Small businesses, the linchpins of our economic recovery, need working capital to manage daily operations and grow. At the same time, small business finance providers, as well as local community leaders, all the way up to the President of the United States, want to increase capital to this segment. This seems like a perfect scenario with everyone in agreement. But something is wrong. Finance providers are not making enough loans to satisfy the need. Small businesses are getting angry, sharing their anger with their elected officials, then turning away from their banking relationships and looking for alternatives.
The good news is that this situation creates opportunity for innovative, nimble and visionary finance providers, but it seems as though they can’t fill the void. So, we have to ask ourselves two key questions: “Why isn’t the existing small business finance system working better for all parties? And why hasn’t there been a breakthrough?”
Risk is the reason things aren’t changing or working well — specifically, risk assessment in underwriting and risk management through the transaction’s lifecycle. Essentially, small business finance providers still use the same tools to score applications and service portfolios that they were using 25-plus years ago. Most underwriting uses the owner’s personal credit score and ratio modeling as risk indicators, yet they don’t predict risk as well as other indicators (like actual daily sales and cash flow — information available today but unharnessed, which will be discussed later). But, these “other” indicators and models are new to them and require significant modeling and technology work. Instead, underwriting tightens up existing indicators — like owner credit scores. Servicing and collections use “monthly billing net 30” and “no adverse action until net 60-plus” models that provide too little data to adequately manage down portfolio risk/performance levels. The capital providers are forced to decline more applications to achieve the risk profile they need in today’s volatile environment. Small businesses are stuck with looking elsewhere — assuming there is an elsewhere. And the economy suffers.
A Paradigm Shift: Daily Remittance Model
The “Daily Remittance Model” is a new way to look at asset structure, risk assessment and risk management. Daily remittance assets are structured to amortize continuously based on payments more frequently than monthly (for these purposes, daily, weekday, weekly or bi-monthly payment or remittance schedules are considered daily remittance). Right away, it is easy to see how risk is lowered as amortization happens more continuously. However, the amortization schedule is not the biggest value to daily remittance. It’s the data, and the data works two ways.
First, the data enables the configuration of highly sensitive risk management workflows fine-tuned to SIC-based seasonality, weather and any number of variables. Such workflows not only create the ability to assess asset performance on a daily basis, but enable machine-driven determinations of when “trouble” arises, and machine-triggered servicing interactions with troubled borrowers on a daily versus monthly cycle. The stimulus (distressed behavior) and response (servicing intervention) cycle times are driven down to days, rather than the months they currently take. When the cycles and outcomes are captured in data warehouses, adaptive learning algorithms can be applied so the risk management workflows “get smarter” every day.
Second, the continuous flow of sales, deposit, merchant processing and payment data points enables the development of dozens of very granular risk indicators — both actual and synthetic — that can feed dynamic risk assessment models that are seasoning risk variables on a daily basis and shifting risk weightings dynamically in response to what is actually happening in the highly volatile small business markets. The result is risk assessment based on risk indicators gathered from actual sales inflow data — a much more predictive basis for risk decisioning than an owner’s credit bureau score can ever be. The small business’ actual daily sales information is available as real-time data streams from merchant processing data, payment data, deposit and ACH data (which banks already have, and other innovative institutions and alternative finance providers have found ways to access and use), and can be integrated into Daily Remittance model workflows that reduce risk substantially while saying “yes” to capital requests much more often.
Next Generation: Dynamic, Data-Driven Risk Scoring Models
This article is not about the design of risk scorecards, but risk officers will recognize that the systematic analysis of daily cash inflows from tens of thousands of borrowers — employing dozens and dozens of actual and synthetic variables for each — quickly gains “critical mass” enabling a highly predictive scoring model. If the finance provider takes the next step, and can “teach” its scoring algorithms i.) how to “learn” based on the daily input of data and ii.) “volunteer” seasoning, deployment and weighting strategies, then an incredibly valuable asset has been created for the entire institution with ramifications for all areas — not just small business lending. This kind of “next generation” risk modeling is already in use. Its outputs are startling to traditional risk managers. In one such deployment, businesses with owner credit bureau scores of 500-600 are routinely approved, while those with owner credit scores of 750-plus are often declined. And those same 750-plus declines are getting auto approvals from credit card departments within 30 seconds of an inbound phone call or Web application!
Product Agnostic Application of Daily Remittance
This article has generally referenced small business loan products, but in reality, daily remittance scoring models and processes can be applied to any number of finance instruments: credit cards, lines of credit, factoring, merchant cash advances, leasing and others. In fact, some merchant cash advances and leases have been structured around daily remittance for more than a decade, with impressive non-performing rates. The ability to apply daily remittance principles with less risk is not the issue. The ability to change thinking and the will to shift paradigms to organize around daily remittance are bigger hurdles, needing senior leadership vision, sponsorship and focus to break through perceived risk issues, organizational barriers and technology and infrastructure development resources.
Implementation Options
Finance providers, be they a bank, factor, leasing company or other provider, can partner, build or buy a Daily Remittance model or product. One alternative is to refer declines to a third party. This option has the advantage of getting to market quickly, and can be done on a co-branded, white label or arms-length basis. It can be done on the finance provider’s balance sheet or the partner’s, or a combination determined through criteria established at the outset of the relationship.
Small business finance providers can build a Daily Remittance platform themselves. Building the system will require time, labor and cash. Then, once built, the finance provider will need the wherewithal to experience the losses necessary to season the risk scoring indicators, and develop the “critical mass” dynamic risk modeling requires to become an ever-appreciating asset of the institution.
Or, finance providers can find a platform and buy it. This option has the benefits of speed to market and control. While they exist, there aren’t many systems on the market that deliver the risk management and risk scoring benefits of Daily Remittance.
As the economy improves, finance providers want to provide capital or extend credit and small businesses continue to need the financial support. Traditional risk scoring and risk management models aren’t getting the job done, and a new paradigm may be needed. Daily Remittance is one such paradigm, allowing small businesses to get the capital they need and finance providers to increase the portfolios that will drive their bottom lines and customer relationships. Finance providers that embrace this next generation approach will win in the small business market. And so will the economy.
Glenn Goldman, president and CEO, joined Scarsdale, NY-based, Capital Access Network, Inc. in 2001 and has more than 25 years of experience in financing, building and strategic positioning of nationwide consumer and commercial finance companies. Prior to becoming CEO, Goldman was a founding partner of G2, LLC, a boutique investment bank targeting the finance and technology sectors.