Small dollar loans to small businesses are a trending topic. With more than 33 million small businesses in the United States, it is easy to why. But, this trending topic struggles to make it beyond an idea stage. As the needs of businesses vary depending on size and maturity, larger dollar loans often take priority over the financing needs of smaller small businesses. The reasons are easy to see – the returns on smaller loans do not justify the operational costs and smaller loans have an inherently riskier credit profile.
It is unfortunate that financial institutions have not fully solved the mystery of realizing the giant market opportunity in this segment of small business lending. While there have been efforts to address the struggle and capture the opportunity, lending to the smallest of small businesses remains just beyond the reach of many financial institutions.
The Challenge
There are two primary challenges that have kept small dollar small business lending less than ideal. A focused effort with the right tools is necessary to overcome these barriers and create the path to serving this market segment.
First, the costs of originating and servicing these loans is inconsistent with the returns. Small dollar small business lending requires a significant reduction in operating costs to be a viable business within a financial institution. To achieve a similar efficiency of larger dollar small business loans, lenders must reduce operating costs over 6x on average.
Small dollar small business loans also come with greater risk of loss in addition to the punitive and disproportionate operational costs. This is the second challenge for financial institutions to overcome. On average, the risk of loss on loans less than $500 thousand to a small business is 2.5x higher than larger loans. Less compelling for the lender, the comparative losses for smaller loans increase during times of economic stress.
For years, financial institutions’ understanding of small business lending risk has been a function of consumer credit or small business credit scores. It should be recognized that consumer credit scores have limited correlation to small business performance and credit worthiness. Rather, the industry continues to broadly apply and, at times, overly weight the owner’s consumer credit score to small business lending decisions. Consumer credit scores minimally contribution to predictions for probability of default (PD) and provide no insight to loss given default (LGD).
To overcome the often-ineffective application of consumer credit scores, lenders have looked to business credit scores to enhance decision making. Unfortunately for the smallest of small businesses, the current leading business credit scores do not perform better than consumer credit scores for assessing risk or improving access to credit. Business scores are often built using different loan types and different market segments that lack specificity for applications to segments in which smaller businesses operate. Furthermore, current business scoring methods are built from data sets that lack the robustness needed for the smallest and newest businesses. As a result, the accuracy of these scores for small dollar small business lending is significantly diminished.
The impact of the challenges for lenders and the challenges for small businesses are the same – missing giant opportunities. According to the Federal Reserve’s 2022 Small Business Credit Survey, 65% of smallest (under $1 million in revenues and less than 10 employees) and newest (aged 5 years and under) small businesses do not receive any of the requested financing from lenders. With limited options, small businesses will often seek financing through nonbank lenders and accept unfavorable loan terms. This path often has unfavorable impacts on the small business and, in turn, leads to unfavorable impacts on the communities that traditional banks serve. As an alternative to unfavorable terms, the positive and compounding impact banks can have by serving the needs of its small business community is evident.
The Opportunity
There are over 33 million small businesses in the United States. On average for the past five years, more than 2.2 million small businesses have applied each year for a business loan, a business line of credit, or an SBA loan. To serve their customers and their communities, small businesses are looking for fair loan terms and tolerable interest rates, timely decisions from the lender, and convenient application processes.
Banks are very well positioned to deliver on each of these thanks to improvements in technology and data-driven insights for credit underwriting. Compared to online lenders, banks are currently better positioned to offer favorable loan terms and interest rates but fall short in the ability to offer convenient application processes and timely decisions or funding. Simply, banks lose market share to online lenders because of technology and underwriting processes.
However, small banks are currently better positioned to close the gap with online lenders, compared to larger bank competition with the added benefit of better serving their communities. Small businesses drive two-thirds of net new jobs and play a significant role in innovation and competitiveness in the United States. The reciprocal benefits are apparent when banks play an active role in fostering small business growth in their areas.
The Opportunity
There are over 33 million small businesses in the United States. On average for the past five years, more than 2.2 million small businesses have applied each year for a business loan, a business line of credit, or an SBA loan. To serve their customers and their communities, small businesses are looking for fair loan terms and tolerable interest rates, timely decisions from the lender, and convenient application processes.
Banks are very well positioned to deliver on each of these thanks to improvements in technology and data-driven insights for credit underwriting. Compared to online lenders, banks are currently better positioned to offer favorable loan terms and interest rates but fall short in the ability to offer convenient application processes and timely decisions or funding. Simply, banks lose market share to online lenders because of technology and underwriting processes.
However, small banks are currently better positioned to close the gap with online lenders, compared to larger bank competition with the added benefit of better serving their communities. Small businesses drive two-thirds of net new jobs and play a significant role in innovation and competitiveness in the United States. The reciprocal benefits are apparent when banks play an active role in fostering small business growth in their areas.
The Solution
The partnership between Lumos Technologies and Lenders Cooperative provides financial institutions with a reliable scoring method to improve underwriting efficiency for small dollar small business loans and a digital solution that reduces the origination and servicing burden for lenders. Together, Lumos Prime+ Score and Lenders Cooperative’s loan origination system improve the lending and borrowing experience.
The Lumos Prime+ Score predicts expected credit losses over the following twelve months. The score is uniquely designed and refined for small business term loans and lines of credit under $500 thousand. Lumos Prime+ is a more accurate and fairer model that uses three decades of small business loan performance data combined with machine learning algorithms to deliver PD and LGD predictions. The expected loss (EL), the product of PD and LGD, is the best indicator of the financial implication of credit risk for a bank. Back testing Lumos’ data set of three decades of performance on two million small business loans through multiple economic cycles shows that 69% of all performing loans would have received a Lumos Prime+ Score above 80. At 69%, Lumos Prime+ outperforms other market leading scores which only predict approximately 50% of performing loans.
Additionally, Lumos Prime+ performs significantly better than other scoring models that give loans a passing score that are ultimately non-performers. Results from back testing show that Lumos Prime+ would have given a score above 80 for 4% of all non-performing loans in the data set. However, with other scoring models, as many as one-third of the passing loans end up defaulting. Lumos Prime+ significantly outperforms the competing scores ability to cull non-performing loans.
Lumos Prime+ greatly expands financial institutions’ ability to provide credit to a greater number of small businesses that will perform while reducing the number of passing loans that ultimately will not perform. Lumos Prime+ is a better small business score.
Lumos Prime+ has undergone rigorous bias and fairness testing to ensure it does not indirectly have unintended disparate impacts. Using the four-fifths example from the U.S. Equal Employment Opportunity Commission, Lumos Prime+ achieves the threshold for excellence in fairness using the proportional parity metric. The Lumos Prime+ Score expands lending and makes small business financing more accessible.
Lumos and Summit Technology Group’s (STG) partnership delivers Prime+ through STG’s Lenders Cooperative loan origination system. Lenders Cooperative’s online origination system provides end-to-end automation from digital online applications through loan closing and core integration. The Lenders Cooperative platform and workflow support small business C&I portfolios, SBA lending, and commercial lending products with full spreading tools, templates, and an innovative credit model. Lenders Cooperative’s users will have initial exclusive access to the Lumos Prime+ Score enabling banks to overcome major challenges with small dollar small business lending.
For You
Lumos Prime+ mitigates higher credit risk while Lenders Cooperative reduces the operating costs of loan origination and maintains a focus on quality service. Approve more loans with greater confidence. The opportunity is tremendous, the tools are available, and the next steps are up to you. Get the job done with greater operational efficiency and a better lending experience with the Lumos Prime+ Score and Lenders Cooperative.