Our experience with the small business segment goes back over ten years. Back then, most banks considered this market an adjunct to their core retail or, more often, commercial businesses. Over that time the business model or approach to serving small businesses has fundamentally changed, the competitive landscape has broadened dramatically and the level of customer sophistication has grown with it.
As we look forward, what are the emerging trends that will impact the fortunes of those banks and non-banks that serve the small business segment?
Overall, we think the forces at work within this segment will result in sharply increased stratification between the performance of top competitors and mediocre “also rans”. In the past, returns of 30 percent and higher were not unusual when serving this market. Several factors will squeeze returns and reduce performance for all but the most targeted players.
Those serving this market need to address some fundamental issues related to products offered, the method used to sell and service those products, and the customer segments served. We believe that in some cases, the required bank response flies in the face of conventional wisdom and the current approach being espoused by many advocates of increased reliance on technology.
Deposits Central To Profitability. To this day, the primary focus of many small business groups centers on loan growth. This is particularly true in those organizations in which small business reports into the commercial side of the bank rather than the retail organization. Yet the recent comment of one bank manager typifies what we have found in client work: “We lose money on 60 percent of our loans.” Only specialty lenders such as card companies appear able to generate consistent profits from credit alone. One key to their success involves the ability to apply risk-based pricing to segmented credit offerings.
At most banks, deposits drive small business profits. One client recently commented, “Deposits make up over 70 percent of our profits.” Still, it is the minority of banks, such as North Fork Bank in New York, that appear to have focused on the importance of deposits and have built a small business solicitation effort around this theme. North Fork makes small business loans when they support a strong deposit relationship or result in a shift in demand balances to the bank.
The future: more banks will establish focused deposit
sales teams aimed at small businesses and create incentives to push deposit
generation across the bank.
But, Deposits Harder To Maintain. While deposits are increasingly important, we also expect them to become increasingly difficult to retain. Not only have Merrill Lynch and Morgan Stanley focused on the upper-end of the small business deposit market, but banks are also beginning to offer market sweep and other investment accounts more forcefully.
Traditionally, sweep accounts have been offered rarely and only as a defensive response to a marketing attack. More recently, bank managers have realized that they need to take a targeted and proactive approach in this area and are developing programs to do so.
The future: increased competition for the small
business deposit dollar will continue. Many banks will experience significant
erosion in the profits they generate from demand deposits, adversely impacting
returns from the small business segment overall.
Slower Loan Growth. Those banks that rely heavily on loan asset growth will likely face a significant slowdown in revenues and profits. Loan decline appears likely due to one or more of several events. Most fundamentally, as the economy slows down, the best-managed small businesses will contract their own growth plans and reduce their borrowing needs. Second, many banks will continue to tighten lending as expected losses and delinquencies mount. For the near term, those businesses that want to borrow may often be those for which the banks do not have the appetite to lend to.
Third, the competitive environment for lending is much tougher, as the entry of non-banks increases small business borrowing options. Direct mail offers from national card issuers such as Advanta, American Express, Cap One, First USA, Fleet, and Wells Fargo arrive frequently, some offering attractive teaser rates to build volume.
The future: Those small business relationship managers
who are in reality old-fashioned commercial lenders will be under intense
pressure to broaden the set of products they sell. In some banks, this will
result in wholesale replacement of small business bankers.
The Internet: Fool’s Gold not the Holy Grail. In recent years, fascination with the Internet has frequently led to a misallocation of manpower and investment. Bank management has invested extensively in providing small businesses with a technology alternative to areas in which many customers are, in fact, asking for more personal attention.
It is no surprise to say that, in most cases, stand-alone Internet banks will fail. The recent failure of PrimeStreet, a loan aggregator and online ASP, as well as the performance of other Internet-only financial services providers supports this view. But even the value of major investments that banks made in building a web presence for small business is, for many senior managers, in doubt.
Too often banks have conducted online initiatives without effective linkage to off-line channels. In most cases, a web investment has not provided banks with a competitive advantage. Going forward, many banks will be more skeptical about the scope and cost of online investments. Managers will demand that the online strategy complements and coordinates with other core delivery channels for selling and servicing customers.
The future: Banks will end the more grandiose
Internet-oriented quests (for example, positioning websites as business portals
or purchasing centers) to focus on the relatively few functions currently
desired by customers. Experimentation in offering new/non-traditional products
will continue, but only if the cost is minimal and/or shared with an outside
provider, or the value/return is clear and demonstrable.
The Internet: Cost, Not Profit, Center. Most financial services providers should consider the Internet as another cost of doing business rather than as a significant revenue generator. However, competitive players must offer customers online access because an increasing number of customers expect it as a core delivery/service option.
Dismissing the concept of the Internet as the Holy Grail is appropriate. However, our client work indicates that the Internet is a critical account retention tool. The “technophile” customers that use online banking maintain higher deposit and loan balances, buy more bank products, and stay with their bank longer.
FIC’s 2001 Small Business State of the Market Report demonstrates that about 30 percent of all small businesses now use e-banking to some degree, almost double last year’s number. However, businesses continue to use it primarily for what we consider passive activities, such as balance checking or routine account transfers. Revenue-generating customer activity, such as applying for loans or even bill payment, is minimal.
If customers do in fact shift more service activities to the Internet channel, banks can realize expected service delivery cost reduction. However, this will occur only by providing a reason to small businesses for altering the way they conduct their banking. Effectively branding the online channel to communicate its value must be accomplished while establishing a telephone- and branch-based staff focused on training customers and responding to inquiries.
The future: Within the next one-two years, the majority
of small businesses will use the Internet to conduct some aspects of their
banking. The challenge banks face involves translating that online activity
into tangible cost savings. Leaders will explore online, telephone, and
branch-based customer training. Additionally, success may require increased
differentiation in pricing based upon channel use.
Three words: segment, segment, segment. It seems that almost from the beginning of banking, most banks have tried to serve all customers, pursuing what often seems an increasingly illusive “relationship”. If profit maximization is a manager’s goal, that unfocused approach no longer works, in small business or elsewhere. While banks struggle to serve all segments, the Merrill Lynch’s of the world pick-off high balance deposit customers and American Express offers $50,000 lines of credit to the most attractive borrowers.
In the face of slower loan growth and tighter competition for deposits, banks need to rigorously determine what they are best at and then set priorities for the customers they choose to serve and the products they choose to sell. Despite all the analysis pointing to selective marketing, most banks fail to do so.
At the same time, segmentation is an evolving analytic process that needs to be guided by in-house data as well as the ability of bankers to execute against plan. Managers need to beware of internal bank analysts and external consultants that develop “elegant” segments that are also limited in real-world applicability.
The future: Banks that have not determined a meaningful
customer, product, and delivery channel focus will see margins and competitive
positions erode. Those that segment well can become category killers with
certain customer types or with specific products.
Power to the People. Bankers constantly state that they wish to serve customers in a way that distinguishes the bank and satisfies customers. But what does the customer want?
Over the past four years, we have conducted lengthy telephone interviews with close to 2,000 small businesses. One theme that emerges year-after-year is the small business’s interest in having access to a person who can address their problems and answer their questions. Selling certain products, such as insurance and investments, requires the type of advisory relationship that demands an investment in relatively sophisticated personnel. Again, most banks need to “pick their spots”; not every player will be able to effectively generate small business insurance volume.
While customers want personal contacts, the response from most larger banks is more technology. Many banks provide the service they want to provide rather than what the customer prefers. As a result, community banks and credit unions have been able to gain share because of their willingness to provide the personalized relationship that eludes most large banks.
In today’s economic environment can banks afford to provide personal service to the small business segment? The better question is, can you afford not to? Without being able to cost effectively leverage a sales and service staff, banks will continue on a treadmill of eroding market share and frustrated attempts to cross-sell more high-value products.
The future: We think a
convincing case can be made for the return of “people power” complementing high
tech. Value destroying customers
without demonstrated potential need to be “pushed” toward automated channels,
while others will benefit from a level of personal attention not experienced
for several years. Banks emphasizing personal attention will do so based upon
strong segmentation, effective linking of business and personal account
management, and the creative use of outsourcing and alliances for select
product sales and service activities.
Small business was once a relatively simply arena in which to compete. That is no longer the case. For the foreseeable future, banks will be beset by a macroeconomic road with many potholes, an ever-expanding competitive set, and a smarter and less loyal customer. Winners will include those that conduct strong self-assessments, pick their competitive spots, and execute while maintaining the flexibility to regroup and redirect as the market environment changes.