COVID-19 has severely impacted small business loan portfolios as well as financial institutions’ earnings and capital position. The banking and financial industry has experienced a historic crunch, and other economic crises are looming large.
It’s not that the demand for small business loans has decreased, but this pandemic has brought a new urgency to a key element of lender strategy. Despite having more loan applications, small business lenders are unable to process the higher volume of loans. Loan closing is more difficult due to the complicated loan approval process, insufficient cash flow, long decision times, new credit scoring models, increased credit risks, changing regulatory requirements, and increasingly stringent lending guidelines.
The pandemic has forced banks, credit unions and other smaller financial institutions to revisit how they determine their borrowers’ creditworthiness, credit risk and make lending decisions. And for these reasons, small business lenders are struggling to find the right lending opportunities that can help them protect and manage their loan portfolio.
Here are some top methods to consider when attempting to unlock the full growth of your loan portfolio, even as the current cycle begins to slow.
Check Beyond 5Cs and FICO Score
Traditionally, the 5Cs of credit (character, capacity, capital, collateral, and conditions) was a common phrase used to determine a potential borrowers’ creditworthiness. Here 5Cs would be determined by a range of assessments from borrowers’ past dealings with the lender.
In other words, conventional methods might suggest borrowers are a right fit for the loan in terms of their financial standing. In old-school methods, lenders used to consider historical data such as credit score, business history, and annual revenue to determine the ability of a business to repay its debt obligations. Maybe the trigger for rejecting an application, or charging a high-interest rate, was a particular 5Cs fault - the borrower’s bad credit history, for example - or maybe it was something credit-biased such as a startup, inconsistent cash flow, insufficient collateral, or limited credit history.
Later, however, lenders started considering credit scores as a transparent alternative to determine creditworthiness, both in terms of fair lending and operational efficiency. To meet this increasing demand, FICO began compiling information on the financial behaviour of borrowers as determined by credit bureaus such as Experian, Equifax, and TransUnion, and selling these scores to financial institutions.
No doubt, the above credit scoring methods are one of the most important factors you should consider while approving a loan application. But in the current lending environment, many applications come from startups and businesses with little or no credit scores but stable cash flow and fully capable of meeting their financial obligations.
Small business lenders who want to improve their loan portfolio must consider the factors that show the ability of a borrower to repay the borrowed amount, beyond just a credit score.
Perform a Comprehensive Portfolio Analysis
If you’ve been in the small business lending business for a while, then you know that performing a comprehensive and precise loan portfolio analysis is imperative. Accurate portfolio analysis will enable your financial institution to get a far more detailed understanding of your current performance and an opportunity to uncover correlations that predict borrower behaviour and identify emerging trends. It helps you reevaluate your current financial product and service offerings, and identify the best performing assets with the largest incremental revenue impact.
Moreover, you will be able to assess the areas of your loan portfolio that are doing great and the areas that need improvement, and discover new pools of qualified potential borrowers. It can help in understanding diversification and identifying overall portfolio risk while achieving long-term, sustainable growth. Ultimately, portfolio analysis allows banks, credit unions and other financial institutions to align their organization goals with business strategy, make informed lending decisions, improve the loan underwriting process, deliver easy and fast loans, and boost ROI.
Use Cash Flow Predictive Data
Small businesses may have specific financial needs during a slower economy like COVID-19 outbreak. But, unfortunately, small business lenders aren’t set up to meet them. Late payments or loan defaults can increase the risk for lenders trying to decide who to extend credit to, and due to the insufficiency of credit data, lenders are struggling to figure out whether a small business has closed, low cash reserves, unstable cash flow, or is behind on existing debt.
Lenders want to be confident that the businesses they’re providing loans to will be able to pay it back. They commonly use historical data such as credit score, revenue, business history, and collateral to quantify and decide whether an applicant is eligible for credit. But by ignoring predictive cash flow data, which is a much more accurate measure for an SME, lenders are ignoring a critical new piece of financial information available to them. Cash flow predictive data provides aggregate data regarding cash or cash equivalents an SME will receive and pay in the near future. Critically, predictive cash flow data supported by other forward-looking data points is an important factor in small business underwriting and can help predict exactly what a business’ cash flow may look like in the future.
Cash flow predictive data helps fill in what's missing from traditional underwriting data to make lending more inclusive. Moreover, it can also help extend credit to SMEs that have just started their new venture or have limited or no credit history - which will be particularly relevant in the wake of the pandemic. Today, small business lenders can collect, analyze and use cash flow predictive data through a variety of financial data APIs. By using this data to determine creditworthiness, reduce credit bias, identify and meet customers’ needs, and provide customized solutions, they can ultimately improve their loan portfolio and grow their own business.