Executive Summary: Recent bank performance suggests that lenders need to revise some of their lending practices to small businesses and that relying on a “lending only” approach may be increasingly difficult to justify. However, the extraordinary attractiveness of this segment remains, given the high profit opportunities that the business, the owner, and employees offer a bank.
Last Tuesday’s The Wall Street Journal featured an article titled, “Latest Groans: Small-Business Loans.” The article begins by stating “Missed payments and losses on small-business loans are surging at banks across the country that were so eager to pad their profits that they essentially threw typical underwriting methods out the window.”
Tracking Down the Losses
The article goes on to feature Bank of America’s “Business Credit Express” product, which “promised big loans with little hassle. Among the selling points: entrepreneurs could borrow as much as $100,000 through an unsecured credit line even if they had been in business for just one day.” The reporters state that the bank’s enhanced lending focus resulted from the disparity between its share of U.S. small business bank deposits (22 percent) versus an 8 percent share of loans.
Two comments on the above. When I started my business in 1995, American Express issued me a Platinum Card even though I had only been in business for about one day. They did it based upon my ten-year plus credit history with them. In addition, since the card was for travel and entertainment purposes versus a line of credit, Amex could have refused to authorize a payment if they felt spending was out of hand and demanded repayment each month. They knew my history, and they had controls in place. What Amex did not do was to offer $50,000 unsecured lines to barbers and others who had no real business reason for them. Barclays Bank has also developed a strong and, apparently, profitable focus on start-ups in the UK.
Our point is there was nothing wrong with the concept pursued by BofA; there may have been something very wrong with its execution.
The second comment relates to the gap between deposits and loans. Every analysis we have ever conducted or reviewed points to the deposit-to-loan ratio as a key determinant of SME (small and mid-sized enterprises) profitability. In general, the more deposits the higher the business’s ROE. One senior lender from a major BofA competitor underscored the attractiveness of deposits versus the uncertainty of loans. He said, “If I did not have to make a business loan, I wouldn’t.” His point was that the attractiveness of deposits was so great that he would focus only on deposit generation, if he could. Obviously, many companies do need loans and expect to receive credit, when necessary, in exchange for maintaining their operating accounts at a bank.
That said, BofA’s basic focus on trying to increase loan share to a level anything like its deposit share may have been off the mark. Many of the best small business banks view providing a loan as the cost of admission for more attractive business, which may include commercial and personal deposits, merchant services, personal banking, and wealth management. For most players, lending is not an end in itself.
A Loan-Focused Approach is Appropriate for Only a Few
Those banks that succeed at lending-only have done so after significant investment; they also operate with very disciplined approaches. American Express and Wells Fargo (with its Business Express product) limit their credit offers and focus on customer types with which they are comfortable. For example, over 50 percent of Amex’s small business card holders are professional services microbusinesses.
Amex has developed great credit expertise in that space. Wells has invested millions and years in developing a proprietary credit-scoring system that few, if any, other lenders approach in quality. In addition, risk-based pricing is critical to success in this type of lending; too many banks continue to provide vanilla pricing to targets that are far away from being vanilla in their credit profiles.
Focus on Small Business-Related (Rather Than Loan) Profit Pools
As noted above, for most banks, the profits are in the deposits. In addition, for every dollar of bank profitability generated by small businesses themselves, the owner and employees generate two dollars or more. A McKinsey study estimated that 14 percent of pre-tax financial services profit results from businesses with revenues up to $20 million. The business owner generates another 12 percent while the employees provide yet another 14 percent of profits.
Banks should consider SME banking as a way in to a much broader relationship, one that emphasizes advice and fees rather than loans. In particular, close linkages exist between private banking and wealth management. One analyst report estimates that within North America owners of private businesses represent 85 percent of all Affluents. Similar percentages exist around the world.
Summary Comment
SME banking remains one of the most attractive and profitable areas for banks to pursue. However, senior management must ensure that the entire bank (including areas such as Private Banking, Wealth Management, Cash Management, and Employee Benefits) joins together to develop opportunities in this space. While, for many years, lending has been the “fall-back” product, it has become increasingly dangerous to rely on as a consistent growth engine. We expect that many banks that have not emphasized deposits and cross-sell to the owner as a core focus will suffer profit erosion in the SME space over the next year.