A basic yet challenging component of the lending process for banks is their ability to assess the creditworthiness of small and medium-sized businesses. In the last few years, alternative lenders have been capturing SMBs’ business with promises of better digital experiences and faster approvals than traditional financial institutions. Now, as alternative lenders face economic headwinds, they are making hard decisions about the segments they will continue to serve, leaving some small businesses on the sidelines.
To win back small businesses and better serve their existing customers, banks need to solve the “two-pocket problem.”
Understanding Small Firms’ ‘Two-Pocket Problem’
To understand the two-pocket problem, consider the simplest of businesses: a sole proprietorship. In this case, the business is owned by a single individual. But this person, as the sole owner of the business, is still occupying two roles in the financial world: business owner and private consumer.
Sorting Out Small Firms' Numbers:
The two-pocket problem occurs when business owners mix their personal and business finances. It’s like having two back pockets, one holding a business wallet and the other a personal one.
When one pocket goes empty, the individual dips into the other, and vice versa. At a given point in time, this can cause businesses to appear more creditworthy or less creditworthy to financial institutions than they actually are.
To understand the context at which the two-pocket problem is occurring, let’s review the small business landscape today.
What Today’s Small Businesses Look Like
In 2021, there were almost 20% more small firms started than ever before, according to the U.S. Census. This is indicative of the evolving nature and definition of “small businesses.” The gig economy has upended old notions of what a business is. Content creators, Uber drivers and single operators now consider themselves business owners. You no longer need a physical storefront nor a team to own a business. People are looking to make some money and want to set up side hustles.
At a time of impending recession and record inflation, the future is becoming murky for these new businesses and other entrepreneurs thinking about starting a business.
With an increasing number of small businesses come different kinds of borrowers. Traditionally, for instance, many banks and credit unions think about small business owners as people in professional services including doctors, lawyers and dentists. Now, business owners who don’t necessarily have the financial safety net of a doctor or lawyer need to borrow money to keep their businesses afloat. These are borrowers who rely on their business income for direct, day-to-day expenses.
This is where the two-pocket problem comes in. When businesses intertwine their personal and business finances, banks and credit unions have a difficult time determining creditworthiness. The back and forth of finances across accounts creates the illusion that certain businesses are risky to lend to, despite actually being a safe bet.
As more partners are added into the mix, lending and proving creditworthiness grows even more complex. Banks need to untangle this problem quickly, with tech, to compete with neobanks and other alternative business lenders.
How Banks and Credit Unions Can Win Back Small Businesses
At the height of the pandemic, businesses needed money and needed it fast. For a hefty price, alternative lenders and neobanks offered loans to business owners with significantly reduced underwriting time. Despite being more expensive, neobanks were simply faster and gave businesses the peace of mind that they would have the funds to hold out for longer.
Alternative lenders’ rates were already quite high, compared to traditional lenders, and in the current economy the nonbank lenders’ rates continue to increase to keep up with inflation.
Here’s some context: We recently spoke to a business owner who received fast cash from a fintech for $30,000, and is on the hook to pay back $50,000 over the course of the loan. While on paper this is exorbitant, business owners see it as fast cash. The reality is that many business owners are feeling burnt out and alternative lenders are using their desire for speed and convenience to make more money.
Playing to Banking's Strengths:
Banks tend to be more transparent and are generally more trusted than fintechs. If they can combine transparency and trust with speed and customer experience, they’ll be in a prime position to win back business from the neobanks.
For banks and credit unions, the “how” behind this is in global cash flow analysis.
The concept is to assess the combined cash flow of a number of entities. Whether a business is a sole proprietorship, partnership or other business entity, this allows financial institutions to get a holistic view of a business’ and guarantors’ finances and examine their true creditworthiness across one or multiple owners and partners.
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Opportunity Demands Shifting to Digital Solutions
While the tech exists for this, it’s still up to banks to adapt. Particularly in terms of smaller regional banks, the segment has been notoriously slow to adopt new solutions, using manual processes which significantly extend the underwriting process. This has led to losing out to alternative lenders who sell speed. But today it’s easier than ever to source, onboard and launch digital solutions — and you don’t need a multimillion-dollar innovation budget to make it work.
With technology, banks and credit unions can provide a certainty that alternative lenders relying on nondeposit funding cannot, while giving their business owner customers the speed and convenience they’ve become accustomed to at a fair market rate.
Couple this with a free or cheap option to create a business deposit account online and banks once again become the better option for struggling businesses across the United States. Now is the time to re-establish banks and credit unions as small business’ lenders of choice.