Key Message: Small business portfolios continue to perform well. So far, they have experienced none of the volatility nor losses of other lending business. Lenders can continue to produce strong results as long as they maintain the disciplines introduced in recent years. It may turn out to be “famous last words” but we foresee no small-business-related credit downturn either in the U.S. or in major European or Asian countries.
Credit Is King, Again
This week’s newsletter continues our focus on basic issues related to SME (Small and Medium Enterprises) banking. Given the recent credit downturn and concerns about the next area to weaken, many of our clients are now putting a greater spotlight on small business credit and risk management activities.
The good news is that most small business groups should experience only a very limited credit downturn. In our view, five factors lead to this positive scenario.
1. Initial skepticism meant strong practices from Day One. Many of the managers leading small business lending initiatives faced, at best, skepticism from their peers and seniors. Concerns included the perceived economic instability of small businesses versus larger companies, their lack of capital and track record, and the possibility of fraud. The managers running these groups knew that any false steps could result in the business being marginalized and their own careers being sidetracked.
These concerns played a role in ensuring strong practices and procedures guided the small business effort from its inception until today. At many of the top performers worldwide, internal best practices from other bank areas have been applied to small business, industry-wide best practices have been uncovered and adopted, and a willingness to learn and enhance has been a guiding operating principle.
2. The business/credit partnership works. One executive we know described his bank as operating like a pendulum. Sometimes the pendulum swung toward selling activities. When that happened, bankers were pushed to call targets and propose deals, fast. When the pendulum swung back the other direction, the emphasis was on credit quality and resulted in the bank tightening its procedures and making it increasingly difficult to get a loan approved. Our experience is that a close partnership between the business and credit is more the rule than the exception among top small business lenders.
The best small business players avoid these dysfunctional swings. I was at a client meeting last week in which both the small business leader and credit head separately mentioned how well each worked with his counterpart. The business head stated how much he valued the credit perspective and wanted to see discussion on credit issues.
3. Exceptions to policy are rare.If your bank allows substantial exceptions to policies, you are probably going to experience a rocky ride. Exceptions often involve the lender “stretching” to do something it prefers not to do, and they often occur to placate an important internal constituency or to meet the extraordinary needs of an established customer.
Exceptions increase origination and processing costs and usually result in higher-than-normal losses. Top banks raise very high hurdles to approve exceptions; those that do so do not usually suffer.
4. Credit scoring works. The most successful small business lenders are increasing their reliance on credit scoring. In no instance have we heard of small business credit scoring resulting in problems for a lender. Most lenders should increase their reliance on auto-decision making rather than insisting on a score-plus approach. Those that want to “touch” applications need to rethink the type and extent of the analysis they do as well as better target their analytical efforts.
Banks failing to exploit credit scoring and auto-decision making are operating at a significant cost disadvantage. In addition, they may also be at a disadvantage in managing credit quality and portfolio risk.
5. Banks need to stick with small business lending. Small business is a segment that most banks cannot afford to lose, and the smartest bank managers know it. Example: one analyst estimated that net income from the combined impact of the small business, the business owner, and employees generates 40 percent of total U.S. financial services profitability. Our client experience suggests that at many banks this percentage is actually higher.
Recently, working both in the U.S. and Asia, we have heard senior executives refer to the SME segment as one of their bank’s top priorities. The continued focus on this segment, a bank’s willingness to stick with this segment when others come and go, is one of the keys to success in this business. This consistency and persistence (as well as a strong offer) is why American Express has one of the most powerful small business brands.
We know of several instances in which lenders to this segment have uncovered portfolio problems and adjusted approaches to deal with them. They kept lending, however, and kept making money. Conversely, others we know have operated in fits and starts, having pulled back from their lending activities several times over the last ten years. Those players have failed to gain any traction and seem to be in perpetual start-up mode.
Concluding Comment
Inevitably, some erosion in small business credit quality will occur and, in fact, we are already seeing higher delinquency numbers in some portfolios we know. Nonetheless, SMEs remain a highly attractive segment for lending as long as the focus and discipline that have guided leaders in the past continues.
* One more word on Organization. Our last newsletter, on the small business organization, resulted in several reader comments. One noted that we showed a clear bias toward placing small business within the retail group. In general, our view is exactly that, namely, a small business team is more likely to thrive in a retail environment. That said, we did not sufficiently underscore that the opposite can also be true. We can cite many instances, both in the U.S. and beyond, in which commercial or corporate banking successfully houses the small business group. In those cases, the knowledge base, culture, and political strengths of those groups fosters a growth environment for small business. As I mentioned we have seen situations in which just about every organizational model succeeds…or fails.