Are returns in traditional middle-market banking peaking? Although the prime-Libor spread remains high, it is expected to decline. And, for most banks, loan volume continues weak.
Today's margins equate to a return on equity of less than 15% after tax for the lending portion of a typical middle-market business unit (although this varies widely by customer.) If we take into account the sale of ancillary services, the typial ROE for the overall business moves up to about 18% to 20%, and higer in the best-performing banks.
But bear in mind that many bank stocks are trading at about 150% to 160% of book value. To support that level of prices, a business earning even a 15% ROE would need to increase earnings sustainably at somewhere between 8% and 9% a year. Alternatively, if a 19% ROE is achieved, the business can buttress the stock price even if it grows at only 3%.
A Hearty Appetite
Are these growth and profitability objectives achievable in the longer term? For those banks offering a diversified product line, they may well be.
The corporate appetite for selected nontraditional services - e.g., risk management (swaps and foreign exchange), structured syndications and private placements, trusts, and advisory - is likely to prove hearty.
Some indication of this forthcoming demand, from at least the upper end of the midle market, is provided by a Goldman Sachs survey of the chief financial officers of bigger firms. The survey reveals that the proportion of bank compensation paid by Fortune 500 companies for nonloan services rose from 35% in late 1991 to 51% in late 1993, while that for the second 500 went from 28% to 44%.
On the other hand, those banks that are primarily loan oriented may have more difficult time reaching growth or ROE targets.
If, as expected, spreads drop, volume would have to rise. But the problem with C&I loan demand is not just cyclical; demand has been in decline for the last decade.
What's more, it is feared that some lenders are beginning to compromise on underwriting standards, which may soon raise risk costs.
Notwithstanding these negatives, we find that a significant minority of banks can sustain a value-enhancing business.
What are the preconditions for meeting customer needs while creating distinctive value for your shareholders?
1. Build an MIS modeling capability that provides the information needed to measure the profitability of the business unit and the customers that compose it.
The resulting profitability data must be risk-adjusted, match-funded, and full-cost-allocated in order to provide actionable insights. The information must also be available in a system that allows for analysis, not just canned reports.
Such systems can now be assembled from PC workstation hardware using data base management software, and this can be done at a fraction of the cost and time needed a few years ago.
2. Use such a system to aggregate customers into market segments - e.g., by industry, sales size, and credit grade.
This analysis will show which segments contain mst of the profitable customers. It will enable the bank to generalize about the formulas that meet the needs of each segment and at the same time produce high ROEs for the bank - i.e., the mix of products, volumes, and pricing that works.
Some segments will be loan driven; others, cash management driven; for still others, the bank will have to adopt a corporate finance orientation, etc.
The various success formulas can be described in ways that are useful to the line, enabling it to know what to emphasize in each segment, and can guide product development efforts - e.g., the addition of more sophisticated "investment banking" type services.
3. Develop plans to upgrade customers who are not yet profitable
Although some 40% to 50% of customers will be adequately profitable, earning the bank ROEs of 20% or more, a substantial proportion of the remainder will be unprofitable.
It is therefore essential that the bank use the knowledge of what separates the profitable from the unprofitable in each segment to develop customer improvement options. Such options break down into roughly four steps: cross-sell, increase volume, price up, and reduce bank risk by obtaining good collateral.
Once again, the insights gleaned from the segmentation analysis can provide calling officers with options appropriate to each segment.
4. Avoid wasting time on those who are not salvageable.
A certain proportion of customers can never be adequately upgraded. The expense dollars and capital devoted to these customers may be better employed elsewhere.
5. Identify and reward those calling officers who actually create shareholder value.
Many institutions still measure calling officer performance in ways that don't necessarily reflect the impact of their work on shareholder welfare.
Though commonly employed, assets, "contribution," and relationships per calling officer are not satisfactory gauges of performance. Some calling officers who manage a lot of assets or customers nevertheless destroy shareholder value, while others who manage fewer assets or customers create substantial value.
A valid measure of performance is one that tells the bank not only whether a calling officer's customers are earning more than the hurdle rate, but also measures the relative importance of his or her overall book of business.
We call this measure NIACC per officer - that is, net income after the appropriate charge has been made for all the needed bank capital.
6. Direct and train underperforming calling officers by helping them to understand and emulate the practices of those colleagues who generate high NIACCs.
The best calling officers are likely to "own" their relationships, delivering to each relevant services at profitable prices. Conversely, the bottom third of officers are probably ineffective at understanding how to meet customer needs and end up with thin-spread loans and poor returns.
Frequently, calling-officer underperformance stems from lack of knowledge about the customer's industry and particular situation. Customers are increasingly demanding that their bank representatives possess such knowledge.
At times, however, a bank's desire to maintain relationship continuity and operate efficiently in a given geography causes it to refrain from realigning personnel by industry segment.
In such cases, it is all the more necessary to provide calling officers with information about the purchasing patterns and costs to serve of the prifitable customers in a given industry.
7. Integrate an understanding of customer profitability and segmentation with other initiatives - e.g., efficiency improvement programs.
Unless this is done, such programs may focus on low-impact areas.
In summary, the middle-market wholesale business can be an attractive one, even when the market environment is not especially favorable. But success must be grounded in the knowledge of segment needs and how each customer impacts bank profitability.
Complete, risk-adjusted profitability data form the basis of the segmentation analysis that determines (1) where to prospect for new business, (2) how to retain good customers, and (3) what steps are needed to upgrade those customers and calling officers who are currently underperforming but need not remain so.