Although Dodd-Frank brought more scrutiny to bank lending practices, banks have been reducing loans to small businesses for far longer than the law has existed. During the last two decades, the proportion of middle market lending advanced by banks has consistently and dramatically declined. In 1994, foreign and domestic banks in the US made 71% of middle market loans, falling to 18% by 2006 (prior to Dodd-Frank) and 12% by 2012.1
Second, banks’ origination channels tend to be expensive and slow, which we believe will lead them to move away from small balance, self-originated consumer and small business loans. Studies report that a typical bank loan takes six to eight weeks to close, requires 13 or more people to approve it, and can cost the bank USD3,000 to USD4,000 in internal costs for a USD100,000 loan.2 These are mainly fixed costs which can also apply to loans as small as USD25,000. Given these economics and the rising costs of compliance, it is clear to us why banks would pivot to focus on larger loan sizes, or borrowers with whom they have fee generating treasury and other service relationships. Businesses which need smaller loan sizes simply have a harder time getting the attention of banks, due to the high administrative and transactional costs of bank processes. We expect this trend to continue.
Third, specialty finance assets tend to be complex and have stringent regulatory requirements (especially in consumer lending). The expertise required to analyze expected cash flows from a specific product, structure a transaction with the appropriate legal protections, negotiate covenants and measurements well matched to the assets and company, ensure compliance with the patchwork of laws and regulations that apply and manage the loans through their life requires a degree of experience and specialization that is not common at regional and smaller banks in our view. Instead of building teams of specialists, we have noted regional banks partnering with higher volume marketplace lending platforms (e.g., Lending Club, Prosper and SoFi) to purchase pools of homogenous consumer loans or small business loans.3 In this way, banks purchase exposure to the asset class without needing to build internal teams. Because we transact with smaller companies (USD5 million to USD30 million deal sizes) producing more differentiated assets, we do not believe banks will invest in the personnel required to ably close transactions instead of purchasing higher volume, more commodified products.
Fourth, it will require time for the government to proffer regulations deriving from the new legislation, and even more time for banks to digest and implement those regulations. We believe any impact on lending could be delayed at best. During this period, opportunities will persist and require investment, and we anticipate that the advantage of long-term relationships, incumbency and experience will be solidified.
Fifth, prior efforts by small and regional banks to engage in specialty finance, and especially consumer lending, have not been particularly successful nor have they led to increased lending in this sector. In 2008-09, for example, the small dollar loan pilot program encouraged local banks to make small loans to underserved consumers who would not otherwise qualify, but at rates far below those offered by non-bank lenders. The program ended with mixed results, and banks have not rushed to create small dollar, short term financing solutions for non-prime customers.4,5 A number of reasons may drive this: non-prime lending, even under the revisions to Dodd Frank, still requires significant bank equity capital to be pledged against the assets; under the Community Re-Investment Act, no special credit or treatment is given for small dollar consumer loans (or non-conforming mortgages); there is no widely accepted “cheap signal” to assess the likelihood to repay of non-prime consumers, and lenders who specialize in this area spend significant time and resources developing custom credit scores which may be beyond the economic resources of small banks.6
The reticence to undertake these loans pre-dated the Dodd-Frank act; and we believe there is little reason to think that once these revisions to the Act come into force – whenever they do – that banks will rush into this area they have historically avoided. To the extent the revisions encourage small and regional banks to lend to consumers and small businesses, we believe that banks may choose to increase their exposure by continuing to purchase loans at a premium from marketplace lending platforms, which allow them to avoid the sunk internal costs of building specialized teams and the transaction costs and complexity of originating and structuring bespoke new loans in modest sizes. The specialty finance assets we find most compelling – those which present the potential to combine attractive yields with robust covenants and collateral position – typically have distinct or unique flavors. We believe that banks could continue to avoid these and prefer products that are more vanilla.
1. Standard & Poors.
2. "Making Small Business Loans Profitably", BAI Banking Strategies, July 7, 2015.
3. American Banker, April 20, 2018, "Consumer credit eases pain of business lending slump".
4. US Government Accountability Office, "Community Reinvestment Act: Options for Treasury to Consider to Encourage Services and Small-dollar Loans When Reviewing Framework", February 2018.
5. Pew Charitable Trusts, "Standards Needed for Safe Small Installment Loans From Banks, Credit Unions", Feb. 15, 2018.
6. "The Effectiveness of the Community Reinvestment Act", Congressional Research Service, January 7, 2015.