Value-Based Innovation for Small Business Lending
The frustration of small business owners with U.S. banks is well known. Despite political pressure on banks to loosen the purse strings, pent-up demand for loans continues to build following the imposition of restricted credit standards in the wake of the 2008-2009 financial crisis. In the second quarter of 2012, only 33% of all small and medium size enterprises (SMEs) attempted to raise financing although over 50% required external funds. Twenty-eight percent of all SMEs indicated a need for bank credit but failed to apply due to hesitation about being approved. As a result of both the reluctance to apply and the lack of access to credit, SMEs have pursued alternative forms of financing, including the use of personal loans, vendor credit, and credit cards.
At the same time, banks have their own frustrations. Hammered by thin margins due to the sustained low rate environment and the rising costs due to increased regulation, retail financial institutions are searching everywhere for growth and SMEs represent an attractive target. With credit criteria unlikely to loosen significantly in the near term, banks must innovate to stimulate profitable growth and gain the loyalty of SMEs ahead of improving economic conditions.
Innovation must start with a deeper understanding of customer motivations and a quantification of their needs and preferences across features, services and channels. Based on this knowledge, banks should re-design the SME lending experience to meet these needs. Through this value-based approach, banks will be able to compete more effectively for high-quality customers and expand the addressable market without changing their desired risk profile. Using these insights to design modular products and rewards programs, banks will create more value for SMEs and increase willingness-to-pay at the same time.
Lastly, by pricing to capture the value created, banks can improve their own profitability while enhancing their customers’ experience through tailored offerings.
Most U.S. banks take a product-centric view of SME lending, typically working from a “plain vanilla” product list with coarse segmentation by credit risk, loan collateral and a few other high-level variants such as geography and loan term. Like credit card providers, business lenders should move beyond this product-based view and adopt behavioral segmentation to categorize customers based on past actions and preferences, not just profiles and product holdings.
For example, of surveyed SMEs who attempted to renew their lines of credit in 2011, 16% were dissatisfied with their new line of credit, and 8% turned down the offer, despite credit approval. Through behavioral segmentation, banks can better identify high attrition-risk segments and propose tailored offerings based on their unique preferences.
In order to increase traffic, take-up and renewal rates for qualified applicants, banks should create a customized experience for these desirable customers. By dissecting the product suite into discrete units – or “building blocks” – of value, banks can enable customers to design their desired lending experience, rather than offering a pre-packaged range of undifferentiated products. A modular approach can provide customers with flexibility around prepayment options, commitment amounts, term lengths, collateral options, channel availability and ancillary products such as insurance. In this sense, customers select only the features, channels and services that they need, increasing their overall willingness-to-pay since the offering is not diluted by low-value features of a traditional product bundle.
For example, financially proficient SMEs may have little need for the branch channel; less financially sophisticated operations may require a relationship manager. Businesses facing temporary cash shortages may highly value prepayment options whereas cyclical businesses which can accurately predict future cash requirements may not require a loan prepayment feature.
To better cater to needs of the high-quality SME segment, incentives can deepen the relationship and secure customer loyalty. Rewards currencies or loyalty schemes are an opportunity to provide customers with bonuses that are highly attractive, such as fee and rate discounts, participation in community events, and access to seminars and expert interviews.
Based on behavioral insights, banks can more accurately quantify customers’ preferences and align price accordingly. Banks must carefully consider SMEs’ psychological and cash flow preferences for different pricing elements, such as interest rate, up-front and event-based fees. For example, Simon-Kucher research shows that up-front fee waivers can stimulate line-of-credit take-up rates by 10 percentage points more than comparable rate discounts for select customers.
By measuring customers’ willingness-to-pay, banks can determine not only the right price structure but also the right price levels. In addition to traditional risk-based pricing, banks should incorporate demand-side considerations into their pricing decisions. Elasticity-based pricing techniques have been shown to increase risk-adjusted loan margins by up to 30 basis points, in our experience.
Relaxed underwriting criteria may be on the horizon, but lenders seeking to take a market leadership position cannot rely upon improved risk conditions to fuel growth. To grow without taking on additional risk, banks can capture additional market demand through more tailored offerings.
Mr. Baumgarten is managing partner and head of North American Banking with Simon-Kucher & Partners, a global consulting firm specializing in product pricing and marketing strategy. He can be reached at [email protected]. Ms. Gurbaxani, director, and Mr. Ke, director, are on his team and can be reached at [email protected] and [email protected]. David Chung, senior consultant, also contributed to this article.