Banking on local business: could SME lending revitalise Australia's mutual banks (and vice versa)?

What happens when community-focused financial institutions become indistinguishable from their larger competitors? This is the quiet crisis facing Australia's mutual banking sector today.

Mutual banks, once the cornerstone of regional financial services, now find themselves trapped in an increasingly commoditised mortgage market, competing against major banks with vastly deeper marketing budgets and advanced digital capabilities. Meanwhile, small businesses in these same communities struggle to secure the capital they need to grow, innovate, and create jobs.

The SME funding gap - an opportunity hidden in plain sight

The numbers tell a revealing story. Small and medium enterprises contribute roughly one-third of Australia's GDP and employ 44% of our private workforce. Yet they face a staggering $120 billion funding gap between the finance they need and what's currently available.

Why? Major banks have been steadily withdrawing from regional Australia and tightening lending criteria for small businesses. Many SME owners report that "major banks aren't providing funding for small businesses," especially for growth-oriented, unsecured loans. This dissatisfaction has pushed small business Net Promoter Scores for banks into negative territory (NPS –3.8 in mid-2024, down from positive territory just two years ago).

The resulting credit vacuum has driven small businesses toward alternative lenders. A decade ago, only 7% of SMEs considered non-bank options. Today, more than half say they intend to use non-bank lenders for new financing.

But here's what's particularly striking: mutual banks seem to have barely noticed this opportunity. As of mid-2023, 93.6% of mutual bank loan portfolios remained in residential mortgages, with just 6% allocated to business or other loans.

Is there a viable path for mutual banks to follow in SME lending?

But let's be realistic - shifting toward business lending isn't without challenges. SME loans carry higher risk than standard home loans and a different set of capabilities (people, process, and technology). But specialist SME banks like Judo Bank have demonstrated the economic viability of this approach, maintaining net interest margins around 3.0-3.5%, significantly higher than the 2.0% average NIMs that mutual banks achieve with mortgage-heavy portfolios.

And regulatory changes are becoming more favourable. APRA lowered the risk-weighting on SME retail exposures to 75% in 2023 (previously 100%) and expanded the definition of retail SME loans to include facilities up to $1.5 million. These changes have effectively reduced the capital mutual banks must hold against many SME loans.

Meanwhile, APRA's proportional regulatory approach provides smaller banks with simpler requirements, lower capital ratios, compared to larger ADIs that have an internal ratings-based approach to credit risk, and exemptions from certain disclosure obligations. These put mutual banks on a more competitive footing for SME lending.

Beyond financial returns - the community multiplier effect

What makes SME lending particularly compelling for mutual banks isn't just the improved margins, it's the alignment with their community-focused mission.

When a mutual bank finances a small manufacturer's equipment purchase, that business can fulfil larger contracts and hire more staff. Those new employees spend locally, supporting other small businesses. Over time, the manufacturer grows into a medium enterprise, anchoring the town's economy.

Research conducted by the Centre for Economic Policy Research (CEPR) suggests that for every A$1 million in small business loans, around 3 to 3.5 new jobs are created within a few years. This creates a multiplier effect that mortgage lending simply doesn't generate. A home loan merely changes ownership of an existing asset; a business loan creates new productive capacity.

So, what could a strategic pivot look like?

For mutual banks considering such a strategic shift, a gradual approach to increased risk (and reward) makes sense:

1. Begin with familiar, lower-risk segments: Target established local businesses with tangible collateral or strong guarantors; think medical practices, farms, or franchise operators. These secured loans can deliver good margins with manageable risk profiles.
2. Leverage collective strength: Consider consortium lending where multiple mutual banks or other lenders jointly fund larger SME deals, spreading risk while keeping relationships local.
3. Develop a "phygital" strategy: Combine fintech platforms, which can process loans efficiently, with personal relationship management, addressing precisely what SMEs say they're missing from major banks.
4. Quantify community impact: Track and promote the jobs created, businesses expanded, and local economic improvements resulting from SME lending through regular reporting on community impact (e.g., "community prosperity")

While every bank and situation will vary, an illustrative prudent approach might be to start with a 5-10% allocation of the loan book to well-secured, low-risk SMEs, gradually expanding to 15-20% as capabilities develop and the model proves itself. Over time, risk-based pricing could be an option to extend support to riskier (but potentially more impactful) businesses.

A return to banking for the community

The mutual banking sector has an established and recognised claimed to put people before profits. By channelling more capital to local businesses, mutual banks can truly deliver on that promise while securing their own future in an increasingly concentrated banking sector.

This pivot wouldn't just provide a path to sustainable differentiation, it could help address Australia's productivity challenges while revitalising the regional communities that form the heart of mutual banking.

As major banks continue their retreat from regional Australia and SMEs seek new financial partners, mutual banks face a defining strategic crossroads. In this moment of when the signals have been of a declining sector, the convergence of commercial opportunity and community purpose offers mutual banks something particularly rare: the chance to grow by rediscovering their founding principles to facilitate the wellbeing of their communities.