Small business is the Rodney Dangerfield of banking - "it don't get no respect." In part this is because many bank information systems don't reveal its importance.
Our analysis shows that small business is responsible for more than 15% of the market capitalization of the banking industry, or around $75 billion. If we add in the contribution of small business owners as consumers, that figure rises to 20%, or $100 billion.
On average, small-business banking earns a return on allocated equity of about 35% to 50%, making it one of the most profitable activities in the industry.
Normally grouped with retail banking, the activity accounts for about 40% to a half of total retail profits. Yet, in many banks, small-business profits are not broken out, and the implicit assumption is that the overwhelming bulk of retail returns come from the consumer. Partly as a result, small business doesn't get the management attention it warrants.
There are several key factors to keep in mind when evaluating the current condition and future of small-business banking:
1. Its contribution to shareholder value is overwhelmingly dominated by deposit activities.
2. Small-business account profitability is highly skewed. This poses problems but also creates opportunities.
3. The profitability and growth potential of the business can be improved through insights derived from improved customer-knowledge.
Deposits dominate loans: About $68 billion of the $75 billion contributed to the industry's market capitalization by small business comes from deposit and cash-management activities. In most institutions, the lending part of small-business banking has marginal economics.
Indeed, the loan ROE at a typical bank currently runs around 10%. Many bankers expect that restructuring the lending function can considerably raise that figure.
Our analysis shows that if the lending process is appropriately rationalized with credit scoring, standardized documentation, centralized servicing and processing, and exceptions-only loan reviews, the typical loan ROE will move up to between 15% and 20%, which will raise the contribution of the lending business to the industry's market capitalization from $7 billion to over $15 billion.
Hence, while worth pursuing, a rationalized small-business lending process will not alter the basic fact that deposit taking is by far the more material aspect of the business. (However, it is important to remember that the potential availability of credit is key to the buying decisions of many small-business customers, even though, for the vast majority of these, the likelihood of drawing down potentially available credit lines is minimal.)
The challenge of profitability skews: The variance of customer returns in small-business banking is wide, though not quite as wide as in consumer banking. The top 20% of small-business customers bring in 90% of income as opposed to 130% in the consumer sector. (About 50% to 60% of consumers lose money for the bank.) Conversely, 30% of all small-business deposit accounts and a whopping 70% of small-business loan accounts generate negative net income after an appropriate charge for capital usage is imposed.
The importance of customer-knowledge: In order to take advantage of these profitability skews, banks must learn more about customers. Knowledge begins with an understanding of current profitability and the behaviors that drive both high or low numbers.
This understanding enables the institution to excel at six fundamental process, thereby increasing customer returns. These processes are:
1. Profitable customer origination.
2. Successful cross-selling of these customers.
3. Effective retention of desirable customers.
4. Efficient turnaround of currently undesirable customers.
5. Continual optimizing of the relationship between the customer's perception of value received and the bank's cost to provide this value.
6. Application of the above five processes to the selection of acquisition targets.
For example, once the bank has put in place reliable numbers on the components of net income after capital charges for each small-business customer, it can improve customer origination (process 1) by:
*Hypothesizing the customer characteristics and behaviors that result in high or low profitability and testing the validity of these hypotheses by reference to the data base that has just been created. This exercise can provide answers to such questions as: To what degree is profitability a function of product usage? And is there a significant correlation between customer standard industrial classification code and return levels?
*Accessing third-party data bases to determine which customer prospects in the general population exhibit the same behaviors as have been empirically shown to result in high profitability internally.
*Targeting these attractive prospects and in many instances formulating "value propositions" - combinations of product features, delivery methods, and pricing alternatives - that will resonate with particular groups. For example, the bank-selection process of, say, a small accounting firm will be materially different from that of a mom and pop grocer.
The bank can improve value-to-cost relationships (process 5) by learning from the data base how small-business customers use delivery channels.
For example, at one bank we studied, the bottom fifth of customers in the small-business profitability distribution accounted for twice the average number of small-business teller transactions in one branch, while, in another, it was the top 20% that transacted disproportionately.
This information should cause branch administration to lengthen wait times in the first type of branch and shorten them in the second, in effect reallocating scarce delivery resources from those unwilling or unable to pay for them and to those whose contribution justifies the delivery expenditure.
In other instances, the new management information system generally will reveal that an inordinate amount of teller traffic is the result of check cashing done by individuals who are not even bank customers but rather employees of small-business firms served by the bank. Here an increase in the value-cost ratio can be achieved by inducing small-business customers to direct-deposit their payrolls - a method that benefits both the bank, by reducing costs, and the firm's employees, by eliminating the need to wait in long teller lines.
We have made an analysis of the potential impact of initiatives similar to these when applied to all six processes. We found that in a representative $35 billion-asset regional institution, such initiatives can increase small-business pretax profits by at least $45 million a year within two to three years - in other words, approximately a doubling of what such a bank would typically earn today.
We have found it useful to characterize banking's progress in effectively utilizing customer knowledge to improve small-business profits as a four-level climb. The key transition is from level 1 to level 2; it depends on developing accurate customer profitability data, calculated using individual customer revenues and costs. Nirvana is level 4, the point at which the institution becomes so attuned to "taking the customer's pulse" that it can launch new products with a materially lower failure rate than its less-advanced counterparts, thereby opening up new vistas for revenue growth.
The climb to level 4 is neither short nor easy. Regardless of the difficulties, however, many of our better banks are already embarked on the journey.
Mr. McCormick is president of First Manhattan Consulting Group, New York.
