Why Community Banks Prefer to Make Loans Unprofitably Rather Than Have a Loan Loss

About 40% of business loans are under $50k.  Consumer loans for cars, HELOCs and other revolving credit average half this amount.  Yet, this large $2 trillion market is unprofitable and not well-served by community banks.  The processing, delivery and servicing costs (see documentation at our website) of small business and consumer loans exceed the revenue earned, with community banks earning average interest rates of 4% to 6% today.  Community bank executives readily admit that while these loans are unprofitable, they do them to serve their customers, relationships and their marketplace.

However, these loans are unprofitable not because of market structure, competition or customer requirements, but because of the decisions made by FIs themselves.  Community FIs do not track and monitor the cost to deliver specific loans, but track and monitor loan loss risk for every loan.  Ask any banker about their loan loss rate, and you will get a quick answer with extensive reporting.  Ask a banker what it costs for them to produce, deliver and monitor a loan, and they will equivocate and have no documentary support.

As a result, the number of loans that go out the door at a loss is not tracked in financial reporting.  No board member has any information to ask about the number of unprofitable loans made.  But loan losses are reported and tracked in great detail.  While community FIs state they are being “conservative” in their lending, in fact for small business and consumer loans they are actually avoiding loan losses imprudently at a significant cost of overall FI profitability. 

This is understandable because two-thirds of the variation in ROA among community FIs can be explained by one financial factor: loan losses.  This focus, however, is misplaced in the case of small business and consumer loans where emphasis on avoiding loan losses is negated by the lack of profitability of the loan as soon as its issued.  The fact that little or no losses occur for a loan is hardly compensation if the loan itself is already unprofitable.

Community FIs would be better served to provide profitable loans at documented, well-defined underwriting risk with the new efficiencies and service benefits of digital technology.  Digital lending provides the efficiencies for automated underwriting under the FI’s control and efficiencies that previously did not exist.  In addition to efficient delivery, customers are willing to pay higher rates for speed and simplicity.  The risk-adjusted pricing and loss ratios documented over the last 30 years at credit card loss rated illustrate this is a highly profitable and sound strategy.  That is why competitors like Marcus are growing so fast. The market for unsecured lending is three times the size and growing fast in comparison to the staid HELOC market loved by community FIs.

Many community banks accept that they do not make money on $25,000 HELOCs or  $15,000 car loans, but they rejoice in knowing losses will be low.  With digital lending, more are adopting the more profitable strategy of also offering unsecured options for such loans at much better rates, documented loss levels, far greater speed and simplicity, and much higher customer adoption and use. An illustration of the profitability of this growing digital strategy for loans is shown below.  For more information, visit our website at www.rcgiltner.com.

The Profitability of Digital Lending for Community FIs