Small Business Lending: Maintaining Equilibrium

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1 Small Business Lending: Maintaining Equilibrium John O Connor Marc Carbonetta BenchMark Consulting International The banking industry identified Small Business as a target market segment over two decades ago. Banks focused on this segment, developed strategies, and grew business. As a result, Small Business became a very profitable line of business for many banks. After continued focus and innovation in Small Business, why do banks still struggle in this space? Many banks embraced credit scoring while others find no comfort in predictive outcomes. Some institutions still ask themselves the question which business line is best equipped to manage Small Business? To understand the questions and determine the answers, one needs to review the origination of Small Business lending. The Small Business segment generally emerged along one of two primary management strategies: either as a bottom-up expansion of Retail banking or as a top-down sub group of Commercial banking. The Retail expansion approach leveraged streamlined Consumer underwriting processes that were expanded to include small dollar, individual owner, and micro ( mom and pop ) businesses. The Commercial sub group strategy solved for underwriting the lower dollar band of business loans through modification of traditional Middle Market judgmental credit policies to accommodate these smaller credits. In many organizations, over the course of the past ten plus years, the two approaches have grown to meet in the middle and embody elements of both strategies. Notably, these elements include credit scoring for the smallest credits and judgmental underwriting for the largest, most complex credits. Small Business thus became a lending hybrid and a unique line of business for many organizations. It is paradoxical that Small Business success contributes to its struggles. Because Small Business is a lending hybrid, its success is dependent upon continually bridging the Retail and Commercial worlds. This creates dilemmas on a number of fronts. Fundamental struggles occur along the lines of management oversight, credit risk, technology and delivery channels. Business Line Ownership Management oversight of Small Business has typically followed from the management strategy that spawned the segment. Less often has Small Business become a truly separate, independently managed line of business. Generally Small Business falls either under the Consumer or Commercial management umbrella. However, BenchMark Consulting often observes fragmented reporting structures in which facets of Small Business fall under both management umbrellas. A common example: Retail controls some of the delivery channels branches and a call center, while Commercial controls the Small Business Loan Center (SBLC), and again retail controls collection activities. Even where organizations remain optimally aligned, consideration of whether the Small Business segment has outgrown current business line capabilities may be in play. For example, Retail infrastructure to support small dollar, simple business loans may not fit larger credit sizes or exposures that warrant more traditional credit underwriting. Conversely, the Commercial infrastructure may not be positioned to handle the small dollar, credit scored loans where the largest unit volume and the natural integration with the Retail branch world resides. At the point where Small Business reached sufficient volume and performance history, many banks created singular 2006 BenchMark Consulting International, N.A., Inc. All Rights Reserved.

2 Small Business oversight. However, more often than not in this scenario, Small Business ultimately reports to Retail as a peer to Consumer. While a peer on the organizational chart, Small Business is generally not seen as an equal, due primarily to its smaller size and reliance upon the Retail world for delivery and infrastructure. While an objective assessment of where Small Business lending best fits in the organization may point to a clear answer, there are internal factors influencing the debate. Most notably is the profit from this segment. Both Commercial and Consumer see the benefit from Small Business growth. Each group typically controls important process technology loan accounting systems, application systems, document preparation, imaging, and collection and recovery systems. These factors weigh in on any claim of whether Small Business should stand alone or if it is a best fit under a specific business line. Credit Risk One of the most attractive features of Small Business is the ability to cost effectively decision the vast majority of application unit volume comprised of small dollar deals. Consumer Lending contributed the assembly line processing methodology that Small Business embraced. The growth in Small Business portfolios can be traced to the increased use of credit scoring and corresponding reduction in underwriting personnel involvement in the decision. A little over a decade ago, scoring with no financial statements was generally limited to credits under $35K. By the end of 2004 and today, most of the top 50 banks decision credits up to $100K based on an application and credit score only. Many institutions are raising that bar to $250K. For most institutions this represents at least 85% of all unit volume processed. Decisions are now made in minutes for the smallest credits and hours for larger credits compared with days required to reach a decision only a few years ago. The rise in score-only credit thresholds mirrors the more robust vendor score cards for larger dollar credits and banks favorable experience. Scored credit performance has often outperformed traditional portfolios providing confidence in scoring at higher dollar levels. As scoring thresholds have increased, so too has the potential effectiveness of the Small Business model. Increased score-only thresholds have enabled banks to raise their individual definitions of Small Business, generally linked to company sales and credit size. As the effectiveness of scoring proves out and banks perform well, utilizing scoring methods in the next higher tier is validated. These processing efficiencies enable SBLCs to redirect the focus of underwriting personnel to ever larger, more complex subjectively decisioned credits. As a result, many banks are pushing their definition of Small Business out to companies with sales of $10M - $20M (some higher) and credit exposure of $3M - $5M. Scoring is used not just for the simplest credits with no financial statement requirements but has now become integral to the decisions on larger credits. Credits up to $500K or more are now utilizing credit scores as a primary decisioning component allowing for a reduction in the amount of manual due diligence and financial statements requested. Only the largest and most complex credits within the definition receive a traditional financial statement analysis and credit write-up. As banks continuously evaluate their appetite to decision larger dollar credits in a streamlined environment, questions are raised for the organization. What is the definition of a Small Business loan and what is the core business driver? The foundation defining Small Business for most banks is credit provided to straightforward, closely held, family run businesses. These are businesses in which the owner cash flow is intrinsically tied to business profitability. Most score cards are heavily weighted towards the individual owner s personal credit performance for predictability. As the dollar threshold expands, more complex ownership structures and sophisticated borrowing needs are seen. In larger sales companies business entity performance begins to stand on its own. Business financial statements can be used to apply traditional analytical methods and the owner s individual performance is less of an influencing factor on repayment likelihood. Business financial information becomes more predictive in companies with larger sales. BenchMark Consulting International 2 Maintaining Equilibrium July 2006

3 While the latest vendor score cards are touting predictability on Small Business credits as large as $750K, many risk managers are concerned with reliability at these levels. These are some of the same questions risk managers asked at scoring infancy and when scoring at the $35K, $50K and $100K tiers were contemplated. In addition, larger companies tend to have multiple credit needs that can quickly raise total credit exposure beyond $1MM - $2MM. Because score cards are transaction based, reliability of scoring for multiple, large credits to single entities poses an added concern for risk managers. However, these larger companies typically would not have any more than $150K of exposure of score-only credit. The question for the organization then becomes, can credit underwriting techniques (score and score assisted) accommodate these larger relationship borrowers? High performing organizations have found that for these larger companies score and score assisted credit origination solves for a great number of these credits. As exposure and deal size increase underwriting techniques become purely subjective (traditional underwriting approach: spreads, trends, analysis and abbreviated write-ups). Successful organizations periodically reevaluate strategy to ensure it matches the evolving objectives, market and risk. While increased definition thresholds raise questions, BenchMark Consulting often observes management struggles with scoring at levels many other institutions have been at ease with for years. Why do some risk managers continue to view scoring and score assisted lending as the wizard behind the curtain? The answer may lie with the origins of Small Business in a particular organization. Where Small Business germinated from Consumer, scoring beyond the simple, most consumer-like credits can create uneasiness. Consumer Risk management may not be as comfortable with business loans. As Small Business groups in those organizations have positioned themselves to grow, risk management may become defensive resulting in risk adverse policies. This fosters risk avoidance rather than risk management. Processing effectiveness beyond small dollar credits is therefore compromised. Conversely, Small Business that grew from Commercial often operates under that risk management philosophy. They too struggle with scoring but from a different perspective. While they understand business credit risk, the typical approach is grounded in Commercial credit methodology. Credit risk is assessed credit by credit rather than on a portfolio basis. While there has been tolerance of scoring on the smallest of credits, moving to the next tier(s) effectively eliminates traditional financial statement analysis at those credit levels. Commercial risk management may have only passing knowledge of scoring and/or relies upon the Consumer side of the house for education. Moving up encroaches upon traditional approaches and wisdom of risk analysis and disturbs Commercial risk management comfort zones. While there may be debate on the merits of reliance upon financial statements for credit quality on smaller dollar credits, there is no debate on the cost to originate loans under this strategy. It is simply too expensive to gather, analyze, and manage financial statements on small dollar credits. The cost disparity can be as high as $2,500 to underwrite credits in this fashion vs. $20 for no financial, scored credits. Further, participants in BenchMark Consulting s Small Business Benchmark program routinely demonstrate that scored portfolios outperform traditional method portfolios on credits <$250K. By and large, the greatest influence on no-financial scoring is risk management s assessment of how well Small Business manages the portfolio. Reluctance to raise thresholds is often grounded in the concern Small Business cannot effectively manage the growing portfolio. Over the past decade, most investment in the Small Business segment was focused upon origination. While scoring was implemented to originate credits, traditional annual reviews of these credits, including financial statement analysis, has been the norm for some institutions. At these banks, many have now reached a point of critical mass in Small Business. Portfolio growth is outstripping conventional approaches to portfolio management. This has led to increased administrative past due levels where the staff can not keep up with the volume of annual renewals that, in turn, inflate delinquency levels. Portfolio personnel are stretched and often the highest risk BenchMark Consulting International 3 Maintaining Equilibrium July 2006

4 profile credits and deteriorating credits do not receive the appropriate attention. There is a mismatch between front-end policies, procedures and technology, and back-end risk management strategy. These situations have caught the attention of Risk management. They are demanding policies, processes and procedures for portfolio quality commensurate with front-end adjudication. Where institutions are mismatched between front office and back office risk, expansion of definitions is stalled and questions are raised on where best to manage portfolio risk. High performers recognized, early on, the importance of building portfolio management infrastructure to support their growing scored and score assisted portfolios. Portfolio management policies and processes have remained in step with advances in origination. This synergy has allowed Small Business to retain control over cradle-to-grave activities. More importantly, these banks historically reflect very low past due and chargeoff rates. Organizations have also employed technology in support of business needs, which leads to the next section. Technology While the Small Business segment grew rapidly over the last decade and continues to contribute profitably to the bottom line, it is typically overshadowed by the Consumer and Commercial business lines. Bank growth has been reliant upon the more established operations of Consumer and Commercial. In its infancy, leveraging counterpart systems represented a cost effective strategy to grow the Small Business area. As a mature business line, continued alignment of Small Business with Consumer and Commercial processes often necessitates compromise, eroding the efficiency and effectiveness of the Small Business model. As noted earlier, the Small Business segment has grown steadily but at many organizations it still represents smaller total dollars compared to Consumer and Commercial segments and small units compared to Consumer segments. As a result, it is difficult for senior management at most organizations to approve investment in relatively costly technology to support Small Business. To create an optimal workflow, banks often need to invest in several systems and/or integrate multiple systems if Small Business is going to operate most efficiently. Systems include an application processing system, front-end application data entry, document preparation that is generated through an application processing system or more commonly through integration with document preparation technology, integration with the loan accounting system(s) and finally portfolio management and collection and recovery technology. Many institutions do not generate the volume of units and dollars to support a large dollar investment in such technology that supports only the Small Business segment. Management at a number of institutions has initiated programs that require investigating opportunities for expanding functionality of existing systems or investment in a single technology solution. There is less tolerance of silo-ed technology investment, especially in light of Sarbanes-Oxley and pending Basel II requirements. Where more holistic solutions are explored, the question of control ultimately arises. Even if the organization s IT group retains technology investment and support oversight, the business lines generating the largest unit and dollar volumes will exert the greatest pressure on technology decisions. This leaves Small Business in the same place it started 10 to 20 years ago dependent upon other business lines to satisfy technology needs. The result may be better technology than currently employed but, ultimately, results in compromises which continue to affect the ideal Small Business operating model. Many of the banks with efficient processes have achieved this state more through integration of existing platforms versus investment in standalone technology. They have created a seamless world for the users through internal investment in bridging various technology platforms. Small Business has been able to marry front-end Consumer application platforms with Small Business application processing and documentation systems and then on to loan accounting systems. Many of these are far from perfect but have greatly enhanced productivity and provided sufficient reporting to meet regulatory and business needs. BenchMark Consulting International 4 Maintaining Equilibrium July 2006

5 Another technology hurdle facing Small Business is a robust Customer Relationship Management system (CRM). A CRM system houses borrower loan and relationship data including products used and deposit account information. The importance of a robust CRM or similar Customer Information File system (CIF) is the ability to quickly view the customer relationship. This comes most critically into play when loading and decisioning credits. Where the application processing system is integrated with a CRM system, borrower data can be systematically loaded for subsequent credit requests speeding the process and reducing errors. By having total borrower and related debt housed within the CRM system, total credit exposure can be readily determined. For those banks without this integration, a great deal of time is expended researching various systems to confirm exposure. Because many of the credits above $100K are underwritten based upon total credit exposure, obtaining the correct borrower loan information is key to adjudicating based on appropriate policy requirements. CRM systems represent one of the most difficult and potentially largest dollar investments. Because Small Business clients span Consumer and Commercial, information must be aggregated from multiple systems to include both the individual guarantor(s) as well as primary and related business entities. Creating a data warehouse for this information represents a large resource investment. Although Small Business is not the only segment benefiting from a robust CRM system, it is perhaps the one segment most heavily reliant upon CRM for efficient processing. Consumer tends to underwrite transactionally and Commercial credits are small in number and can afford the time to manually research exposure. Some leading organizations have implemented early warning systems that support their portfolio management approach. Others without improved technology to support portfolio management processes cannot effectively manage their portfolios. The same management acceptance of credit scoring and streamlined approaches to underwriting new credits is needed in portfolio management. Pending Basel II requirements may provide the impetus for those banks that lag in this area to invest in technology or resources to create a better portfolio process. Without investment, risk management may decide to shift portfolio management responsibility to areas with technology Consumer, or in the case of larger credits Commercial. Either of these choices fragments Small Business and may not represent the ideal long term solution. A more recent trend has grown from the inability of branches to efficiently originate Small Business products through the SBLC. This contrasts distinctly with their Consumer experience where applications are electronically loaded, systematically sent for scoring, decisions are returned systematically within minutes, and often additional products are pre-approved. Technology limitations on loading small business borrowers into an electronic application necessitate manual completion of an application and faxing to the SBLC. This is followed by faxing any follow-up information. Often, SBLCs lack systematic communication with branches, frustrating the branch personnel. Branches cannot determine if faxed applications were received and what the status is on their request, and must wait for a fax or for the decision result. These frustrations have led a number of banks to shift processing and underwriting for micro small business loans (typically less than $100K) to their Consumer processing sites. They create a separate group dedicated to the micro deals but leverage the existing Consumer front-end and application processing systems. This provides the Consumerlike experience and expedites processing. While the shift in processing solves an immediate need, there are questions and issues for the long term. Although the Consumer group processes the micro products they must still follow Small Business Credit underwriting policies. What, in effect, has occurred is a bifurcation of the SBLC function. There can be confusion on where to send credits, the policy for credits that lie just outside micro policy parameters, and procedures for micro customers that outgrow this group. Some organizations find, due to policy exposure, rules that deals could be sent to the Consumer group only to be re-routed - creating timing, handoff, and ownership issues. The question arises, if Small Business were provided the technology to interface with the BenchMark Consulting International 5 Maintaining Equilibrium July 2006

6 Consumer front-end, would the SBLC not be the more logical repository for all levels of Small Business credits? For those organizations that have split off the smallest deals to Consumer, there is consideration given to shifting the larger credits under the Commercial world. The micro credits represent the greatest volume of units. Without the base of small units, some have called into question the need for the remaining credits to be processed centrally in an SBLC. Some have answered that question with the elimination of the higher dollar SBLC - pushing these deals back out to the field to be underwritten utilizing traditional middle market techniques. From a processing effectiveness and efficiency standpoint it appears that these groups have gone backward Delivery Channels Small Business relies essentially upon two channels to deliver the bulk of units and dollars. The Branch or Retail group is essential for driving the smallest dollar credits. Utilizing well-defined, simple product sets; the branches represent a cost effective channel for this subgroup of Small Business credits. Larger, more complex credits are generally delivered by Business Bankers. This group is typically more experienced in business credits, solving for relationship borrowing, and deposit needs. They are more highly compensated and, therefore, best matched to customers with more sophisticated requirements. While there may be variations to this delivery strategy, most banks follow along these lines. In order to effectively deliver through these two channels, Small Business must have clearly defined product sets developed for each. BenchMark observes the most successful banks as those that have effective strategies that incorporate products, pricing, and incentives to drive desired behavior in each channel. Yet, a majority of banks still do not have well-developed origination models. In the case of the branch channel, the impact of fragmented Small Business oversight can negatively impact production. Branches are typically responsible for selling as many as 20 different products (consumer, mortgage, small business, deposit, etc.) during the course of a business year. Some products are sold continuously while others may be emphasized seasonally. Small Business products are often viewed as another product on an already full tray. Without alignment on an overall strategy, Small Business products may receive the lowest sales priority. Two factors tend to impact branch channel effectiveness. The first factor is a set of well designed branch products. Branch personnel generally receive little or no Small Business training. Therefore, the best designed Small Business products are those that closely resemble Consumer products, thereby increasing acceptance (familiarity) and lowering the amount of training required. Application-only products reliant upon credit score are most easily sold. No financial statements are required and branches are comfortable selling business loans where minimal discussion of business activities is required. Poorly designed products are often not sold or only sporadically sold. The second factor is a set of incentives that help drive Small Business product sales. Strategy that incorporates Small Business products into overall goals is the most effective. Management is key to educating on the interrelationship Small Business products play in achieving Consumer goals. Selling into a Small Business provides the opportunity to sell Consumer products to the owners as well as employees and the same goes for deposit products. In numerous interviews with Branch personnel, the most successful performers leverage Small Business Products to reach their overall goals. In the absence of well designed products or an effective strategy, branches revert to the path of least resistance. Those uncomfortable selling business loans will often steer clients toward Consumer products even in violation of business purpose restrictions. This has implications for Consumer credit risk as potentially large populations of business purpose loans are parked in the Consumer portfolio where they do not receive the appropriate risk oversight. Using the Consumer channel for Small Business needs also results from poorly constructed incentive plans. Where branches are either minimally incented on Small Business products or have the option of reaching goals in the absence of Small Business products, they will emphasize Consumer products. BenchMark observes these BenchMark Consulting International 6 Maintaining Equilibrium July 2006

7 incentive plan issues most often where fragmented management oversight is seen. Combine poorly designed incentives with a frustrating process as detailed earlier and it is easy to understand where opportunity lies with this channel. Struggles are seen with business bankers where products, incentives, and training are poorly executed. In the absence of clearly defined product sets, business bankers often customize loan products in terms and pricing to win the deal. Customization hurts back office processing by requiring SBLC personnel to remove deals from the efficient assembly line process and decision on a one-off basis. As more custom volume is received in the back office process integrity is compromised and ultimately back-end portfolio management processes must accommodate these credits. Essentially, the loans are unprofitable. Just as in the branch world, incentives help drive desired behavior in business bankers. Incentives also keep business bankers from generating credits outside of the desired target market and focused on the best opportunities for profitable relationships. Lack of defined products, incentives, and training can also create discord in a situation where deals don t get done, both business bankers and SBLC personnel are frustrated, and the segment does not meet goals. These issues can lead management to question the effectiveness of business bankers and whether they should report outside of Small Business. Competing organizations that have solved for products, incentives, and training see real growth (size of portfolio and profitability) in Small Business. Those that measure client satisfaction find that this increases, as well. Summary It is evident for many institutions there are a number of factors that contribute to Small Business effectiveness. The question of management oversight, technology dependence, delivery channel strategies, and risk management are the primary issues. Even after decades of focus and growth there are many institutions that continue to solve for one or more of these factors. So why have many banks of all sizes moved beyond these issues to become comfortable in the Small Business segment? Perhaps the greatest contributor to successful implementation of Small Business in organizations is strategy. Where senior management has eliminated or bridged business line silos, overall and long term strategies are effectively implemented. Ideally, singular oversight of Small Business is desired, but singular oversight is the exception rather than the rule. Clearly set corporate goals and management focus on deliverables can break down the traditional line of business barriers. To be certain, setting clear corporate goals alone does not eliminate all of the issues and factors noted in this analysis. Overcoming the hurdles noted with risk management for utilizing credit scoring to its fullest advantage can be a long term effort. Successful organizations ensure risk managers are included in setting overall strategy. Organizational growth and risk appetite are clearly understood. Risk managers become part of the solution. Even so, moving beyond historical comfort zones is not automatic. Developing a plan for moving to the next tier and supporting requests with external and internal performance data makes the decision an objective one. Success in moving to subsequent scoring tiers hinges on the performance and measures of current tiers. Where organizations are mismatched between origination and portfolio management policies, interim solutions can be developed to allow growth to continue. BenchMark has assisted organizations in developing effective short term and long term policies and process changes to support both origination and portfolio management groups. Solutions leverage current technology and modify policies where nominal lift to decisioning risk is provided. These short to medium term solutions build the foundation for potential long term technology solutions. Longer term, technology investment is overlaid to support the streamlined policies and processes. Due to the numerous factors sited, management oversight will continue to be a struggle for many institutions. Strong core leadership ensures success where Small Business oversight is fragmented. Successful institutions have made adjustments as the Small Business segment grew and prospered. Periodic evaluations of whether Small Business should reside under Consumer, Commercial or become stand-alone were BenchMark Consulting International 7 Maintaining Equilibrium July 2006

8 undertaken. In some cases re-organizations were in order. In some institutions re-organizations have come about as the result of recent events or without proper evaluation of factors leading to the current climate. In such cases, organizations continue to struggle. Technology spends specifically on Small Business are not common. A more holistic solution is preferred; however that entails appeasing several business lines, which historically is not an easy task. Advances by vendors and even internal technology groups may provide solutions which can be leverage by several business lines. An example is a rules engine. An application is presented, and depending upon attributes such as cost center or product type, the engine will systematically direct the credit to the appropriate subset of business rules specifically set for that product. While not commonly in use today, organizations are exploring such solutions. Facilitating workflow is proving a dilemma for some as in the case of branch-generated Small Business products. Longer term, the best solution is to bridge the technology gap between the branches and SBLC to enable processing of all Small Business loans in a central location. Many organizations have done this by developing screens within the Consumer application that look and feel similar to Consumer screens but connect directly to Small Business systems. Elevating the branch processing issue then helps resolve contemplation of transferring responsibility and processing of larger SBLC credits to Commercial in a decentralized environment. Developing well defined product sets specifically matched to the target delivery channel creates lift on many fronts within Small Business. As noted, defined product sets are easier for branches to sell and enable back office origination processing as well as portfolio management efficiencies. Additional benefits include ability to set customer expectations, shorter turn around times, and improved closing ratios. Defining products, alone, is straightforward. However, products must be developed in concert with credit policies, SBLC process capabilities, and technology availability. This requires organizations to set strategies which may cross several business lines. With a defined strategy and strong management, the hurdles facing many organizations can be overcome. BenchMark Consulting International 8 Maintaining Equilibrium July 2006

9 John O Connor is the Commercial Lending Practice Manager responsible for the sale and delivery of commercial banking engagements. He holds extensive experience in commercial banking management, reengineering and streamlining operations, product and project management, mergers and consolidations. Marc Carbonetta is a financial service professional with twenty-five years of experience in commercial, small business, and regional and retail banking. He has a comprehensive background in lending with emphasis in credit structuring, credit review, commercial lease finance, private banking, project management and training. He has demonstrated expertise in identifying process improvement and savings opportunities through business process assessment, design, and change implementation. BenchMark Consulting International has specialized in improving the financial services industry since The company is a management consulting firm that improves the profitability of its financial services customers through the delivery of management decision-making information and change management services to realize the benefits of business process changes. BenchMark Consulting International s expertise is in the measuring, designing, and managing of operational processes. The firm has worked with 39 of the top 50 (in asset size) commercial banks, all 14 automobile captive finance corporations, several of the largest consumer finance corporations and many regional and community banks throughout the United States. Internationally, BenchMark Consulting International has worked with the five largest Canadian commercial banks, more than 40 European organizations in 11 different countries, in addition to financial institutions in Latin America, Australia and Asia. The company is a wholly owned subsidiary of Fidelity National Information Services, Inc., with clients in more than 50 countries and territories, providing application software, information processing management, outsourcing services and professional IT consulting to the financial services and mortgage industries. BenchMark Consulting International has dual headquarters in Atlanta, Georgia and Munich, Germany. For more information please visit BenchMark Consulting International 14 Piedmont Center NE, Suite 950 Atlanta, GA (404)