Ready to Evolve
Small Business is a top priority for banks for two reasons. First, the challenges to core mass market consumers due to the restructuring of overdraft/NSF fees have led banks to look for growth in higher-value segments. Second, the recent deposit crisis has reinforced that Small Business deposits are more stable than others, and offer a lower beta – hence the overall Small Business relationship becomes increasingly more important. Amid increased Fintech competition, this space is one of the few in which local and regional depository players can still gain an edge. Unlike other categories, such as Consumer Checking and Commercial, where the top three banks account for more than half of the market, regional players still have material share of balances in Small Business.
The primary anchors of a Small Business relationship are the operating account and a lending relationship. This article will focus on the latter, where we believe there is a material opportunity to optimize pricing to drive market share gains while improving margins by ~25 bp, or ~$2.5M dollars in revenue for every $1B in originated loans. This is not a one-time benefit but a continuous gain for each year of originations.
As the Small Business Lending space continues to evolve and grow, understanding pricing and its variation, both explained and unexplained, will be paramount to aligning customer value with the cost to sell and serve as well as to finding areas ripe for success. There is less pricing precision than we see in other lines of business, which presents an opportunity, especially locally, for those willing to champion it to take Small Business Lending to the next level.
Even after multiple rounds of PPP, we see not only an increase in demand for loans and lines of credit but also a shift in their nature. While this increase in demand from 2021 to 2022 slowed, it still persists in early 2023, and it has shifted from Unsecured Lines of Credit to Unsecured Loans. But without understanding the trends, causes, opportunities and how these trends change throughout the year, many banks will be left without their slice of the increasing Small Business Lending pie.
This demand, moreover, is occurring in an immature space where many lenders are without the proper processes and tools in place to know how and where to mine it. Without them, lenders will struggle to keep up as the category advances and matures. To perfect their strategy and stay ahead of the competition, a critical component will be a more concerted effort applied to pricing.
Bringing Precision To The Forefront
Market Intelligence
One of the biggest factors keeping lenders from pricing their loans and lines of credit to match demand is the lack of data in the Small Business Lending space. This leaves lenders, even those willing to evolve, stuck in a cost-plus approach to pricing that results in the market inefficiencies we see today.
Using the LendersBenchmark Analyzer for Small Business Lending consortium, which contains true funded rates and volumes, we analyzed the market and found that there are material differences in pricing strategies across Small Business Lending, even when controlling for variables such as loan/line size and risk. Without adequate data to drive pricing strategies, we find variation that is unexplained, suggesting both inefficiencies in the market, and therefore opportunities lenders could harvest, and differences in customer demand. Because of different institutional cost of funds, a cost-plus approach to pricing can drive some of the pricing variation, but it completely ignores the demand of the market. Even when controlling for the lending institution, geography, risk and loan size, we find that the 25th percentile and the 75th percentile have more than 200 basis points of unexplained pricing variation, a number that is typically between 50 and 75 basis points for other lending verticals. This dispersion is evidence of an inefficient market where there are opportunities to optimize for margin or volumes. Those prepared to take advantage of this pricing inefficiency stand to see margin improvement and gain revenue versus their peers.
Not surprisingly, the main drivers of pricing variation are loan/line of credit amount (figure 1a) and the underlying risk factors (e.g., credit score, figure 1b). Even for very similar risk and loan attributes, however, lending institutions have very different pricing, and the difference does not appear to be purposeful or intentional. Pricing without intention or that doesn’t take into account the demand of the products results in an inefficiency that lenders with the proper tools and processes in place can take advantage of.
Figure 1a: Rate Dispersion by Line Amount
Source: Curinos Small Business Lending LendersBenchmark Consortium
Figure 1b: Rate Dispersion by Personal Credit Score
Source: Curinos Small Business Lending LendersBenchmark Consortium
Taking geography as an example, we see a 250+ basis point dispersion across the country in the Unsecured Lending space, even when controlling for line size. (Figure 2.) This compares with less than 75 basis points for Mortgage, a much more efficiently priced product category where many more market data points are available. The variation in market pricing, however, is not driven by differentiation within bank portfolios but by the mix of local competitors, which indicates that most banks are not varying their pricing intentionally by market. We see similar patterns for other factors, such as client revenue/sales and industry segment.
Figure 2: Rate Dispersion by Business State
Source: Curinos Small Business Lending LendersBenchmark Consortium
We also see that pricing varies markedly and rapidly both within and across markets, pointing to the need for systematic tracking and response analytics.
As Small Business Lending continues to evolve and grow, we expect the pricing dispersion to narrow, and those banks that are pursuing valuable segments more precisely by using critical market data will be the ones to profit.
Pricing Analytics
Through our analysis, we found that the supply side effects of pricing to Small Business Lending market demand are being largely ignored by most lenders. The two main factors that explain most of the variation (loan/line size and risk) in a predictive pricing model suggest that many lenders are applying a margin on top of the costs to fund the product, driven by a cost-plus pricing strategy. This strategy is not unfamiliar; it has been seen in many lines of business prior to a pricing maturation that includes the demand of the products versus a measure of competitiveness. Even when normalized for the current state and the supply-side nature of pricing, however, the variation seen suggests a lack of pricing discipline, especially regionally.
We ran basic pricing analysis to produce models that used various factors to explain the pricing variation present in the market. There were two main models: one that used supply-side effects using only credit quality, risk attributes and the size of the loan or line, and another that incorporated other attributes including demand-based factors and performance of the lenders. (Table 1.)
While we can clearly delineate that credit quality, as expected, is a main factor in pricing even when we control for this, there is wide and systematic variation. This suggests not only that lenders are using a cost-plus approach as the base of their pricing, but there are also clear differences in how the costs are calculated by each lender and, moreover, that the strategies employed on top of a cost-based approach are diverse. Without adequate data capturing the market dynamics, lenders are flying blind. This is evident through the results showing that lenders are pricing more competitively in markets where they have larger presence in both share of deposits and brand, thereby forfeiting the pricing power they have.
Table 1: Price Response Models
There were two models run using various explanatory variables:
- Credit Quality – the credit quality of the borrower
- Loan/Line Size – the dollar amount of the loan or line funded
- Deposit Share – the level of deposit share for the bank in the area the loan/line was funded
- Regional Performance – an indicator if the lending bank was a top performer in the region in which the loan/line was funded
- Bank Brand – comparison of individual bank pricing data compared against one another
We see that the supply-side model explains a lot of the current market pricing, with a quarter of all variation explained by credit/risk metrics and the loan/line size. When the credit worthiness increased, we saw a decrease in the pricing offered, and to a larger factor, when the loan/line size increased, we saw a decrease in the pricing offer. Both effects are expected and are main drivers of pricing but still explain only about a quarter of the overall variation we see.
In the second model, when we add more covariants that encompass the demand-side of the picture, however, we see that not only does the fit increase, but the impact of the supply-side effects is lessened, with more variation explained by other factors.
We see in the full covariant model, when both bank strategy/brand and loan/line size are included, they have a similar-sized impact to the ultimate price variation. Simply controlling for separate lenders covers a similar amount of variation as the size of the line/loan funded — a stark difference from what you would expect! Looking at a different bank for the loan could change the price just as drastically as requesting a $5K line versus a $150K line!
To a lesser degree, but arguably as important, the bank’s performance in the area the loan/line was funded explained some variation. We see that as the deposit share increased, the overall pricing decreased. Moreover, when also taking those regional differences into account, we found that lenders are pricing more competitively where they have larger market power — essentially relinquishing the pricing power that could be gained because of market and brand presence. This is an inverse relationship from what is expected and contradicts the opportunity to target either volume or margin precisely.
Even with these factors added in, there is still a lot of unexplained variation in the pricing, where pockets of variable demand and inefficient pricing practices are driving the bulk of the disparity.
Once the competitive landscape is better understood, there is still the problem of trying to determine how to take advantage of any found opportunity. One way of attacking this is for lenders to identify segments of the pricing grid where margin can be gained without a significant impact to volume, or where the extra margin can be used to grow volume.
Putting The Pieces Together
Given these factors and the opportunity they represent, what do they mean for banks in the Small Business Lending space? As the line of business evolves and grows, we expect that the market inefficiencies will be discovered and those armed with the right data and tools will be able to take advantage.
One opportunity is around better market data, which is critical in a relatively opaque space. Tools such as Curinos’ LendersBenchmark Analyzer provide near real-time information on volumes, share and pricing, which are all critical enablers of more analytic pricing
As lenders continue integrating more risk-based pricing dynamics to mature the supply-side of the equation, we expect that those who are capable will also incorporate the demand-side using a timely picture of price elasticity. Once both sides of the market are understood, lenders will finally be able to understand the internal volume-profit tradeoffs that will allow them to hit simultaneous volume and margin targets and to help them significantly improve their competitive positions.
Table 2: Pricing Sophistication
The next phase of the Small Business Lending landscape will be one of evolution and growth, and lenders that stay with the current paradigms in pricing will be left behind, as those more prepared take advantage of regional and segment-level pricing opportunities. Incorporating the demand-side of the equation will be crucial for success in the evolving space.
Even with a medium amount of pricing evolution, lenders can capture 10–15 bp of pricing power, resulting in more than $1M per $1B origination each year (accumulating over time). The current state of the Small Business Lending market, along with the expected increase in competition in this profitable segment from both fintech and traditional banks, indicates that these inefficiencies will be available only to the first movers and a few fast followers. Those that attack the pricing problem with purpose will find themselves leading the charge on the next wave of profitable growth.
