Bankers: Build Your Own Small Business Loan Platform

Banks that grow revenues do it in spread or fees. To grow spread, increase your net interest margin, or grow earning assets while maintaining net interest margin. To grow fees, either increase your fee schedule or the activities that generate fees, or grow fee-based lines of business. 

Since 2007, banks have been challenged to grow revenues. And if the bank strategic planning sessions I attend are an indicator, bankers think small business account acquisition and growth will be a significant driver of revenues.

This presents a challenge. Many if not most small businesses are not “bankable”, in the lending sense of the word. I once offered this hypothetical situation to a senior lender: An owner of a three year old engineering firm wanted to expand. The expansion would take him into the red for the next two years and his seed capital, taken from his personal savings and a home equity loan was not enough to fund the expansion. He leased his office space. Would the senior lender make the loan? His response: “I’m glad you’re not one of my lenders.”

Would his reaction be different at your bank? Check out your current and recent past loan pipeline. How many non real-estate backed business loans did you make? Yet this hypothetical business is more typical of the businesses that will lead our economy forward. So to grow revenue, perhaps your bank should be a little more creative in getting capital to businesses of the future.

No risk appetite to do early stage business lending? There are alternatives to help that business get much needed capital to grow without plunking a risky loan on your balance sheet. Perhaps develop a small business lending marketplace with several options. One option could be balance sheet lending in the form of home equity loans or other similar avenues that fit your bank’s risk appetite. Think: Your Bank’s Small Business Capitalizer package.

If outside of your risk appetite, how about SBA lending? Ridgestone Bank, a $395 million in assets Wisconsin bank was ranked seventh in SBA 7(a) lending last year, generating between $20 – 25 million in gain on sale of loans per year. 

SBA loans not an option for our hypothetical engineering firm? How about a partnership with a peer to peer lending platform such as Prosper that can be co-branded with your financial institution? Prosper will pay an affiliate fee for each loan offered. OnDeck Capital, which specializes in business cash flow lending, will also affiliate with financial institutions, providing another avenue to fund our hypothetical engineering firm.

It’s not necessarily the affiliate fees that will move our revenue needle, but providing budding businesses within our communities the needed capital to succeed will build loyalty, deposit balances, and eventually “bankable” loans should these businesses succeed. Instead, we send them elsewhere, giving a potential competitor the opportunity to win these businesses’ relationships.

Imagine the “Your Bank” small business loan platform, with multiple opportunities for the local business person to help fund their growth. You start with the least expensive, such as “bankable” real-estate secured loans from your bank, and work through the other options such as SBA, OnDeck, Prosper, and even equity platforms such as Kickstarter. That would be a bank dedicated to small business capital formation, and growth, within their communities.

And a growing community usually leads to revenue growth at your bank.

Or you could stick to business as usual, and hope small businesses come your way. Your choice.

~ Jeff


Note: This article was previously published in the April 2015 issue of ABA Bank Marketing and Sales magazine in the Growing Revenue series.

De Novo Banks: Only Apply If You Intend to Matter

ABA President Frank Keating wrote an Op-Ed piece recently in The Hill entitled New jobs and new growth call for new banks. I don't believe it. A more accurate title should have been New jobs and new growth call for new businesses. His leap-of-faith assumption was that new banks are critical to new business formation. I'm skeptical.

Why? I don't think de novo banks are key players to business startup capital formation. Sure, if you cite studies that say these banks' loan books are predominantly small, as the FDIC measures them. But that is because de novo's are limited to making a loan to one borrower of 15% of their capital position. If a de novo starts with $15 million of capital, its largest possible lending relationship is $2.2 million. So the bank necessarily hunts for smaller relationships.

I'm also skeptical that small community banks in general are financing startup businesses. See the accompanying chart for the loan composition for all FDIC-insured banks and thrifts with less than $1 billion in total assets.

So, if a de novo bank has $100 million in total assets after its first year of operation, and it's loan portfolio was $70 million, then its business loan portfolio would be $9 million, if they achieved the community bank average. And that's all non real-estate loans to businesses, not necessarily startup or early stage businesses. Since I often hear credit people talk of getting three years of tax returns to get a loan decision, it makes me wonder how a 1 year old business can satisfy the requirement.

OnDeck Capital, not a bank, will lend to businesses with one year of operating history and only $100,000 of annual revenues. How do I know this? They tweeted it to me. That's right, they tweeted it.

I am doubtful many financial institutions would make such a loan.

To be fair, the loan portfolio composition in the above pie chart is from Call Reports, which categorize loans by collateral, not purpose. There may be small business loans in the residential category, because the business owner pledged his or her house as collateral for the loan. But I doubt OnDeck or similar neo-banks are requiring such collateral. And OnDeck and similar lenders are growing rapidly in the startup or early stage business financing landscape.

So, no, Mr. Keating, I don't think de novo banks, being run and regulated as they are currently, are critical to small business formation. Who wants a regulator to come in for their periodic exam cycle and ask "why did you make this loan"? What banker is running to capitalize an early stage business without real estate as collateral?

I don't know of many.

Do you think de novo banks are actively participating in startup or early stage business financing?

~ Jeff

Why are start up businesses not creating jobs?

I posed this question to a Fed economist today. Her answer: lack of capital.

The above chart is from a Federal Reserve Bank of San Francisco Economic Letter: Slow Business Start-ups and the Job Recovery published in July.

But in strategic planning retreats that I moderate, community financial institutions insist that they lend to small businesses. In fact, when I recently spoke to a group of New York bankers, I opined that community FIs would lend to small businesses only if they have three years of operating profit and a building as collateral. Some took offense.

The chart above, taken from a Harvard Business School Working Paper: The State of Small Business Lending written by a former SBA Administrator and also published in July, shows that only 34% of small businesses use a regional or community bank as their primary financial institution. The second chart shows the primary sources of capital. Yes, a loan is the most often cited. But trade credit and credit cards also weigh in heavily.

The above chart, taken from the same HBS working paper, shows the use of proceeds of small business credit. Given a community FIs lending proclivities, one would assume that small businesses borrow to finance a building. But no, the primary use of proceeds is for cash flow. Real estate structuring is pretty low on the list.

I discuss this disparity between how bankers perceive they contribute to small business capital formation, and why businesses need capital. In March 2010, I wrote about the decline in business lending among community financial institutions in a blog post titled: Have we checked out of business banking?

So we limit small business lending to those businesses with three years of operating profit and have real estate as collateral. Not exactly lending into the industries that are projected to grow, such as service firms and professional/technical practices. These businesses are commonly located in an office building that they do not own. 

Another challenge is the number of businesses that do not borrow. According to the HBS working paper, only 40% of small businesses apply for credit. Out of the forty percent, 43% did not receive the credit they requested (see chart). 

So let's extrapolate... eleven percent of small businesses borrow for real estate structuring and another 13% for debt restructuring. But only 40% of small businesses borrow. So 40% of 23% is 9.2%. But only 43% get approved for the amount of loan they requested. So about 4% borrow for real estate or debt restructuring and get the credit they requested. But only 34% of small businesses bank with regional and community banks. 

So for 1.35% of small businesses, community FIs stand ready to lend!

Of course, I exaggerate, because many small business loans used for cash flow, inventory, etc. are collateralized by a commercial or residential building and financed by community FIs. But I think our participation in small business funding is far smaller than we claim.

So if we want our communities to thrive now and into the future, small business formation and growth will be critical. Lack of capital is always a top of the list constraint to small business success.

Are we participating in this critical segment of our economy?

~ Jeff