From Risks to Rewards in Small-Business Lending

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Technology solutions can help revitalize a critical source of bank profitability

During the Great Recession, banks circled the wagons in the face of a struggling economy and significantly cut commercial lending, especially to small and mid-size businesses. As the economy begins to recover, more banks are shifting their inward "survival" focus to one of growth. The overall amount of commercial and industrial loans has increased significantly since 2008, according to theFederal Reserve Bank of St. Louis (see graph).

However, a recent report from the Cleveland Federal Reserve Bank shows that between 2007 and 2012, commercial loans in amounts less than $1 million have fallen by some 344,000, while the number of small businesses has risen by about 100,000.

Lower demand for commercial lending during the recession is certainly part of the explanation for this trend. However, banks' credit requirements also tightened and they are increasingly reluctant to lend smaller amounts to true Main Street companies, instead preferring loans in the hundreds of thousands of dollars or more. On the one hand, this makes sense, because even though commercial loans carry higher net interest margins than some other types of interest-bearing assets, the sheer manpower needed to service smaller commercial clients could be burdensome if relying on traditional methods of risk management and client service.

Source: Board of Governors of the Federal Reserve System.

On the other hand, the reality is that banks of all sizes have seen net interest margins decline over the past year. Small-business lending is a key opportunity for many banks to increase sales and improve margins and retention rates. Small businesses provide low-cost deposits, high-quality loans and numerous cross-selling opportunities.

How, then, can a bank seize this opportunity without significantly increasing staff and outlays on technology infrastructure like additional hardware?

Technology for Scalability

The recession years and beyond have been prime time for new financial technology start-ups to make their mark and disrupt arcane processes, while also helping financial institutions comply with increased regulation. The emergence of big data analytics and cloud computing has amplified the effect new solutions can have for banks. These include greater transparency between departments and much more insight into customer behavior and business trends, which can help banks create customer-driven solutions to increase retention levels.

Customer-facing technology and big data will be the keys to helping banks, particularly smaller ones, scale capabilities and expand their small-business lending practices. Banks that can harness their commercial customers' data and display it in a centralized, transparent system will be rewarded with significant comparative advantage vis-à-vis banks without such scalable systems.

Technology (especially software-as-a-service, or SaaS, solutions) helps bankers make better loan decisions up-front and monitor credit lines to strengthen risk management best practices.

Additionally, solutions that are customer facing will enable bankers to offer value-added services to clients, thereby increasing retention rates and cross-selling opportunities.

Small businesses often have various banking product and service needs, yet their banks do not proactively identify them, giving business owners incentive to look elsewhere. In fact, the National Federation of Independent Businesses reported that 25% of small businesses have switched banks in the past four years; of those who switched, nearly 40% said they felt "mistreated" by their former banks.

Bottom Line

As mentioned before, the rewards banks can expect from expanding commercial lending are increased interest spreads, which are direly needed as net interest margins, even at the largest banks, remain stagnant. By utilizing customer-facing and/or cloud computing solutions, financial institutions can also effectively scale existing resources to manage increased loan volume and maintenance requirements, reducing the need to hire and train an army of loan specialists.

Of course, small businesses are subject to the same economic winds as consumers. Another economic downturn would further reduce the creditworthiness of these businesses and increase overall risk for the lender. However, we've seen how overexposure to one revenue source (residential mortgages) affected banks large and small during the recession--and the risk of repeating the same mistakes should be top-of-mind for all bankers.

James Walter is CEO and co-founder of Finagraph, a Seattle company with a cloud-based automated financial intelligence tool that connects financial institutions and accounting firms to their business clients.


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