During the past few years, changes in the financial services industry have put increased pressure on profits banks earn from the small-business segment.

Lower interest rates have led to shrinking margins in loans and deposits to small businesses, commonly defined as companies with less than $5 million in revenues. Competition for their business has precipitated a decline in both absolute spreads and loan quality. Those products that banks can cross-sell to this market segment, such as cash management, also have suffered fee declines in the face of competition and customers who are tougher negotiators.

Yet, in spite of a competitive environment and less guarantee of high profits, the top-tier players in small-business banking still earn extraordinary returns on equity. A survey we recently conducted with Robert Morris Associates shows several regional banks with returns on equity in excess of 40% to 50%. What distinguishes these companies from the laggards and mediocre performers?

Product standardization, centralized underwriting, and streamlined internal processes are important foundations for generating high returns. How to get the most benefit from each of these areas merits focus by bank management. Another critical area that receives less attention is product and relationship profitability and its key role in sustaining small- business success.

The top players in small-business banking have taken a lesson from their corporate and investment banking colleagues. These banks have refined their approach in order to understand the key drivers of both product and relationship profitability. This approach requires a strong understanding of the costs associated with risk and how these costs should be allocated across the small-business customer base, where product and relationship profitability are driven by the disparate risks generated by different customer types.

Unlike the easily quantified expenses of maintaining and staffing branches and small-business offices, most expenses associated with risk remain hidden within the small-business profit-and-loss statement and the balance sheet.

The greatest variability - and potentially the greatest danger to the bottom line - arises from the differences in credit risk. When all the shouting about cross-selling and reengineering is over, high credit quality remains essential for strong account performance. While some level of customer risk is captured in most small-business banks through a risk grading system, very few banks actively use these grades to allocate the full cost of risk across their customer base.

Each time a loan payment is past due 30 to 60 days, the offending company eats as much as 10 hours of a relationship manager's or workout officer's month, equivalent to thousands of dollars in salary and other costs on a yearly basis. Further, the related opportunity cost is huge if the manager is unable to call on profitable customers or high priority targets. As a loan moves from performing to nonperforming status, collections and workout costs can easily exceed the net interest margin and turn the loan into a profit eater.

Additionally, loan-loss provision rates, equity requirements, and reserve requirements increase exponentially with the deterioration of credit quality. This combination of expenses lowers net income and increases the hurdle rate required to cover the cost of equity.

Of course, higher expenses also can be redeemed through higher fee income. Traditionally, many small-business lenders will discount the price of a loan to capture a company's personal, deposit, and cash management business. However, poor profits can result from depending upon the profitability of the overall relationship rather than demanding that the loan product meet stringent hurdles. For most banks relationship building still remains a distant and illusory goal rather than a current reality.

Mr. Wendel is president of Financial Institutions Consulting Inc., New York. Jennifer McCabe, an associate, contributed to this article.

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