When General Electric Capital Corp. acquired ITT Corp.'s small-business finance group last year, it was obeying the same basic instinct as most of its nonbank peers: follow the money.

"Small business is the fastest-growing, most dynamic segment of the economy now," said Michael J. Pilot, president of the St. Louis-based unit, now known as GE Capital Small Business Finance Corp.

Across the country, nonbanks are making large bets - in the form of capital, acquisitions, products, and people - to get a piece of commercial banks' small-business niche. Increasingly, when small-business bankers confront competition, its from the GEs and Merrill Lynches.

And while the banking industry still holds the bulk of the small- business market, it would ignore the surging nonbank competition at its own peril - as its history of losing market share in large commercial lending attests.

"I don't see the nonbanks in the direct competition much just yet, but I see them coming over the hill and charging toward us," said Ronald Hance, vice president and manager of Los Angeles-based Union Bank's small-business program.

Mr. Pilot says he has big plans for the GE Capital division. By the end of 1996, he intends to double its number of sales offices to 80; become a preferred SBA lender in 40 markets - up from four; and crank out $250 million in loans. The unit ended 1995 with a loan portfolio of about $750 million.

Moreover, the unit also can be a potent cross-seller by offering products such as credit cards, leasing, and retirement planning from other parts of GE Capital.

Other threats abound, and bankers know it.

A soon-to-be-released survey by the Consumer Bankers Association concluded that 58% of respondents considered Merrill Lynch & Co. to be their third biggest competitor for small business, after regional and community banks.

And while small-business banking is a growth industry, Merrill's sights are on existing bank customers.

"Most of the growth we expect to experience is going to come from taking it from someone else," said Merrill's Peter Stanton, first vice president of Merrill Lynch Business Financial Services.

According to a 1995 Federal Reserve study, based on a 1993 survey of 5,300 small businesses, 37% of the companies obtained credit lines, loans, and leases from commercial banks. Meanwhile, 19% received funding from nonbanks such as finance companies, leasing companies, and brokerage firms.

"The nonbanks aren't big players in small business now, but ultimately they could be," said Cynthia Glassman, managing director of Furash & Co., a Washington-based consulting firm.

John Timmer, a senior vice president for First Chicago NBD Corp., said although other banks provide most of the competition for small businesses in the Chicago area, Merrill has made a mark.

"Merrill Lynch has made a big push," Mr. Timmer said. "They are the ones you run into the most."

Merrill entered the small-business arena to capture more of its clients' wealth, observers said. Many of the entrepreneurs it targets run the more established and profitable businesses - in some cases, ones that banks helped get off the ground.

"Merrill sure knows who our best customers are," said Robert M. Kottler, senior vice president of New Orleans-based Hibernia National Bank. "I've watched our loan payouts. There's not a large number that go to Merrill, but the ones that do are generally older companies that are more stable and have more cash."

Mr. Stanton declined to comment on the specifics of the New York firm's program, but he credited part of its success to an approach he considers more flexible than that of many banks.

"We try to stand back and look at the individual that's running a small business and ask 'What are your goals,' and find out their needs and see if we in fact can help," he said. The Merrill representative "doesn't care too much about any one product. There's not someone who's in charge of loans and all they care about is loans. Our person thinks, 'I have clients who need things.'"

Mr. Stanton said he saw at least two factors for small business defections to nonbanks.

Because of changes in the market, banks are no longer the sole source of credit for companies, he said.

"Financing has become more and more of a commodity," he said. "Small businesses can shop a transaction for a deal and not worry about it being the be-all, end-all of a relationship."

Indeed, the country's largest SBA lender isn't even a bank; it's The Money Store, a Sacramento, Calif.-based finance company that cranked out $403 million SBA loans last year.

Ominously, The Money Store may at some point employ its sizable retail network to expand its offerings to nongovernment-guaranteed lending, said Paul Leliakov, president of The Money Store Investment Corp., the company's SBA lending subsidiary.

"I think we could be competitive in the right niche at the right time in expanding our small-business activity," Mr. Leliakov said.

Mr. Stanton also said banks have lacked creativity in competing for small businesses.

"Banks have decided that the best way to make money off of small businesses is the interest-free checking accounts in lieu of charging fees," he said. "Banks can compete very effectively with nonbanks. They should be working harder on cash management and sweep vehicles."

But Mr. Stanton conceded that banks aren't standing still. Since the early 1990s, some of the large banks have been attempting to streamline lending processes and expand the range of products and services offered to small businesses.

"The bigger banks either are centralizing or have centralized their small-business lending," said Charles B. Wendel, president of New York- based Financial Institutions Consulting. "They're looking at it more like a credit card."

By use of credit scoring, some banks have been able to directly solicit loans by mail, Mr. Wendel said. Wells Fargo Bank's nationwide program, kicked off last year, is the most notable example.

But banks still have a long way to go, Mr. Wendel said.

"What banks have almost uniformly missed is grabbing as much of their customers' business as they could," Mr. Wendel said. "I have grave doubts that many banks are taking full advantage of cross-selling opportunities."

Banc One Corp., Columbus, Ohio, currently is in the midst of such a transformation. The $88.4 billion-asset company said it plans to establish companywide small business-loan practices. It's been using credit scoring since 1994 and has been adding 401(k) and cash management products to the small-business effort, said William L. Parsons, vice president of Bank One, Columbus.

Some banks have been learning from the example of their nondepository rivals. Mr. Kottler said $7.4-billion Hibernia, one of the most progressive small business-niche banks, is designing a credit card to meet the growth of small business cards offered by nonbanks such as American Express and Visa.

"There's a new wave of business credit cards that can take a lot of a bank's bread-and-butter business," he said. "Why would you come in for a small loan if you have one of those credit cards?"

But not all banks hear the footsteps of nonbanks behind them.

A Norwest Corp. spokesman maintained that many of its customers enjoy the personal relationship with the bank, and would be reluctant to begin one with an upstart nonbank.

"From our perspective, we do not see a tremendous amount of competition from the nontraditional providers like Merrill Lynch, or the Money Store, or Wells Fargo," said James B. Schmitt, director of business delivery sources for Minneapolis-based Norwest. He added, however, "That may be wishful thinking on our part."

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