This column recently laid out the case for the rise of the alternative lender as a natural consequence of the hole left by conventional banks withdrawing from the small and medium enterprise market. This article examines what a successful alternative lender might look like.
The first step is to understand the relevant characteristics of a conventional SME lender. Conventional banks are mature companies with an inflexible and conforming operating culture. This leads to risk rigidity – banks will usually get comfortable at one point of the risk curve and they will rarely leave it.
This in turn leads to product concentration and possibly myopia at the macro level, with innovation only at the micro level. The basic types of products do not change, so a salary loan will be pretty much the same at all the banks in terms of tenor and structure. One bank might add a competition to the loan and another bank might allow deferral of one payment per year, but overall they are the same.
How might a bank innovate at the macro level? How about a bullet loan, in which the principal is not amortized over the life of the loan but all paid at the end. How can it be structured so that it meets regulations? Simple – a regular loan in which all principal payments may be deferred to maturity.
The problem with this innovation is that the risk structure changes tremendously. An amortized loan simplifies thinking about risk. A bullet loan requires expanding how risk is viewed, measured and managed.
The next characteristic of banks is price supply inelasticity. This means that the supply of credit from a bank does not increase with an increase in price, or interest received by the bank. This might seem counterintuitive, but what it really means is that banks can process an extremely large amount of relatively homogeneous loans quite efficiently. In other words, they have low operating leverage – they are an OCD loan processing machine.
This is a good thing. It just should not be the only thing.
The low operating leverage is what requires banks to maintain massive balance sheet leverage – more than 10 times on the balance sheet and the same or more off the balance sheet.
This points the way to the characteristics of a successful alternative lender. The lender needs to be able to innovate at the macro level for products to provide creative solutions to an SME’s needs that remain after it has exhausted conventional bank financing. This requires two main characteristics.
The first is that alternative lenders must be price-supply elastic. They have to be willing to come up with a solution that offers advantages in exchange for a higher price than what conventional banks would charge. The second characteristic is that alternative lenders must be risk-flexible. They have to feel comfortable moving up and down the risk curve and managing different risks appropriately.
To be able to do this, alternative lenders need to foster an entrepreneurial and innovative culture. The entrepreneurial culture is necessary for alternative lenders to think outside the box and understand that there is a large product and risk landscape that is unexplored. Innovation is needed to create appropriate products and seek viable risk points.
This means that alternative lenders are able to process a large variety of heterogeneous loans efficiently.
Building a successful alternative lender requires as one of the first steps understanding the target culture well before designing the target operating model. The characteristics for an alternative lender have far more in common with alternative investment managers such as private equity, hedge funds and real estate, than they do with conventional banks.
In fact, if someone were to describe a financial institution as being entrepreneurial, innovative, flexible, risk-adjusted, return-agnostic and risk-management sophisticated, which of those institutions would you think they were talking about?
Sabah Al Binali is an active investor and entrepreneurial leader, with a track record of financing, building and growing companies in the Mena region. You can read more of his thoughts at al-binali.com
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