Most community banks want to lend to small businesses, but many of those potential clients are unable to qualify for traditional financing.

In an effort to keep such customers happy, some community banks are working with alternative lenders that provide small-dollar loans to businesses. But bankers must be mindful of the potential regulatory and reputational risk tied to referring clients to outside firms.

"Banks are trying to figure out their competitive advantage," says Terry Keating, managing director at Amherst Partners. "There is a place for referrals [to alternative lenders] but it needs to be done with care."

Often the smallest firms, which have borrowing needs of $5,000 to $100,000, are overlooked. The U.S. Small Business Administration is trying to better serve this population by eliminating fees to guarantee 7(a) loans of $150,000 or less.

Smaller customers are often difficult to serve because they lack the proper documentation, credit history or collateral required for traditional bank financing, industry experts say. It can also be challenging for small banks to make money from originating small loans, or the applicant may need financing faster than a lender can provide it.

"The bank's underwriting and regulatory requirements are seen as making them increasingly irrelevant in this space," says Nick Miller, president of Clarity Advantage. Nonbanks "have come up with ways to do it. So a doctor's office that could get bank financing might go with someone else because they require less documentation and provide more flexibility."

These developments have led some community banks to refer clients they can't help to alternative lenders, industry experts say. Doing so helps the bank satisfy the customer and keep their deposits, while holding out hope that the business will eventually qualify for traditional loans.

Still, banks must complete extensive due diligence to avoid referring clients to a firm that provides terrible terms or poor service. The biggest factor to look for is an outside firm's transparency, industry experts say.

"You need lenders that can fill in the gaps and help the economy grow," says Dinesh Goswami, senior vice president of sales and strategy at Indus American Bank in Iselin, N.J. "If a customer comes to me and I have to say no, at least I'm giving them another option. We're not influencing anyone's decision, just giving them another source to try."

The $211 million-asset Indus American began working with QuarterSpot a few months ago after several meetings with the online lender's executives that helped management become more comfortable, Goswami says. Indus American has referred roughly 16 clients to QuarterSpot. About half of those customers have received financing, he says.

It's important to make sure that a lender is willing to disclose its interest rates and terms such as prepayment penalties and the need for personal guarantees, Goswami says.

Banks should also verify that the terms are clearly outlined to clients, says Adam Cohen, chief executive of QuarterSpot, which pays banks an origination fee for referrals. For instance, banks should avoid working with lenders that talk about the loan in factor rates, which usually sounds better to a borrower.

Banks should also pass on working with lenders that structure deals as a merchant cash advance, where a lender advances funds against credit card receivables generated by a business, Cohen says.

"A lot of terms sheets are creatively constructed to obfuscate the amount of interest being charged," Cohen says. "I would insist on a partner that will talk about the loan in dollars and in simple terms."

A lender's underwriting criteria is extremely important, says Phil Marleau, founder of IOU Financial, which provides small-businesses loans through its IOU Central unit. IOU has worked with a few banks, but is considering stepping up its efforts, he says.

Default rates should be reasonable, says Brendan Ross, who runs a hedge fund, Direct Lending Investments, that buys loans from firms such as IOU Central and QuarterSpot. Ross generally buys loans that mature in a year or less with interest rates ranging from 15% to 40%. Default rates usually run from 6% to 8%.

"Banks should find a company that does business like they would if they were in the business of making semi-collateralized small loans," Ross says. "The lender should feel sort of like a bank in the most respectful sense."

Banks should provide clients with referrals to multiple alternative lenders, says Rohit Arora, CEO of Biz2Credit, which matches small-business borrowers with lenders. More banks are referring small-business customers to Biz2Credit if the bank can't provide financing, he says.

Additionally, banks could fulfill Community Reinvestment Act requirements by referring clients to a community development financial institution, or CDFI, which would provide better terms, Arora says. But CDFIs often lack technology, such as online loan applications, that applicants desire. And they are often unable to fund big loan requests.

"Once banks send their customers to other lenders they have no visibility," Arora says. "Banks need to do due diligence on a few places and give their customers options. They need to make it clear that it is the customer's choice."

Besides upfront due diligence, banks should constantly monitor the relationship, Keating says. This could involve completing routine surveys — something that can be outsourced — to make sure referred customers had a good experience.

Banks must consider the regulatory implications of working with alternative lenders, industry experts say. Regulators are urging banks to enhance oversight of vendor relationships. They have also held banks and nonbanks responsible for the practices of third parties.

Still, if banks properly vet these lenders, it is worth the effort to help their clients, experts say.

"There's a need for these types of lenders," Goswami says. "If we do our due diligence and refer customers to companies that we know are good, then we could stop them from going to someone who is predatory."

Jackie Stewart is a reporter for American Banker covering community banking. 

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