Providing financial services to small and midsize enterprises demands approaches that address the sharp contrast between these two markets and the potential profitability of each for banks and nonbanks.

In recent years the small-business market has become a major growth engine for financial services providers. At the same time, we believe that for many banks the middle market has entered a long period of systemic decline.

The appeal of the small-business segment rests on several factors, the first being its size. If they are defined as having revenues of $1 million or less, small businesses constitute more than 95% of U.S. companies, numbering more than 10 million. Second, branch profitability analysis reveals that a substantial portion of balances - for some branches, the majority - come from small-business accounts. Third, and perhaps most important, small business can deliver very attractive profits. One Northeast bank we know stated that its small-business-related return on equity for the first three quarters of this year was 70%. While that is an extraordinary performance, many banks can generate ROEs well above 20%.

We regularly hear from our bank clients that small business is one of the top two or three growth areas. Though five to 10 years ago it was submerged within the overall retail or commercial sector, today it is becoming a central focus.

The middle market

While banks and nonbanks continue to invest in the small-business segment, banks addressing the middle market face many challenges related to the sustainability of current performance. (The term "core middle market" typically describes companies with from $10 million of revenue up to the hundreds of millions.)

Why has this become a difficult business for banks? First, the cost to serve is high. Many banks are struggling to maintain middle-market-related return on equity in the 12% to 15% range. Too often, relationship managers are handling roughly the same number of accounts today that they did five years ago; technology has had marginal impact at best. This situation would be acceptable if individual account product sales and net income were on the rise.

For all the management talk of cross-selling, however, relatively few banks have improved their wallet share with this group. Middle-market companies are being targeted by direct selling from insurers, retirement specialists, and investment banks, making cross-selling difficult. For every Chase bank with a deep emphasis on cross-selling, there are many other banks that still focus on credit rather than an overall relationship.

Second, this is a small segment. There are fewer than 150,000 companies with revenues of $10 million to $250 million. Of that total, almost half have revenues of $10 million to $25 million. We think marketing responsibilities for that lower-end middle-market group will increasingly become the responsibility of small-business managers, because their approach has worked. The migration of smaller middle-market names to business banking will shrink the potential playing field for banks.

Third, the core loan product has become a commodity, subject to commodity pricing. Unless a middle-market lender has a strong industry specialty or focuses on structured or asset-based loans, it will have a very hard time getting strong returns. At the same time, the middle market has become much more sophisticated in cash management techniques, reducing the returns from deposit accounts.

Issues and obstacles

The issues facing these two segments are complex. They include:

Reduced small-business loan growth. Banks and nonbanks have been aggressive in providing credit offers to small businesses. Small businesses receive frequent solicitations from national players such as American Express, Citibank, CapitalOne, and FleetBoston, among other lenders and lessors. At the same time, more community banks and even credit unions are eager to make small-business loans. Several new small-business-loan Web sites have further increased lending options.

And though a lot of money is available, many attractive small businesses are still reluctant to borrow. Recent surveys of such companies point to owners' concerns about an economic slowdown and their emerging tendency to reduce capital investments and credit requirements.

Lenders hoping for continued growth may find that many of their takers are marginal credits. We have already heard of quality problems related to loans generated through nontraditional channels. In the past year some banks and nonbanks may have been too aggressive on the lending side, and may feel repercussions in the next 12 to 18 months. To avoid such problems, lenders will depend more on segmentation in targeting customers.

Frustration with the online channel. For many banks, Internet access is simply an additional cost of doing business. Tracking the cost of providing online capabilities is relatively straightforward; tracking revenue gains is not. Expecting the Web to generate new revenues or to reduce transaction costs may be unrealistic.

There is no doubt that the number of online customers will increase sharply over the next few years. But most will use the Internet in a very limited way. Sales of financial products will largely remain a branch business or a person-to-person business.

The importance of electronic bill payment and presentment. While the online channel may be frustrating, leveraging it effectively with small and midsize enterprises is critical. One major emerging growth area may involve enhanced bill presentment capabilities. Banks such as Wells Fargo, Citibank, and Bank of America have demonstrated a willingness to invest in this area.

Increased competition. In recent months Morgan Stanley, Lehman Brothers, and Smith Barney have all shown interest in the small-business market. As Merrill Lynch's marketing philosophy demonstrates, banks should expect the brokers to try to take the cream deposit accounts away. Moreover, the investment banks' highly centralized credit underwriting and processing may give them a cost advantage in that area.

Fewer banks serving the middle market. In the past year several banks have paid less attention to the core middle market. Some have combined middle-market operations with their merchant or investment banking sales programs, and others have shifted some part of the middle market to the small-business category.

More banks are finally taking a hard look at the cost structure involved in serving this segment. Reengineering exercises will improve some groups' returns. Other banks will be unwilling or unable to restructure their groups to make them more profitable. The net result will either be fewer players in the middle market or, at the very least, more selectivity in targeting and product offerings.

Editor's note: Mr. Wendel will delve deeper into this topic in three subsequent columns.

Mr. Wendel is president of Financial Institutions Consulting, New York.

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