SMEs are a major source of economic growth in many economies and with respect to SME lending banks have been moving away from traditional relationship lending, and moving towards transactional lending. Net result banks are embracing credit evaluations shift from one end of the spectrum to the other and this has accelerated the growth of the banks.
Relationship lending is based upon the five Cs [Capacity, Capital, Conditions, Character and Collateral]. Risk is assessed by a loan officer who has personal knowledge of the client, his/her reputation, standing in the community, connections, current product holdings, history with the organization, and other various other factors. This is accompanied by a diligence of secrecy relating to any information obtained directly from the client.
Small businesses are opaque and have fewer financing opportunities than larger companies. Those with strong banking relationships benefit from lower interest rates, reduced collateral requirements, lower reliance on trade debt, greater protection against the interest rate cycle and an increased credit availability.
The problem with relationship lending is the cost, due to the time and effort required to cultivate the relationship. Small/Boutique banks can use this as a basis for their competitive advantage, but their capacity for growth will be limited.
In the case of transactional lending, rather than relying upon information known only to the loan officer, transactional lending relies upon other automation, especially credit scoring to evaluate borrowers financial statement, payment histories, both internally and with the credit bureaus and environment assessments [eg: Current economy, Market, Location and Industry]. Automation leads to increase in cost of delivery on the lender side but it is overseen by better and faster decisions and in turn benefits lenders from the diversification of the large portfolio of small loans.
Automation on the SME market has played a significant role and it has lead to less face-to-face contact and documentation. In turn has resulted in lenders focusing on the wealth of readily available hard data. Tremendous productivity gains have been achieved, with borrowers benefiting from improved access and increased choice, while lenders have increased volumes and reach.
Automation has lead to a correlation between borrowers credit scores and the interest rates that they are charged. Many lenders use risk-based pricing, borrowers that are declined on one product may be accepted on another that is more expensive, and/or has stringent terms.
While credit scoring can provide benefits to almost any bank, there is often a reluctance to move from relationship to transactional lending. Smaller banks in particular believe that their competitive advantage lies in personal service.