The notion that Google, Amazon and Facebook will disrupt small-business lending has taken root in the media lately. It’s a logical theory that sounds reasonable on its face: Since most small businesses already use Google, Amazon and Facebook for marketing, it will be easy for these tech giants to market loans to small businesses that they already have as customers.
One CNBC headline sums up the sentiment: “Another industry Amazon plans to crush is small-business lending.” The story notes that Amazon has already made billions of small-business loans to thousands of merchants and suggests that the online giant could come to dominate lending. In addition, there are countless fintech startups also seeking to disrupt small-business lending.
But as these tech firms dip their toe in the banking world, they are more likely to take business away from national lenders than smaller community banks.
That’s because the theory misses a crucial detail: When tech giants and fintech startups target a business segment, they take a programmatic approach of catering to the most common use cases. That’s the opposite of what community banks do.
As the head of the Utah Bankers Association, Howard Headlee, told American Banker earlier this year, “small banks succeed because they are in their communities dealing with the tough credit issues that nobody else wants to solve. Amazon and Google aren’t going to do that.”
To secure a loan from a traditional commercial bank, a lender must go through an underwriting process looking at what bankers call the 5 Cs of credit — capital, collateral, conditions, creditworthiness and cash flow. Large commercial banks require strength in all five Cs, but a U.S. Small Business Administration-backed loan from a licensed bank has some flexibility. An SBA-backed lender might, for example, accept less collateral if cash flow is strong enough to support repayments, or it might accept less equity if other areas show strength.
Risk for national and online lenders is a cookie-cutter discussion — the lender either fits within strict parameters or does not. Community banks take all unique risk factors into account when making decisions. For example, an online lender will not finance a business acquisition because it means a change of ownership, but a community bank can assess the implications of that change and therefore can consider the loan.
A recent case came across my desk that was illustrative. A startup software company with no assets to speak of wanted a $1 million loan to add staff to fulfill a contract that would lead to an additional $3 million in revenue at a 75% gross margin. An online lender could not make the loan because of a lack of assets, but we signed an SBA-backed loan based on historic cash flows and collateral, strong financial projections and knowledge of the business.
Online lenders market themselves as an easy way to access loans in just minutes, compared to a community bank underwriting process that is customized for each client and is therefore slower. While online lenders have the goal of processing a large volume of loans, small banks align their success with that of the borrower.
Because banks have tight profit margins of between 1.5-4% on loans, the typical bank wants to keep defaults at about 1%. Online lenders use an algorithm for underwriting decisions based largely on credit ratings and can withstand 15% or more of loans to default. Small banks must keep defaults low because they charge about 7% for loans, compared to online lenders that often charge more than 20% annually.
In addition, when a company has a challenge and struggles to repay a loan, a community bank will work to restructure the loan or help an executive to get past a rough patch or develop a turnaround plan.
It some cases, it’s sometimes even better to get a loan rejection from a small community bank than to be approved elsewhere. A case in point was one Denver-area veterinarian practice that wanted to expand into the pet boarding business and sought an SBA-backed loan. The deal initially made sense, but the municipality made demands about improvements to the site.
As a result, we rejected the loan application because projected cash flows no longer supported loan repayments. We urged the business to find another location to expand.
Instead, the business owner took a loan from a commercial lender and, as we had forecast, the business failed within 18 months.
It’s a fact that the banking industry faces disruption from tech players in the coming years and that these new lenders will build a considerable portfolio of business loans.
However, the unique nature of small-business lending suggests that Google and Amazon, if they do get in, will ultimately be more disruptive to the major national banks than they will be to community banks.
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