Winning in the SME Marketplace

By Charles B. Wendel

Small and medium-sized enterprises possess distinctly different operating characteristics and require different management styles. Similarly, successfully providing financial services to these two segments demands approaches that address the sharp contrast between these two markets and their potential profitability for banks and non-banks.

In recent years, the small business market has become a major growth engine for many bank and non-bank financial services providers. At the same time, we believe that for many banks the middle market has entered a period of long-term systemic decline.

Small Business: Focus on growth

The attractiveness of the small business segment rests on several factors. First, when the definition included companies of $1million or less, small businesses encompass more than 95% of all US companies, totaling well above 10 million companies. Second, branch profitability analysis reveals that a substantial portion, in fact for some branches the majority, of balances result from small business accounts. Third, small business remains a “natural” franchise for banks to focus upon. Fourth, and perhaps most important, small business can generate very attractive profits. One Northeast bank we know stated that their small business related ROE for the first three quarters of this year approaches 70%. While that is an extraordinary performance, many banks can generate ROEs that well exceed 20%.

We regularly hear from clients that small business is one of the top two or three growth related areas within their bank. While five-ten years ago it was submerged within the overall retail or commercial sector, increasingly today it is a central bank focus.

Middle Market: Increasing productivity and maximizing cost containment

While banks and non-banks continue to invest in the small business segment, banks addressing the middle market face many challenges related to the sustainability of current performance. (The typical definition of the core middle market includes companies from approximately $10 million in revenue up to the hundreds of million.)

Why has this become a difficult business for banks? First, the cost to serve is high. For example, many banks are struggling to maintain middle market related ROEs in the 12-15 % range. Too often, relationship managers are handling about the same number of accounts today that they did five years ago; technology has had marginal impact at best. That situation would be acceptable if individual account product sales and net income were on the rise.

For all the increased management talk of cross-sell, however, relatively few banks have

improved their wallet share with this group. Middle market companies are being targeted by direct selling from insurers, retirement specialists, and investment banks, making cross selling difficult. For every Chase Bank with its deep emphasis on cross-sell there are many more banks whose focus remains on credit rather than focusing on an overall relationship.

Second, this group consists of a limited number of companies. There are fewer than 150,000 companies with revenues from $10 million to $250 million. Of that total almost half generate revenues from $10-25 million. We think marketing responsibilities for that lower end middle market group will increasingly become the responsibility of small business managers, due to the success of their approach. This migration of smaller middle market names to business banking reduces the potential playing field for banks.

Third, the core loan product has become a commodity, subject to commodity pricing. Unless a middle market lender has a strong industry specialty or focuses on structured or asset-based loans, it is very difficult to obtain attractive returns. AT the same time the middle market has become much more sophisticated in cash management techniques, reducing the returns from deposit accounts.

Going forward

As future columns will detail, the issues facing these two segments over the next 12-18 months are complex and increase uncertainty. They include:

Reduced small business loan growth. Banks and non-banks have been very aggressive in providing credit offers to small businesses. Small businesses receive frequent solicitations from national players such as American Express, Citibank, CapOne, and Fleet, among other lenders and lessors. At the same time more community banks and even credit unions are eager to make small business loans. The advent of several small business loan sites has further increased lending options for small businesses.

While a lot of money is available, many attractive small businesses remain reluctant borrowers. Recent small business surveys point to owners’ concerns of an economic slowdown and their emerging tendency to reduce capital investments and credit requirements.

Lenders hoping for continued growth may find that many of their takers are marginal credits. We have already heard of quality problems related to loans generated through non-traditional channels. In the past year some banks and non-banks may have been too aggressive on the lending side. In the next 12-18 months, those problems will surface. To avoid problems lenders will depend more on a segmented approach to targeting customers.

Frustration with the online channel. As we will discuss in our next three articles, for many banks online access may simply be an additional cost of doing business. Tracking the cost of providing online capabilities is relatively straightforward; tracking revenue gains is not. Expecting the online channel to generate new revenues or to reduce transaction costs may be an illusory goal.

There is no doubt that the number of online customers will increase sharply over the next few years. However, most will use the Internet in a very limited way. Sales of financial products will largely remain a branch or person-to-person business.

The importance of EBPP. While online may be frustrating, leveraging it effectively with SMEs is critically important. One major emerging growth area may involve banks offering enhanced bill presentment capabilities. Banks such as Wells Fargo, Citibank, and Bank of America have demonstrated a willingness to invest in this area.

Increased competition. In recent months Morgan Stanley, Lehman Brothers, and Smith Barney have all evidenced interest in the small business market. As with Merrill Lynch’s marketing approach, banks should expect the brokers to try to take the cream deposit accounts away. Further, their apparent reliance on a highly centralized approach to credit underwriting and processing may give them a cost advantage in that area as well.

Fewer banks serving the middle market. In the past year several banks have reduced their focus on the core middle market. Some have combined this effort with their merchant or investment banking sales effort. Others have shifted some part of the middle market to the small business area.

More banks are finally willing to take a hard look at the cost structure involved in serving this segment. Reengineering exercises will improve some group’s returns. Other banks will either be unwilling or unable to restructure their groups to make them more profitable. The net result will either be fewer players in the middle market or, at a minimum, increased selectivity in targeting and products offered.

As we develop this series of articles we will explore the above issues as well as issues related to segementation, cross selling, and the card products, among others.