How to Merge the Art and Science of Small Business Lending

There is an art to small business and commercial and industrial (C&I) lending.

Underwriters across the financial spectrum of banks, credit unions, and independents do a great job of mitigating risk when dealing with large, complex lending requests. Medium and large dollar lending is an art form and that process requires a lot of data in order to make that decision. Business owners expect a longer, more intensive lending process if they’re requesting $500,000 or more. And lenders understand that one $1M mistake can erase the profits of the entire portfolio. No stone should go unturned in the case of larger dollar loans.

What do I mean when I say there’s an art to C&I lending? The larger the lending request the more complex the deal becomes. The complexity can be due to the deal itself (what is influencing the request, the number and type of parties involved, etc.), the data being considered (bureau reports, resumes, business plans, financial spreading, etc.) the number of, terms of, and types of products in the offering, and more. A complex, large dollar loan is painstakingly crafted by an underwriter within the strategy and risk tolerance of the lending institution much like an artist using a blank canvas and the paints on the palette.

Smaller dollar loans are much different. The terms are simpler, the products more defined, and the dollar amounts much less. This level of risk mitigation can be tackled by some models, a solid risk strategy, and the directed review of an underwriter. The science of this lending includes a trusted risk model, a data defined strategy implemented by a loan origination solution, and the directed review of an underwriter to confirm the findings.

Small business lending should be approached using science in addition to art

I speak and interact with several financial institutions a week on the topic of small business lending but rarely get to interact with small business owners. When I do, I always leave the conversation enlightened about the key issues small businesses face when they apply for lines for credit.

For example, I recently spoke with the owners of a small film company who were looking for a $35,000 line of credit to purchase a new camera that they needed for a new project. They applied at their deposit bank, which was a $20B institution. They thought the application process would be easy given that they were loyal customers and the relatively small amount of the loan. They were wrong.

In order to apply for the loan, they had to fill out a long application packet which would have taken them about 8 hours to complete. The process did not accommodate for their busy schedules or the timeline for their deliverables. Even as they continued speaking with their bank about the loan, they were forced to look at other options. One of the options was to contact the financing partner of the camera manufacturer. They called the lender on the phone, obtained a loan for the camera, and was unboxing it in about 4 days. One of the owners was literally unboxing the camera when their bank emailed them stating, “We’ve figured out a game plan.”

So how can one lender approve a loan in five minutes and a well-established bank take two weeks?

To paraphrase Treavor Knott of BSG Financial and the author of “The business case for adopting digital automation for small business and consumer loans,” small business owners are willing to pay more for convenience if they can avoid a burdensome loan process. Additionally, he states, that the breakeven point for a traditional, manually unwritten loan is about $38,000. In the story above, the bank should be glad it didn’t book the $35,000 loan as the profitability of that loan would have been questionable.

Knott’s analysis also states that even when you factor in the potential higher loss rate of an auto-decisioned loan process, using analytics and digital decisioning is the more profitable route to take for small dollar loans – and it’s not even close.

A lender’s first stated intent is to find a way to reduce the time it takes to decision small dollar small business loans ($5,000 to $250,000, generally). Because application processes at several banks are still 100% manual, it loan request is almost not worth their time.

Expedite the process and manage risk with analytics

A successful small business lender one can take steps to expedite the process and still effectively manage risk – even by the most conservative of financial institutions. A financial institution can use a solid small business risk score and a proven risk strategy built within a loan origination solution to reduce the time to decision of most small dollar loans while still identifying the risk of each application.

Let the analytics and embedded risk strategy (built in conjunction with your underwriting team) expedite the lending process for the smaller requests.  Lenders need to empower the underwriter with enough information to make a decision as quickly and efficiently as possible. This can be done by establishing high and low cutoff scores with which the risk team is comfortable. The applications that fall in the high and low ranges are reviewed to verify that the data and the score indication are accurate. Once the underwriter verifies the automated decision, that decision stands and the underwriter can move to the next application. Applications are turned around in hours, not days, and allowances for overrides are made, but should be kept to a minimum. The applications that are in the middle, or the gray area, are the applications that will be underwritten in the traditional way. This process allows underwriters to spend more time on the gray area applications.

There is certainly an art-form to lending (whether for large or small business loans) but it needs to be backed by science. This is especially true in making the origination process for small business loans actually work for small businesses. Using scores like FICO’s Small Business Scoring Service (SBSS) in conjunction with a good loan origination system can greatly assist an organization in speeding up the process and competing with the online lenders. Community banks and credit unions can still enjoy a close relationship with their small business customers and provide them quick decisions that will help them in their own business and solidify their loyalty to their bank.