components include: loan origination, $1,000-1,500; underwriting, $1,000; loan review, $100; operations, $250; monitoring and collections, $500; compliance, $250-350. The total cost: between $3,100 and $3,700.
Our take: We know banks that are very efficient and focused in their marketing practices and others at which the bankers and branch managers make only a handful of small business loans, inflating origination costs. Unless banks are disciplined in their origination focus, with all bankers clear about what is and is not acceptable from a credit perspective, origination costs tend to balloon. Banks applying the benefits of “Big Data” to target customers and prospects that meet acceptable screening criteria can lower origination costs and increase productivity. While some alternative lenders state that their origination costs exceed the above range, they make up for it with risk-based pricing; few banks operate with a true risk-based pricing discipline.
A number of non-origination costs have increased substantially in recent years largely due to compliance and regulatory issues that have hiked the cost of small business lending. For example, a few years ago, compliance costs were small; now, they are prominent and growing as a category as banks hire compliance officers who increase expenses without adding revenues. At many banks, ongoing monitoring costs have also risen due to privacy concerns and enhanced reporting requirements.
Locking in a Loss?
Let’s take this analysis a step further and consider the impact of a loan with the above cost on a lending unit’s bottom line, assuming a 6.25% interest rate and an interest charge to the small business unit of 3.0%. The interest income on such a loan would be $6,250. The loan cost charged to unit: $3,000. The total non-interest costs to generate the loan: between $3,100 and $3,700. So, the net income and pre-capital costs for the $100,000 loan would range from negative $450 to positive $250.
Our take: First, on average, most of the small business loans banks provide are for less than $100,000, meaning that, with their fixed costs, these loans generate even worse economics. Second, capital requirements make many “profitable” loans unattractive as low single-digit returns fail to justify the required risks. Third, the natural tendency of a bank with this cost structure is to move upmarket to make larger loans that can cover the fixed costs and allow a bank to make a favorable return. Numbers like these push banks to deemphasize small business lending in favor of more attractive loan targets.
Of course, some of these are one-time costs or decline over time as a loan terms out or renews. Shorter-term working capital loans may involve the greatest value destroyers, while also being critically important to many small business customers. Beyond initial origination, banks should quantify the cost/benefits of a loan’s entire life cycle, ideally also including the non-loan revenues that can bolster relationship profitability.
Reversing the Losses
This analysis presents a range of numbers that each bank needs to customize to itself. Bank management should set a clear priority to immediately develop an internal analysis that represents its own unique situation and cost structure. However, in most cases the end result will be the same as above: banks are losing money or making inadequate returns from small business loans.
Management has several options for turning around this loss-making situation:
Evaluate the profitability of the small business effort on a more holistic basis. In effect, lending serves as a loss leader for other product sales and the overall relationship with deposits, personal loans, owner investments, cash management, etc. making the entire small business and business owner relationship attractive.
Increase cross sales. Given the above, banks need to sell more to each small business customer to justify a loan’s cost. However, most banks are mediocre, at best, at cross selling.
Process improvement. Like barnacles clinging to the bottom of a ship, banks often allow processes to become too complex and, once established, fail to revisit them in order to simplify. Today, that situation seems particularly true at many banks with their strong focus on concerns related to risk and compliance issues.
Outsource or partner on lending. Alternative finance players may provide banks with a way to reduce their costs, increase productivity and meet the borrowing needs of their customers. Depending upon the company, they can provide banks with enhanced operational and risk management platforms and/or buy loans from the banks as a source of fee income. Banks need to understand whether and how they want to participate in the alternative finance ecosystem.
Bottom line: banks need to determine how they can break out of the trap many of them find themselves in today, a high cost/low profit small business lending model. Failing to do so inevitably limits their focus on a critically important constituency, one that needs a bank more than most other customer segments.