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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