“Is it worth it weighed against the potential penalties?” a senior banker recently asked. The “it” involves teaming with third-party lenders, commonly termed alternative finance companies (AFCs). AFCs provide digitally enabled lending to borrowers that usually operate outside a bank’s credit comfort zone.
More banks are now evaluating whether and how they should partner with AFCs —particularly related to small business loans. However, as this banker’s comment underscores, bank management needs to address both real and perceived risks before traveling down the partnership path.
The payoff to partnering for banks can prove substantial and result in improved operating expenses, increased revenues and an enhanced customer experience. Today, most banks lose money on business loans up to $250,000 or more. Some costs are one-time, such as loan origination and underwriting — while others continue throughout a loan’s life, including loan ops, loan review, compliance, and monitoring. Costs have also increased with the advent of additional reporting requirements.
The net result is this: Each small loan destroys value. Yet outside of lending, small businesses remain a very attractive segment that generates high deposit levels and provides reliable fee income both from the business and the business owner. AFCs can offer banks a path to capture more of that opportunity.
Then there exists the above-mentioned penalties the senior banker referenced. These include potential reputation risk from working with a lender that charges high rates — and even more serious, regulatory risk if the AFC third-party partner is viewed as abusing a borrower. While caution is necessary, the good news is that many AFCs have established positive track records. Some offer rates well below credit cards and have achieved high customer satisfaction levels. While we are still in the early innings of the AFC partnership game, some winners have begun to emerge.
AFCs now focus on where they believe they can provide much greater value to banks in growing small business franchises. They continue to “pivot” and offer new approaches, operating with the flexibility and willingness to customize how they work with partners, based upon a bank’s needs. As one banker commented, “When we go to customers, too often we tell them what we will do for them. When [AFCs] come to us, they ask us what we need them to do, what problems they can help solve.” The marketplace remains dynamic and a year or two from now, partnership types and structures may change significantly.
Currently, four main AFC partnership approaches dominate:
Referrals. When AFCs began to partner with banks years ago, their primary focus was to provide a second look for rejected loans. Applying the AFC’s proprietary scoring and risk methodology to the loan application, they could potentially offer a loan but with an interest rate higher than what a bank charged. For multiple reasons (including a low number of loan referrals from banks) these partnerships have largely disappeared.
Some banks that wish to stick their “toe in the water” may begin to work with an AFC in this type of referral relationship. But in general AFCs also avoid these agreements, unless they involve specialized bank products such as factoring, or the bank agrees that referrals serve as the beginning of a fuller relationship, rather than the end point.
Small Business Origination Platform. Some banks want to adopt a digital approach to small business loan originations. This can reduce costs and bureaucracy while maintaining existing credit standards and full relationship control—and without offering turn-down lending from an AFC. These banks can work with an IT provider that specializes in offering a transition to digital. Often, they can also supply data analytics, marketing assistance and second-look loan capabilities on a modular basis. This provides a bank with the ability to expand its third-party relationship if and when it desires.
“Light” or Full integration. Increasingly, AFCs want to establish fuller partnerships with banks where they serve as a “white label” provider. For example, customers can apply for a loan using the digital software provided by the AFC. Once a customer completes the application, it is scored and decided upon using the bank’s traditional criteria. If it clears bank hurdles, the bank can fund the loan. But rejected applications also get reviewed using the AFC’s proprietary guidelines. If the AFC approves the loan, they pay the bank a fee; the bank then maintains full control over the non-loan relationship.
AFCs can provide technology and loan support to the branch, small business bankers and/or the online channel. Banks that travel this route do so to improve their customer’s and prospect’s experience, offering loans to more customers without taking on additional credit risk. At the same time the bank can pursue deposits and other more profitable areas.
Beyond this “light” integration, banks can also avail themselves of additional AFC capabilities. For example, AFCs can provide marketing intelligence that targets loan opportunities to both current prospects and customers. Several AFCs have developed risk models that take into consideration more factors than a bank does, and this potentially allows a bank to exploit an AFC’s investment in this area to expand its own risk parameters. If integration moves from “light” to include more activities, the AFC’s impact on a bank’s approach to small businesses can be dramatic and help move this segment to a new level of performance.
Portfolio Purchases. Some banks buy loan portfolios from AFCs. One current partnership involves an AFC helping to satisfy a bank’s CRA requirements by finding borrowers who meet those criteria.
Don’t Partner; Become an AFC. A non-partnership approach has banks deciding to streamline internal processes, leverage in-house and third party data, and design an offer that competes with AFCs. Usually, only larger banks possess the capabilities to do this, as most others lack the skills and revenue required. However, companies are now working to make “alternative finance in a box” available to all banks. Stay tuned.
Bank should determine which option best fits their needs today and in the future. For example, banks may prefer to work with an AFC to digitalize current processes. Further on they may want to take advantage of advanced data analytics, enhanced underwriting, and/or the ability of the AFC to provide loans. Management needs to pick a partner that can provide additional capabilities on a modular-like basis.
Selecting a partner requires that decision makers work from all across a bank to address business, technology and compliance issues, among others. Many AFCs possess experience in navigating the partnership process and can offer guidance and link potential clients to current bank partners to gain insights on issues to address.
To determine whether a partnership is “worth it” each bank needs to follow six steps:
- Quantify potential revenue gains that a successful partnership can generate
- Set cost and revenue goals
- Be comfortable that third party risks are limited and manageable; conduct intensive due diligence
- Commit resources to design and implement a digitally-oriented marketing and sales approach
- Develop a detailed implementation plan for marketing, selling and servicing customers and targets in a digital environment
- View the partnership as long term
A partnership with an AFC can transition a bank to generate sustainable revenues as the industry inevitably moves to a digital environment. All in all, it represents one more reason why banks should view 2017 as a year to assess available options, evaluate partnership opportunities, determine the importance of partnering versus other priorities—and agree on their best options.
The president of Financial Institutions Consulting (FIC), Charles Wendel has extensive experience as a banker and consultant. He is a regular contributor to American Banker and other financial services periodicals and a veteran commentator for BAI. He can be reached at CWendel@ficinc.com.