Banks have long struggled to make a profitable business out of serving small and medium-sized enterprises (SMEs)—arguably to the detriment of overall economic growth, productivity and employment. There are a number of reasons for this.
One is, as McKinsey explains (“How banks can use ecosystems to win in the SME market”), that “finding the optimal balance between providing a great customer experience and managing the cost to serve has…proven to be difficult”—i.e., small companies can pay only small fees. Another is that the credit quality of SME assets tends to be uneven, so credit losses are potentially high.
What tech knows
Technology can help overcome those difficulties:
First, it allows lenders to analyse companies that do not fit pre-existing credit models by using “alternative data” and alternative sources of data. That should broaden the scope and cut costs.
Second, technology can give lenders access to low-cost, real-time data on company performance and outlook, which not only helps support near-instant credit analyses but also advice and networking services.
Third, lenders could use “big data” to build realistic models of the world in which an SME operates now and might operate in the future. Artificial intelligence and machine learning could then, in principle, be used to help small companies solve problems such as finding new opportunities, being sustainable or hiring the right staff.
What banks know
Really powerful solutions for SMEs are still in the future. This is partly because banks have always had a privileged data position: they know what the financial “ground truth” of a company is. Cloud accounting and open banking can now make bank client data available to non-banks. However, they also make it easier for banks to access and use data from any customer in the market.
Alternative data, such as from a payments hub, can be used to see cashflow and, so, to build lending models—but nothing beats the actual numbers. That is why alternative credit-scoring companies such as LendUp, which provides loans to individuals, “seeded” their algorithms by making small loans. That was the only way for them to be sure that non-financial data gave accurate enough insight into likely credit behaviour.
One of the challenges for incumbent banks is that, although they have “ground truth”, their systems were not built to expose that data to the analytical tools used now.
“It can be easier for some banks to access and model their own data via the external facing open banking APIs than it is to access it from their own platforms directly,” said Jonathan Holman, Head of Digital Transformation at Santander.
Why banks are needed
There are some big-tech platforms that look as though they should be better positioned than fintechs—or even small lending banks—when it comes to analysing SME performance. Amazon, for example, has data on cashflow, inventory, website ranking, the speed of response to customer requests and many other parameters. Amazon uses that data to price loans to the merchants on its site. In theory, that should work well. In practice, Amazon Lending struggled—and is set for a relaunch this year.
What went wrong?
There were reports that Amazon couldn’t really assess creditworthiness because its view of an individual SME’s business was too narrow. In its 2018 annual report, Amazon said that the allowances for “doubtful accounts” in its lending program were US$237 million at the end of 2016, $348 million at the end of 2017 and $495 million at the end of 2018, with additions on top of $48 million, $111 million and $147 million, respectively.
However, Amazon is not leaving the SME market. It announced in its fourth-quarter 2019 results that it will invest US$1 billion in helping MSMEs (micro, small and medium-sized enterprises) in India get online. The aim is to “enable” $10 billion in cumulative Indian exports by 2025. As of early February 2020, there were press reports that it is going to cooperate with Goldman Sachs and other banks on providing SME credit.
What SMEs want
Many SME founders have little more financial knowledge than the general public. That can make wrestling with the intricacies of getting funding or handling accounts a time sink. Ideally, a bank would take that burden away. However, that is not always what has been on offer.
“SMEs need to focus on running their business, doing business day to day. Banks support this best by helping the management do business, not by helping them do banking. For some, this is a mindset shift in the industry,” Holman explained.
That gap in the market, together with the rise of online businesses and “alternative data”, has opened up potentially lucrative opportunities for non-bank financial-services firms to offer cost-effective and supportive services for SMEs—including full-service banking. A number of fintechs—including Coconut, Countingup, Mettle and Tide—have launched in the United Kingdom to support SMEs. Big tech is equally interested in the segment, even if players such as Amazon have not done well in the United States and Europe to date.
A better partnership
SMEs can clearly benefit from speedy access to well-priced financing. Back-up support around taxes, accounting and strategy also has obvious value. What may be less beneficial is having to provide a large competitor with details—even in part—of the company’s performance. A company like Amazon could, after all, use the information it has on the performance of small companies on its platform to move against them. It could, in theory, also offer that data to third parties that compete with those SMEs. The core business of big-data platforms is, after all, data—not bookselling or financial services.
Banks, in contrast, are pure financial-services providers. They do not compete with their clients, and keeping data private is central to what they do. They are also large-scale, regulated, deposit-taking institutions. That gives them not only reach but lower cost of funds.
“Alternative finance providers struggle to match the cost of funds of banks and therefore the price of financing they can provide. Thus far they’ve been able to justify this premium in speed of execution, enabled via their often superior technology,” Holman explained.
Banks and Open Banking
But what if all potential lenders had great technology and access to the “ground truth” of bank data? Open Banking in the UK and PSD2 (Revised Payment Services Directive) in Europe give SMEs (and individuals) the right to allow providers other than their banks direct access to their bank data. The regulations were designed to spur competition and innovation in financial services. The idea is that those third parties could merge financial and other data to develop completely new services. A strong take-up of Open Banking could, in theory, blunt the edge that financial data currently gives to bank lenders.
As of the end of 2019, there were one million users of Open Banking in the UK, according to UK Open Banking, so the service is still nascent. It might still do great damage to the business models of incumbent banks. However, it is not only fintechs and challenger banks that can benefit from broader access to bank data. Banks can, too.
Big banks are not usually perceived as offering innovative fintech services, but that is changing. Some are setting up stand-alone fintech challengers—as Royal Bank of Scotland (RBS) has done with Bó—and some are innovating on top of existing platforms. Innovation will be the way forward, according to Holman. “Banks need to offer value-add services, to SMEs, on top of open banking to encourage data permissioning.”
Large banks already have trusted brands, a big customer base and lower funding costs. Access to the bank data of even more companies should enable them to leverage those further. To help banks to do this, we at LIBF have just launched a new qualification—a Level 3 Certificate in SME Lending and Alternative Data.