Why SME lending is the big battle for the future of business banking

Small to medium sized businesses have struggled to access the sort of finance needed to grow since the financial crisis, but a new upswell of government support and the entry of some innovative, technology-enabled new entrants to the market has led to a quickly shifting landscape

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Early last year established hoteliers Simon Rhatigan and Simon Kershaw had a great idea for a new hotel concept and went out to raise about £3 million in funding to get started.

"Initially we looked at venture capital but we didn't want to do lots of work and end up giving a lot of it away," Kershaw told Computerworld UK. "Then we started talking to the high-street banks and specialist providers and it quickly became obvious that, quite frankly, anything under £2 million wouldn't happen and anything over £10 million was deemed as a major investment, so we fell between two stools, as it were."

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This was when they were introduced to OakNorth, a relative newcomer lender established in 2015 which recently raised $440 million in funding from the SoftBank Vision Fund - putting its mission to "help the UK's growth businesses and entrepreneurs reach their potential by providing them with bespoke, no-nonsense debt finance solutions" on the map.

Where the established banks would try and shoehorn the two Simons' project into their categories, OakNorth took "a whole new approach, they looked at the project and people and feasibility to outline how to fund us from A to B," Kershaw explained. "They knew the sector and what we needed to get open and trading and how to structure the funding around what was right for the business."

With that money secured in October, the pair purchased the Mount hotel in Scarborough to be the first in its chain of Bike and Boot Inns, a new mid-range countryside leisure hotel concept aimed at cyclists and walkers.

Rhatigan made his name in five star accommodation, running Le Manor aux Quat' Saisons in the 90s and the award-winning Faversham Arms in the noughties. Now, alongside Kershaw, the pair are looking to build the Bike and Boots brand across the UK, with another site in the Peak District already lined up.

It's safe to say Kershaw has been happy with the OakNorth approach, one which leverages technology to better understand the risk of its investment, leading to zero defaults in its four years of lending so far.

"It took us six years to find OakNorth, which tells you how tough it is out there," Kershaw said. "We lost time and have put a number of businesses in touch with OakNorth which are having the same problems we did, and these are established businesses going to high street banks that just said they aren't interested, and that is really limiting things for small businesses."

This is just one of many stories of small businesses struggling to access the right sort of funding they need in the wake of the 2008 financial crisis. Since then lending to small-to-medium-sized enterprises (SMEs) in the UK has shrunk to unprecedented levels, with the value of bank loans issued to SMEs through the government's small business lending scheme falling to just £55.6 million in the last quarter of 2018, down 78 percent from its peak of £255 million in 2009.

As the big banks have looked to de-risk their balance sheets and shore up their capital in the wake of the crash they have rapidly receded from lending to SMEs and gone about imposing stricter and stricter requirements upon them to get access to cash.

While this may be a source of frustration for many business owners, it also provided a funding vacuum and subsequent opportunity for innovative new providers, and the rest of the industry is starting to sit up and take notice.

The SME lending landscape today

Ryan Edwards-Pritchard is the managing director of Funding Options, a UK fintech that aggregates sources of funding for small businesses using open banking data.

"If you go back to 2008, what we saw was the big banks - the CMA 9 - pull out of the market at the commercial finance level, so we saw a huge drop in lending volumes from them and still now really in the SME space," he said, speaking with Computerworld UK. "So small business owners are still short changed."

As EY wrote in its 'Future of SME Banking Report' in December: "Banks have implemented stricter lending requirements, deterring many SMEs from applying for funding and leading to a year-on-year reduction in the number of approved loans."

The consultancy estimates there to be 5.5 million SMEs in the UK, contributing just over half of all private-sector turnover in the UK, yet these companies - from the hottest new tech startups to restauranteurs and florists - are struggling to get access to the sort of working capital needed to grow their businesses.

Add into that heady mix of factors the increased uncertainty wrought from the ongoing Brexit proceedings and you have a market that, according to Validis in its overview of the British Business Bank's Small Business Finance Markets 18/19 report: "Are either using external finance to put in place contingency plans or reducing their finance requirements as they delay longer term investment and expansion decisions."

"Overall there is declining demand for finance, although, awareness and use of alternatives to traditional finance is rising," the financial data specialist firm added.

That BBB research also threw out one last damning statistic: just 36 percent of smaller businesses now use external finance, down from 44 percent in 2012, and over seven in 10 firms say they would rather forgo growth than take on external finance.

"The reality is that despite the best intentions and political posturing, the clearing banks and mainstream banks have not been focused on helping small businesses with debt," Ben Barbanel, head of debt finance at OakNorth told Computerworld UK.

"The financial crisis gave them an excuse to come out of that market and, fundamentally, mainstream banks realised they couldn't make a lot of money lending to this end of the market, as they couldn't afford to do right analysis for the margins involved there, and I don't blame them."

Government support

As the banks receded from SME lending, politicians have started to pay attention, realising that lending to small businesses is integral to fuel any sort of financial recovery post-crisis.

The Banking Competition Remedies (BCR) scheme was born out of the fallout from the financial crisis and subsequent restructuring of the Royal Bank of Scotland. It focuses on the incentivised switching scheme as well as a Capability and Innovation Fund, which will eventually allocate £425 million in four pools to encourage "eligible bodies to develop and improve their capability to compete in the provision of banking services to SMEs and develop and improve the financial products and services which are available to SMEs".

Separate to the work being done with the BCR, the British Business Bank launched its Enable Guarantee programme earlier this year to encourage banks to increase their lending to smaller businesses, by reducing the amount of capital required to be held against such lending. This means the UK government takes on a portion of the lender's risk in return for a fee.

The UK government also launched the bank referral scheme (BRS) in November 2016. Under the scheme, businesses that have been unsuccessful in a credit application process with a bank will be asked for their permission to have their financial information passed to designated finance platforms, who can contact the business with an offer in a regulated time-frame.

This scheme has come under criticism, however, with the CEO of small business lender Iwoca, Christoph Rieche, writing to the chancellor Phillip Hammond to say: "One of the cornerstone initiatives designed to help make finance more available to small businesses is at risk of failure."

Iwoca has certainly benefitted from the scheme, having approved 35,000 small businesses for finance since launching, with more than half of those facilitated through the BRS.

Rieche subsequently recommends leveraging the new open banking capabilities to make the process more seamless, as well as setting up a task force "that brings industry leaders and policymakers together" quarterly to review the effectiveness of the BRS, and to "recommend solutions to unlock its full potential".

Things are changing

Now, incumbent high-street banks and a new set of hungry, nimble fintech startups and challenger banks are looking to drastically shake up the way they lend money to SMEs by leveraging new technology and data streams to do away with manual loan approval processes, reduce the risk of defaults and get cash into the hands of business owners more quickly.

The arrival of open banking in 2018 has also removed another key barrier to innovation for new lenders as the banks are forced to open up customer transaction data via a set of common, secure APIs. This allows lenders to tap directly in to a business's transaction data, with permission of course, further removing friction and easing the credit decisioning process along.

Take Iwoca, the eight-year-old startup that promises it can provide overdraft facilities and loans of up to £200,000 to SMEs in a matter of hours. The company says it now holds 12 percent market share of new small business overdrafts as of the fourth quarter of 2018, according to Yahoo Finance. That is more than incumbents like Santander (nine percent) and HSBC (11 percent).

Iwoca is already eying these new open banking capabilities, moving beyond its old model of scraping information from statements submitted by customers manually. Now, with seamless access to transaction data, Iwoca should be able to remove this friction, and any risk of human error or fraudulent documents being submitted.

As a result Iwoca has built integrations with the likes of Barclays, HSBC and Lloyds Bank to allow small businesses that bank there to apply for loans or a credit facility quickly and easily by giving them direct access to five years of transaction history instantly.

"I believe open banking makes this data flow a lot more secure and seamless and there will be much higher adoption due to the increase in speed," CEO Rieche said.

Then there is OakNorth, which has already leant more than £3 billion to British businesses, although with a minimum loan value of £500,000 it is admittedly targeting companies at a slightly larger scale than those typically using Iwoca or Funding Circle (£10,000-£500,000).

Its underlying technology, the OakNorth Analytical Intelligence platform, allows the lender to make lending decisions in weeks not months, while also promising a lower risk of default by spotting warning signs early. This technology has proved so effective that 12 financial services firms have licensed the white label version of the software for themselves, giving OakNorth another revenue stream in pure technology.

This technology allows the lender to operate "at speed such that an entrepreneur finds themselves in a situation to move quickly and not wait 20 weeks for a 'no' that you might typically get with high street providers," as Barbanel at OakNorth put it. "That differentiates us and is really important to allow people to focus on running their business rather than arranging finance."

Read next: Entrepreneur-focused OakNorth becomes first UK bank to move core system to the cloud with AWS

These new players may serve slightly different slices of the market, but they all share an approach that hinges on giving customers more flexible funding options with clear, transparent repayment structures and options. They are also starting to prove that lending to SMEs can be an effective business model, with OakNorth a rare example of a profitable fintech startup, and the big banks are starting to pay attention.

Other new players

It wasn't just the big banks that benefitted from the Banking Competition Remedies money earlier this year however, with challenger clearing bank ClearBank winning its share off the back of a joint proposal alongside Tide, a fintech that has seen good momentum with its online business current account offering over the past few years.

The ClearBank Tide Business Banking proposition was awarded £60 million in February, with a commitment to a forward-looking credit proposition which could provide the blueprint for SME banking and lending in the future.

The product promises "a number of solutions tightly linked to the business current account to avoid cashflow issues" such as invoice chasing and "next-generation direct debit", as well as protection against cashflow issues "by integrating with debtor insurance providers" and a number of bridge cashflow options, either through working capital or integrating with existing lenders.

Challenger bank Starling also went all out with its commitments, after being awarded £100 million as part of that same Pool A award. The bank committed to building "a full suite of 52 digital banking products to meet the needs of all sole traders, micro businesses and small SME businesses. Examples include flexible deposit accounts, multiuser card functionality, instant invoicing, VAT management, advanced invoice financing, smart FX, supply chain finance using blockchain based technology and secured business lending."

On the lending front, Starling outlined plans to build "a suite of lending products using automated and secure processes that deliver loans in minutes to boost SME growth and productivity," committing to provide £913 million of additional lending to SMEs by the end of 2023.

What the incumbents are up to

So how are the big banks responding? The answer is with a variety of approaches, all of which are underpinned by technology and a change in mindset around what SME banking, and lending, should look like in the future, while finding the sweet spot in terms of margin to make it a viable business plan.

Nationwide Building Society, for its part, was awarded £50 million in Pool B of the BCR scheme in May, committing to more transparent banking for its business customers, with a range of "borrowing choices based on clearly presented options, including price quotes and eligibility indicators, all without leaving a footprint on their credit records."

"We have looked at this market a number of times and it has never really been one we felt ready to enter, for a number of reasons ranked against other priorities of our member's needs and how it impacts the broader IT estate," Rob Angus, chief proposition and finance officer at Nationwide for Business told Computerworld UK.

Angus says the availability of the BCR fund shifted this mindset for the building society in that it "helps us justify the use of that money to make an impact on this market".

He also highlighted technology improvements as a key driver: "We want to leverage the latest cloud-native microservices stack to come to this market and build it separate to our core IT estate."

As part of that strategy, Nationwide also invested £15 million in 10x Future Technologies in exchange for a minority shareholding, as it looks to partner with the company to build a new business current account, and is slated to launch a pilot product by early 2020.

The building society says it will focus on the small end of the SME market, so annual turnover no higher than £5 million. The current account will be built out into "a full banking service with unsecured lending, credit card and broader facilities to make it easier to run their business with tax and cash flow tools," Angus explained.

He added that lending will be provided through partners and integrations with alternative lending facilities if they are unable to provide the appropriate lending themselves.

"We believe that by starting from scratch we can build the best technology and SME banking products in the marketplace," he said. "They want an easy process and understand if they will get that funding and, if not, why."

Metro Bank, for its part, outlined a new product in its commitments after a BCR award of £120 million that would allow for: "SMEs up and down the country access to an unrivalled and radically different type of business banking, one that offers in-store debit card printing, lightning-fast lending decisions, fully digital on-boarding, integrated tax, receipting and invoicing, and breakthrough innovations like on-demand cash pick-up and delivery."

Partnerships

Other banks have looked to partner with best of breed fintech providers to bring new funding options to their business banking customers.

High-street stalwart Barclays took a stake in fintech challenger MarketInvoice in August 2018 and launched an online invoice finance option for its business customers as a result.

This facility allows SMEs who bank with Barclays to unlock some of the money tied up in unpaid invoices for better liquidity. However, this is only available to companies with £500,000 of annual turnover and who have been operating for two years. Customers can also apply for unsecured loans of up to £25,000 via their online banking app, with handy sliders to assess your options.

Similarly, TSB chose to partner with Funding Options to offer a simple, transparent business marketplace tool on its website for business customers to seek out alternative routes to finance.

Another example of this collaborative approach didn't involve one of the major banks, but upstart business finance lender Growth Street partnered with the cloud accounting platform Xero in May, meaning small businesses that use Xero will be offered GrowthLine working capital finance options for up to £2 million.

Standalone propositions

Compare this approach to the new standalone Mettle proposition at RBS, which was built with specialist consultancy 11:FS to bring together the best of breed from fintech providers to offer a modern business current account.

The fact that both RBS and Nationwide decided to effectively ringfence these new business banking propositions, both by creating standalone teams to design them and by building them on relatively greenfield tech stacks, shows that agility and efficiency are vital for the incumbents to succeed in the SME banking space.

"The work we did with Mettle and all these new entrants are about empowering entrepreneurs to make decisions and sleep better at night as they have more control over their businesses," David Brear, group CEO at 11:FS told Computerworld UK.

"Customers have been burned by the big banks," he added, "where the answer to every question was a loan or they try to sell you something, that makes it difficult to build a relationship. This reflects the level of distrust that remains around the tier one high-street banks. People trust them to not disappear, but maybe not to get the right level of advice, and that is the opportunity for these challengers."

Global bank HSBC is also reportedly planning a new standalone digital bank aimed at small business customers under the project name 'Iceberg'.

What next?

What we are seeing emerge here is a shift towards a more holistic business banking solution from a wide range of established and upstart providers.

The goal appears to be a digital business current account which will act as a financial hub for business owners and entrepreneurs to manage their cash, tax, invoicing and borrowing facilities, all underpinned by data and as little friction as possible.

Pair this with a new industry-wide commitment to openness and partnerships, and we should soon see a far simpler route to finance for small business owners, with quicker access to cash, less form-filling and fewer rejected applications.

As EY outlined in its SME banking report: "We expect to see financial platforms further evolve to digital [financial institutions] 'app stores', where customers can select desired services from multiple providers to build their own bespoke financial experiences."

This of course will require a change in mindset from traditional players as they learn how to interoperate with partners in an ecosystem and find ways to protect their bottom line while doing so.

"It still remains the case that a more collegiate approach will be required, in order to engage and tackle other issues - especially around policy reform and indirect discouraged borrowing, notably where this involves wider stakeholder cooperation," trade association UK Finance stated in the conclusion to its SME report in December. "Only by achieving the correct mix of competitive pressure and stakeholder cooperation can the best overall impact be made on the UK SME external finance market and the UK economy as a whole."

This will be the holy grail for cracking SME banking in the next couple of years. Who gets it right is now a question of execution.

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