Is It Worth It?
Is It Worth It?
The question that serves as the core barrier to financial inclusion
Growing up in Northern Michigan there were many mornings when I would have to dig the family car out of the driveway after a very heavy snowfall to get to basketball practice. Standing there in the dark of dawn with a shovel in my hand, I would think: is this worth it? I'm often reminded of that childhood scene when I find myself contemplating various decisions, from mundane to complex, in my everyday life.
Most people consider the question implicitly of course, but a business has to do this cost benefit analysis explicitly. Their decisions ultimately show up on profit and loss statements. No surprise then that businesses offer products and services or solve problems that they believe will be worth it from a profitability standpoint.
The Core Barrier to Financial Inclusion
Profitability, then, is the core barrier to financial inclusion.
Let me explain. In my last post, I talked about six commonly cited barriers to financial inclusion: financial literacy, branch deserts, language, identity documents, discrimination and high bank fees. All of these barriers are indeed real problems, but what didn’t make sense to me was why banks haven’t been able to solve these problems?
After all, there is nothing new about the problem of educating your customers or having to figure out distribution and so on. Businesses that want to solve these kinds of problems seem to be able to do it all the time. Why do they make the effort? Because they think it’s going to be worth it. This provides us a hint as to why banks seem to allow the other six barriers to persist: maybe it’s just not worth the effort to solve them.
The Case of Small Business Lending
Let’s look at one of the common services a bank offers — lending — to understand the benefits (or revenues) and costs from the bank’s point of view. I’ll ask you to follow along with some back-of-the-envelope math comparing the profitability of lending to a small business versus a relatively larger one.
Revenue and Costs
Suppose two business owners walk into a bank that's offering loans at an annual rate of 10%. One of them is a small business owner and needs a loan for a $50K and the other owns a large business that wants to borrow $5M. Let's assume for now that it costs the same for the bank to serve both owners and both want to borrow the money for a one year period. Which loan would earn the bank more revenue?
Congratulations if you thought it was the large business owner. From the bank's point of view, being able to charge 10% on $5M earns $500K in revenue whereas the bank only earns $5K from lending the small business owner $50K for a year at 10%. Given the option, which would you prefer?
It’s one thing to earn lower revenues, but it’s another thing to not make anything at all. What I mean is that it costs to the bank the same amount to underwrite and service the loan to the bigger business compared to the smaller one. In fact, it's probably more expensive if you consider the differences in risk that might also be involved because data from small businesses are both harder to come by and often less reliable driving up the cost of underwriting. Also, in the case of nonpayment, it's easier for smaller businesses to up and disappear than bigger ones, so the cost of servicing and collections is also potentially higher.
If the revenues are not enough to cover the costs, the bank risks not making any money at all.
An analysis from 2015 estimated that the cost of a loan of less than $100K to be around $7K [1]. So in the hypothetical example, would actually lose the bank money on the loan to the smaller business.
Can’t the Bank Just Charge Higher Rates?
One obvious thing left to consider is the question of why banks don't just charge higher interest rates than around 10% for small business loans so that they can more profitably cover the cost of those loans [2]? The short answer is that they can and sometimes do, but the fundamental question remains: is it worth it?
First of all it might be worth considering what they could raise the rates to. The Small Business Administration (the SBA) typically offers loans to the businesses through their 7(a) program at about 15% [3]. Online or non bank lenders and be around 50% [4]. Factoring products or merchant cash advances are not priced directly in annual interest rates but converting their factor rates suggest that the APR's would range from the high double digits into the triple digits [2].
Ignoring any regulatory or competitive constraints, maybe the bank could charge somewhere between 50% and 100% interest rate like the non-bank lenders.
Now let's go back to the back-of-the-envelope example we did before and see what the bank would have earned in revenue from the small business by charging 100% interest. Even at that maximum rate the bank would earn $50K on lending $50K for a year. This would certainly improve their margins but notice that the bank could still earn way more revenue - 10 times more - by serving the bigger business that wanted to borrow $5M.
Even with very high rates, its still not be worth it for banks to pursue small dollar loans.
Sidebar on Market Failure in Credit
As a brief aside, there are other structural features of credit markets specifically that can lead to credit rationing or market failure. A big problem is that the lender cannot ever fully know whether the borrower truly intends to repay or make productive use of the loan proceeds. Economists refer to this as information asymmetry which can lead to problems like adverse selection and moral hazard. Externalities, barriers to entry, concentration of economic power for lenders and so on are all important factors that can affect how credit markets function. If you are interested in this, please check out this overview paper [5] or the classic Market for Lemons paper by George Akerlof [6].
Parting Thoughts and What’s Next
So as you can see from the simple calculation and example there just isn’t that much incentive for banks to go after the types of small dollar loans that small businesses need.
Its not a stretch to extend the logic we see in small business lending to other financial services to low income consumers. The high fees for minimum balance and overdrafts start to make sense as do the other six barriers.
Even if it may not be worth it for banks to focus on the financial needs of small businesses and low income consumers, we know that it’s important for society as a whole. So what can be done about it? Well, now that we have some clarity on the barriers to financial inclusion, in my next post, I’ll turn to various pathways that can overcome these barriers and where we’re focusing our efforts at Vaya.
Footnotes
[1]: https://www.bai.org/banking-strategies/making-small-business-loans-profitably/
[2]: https://www.bankrate.com/loans/small-business/average-business-loan-rates/
[3]: https://www.nerdwallet.com/article/small-business/sba-loan-rates
[4]: https://www.lendingtree.com/business/alternative-lending/
[5]: https://documents1.worldbank.org/curated/pt/886611468740656863/pdf/multi-page.pdf
[6]: http://personal.kent.edu/~cupton/Senior Seminar/Papers/akerlof.pdf