Turn SMB lending economics around with updated credit risk pricing and other tech advantages

Key Takeaways:

Tip of the spear. Small businesses need access to capital. And banks want to expand beyond retail customers. Lending banks see advantages with small business loans. It’s a tip of the spear product. Start with loans, and typically, you can bring in deposits, thus creating a banking relationship. The key is getting the economics right, says Moody’s Senior Director Laurence Stock.

More efficient servicing. With digital onboarding, AI-driven credit decisioning and other ways to reduce the amount of human contact, especially for small-dollar loan amounts, costs increasingly can be held in check for banks and SMBs.

Take the guesswork out of pricing. Banks today heavily lean on technology to price credit risk and create an advantageous spread. Combine this with cost savings, and SMB lending economics completely change for the bank, says Moody’s Laurence Stock.

Transcript

BAI’s Rachel Koning Beals: Let’s start at a high level. How valuable is it for banks to make capital available for SMBs? They’re borrowing anywhere they can. They’re putting it on a credit card. They’re tapping friends and family, or, unfortunately, they run out of options. So, in your view, what is it about this market segment that’s so important to the banking sector, to local economies? You know, it’s one that banks can’t afford to ignore, I would argue. What do you think?

Laurence Stock: Yeah, I mean, I think it’s a huge, important segment, as you said. You know, they drive employment in most locations. They’re sort of woven into the fabric of local communities, you know, from and so. And if you ask small business owners, if you look at the surveys, their No. 1 issue, typically, is access to capital. So they’re very creative about how they get that. But the sort of the ease of bank-provided capital that exists commercial customers just doesn’t exist in small businesses, right? So they need the capital and that’s sort of a huge issue for them as a business.

What kind of resonates across all the research … on the banking side, on the lender side. Why is it important? Well, small businesses can become large businesses. Small businesses drive local economics. As I mentioned, it’s a key differentiation point for lenders that are focused on their local communities to be able to lend to those small businesses. They’re chronically underserved by larger lending institutions, and so I think there’s sort of, there’s definitely two sides to this. The businesses need access to capital. It’s one of their key constraints on growth. And then lenders have some real advantages as to why they would do that. It’s a tip of the spear product. Typically, you can bring in deposits. You can bring in banking relationships. If you’re willing to lend, you could. You can bring in connections to business owners. Business owners have founders. They have wealth. They have insurance needs. And so again, there’s just more and more layers as to why this is important, both to the businesses and also to the lenders.

BAI: Why, though, has this been a market segment that perhaps historically, many banks have been underserving, and may still be underserving?

Stock: I think there are a couple of components here. I think there’s a structural component, which is, you know, where does small business, small- [and] medium-sized enterprises – where do they live? If you’re a lender, at the very low end, you’re talking about sole proprietors, which are sort of one small notch above the consumer segment. At the upper end, you’re at the low end of commercial and so what’s the right way to service that segment? Do you try to service them through your retail network? Do you put them into the commercial group? But now you’ve got really small transaction sizes for lenders who want to go after the big deals. And so I think institutions often struggle with, where’s the right home for this? And you’ll actually see this group sometimes kind of bounce between those two over time.

And then there’s some hard economics, which is, you know, you’ve got to be generating income. That’s what banks, that’s what lenders want to do. And I think there’s a How do we service them challenge, and I think the combination of those two makes it a hard nut to crack for a lot of organizations. And I think that attention gets diverted elsewhere, even though I do think there is this belief that it’s an important segment, but it’s one that has challenges.

BAI: If banks want to be, need to be in the money-making business, there is a piece, how do you price this line of business? How do you differentiate? You can’t just, you know, make it sort of a value-added pricing. And you certainly shouldn’t make it one- size-fits-all, right? So talk to us a little bit about the pricing component?

Stock: I think the secret here, overall, in economics, is you have to solve for two problems. You have to solve for, how can I fundamentally originate these loans cheaper? You can’t run a $50,000 loan through the origination process that you would use for a loan that’s 10 or 100 times the size. And so you’ve got to digitize everything, automate as much as you possibly can, streamline the process and reduce the number of human touches on that process to the bare minimum. That’s taking the cost side of the equation out. And the good news is the tools exist to do that. That’s sort of great, but probably not enough. You also need to fix the income problem, which is, how do you make these loans more profitable from a spread perspective. And I think that traditionally, you know, if you kind of manually originating these loans, you can’t have a lot of complexity in the pricing policy,

[For example] We’re Prime plus X, and we try to be 25 basis points lower than the bank down the street, because we compete with them in the market. But what these new solutions offer is the ability to price risk, and so not everyone’s going to pay the same price. And so we can understand the risk of the business, the risk of the credit history of the owners, the geography, or whatever factor you want to take into account, and you can run much more nuanced pricing and get more spread.

And then there’s also the issue of convenience. I mean that is really not up for debate anymore. Small business owners will pay for convenience. They’re actually, you know, they don’t want to spend any more money than they have to, but they want [lending] products that are easy to access, that are convenient and streamlined. And they will pay for that. I think the proof exists to demonstrate that. So I think you have to solve kind of both sides of the equation.

BAI: There is something fundamental for banks about keeping a footprint, a presence in the community. And maybe that does sort of go hand in hand with small business lending. In a way, you really are out there in the community. But as you very smartly noted, SMBs want digital ease too. You know, it’s a lot of resource drain on banks. Is there a balance between presence but yet seamless flow between the channels?

Stock: There is a win-win hidden here, actually, because you know what the small business owners want is, I want the convenience of being able to engage my bank in whatever channel mode makes sense to me. So it’s 2 a.m., I’ve just finished up a really long day. I’m on my mobile phone. I have a need for capital. I want to be able to jump on that website, fill that application in, and know that I’ve got a process going. But I also, if I did that, I want to be able to walk into the branch and ask the branch manager, hey, you know, I’m having an issue understanding something here, or I need help, or I want to call the call center, and so, you know, I don’t love the words “omni channel,” but you need to be able to have a process that can span those channels and have the small business owner be able to elect how to engage.

Now, the flip side of that is some of those channels are much cheaper for the bank to actually support. You know, we’ve seen very successful call center programs for small business owners. We’ve seen great adoption of self-service applications, for example. So small business owners will do their part of making these transactions cheaper for the lender, you know, and I think it also solves for the challenge in the branches, because, to your point, you know, you need that local presence. You need to be physically in the community as well as you know, banking into the community. But the challenge is, you can’t stock those branches with experienced lenders. And so how do you bring a simplified, intuitive, obvious, streamlined lending process in that not only can be understood by small business owners who have varying degrees of sort of financial literacy, but also, you know, people in the branch who can just sort of help you navigate through that process, and don’t have to be seasoned lenders with 30 years of experience.

BAI: It sounds to me like relationship manager isn’t necessarily dead as a role, but maybe it looks a little different?

Stock: Yeah, I think so. I mean, if you think about the commercial space, we have the traditional model of relationship managers owning those relationships, but of course, there’s the economic support. You can be dedicated and spend a significant amount of time talking to a much larger potential lending situation. Relationship managers, or the people who own the relationship in banks, is often the Assistant Branch Manager who sees the customer, obviously, often, or the branch manager. And so you just need to empower those people to do that in a lending context and not just do that in the other context of helping them manage their deposit or, you know, other relationships they have with a bank. And so yeah, that’s, I think, in a space where you can’t dedicate cost, you know, dedicate resources to service those customers. I think you just need to empower the people that you do have who are interfacing with those customers to kind of play that role. So I think it’s sort of a more nuanced view of how we do relationship management.

BAI: We’re here talking about lending, but banks have again, made deposit attraction and retention a top goal. Our annual outlook tells us this. Can we draw a link between small business customers, lending customers and deposit stickiness?

Stock: Let’s take the new customer example there. You know, we’ve seen lenders be very successful with leveraging that loan to that non- customer and saying, you know, this loan is contingent upon you bringing us your deposit business. And I think that’s a very natural conversation. I think customers understand, yeah, I understand that if you’re going to lend me money, you want my business. And so it’s tough. I mean, again, small business owners are busy. It’s tough to, sort of in a vacuum, ask them to move their operating relationship with a bank. It’s a pain to do, right? It requires some effort, and I’m busy running my business. But, you know, we see that happening when there’s a loan situation there.

So again, great tip of the spear product to kind of facilitate the capture of that deposit relationship. And so, you know, in many ways, these small business programs for prospects are net deposit positive on day one in terms of bringing those relationships in for existing customers. I mean, I think if you look at the research, it’s pretty compelling. The more products you have, the stickier the relationship is. And so if you have a lending relationship alongside a deposit relationship, and you potentially have some other services, those are the situations that are just least likely to churn and have somebody move to another institution. So I think there’s an existing customer angle to that, and also, you know, a new customer angle as well.

BAI: AI is driving many conversations in banking and in small business operations, too. You and I were talking recently, and I liked a use case you brought up: SMB owners might be sole proprietors, but regardless of the size of their business, these operators are busy running their business. They’re not loan experts. AI, at a minimum, might do some of the leg work in loan knowledge. They’re asking themselves: Where do I even begin? I liked how you sort of offered up to me like they might start with AI as a way to kind of start the loan process on their side. Walk us through that a little bit.

Stock: I think just sort of establish the baseline, you know, the digital approach to taking a small business loan application and processing that through to money in your account. I think we’ve proven that we can do that in a way that is simple and intuitive to small business owners. If you look at the PPP lending wave in the pandemic, by the time we came around for the later rounds, then nine out of 10 applications were getting submitted self-service. And if you remember back that was a complicated lending process, lots of rules, lots of documentation. And so, you know, we were able, alongside, you know, other providers in the space to simplify that and make that intuitive. And so, you know, I think that the tools exist to do that, and the proof is that it is working great. What portion of these small business owners don’t have the literacy to know what a revolving facility looks like?  And I think that AI could play a really important role as kind of that next layer of just continuing to make the process more intuitive.

BAI: Maybe a couple examples, how could AI be additive inside the bank to the lending process?

Stock: I think certainly at the low end, you know, we see banks wanting to automate the sort of the decision and the credit underwriting of loans. If it’s a low dollar amount loan, and you’ve got a great credit score and you don’t see any red flags around the company, maybe that’s just a decision you want to give somebody in 20 seconds and get them on their way. And so we see that’s being done today. But again, I think AI opens up the possibilities of making that process much easier to set up and manage. For example, you could actually just consume a credit policy written in plain English, rather than have to sort of configure all of the levers to make that happen.

And then, you know, in terms of how these applications get handled, how they get routed, what decisions you make about how do I need to underwrite this deal? Given these different circumstances, what documents do I need? What documents do I already have? If it’s a repeat customer, maybe I already have some of their financials, or maybe I’ve gotten them since. And so, I think AI really opens up the ability to make that entire lending journey even more data-centric and even more intelligent than it is today. We have the tools to do that today. But I think, again, it’s just another level that could really just take even more friction and cost out of the process.

BAI: You’ve been at the forefront of rethinking processes, putting capital to work as quickly as possible, any final thoughts on small business lending and the importance of streamlining, both for banks and the businesses that really can’t afford disruption.

Stock: I think I just come back to this disconnect between how important we all intuitively know this segment to be and where it’s ended up in our priority. I think the challenge to the industry is to acknowledge that we have the tools to fix that disconnect, right? We’ve got the tools to build these efficient, profitable small business lending programs, and that’s going to solve the “I don’t make any money, and it’s really small” problem that I think is sort of the disconnect, and as I said earlier, this is a potentially huge differentiator for banks that value their relationships with their community and see all the sort of the tentacles of the connections that exist in communities around businesses. And so, I think the challenge is on us to leverage both what exists today and what’s coming with the advances in AI, to just get these programs up and running and get the capital to the businesses we know they need.

BAI: I’m Rachel Koning Beals, senior editor with BAI. I want to thank Laurence Stock of Moody’s for joining us today on the Banking Strategies Podcast.

Stock: Thanks, Rachel, a topic near and dear to my heart, as you can tell. I really appreciate the conversation.