Do Relationships with Banks Still Matter?
Can the close relationship banks have had with small and mid-sized businesses survive the challenges posed by new, nontraditional lenders and heightened regulation?
The importance of relationship-building was one of the key themes to emerge from the second-quarter Markets and the Hill (MATH) briefing with congressional staff on June 23. The meeting, convened by the Milken Institute and the Georgetown University McDonough School of Business, focused on capital access in the U.S. and the various financing options available to small and mid-market companies.
The importance of the relationship between banks and businesses can clearly be seen in the report published by the Milken Institute and National Center for the Middle Market, “Access to Capital: How Small and Mid-size Businesses are Funding Their Future.” In the report, nearly one-third of the more than 600 small and middle-market firms surveyed said they had borrowed from banks within the past three years and nearly the same proportion of respondents said they expected to finance through banks in the near future. More importantly, nearly 80 percent of respondents stated that they turned to banks because of a strong relationship developed in previous transactions. The relationship, and a bank’s understanding of a company’s capital needs, become even more important and more developed as businesses look to expand, according to Doug Farren, associate director for the NCMM.
But can these relationships last at a time when new lenders are entering the small-business lending space and as traditional banks pull back from lending due to heightened regulatory requirements? Todd McCracken, president of the National Small Business Association, noted that relationships have either become constrained or haven’t developed in the aftermath of the financial crisis, especially as community banks fade away — a problem that has persisted over the last 30 years. Understanding of the business and the business model became less important to banks as lending became much more formulaic — to the detriment of small and mid-market firms seeking capital.
Technology-driven innovation in financial services is also driving a wedge between these traditional relationships. As Michael Weil, CEO of RCS Capital, said, “technology can change everything with regards to access.” Alternative forms of finance, often referred to as shadow banking, are becoming much more commonplace in today’s economy and are driven by technological innovation that removes the pain points (process, wait time, etc.) that small and mid-market firms face when approaching traditional financial institutions.
Daniel Gorfine, vice president for external affairs and associate general counsel at OnDeck, described how the market for loans for less than $1 million and, to a greater degree, those below $250,000, have not recovered since the financial crisis. This, he said, has opened up opportunities for his firm, as well as other marketplace lenders, to move into this space using technology. With the advent of big data analytics and greater ability to arrange financing over the internet, firms like OnDeck have been able to go beyond traditional scoring models such as FICO for measuring risk and have drastically cut the time it takes to come to a decision on whether to finance a business.
This presents a challenge to incumbents. While relationships between banks and small and mid-size firms remain important today, will they matter tomorrow? Our report notes that bank loans still dominate financing because these relationships are strong. However, when respondents were asked whether nonbank sources of capital are superior to traditional lenders, roughly a third of respondents answered yes, another third said no, and the final third was undecided. That result presents a significant opportunity for alternative forms of finance to break-up these traditional relationships.
Whether alternative lenders can establish strong relationships with small and mid-market companies depends on the companies’ awareness of these new options. According to our study, nearly 80 percent of firms are unfamiliar with recent changes in securities law brought about by the Jumpstart Our Business Startups (JOBS) Act, and less than one-third of firms surveyed were aware of nontraditional sources of financing other than private equity. As a few panelists noted, borrower education is crucial to making businesses aware of alternative sources of financing.
If bank relationships with small and mid-market businesses decline, as some on the panel suggested, tech-driven platforms could certainly capitalize on the turnover. But the extent would ultimately depend on the level of education and awareness, which is sorely lacking at this point. Bridging this gap could certainly give nonbank lenders a significant advantage.