Can The Federal Reserve's Main Street Lending Program Be Manna From Heaven for Community Banks?

"How much more abuse can small businesses take from big banks?"

~ Community Bank CEO

PPP is winding down. Community banks not only took care of their small to medium sized businesses (SMEs), but also helped big bank customers when their calls went unanswered.

Why? Because the big banks prioritized. It was a first come, first served program. And the race to the gate was intense. Ask any banker and SME CEO worried that the program would pass them by. So when they didn't hear back from their big bank, they started calling the local banks. 

Opportunity to win new customers? I think so. And bankers ought to be strategizing on how to turn those borrowers into core customers. 

Main Street Lending Program

But there's more! Now I sound like I'm selling you two Shamwow's for the price of one. Could the more be the yet to be launched Fed's Main Street Lending program? Set to launch May 29th and end on September 30th.

There are three lending facilities: Main Street New Loan Facility (MSNLF), Main Street Priority Loan Facility (MSPLF), and the Main Street Expanded Loan Facility (MSELF). In this post, I want to focus on the MSPLF, because it looks to be uniquely set up so community banks can win those local customers that have stubbornly remained with your large bank competitor.

Fine Print

Let me copy/paste a unique Eligible Borrower certification/ covenant of the MSPLF:

"The Eligible Borrower must commit to refrain from repaying the principal balance of, or paying any interest on, any debt until the Eligible Loan is repaid in full, unless the debt or interest payment is mandatory and due. However, the Eligible Borrower may, at the time of origination of the Eligible Loan, refinance existing debt owed by the Eligible Borrower to a lender that is not the Eligible Lender." (emphasis mine)

So, as I read it, if the Eligible Borrower has a loan outstanding at a big bank, it can saunter into your office, apply for an MSPLF, and repay a loan at the big bank. And the MSPLF loan is LIBOR +3%, which is currently 3.42%. And the loan is unsecured and the amount is based on the Eligible Borrower's 2019 EBITDA. Six times their EBITDA. Oh, and no payments for the first year. Years 2-3 amortization is 15% of outstanding balance, and year 4 is a 70% balloon. And your bank need only maintain 15% of the balance and the Fed will participate the other 85% through a special purpose vehicle.

I doubt the big bank will be calling their smaller customers that are current on their loans and have a good chance of making it through the pandemic.

So why is that stopping you?

Thoughts?

~ Jeff

Update: This from the ABA's Daily Newsbytes on the MSLP:

The Fed announced that it would hold a drop-in session on May 22 at 2 p.m. EDT and an informational webinar on May 28 at 2 p.m. EDT for potential lenders in the MSLP. The drop in session will provide an opportunity for lenders to ask questions about the program, while the webinar will give lenders a chance to learn more about the infrastructure and operations of the MSLP.

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Registration for these live sessions will be limited to two representatives per institution, and recordings will be available after each program. Register now. Questions may be submitted in advance to questions@askthefed.org.

Bankers: Build Your Own Small Business Loan Platform

Banks that grow revenues do it in spread or fees. To grow spread, increase your net interest margin, or grow earning assets while maintaining net interest margin. To grow fees, either increase your fee schedule or the activities that generate fees, or grow fee-based lines of business. 

Since 2007, banks have been challenged to grow revenues. And if the bank strategic planning sessions I attend are an indicator, bankers think small business account acquisition and growth will be a significant driver of revenues.

This presents a challenge. Many if not most small businesses are not “bankable”, in the lending sense of the word. I once offered this hypothetical situation to a senior lender: An owner of a three year old engineering firm wanted to expand. The expansion would take him into the red for the next two years and his seed capital, taken from his personal savings and a home equity loan was not enough to fund the expansion. He leased his office space. Would the senior lender make the loan? His response: “I’m glad you’re not one of my lenders.”

Would his reaction be different at your bank? Check out your current and recent past loan pipeline. How many non real-estate backed business loans did you make? Yet this hypothetical business is more typical of the businesses that will lead our economy forward. So to grow revenue, perhaps your bank should be a little more creative in getting capital to businesses of the future.

No risk appetite to do early stage business lending? There are alternatives to help that business get much needed capital to grow without plunking a risky loan on your balance sheet. Perhaps develop a small business lending marketplace with several options. One option could be balance sheet lending in the form of home equity loans or other similar avenues that fit your bank’s risk appetite. Think: Your Bank’s Small Business Capitalizer package.

If outside of your risk appetite, how about SBA lending? Ridgestone Bank, a $395 million in assets Wisconsin bank was ranked seventh in SBA 7(a) lending last year, generating between $20 – 25 million in gain on sale of loans per year. 

SBA loans not an option for our hypothetical engineering firm? How about a partnership with a peer to peer lending platform such as Prosper that can be co-branded with your financial institution? Prosper will pay an affiliate fee for each loan offered. OnDeck Capital, which specializes in business cash flow lending, will also affiliate with financial institutions, providing another avenue to fund our hypothetical engineering firm.

It’s not necessarily the affiliate fees that will move our revenue needle, but providing budding businesses within our communities the needed capital to succeed will build loyalty, deposit balances, and eventually “bankable” loans should these businesses succeed. Instead, we send them elsewhere, giving a potential competitor the opportunity to win these businesses’ relationships.

Imagine the “Your Bank” small business loan platform, with multiple opportunities for the local business person to help fund their growth. You start with the least expensive, such as “bankable” real-estate secured loans from your bank, and work through the other options such as SBA, OnDeck, Prosper, and even equity platforms such as Kickstarter. That would be a bank dedicated to small business capital formation, and growth, within their communities.

And a growing community usually leads to revenue growth at your bank.

Or you could stick to business as usual, and hope small businesses come your way. Your choice.

~ Jeff


Note: This article was previously published in the April 2015 issue of ABA Bank Marketing and Sales magazine in the Growing Revenue series.

De Novo Banks: Only Apply If You Intend to Matter

ABA President Frank Keating wrote an Op-Ed piece recently in The Hill entitled New jobs and new growth call for new banks. I don't believe it. A more accurate title should have been New jobs and new growth call for new businesses. His leap-of-faith assumption was that new banks are critical to new business formation. I'm skeptical.

Why? I don't think de novo banks are key players to business startup capital formation. Sure, if you cite studies that say these banks' loan books are predominantly small, as the FDIC measures them. But that is because de novo's are limited to making a loan to one borrower of 15% of their capital position. If a de novo starts with $15 million of capital, its largest possible lending relationship is $2.2 million. So the bank necessarily hunts for smaller relationships.

I'm also skeptical that small community banks in general are financing startup businesses. See the accompanying chart for the loan composition for all FDIC-insured banks and thrifts with less than $1 billion in total assets.

So, if a de novo bank has $100 million in total assets after its first year of operation, and it's loan portfolio was $70 million, then its business loan portfolio would be $9 million, if they achieved the community bank average. And that's all non real-estate loans to businesses, not necessarily startup or early stage businesses. Since I often hear credit people talk of getting three years of tax returns to get a loan decision, it makes me wonder how a 1 year old business can satisfy the requirement.

OnDeck Capital, not a bank, will lend to businesses with one year of operating history and only $100,000 of annual revenues. How do I know this? They tweeted it to me. That's right, they tweeted it.

I am doubtful many financial institutions would make such a loan.

To be fair, the loan portfolio composition in the above pie chart is from Call Reports, which categorize loans by collateral, not purpose. There may be small business loans in the residential category, because the business owner pledged his or her house as collateral for the loan. But I doubt OnDeck or similar neo-banks are requiring such collateral. And OnDeck and similar lenders are growing rapidly in the startup or early stage business financing landscape.

So, no, Mr. Keating, I don't think de novo banks, being run and regulated as they are currently, are critical to small business formation. Who wants a regulator to come in for their periodic exam cycle and ask "why did you make this loan"? What banker is running to capitalize an early stage business without real estate as collateral?

I don't know of many.

Do you think de novo banks are actively participating in startup or early stage business financing?

~ Jeff

Why are start up businesses not creating jobs?

I posed this question to a Fed economist today. Her answer: lack of capital.

The above chart is from a Federal Reserve Bank of San Francisco Economic Letter: Slow Business Start-ups and the Job Recovery published in July.

But in strategic planning retreats that I moderate, community financial institutions insist that they lend to small businesses. In fact, when I recently spoke to a group of New York bankers, I opined that community FIs would lend to small businesses only if they have three years of operating profit and a building as collateral. Some took offense.

The chart above, taken from a Harvard Business School Working Paper: The State of Small Business Lending written by a former SBA Administrator and also published in July, shows that only 34% of small businesses use a regional or community bank as their primary financial institution. The second chart shows the primary sources of capital. Yes, a loan is the most often cited. But trade credit and credit cards also weigh in heavily.

The above chart, taken from the same HBS working paper, shows the use of proceeds of small business credit. Given a community FIs lending proclivities, one would assume that small businesses borrow to finance a building. But no, the primary use of proceeds is for cash flow. Real estate structuring is pretty low on the list.

I discuss this disparity between how bankers perceive they contribute to small business capital formation, and why businesses need capital. In March 2010, I wrote about the decline in business lending among community financial institutions in a blog post titled: Have we checked out of business banking?

So we limit small business lending to those businesses with three years of operating profit and have real estate as collateral. Not exactly lending into the industries that are projected to grow, such as service firms and professional/technical practices. These businesses are commonly located in an office building that they do not own. 

Another challenge is the number of businesses that do not borrow. According to the HBS working paper, only 40% of small businesses apply for credit. Out of the forty percent, 43% did not receive the credit they requested (see chart). 

So let's extrapolate... eleven percent of small businesses borrow for real estate structuring and another 13% for debt restructuring. But only 40% of small businesses borrow. So 40% of 23% is 9.2%. But only 43% get approved for the amount of loan they requested. So about 4% borrow for real estate or debt restructuring and get the credit they requested. But only 34% of small businesses bank with regional and community banks. 

So for 1.35% of small businesses, community FIs stand ready to lend!

Of course, I exaggerate, because many small business loans used for cash flow, inventory, etc. are collateralized by a commercial or residential building and financed by community FIs. But I think our participation in small business funding is far smaller than we claim.

So if we want our communities to thrive now and into the future, small business formation and growth will be critical. Lack of capital is always a top of the list constraint to small business success.

Are we participating in this critical segment of our economy?

~ Jeff

Shark Tank: Bankers' Edition

Reality shows are generally not my thing. Don’t get me wrong, I’m often subjected to the genre because I submit to family preferences. How else would I know that Emmitt Smith is quite the twinkle toes. But, while channel surfing, I discovered Shark Tank.

On Shark Tank (see the clip below), entrepreneurs pitch their ideas to a panel of angel investors, known as sharks, to win funding for their enterprise. The sharks, one of whom is Mark Cuban, the colorful owner of the Dallas Mavericks, pillory the entrepreneur with questions about their product(s) and business plan. After the Q&A, they decide if they want to fund the venture, and at what level. Watching and listening to the questions, answers, offers and counteroffers is fascinating.

I recently read a NY Times You're the Boss Blog article regarding how banks can fund small businesses. It made me think of Shark Tank. Businesses evolve through various stages. In early stages, entrepreneurs struggle to get funding. It’s generally too risky for a bank loan. So, early stage funding typically starts with owner’s capital, then to friends and family if it gets that far, then to angel investors. Banks will entertain a loan typically after a few years of successful operation. There are exceptions, however. The SBA loan program was designed to get earlier stage capital to entrepreneurs. But generally, young businesses need equity, not debt.

Many banks are headquartered or have significant presence in communities that are experiencing economic difficulties. This impacts loan quality, loan demand, growth, and profitability. But most banks remain on the sidelines when it comes to small business formation. The businesses formed today, appropriately capitalized, will be those that sustain our communities in the future. Some of the fastest growing companies today are not that old...i.e. Priceline.com, VistaPrint, Netflix, etc.

These businesses needed capital. Many top new companies are located in California’s Silicon Valley, and not coincidentally, that is where many venture capital firms are located. As traditional providers of capital, can banks participate in funding early stage ventures? I say yes because of community banks’ unique position in our communities.

But funding early stage businesses does not have to be with the traditional bank loan, or even an SBA loan. These are equity investments, higher risk seeking higher return. I think banks can sponsor their own version of Shark Tank. Not as sole investors in an angel fund, but as investors and managers of an angel fund, much like the sharks of Shark Tank. What would be bankers’ objections:

1. It is an impermissible activity… jfb response: Put it at the holding company. Many banks manage mutual funds in their trust companies, don’t they?

2. It wouldn’t be profitable… jfb response: I wonder how venture and angel funds do it? A small, $10 million fund can earn a 2% annual fee ($200,000) and 20% of the “ups” (fund returns). So if an angel fund averaged a 10% annual return (low for venture fund standards), the revenues to the manager of the fund would be $400,000 ($200,000 annual fee plus 20% of the $1 million annual return). You couldn’t manage a $10 million fund for $400,000/year?

3. We would have to turn down more businesses than fund… jfb response: True! But it would force startups to develop a business plan to chart their future and present to the sharks. Even if the venture doesn’t win the funding, the entrepreneur would have thought through the business more thoroughly. How many times do you drive by a new business that you don’t think will make it? Through this process, those that get turned down may turn their entrepreneurial spirit to a more sustainable venture, or burn with a greater desire to prove you wrong!

The benefits, in my opinion, would be:

1. Get more funding to promising startups. One of the top reasons for business failure is lack of capital.

2. Turn your community into a business incubator. Bring enough publicity to your process, you are likely to get more businesses seeking funding. Do you see having more, higher quality startups in your community as a good thing?

3. Build a sustainable future for your community. The employers of today are not likely to be the employers for the next generation in your local area. Acquisitions, changing consumer preferences, and general corporate inertia make today’s strong business into tomorrow’s dinosaur. Remember the Palm PDA? Strong, vibrant communities should always be looking to the next ventures that will sustain them into the next generation.

What do you see as advantages and disadvantages of a community bank sponsoring its own Shark Tank?

~ Jeff

Common Misperceptions: Community Banks are Beating the Behemoths

My firm constantly evaluates industry trends and happenings to formulate what we term our Industry Overview. Although a constant process involving hypothesis, research, and re-evaluation, we center our thinking annually to ensure we properly debate, debunk, and determine where our industry is moving.

As part of the process, our staff does a lot of research. Some of the research focuses on themes we hear multiple times over in client strategic planning sessions. One such theme was the right sizing of community banks' funding sources.

Since the dawn of the financial crisis in 2007, loan demand has fallen off of the cliff, and therefore community banks did not need their historically high amount of CD funding. As a result, we dropped rates to such a level that it wasn't attractive to traditional CD customers and they began parking money in liquid savings vehicles, such as the money market account.

Our deposit coffers swelled like a puffer fish. In many strategy sessions, senior management teams began to feel pretty good about their efforts in attracting core deposits, and how they are beating the big banks in deposit gathering.

Not so fast. As the chart below shows, although community FI deposit growth has been quite robust, with an emphasis on core deposit growth, the big banks (defined as top 25 US banks) are outpacing us. This is exemplified by Bank of New York/Mellon charging their largest depositors negative interest for the convenience of parking their cash in BNY's vaults.

Another theme we hear in community FI strategic planning sessions is how much better we are at serving small businesses. We provide access to decision makers, custom loan structures, and better service than our larger brethren, so the discussion goes.

But the chart below from recent Small Business Administration research, although using 2009 data, demonstrates a trend worth noting. In 2005, banks with greater than $50B in total assets accounted for 32% of small business loans, defined as loans less than $1 million. In 2009, that percent rose to 37%, although that is off 1% from the prior year.

All other asset sized FIs either held their market share or slightly declined. Does access to decision makers, custom loan structures, and better service result in more business? Intuitively it should. So why hasn't it?

How do we, as an industry, turn the competitive advantages we have over behemoth banks into real wins in the marketplace? I'd like to hear from you.

~ Jeff