It Really Shouldn’t Be This Difficult: Small Dollar Small Business Lending

Somehow, even with more than 33 million small businesses in the United States, making small dollar small business loans lacks the process efficiencies to make it worthwhile for banks. It’s not for lack of desire — it’s no fun, as a banker, to try and dodge your friend (a small business owner who came to you seeking, what seems to be, reasonable financing for a new piece of equipment) at the grocery store because your credit team cannot reach consensus on the approval. Geez, he’s lingering in the deli section and you need that ham! You can’t go over there; you’ll look ridiculous. Ahhhh, why is this happening!?

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. It’s uncomfortable to admit that even though you know the right thing to do is to help the small business owner obtain reasonable financing, the returns on smaller loans do not justify the operational costs and smaller loans have an inherently riskier credit profile.

The problem is, making small dollar loans to small businesses is complicated — more so than what folks have historically considered it to be worth. And when banks start to try and dig into the varying needs of businesses, larger dollar loans often take priority over the financing needs of smaller small businesses. Thus leaving the unsolved mystery of seizing the GIANT market opportunity (33 million of these businesses are out there, remember?!) in this segment of small business lending.

Friends, it really shouldn’t be this difficult.

The Opportunity

We mentioned before that there are over 33 million small businesses in the United States. 33 MILLION! And of that 33 million, the 5 year running average tells us that each year more than 2.2 million small businesses have applied for a business loan, a business line of credit, or an SBA loan. Just a casual 2.2 million requests for financing so that they can continue to serve their customers and their communities — that’s incredible when you consider how many businesses need financing and don’t even apply because of how big of a headache the process can be! And, just a reminder, small businesses aren’t asking for something new and unique. They are looking for the same thing as any other loan applicant… fair loan terms and tolerable interest rates, timely decisions from the lender, and convenient application processes. 

Compared to online lenders, banks are currently better positioned to offer favorable loan terms and interest rates but fall short in their ability to offer a convenient application process, timely decisions or funding. It’s 2023 and the customers are rightfully expecting businesses to level up their technology for a smoother experience — banks are no exception. When the process is clunky and technology is stuck in an era that rivals your 1997 Nokia cellphone (seriously, are they underwriting using T9 mode?! Why is it taking so long?), you will lose market share to online lenders.

You probably know that small businesses drive two-thirds of net new jobs and play a significant role in innovation and competitiveness in the United States. Here’s a plot twist you might not have expected… small banks are currently better positioned to close the gap with online lenders, compared to larger bank competition. And bonus, there is the added benefit that these smaller banks can likely better serve these communities — don’t ever underestimate the power of actually knowing your customers. The reciprocal benefits are apparent when banks play an active role in fostering small business growth in their areas.

The Challenge

I guess we should clarify, there are actually several challenges but we are going to focus on the big two. These two primary challenges are the ones that have kept small dollar small business lending feeling a little like the Wild Wild West. Ok, maybe that’s extreme… but it’s definitely been less than ideal. 

First, it’s just too much. The time, the money, the mental gymnastics… It’s too much. The bottom line is that the costs of originating and servicing these loans is inconsistent, at best, 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 put this in perspective, to achieve a similar efficiency of larger dollar small business loans, lenders would need to reduce operating costs over 6x, on average 

Secondly, it’s risky! Small dollar small business loans come with greater risk of loss. On average, the risk of loss on loans less than $500,000 to a small business is 2.5x higher than larger loans. (So more cost and more risk — what’s not to love? Yikes!) And, to add salt in the wound, what makes it even less compelling for the lender is the comparative losses for smaller loans increase during times of economic stress. Wow! None of this is really compelling you to charge full speed down the small dollar small business lending path. This is The Challenge section of this article, remember? We’re not here to sugar coat it.

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. Just in case you skimmed that over, I’ll give it to you one more time, and a little louder, for the folks in the back…


But what we see is the industry continues to broadly apply and, at times, overly weight the owner’s consumer credit score for small business lending decisions. The fact remains, consumer credit scores minimally contribute to predictions for probability of default (PD) and provide no insight to loss given default (LGD).

You might be thinking… That’s why lenders have looked to business credit scores to enhance decision making. Not so fast. 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.

If you wanted to write a book about this conundrum (and why would you because this article is already firing on all the cylinders we need!) Of the challenges for lenders and the challenges for small business could have the same title, “Missing Giant Opportunities”. According to the Federal Reserve’s 2022 Small Business Credit Survey, 65% of smallest (defined as 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. None! With limited options, small businesses often seek financing through nonbank lenders and accept less than desirable loan terms. And that is putting it nicely — these terms often have crippling effects on the small business and, in turn, lead to unfavorable impacts on the markets that traditional banks serve.

Imagine what could be possible, the positive and compounding possibilities, if banks could better serve the needs of the smaller businesses in its community. That reality is attainable. A focused effort with the right tools is what you need to overcome these barriers and will create the path to serving this market segment.

The Solution

Here it is, friends. Some have been calling this the peanut-butter and jelly of small dollar small business lending. Who? Don’t worry about that; some!

We’re talking about the partnership between Lumos Technologies and Lenders Cooperative. Together it provides financial institutions with both 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. That’s what we call a win/win for the lending and borrowing experience.

The Lumos Prime+ Score is an auto generated score that predicts expected credit losses over the next 12 months, specifically for small business term loans and lines of credit under $500,000. To geek out a little — Lumos Prime+ uses three decades of small business loan performance data combined with machine learning algorithms to deliver probability of default (PD) and loss given default (LGD) predictions that are more accurate and fairer. The product of PD and LGD, the expected loss (EL) is the best indicator of the financial implication of credit risk for a bank.

What does that mean? It means with Lumos Prime+, banks can both reliably approve a greater number of small business loans (that will perform) AND reduce the number of loans that pass through that, ultimately, will not perform. Lumos’ data set includes three decades of performance, on 2 million small business loans, through multiple economic cycles. Many would call that “robust”. We agree and would add that with Lumos Prime+ you can say “Yes!” more often with confidence.

Still not convinced? Allow me to illuminate… 

Results from back testing show 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 (what a nightmare) and the competing scores ability to weed out non-performing loans. Lumos Prime+ greatly expands financial institutions’ ability to provide credit to a larger number of small businesses that will perform, while reducing the number of passing loans that ultimately will not. 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+ is the better small business score. Mic. Drop.

Oops, not quite. I got carried away there. This next bit is pretty important…

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, and in most instances well surpasses, the threshold for excellence in fairness using the proportional parity metric. The Lumos Prime+ Score expands lending and makes small business financing more accessible.

All of this is made possible by the Lumos Prime+ and Summit Technology Group (STG) partnership with 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.

What now?

Now that you know Lumos Prime+ can mitigate higher credit risk and that Lenders Cooperative can reduce the operating costs of loan origination (without losing sight of quality service), it’s up to you.

Are you ready for your financial institution to take hold of a massive opportunity to approve more loans with greater confidence? Or to stay in the foggy unknown? The opportunity is tremendous and the tools are available to help you to see the whole story. Let Lumos Prime+ Score and Lenders Cooperative illuminate your path to greater operational efficiency and a better lending experience.

For real this time… 

Mic drop.