With a handful of consumer-facing “neo-banks” now at scale and listed (or soon to be listed) on stock exchanges, there is now what the markets believe to be a clear and present danger to the traditional banking system within consumer banking. For many bankers, this competitive paradigm shift felt gradual then sudden after the COVID pandemic forced the rise of a digital society and resulted in a huge market share shift in certain segments of consumer banking.
The same paradigm shift is beginning to occur in small and medium sized business (SMB) banking. Square, a $100 billion plus market capitalization company founded in 2009, is offering a suite of integrated business and financial services. Dozens of vertical SaaS companies are doing the same with a focus on serving specific industry segments. Many of these digital disruptors are integrating lending and banking into their product suite and are poised to supercharge their customer lifetime value. Fending off the SMB version of neo-banks will ultimately require a modern banking approach that bundles third party business services into the banking experience, while simultaneously reassessing lending and portfolio construction strategies.
Banks should also be looking to adopt to an evolving market by pursuing strategic partnerships with digital disruptors. In order to do so, banks will needflexible digital loan and account origination capabilities that can integrate with third-party platforms to support the digital customer experiences necessary.
In the near-term, it is imperative that the banking community ramps up lending efforts in their existing customer acquisition channels to preserve market share. The inordinate amount of stimulus money injected into the SMB economy is wearing off and demand for capital is increasing. Demand for SMB loans should soar as the economy rebounds. Banks that fail to activate their sales and marketing channels and institute accommodative credit policies will fall behind as the competitive environment has already changed. Within the last year, millions of SMBs obtained Paycheck Protection Program funding from fintechs who are aiming to become the SMB neo-banks of the future. These disruptors are looking to monetize their newfound SMB relationships and compete with their traditional banking rivals.
To keep pace, traditional banks should rethink their lending and portfolio strategy for this segment. The SMB community has learned to operate in a pandemic environment. More so, small business loan and credit card portfolios have been stress-tested once again. Did inordinate stimulus money help portfolio performance? Of course it did. Yet, the loss rates that many banks experienced in these portfolios resemble that of prime commercial loan portfolios. With SMB portfolio yields that are typically well above those of larger commercial loans, banks have attained compelling risk adjusted returns.
This begs the question, should small business lending within banking be approached as small commercial lending or more of a risk-based portfolio construction model? “Take more risk” is usually a lender’s famous last words, but lending is a risk-adjusted business and risk taking is a matter of degree. Lending should be analyzed based on through-the-cycle risk adjusted returns, not just an absolute level of risk. Each incremental level of marginal risk tolerance introduces another degree of loss volatility, a degree of which can be solved through price and another degree through loan sizing and line assignment strategies. For lenders, the challenge will be where to draw the line while maintaining acceptable through-the-cycle risk adjusted returns.
The instruments available to develop an analytically derived risk-based lending strategy in the SMB segment has never been stronger through data availability and analytical techniques. A robust library of third-party data sets spanning traditional and alternative data exist and can be combined with internal relationship and transactional data in real-time through APIs. In addition, statistically derived models have been stress tested and can be developed using stress tested data.
At a time when the competitive headwinds are getting stronger, many banks may be sacrificing market share because of their small business loan portfolio construction. The time is now to be more proactive in serving the SMB segment and in the disciplined analytical construction of an SMB loan and credit card portfolio strategy. This paradigm change can be gradual (not sudden) but should be expedient.
