Taking a Cue from FinTechs
Commercial Credit, Small Business Credit, Digital Lending, Credit Risk Modeling
There’s no doubt that private businesses have a profound effect on the economy. With over 28 million private businesses that account for at least half of the U.S.’s GDP, this segment plays a significant role in how our nation is doing when it comes growth or contraction. The good news is that we have seen this segment come to life over the last six months – putting money to work and making contributions to the labor market, wage growth and other factors that have subsequently elevated the financial well-being of the American worker and consumer.
An essential factor to private business vibrancy and U.S. economic prosperity is access to credit, which helps fuel investments. Yet, even as the economy continues to grow, private businesses have struggled to gain access to credit.
As a result of the financial crisis in 2008, large banks substantially pulled back from lending, and small and medium-sized banks as well as FinTechs were unable to entirely fill the credit gap. This resulted in fewer loans to private businesses – in fact, the national average for bank originations was down 24 percent while local GDP was up 20 percent since 2008.
This is significant trend that will need to change in order to keep the economy healthy, vibrant and moving in a positive direction.
Recently, I sat down with Bill Handel, vice president and chief economist at Raddon, to discuss this issue as well as the recent PayNet/Raddon research report Gimme Credit: Faster, Simpler, Safer Credit for Main Street America, which provides key insights into the private business credit market, and solutions for financial institutions to overcome challenges so that they can capitalize on the opportunity to further contribute to strengthening the economy.
Q&A with Bill Handel, VP and Chief Economist at Raddon
Phelan: Roughly 70 percent of private businesses have growth plans, and a decent amount of those plans are fueled by borrowing. However, major banks have pulled back significantly in lending to this segment. How can private businesses get access to the much-needed credit?
Handel: Amid all the recent good economic news – positive GDP growth, low unemployment rate, etc. – there is an underlying trend which is disconcerting. Private businesses have had their access to credit significantly reduced since the financial crisis nearly ten years ago. This was led by the largest banks, which significantly pulled back their private business lending.
The PayNet/Raddon research report indicates that seven in ten private businesses consider one of the large banks as their primary financial institution; it is likely that they will turn to those banks to meet their credit needs. Impacted by the economic environment and legislation such as the Dodd-Frank Act, the largest banks curtailed credit to private business, leading to this much slower economic recovery. The current recovery, while long in duration, has been noticeably lower in growth and, in fact, only about 70 percent of the historic norm. This is due in part to the lack of credit availability to private business, an engine of economic growth.
To fill the credit gap, other financial service providers are starting to step up. PayNet research shows that community and mid-tier banks were not as restrictive in lending to private businesses following the financial crisis. The challenge for community and mid-tier banks is the cost curve associated with this lending. While many smaller banks would like to be able to serve private businesses, the typical credit size, especially in Commercial and Industrial (C&I) lending, makes this an unprofitable endeavor given the high underwriting and loan review costs.
Our research shows that the average credit private businesses are seeking is only $75,000, and the industry’s underwriting processes cannot economically support credit/loans that small at interest rates the private business can afford.
FinTechs have also rushed to help private businesses. Unlike banks, FinTechs often have processes that allow them to provide smaller amounts of credit much more economically. The issue for FinTechs, however, is that they lack the brand awareness and brand strength in the marketplace. This results in high marketing costs which can ultimately offset the cost savings from improved underwriting processes.
Phelan: Between 2014 and 2017, the number of private businesses applying for online loans has gone from 14 percent to 24 percent. What’s driving that shift?
Handel: That’s simple: the lack of affordable credit. Private businesses are attracted to easier, simpler processes and faster speed of decisioning – which has resulted in this segment turning to the FinTech world to find credit. This trend has put traditional sources of financing – including community and mid-tier banks – under pressure. It can also present an issue for private businesses because financing through FinTechs can leave them without access to local experts who know them and know their marketplace.
Phelan: Given this environment (a move toward non-traditional private business loans), what’s the opportunity for smaller, community-based financial institutions?
Handel: Community-based financial institutions need to find a way to reduce private business loan costs. A large part of these are underwriting and review costs, which can be significantly reduced if automated. Through the appropriate use of technology, the process can be significantly streamlined or even eliminated without deleterious impact on portfolio quality. By reducing these costs, the institution can reduce the loan rate needed to reach the desired return-on-equity (ROE) or reduce the minimum loan amount the financial institution is willing to write. In either case, the bank benefits, the private business borrower benefits, and the local economy benefits.
Phelan: What do C&I lenders need to do to reduce costs and accelerate approval and funding rates so that smaller dollar business loans remain profitable?
Handel: Take a note from FinTechs – who have helped pave the way. Identifying ways to reduce the lending cost curve can result in a much more attractive C&I loan product. It’s important to not treat all C&I borrowers in the same manner, as different industries have inherently various levels of risk. Likewise, loans of differing sizes also should not be treated uniformly. For example, the effort put into assessing the risk on a $90,000 C&I loan should be very different than the risk-assessment effort behind a $2 million loan. It’s also important to take advantage of data that can better inform lending decisions and help manage risk while reducing the time to underwrite and service. Taking these steps will reduce the cost curve.
Phelan: How does that impact the overall economy?
Handel: As I said, a major factor in the slow pace of the recovery is the lack of credit availability to private business since, a gap that was created when the largest banks abandoned this market. At the same time, we have some of the highest levels of private business optimism we have ever seen. Community and mid-tier banks can fill this credit gap effectively and profitably by evolving their C&I lending processes and shifting the lending curve downward. The result will be more private business loans and more prosperous communities.