Executive Summary: One lesson that all banks working in the small or middle markets should have learned by now is that heavy reliance on lending as an earnings or growth engine is both unsustainable and a mistake. Remarkably, despite recent volatility and current trends, many banks still do not get it.
Last week I received the following email from a consulting colleague with whom I have worked in an emerging market on small business issues: “I was doing some work with a(nother) bank in [undisclosed country] recently; we went over the usual SME banking stuff and why it is so important to focus on banking (holistically) and not just lending – all the usual stuff – when they turned round to us and said – ‘no, we’re too small to do that and compete with the other banks, so we want instead to adopt a ‘mono-product’ approach’ (for which read ‘credit’ only).”
My colleague went on to write that basically he thought this approach was wrongheaded, but he wanted to check out our experience, particularly in the U.S. Not surprisingly, FIC’s view is aligned with my colleague’s. But, we also suspect that while most U.S. bankers are saying the right things related to the need to develop a solutions-based relationship, in fact, the reality is that most bankers are comfortable leading with and emphasizing lending and not much else.
Credit-only cannot work. There are multiple reasons why a credit-only approach in the small and middle markets is both impractical and dangerous as a winning strategy for the long-term.
* The demand may not exist. Last week, Wells Fargo’s head said that his bank was finding it difficult to find qualified and interested business borrowers. In today’s economy many businesses are operating as if in a crunch, making sure they have the wherewithal to manage through what remains an unpredictable operating environment.
* Cycles happen. Many bad credit decisions were made in recent years. However, in addition, “uncontrollable” variables further impacted credit quality. For example, the economies of the “sand states” dropped like a rocket, and few banks avoided huge increases in loan losses. Banks that rode the commercial real estate (CRE) cycle up also rode it down.
* Lending is not a consistent growth business. As the CRE and residential real estate downturns illustrate, predicating growth on lending alone is not a sustainable strategy.
* Lending margins require a low cost and stable funding source. In order to lend with success, underwriting excellence needs to be matched with attractively priced funding sources. Banks need DDA customers and other low cost funding sources rather than hot money and broker dollars. Effective lenders need to put at least an equal effort into deposit-gathering as they do into lending.
* Capital needs are high, given the cyclical nature of lending. Lenders need higher capital than banks with a more diverse product platform because of many of the challenges listed above.
* “Small” means diversity may be even more critical. The fact that the client mentioned is, in effect, a community bank points even more strongly to the need for some diversification and an emphasis on fee-based businesses. Small players usually have less of the capital and liquidity cushion required to withstand a downturn.
Lending only can work, but… Two major approaches exist for the lending-only player. Both probably require the capabilities of a larger company and neither provides a sure path to success.
1. Expertise. The lending-only route can work if a lender possesses a strong focus on a specific capability and/or industry knowledge. For example, equipment finance is one area that remains largely loan focused. These specialist lenders know the ins and outs of trucking, aviation, or other equipment financing. Even with their expertise, however, many have suffered from the decline in the overall economy. Increasingly, these lenders are linking up with banks, for the funding, capital and customer cross-sell opportunities they provide.
2. Sale of risk. Investment banks thrive based on their ability to package and sell off risk, keeping little if any for their own portfolio. However, the market for this type of offer has declined in the face of the downturn and regulatory and market pressures are pushing these banks to retain more of the risk rather than “stuffing” the investors. To the extent this opportunity exists, larger players with strong capital positions will probably control it.
The lending bias still exists. The lender quoted above was honest in stating his business preference; many in the U.S. are not. Old style lenders continue to dominate the ranks of many small business and middle market groups. Oftentimes, they are uncomfortable with selling fee-based businesses. Many appear to believe the only way they can distinguish themselves is by offering a loan; they fail to require the DDA/operating accounts of the business and owner as well as proactively introducing other parts of the bank to their customers.
The senior management of these banks needs to be considerably more aggressive in demanding a non-lending emphasis. Frankly, in many cases the business line head and many of the staff will need to be replaced to make this transition. Otherwise, excuses and stonewalling may inhibit change.
Concluding thought. As I wrote to my colleague, given the focus of some of the banking industry’s best players, this emerging market’s bank has articulated an intriguing and counterintuitive concept. However, I just do not see how it works whether in the emerging or more developed markets. Banks need to take the hard, but ultimately more rewarding, route of using lending as a way in to a broader relationship, limiting reliance on a product with high inherent volatility.