This is a reprint of an article that originally appeared on The Financial Brand on December 29, 2022.
For decades, the success of many community and regional banks has been tied to the towns and counties where they do business. As a result, these institutions hold more than a third of the banking industry's small business loans. Yet many institutions fall short in providing business loans to small firms in their markets' most financial underserved areas.
The gap represents an opportunity to nonbank small-business lenders, notably digital lenders that can bring new technologies to bear.
In fact, a shift has been underway for some time. A fall 2022 paper on small-business lending from the Bank for International Settlements found that two prominent U.S. fintechs that make small-business loans — Funding Circle and Lending Club — lent more than their bank competitors in zip codes with higher unemployment rates and higher business bankruptcy filings. (The period studied ran from 2016-2019.)
This finding represents a competitive threat not only now but going forward. The Bank for International Settlements report concluded that fintech lenders have the potential to "create a more inclusive financial system, allowing small businesses that were less likely to receive credit through traditional lenders to access credit and to do so at a lower cost."
Digital Technologies Are Changing Competitive Balance
The main differentiator with fintechs' success in this area primarily comes down to better technology. The paper indicated that this advantage includes improves ability to evaluate credit risk as well as the ability to gather "soft information" formerly regarded as the advantage of local banks with "boots on the ground." One example cited is remote lenders' access to customer ratings and satisfaction levels posted online, such as restaurant rating sites.
In recent years traditional banks have adopted emerging technologies, such as digital loan origination capabilities. However, there is still untapped tech potential in areas like automated loan underwriting and use of more robust data and analytics in the institutions' credit models.
The banking industry, in general has been slower to develop digital credit products that cater to the needs of small and medium-sized businesses. Fintechs and neobanks, realizing banks' missed opportunities, have been quick to cater to this segment.
Yet banks still have multiple opportunities to catch up — and even surpass — what specialized fintechs are doing today. Success hinges on adopting three key technologies.
1. Automated Loan Underwriting Is Becoming Essential
A growing portion of the lending industry has broadly migrated to this technology to speed up the processing time for all loan types, yet many banks still lag in this area.
A 2022 study by the Conference of State Bank Supervisors found that only 13.1% of institutions surveyed have adopted automated loan underwriting technology, with 13.9% reporting plans to adopt it within a year. That's just one out of four respondents, all told.
The Promise of Automated Underwriting:
Automated loan underwriting could improve bank lending in financially underserved areas. Potential benefits: quicker loan processing, better credit decisions and fraud detection, and enhanced customer experience.
Worth noting: Not all lending can be automated. Leveraging technology for "streamlining" to be more efficient with human capital, rather than eliminating, can also help improve service to underserved areas.
This suggests that there will long be a role for the local lender.
2. Alternative Credit Data and New Scoring Methods Can Help
Accepting only the mainstream, traditional credit data that's often associated with consumer lending leaves opportunity on the table. There's growing acceptance of nontraditional data as a means of evaluating small business prospects and customers, especially sole proprietorships.
A lender's ability to examine cash-flow trends can help predict whether an applicant can repay a loan on time and in full. Fintech lenders tout that they regularly use such data in their credit risk evaluation and scoring to supplement the traditional FICO scoring.
Financial institutions that can incorporate a firm's cash flow, local economic trends, census data and other key factors into their automated loan underwriting systems gain the ability to reach new business banking customers. There is also the added social benefit of specifically reaching more businesses in underserved areas and among overlooked business owners who have been flocking to fintechs in recent years.
3. Gain Insights into the Transactions that Make Small Businesses Tick
Banks can better meet the credit needs of small and medium-sized firms if they have better insight into revenue streams. this is an advantage that companies like Block's Square and Intuit have had for years and, more recently, Amazon as well.
With Amazon, the financing options for companies that sell their goods on the ecommerce giant's site just keep growing, ranging from merchant advances, the latest lending form, to term loans, interest-only loans and lines of credit.
A key element of all of the Amazon business lending programs is that the company and its lending partner have a degree of insight that other lenders don't. In operating the sales platform, Amazon knows precisely how much and how frequently the third party seller is making sales.
Banks can gain insights along these lines and also help deliver services that businesses want. Research by Cornerstone Advisors has found that small businesses want to obtain accounting and payments services from their banks or credit union. (The same research also found that respondents would overwhelmingly prefer to borrow from their primary bank.)
Financial institutions that develop proprietary retail-focused accounting and payments services could leverage the insights available to them to better serve their small-business customers and build deeper, more profitable relationships. This could give banks better insight to how a business might perform in the long run, which in turn could lead to more loans for businesses in underserved communities.
To make this happen, banks should be exploring open banking capabilities. Open banking is often more closely associated with consumers, but the ability for banks to give these businesses a more personalized and streamlined experience could go a long way in better servicing this segment.