It's not just technological gaps that confront community banks' ability to compete with the alternative lending wave. It's also — plain and simple — the principle of what it means to be a traditional bank that highlights the difficulty in keeping up with fintech.
Whereas alternative lenders have no depositors or prudential regulators to worry about, community banks may be the most conservative organizations on the planet. The deposits they take in cannot sit inside the bank — they are lent out. That makes them highly levered. As a result of having relatively little cash and a lot of debt, banks have to be extremely careful in the loans and investments they make.
Take the average bank in the U.S. For every $100 it has in assets (loans), it might have about $10 in equity. Compare that to an average manufacturer: for every $100 it has in assets, it probably has $70 in equity; i.e., it might only owe $30 on those assets worth $100. Simply put, banks can't lose much money on the loans they make.
For the best simple explanation of the comparative cash difficulties of a banker, look to none other than George Bailey in the iconic film "It's a Wonderful Life." As his bank faced a run from customers clamoring for their cash, he made a valiant attempt to distill for them the complex U.S. banking system: "The money's not here. Your money's in Joe's house and in the Kennedy house and in Mrs. Maitland's house and a hundred others," he explained. "You're lending them the money to build and then they're going to pay it back to you as best they can."
With that still the basic model today, how can a community bank begin to adapt to the rapid change from the fintech movement? In addition to the fact that banks have the cash of other people and lend it out, that fact means that they must have stringent regulation. If McDonald's failed, the result would be fewer Big Macs. When banks fail, it affects people's life savings.
Community banks, which make up 97% of all U.S. banks, report that regulation is a significant barrier to growth. That's probably true. And with the emergence of alternative online lenders and financial-services companies, community banks are at a strategic disadvantage in the marketplace. Traditional banks' loan decisions by nature will be more conservative, so they are unable to take on some of the business the startups are grabbing.
Community banks find themselves at a crossroads. They could choose to continue with business as usual and write off fintech or alternative lending as just another threat that could come and go. Or they could explore how to compete with the fintech wave within the parameters of the traditional bank model. Here are three steps for smaller banks to pursue the latter option.
Embrace Technological Change via Collaboration
Look for ways to partner with innovative fintech companies as a means of generating a new revenue stream, diversifying your portfolio or getting higher returns. Some banks are generating referral fees by referring non-ideal applicants to alternative online lenders for service. Other banks are purchasing consumer loans that were originated online through these alternative lenders. Another avenue for banks would be to contract with alternative lenders to originate certain loans that generate higher interest rates due to the higher risk.
Such partnerships could increase risk because they mean higher loss rates, but they should also mean higher income and higher capital adequacy ratios if the risks are managed well. Originating loans in partnership with alternative lenders is something to look at if the bank can create a pool of loans that are diversified.
Play to Their Strength
Community banks can take this opportunity to double down on understanding the true nature of the credits they are underwriting. We don't have 100 years of historical data on the losses associated with the types of loans that alternative lenders are willing to make today, because banks have historically chosen not to make them. If community banks focus on generating data before and after approving loans to better assess risk, they'll be able to be more competitive for the less risky customers they want. Alternative lenders today don't play in low-risk loans so it is important for banks to protect this niche. The single largest expense for banks is credit risk expense, so using better data and analytics to make better decisions on risk is vital.
Use Automation to Speed Up Lending Process
It seems obvious that community banks have to get costs lower and speed up approvals in order to compete. Automating more of the workflow, and loan-approval and monitoring process, is how you do that. Online alternative lenders are already using technology to streamline and automate applications, speed up underwriting and price in risk. This is how they are promising applicants faster decisions and quicker access to funds. Traditional banks, too, have to take advantage of these efficiencies to remain competitive.
Brian Hamilton is chairman and co-founder of the financial analysis and risk management software company Sageworks. Mary Ellen Biery is a research specialist at Sageworks.