Why Banks Are Missing the Bullseye for SMB Lending

According to Cornerstone Advisors’ annual What’s Going On in Banking study, for the third year in a row, small business loans are among the top lending priorities for banks. 

That shouldn’t come as a surprise to anyone.  

The Small Business Administration reported that new small business C&I lending increased nearly 38% year over year from Q4 2020 to Q4 2021, excluding Paycheck Protection Program (PPP) lending. Another positive sign: credit quality continued to improve with loan approvals, increasing across all bank asset tiers.

That was the good news. 

A survey from First Citizens Bank (NC) found that many small business owners worry about high costs and slowing economic conditions looking ahead, with less than half reporting confidence in the 2022 economy.

This is why banks should worry.  

Why? For these three reasons:

1) Status quo small business underwriting stunts growth 

There’s no question that many banks need to digitize their loan application process to better compete with fintechs serving the small business market. But banks’ challenges go deeper than the front-end experience. According to Nick Mathews, CEO of Mainvest, an investment platform that aims to connect small business owners and investors:

“Even in normal times, small businesses struggled to get loans from traditional banks because the underwriting models are really designed to look at multiple years of historical financials to risk assess whether they can deploy that capital. The banks don't know how to reconcile their traditional models to this crazy level of variability. The underwriting models that banks use are designed on consistency, and so when you lack that consistency for multiple years, it makes it really challenging for large institutions in order to adapt to that.”

Fixing the front-end is a necessary step. But ignoring the back-end processes may limit and depress banks’ small business loan growth.

2) Lending is the new frontier for fintech payment players

Even if demand for small business loans continues to grow, banks have no lock on the business. Large fintechs that began by offering small businesses payment processing or eCommerce capabilities have emerged as financing options, including:

• PayPal. Among small businesses that use PayPal’s payments service, 72% have secured short-term financing from the company. 
  
  
  
  
• Square. Now named Block, the company began offering small-business financing in 2014. Among its base of merchants, 36% get financing from the company.
  
  
  
  
• Shopify. The platform, which began by helping small businesses set up online stores, began offering financing in 2020. More than a third of small-business owners who use Shopify products also use its financing.

These fintech platforms leverage their operational relationship with merchants to tap into payments and cash flow data about the small businesses, which enables the fintechs to proactively offer small business loans. 

3) Borrowing mix - cash advances and credit - drive new behaviors 

Small businesses are increasingly seeking alternatives to traditional small business loans. A survey from JPMorgan Chase found that nearly half of small businesses plan to use business credit cards to help raise capital—up from 38% in 2021—with line of credit funding being the next most common funding method. 

A study published by Smarter Loans revealed that 40% of business loan seekers compare more than six options. Although the study focused on the Canadian market, according to financial news source deBanked:

“It may partially explain a finding in the US, that more small business owners seeking capital are seeking out a merchant cash advance as a potential option than ever before. A Federal Reserve study said that 10% of SMB capital seekers sought a merchant cash advance in 2021. That would make sense if business owners are obsessively applying to multiple sources for the sake of making more comparisons.”

Small business owners may be shopping around, but Smarter Loans found that only 60% of small business loan shoppers felt informed about their options, and of those that got a loan, 40% were not satisfied with their loan provider.

What Banks Must Do to Win in Small Business Lending

You know that parable about the blind men who have never come across an elephant before and who learn and imagine what the elephant is like by touching it?

I’m reminded of that story when thinking about how banks are approaching the small business lending market. 

Some address the situation by believing all they need to do is digitize their loan application process. Others are focusing on capturing more data about small businesses. And others are expecting to capture more business by improving their marketing and CRM capabilities. 

These are all important things to do—but separate parts of the small business elephant. 

Banks that don’t take a holistic approach to developing a small business strategy (note that I didn’t say small business lending strategy) are destined to fall short of the small business lending objectives for the foreseeable future.

The starting point isn’t digitizing loan applications, collecting data or investing in CRM technology. The starting point is determining who is in the center of their small business bullseye. 

The center of the small business bullseye are those types of small business—by vertical market, size, location and banking needs—that the bank wants to attract (or has already attracted). Everything about the small business strategy should be designed and built around this segment of the small business market. 

But that’s just a small percentage of the total market, no?

It is. But a bank that can better serve the small businesses in their bullseye will likely be better serving other adjacent and analogous small business segments. 

Boiling the small business ocean isn’t going to win this battle for banks. But the opportunities are huge.