Executive Summary: All banks say that want to serve the small business space, but few succeed. As strong returns on capital become more difficult to achieve, banks should evaluate where they are focusing. Some will find that small business is a mismatch while others will go “all in.”

 

 

In recent weeks, I have spoken to a number of lenders, several of whom are rethinking their focus on the small business space. With so much media focus on this segment and so many bank pronouncements about their commitment to it, it is worth considering the factors that are compelling some players to move in the opposite direction.

 

Growth is less important than portfolio quality

With few exceptions, banks lenders are focusing on portfolio management and quality rather than growth. (Yes, for some this is a case of closing the barn door after the horses have escaped.) Therefore, the growth opportunity that the small business segment offers is simply irrelevant for some…at least for now.

 

The cost of serving the small business segment is increasing

Multiple factors are increasing the cost of small business lending, among them:

 

• Decreased reliance on credit scoring (discussed below).

 

• More touch with continued high tech investment (also see below).

 

• More difficulty in finding quality borrowers (The head of the small business group at a British bank recently commented that they had 25% fewer borrowers, borrowing 25% less than a year ago).

 

• Less tolerance for high losses. Schemes in which high credit losses will be compensated for with higher spreads and strong returns are unattractive to those banks that want to reduce their risk profiles, no matter the potential returns.

To the extent that a lender relied on credit scoring and app only reviews, they will no longer do so

Whether a fair assessment or not, some lenders believe that credit scoring failed them during the downturn. One executive from a company that used “automatic” credit decisioning for its smaller loans stated that, until the downturn, credit score-decisioned loans outperformed manually underwritten loans. However, in the recent downturn, the reverse was true….and by a wide margin. This manager stated that the degree of market dislocation was such that no stress test could have anticipated the extent of the crisis. (As an aside, companies selling credit scoring technology need to aggressively address the skepticism that may exist in the banking marketplace concerning their services.)

 

In addition, more lenders want to focus on the qualitative as well as quantitative analysis prior to making a loan decision. Understanding a loan’s purpose and the business plan that a company is following is gaining increased prominence at many banks. This approach is fundamental to a how banks underwrite middle market companies.

 

Banks will continue to use credit scoring and other similar methodologies (high tech) even though many will rely on them less going forward; they still serve as an important input into the decision process. However, continuing to invest in technology as well as spending more time on qualitative assessment further increases the cost of and time required for small business loans.

 

The risk reward tradeoff is not there

Some lenders are finding that the available returns fail to balance the risk of lending to this segment. They say that the industry needs to accept the fact that, over the near to medium term, returns on assets and equity will be substantially reduced from two-three years ago. Small business groups have always marketed themselves internally as high return units. With the cost of lending rising and available deposits (and their value) decreasing this may no longer be true, at least in the near term.

 

Going larger offers increases transparency and improved efficiencies

Several lenders mentioned that financial information was both more detailed and of higher quality with larger companies versus small ones. Further, one lender mentioned that the cost of originating, underwriting, and monitoring a small loan was no longer very different than the cost of a much larger loan. Obviously, if that is the case the operating efficiency of the small business effort will pale in comparison to other areas.

 

Therefore, focus on increased selectivity

Of course, even the lenders mentioned above continue to make small business loans. What they are insisting on, however, is much greater discipline in their market focus and a willingness to a lower return on each loan.

 

Concluding thought

FIC views the small business segment as one of the most attractive areas for a bank wishing to establish itself as a relationship-based company. However, the concerns outlined above provide important and valuable issues for banks to consider and address. The small business arena has changed significantly in recent years. “Old” approaches and biases may result in market failure.

 

In our next newsletter we will summarize why small business remains highly attractive for many banks and outline how banks should approach this segment to succeed.