We sat down with Ted Kosev, recent addition to JUDI.AI’s Advisory Board, to get his perspective on small business lending and the lessons he’s learned through his experience at traditional banks and fintechs, including Amazon and Square Capital.
- Fintechs have been exploiting the gaps in funding from traditional lenders
- There is significant demand for microlending – don’t neglect it
- Factor in the lifetime value of a small business relationship
- Leverage “alternative data” for credit risk
- Drive portfolio growth with pre-qualified offers
- Leverage transaction data to rightsize the amount to lend
- Design a simplified repayment mechanism
- Optimize for speed and access to capital over rate
- Start with your existing small business base
- Leverage a key competitive advantage – your lower cost of capital
In his eyes, community financial institutions (FIs) have all the attributes required to build successful small business lending programs. If your institution is not active in this segment, his advice would be to make it a part of your growth strategy.
#1. Fintechs have been exploiting the gaps in funding from traditional lenders
Ten years ago, a business with less than $1 million in revenue had maybe a 1-in-10 chance of being approved by a bank – and even then, many didn’t get what they needed. Small businesses were being overlooked by traditional lenders, and fintechs stepped in to meet a huge supply-demand gap.
I joined Amazon in 2011 to start a lending program for sellers on their marketplace. We were probably the first to embed financing into an online platform. We could see how a business was performing, their consistency in sales, growth and other fundamental business metrics. This made it possible to assess their risk and ability to repay in the future so we could make a lending decision without requiring a ton of paperwork from the business. We made it easy for a seller to apply for capital, get a quick decision and receive fast funding. Other platforms like PayPal, Square (which I joined in 2015), Shopify, etc. followed with similar programs. Standalone fintech lenders also emerged, leveraging business transactional data for automated credit risk assessment.
As a result, fintech lenders have grown from near zero to over $20 billion annually in small business loan originations in the last 10 years.
#2. There is significant demand for microlending – don’t neglect it
Community FIs need to offer lending products that are appropriate for small businesses of all sizes, not just the largest ones. Over 90% of small businesses are “micro-businesses”, defined as less than $1 million in revenue. The majority of small business loans are C&I loans under $250k, with many small businesses looking for a much smaller amount, such as a $5K-$10K loan, line of credit or credit card. Frequently, what they find at their local bank or credit union are product minimums they cannot meet and long, cumbersome processes that are geared toward larger commercial enterprises.
To align with this microlending model, community FIs need to streamline their credit application and underwriting processes. This is what fintechs have done successfully to reach over $20 billion in annual originations through millions of loans per year.
#3. Factor in the lifetime value of a small business relationship
Fintech platforms have also seen the benefits of providing access to capital in terms of customer growth and retention. Throughout my experience, I saw that when small businesses took capital they grew their sales, which made them eligible for more funding, benefiting both the small business and the lender. Providing capital can improve trust and significantly lowered attrition for some of the most profitable small business customers.
More than just the transactional value of making a loan, I think that successful fintechs really get the lifetime value of the relationship and are willing to invest in this by creating a fast and easy lending application process with quick turnarounds and funding. The key to enabling this has been underwriting risk using real-time business transaction data which can assess the health and future growth of a business. This, in turn, gives confidence that the borrower will repay the loan.
Banks and credit unions already have access to small businesses and their bank transaction data and I have struggled to understand why they are not exploiting these advantages to grow their small business loan portfolios. I have come to believe that it is a combination of internal prioritization and a focus on transactional profitability vs. LTV. The small business lending segment may seem small relative to large consumer or commercial projects and be difficult to prioritize. In some cases, small businesses are also folded in the broader consumer or commercial portfolio, which leads to inadequate approaches to understanding the customer.
To fully realize the potential from small business lending, traditional financial institutions should treat small business as its own distinct segment, and optimize for the lifetime value of the small business relationship rather than focus on individual loan revenue. For example, providing a $10K line of credit to a business with $200K in annual revenue may allow the business to grow, expand facilities and hire employees. They then qualify for more lending products, sign up for additional banking services, and remain loyal customers. Behind every small business is one or more consumers, who need banking services, mortgages, wealth management, etc. A small business banking relationship can be a key strategic anchor to a broader and long-lasting relationship.
#4. Leverage “alternative data” for credit risk