How banks can do more for small businesses

One of the pandemic’s significant impacts is that it has led to a surge of new small businesses being formed across the U.S.

Karl Dahlgren, managing director for research at BAI, joins us to talk about new BAI Banking Outlook research that sheds light on what small businesses want from their banks.

A few takeaways from the conversation:

  • The BAI Banking Outlook research tells us that small businesses want more tools and ways to customize banking solutions.
  • Lower fees and better rates are the most likely reasons a small business owner would switch primary banking institutions.
  • And even when a bank has relationship primacy, sizable opportunities remain to get more of the SMB customer’s business.

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Below is a full transcript of my interview with Karl Dahlgren.

Karl, so listeners have a better understanding of the BAI Banking Outlook research, before we get too deep into it, can you give us a little more background on this small business survey? How you define what a small business is, when the survey work was done, how big a respondent pool you had, that sort of thing?

Yeah, absolutely. In February of this year, BAI surveyed 600 business owners with businesses that are under $20 million in annual sale size. And we sampled an equal number of them in four different sales-size tiers. One of them was $1 million and under in revenue, the second was $1 million to $5 million, then $5 million to $10 million, and then $10 million to $20 million. Of those, 60% said large banks were their main service provider, 18% said regional banks, 16% said neobanks, and then 4% community banks and 3% credit unions. Interestingly, neobanks have a decent share at 16%. That’s interesting mainly because they’re relatively new on the scene, and they’ve done especially well in that $1 million and under category, where they have nearly 24% of the market share versus the 16% overall. They are serving the underbanked and figuring out how to attract this segment and service it at an appropriate cost to serve.

Okay. Before we get into these specific banking-related results, what sense do we have from the survey about how small businesses are thinking about some of the key macro conditions we’re seeing in the economy, things like rising inflation and growing concern that Fed policy moves may trigger a recession?

At the time we did the survey, and that was in February, half the business owners were very concerned about inflation negatively impacting their business. It’s not equal across all the different types of businesses. Two-thirds of the manufacturing and real estate respondents were very concerned about inflation, but if you move to other sectors like healthcare and professional services, it’s only 40%. So, it depends on the sector that you’re talking to. And then also the age of both the business and the business owner. So the younger business owners, 38 and under, as well as the new businesses – they’re more concerned about inflation than the more mature owners and the more mature businesses. Now, obviously, this is in February. This is a fast-changing economic environment and things will change, but we wanted to know how the current economic climate was impacting profits and profit margins. And nearly half of the small business owners are forecasting profit increases, which is good, but a little bit less than that, only 40%, are expecting a profit margin increase. People are looking to grow that top line. There’s a fair number of businesses that are going to do that. But obviously, inflation and the cost of supplies, whether it’s labor or otherwise, going up, and so that’s causing pressure on the margins.

Thinking about it at a high level, what does the research tell us about what’s on the collective mind of these small businesses when it comes to their current banking customer experience versus what they want out of their banking experience?

Business owners said that delivering tools and options to customize solutions from both the products themselves to also the way in which they’re delivered, So, for example, if they’re delivered digitally, it’s really their top experience priority. Also—I found this interesting—transforming branches for better in-person experience was also a really high priority for business owners. So those branches are still important part of the experience that they’re looking for. We also asked business owners why they would switch primary financial service organizations, and the top two reasons are lowest fees and best rates. So, there’s still, what I’d say, a hyper-focus on fees and rates. And then when you get into the things that aren’t fees and rates, like understands my business, my bank understands my business or positive reputation, those actually have slipped down relative to the last time we performed the survey, like three years ago in 2019. There is some difference amongst the size of the business. The larger businesses have best products in their top three, so it’s important for them to have products that fit their needs. But coming back to that, understands my business and positive reputation – those don’t cost the organization hard dollars like fees and rates. It seems like, given the slippage, the fact that it has a lower hard cost, if there’s some space to improve that area and hopefully take away some of that sensitivity to fees and rates.

What have we learned about the banking products and services that are most in demand by small businesses? And has that been changing over time?

It has. Loan demand has decreased over time. We’re talking about small business here. That’s the specific segment that we’re referencing. Overall, 23% of businesses do not have any loans with a balance, and that’s quite a bit different than the 2019 survey, when it was 13%. More businesses have grown deposits over the last two years, and they’ve used those deposits to fund their business needs. They’re funding their business out of cash flows and they’re also paying down some of those loans with those deposits. Obviously, that was affected by the injection into U.S. businesses with government PPP loans. Loan demand does vary widely based on the size of the business. The larger businesses that are $5 million and over in sales are more likely to have a loan outstanding, and that’s at 90%, versus like when you get into the smaller businesses that are $1 million and less, only half of them have a loan with an outstanding balance. So, their loan needs vary depending on the size of the business and then also on the maturity of the business. Those that have less than 10 years of maturity have increased their loan balances, and then also you can slice it by the type of business. Manufacturing and retail businesses have increased their loan balances as well. So, the loan demand is really relative to the size of the business, what sector it’s in and how old the business is.

You mentioned PPP. Back in 2020 when it started, and for the later rounds as well, the program was seen by many as a way for banks to develop new and/or deeper connections with small businesses. Do we see anything in the research that indicates whether that potential positive has actually come to pass?

Banks really serve their purpose in the economy during the time. It was off to a little bit of a rocky start because, basically, it was switched on overnight, but it changed over time as banks got comfortable with the process. PPP loans vary greatly – the use of them – by the size of the business. Less than two out of 10 businesses under $1 million took out PPP loans versus six out of 10 when you get into the $10 million to $20 million revenue size. It also is the same for the number of employees. Less than a quarter of the businesses that had less than 10 employees took out a PPP loan, but two out of three did so when their employee number was over 100. So, the larger businesses tended to be the ones that utilize the PPP program. What’s interesting is, if you look at something else that we asked and that is related to the net promoter scores – in 2019, when we looked at net promoter scores, they came in at 24 on average, and now they’re up to 38. Neither one of those scores is all that good, but what’s interesting is the change over time, right? And while we can’t directly say that PPP was causal, it certainly is correlated. And it seems that as banks were servicing the needs of the small businesses during the pandemic, that played favorably in their net promoter scores.

The quest for relationship primacy is something that you and I have discussed in previous podcasts that having the status as the customer’s main bank, it’s a highly coveted position for generating customer lifetime value. What does the BBO research show regarding primacy and loyalty trends?

If you’re an FI and you’re a primary provider, you’re going to win approximately one-third of your customers’ future business for deposits, treasury management and merchant services. The loan business, though, is a little bit more competitive. The primary providers will win about one-quarter of that future business. So obviously, being in that position is coveted. However, there’s still a lot of room for growth. And again, here’s some differences between smaller and larger businesses. The average number of providers used for deposits is 2.1, and 1.7 for the smaller businesses. And then when you get into the $10 million to $20 million range, the average number of deposit relationships is 2.2, and same number, 2.2 for the loan relationships, too. We looked at owners who have a loan also with their main provider, and 62% of those businesses had only one deposit relationship versus 43% of the overall base. So clearly, having that loan relationship, it’s an important part of primacy and making sure that that customer is delivering to you future business.

You mentioned that room for growth, that opportunity for banks to grab more share for deposits and loans. How should they be going about doing that?

FIs need to really provide the business customer with a compelling reason to consolidate all of their products – deposits, loans, treasury management and merchant services – within that one main primary provider. What we found is that most business owners really don’t see a strong connection between giving more business and then receiving more value. One of the issues that we’re seeing is that, for example, an organization like a bank might emphasize loans because they want loan growth and they think it’s going to be profitable or economical for them. But it’s really not the holistic approach from the customers’ lens. One area for opportunity is for financial services organizations to work on removing the data silos, which allow them to package products in a more compelling way so that the customers are easy to perceive the additional value that they would receive by giving their primary bank additional services. Treasury and merchant services are especially important. They’re really sticky services and help really retain the business relationship over time. The ongoing challenge has been trying to make products that were really built for the larger businesses and then taking those products and moving them downstream and trying to fill the need for the small businesses with those same products. And really the one-size-fits-all is not really effective. You got to make sure that your products are tailored to the segments that you’re serving.

Merchant services are an area where banks have a particular interest because it can be a reliable source of non-interest rate income. What did the BBO research show regarding how successful financial services organizations are being in terms of developing these valuable merchant services relationships with small businesses?

We talked to the business owners and we asked them a few questions. And the top two reasons that they don’t use their main provider for merchant services is technology and cost. They believe that it costs too much and they just don’t have the latest technology relative to some of the other players like Square or neobanks. Here’s really an opportunity. Banks have the customers, and merchant services are very sticky and it’s an opportunity for them to cross-sell. It’s also an opportunity here to partner with those that don’t necessarily have the customers but do have the technology, and the technology allows them to provide services at a lower cost. And so, I would just say that there’s an opportunity to look at partnering in this space and making sure that it is addressed. There’s room for growth here, given a different product set that addresses the technology and cost situations that small businesses are identifying.

We’ve been focusing on the product and service side, but now I want to ask about how small business customers are getting access to banking products and services. For consumer banking, it seems that most people can set up accounts and do all of their banking with their device, never needing to interact with a banker or even set foot in a branch. How does that digital-first experience compare to what small businesses encounter?

Well, it’s a little bit different. Most business owners begin their search for new accounts on their main financial services provider’s website, and then to open the account, they end up going into the branch. So, it’s not as strong as what you just identified on the consumer side. Credit cards and non-checking deposits have the highest percentage of new account openings online compared to other products. However, in-branch was still the dominant channel used for opening those products as well. The question is why are business owners shopping online and then ending up in the branch? Do they prefer that, or is it that their main bank simply isn’t allowing the accounts to be opened online? Nearly 70% of business owners preferred to open deposit accounts online, but 60% of them ended up opening them up in the branch. So, it’s clearly the case that the preference is online, but they’re just not able to do so. Bank isn’t allowing it for some reason or another. And over half, 56% of business owners, preferred to open loan accounts online, yet 60% of them ended up opening them up in the branch. So, either organizations have not had enough information online and have made it easy enough for the small businesses to open up those accounts, or they’re simply just not allowing it at all. But there’s clearly a space here to take a look at how they might improve that online experience because there’s a desire to open those accounts online. There just isn’t the capacity to do so yet.

Karl, for several years now, fintechs have aggressively targeted small businesses, and they’ve had a lot of success on that front at the expense of banks in a way that’s attracting a flood of private equity and other investment capital. Tying together what we’ve been covering in our conversation on the BBO research, what’s our best advice to banks on upping their game to better compete with the financial upstarts?

There’s an opportunity for financial services organizations to recognize the value of the entire relationship that they have with small businesses on the business side and the personal side. Most business owners say they don’t see more value when they’re giving their main bank more business, and when they think more business, they’re not thinking in a silo. Is it more business on the business side or is it more business on the personal side? They’re just thinking, in general, their entire relationship with the organization. Record number of new business formations occurred during the pandemic, which creates a lot of opportunities. Credit cards and checking accounts are key products to focus on, particularly if you’re prioritizing online services because these are the most popular services and most desired to be opened online. If the loan application processes are not efficient when opening these new accounts, most business customers will either have to revert to the branch to open the account or they just get frustrated and go somewhere else. So, I think there’s an opportunity for banks here to make sure that they are looking at the relationship both on the personal and the small business side, accounting for the entire holistic relationship and then making the online application process more fluid, like they’ve done on the consumer side. One of the large difficulties in servicing the small business segment has been the cost to serve. You just can’t use the cost structures of, say, commercial relationships and use those cost structures to address the small business. If you automate the stuff, it’s good for the customer. They want to have that automation. They want to use the online channel and it reduces the cost structures to serve the customer. So, I think it’s a win-win for both sides.

Right, borrow from the tech-centered playbook being used effectively by fintechs and other upstarts, but at the same time, small-business customers say the branch is also important, so that’s another potential way to win. So, Karl Dahlgren, managing director for research at BAI, we appreciate you sharing your perspectives from this new BAI Banking Outlook research focused on small businesses. 

Fantastic. Thanks for having me, Terry. I appreciate it.

Terry Badger, CFA, is the managing editor at BAI.