Executive Summary: Increasingly, banks will need to work closely with partners in order to provide current and potential customers competitive business and consumer products. Particularly on the commercial side, however, many banks lack the organization and culture to allow these relationships to thrive. That needs to change.
Banks need to find new avenues for growth. Many revenue growth paths have been cut off or curtailed: “free” checking (usually a misnomer) has been curtailed; credit card and debit fees are under continued attack; mortgage activity is down.
Reduced revenues likely.
A Bloomberg Business Week article published this week entitled “Shrinking Bank Revenue Signals Decade of ‘Worst’ Growth” summarizes the challenging environment banks face: “Revenue so far this year [for the six largest banks] is down by 4.1 percent.” The article goes on to quote a banking analyst stating, “Next year will start off a decade that will bring the ‘worst revenue growth’ for U.S. banks in 80 years.”
Commercial banking activity is part of the revenue problem at many banks. Due in part both to more restrained lenders and more cautious borrowers, commercial real estate (CRE) lending, once the driver of asset growth at many banks, has been severely curtailed. Many community and regional banks over-concentrated their efforts in this area. The recession resulted in the poor operating performance of these loans and, subsequently, regulatory insistence that banks diversify their asset mix.
As discussed in earlier newsletters (see our website at ficinc.com), with consumer banking activities less buoyant and CRE lending down, banks are increasingly turning to commercial and industrial (C&I) lending. However, in pursuing C&I, many banks limit their marketing focus, since they operate with a product and capability gap versus the needs of the small and mid-sized segment (SME).
Opportunities exist.
A recently published report by Ftrans, a company that assists banks in managing their working capital loan programs, quantified the potential market opportunity in the $1-$25 million revenue company space. First, it is worth noting that almost 50 percent of SME companies are non-borrowers. (More on the opportunity with that group next time.)
Their analysis estimates that banks pursuing only unsecured working capital borrowers are aiming at just 15 percent of the total market. At least the same number of targets consists of companies that require some degree of asset monitoring to support a loan. However, many banks avoid this type of lending because of insufficient knowledge and/or lending appetite. This is where working with a third-party can be invaluable.
The role of third parties.
Bankers routinely work with third-parties in areas such as treasury services or investment management. For example, today, no bank, other than the very largest would consider launching its own mobile banking application or mutual fund. Working with third parties is a natural element of serving customers with competitive products. Nonetheless, working with third parties related to lending activities remains relatively unusual.
Why? We think there are at least three factors impacting the reluctance of commercial bankers to team up with outside firms:
1. Insularity. Many commercial bankers view themselves as experts about customers and their related needs. Period. They prefer to ignore those C&I customers who do not fit into their comfort zone. That may be understandable, but it limits revenue opportunities.
2. History. Every senior banker can recount a story featuring the failure of a third-party initiative. That past failure serves as a strong excuse for not revisiting the use of outside vendors.
3. Insufficient understanding of the economic opportunity. Banks do not understand how much money they may be leaving on the table by failing to pursue non-traditional clients. Until recently, little reason has existed for them to consider this somewhat unchartered territory.
Banks need to consider going beyond CRE and unsecured C&I lending to provide clients and targets with financing solutions that may include leasing, asset based finance, receivables discounting, and/or factoring, among other areas. One challenge is that, individually, no one of these areas may “move the needle” on the bottom line. However, as a group these products may be able to favorably impact the bottom line.
Given the current slow growth environment, banks should consider developing an “alternative financing” unit that targets customers requiring what Ftrans terms a “lightly monitored” or asset based lending approach. Leveraging the relationships within the bank, this unit can focus on reaching targets with the assistance of specialist firms, potentially allowing a bank to extend its lending reach beyond low growth segments to ones that are growing, need financing, and are willing to pay higher spreads.
Obviously, with that opportunity comes higher risk. However, much of that risk can be mitigated through third-parties. Some outsourcers may assume the risk and simply pay a fee to the bank for origination; others may share risk and provide the systems required to track performance and anticipate changes. Virtually across the entire loan “business system” – origination, underwriting, monitoring, collections, asset recovery – excellent third parties players operate.
Bank risk management leadership needs to be fully involved in this evaluation process. Many risk managers, already gun shy from the recent downturn, need to be convinced of the prudence and cultural fit involved in their bank providing what is for them non-traditional financing products. We think the risks can be controlled but, still, this approach will not be appropriate for, or embraced by, all banks.
Concluding thought.
Banks should assess their local market and quantify the economics tied to pursuing loans requiring increased security and structure. If the opportunity is sufficient and the required skill set not in-house, then they should look outside to engage with third parties to capture loans for which the origination process is more complex, underwriting requires a different skill set, loan monitoring demands a close tracking of collateral, and/or collateral recovery capabilities are critical. Particularly today, more customers require these types of structured products. Banks can choose to provide them or risk losing wallet share opportunities as well as potential new income streams.