| Small
Business Banking: Set Strategy or Face Atrophy
By Jeffrey S. Brown and David
Van L. Taylor
Aided by advancing technology
and falling legal barriers, hungry competitors are clawing
into the lucrative small business market. Banking players
must move beyond tradition if they are to withstand the
onslaught.
For years, banks have dominated
a lucrative corner of the growing small business market,
leveraging their branch systems to outstanding effect
in selling traditional offerings such as checking accounts,
lines of credit and cash management services.
In 1995, for example, banks claimed
a more than 90% market share in such products, scooping
up nearly $31 billion in net revenues for themselves while
surrendering scarcely more than $2 billion to other types
of financial services competitors. Many financial institutions
earn enormous profits from their small business operations,
moreover, posting annual equity returns exceeding 30%.
Expense/revenue ratios often dip below 40%. And growth
prospects are healthy, particularly in the flourishing
services sector.
But banks should not be lulled into
complacency by these favorable circumstances. Powerful
forces of change are sweeping the small business market,
defined as the universe of firms having full-time employees,
annual revenues of $10 million or less and owners functioning
as primary financial decision-makers.
Players caught napping risk losing
ground rapidly. Even as technology frees both banks and
customers from the need to conduct business at local branches,
predators are seizing upon the transition and the elimination
of regulatory barriers to invade previously inaccessible
markets. Using credit scoring techniques and direct mail
to offer pre-approved lines of credit nationally, for
example, Wells Fargo & Co. boosted its small business
loan portfolio by $1.4 billion in just two years. Nonbanks
are in hot pursuit of traditional small business banking
customers as well, including formidable players such as
General Electric Capital Corp., Fidelity Investments,
Merrill Lynch & Co. and American Express Co.
These changes point to a potentially
profound realignment of market economics. Customers have
more choices and are demanding more value. Already, 53%
of banks have introduced interest-bearing sweep accounts
in a bid to retain small business clients, and an additional
21% plan to follow by the end of this year. If customer
balances do not rise, this trend alone could erode traditional
small business banking profitability by 25%. There's more.
Product fees and credit spreads will fall. Customers increasingly
will apportion their business among many providers, and
their propensity to sever long-standing ties will rise.
In turn, sales and marketing expenses will surge. Over
the next five years, the value of the small business customer
relationship could drop by as much as two-thirds if banks
do not respond to market changes.
In the short term, banks can try to
hold their ground by enhancing operations. Many institutions
are modernizing the management of customer information,
using database-driven analyses to illuminate relationship
profitability dynamics and uncover marketing opportunities.
Leaders also are overhauling service and sales practices,
developing leaner and more responsive organizations staffed
on the front lines by proactive sales representatives.
Mergers can buttress small business banking operations,
enhancing economies of scale and marketing clout. Diagnosing
and curing unprofitable relationships is a further and
promising avenue for near-term gains.
Though constructive, these steps will
not suffice for the long term. Success largely will hinge
on strategy, and it must be distinctive and robust. Executives
must make pivotal decisions and take action. Which customers
will we serve? Which products will we sell? How can we
optimally align distribution and manufacturing capabilities
with the changing market?
Winning strategic options center around
three broad orientations: distribution, manufacturing
and information services. Distribution-oriented strategies
are aimed at capturing a larger portion of each customer's
business. Manufacturing-oriented strategies emphasize
the creation of unique products and services. Information
services strategies focus on the selection and distribution
of products and services that help proprietors manage
their own businesses. Each path has its own set of advantages,
required competencies and risks.
Thus, the challenge before senior managers
is developing far-sighted strategies while realizing near-term
performance enhancements needed to sustain profitability
and support the next phase of competition. The task is
huge, no question about it, but players serious about
staying in the game have little choice but to acknowledge
these market realities and work to handle them. "The key
is to create product offerings that provide the responsiveness
of a focused competitor, the convenience of multiple delivery
channels and the personal touch of relationship banking,"
says Richard C. Hartnack, vice chairman of Union Bank
of California.
These insights spring from a major
study of small business banking jointly undertaken by
Chicago-based Bank Administration Institute, an independent
research and educational organization that publishes Banking
Strategies, and McKinsey & Co., an international
consulting firm operating in more than 35 countries. The
90-page study is titled Unlocking
Winning Strategies to Serve Small Business: Banking the
American Dream. Project advisors are Fair Isaac
& Co.; First Chicago NBD Corp.; Hibernia Corp.; LaSalle
National Corp.; Mellon Bank Corp.; NationsBank Corp.;
SunTrust Banks Inc.; Union BanCal Corp. and Wachovia Corp.
Defining the Market
Banks often confine their view of the
small business market to traditional products such as
checking accounts, short-term investments, lines of credit,
mortgages, term loans and a few other services. This is
the $33 billion revenue (net interest income plus fee
income) segment that they virtually own.
However, there's an additional $45
billion revenue stream largely claimed by other types
of financial services providers. These non-bank competitors
are deeply involved with small businesses, providing services
such as insurance, accounting, payroll processing, leasing,
business credit cards, long-term investments and retirement
plans. They are leveraging capabilities and relationships
to boost market share and profits.
Combining the two revenue segments
and viewing the commercial small business market from
this larger, $78 billion perspective, banks have a roughly
40% share (see chart on this page). Instead of being big
fish in small ponds, banks are discovering they are average
fish in a much bigger sea.
Factoring in the retail needs of proprietors
and employees, the market swells to oceanic dimensions.
The roughly 5.5 million owners of small businesses also
are great retail customers, significantly more attractive
than the average household banking relationship. Their
personal financial services purchases generate an additional
$30 billion of annual revenues and nearly $9 billion of
profits. Then there are the 37 million employees of small
businesses. Though hard work and innovation will be required
to reach these customers, they do represent a further
$92 billion of annual revenues and $23 billion of profits.
No one formula will work in tapping
the diverse and rapidly-changing small business market.
Growing numbers of service businesses are emerging. An
increasing proportion of the market is made up of home-based
businesses and small-scale firms having fewer employees.
Technology usage also is proliferating. The preferences
and behaviors of customers are diverging, posing a tremendous
challenge for providers.
Dealing with Complexity
There is one common thread of concern
among small business owners, however, and their response
pattern helps provide insight into approaching the market.
The issue? Growing complexity. Many entrepreneurs are
overwhelmed by the proliferation of government regulations
and the pace of competition and technological change.
When it comes to financial services, they tend to respond
to increasing complexity in one of three ways: either
trusting an institution having a well-regarded brand;
turning to a personal advisor; or handling things themselves
by scouting the market as needed.
In turn, providers have three broad
ways to position themselves with customers. Just as personal
computer vendors tout brand names such as "Windows 95"
and slogans such as "Intel Inside" to inspire confidence
in their products, so too will financial services players
seek to build nationally recognized brands that provide
broad entree into the small business market. In the universe
of personal advisors, bankers and certified public accountants
prevail today, but future main contenders might be financial
planners and interactive information conduits such as
the Internet. Self-directed purchasers of small business
financial services will be assisted by organizations whose
sole job is to help simplify choices, as exemplified by
Morningstar and Consumer Reports.
Keep in mind, though, that banks won't
have collective or individual sovereignty over any geographic
or customer segment of the small business market. The
competitive interactions of banks and nonbanks are reshaping
the landscape, as is new technology, and strategists must
take this into account as they chart institutional courses.
Within the traditional banking industry,
numerous institutions--many of them quite large--are stepping
up small business campaigns by embracing national competition,
alternative delivery channels, alliances, sophisticated
information management techniques, product innovation
and aggressive marketing. Amid the transition, some banking
companies are growing dramatically in the small business
market, wresting significant share from competitors. For
example, Mellon Bank increased its small business loan
portfolio by 136% in 1996 alone.
Players are offering new combinations
of products and services. First Union is acting as a group
buying agent, passing along discounts on third-party services
such as long distance telephone and overnight delivery.
Barnett Banks Inc. is offering employee leasing services.
KeyCorp is offering retirement plans. Wells Fargo is testing
a low-fee checking account administered through automated
teller machines.
Other banks are creating specialty
branches designed around small business needs. First Chicago
NBD and National City Corp. are among the institutions
rolling out small business banking centers that blend
traditional offerings with accounting, advisory and information
services. KeyCorp recently struck an agreement to operate
small business branches in certain Office Max and Copy
Max stores.
Notably, some banks also
are venturing far beyond the confines of their branch
networks. For example, First Union is experimenting with
credit offers outside its current markets, mailing business
credit card solicitations to one million small businesses
in 20 states.
Merry Invaders
Together, these forces are undermining
banking's vertically-integrated approach to the small
business market. No longer can institutions stake their
futures on the sale of proprietary products through proprietary
branch delivery systems. As with mortgages, mutual funds
and credit cards, the business system of serving small
business will break into many pieces. Customers will use
multiple access channels to obtain products from multiple
providers.
Indeed, nonbank players are merrily
invading the small business market from myriad vantage
points. They are leveraging relationships, channels and
skills to powerful effect. Brokerage and investment management
firms such as Merrill Lynch and Fidelity are reaching
the small business owner through retirement plans and
investment products. Software companies such as Intuit
and service providers such as Automatic Data Processing
are swarming into the market via the payments business.
Insurance firms such as State Farm Insurance Cos. already
have a significant presence and need only expand product
lines to make further inroads. Specialists such as The
Money Store and General Electric Capital Corp. are aggressively
pushing select credit and lease products.
Fighting back, progressive banking
players are exploring relationships with "natural complementors"--providers
of the products and services small businesses use frequently,
such as telecommunications, PC hardware and software,
office supplies and equipment, and mail and delivery services.
Last fall, for example, Glendale Federal Bank signed a
deal to place branches in 20 Kinko's franchises in California.
In some cases, this can be an ideal, low-cost expansion
strategy.
This approach carries its own hazards,
however, in that complementors can be adversaries as well.
By steering customers into complementor outlets and relationships,
banks expose clients to the sales pitches of entities
that also may offer competing financial services. Consider
American Express, which already offers a plethora of small
business financial services such as corporate cards, Small
Business Administration (SBA) loans, accounting services
and small-ticket leasing. Many complementors interact
with small businesses just as frequently as do banks.
As financial institutions explore complementor arrangements,
they should ponder whether prospective allies have the
potential to become antagonists.
Coping with Technological Change
Advancing technology is a further dynamic
in the small business market. Developments such as computer
integrated telephony, the Internet, electronic commerce
and database management tools facilitate the emergence
of new products and services, and they can materially
change the economics of current offerings. Technology
also is eliminating geographic barriers, lessening the
importance of the local branch in providing convenient
service and maintaining customer loyalty.
As small business customers increasingly
use electronic channels to access financial services,
crucial questions arise about banking's place in the payments
system. Can banks retain broad-based customer loyalty
as the online migration accelerates, or will new players
skim off the best relationships, leaving traditional banks
with the customers costing the most to serve?
Much of this issue revolves around
the large noninterest-bearing accounts small businesses
traditionally have held with banks. Buoyed by investment
income from these "free" funds, banks could afford to
carry transaction-intensive clients who clog teller lines
and process mountains of cash and coin. Now competitors
are diverting small business balances into money market
vehicles yielding higher returns. Rivals such as Merrill
Lynch are specifically targeting small business banking
customers who are less dependent on branches. In turn,
banks are left with the less profitable relationships.
The situation likely will become increasingly
difficult as more effective cash management tools come
into play. Branches will lose relevance as a range of
card-based, electronic check and Internet payment mechanisms
permeate the small business community. This raises a larger
set of questions:
- Can banks confine migrations of noninterest-bearing
funds to their own sweep accounts, keeping such resources
in the family, or will firms such as Merrill Lynch and
Fidelity siphon them out of the industry?
- Will banks offset the loss of spread
income by lifting payment-related fee revenues through
better pricing and the introduction of new services?
- Can banks build new payments capabilities,
assuring that they--instead of alternative providers--capture
the valuable customer information that can be gleaned
from payments?
- Can banks rationalize operations,
ensuring that when transactions are routed away from
branches, expenses fall commensurately?
Direct Credit
A second technology-driven trend is
the commoditization of lending. Heretofore, small businesses
were underwritten locally, with differences in client
needs and types of endeavors included in personal assessments
of credit eligibility. This approach is yielding to the
forces of automation and specialization. Certain clusters
of focused institutions will come to dominate major small
business lending categories on the strength of credit
skills, scale and distribution capabilities. Recent blanket
issuances of credit lines with pre-approved limits of
up to $100,000, aided by automated credit scoring, further
lessen the need for relationship-based underwriting.
The compelling economics of pre-approved,
alternatively delivered credit--as provided by Wells Fargo
and other direct originators--can put to shame the branch-oriented
credit dispensation process still at work in most banks.
As measured by net present value, direct credit can be
twice as valuable as branch-generated credit. This differential
gives direct lenders a competitive edge by freeing resources
that can be used to bolster brands; multiply distribution
channels; cut fees and spreads; and invest in information
technology that can further improve competitiveness and
returns. The power of this approach already is reflected
in credit cards, mortgages and mutual funds.
Finally, regulatory changes are redefining
the small business playing field. Nationwide banking will
bring forth a generation of bigger players endowed with
powerful marketing muscle and economies of scale. New
banking access to insurance products will enlarge sales
opportunities.
Distribution Strategies
Distribution-oriented strategies seek
to overcome deteriorating market economics by more fully
capturing the value of each customer relationship. As
profit margins on individual products fall, institutions
supporting costly branch systems and sales forces will
find it increasingly necessary to lift the number of products
sold to each small business customer. Three permutations
of the distribution strategy--"broadline," "customer segment-focused"
and "local advisor"--are rooted in cross-selling but vary
greatly in focus and execution. A fourth, "discount,"
relies on efficiency.
Broadline.
This strategy melds personalized advice and service and
the convenience of one-stop shopping. It calls for a strong
brand reputation; a wide range and depth of proprietary
and nonproprietary products; and multiple access channels.
The target customer is willing to pay a premium price
in exchange for convenient service, expert advice and
a personal touch. The broadline distributor approaches
the market through consulting agents; has costly and complex
operations; and depends heavily on economies of scale,
quality products and execution and, most of all, sales
prowess.
Customer segment-focused.
Though aligned with broadline in its emphasis on one-stop
shopping and personal service, this strategy differs by
focusing on specific customer segments. It rests on customized
offerings and a deep knowledge of target segments. Target
customers reward providers of specialized service with
greater loyalty and a willingness to pay premium prices.
Distribution most often is accomplished through low-cost
remote channels such as mail and telephone, offsetting
higher development costs on tailor-made products. The
strategy requires superior customer comprehension and
service.
Local advisor.
Particularly suited to community banks and independent
insurance agents, this geographically-oriented strategy
capitalizes on strong local ties and brands. Players operate
just a few area offices, blending reassuring, personal
service with product lines broad enough to meet most customers'
financial needs. Target customers operate in smaller communities
not dominated by larger financial services competitors.
This strategy hinges on high customer retention and "share
of wallet." It requires deep customer knowledge, sales
and service strengths and outsourcing skills needed to
streamline operations and expand product lines.
Discount distributor.
Institutions pursuing this high-volume strategy offer
standard products at low prices, simple service and convenient
(mostly direct) distribution. They heavily rely on information
technology to support channels and marketing. Target customers
either lack the resources to deal with high-touch advisors
or simply prefer rock-bottom prices over personal service.
This strategy hinges on razor-edge efficiency, a tight
product focus and superb merchandising.
Manufacturing Strategies
Manufacturing-oriented strategies seek
to overcome deteriorating market economics by leveraging
unique product skills and value propositions. "Category
killers" draw on their ability to make standard, high-volume
products more cheaply and/or with better features than
the competition. "Specialists" leverage skills in providing
complex, low-volume offerings meeting distinct client
needs.
Category killer.
Under this manufacturing strategy, players use unique
skills to make competitively superior products having
great value, appeal and profit potential. Examples include
credit cards, self-directed retirement plans and credit-scored
small business loans. As they build sales by offering
value, strategists develop brand identity, augment economies
of scale and further refine products and services, continually
repeating the spiral in pursuit of market dominance. Substantial
reinvestments in products, distribution systems and brand
development are required, and managers must take care
lest narrow approaches translate into inordinate risk
exposure.
Specialist.
This niche player supplies skills in critical and complex
circumstances requiring products tailored to individual
needs. Examples include family trust and estate planning;
environmental liability insurance; and the purchase and
sale of businesses and partnerships. Such services are
costly to provide but command substantial margins. Business
primarily comes through referrals from distributors, trade
organizations and specialty publishers. Specialists must
constantly hone their skills and do face challenges from
category killers. But they enjoy many advantages, including
high margins, solid referral networks and high barriers
discouraging entry from other competitors.
Information Services Strategies
Information strategists capitalize
on improving technology and competitive changes in the
small business market, helping flesh out product lines
and handling processing for smaller financial services
players, and providing financial management services to
small businesses. The "product aggregator" supports smaller
distributors and local advisors with products and processing
services. The "integrated payment provider" supplies sophisticated
financial management services to businesses not large
enough to support a dedicated financial officer.
Product aggregator.
Players pursuing this strategy act as wholesalers by tapping
the demand of many small distributors and using this combined
purchasing power as a negotiating tool to procure the
best products and prices from providers. They may also
provide processing and information technology services
to small distributors wanting to outsource such functions.
The strategy feeds on economies of scale. This is a growth
market that rewards competitors possessing superior skills
in processing, account management, negotiation and information
technology. Coordination is crucial.
Integrated payment provider.
This class of competitor offers the convenience of electronic
commerce and the money-saving capabilities of sophisticated
cash management. Players are savvy electronic financial
managers providing cash management, tax payment services
and electronic bill payment services, along with online
access to many financial products and services such as
investments, loans and basic financial advice. Target
customers are small business owners wanting to avail themselves
of sophisticated services without having to hire dedicated
financial managers or roll up their own sleeves. Superior
software and network capabilities are essential.
These eight strategies provide keys
to prosperity in the tumultuous small business market
looming ahead. The opportunities are exciting, but many
institutions will be pitted against each other, both within
and across the different strategic paths, and the competition
for attractive customers will be fierce. In the end, successful
institutions will be those that quickly adopt workable
strategies and execute them better than competitors.
Mr.
Brown is a director of McKinsey & Co., and Mr. Taylor
is an executive vice president of Bank Administration
Institute.
Copyright © 2003 by Banking
Strategies, published by BAI.
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