The Business Case For SBA 7a Lending For Community Banks

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1 The Business Case For SBA 7a Lending For Community Banks How Community Banks Can Prudently Make Loans to Small Business By: Joanne Thompson SBA OneSource, LLC This paper examines the business reasons for including the SBA 7a guaranteed loan program as part of a bank s commercial loan product line. The paper assesses the benefits of offering SBA 7a from the perspective of asset soundness, bank profitability and customer growth potential. The challenges of offering the program are also examined, such as major commitments of time and resources, and solutions to those challenges are presented. SBA OneSource - all rights reserved

2 Community Bank Business Case for SBA 7a Lending How Community Banks Can Prudently Make Loans to Small Business Overview Research clearly demonstrates that small businesses are vital to the strength of our economy. They represent 99% of all employer firms and employ half of the private sector workforce. Community banks play a major role in providing the capital needed by small companies. In fact -- according to the Chairman of the Independent Community Bankers of America -- while community banks represent only 12% of all bank assets in the United States, they make 20% of all small business loans. Cynthia Blankenship, Chairman of the Independent Community Bankers of America, emphasized this point when she testified before the U.S. Senate Committee on Small Business and Entrepreneurship, stressing the importance of community banks in providing small businesses with access to capital. She also highlighted the critical role that SBA loan programs have in providing that access. Community banks generally fall into three broad categories in their approach to lending under the SBA 7a program. The first group has contemplated offering the 7a program but is unsure about proceeding. The second group is committed to making SBA loans at some level and processes a handful of 7a loans on an as-needed basis. The third group has a strong commitment to utilizing the program. There are a number of solid business reasons for community banks to offer the 7a SBA guaranteed loan program to small business customers. This paper examines those reasons from the perspective of asset soundness, bank profitability and growth potential. It also looks closely at the challenges of SBA loans, because lending is risky, with or without a government guarantee and because the SBA loan process can be onerous. Finally, the paper explores ways to offer the SBA 7a program without a major commitment of time or resources. SBA 7a Guaranteed Lending: The Basics The SBA 7a program has been around for more than 50 years and can be used for any business purpose, provided the small business meets certain eligibility requirements. Proceeds may be used for permanent working capital, business start-ups or acquisitions, expansion, equipment purchases, real estate purchases and refinance of existing debt. Page 2

3 In a nutshell, the program provides an alternative way for small businesses to access capital when funding is not available through conventional lending methods. With the 7a program, Lenders fund 100% of the loan, and the SBA guarantees 75-85%. Lenders want collateral and they need to match short-term funding sources with short-term business loans. By providing a 75% to 85% guarantee on the loan, the SBA allows banks to lend when there is a collateral shortfall, when longer maturities are needed to improve cash flow, and when the business is undercapitalized. Prudent lending standards still apply, so the guarantee won t make a bad loan good; and cash flow must still be adequate to service the debt. Critical Business Drivers: Soundness, Profitability, Growth There is not a banker on the planet who is not aware of the current credit crisis. Lending standards have tightened; friends have lost jobs; and banks have been closed by regulators. A community banker s job is to protect the bank s assets (soundness), provide a reasonable return to shareholders (profitability) and prudently meet the needs of the community (growth). Not an easy task in a world where business risks increase daily and the unknowns are abundant. The SBA 7a guarantee loan program is uniquely positioned to offer much-desired protection for community banks that want to meet the needs of their local small business clients in a way that preserves asset quality and provides a good return. Within the framework of these three critical drivers soundness, profitability and growth -- there are seven solid business reasons for community banks to offer the 7a SBA guaranteed loan program. 1. Reduce Portfolio Risk: A traditional strategy for reducing portfolio risk is to tighten lending standards and reduce availability of credit. This strategy is particularly harmful to small businesses that rely heavily on access to debt for sustainability and growth. The 7a program allows banks to have the best of all worlds. They can meet the needs of their small business customers, continue growing the loan portfolio and reduce portfolio risk while continuing to generate interest income. An example of a 7a loan achieving all four of these outcomes involves a very successful, rapidly growing company that needed additional capital for growth. The community bank had an existing relationship with this customer, and was uncomfortable with increasing its credit exposure. The bank had planned to ask the business to find a new home, which neither the bank nor the borrower wanted to happen. The 7a guaranteed loan program enabled the bank to refinance its existing debt and provide the small business with new funds for growth and Page 3

4 equipment purchases. Although the loan amount tripled, the credit exposure actually declined since the bank received a 75% guarantee from the SBA. The bank reduced its portfolio risk without stunting loan growth and retained an important customer. 2. Expand Business Banking Market: Small business owners express a consistent preference for dealing with community banks because they are treated as important customers and they don t get lost in the system as they might at larger banks. Unfortunately, community bankers are not always able to help their community s small businesses, even though they are the preferred lender. Collateral shortfalls, longer term requests, and undercapitalization are just a few of the reasons community banks may turn small business customers away. The business owner is then forced to go to the competition, often never to return. It s not just the business loan that is lost, but all the benefits and cross sales opportunities that customer represents: business deposits, employee deposits, car loans, HELOCs, and future loans to the business to name just a few. However, because the 75% - 85% guarantee of the 7a SBA loan program mitigates the common risks of small business loans, it enables lenders to make loans that fall outside conventional loan policies. This not only facilitates the small business loan, but paves the way for other opportunities for servicing the customer. The 7a program is an excellent tool that allows banks to prudently expand market share and capture opportunities that they might otherwise lose. Ignoring the potential of SBA 7a is tantamount to putting money in a competitor s pockets by handing over a customer, as well as all the profit opportunities that customer represents. 3. Generate Profit with Less Risk: A typical 7a loan scenario might look like this: A $500,000 loan priced at Prime % with a 7-year maturity and a corresponding cost of funds of 2.0% results in gross income of more than $100,000 over the life of the loan. While a conventional loan might have the same returns, SBA will guarantee 75-85%, thus reducing the bank s risk and exposure. 7a also allows banks to make these loans in cases where conventional lending policies might prevent the bank from doing so thereby creating an additional revenue stream. When the objective is to grow profits more rapidly than the balance sheet, lenders have the option of selling the guaranteed portion of the loan on the secondary market. Historically, the premium earned on the guaranteed portion of an SBA loan could be as much as 10%. The current credit crisis has disrupted the secondary market and the lucrative profits typically generated, but premiums and profits will recover as the secondary market returns to normal. Page 4

5 While their initial returns are better for selling the loan, over the life of the loan, revenues are greater if the bank keeps the loan on the books. But if fee income generation is part of the bank s business model, secondary market sales provide significant and quick returns. In addition to direct income, there are also numerous indirect income possibilities through cross selling other bank services. Most companies tend to stick with the lender that provides their financing. By not being that lender, deposits and other fee income opportunities can be lost forever. 4. Create Liquidity: Even though secondary market premiums are not currently lucrative, some banks are taking advantage of secondary market sales to create an immediate source of liquidity. Selling on a case by case basis allows community banks to meet the credit requests of key customers and prospects, and retain their business. The SBA is taking action to get the secondary markets functioning again. For example, as of November 13, 2008, the SBA is allowing banks to use not only prime as the base rate, but also the 30 day LIBOR plus 300 basis points. Because investors prefer LIBOR-based pricing, we should begin to see some movement in the markets. 5. Reduce Capital Requirements: Under traditional commercial lending methods, the bank funds 100% of its loans and must include the entire loan amount in its risk-based asset calculations. With SBA lending, while the bank still funds 100% of the loan, it only includes the 15% to 25% un-guaranteed portion of the loan in its risk-based asset calculations. This can dramatically improve the capital ratios of a community bank. For example, during a review of the commercial loan portfolios of 148 banks across the country, SBA OneSource calculated that had those banks used the 75% SBA 7a guarantee on all their C&I loans, their Tier 1 Risk Based Asset Ratio would have improved by an average of 15% when risk weighted assets were adjusted for the guaranteed portion. 6. Increase Lending Limits: With SBA 7a lending, only the un-guaranteed portion of the loan counts toward the bank s legal lending limit. For example, if a bank makes a $1.0million SBA loan, it would receive a 75% (or $750,000) guarantee. The un-guaranteed portion, or $250,000, is all that would count toward the legal lending limit. If a bank has a legal limit of $1.0million, it could lend the maximum allowed under the program or $2.0 million and still be in compliance. This is another way that the 7a guarantee program allows community banks to expand market share and improve profit margins while reducing portfolio risk. 7. Mitigate Turbulent Times: The current economic climate is one of the most challenging times the banking industry has ever experienced. It s easier to say no when business customers submit loan requests than it is to say yes. But saying yes to the right customer in tough times will cement a relationship that could last for years. A 75% to 85% guarantee might be just the insurance policy Page 5

6 needed to comfortably say yes to a small business loan request; and that s why smart community bankers are maximizing their use of the SBA 7a program in the current business environment. In light of these clear and compelling benefits, why don t more community banks take advantage of the SBA 7a loan guarantee program? Challenges It is no secret that SBA lending can be challenging for banks that don t have internal SBA expertise. The banks that dabble in this program without experts on hand to give direction and advice throughout the loan process often don t have a particularly positive experience. Because they do not understand the unique policies and procedures associated with SBA lending, they experience the process as cumbersome, time consuming and fraught with details and requirements that create entirely too much paperwork. Certainly SBA lending is more exacting than conventional lending. Borrowers must meet certain guidelines to be eligible for the program; for example, businesses cannot exceed revenue or employee size standards depending on their NAICS category. The credit write-up must address specific issues such as the source of an equity injection in a business acquisition. Additionally, at closing, specific SBA documents are required such as the SBA s own version of a promissory note. After closing, SBA loans have specific servicing requirements and reports must be filed regularly. The risk of not getting the details right is losing the guarantee if the loan defaults. SBA 7a s guarantee is not unconditional. It is conditioned upon the lender following all SBA policies and procedures; and it is the lender s responsibility to understand what those are and to comply. Because of these challenges, many community banks have stayed away from the program. That is unfortunate because if done correctly, the program is a terrific way to expand market share, generate exceptional revenue streams and enhance the quality of commercial loan portfolios. The Outsource Solution Community banks have a long history of outsourcing a variety of services. It can make good business sense to outsource the SBA loan function as well. Indeed, for most community banks, it is the recommended approach. At minimum, it takes three people to staff a properly functioning SBA department: a business development officer, an underwriter and a closer/servicer. A conservative estimate of salaries alone is $285k annually. With other costs and overhead factored in, start-up costs are usually considerably more than most community banks want to invest in a department or product line with unknown and unproven demand. Page 6

7 That is why outsourcing SBA loan processing is an excellent alternative for community banks who want to offer 7a loans to their small business customers, but do not want to staff up to do so. Community banks that have successfully outsourced their SBA processing cite the following reasons for doing so: 1. Converting fixed costs to variable: The market is currently full of bankers looking for jobs. There were already an estimated 30,000 bankers looking for work in the U.S. when Citigroup laid off more than 50,000 employees in November of The model of fixed overhead and variable income doesn t work well in an economy like this. Rather than staff up for an uncertain demand, savvy banks are choosing to hire experts and tie a variable revenue stream to variable costs. Resulting profit margins are more consistent and predictable. 2. Eliminating the learning curve: SBA lending is complex and bankers typically either specialize or avoid this type of lending because it takes years to fully understand the nuances of the program. Rather than hire internal staff and hope they are up to speed, many community bankers look to outside expertise. This on-demand approach ensures top talent that is up to date on all current SBA policies and regulations. Eliminating the learning curve also means that the bank can react quickly to market opportunities. The good loans disappear quickly and reacting slowly frequently means the deal walks across the street. 3. Ensuring compliance: Bankers understand compliance and know that being out of compliance is costly. Compliance is a critical component in SBA 7a lending. Obtaining correct eligibility assessments; underwriting according to SBA policies; and properly closing, funding and servicing SBA loans the SBA way are absolute necessities. The SBA s guarantee is conditional, and lenders must be in compliance with policies and regulations from start to finish. Rather than having to worry about compliance issues, community banks that outsource to 7a experts report tremendous peace of mind regarding compliance issues. 4. Reducing paperwork and hassle: Most community bankers have heard the horror stories of how long it takes to process an SBA loan and the onerous paperwork involved. A recent situation illustrates a common frustration. The lender worked on a loan for three months only to have it declined by SBA for a relatively simple eligibility issue, which an experienced SBA lender would have identified immediately. Often, even sophisticated lenders don t understand what it is the SBA wants and needs, and the SBA doesn t understand what it is the banker doesn t know. Page 7

8 SBA experts who work with community banks know that most bad experiences are a result of inhouse processors not knowing what they don t know about the SBA process. Outsourcing cuts through all the confusion and red tape. For really complicated issues, the top 7a experts have built up solid relationships with SBA staff members and know exactly who to call for answers and fast results. What to Look For in Outsource Service Providers Not all SBA 7a service providers are created equal. In 7a SBA lending it is especially critical to get competent experts working with and for the community bank because even one small mistake can be costly, and the SBA holds the bank accountable whether the loan is processed internally or externally. The most important qualities to look for in selecting an SBA 7a provider include: 1. Flexibility: Will the provider adapt its services to fit the bank s business model or require the bank to fit into theirs? For example, some service providers require banks to sell all loans in the secondary market. That works well if the bank s primary objective is to generate fee income, but if building the bank s balance sheet is a top priority, then a conflict may arise. 2. Breadth of Services: Does the provider offer the full range of services found in a typical SBA Department? From eligibility screening through underwriting, closing, funding and servicing, it is important for a provider to offer a full complement of services. Does the provider also offer training, consulting and ongoing support for special situations? And if the bank requires only a few services to augment existing staff, does the provider allow the bank to pick and choose only what it needs? 3. Competence and Experience: How long has the service provider been in the business? How experienced is the staff? Does staff have experience outside the world of SBA? Real world lending experience is critical for an SBA provider to optimally function as the liaison between the bank and the SBA. 4. Response Time: Banking is a people business. It s critical to get back to loan customers in a timely manner. Does the service provider have enough staff to be responsive? And, do they have the systems in place to support their services? Good loans go quickly. These are some of the key characteristics to look for when selecting the best outsourced SBA 7a service provider to assist community banks in taking full advantage of the benefits of 7a loan guarantees without taxing the bank s resources. Page 8

9 Summary SBA 7a guaranteed lending is a valuable addition to any community bank s commercial lending product line. From a business perspective, 7a can expand market share, reduce portfolio risk, diversify the bank s revenue stream and provide an excellent profit stream. However, SBA 7a lending is highly technical and specific, and therefore expertise is a critical component of a successful program. Because few community banks make the volume of loans necessary to justify creating their own internal SBA department, hiring outside expertise is recommended. By outsourcing SBA loan processing, community banks and their small business customers can reap the benefits of the SBA 7a program, without having to invest the time, money, energy, overhead and staff required to process these loans. SBA OneSource SBA OneSource is an outsourced SBA 7a loan provider servicing community banks throughout the United States. Functioning as the bank s own SBA lending department SBA OneSource ensures a pleasant SBA 7a experience for the bank and its small business customers. About the Author Joanne Thompson is the owner and managing partner of SBA OneSource. Prior to starting the company, Joanne was a commercial lender herself, and has made hundreds of SBA and non SBA loans. In 2003, she started SBA OneSource to fill the void created by SBA s centralization of processing and to assist community banks in offering SBA 7a loans. Joanne can be reached at joanne@sbaonesource.com or More information about the company can be found at SBA OneSource - Your SBA Lending Department Denver, Colorado Page 9