How Banks Can Defend Their Weakened Franchise in Small Business Lending

This article originally appeared on Forbes.com.

Many banks are ambivalent about small and midsize enterprises (SMEs) since the financial crisis drove huge credit losses and prompted restrictive regulatory responses. Large U.S. banks, for instance, make fewer small business loans than a decade ago, forcing small firms to turn to higher-priced alternatives.

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That retrenchment has opened the door to financial technology insurgents in payments (such as Alipay), trade finance (GreenSky) and traditional lending (OnDeck). Private equity funds, pension funds and insurance companies also have stepped up their lending to midsize companies.

Unless banks actively defend and seek to grow the business, they stand to lose a sector that’s important both to bank portfolios—50% to 60% of corporate revenue for banks in Europe, for instance—and to the broader economy. SMEs can offer attractive returns if banks take a more carefully designed, tailored approach.

Some banks are turning the SME sector into a winning proposition by making strategic choices that cluster in four areas:

  • Defining an explicit ambition in serving SMEs;
  • Choosing where to play;
  • Taking a deliberate approach on how to win in each chosen market; and
  • Mobilizing the organization for change.

What’s your ambition?

The fundamental choices in setting one’s ambition lie along two dimensions. First, how restrictive or expansive will a bank be in SME markets. A bank could reduce or expand its exposure overall, make selective investments in current positions, or at the extreme, exit the business altogether.

The second dimension involves the extent of disruption to the current business model. A bank could adapt select elements of the current model and set about improving them, reinvent the model by adding new regions or significant partnerships, or disrupt the model by moving from a branch network to a largely online model.

For both dimensions, it’s useful to ask what the business should look like five years hence and work backward.

Where should you play?

Once a bank has defined its ambition, it is ready to make deliberate choices about customers, products and distribution methods. How should it segment the customer base, and which segments should it emphasize over others? What value propositions should the bank offer to the different segments?

Advanced segmentation starts with decisions concerning whether to apply one focused suite of products to all customers or to pursue tailored strategies for certain segments. One option consists of a broad multiproduct suite across all segments, with standard pricing and a simple distribution setup. Most US community banks, which tend to focus on basic core needs, use this model.

For a second group of banks, it will pay to sharpen the focus and fine-tune the offerings, with a tailored offering for specific segments and a standard offering for most of the rest. Bank of America has targeted medical doctors among its special segments, through new-practice financing, equipment financing and practice sale/purchase expertise.

A third group of banks will go further to segment the entire customer base, with each segment receiving a tailored offering. JPMorgan Chase has taken this tack, specializing in 12 industries.

Banks can also choose a product-centered model in which they differentiate on the strength of the product. Standard Chartered and HSBC, for instance, have chosen to emphasize international trade finance for SME customers that need it.

Each of these four models could be profitable. The danger lies in failing to commit to one main approach and winding up stuck in a middle ground.

How can you win?

Defining what the bank’s ambition will be and where it will compete leads to the next set of choices about how to win with each segment. This requires a clear-eyed assessment of the starting point, as well as the strengths and weaknesses of the bank’s organization and capabilities.

Winning with small local retailers requires a well-defined, easily understood standard offering that covers basic banking needs as well as distributed cash handling. A larger real estate developer, by contrast, requires specialized advice on integrated financing and risk solutions, and values product expertise in areas such as bond origination, derivatives or asset management.

Some banks have been directing their investments accordingly to support clear strategy choices. One Nordic bank, for instance, recently decided to focus its core on larger, complex SMEs. It earmarked investments in centralized, high-touch financial centers with dedicated product specialists, senior relationship managers and dedicated credit teams. It moved very small, simple business customers to a cost-efficient direct online channel that could function with existing call-center infrastructure.

Mobilizing The Organization For Change

Rethinking SME banking will likely require significant changes for many incumbent banks. Winning banks communicate a clear strategy and priorities all the way down through the front line so that everyone understands the business strategy and priorities as well as what new behaviors are expected. They clarify accountabilities—especially among relationship managers, product specialists and the credit organization—and they align performance incentives with the new accountabilities.

SMEs remain a big business for many banks, one that can return to sustained profitability with deliberate, fundamental choices about where to play and how to win. Winning banks will choose their segments and design their offerings carefully, doubling down on the best bets and avoiding the areas where they cannot build a competitive advantage.

Martin Tornes, Niels Peder Nielsen, Joe Fielding and Peter Stumbles are partners in Bain’s Financial Services practice.