Despite significant efforts from central banks all over the world, interest rates remain high, and the cost of living continues to rise substantially—a global recession is very likely on the horizon.
Recessions can be a treacherous time for any business. And yet, for alternative lenders, the next 6-12 months are primed to be a golden opportunity: small business owners are going to be in dire need of alternative sources of funding. Costs are going to continue to rise, and traditional bank loans will soon become prohibitively expensive.
The difference between surviving and thriving during the coming uncertainty will be determined by how quickly you can recession-proof your SME lending business. Our advice? Prepare now, before the recession officially hits. Today, we are going to look at eight best practices to help you do exactly that.
Let’s dive in!
How Economic Uncertainty Is Impacting SME Lending
So, how is the current uncertainty impacting SME lending?
Well, to begin, the IMF world uncertainty index rose sharply in April 2022 for the first time since the Covid-19 pandemic. To add fuel to fire, experts at the OECD project the economic growth rate in the US to be 1.6% in 2022 and 1% in 2023 (compared to 5.7% in 2021).
Understanding that a recession is a significant and prolonged downturn in economic activity, we may be very close to one despite the fact that unemployment is actually declining across the United States. The main factors driving the current uncertainty include supply chain disruptions, inflation, fed rate hikes, and the inversion of the yield curve.
When the recession finally hits, most (if not all) small businesses will struggle to raise capital. SMEs will find it increasingly challenging to obtain funding from traditional sources, like bank loans. In this context, SMEs are in need of alternative lenders, perhaps more than ever before.
8 Best Practices to Recession-Proof Your Lending Business
Although “recession = opportunity” might sound compelling to you as an SME lender, it’s also important to remember that letting in everyone who knocks at your door isn’t the most prudent strategy either. The key to recession-proofing your SME lending business is to double down on your strengths, reinforce your weakness, and keep risk at the forefront of each new lending engagement.
Here are eight best practices that follow this model.
1. Tighten Your Application Requirements
As the market shifts, so too do the needs of your business and your ideal target audience.
Financing packages that met the needs of SMEs in 2020 and 2021 are not the same packages they will need to survive 2023. By leveraging data insights from both your lending platform and your sales team, you can reassess the application requirements for your financing packages and adjust them to meet the needs of the current environment.
In addition to focusing on product/market fit, it is also important to double down on efficiency. Assessing and redefining the eligibility criteria for SMEs, especially when your underwriters are overloaded with credit assessments, will ensure that only applicants who stand a good chance of approval can begin the process with you, helping you save time and resources.
2. Refresh Your Underwriting Model
Your existing underwriting model might have worked just fine for a recovery period like the one we just experienced, but it may not be suitable for what’s coming. If you survived the disproportionately elevated credit risk of the COVID-19 period, then you know how vital model upkeep is.
Look to adjust your underwriting model to leverage borrower data so you can better evaluate historical trends. Utilizing data in this way leads to faster, more sophisticated, and more cost-effective credit modeling. BUT there is a caveat. It is important to remember that positive trends from a borrower’s previous financial statements are not guaranteed to translate into future cash flows. This is particularly true when comparing data from periods of divergent market stability.
Finally, in addition to reviewing model variables and model methodology, it’s also a good practice to include a slightly larger than normal margin of error moving forward.
3. Diversify Your Lending Portfolio
Sectors that require high capital to fund assets, such as manufacturing and real estate, will undoubtedly be hit harder than others during this recession. Conversely, other sectors, such as software and online-based businesses, are less likely to experience financial complications during a crisis.
Given this fact, it’s a best practice to assess your portfolio as it stands and calculate the amount of risk your business is carrying today. Digging down further will allow you to identify which clients are in good financial health and which ones need closer monitoring. Rely on your financially stable clients (and prospects) to counteract the increased risk from the clients in sectors vulnerable to the current environment.
4. Focus on Early Customer Communication
Open communication with borrowers is one of the most critical factors in effectively preparing them for the tough times to come. Look to inform your clients well before ramping up collections, and be transparent throughout the process to ensure that you maintain a high level of borrower trust.
You can earn a better reputation for your business by supporting borrowers through this time of uncertainty as you empathize with and respond to their needs proactively. The better they do, the better your business will do. Early two-way communication is key to achieving this.
5. Bulletproof Credit Decisioning With Lending Analytics
In a recession, risk management becomes of paramount importance. And as an SME lender, this means applying increased scrutiny to your credit decisioning workflows. Advanced analytics can help you weed out potential bad accounts more quickly and accurately as you look to limit risk.
Yes, credit scores are useful in determining how a borrower or potential borrower will respond to economic uncertainty, but they don’t tell the whole story. Advanced data analytics via a SaaS lending platform will help you analyze a wide variety of data points as you set thresholds, identify outliers, and make informed decisions based on real-time reporting.
6. Implement Business Credit Scorecards
As more SMEs go on the hunt for capital, the alternative lending industry will become even more fast-paced than it already is. You will need to make fast, accurate, and efficient loan decisions, with little margin for error. This is where business credit scorecards can be a real difference maker.
A business credit scorecard is a customized formula with multiple variables, designed to dictate the level of risk a lending company will accept. The goal is to consistently make the right credit decisions while efficiently allocating resources. One McKinsey study from 2021 reported that credit scoring models of this type have the potential to reduce credit losses by up to 40%.
7. Think of a Recession as an Opportunity
Recessions aren’t selective in their impact, and unfortunately, SMEs tend to get the worst of it. In fact, around 1.8 million small businesses had to cease operations during the 2008 financial crisis. The main reason behind SMEs’ struggles in times of crisis is that, unlike large enterprise organizations, they don’t have multiple revenue streams to rely on.
Instead, they tend to rely more on monthly cash flow to keep their operations afloat. SMEs will struggle to obtain funding from traditional bank loans during a recession and will come to you for capital. As bad as this sounds, this means more business for you, so it’s best to be prepared to scale quickly.
8. Consider a SaaS Lending Platform
If there was ever a time to cut costs and make your alternative lending business more efficient, it’s right now. In this respect, technology can be a real difference-maker. We have written at length about the benefits of SaaS lending platforms, but they are worth repeating and understanding with a recession mindset:
- Automation: reduce errors, save time, and better manage your portfolio.
- Customization: organize your platform in the way that works best for you and your stakeholders.
- End-to-End Management: complete control over the entire loan lifecycle.
- Collaboration: from application to collections, empower your lending stakeholders to work as a team.
A SaaS lending platform like Onyx IQ can help your business increase revenue and reduce costs, even as you navigate uncertainty. You can process more accounts and make wiser, more informed decisions, in less time and with fewer errors.
Onyx IQ: Your Partner In Times of Uncertainty
While this may not be your first recession rodeo (most of us vividly remember the impact of the 2008 crisis), it is important to prepare now for the coming uncertainty. The best practices covered in this article should provide you with a starting point as you look to analyze the strengths, weaknesses, and opportunities of both your organization and the market.
If COVID-19 has taught us anything, it’s that digital transformation with respect to technology and risk management is no longer a luxury in the world of SME lending.
Right now is an excellent time to reconsider the tools that you use to manage your lending business. If you’re still using legacy lending systems, you’re likely unprepared to handle the adversity that the impending recession will throw your way. Whether you need better stakeholder collaboration, application management, or more in-depth portfolio monitoring, Onyx IQ is the SaaS lending platform you need to recession-proof your business.