Growth remains a universal, timeless goal for financial institutions and many pursue loan growth to offset rising compliance costs and maintain profits. Yet those loans also undergo constant examiner scrutiny, meaning banks must employ prudent underwriting and review strategies.
That noted, one strategy works toward both a bank’s growth goals and risk management requirements: lending to quality, small-to-medium sized businesses, or SMB lending.
In the past, this segment may have attracted less focus due to perceived lower returns relative to larger commercial and industrial deals. But when effectively managed, an SMB lending strategy sets an institution apart from its peers because it reaches out to an underserved market. Banks and credit unions that build relationships with local businesses can also decrease friction in the internal underwriting processes—even as they increase SMB lending program profitability and potential loan growth.
SMB loans: disunity to opportunity
The 2016 Small Business Credit Survey (SBCS) conducted by the Federal Reserve Bank of New York found that business owners remain generally optimistic about growth prospects, profit levels and hiring. More specifically, 53 percent of the responding firms were profitable; 50 percent reported increased revenues; and 35 percent added employees at their firm. Additionally, 71 percent of surveyed firms expected higher revenue in 2017 while 46 percent planned to hire more employees.
And for financial institutions, here’s the key: To drive this growth, small businesses will likely need funding. In the SBCS, however, 44 percent of businesses surveyed said that credit availability or securing funds for expansion remained a significant financial challenge they faced in the last year.
Looking towards the next 12 months, 19 percent of small business owners expect to increase their debt while 45 percent had already applied for financing in the prior 12 months. This presents an opportunity for community banks and credit unions.
Small businesses love small banks
SMB borrowers gain certain benefits when they bank with community-based institutions rather than online or mega banks. The Small Business Credit Survey reports that businesses using small banks and credit unions, on average, had a higher satisfaction level than those that use mega banks or online lenders. Some perceived benefits include:
- community institutions’ vested interest in supporting the local economy
- a personalized experience that includes a consultative aspect business owners appreciate
- building on a potential existing relationship with consumer deposit or loans
- familiarity with the local economy and its performance
Local businesses may land opportunities for capital through Small Business Association (SBA) loans. Community banks and credit unions traditionally welcome SBA loans because of the SBA loan guarantee program.
In many cases, small businesses seek “micro loans” of less than $100,000, which can be difficult for them to secure. This gives community banks a chance to step up; in particular, the 2016 Small Business Credit Survey found that for businesses with less than $1 million in revenue—those most likely to seek micro loans—only 33 percent received all the funds they requested. Another 38 percent received just a portion of the requested funds and 29 percent received no funding at all.
Lending SMB lending a hand
Even as small businesses actively seek credit, they struggle to secure funding. This may stem from the repressed profitability that often accompanies smaller loans. In many instances, a $50,000 loan requires the same underwriting and resources (people, documentation, review) as a $500,000 loan. This eats into profit margins on smaller loans—and as discussed in this article on the role of technology in SMB lending, a streamlined origination and underwriting processes can make even the smallest loans profitable for community banks and credit unions
Putting it all together: Three small businesses lending best practices
Once an institution lowers SMB loan costs by integrating technology solutions into the origination processes, they can focus on three best practices to jumpstart their SMB lending program:
- Offer business owners a better borrower experience. Many business owners bypass community banks and credit unions in favor of online lenders because of a difficult, manual and paper-based application process. By digitizing the loan application process, banks and credit unions can smooth the path for business borrowers and keep pace with the expectations online lenders set in the market.
- Build relationships with small businesses. If a lender offers online-only applications and nothing else, it may mean a more streamlined experience, but it also deprives SMBs of consultative conversations and getting questions answered in person. Some small business owners want a consultative approach from their bankers and desire to build a relationship or partnership.
- Gear the underwriting process towards small business-specific risk factors. Economic trends often impact small businesses more than medium- and large-size businesses; they may not have the diversification or safety nets larger organizations do. This higher volatility level means more risk than loaning to larger enterprises. Effective risk management practices are crucial to ensure profitability on these loans. Consider financial covenants that keep cash flow in check or require more collateral. For example, a covenant could require a minimum 1.50 debt service coverage ratio or a maximum 65 percent loan to value. If the loan becomes noncompliant with those covenants, the interest rate on the loan will rise 25 basis points or more, depending on how far the metrics drift from compliance. Banks can also utilize advanced risk management practices by tracking the number of past due payments. By raising interest rates when certain late-payment thresholds are exceeded, borrowers have an incentive to prioritize their small business loan obligations. The institution should also use apple-to-apple comparisons for business benchmarks. Rather than compare small business to publicly available, large company data, look for benchmark reports tailored to small business peers.
Projected growth in small business lending could make the segment profitable for banks and credit unions. For local businesses, building relationships is paramount; so is offering a smoother borrower experience. And for community banks and credit unions, attention must be paid to evaluating the institution’s underwriting process to mitigate risk effectively. With such attention paid to both sides of the coin, banks and businesses will in turn populate their coffers with many, many coins.
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Chance Castellucio is a credit risk consultant at Sageworks, where his primary responsibilities include assisting financial institutions with credit analysis, loan administration, and risk rating best practices.