Square’s small merchants are in trouble. Will a bank license be enough to help?

The coronavirus is hitting small businesses hard, slamming one of Square’s core markets just as the payments company got a long-awaited industrial banking license.

Square’s small business lending product, Square Capital, uses payment flows to pay down loans that businesses can use for sourcing or to maintain liquidity. Square last week received an industrial banking license, something that could add more lending options at a time merchants need them most.

Overall this licensing should be great news for Square, since it greatly reduces Square’s need to rely on partner banks to make direct loans, giving Square more control over speed to market. It would also give Square a potential leg up on other fintechs that do not yet have a banking license but compete in the same small-business lending space, such as PayPal, Kabbage and potentially Stripe.

“Once you have the customer base and you’re digital, you can bring in third party apps and can also get direct revenue through partnerships,” said Alenka Grealish, a senior analyst at Celent. “Without a banking license, if you want to move faster than your partner bank it’s a challenge. There’s still a middle man.”

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But the coronavirus clouds that narrative. The virus-related lockdowns may shut businesses for weeks. There’s likely to be some government relief for small businesses as part of a coronavirus stimulus package. But as stores try to reopen, they will need access to credit over the course of a recession recovery that could last into next year.

That seems like an opportunity for Square and any other fintech that gets a banking license, but the merchants may be too financially strained to take full advantage of the credit on offer.

“In normal times Square’s winning an ILC license would be great for everyone except traditional banks,” said Eric Grover, a principal for intrepid Ventures. “It gives them greater control of the entire stack of financial services it’s providing for small business.”

The pandemic has shut restaurants, bars, gyms and many of the micro-merchants that were Square's earliest client base — the ones who started accepting credit cards only after plugging a Square dongle into their smartphones.

These businesses have grown with Square, and Square has expanded its product line to take on more of these businesses’ relationships. As of the end of 2019, Square Capital has made $5.5 billion in loans to 275,000 small businesses. The average loan size is $6,500, though the loans can be as small as $500 and as large as $100,000.

Square has made numerous moves over the years as it's moved closer to banking, such as a card for business owners and more consumer-oriented moves such as a prepaid card. It also opened its technology development tools in an effort to attract larger merchants. Square has positioned its quest for an industrial banking license as a way to reach businesses that are underserved by traditional banks, rather than an attempt to compete directly with banks.

Square referred questions about its new license to its press release detailing the new unit, Square Financial Services, which is scheduled to launch in 2021. In a research note, Morgan Stanley said Square’s offerings will largely be confined to existing products for now, given the larger economic challenges.

Square Cash’s P2P app has also provided a boost for the company’s financial performance, enough to make it competitive with PayPal’s Venmo app. But Square Cash has some exposure to small businesses, which use the app to pay staff, CEO Jack Dorsey said at an earnings call in 2019..

“Square Capital and other Cash App offerings are likely to see pressure from the recent macro slowdown tied to COVID-19, which could push out new product launches until conditions stabilize,” the Morgan Stanley research note said, adding the license could also reduce capital risk by providing access to FDIC insurance for deposits held on the Cash App platform.

The margins are thin for the small-business market. Companies with less than 500 employees usually have less than a month of cash on hand, according to JPMorgan Chase.

“Square’s bank is a commercial enterprise and not going to extend credit to small businesses struggling or going under because government mandates have closed them,” Grover said.

By lending to small businesses, and with the freedom to move faster without relying on partner banks, Square could be in position to capture more of its clients' business longer into the future. “If Square can get businesses through this situation, they will stand to have a lifetime customer,” Grealish said.