FINANCIAL INSTITUTIONS CONSULTING, INC.
http://www.ficinc.com/

December 13, 2006

TODAY'S TOPIC: LOANS: ACHIEVING SMALL BUSINESS GROWTH IN 2007
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By Matthew Harvey and Charles Wendel

At most banks, deposits drive small business and middle market profitability. (See our last newsletter for a discussion of tactics for deposit growth.) The best banks know this and build their growth strategies around this tenet. Nonetheless, lending remains a critical part of the small business profit puzzle and goes hand-in-hand with deposit generation. Even non-borrowers need to believe that their bank will provide credit if and when required. If banks fail to respond effectively to current borrowers and send the wrong message to other targets, not only will lending stagnate, but deposit retention and growth will suffer.

Despite the importance of credit and the tougher competition around lending, banks operate with many internal barriers to loan growth. By addressing these issues, banks can grow assets and improve profitability without increasing origination or credit-related costs. Sounds great, right? But, achieving this growth requires objective analysis, management action, and, in some cases, discipline and courage to address the roadblocks, some of which are both chronic and fundamental.

Bankers don't sell. It was true ten years ago and remains true today: Most bankers spend their time doing almost everything else but selling. This includes performing administrative tasks someone else could do at least as well and evaluating credits, even in instances in which they have no loan authority. Until management addresses this basic issue (salespeople who do not sell enough), loan opportunities will continue to go out the door. Banks that fail to address this area will continue to live with poor productivity. By the way, top banks, such as Bank of America and Wachovia, operate with salespeople who spend most of their time selling.

Banks lack discipline. We often hear from banks that they require the operating account of borrowers as a part of providing a loan. However, upon evaluating the bank's portfolio, we frequently find that the facts differ from the bank's fantasy. One bank we know that generates strong deposit numbers insists that potential borrowers provide their previous three months of bank statements. The bank monitors both the balances and the activity in the account and compares it with the levels from the old bank statements. They get the balances that others claim to get. Sales managers and top management need to enforce this type of discipline; usually, they don't.

Banks love silos. The best banks see small businesses as an opportunity to sell loans not only to the business but also to the owner and the employees. How many of these "best banks" are there? Maybe, emphasize maybe, ten percent of banks operate with a consistent approach to cross-sell. Most banks let dollars go out the door simply by not thinking about the "household" opportunity.

Banks often lend too much to risky clients and not enough to strong credits. At some banks, the fundamentals around lending may be out of whack, a particularly dangerous situation as the risk environment becomes more volatile. Research from a partner company that provides predictive risk management tools for small business lending indicates that banks routinely turn away deals that competitors book and that perform well. For example, one bank rejected over 50 percent of loan applications from its top quality applicants. Subsequent review revealed that banks that ultimately extended credit to these rejected applicants experienced virtually no delinquencies or defaults.

Conversely, data also indicates that banks often approve a significant number of deals from companies at the bottom of the credit scale. In one example, a bank approved 42 percent of applications from "D" rated companies and 27 percent of applications from "F" rated companies. That bank experienced default rates in excess of 20 percent on these deals.

Two factors may lead banks to decline solid deals while approving weak ones:

• Credit scoring - Basically, if you are not using credit scoring aggressively, you are operating at a huge knowledge and cost disadvantage. Credit scoring has proven to be a far more reliable predictor of default than manual underwriting. One example: our experience indicates that overrides of credit-scored turndowns are far more likely to result in defaults. Too often, banks not using scoring technology are missing good deals while increasing their risk of booking bad deals.
• Screening criteria - All banks need to reassess the criteria by which they automatically reject loans. In many cases a bank's largely anecdotal view of particular industries or client types is simply wrong and unsupported by performance. That is why banks like Wells Fargo are happy to act as a third-party lender for other banks. Typically, their returns from referred deals can average 200+ bps higher than the referee bank normally earns.

Little relationship exists between risk and pricing. A handful of banks have the discipline, technology, and confidence to align risk and pricing. Conversely, most fail to consistently or rigorously apply risk-based pricing to small business credits. Many bankers cite "an existing relationship" as a reason to reduce loan pricing below that which is required based on the applicant's credit profile, often without quantifiable justification.

One major factor causing below-"risk reality" pricing: bankers have an insufficient pipeline of prospects. They want to hold on to every customer they have, even if it is a value destroyer for the bank. The solution: more selling and a fuller pipeline of opportunities to choose from.

Concluding Thoughts

Faced with slower growth, eroding margins, uncertain credit, and an increasingly jittery investment community, senior management should have sufficient motivation to act now to reconsider how their bank sells and to whom. Without that type of objective assessment and some near-term actions, managers will face a very bumpy road in 2007.

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QUOTE OF THE WEEK

"We are beginning to see more issues in our loan portfolio."

--Senior Executive, Top 20 Bank

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ABOUT US

FIC is a strategy consulting firm addressing issues related to growth and profitability for financial services clients. We emphasize practical, bottom-line results for your company. For more information about our consulting services or if you have questions or comments, please e-mail info@ficinc.com.

Financial Institutions Consulting
324 Silver Spring Road
Ridgefield, Connecticut 06877
Telephone: 203-431-8330

Email: SME_Newsletter@ficinc.com
URL: http://www.ficinc.com
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