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Cracking the Code on Small Business Credit

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Before the recession, community banks were able to provide tools, guidance, education, and financing to grow their small and mid-size business customers. Since that time, a more volatile economy and increasing regulatory requirements have introduced new concerns and costs that divide their focus and increase the cost of providing the high touch services community banks are best known for.

On the whole, banks became less tolerant of risk during the crisis as loans became more difficult to sell and equity capital more expensive.[i] Combined with the marginal returns on loans under $1 million and the lack of a secondary market, it’s no wonder that small regional and community banks who rely on revenue generated from SMBs are currently struggling to overcome profitability and growth issues themselves.

The problem that SMBs are experiencing today—the struggle to secure credit from traditional banks—was bubbling up well before the financial crisis. Its roots lie in credit analysis and risk assessment processes that work best when the pace of change is predictable, when economies are stable, and when the past is a reliable indicator of the future. When these disappear, as happened during the crisis, the process breaks down. It becomes extremely difficult to get or give credit when a way to obtain reliable, verifiable insights into a company’s current and future financial performance is missing, or misleading. 

It used to be that community banks could depend on their personal knowledge of a loan applicant to quickly determine if the SMB was creditworthy and whether they believed the SMB leadership would be successful. They had a history with these businesses, after all, and if a lender was comfortable with the risk and they were confident the loan was profitable for the bank, the credit was approved.

New regulatory reporting requirements put far more emphasis on objective means of validating and verifying the financial documentation provided by SMBs. What’s driving these new oversight requirements is an attempt to process risk ratings more accurate by ferreting out any obscure or hidden risks.

Online digital lenders are trying to win the race to solve this problem. By employing new data mining models and predictive algorithms, they are able to assess the creditworthiness of loan applicants faster and provide necessary financing to cash strapped SMBs more quickly. However, there isn’t conclusive evidence yet that the methods these alternatives lenders are using are any more effective at assessing the risk of an SMB than traditional underwriting methods. 

In addition, the absence of regulatory oversight and the expensive terms of their short-term loans may lead to unintentionally creating a new subprime market.

Although easing SMB access to credit is critical to our economy’s growth, it is not a long-term solution in and of itself. Accessible cash is not a tool that helps business owners and leadership teams make smarter growth decisions. It doesn’t help them plan for costly surprises such as losing a large customer or a key salesperson. It’s not going to give them insights into how to manage their cash flow so they have more working capital, or show what can happen if nothing is done. And it clearly won’t provide money management tools and services to support ongoing growth.  

New companies have joined the race to provide faster, more accurate ways to assess SMB risk. Some of these competitors offer automated credit scoring and rating services, such as Standard & Poor’s and Moody’s and Dun & Bradstreet. While they have a strong history of providing these services, their ratings are still considered well-respected “opinions” on a company’s willingness “to meet its financial obligations in full and on time…and the relative likelihood that the issue may default.”[ii]

Still other companies are selling credit analysis technology, oftentimes retrofitted to analyze SMBs rather than developed specifically for SMB realities. Even when the technology addresses the unique variability of SMB financial reports, the basis of the analysis is still based on past financial performance.  Trends and patterns are observed in the data and then projected into the future. Given the fast pace of change and the dynamic nature of the SMB market, analyzing trends in historical data and using that to accurately predict a possible future is a fruitless exercise.

As it stands today, all of these tools and methods omit a critical ingredient in their approaches. They don’t share the results with the SMB owners and their leadership teams, or they don’t share it in a way that makes sense to those actors. This omission is strangely near-sighted (though maybe economical), when you consider that numbers are just a reflection of actions, and the only people that can change those number are the SMBs themselves.   

An effective solution will need to overcome more than the problem of SMB access to credit. For it to be more than a short-term fix, the solution must also:

  • streamline costly and time-consuming underwriting processes by translating the wide variety of SMB financial statement reporting into a standard format  

  • open up secondary markets for these credit facilities

  • increase the accuracy of risk assessments and risk ratings

  • provide insights into the future financial performance of each SMB loan to improve regulator and investor confidence in SMB financing

  • share the knowledge with the very people that have the ability to directly impact the numbers—the people who lead and run the SMB companies
     

The key to a sustainable, long-term solution lays in the hands of the small regional and community banks precisely because of their commitment to building strong relationships with the businesses and communities in which they’re located. This strength gives them a superior advantage over transactional competitors who keep SMBs at arm’s length.  On its own, technology is not enough to enable sustainable growth. It takes shared knowledge and strong relationships to grow successful businesses.

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