At most banks the state of the small business banking they offer, that is, their ability and willingness to serve the needs of small companies, is at its nadir. Despite all the hype from banks about how they support small businesses, the reality is substantially different.

What’s happened to bring banking to this low point with what should be one of its major target segments?

1. Deposit values are down. The majority of small businesses are not borrowers, and balances have long driven the total profitability of a bank’s small business portfolio. With the value of those deposits reduced substantially, so too has the attractiveness of the segment dropped.

2. Companies have reduced their borrowings. Many small businesses remain concerned about the slow growth economy and have reduced their growth plans and borrowing needs. In many cases banks are targeting this group of conservative borrowers with the same lending offers, leading to an oversupply of funds for certain customers.

3. Banks have narrowed their credit box too tightly. The November Inc. magazine features an article titled, “After the Squeeze” that details how banks have abandoned this customer set. It reports, “From 2008 to 2010 the volume of business loans dropped some 22 percent. In cash terms, commercial lending experienced a $325 billion decline over those two years; the volume of small business loans (generally defined as loans of less than $1 million) fell by $26 billion, and then kept falling. By June 2012, small business loans were down $56 billion from their June 2008 peak of $336.4 billion.”

Whether fairly or unfairly, the article presents examples featuring Charter One (Citizens), PNC, and People’s United as banks that turned down current customers’ lending needs and caused them to scurry to find replacement banks. In one case Charter One was reported to have remarketed to a company it had previously turned out of the bank. That does not work. I remember being a young Citibanker calling on a list of marketing names I had been give. One target whom I called remembered being declined by Citibank decades earlier, and quickly hung up.

4. The death of innovation. The only innovation occurring at most banks involves the application of technology in a lemming like fashion by one bank after another. This is good news for technology firms and IT consultants, but in most cases it is unlikely to move the dial in revenues or customer service. For example, many banks now talk about what could be a breakthrough area, namely, the need and opportunity to link the business owner and the business in the bank’s offer; few banks do so effectively.

5. The organization remains broken. Banks that lump in the smallest businesses (say $0-2 million in revenues) with their overall small business effort (often up to $10 million in revenues) are ensuring that they fail in selling and servicing lower end customers. Banks that lump in the smallest companies with the branches and expect branch personnel to sell and serve this segment are similarly condemning themselves to failure. One large bank I spoke with recently acknowledged that their organizational approach was ineffective. However, that senior manager commented that no internal will existed to change how the bank was organized toward this segment despite the need to do so.

6. Regulators are making the situation worse. It was Ben Bernanke who said that banks should lend more to small businesses but that they should do so safely. The banks view regulators as giving mixed messages. In fact, if anything, regulatory actions result in the banks becoming even more risk adverse in their business lending. No upside exists for a bank to “stretch” its lending parameters when it has the government looking over its shoulder more closely than ever.

Implications.

The fact is that the reticence and ineffectiveness of most banks in this space creates an opportunity for many regional and community banks. To exploit this opportunity in many cases they need to bring in new hires who are knowledgeable in areas where they currently lack skills, for example, working capital lending and, perhaps even more critically, sales. Only a handful of banks have the resources and the management leadership to travel this path.

One other major implication centers on the opportunity the banks’ failure to serve the business constituency provides nonbanks. Whether companies like Wal-Mart, factors, merchant advance firms, check cashers or other “alternative” players, tremendous growth opportunities are available to these niche concerns.

At most banks focusing on strategy has lost out to compliance concerns and technology management. Increasingly, the needs of the customer are becoming an afterthought. Banks should not be surprised if customers believe that they simply do not care.