Small Business Banking-Do You Know The Score
Let's get something straight. Banks are businesses, and therefore, are in business for one fundamental purpose: to make money for their shareholders. Period!Sure, banks are valuable members of the marketplace and good corporate citizens. It's true most banks make significant contributions to the quality of life in their communities. But a bank's prime directives are to make a profit, drive the value of its stock, and pay dividends to its shareholders.
Banks make some of their profits by investing the deposits that individual and business depositors make in return for banking services. A loan is a type of investment. In this article, I am only interested in loans to small businesses.
Small Business Loans Are Inherently Risky
I'm sorry to have to tell you this, but a loan to your small business is among the riskiest of all loans a bank will make. Here are just a few of the reasons:
1. You're probably operating with a limited number of contributors to your company's business decisions. Maybe one decision maker - you! If you make a bad decision, it could take you down.
2. Your business is more vulnerable to a competitive assault, or a market or industry cycle.
3. As sophisticated as you may be, you are likely to be less sophisticated than your big business neighbors and competitors.
4. Statistics show that you are probably undercapitalized, making you closer to closing up than both you or your banker are comfortable discussing. And remember, when you are undercapitalized, even profitable sales growth can be dangerous for a business.
Yes, I know, there are millions of small business loans made every year. I've gotten my share of them, and as a business consultant, have helped many small business owners get theirs. But we are still risky borrowers, which is why you and I live in a dimension that we will talk about next.
The World Of Prime Plus
A bank's prime rate is the rate they charge to loan money to their " best" customers, usually for short periods of less than 12 months. These are the guys with large daily compensating balances in their checking account and a beautiful balance sheet. While you and I are not chopped liver, alas, as small business owners, we are not likely to fit this profile. Consequently, the interest rate we pay for our loans is the prime rate, plus some percentage.
If you have a good track record and have performed well on past loans, you might qualify for prime plus 1%. If you have a decent record, but the bank still feels it's taking a chance on you, you might get prime plus 2%. If you need a loan to get you through a slump in sales or collections, if your business is brand new, or if your banker knows you have no where else to turn, you will become acquainted with the dreaded prime plus 3%, and so on.
Don't take Prime Plus personally. It's not about you, it's about risk/reward. Your loan is risky, and the bank must adjust the reward to compensate for the level of risk. If you extend credit to a customer who doesn't have an established credit history, you should charge a higher profit margin than you do for the customer who has a solid record of paying on time. Business is business.
Morte De Relationship Banking
I am concerned about the future of small business lending. " But Jim," you say, " every bank I know advertises that they are THE small business bank in town. What's up with that?"
Yes, many banks have an aggressive small business marketing program. But that's marketing. I worship at the throne of results, and the results I'm looking for is for a bank to invest the time and resources to really help small businesses with their capital needs. I don't mean invest in computer software that asks sterile questions, digitizes the answers, and spits out a credit score.
I am troubled by the increasing practice of credit scoring of small business loans. The attraction of credit scoring is that it allows a bank to process lots of loan applications using lower paid staff. These deputy, associate, assistant 3rd vice presidents only have to collect answers to predetermined questions, load them in the hopper and read the number that pops out. It's kind of like Bingo: under the " g" , number 16. If that's your 16, and the bank's cut off for small business loans this month is 17, welcome to high tech banking and credit scoring. The handshake at the introduction, and the kiss-off in the " loan declined" letter are as close as you get to a relationship with that bank.
Our Brain Trust's resident banker, Mike Menzies, President of Easton Bank and Trust, in Easton, Maryland (an independent bank), says credit scoring models create a "repayment probability" profile using some classic credit criteria, plus each scoring entity has their own secret criteria they won't talk about. Mike admits even some good small business lenders may use credit scoring, but only as one facet of the approval process.
Do you know if the bank you're giving a loan proposal to uses credit scoring? How would you find out? The old fashioned way, ASK! You have a right to know the method your banker is using to evaluate your loan proposal. I'm not saying you shouldn't allow your proposal to be scored. People do actually win at Bingo. It might be you this time.
One of my problems with small business credit scoring is, when banks use it exclusively, they pick off the best loans and leave the rest. There were times in their careers when Henry Ford and Bill Gates would not have gotten a loan if credit scoring had been used. Small business owners need to be helped, not scored.
Character Shmaracter
In another banking article I talked about the Six Cs of Credit. Five of the Cs, 2 through 6, can in fact be digitized and scored: Capacity, capital, collateral, coverage, and conditions. But the numero uno C, Character, the character of the borrower, can never be credit scored.
Character is to relationship banking what loyalty is to friendship. Can't have one without the other. In relationship banking, the character of the borrower is a major element of the approval process, typically weighing heavier than any of the other Cs. When a small business loan application is considered by credit scoring alone, your good character and eight bits will get you a double latte.
The Stock Market Is Not Small Business's Friend
Banks need to make loans, but they MUST have deposits. For some time now there has been an erosion of traditional bank deposits to non-bank competition in the form of alternative liquidity instruments, like money market accounts for one, and the stock market for two.
The folks at the Federal Reserve Board tell us that Americans are saving less and less. But if there is so much prosperity around, where is all the money going? It's going to buy stuff, and it's going to buy stocks, not into CDs. Have you heard of the investor class? Well over 40% of Americans are currently invested in the stock market. Ten years ago that percentage was around 20%.
Since banks don't have as much deposits as they used to, they may have to borrow the funds to make your loan. Borrowed money costs a bank more than deposited funds. Your loan just got less profitable, ergo, more risky. The only way for the bank to fix this problem is Prime Plus Plus, or more stringent lending limits. Either way, your small business loses.
Play The Field
You've probably heard me say this before: ALWAYS take your loan proposal to more than one bank. Simultaneously. If you find that you are being scored at the first bank, you MUST talk with another bank. If you get two acceptances, congratulations. That's a high class problem. Take the best deal.
You are more likely to find credit scoring at the large regional, and national banks, and less likely to be scored at an independent community bank. I like working with the small banks. Here's an unsponsored, unsolicited endorsement from years of experience: Year after year, community banks are a small business's best friend.
Find a bank that practices old fashioned relationship banking. Your character will be welcome there. They're hard to find, but they do exist. But never, EVER, depend on just one banking relationship. ALWAYS do business with at least two banks.
Take heart!! There is a loan out there for your small business. The lesson here is to know the score: Who are the players, and how do they play.
Write this on a rock... Remember that other Golden Rule: He who has the gold makes the rules. As a small business owner, you MUST know the rules of small business banking.
