Executive Summary: Lending continues to drive most banks’ focus on the small business segment. Breaking away from that emphasis, while also effectively responding to the role that credit plays, remains a challenge for banks trying to establish or reestablish their effectiveness with small businesses. Banks need to reexamine how and why they lend and focus on day-to-day execution issues.

 

 

In several recent newsletters I have deliberately downplayed the role of lending in the product mix that banks offer their small business clients. One of the main reasons is that many bankers tend to fall into a traditional view of themselves as commercial lenders first and miss the multiple other opportunities that may, in fact, be more important to the customer.

 

Bankers seem to be pulled toward lending as if by a magnet both because of personal preferences and market pressures that ingrain in them an emphasis on lending. As one reader commented, at his bank the prime basis for comparing his performance versus competitors is loan market share. That number is relatively easy to obtain versus small business deposit share or other product statistics.

 

While lending will remain an essential offer to many customers, banks need to realize that the economic attractiveness of small business lending may now be significantly lower today than in recent years. Why?

 

* Good borrowers are harder to find. Today, banks are not going to stretch to approve credits that they might have approved 18 months ago. The “funnel” through which potential deals must pass prior to approval needs to capture more opportunities for, probably, fewer loans. As one banker commented recently, “Who will be so brave as to take a swing at a hard credit?”

 

* The cost of lending has increased and will continue to do so. The need for more capital, higher reserves requirements, fewer good deals, even the lower earnings rate of demand deposits: all these elements support the view that origination and underwriting cost related to all lending, but in particular small business lending, will increase.

 

* Success demands more touch. While the credit scoring of small business loans is hardly going to disappear, more lenders will understandably insist on increased “touching” of small loans. By this I mean that, at least for the foreseeable future, underwriting will be more hands-on and less reliant on scoring technology. The need for more intensive underwriting contributes to the cost issue mentioned above.

 

I recently spoke to one lender who decided to move up in size to larger companies and credits. In his view generating quality small loan volume was increasingly difficult to accomplish, and the available risk premium did not justify the higher costs to originate and higher loss experience.

 

So, if lending remains critical both to a bank’s sense of itself and to a significant customer segment, banks need to develop a rigorous lending execution strategy that includes:

 

* Centralizing lending authority. While many banks have already gone this route, some lenders continue to allow field-based decision authority or the ability to make exceptions. This approach can work but only when the bank has a very strong culture as well as excellent risk management training and procedures. Only a small percentage of banks can execute a decentralized approach without risking major blow-ups.

 

* Centralizing operations. Operational efficiency and consistency will be even more important going forward. Allowing field staff to manage operational issues that could be centralized may negatively affect both cost and quality.

 

* Strengthening risk management. FIC has been leading several projects related to FDIC shared-loss banks, allowing us to review hundreds of loans, both small business and middle market. It should not be a surprise that in most cases the bad loans occurred due to poor underwriting, from either poor policies and/or the bank’s willingness to allow exceptions to them.

 

* “Demanding” cross-sell. Is there any reason for a bank to agree to a loan without also obtaining the demand deposit account of a commercial customer? Is there any reason to make a business loan without at least evaluating the attractiveness of the owner as a customer? Amazingly to me, even today, when so much has been written about the value of cross-sell in general and obtaining a company’s operating account, in particular, many banks fail to capture as much customer wallet share as possible.

 

* Evaluating household profitability. As mentioned, lending alone will be harder to justify on a risk return basis. Lending becomes attractive when it is part of a portfolio of products sold to a business and its owner.

 

* Breaking silos. One of the reasons that cross-sell and householding has not swept banking can be traced to organizational structures and the silos in which banks seem to love to operate. If any economic environment is one in which silos much be destroyed, it is this one. If any segment demands the breaking of internal silos, it is small business. Banks that want to keep their silos should avoid the small business space.

 

Concluding thought. For most banks, lending must play a key part in their small business strategy. However, as Thomas Edison said, “Vision without execution is hallucination.” All signs point to an uneven economy, at best, over the next six-twelve months. Disciplined, rigorous execution has to drive the small business effort.