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Embedded Briefing: How embedded platforms rose in preference for SMBs looking to borrow

  • In 2021, alternate lenders led the uptick in SMB loan application approval, approving 24.5% of the loans, as against the 23.8% approved by institutional lenders.
  • Why have traditional lenders been unable to effectively meet SMB demand? Because they can't figure out how to do it profitably.

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Embedded Briefing: How embedded platforms rose in preference for SMBs looking to borrow

Small to medium-sized businesses need credit — especially now, as they bounce back from the pandemic-fueled economic downturn. While data from the U.S. Chamber of Commerce suggests SMBs' recovery is going strong, there is a growing demand for capital to sustain the pace of recovery and continue growth.

82% of SMBs go bust due to poor cash flow management, and another 29% simply run out of cash. They need access to capital. However, even with high demand, American financial institutions are unable to serve SMBs effectively and profitably.

Lenders have historically been less interested in serving SMBs on favorable terms, primarily because they haven’t been able to figure out how to. Traditional FIs are accustomed to lending to bigger businesses that need an influx of millions at a time and check the right boxes — good credit history, substantial cash flow, and hefty collateral. Underwriting them is easy, straightforward, and less risky. Additionally, lending to big businesses is simply more profitable.

So, over time, lenders' operating models have developed around serving big businesses only.

It's not just that big businesses operate on such a scale that lending to them is lucrative, stable, and predictable — key drivers in the business of lending — but also that serving SMBs has historically been considered expensive in relation to revenue generated. A common reason attributed to that is the high acquisition costs associated with attaining SMB business.

“I think the imperative word here is profitability," Capital on Tap's COO Damian Brychcy told Tearsheet. “SMBs are notoriously hard to market to and acquire, so you spend a lot of money getting them as customers. Then the revenue and profit of an SMB look much more like a consumer than a corporate entity. Add that all up and it's hard to profitably serve many SMB segments.”

Capital on Tap is a global fintech providing an all-in-one small business credit card and spend management platform, which has been used by 200,000 small businesses to spend $5 billion thus far.

The traditional banking model is simply not set up to serve the needs of SMBs profitably. And hence, FIs that aren't tech-enabled and haven't automated a lot of processes are going to struggle to serve SMBs in a profitable way.

Furthermore, the common practice in lending to SMBs is to look at a business's revenue and profits over the past few years and underwrite a business based on that. What lenders are commonly looking for is if a business has enough profits to make its monthly principal and interest payments if they were to offer it a loan (and include a margin of safety to avoid losing money).

This puts smaller businesses at a disadvantage. That's because while these businesses are often the most dynamic and exciting, and are termed the growth engine the US needs to thrive, they have fewer profits and need loans to invest in their business.

A roadblock to big banks being able to serve SMBs better is the “that’s the way we’ve always done it”  mentality, according to David Snitkof, head of analytics at Ocrolus. Financial institutions that have manual review processes and/or more traditional methods of adopting and integrating technology have a difficult time re-engineering internal processes for efficiency. Such banks’ loan processes are slow — which won’t work with SMBs today, and costly — which means the unit economics don’t quite work out for the lenders.

Such an environment created a space in the marketplace where demand exceeded supply considerably. And that’s where fintech lenders found fertile ground. While SMB business remains expensive to acquire, new alternate lenders worked on reducing costs elsewhere. They created software that automated processes traditionally performed manually by high-paid labor, like underwriting and decision-making. In doing so, they not only figured out how to approve and originate loans cheaper, but they were also able to deliver capital much faster.

“Business owners now have expectations of immediacy in access to capital that hasn’t been met by traditional financial institutions,” Snitkof told Tearsheet. "This is the reason online lenders have taken substantial market share over the past two years. Forward-thinking lenders are automating their processes to both decrease operational costs and make high-quality credit decisions from diverse data sources."

As SMBs focused on recovery and growth, alternate digital lenders began claiming the main stake in SMB lending. They outpaced all other sorts of lenders in serving SMB clients and became the most popular source of capital among small businesses.

In 2021, the SMB loan approval rate generally saw an uptick. This trend was led by alternate lenders, which approved 24.5% of the loans, and institutional lenders, which approved 23.8%. Credit unions contributed by approving 20.5%, and small banks by 18.9%, while big banks predictably lagged behind, at 13.6%.

The path fintech lenders have taken is just as open to traditional FIs too. To catch up, they could bring best-in-class tech to their SMB onboarding and lending processes. By investing time and money – both of which FIs have – they can attain the tools and software to automate everything, from credit to KYC to fraud checks. The reason FIs have trailed thus far is simply that they’ve been reluctant to invest that time and money.

Chart of the week

FIs have already begun jumping aboard the open finance train, with many building open banking structures, platforms, and API capabilities to embed their offerings into other firms’ ecosystems. Then there’s the notion of the supper apps, born out of consumers’ and small businesses’ expectations of seamless and hyper-personalized digital journeys. EY’s new study suggests that FIs entering the open finance space unlock new business models that can ensure their success and promote growth as financial services become more ecosystem-based.

Source: EY

Here are some examples of how FIs are adopting these business models:

  • Green Dot

The firm has collected multiple assets, like a bank charter, full tech stack, and expansive retail network, and offers a variety of modern money management and payment solutions.

  • SoFi

The firm is using strategic mergers and acquisitions to transform itself into a licensed digital bank for small businesses and young professionals. SoFi acquired Golden Pacific Bancorp and Galileo Financial Technologies to also play an aggregator's role in clients’ digital lives.

  • The Bancorp

The firm runs an ecosystem of white-label products designed to be run by non-financial companies. It provides checking and savings accounts, debit cards, payments, and other banking services for fintech firms, while also enabling loyalty programs and gift cards.

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