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Sifting the Gold

BY CHARLES B. WENDEL

As small business banking begins to suffer credit issues, bankers need to sift value from the market turmoil.

| SYNOPSIS | Faced with weakening credit in small business banking, institutions are tempted to throttle back on their growth in this market. While some pullbacks may be necessary, consultant Charles Wendel advises that banks avoid alienating good customers with an eight-step program that contains losses while continuing to pursue growth in the small business banking sector. Some examples: identify the weaknesses, stop the credit bleeding, improve collections, selectively reduce expenses and poach customers and banking talent from your competitors.

The easy money days in small business banking are becoming a distant memory. At the end of last year’s fourth quarter, banks such as Wells Fargo & Co. and Bank of America Corp. began warning publicly about emerging credit problems in their small business portfolios.

Appropriately, many banks are focusing on tightening risk management and collection procedures. They are striving to reduce exposures and avoid marginal borrowers.

Related Charts Staying On Top Of Collections

Yet cut-and-run is not an option in this market. American Express Co. CEO Kenneth Chenault recently highlighted the tension that characterizes the attitude financial services companies have toward this sector when he noted that small business cardholders often “have higher loss rates than consumers” but “higher spend and higher returns” as well. So the market is attractive long-term; the challenge is managing through the short-term slump generated by today’s credit turmoil.

Unfortunately, some lenders will simply pull back on credit exposures without a long-term game plan aimed at maintaining their position in the market. The wiser heads will more thoughtfully view the unsettled environment as an opportunity to re-price and restructure current loan facilities while pursuing stronger long-term growth.

In our view, while caution is required, today’s lending environment offers very attractive opportunities to banks that analyze their current risk positions with rigor and then act on the implications of that assessment to build a foundation for growth. As we suggest below, this requires targeting both the customer and internal bank staff for change.

The worst-case scenario is one in which banks mismanage through this period while alienating good customers and prospects. Businesses, in particular small businesses, have long memories. As a banker years ago, I remember phoning a prospective client to request a meeting. Before he hung up on me, the prospect groused that my then-employer, Citibank, had turned him down for a loan more than 20 years ago. Despite the intervening decades, that memory remained raw.

Selective Pullback
No one action will guaranty strong performance during a volatile credit environment. However, a multi-pronged approach that combines analysis of your bank’s current small business performance with a near-term action program can position you as a small business leader, no matter the macro-trends. Pullbacks from this segment may be justified, but they should be selective and matched by new initiatives focused on generating quality growth.

Our experience indicates that an eight-part process can provide the plat-form to generate the type of surgical actions required to improve small business performance both in the next quarter and over the longer term.

1. Get the facts. Management needs to ensure that it has assembled the fact base required to address all questions concerning the current state of the bank’s small business loan portfolio. How is it performing in terms of metrics such as net margins, delinquencies and charge-offs? Where are weaknesses appearing? In all likelihood, any problems are confined to a few geographies, industries, customer or loan types. For example, we know one bank whose unsecured loan losses are increasing above 200 basis points while losses related to secured real estate loans are negligible.
2. Beyond evaluating the current performance, portfolios also need to be stress-tested to project their likely future performance based on a number of “what if” scenarios, including interest rate changes, changes in industry prospects and downward shifts in collateral value. This requires a process in which a bank’s best credit minds, in effect, make their best guesses about how the portfolio will continue to perform.

   The “Get the Facts” process enables the bank to determine if it is looking at a credit storm or a tsunami. Depending upon the answer to that question, action steps and options will vary dramatically, ranging from severe and draconian actions to merely increasing credit vigilance.

   Some banks, such as JP Morgan Chase & Co., may be operating with a competitive advantage because they are better able to pinpoint areas of concern and management focus. These banks can determine where any credit bleeding is occurring and quickly focus on addressing those loss-making areas, whether they involve particular demographic groups, geographic regions, or specific types of loans.

3. Stop any credit bleeding. If the analysis points to certain industries, loan types or other attributes as key contributors to current or projected losses, the next steps are clear. First, stop making additional loans of that type. Second, determine if the bank has the legal right to curtail open lines to existing borrowers in those markets. Some documentation allows for loans to become term loans on demand or if deposit levels have fallen below certain levels. Our point is that borrowers who are flashing red or yellow warning lights need, for whatever reason, to be identified and contained as quickly as possible.
4. Reaffirm/readjust policies. In recent years, many banks relaxed their standards in reaction to competitive pressures and customer requests. Those days are over, at least for awhile. Our clients’ experience suggests that portfolio analysis will show that loans made as an exception to bank policy result in substantially higher charge-off rates compared to loans made within policy. Most banks have well-crafted loan policies; problems occur when those policies are skirted or ignored.

Frequently, we find that exceptions occur when branch managers or geographic leaders ask the functional head of small business to bend rules in order to meet the needs of particularly important customers. In effect, the business heads allow themselves to be lobbied to break their own rules, relying upon the geographic executive’s supposedly superior knowledge of the local client rather than well-tested credit policies.

In our view, either the credit policies are appropriate or they are not. Hurdles to granting exceptions should be significant, bordering on the painful. If exceptions have become a relatively common occurrence, senior management may even need to take the head of small business out of the exception-approval equation. Frequent exception-granting often signifies weak small business leadership rather than customer-focused flexibility.

As banks strengthen existing policies, they should put particular emphasis on collections (see chart, “Staying on Top of Collections”). Banks with a strong centralized approach to collections, such as Wells Fargo & Co., can better assess portfolio trends and act on them rapidly. By providing the line with quick feedback related to delinquencies and defaults, small business leadership can identify changes required to their origination focus and underwriting guidelines.

Our recent work in this area indicates that banks demonstrating best practices in collections do so by following a number of standard policies. They base their collections philosophy on fundamental principles such as speed and consistency. Organizationally, they operate with a team that is dedicated to resolving small business issues. The information flow between special assets, collections and the lending areas is strong and periodic. Both the collections group and special assets unit position themselves as major information sources and resources for the line. They provide small business leadership with periodical insights concerning both the state of the current portfolio and, perhaps more importantly, insights concerning emerging trends.

Banks are operating at a significant disadvantage if their line and collections areas are not interacting frequently to exchange information.

5. Determine your competitive position. As concerned as you may be about your portfolio, chances are that a significant number of competitors are facing more significant challenges, providing you with an opportunity to take advantage of their problems.

I recently spoke to a group of clients who were bemoaning their recent performance and the likely scenario for 2008. While their concern was reasonable, they did not understand how strong their competitive position was in comparison to other players. This bank had avoided a mort-gage hangover, a subprime disaster and a commercial real estate calamity. And, like most of the banks in the U.S., it appeared to be surviving the downturn relatively unscathed.

Banks in that situation enjoy a significant near-term opportunity to attack weaker players and take quality share from them. Consider that many of the largest banks in the U.S., such as Citicorp Inc. and Washington Mutual Inc., will operate with an inward focus for the next six to 12 months or longer. Some are closing branches and reducing staff, focusing on expenses rather than revenues, while others appear leaderless, at least in the small business space.

Now is exactly the time to target the weakest competitors, large and small, in your market and go after their most attractive clients. In many instances, target customers will be aware of the internal chaos at their bank and may be looking for a more stable banking partner. Over ten years ago, the old Chemical Bank (now JP Morgan Chase) achieved great success in aiming its marketing initiatives at banks that, for whatever reason, appeared vulnerable. Today, it is easier than ever to pinpoint the clients of competitors and focus on stealing them away from their current banks, many of which will not notice the robbery.

6. Clean up your house with cost reduction and expense control. Banks facing a slowdown often dictate across-the-board cost cuts of 5% to 10% or more. For highly profitable and growth-oriented businesses such as small business, private banking and wealth management, that approach is short-sighted at best and suicidal at worst. Why? For many banks, these groups represent the long-term future of their institution. Cutting fat is fine; cutting muscle is an error. Core areas for future growth should not be subjected to the same expense reduction requirements as businesses that are suffering from long-term cyclical decline.

Nonetheless, cost reduction opportunities exist in the small business space. At many banks, the small business bankers are too focused on non-sales activities. Addressing this imbalance can produce a productivity improvement opportunity. Business bankers, like their middle-market colleagues, often spend time on administrative and customer activities that can be transferred to lower-cost administrators or para-bankers. Particularly today, banks cannot afford to misuse their costliest staff.

Banks should begin by building an information base that captures their bankers’ current day-to-day activities. For example, management can create a simple online survey that enables business bankers to chronicle how they spend their time and high-light activities that can be shifted to others. Analyzing the survey and layering in the input from selected one-on-one interviews will allow banks to uncover a significant opportunity to free up relationship managers (RMs) from activities that keep them behind their desks by emphasizing a team approach to client management.

This is an area in which regional and community banks can learn from big banks such as Wachovia Corp. and Bank of America, which have refocused RMs on sales. These institutions insist on teaming and clear role definition rather than allowing bankers to self-define their jobs.

7. Upgrade staff. Unfortunately, behind the desk is where many bankers wish to remain. Freeing up RM time can increase productivity and unleash significantly more selling energy only if the RM or business banker possesses the aptitude and the desire to sell. Some maintain and administer because that is precisely what they wish to do, not because of the job’s requirements.

The current environment offers an excellent environment to cull poor performers from your staff, which can have a powerful boost to your bottom line. There’s also an opportunity to “lift out” strong individuals or teams from other banks. Bad earnings generate disgruntled bankers looking for opportunities elsewhere and the list of banks announcing large write-offs and personnel cutbacks seems to increase weekly. Now is the time to take advantage of that situation.

8. Restate your value proposition for small business. How do you differentiate your bank with your small business clients and targets? Service? If so, how is your service distinctive from all the other banks that say they offer distinctive service? Products? Unlikely, since most bank products are largely the same. Segmentation? Which segments? And do companies within those segments view you as a leader or are you deluding yourself, meaning that you see the dross rather than the quality deals?

We ask these questions to drive small business managers to push them-selves to ensure that their bank does offer something “unique” and then focus on marketing that uniqueness to select targets. Such an emphasis is now more important than ever because this environment is one in which you should be communicating, both internally and externally, that your bank is not all things to all small businesses. Banks can achieve meaningful growth even in what may be a significant down cycle. However, the growth focus should be targeted on priority industries, geographies and demographic groups based upon the fact base developed in step one of this process.

9. Sell and take share. Now comes the really hard part. The present economic environment encourages bankers to mimic ostriches, looking inward and acting defensively rather than searching for a targeted growth opportunity. However, once the work suggested above has been accomplished, it is time to take advantage of market discontinuities and combat the competition.

Small business leadership may have to demonstrate to top management that such a course is not only prudent but dictated by the extent of the near-term opportunity and the long-term attractiveness of this segment. Not pursuing such an approach may mean that you miss a once-in-a-career opportunity to build quality share and solidify your bank’s reputation as a small business player.