Small Businesses Are a Big Deal, But Banks Are Giving Short Shrift
By Charles Wendel
American Banker, February 7, 2003

Small business is among the top two or three priorities at almost all the financial services companies we know. That includes markets in Europe and Asia as well as in the United States. Why?

Portfolio volatility is low.

In the old days -- actually only three or four years ago -- large corporate customers provided the big earnings for many banks. Today they provide the big writeoffs. The concept of banks serving as a one-stop shop for larger companies brought with it increased portfolio volatility.

Contrast that world with small business. Certainly, many small-business lenders have experienced deterioration in their portfolios, but this has typically raised writeoffs only into the high two-digit or low three-digit basis-point area, well within tolerance. The "natural" diversity of the portfolio has minimized losses.

Portfolio quality remains high because of several factors, including centralized decision-making and the use of credit scoring as a decision tool (though a minority of the loan decisions are automated). Since most of the loans are personally guaranteed, small-business owners also tend to self-regulate their borrowing.

Returns are high.

There has been increased strains on bank returns from middle-market and large corporate business. Given the intense competition and credit issues, even a 15% return on equity is becoming rare. A bank makes fewer dollars for each small-business transaction, but the achievable margins are significantly higher, resulting in returns of well above 30%.

Small business is a deposit-generating machine.

The high returns from this segment depend on deposits rather than loans. At some clients, 50% or more of the business customers are nonborrowers. It is not uncommon for a bank's small-business portfolio to generate $2 to $4 of deposits for every $1 of loans. The portfolio's self-funding nature can significantly reduce funding costs.

Success with small businesses does not depend on loans. Small businesses define their relationship bank as the institution at which they maintain their deposits.

For many small businesses, loans have become a commodity, with more loan sources approaching them almost every day. The good news for banks is that they can make more money in other, less risky, areas related to deposits, cash management. and owner banking.

Relationships between banks and small businesses offer substantial payoffs.

Most banks have the same goal: broad and deep relationships with their customers. Practically, however, there may be only two market segments that offer an opportunity for such relationships: consumers and small businesses. Other segments increasingly employ RFPs and have employees dedicated to grinding out the last penny from their banks.

Too often banks delude themselves into believing that they have a relationship with their customer when the customer simply wants to complete a series of transactions. But many small businesses prize counsel from their bankers.

Small business remains largely undiscovered.

Remarkably, many banks are still just waking up to the segment's positive economics. Small business has been overlooked because it was outside the branch manager's radar and too small for commercial lenders to focus on. Particularly at banks with a strong consumer orientation, small business is a natural market extension.

It is puzzling to see banks giving this segment more lip service than real focus. Organizational dysfunction usually plays a major role. Small business should be housed in the retail organization, but too often responsibility is split into two or more areas, including retail, commercial, private banking, and cash management. The best players have a head of small business charged with leading a coordinated bankwide effort.

They are already in your portfolio.

Many consumer accounts are in reality small-business accounts. An analysis of a bank's consumer portfolio can show that up to 5% to 10% of its account holders are businesses. Once these customers are discovered, they can be shifted to business accounts and cross-sold other products for their specific needs.

Small business ties into an emphasis on wealth management.

Most small-business owners consider their personal and business needs to be closely interlinked. However, most banks have different groups serving personal and business needs. They are missing a great opportunity if they fail to link their small-business effort with a program aimed at capturing the owner's personal business.

At most banks we know, 30% to 40% of the business owners maintain primary personal accounts at banks other than their business bank. In many cases the business bank has never asked for their personal account. Yet, our experience is that banks capturing both the personal and commercial business achieve significantly more profitability and higher retention levels.

A bank franchise.

We view small business as a "natural" bank franchise. But nonbank competitors are skimming some of the cream from the banks. Banks should act decisively to maintain and build their position with a segment that, for many, is critical to their economic health.