36

The Future of Retail Banking

Rebounding in Small Business Banking

Small business banking is at a crossroads. The financial crisis exposed weaknesses across a number of core capabilities in the space, leading to unprecedented losses. Unsurprisingly, banks retrenched, virtually shutting down small business lending. While these events have shaken the industry, small business banking will recover, and winners will emerge. This is a rich and under-penetrated market, and banks that are willing to invest in delivering credit, stability and a positive customer experience stand to gain significant share. Small businesses have always been a critical part of the U.S. economy, with an estimated 34 million in the country today. On average, small businesses are more profitable for banks than the average retail customer, as they often have a steady stream of deposits and many require consistent access to credit. An estimated 30 percent of total pre-tax profit from U.S. financial services is related to small business, with 10 percent coming from small businesses, themselves, another 10 percent coming from small business owners, and the final 10 percent coming from small business employees. While the latter two segments are often ignored, they are critical to capturoptimism is growing, ing the full value of the small business opportunity. As recent events have demonstrated, however, the nature of small businesses makes them highly susceptible to broader economic changes. The financial crisis hit this sector especially hard, with approximately 50 percent more small businesses declaring bankruptcy in 2008 than in 2007. Uncertainty continues to limit small business investment. These difficulties extend, of course, to banks serving small businesses. Revenues and profits shrunk from peak levels in 2007 to barely break-even in 2009 (Exhibit 1). While this is primarily due to credit losses, tightening spreads have also reduced overall deposit profitability. Banks are seeing not only the highest charge-off levels in a decade, but also declining balance growth, as underwriting standards get stricter and fewer small businesses apply for credit. The low point for small business banking profits was likely 2009, with losses reaching

While uncertainty continues to limit small business investment.

Rebounding in Small Business Banking

37

nearly $25 billion (or 6 percent of loans outstanding), and most banks struggling to break even within their small business franchise. The small business cards market has also been under siege, paying now for the higher credit limits and relaxed underwriting standards of the boom years. Some institutions have been shuttered due to heavy losses (e.g., Advanta); other major small business card issuers have significantly slowed underwriting. Despite the challenging environment, the upheaval in the small business banking space has created opportunities. Small businesses have historically been an under-served segment, and several large players have slowed their customer acquisition rates and cut back on their small business offerings. Customers are likely to flock to banks that can provide the credit and services they need. And while there has never been a clear market leader in small business banking (the top 10 small business lenders have only 30 percent of total loan volume), the current uncertainty provides the perfect window for focused institutions to gain share. Banks should be cognizant, however, that not all small business segments will recover at the same rate. Pockets of opportunity will begin to emerge, and banks should be prepared to take advantage selectively.

Exhibit 1

Small business banking profit pools

Small business and business banking profit pool historical and forecast (2007 2013E)1 $ billion
39 2007 31 2008 2009E 2010E 2011E 2012E 2013E

Deposit profitability
26 23

Loan profitability
26 22 9 5

15 2007 8 2 2007
1

2008

2009E 2010E 2011E 2012E 2013E

Credit card profitability

4 3

2008 2009E 2010E 2011E 2012E 2013E

2007

2008

2009E 2010E 2011E 2012E 2013E

Small business profit pool estimates include business with < $10 million in annual sales

Source: McKinsey Small Business Profit Pool Model

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The Future of Retail Banking

Trends shaping the recovery

With the thawing of the lending market, and a return to GDP growth, the small business banking market should begin to cautiously recover in 2010 and 2011, and return to higher profitability in early 2012. Recent events have shifted the industry landscape, and three trends will shape the recovery: An underwriting model in flux. In the wake of unprecedented small business losses in lines of credit and cards, underwriting is going through an overhaul. This is likely to both increase cost and slow overall growth, as banks revert to manually underwriting smaller loan sizes in hope of reducing defaults. Score-based approaches have been scaled back (with lower approval limits) and banks are layering in additional attributes and requirements. There will also be a reduced role for small business credit cards and unsecured lending products in the near term, until underwriting models can be trusted again. This will have a particularly hard impact on profitability, as credit cards bring in more revenue and profits than traditional loans or credit lines. Given the expected decline in traditional credit cards, banks are also rethinking the card model and moving to innovative charge-card type offerings, in which balances are either paid off at months end or secured by collateral. While these types of credit products are relatively novel in the United States, countries including Brazil and China have been using non-traditional credit models, such as receivables-backed credit cards, for years. A shifting competitive environment. The small business competitive space is still taking shape following the financial crisis. In todays tight credit environment, business banking customers are more willing to switch primary institutions, and banks that are lending are grabbing share from more conservative peers. At the same time, as banks reshuffle and cut staff, many small business relationship managers (RMs) have switched institutions, often taking their customer relationships with them. The chaotic merger and acquisition activity in late 2007 and 2008 has also led to increased switching propensity among customers of acquired institutions. These dislocations in the market are creating windows of opportunity for proactive banks, which could translate into longer-term advantage. Increased role of government and regulation. There is also still much uncertainty concerning the long-term ramifications of regulatory change for the industry. Further disclosure and reporting requirements are likely to accom-

Rebounding in Small Business Banking

39

pany increased government intervention, which will raise banks cost to serve. Although the ultimate impact of increased government scrutiny is still uncertain, banks will need to closely watch the situation for both opportunities and challenges.

Winning in small business banking

While the credit crisis will leave lasting scars, some banks will emerge as clear winners in small business. To join the ranks of those winning institutions, banks need to quickly address and focus on four critical elements of their business model. Segmentation and coverage As a first step, banks must reexamine how they define the small business segment from the size of the businesses they serve to the coverage and resourcing models they employ. Historically, small business has often been the forgotten step-child, with most large and regional banks rolling the business in with retail and spending limited time and effort understanding customer needs. Moving forward, serving small business should be a well-planned, strategic decision, based on careful analysis of the customer base, in-footprint growth opportunity, cost to serve customers, and the culture of the bank. Segmentation in small business can drive significant value, but needs to be simple and actionable. At the highest level, segmentation and sales coverage should be based on size, as the revenues of a Historically, small business business often dictate the complexity of its banking needs. For instance, smaller small businesses has often been the forgotten tend to behave more like consumers, while larger step-child, with most large and small businesses trend toward more complex regional banks rolling the business product needs, such as cash management.

in with retail and spending limited time and effort understanding customer needs.

Once a bank has executed this top-level segmentation, it can begin to target a small number of sweet-spot industries. The choices will vary by bank, considering footprint and risk profile, but should be based on a thorough evaluation of what segments are most attractive, given the unique profile of the bank. Characteristics such as account/transaction activity, product needs (credit-only versus cash management plus credit), growth potential and industry risk (expected losses, volatil-

40

The Future of Retail Banking

ity) should all be considered. As an example, more than half of small business profit pool revenue is in industries with relatively lower volatility (Exhibit 2). Another important consideration is level of deposits; deposit-rich industries are particularly attractive in todays environment. Through analysis and select industry targeting, banks can construct a balanced customer and product portfolio, thus improving overall returns on the business. Underwriting model Banks must fully reexamine and rebuild their small business underwriting processes and models, both for cards and the broader set of lending products. Getting the underwriting model right is a critical part of restoring confidence and profitability to industry. To drive this end-to-end improvement, banks need to address three key levers. These levers will not only improve the underlying predictive power of their underwriting models, but also reduce the pricing variability and leakage issues that erode bank margins.

Exhibit 2

Average volatility by small business size and industry

Average annual revenue by industry and revenue band Percent of total, $ billion 40 Manufacturing Real estate services 18% 18% 18% Retail sales Agriculture/mining Construction Trans./Comms./Public Utilities Wholesale sales Business services Health/Social services Personal services Professional services 0
Source: McKinsey Small Business Profit Pool Model

Profit Volatility1 < 40% 63 6% 40 50% > 50%

4%

23 10%

20% 2% 9% 2% 4% 12% 6% 7% 15% 1.0 MM 18% 15% 3% 8% 5% 9% 5% 6% 2%

18% 2% 9% 6% 9% 6% 5% 16% Total 3%

1.0 MM

10.0 MM

1 Change in NIBT from 2009 to 2013/Average Revenue of 20092013

Rebounding in Small Business Banking

41

Improve credit process boundaries and design. Prior to rebuilding credit models, banks need to take a hard look at the number and types of models and processes they are using today and where The ability to leverage proprietary they are drawing the chalk lines, or limits, between them. Depending on the volume and size of customer data, and the analytic loans processed, banks may want to employ a skills to exploit the outputs, can mix of pure score, score-plus and manual credit give banks a competitive processes, each with varying predictive power and marginal cost. Deciding where and how to advantage over their peers. use models is a trade-off between efficiency and effectiveness, balancing evaluation cost and timing against potential credit losses and lost profitable accounts. Upgrade data and credit models. Small business lending models often have the lowest Gini coefficient (degree of predictive power) in the banking industry. This can be dramatically improved through the use of enhanced, richer data sets, more frequent refreshing of the model (every two to three years), and the addition of a qualitative credit assessment (see sidebar). With this approach, banks can see increases of between 30 and 35 points in their small business Gini coefficient, which can have a sizeable bottomline impact. For example, improving underwriting models by just one percent (raising the Gini coefficient by a single point) can reduce credit losses by $3 million per year on a $10-billion portfolio (assuming a 2 percent loss

What is a QCA?
In addition to traditional quantitative scoring models, banks can benefit from incorporating a qualitative probability of default (PD) rating model, QCA (qualitative credit assessment), to improve the predictive power of the process. QCAs can be complementary to statistical scoring models or can stand alone. If used correctly, they can be extremely powerful, increasing the Gini coefficient of models by more than 15 to 30 percent. A true QCA approach is a highly standardized qualitative assessment tool with between 15 and 25 questions and a clearly defined and balanced set of answer options. The answer options are designed to be objective and observable, making this process very different from the ad-hoc expert RM/underwriter judgment used by some banks. QCA questions are focused on real risk drivers, such as demographics, market position, company operations and management, and each is assigned a weight based on its relative predictive power. The end result is an effective and efficient PD rating tool that can significantly improve small business underwriting performance without significantly impacting speed or cost.

42

The Future of Retail Banking

rate). Improving the Gini by 20 to 30 points can reduce credit losses by up to $100 million on a $10-billion portfolio. When upgrading models, banks need to move beyond the traditional data sets and incorporate more creative variables, such as industry and sectorspecific inputs and geographic factors, to build maximum differentiation and predictive power. For example, banks could look at recent industry failure rates as a new model input to developing the probability of default (PD) score. On average, small businesses focused on construction had approximately 1.5 times greater business failure rates than those focused on professional services (Exhibit 3). This suggests that banks that identify higher-risk segments and adjust their models accordingly could see lower losses than peers. Additionally, banks should integrate existing customer information into their scoring models, including business owner personal data such as DDA history, savings account balances and credit card usage. The ability to leverage this proprietary customer data and the analytic skills to exploit the outputs can give banks a competitive advantage over their peers.

Exhibit 3

Business failure rates by industry

Indexed failure rates by industry1 Percent of overall failure rate Overall Health and social service Professional services Business services Personal service Agriculture and mining Real estate Wholesale Manufacturing Retail Construction Trans./Comms/Public utilities 67 80 80 80 88 97 100 102 117 119 123 100

1 Average of Dun & Bradstreet and U.S. Census reports Source: Dun & Bradstreet June 2009 U.S. Business Trends report, U.S. Census Bureau 2006 Business Tabulations report, McKinsey analysis

Rebounding in Small Business Banking

43

Make the right offers and reduce leakage. Even when models are correct and generate accurate PD, many banks still have challenges with pricing and offer discipline, with significant inconsistencies across products and RMs. This disparity leaves a considerable amount of money on the table and can often quickly be improved with enhanced pricing tools and analysis and frontline incentives. Accurate pricing requires understanding the drivers of expected loss, which is based on the PD, expected loss given default (LGD) and estimated exposure at default. Correctly estimating LGD is especially critical in lending to small businesses, as they typically have a higher PD, and inaccurate LGD estimates damage profitability by underpricing high risk and overpricing low risk. The recent crisis demonstrated the weaknesses in existing models, and banks now need to revisit and refine those models. Additionally, even when the recommended pricing is correct, many banks have weak offer discipline, creating wide variations in profitability (Exhibit 4). While this can be addressed through strengthened pricing guidelines and realignment of incentives, it may also require a shift in mindset, in which RMs are focused on longer-term profitability implications, as opposed to shorter-term volume targets.

Exhibit 4

Pricing discipline by relationship manager

Actual rate versus target rate (for signed contracts) Percent, N = 60 2 1 0 1 2

Average loan priced 11 basis points below target rate

Average = 0.11%
Source: McKinsey analysis

44

The Future of Retail Banking

Relationship banking Banks must also move away from single-product customers toward a multiproduct, relationship-based approach. This is a large opportunity in the small business segment, as banks can capture not just the small business account, but also the business owners personal account and potentially even employee personal accounts. Business owners represent an additional 10 percent of the financial services profit pool and tend to be much more affluent and profitable than the average retail customer. As we describe in Back to the Future: Rediscovering Relationship Banking (page 56), the relationship banking approach is about more than cross-sell; it is about serving the customer in a more holistic and coordinated manner. Superior service, a high-touch customer experience ability to consider a businesss and multichannel support are all critical to a relationship banking approach. risk across both personal Relationship banking also allows banks to leverage proprietary data about customers to make more informed lending decisions. This drives customers with good credit to do more of their lending business with the bank, as that bank will be able to utilize unique, customer-specific data to create a better offer for the customer. The ability to consider a businesss risk across both personal and professional deposit and lending accounts can result in a 15 to 25 percent increase in approvals, but few banks today have this capacity. Additionally, banks with a cross-product perspective on their customers can offer multi-product approvals, pre-qualifications or product recommendations at the same time, creating more hooks for the customer to bring further business to the bank. Portfolio management and collections Lastly, improving small business portfolio management and collections processes are foundational capabilities that banks cannot afford to ignore. These capabilities are critical as banks emerge from recent heavy losses and will create a sustainable advantage when the cycle turns. Portfolio management and collections should be seen as part of a disciplined approach along with underwriting and credit processes to consistently reviewing and managing loan performance. Portfolio management focuses on identifying changes in a client risk profile and proactively managing that risk to reduce potential losses. Critical activi-

The

and professional deposit and lending accounts can result in a 15 to 25 percent increase in approvals, but few banks today have this capacity.

Rebounding in Small Business Banking

45

ties include creating models to predict changes in industry risk, developing early warning systems that flag high-risk accounts and conducting regular account reviews across the entire portfolio. For example, research has shown that when businesses are in financial distress, they are likely to increase their credit line utilization. One large bank saw average line utilization spikes of 24 percent, 34 percent and 133 percent across three different credit products in the months leading up to customer default. Superior collections practices can also significantly improve loss ratios in small business lending. Small business collections are distinct from consumer and commercial collections and require a dedicated approach that leverages both the personal and individual-driven approach used for consumers and the commercial skills and mindsets that allow collectors to stress-test information and make decisions on a businesss ability to pay. Best practices in small business collections include identifying the right segmentation (based on balance and risk), developing collector load ratios based on account complexity, developing clear and simple tools to guide interactions, and empowering the front line to offer treatments. By establishing dedicated small business delinquency and workout groups, banks can capture significant value that would have otherwise walked out the door. *** Small businesses were hit especially hard by the financial crisis and are still working through the aftermath. But this critical piece of the U.S. economy is poised for resurgence. As small businesses recover, they will look for banks to deliver credit, stability and a positive customer experience. Banks that are willing to invest in improving core capabilities and developing clear strategies about what segments will be most profitable stand to gain sustainable share.

About McKinsey & Company

McKinsey & Company is a management consulting firm that helps many of the worlds leading corporations and organizations address their strategic challenges, from reorganizing for long-term growth to improving business performance and maximizing profitability. For more than 80 years, the firms primary objective has been to serve as an organizations most trusted external advisor on critical issues facing senior management. With consultants in more than 40 countries around the globe, McKinsey advises clients on strategic, operational, organizational and technological issues. McKinseys Consumer & Small Business Banking Practice serves leading North American banks on issues of strategy and growth, operations and technology, marketing and sales, organizational effectiveness, risk management and corporate finance. Our partners and consultants provide expert perspectives on a range of topics including corporate strategy, business model redesign, product and market strategy, distribution and channel management, the impact of financial services regulation and performance improvement. The following McKinsey consultants and experts contributed to this compendium: Whit Alexander Philip Bruno Robert Byrne Liam Caffrey Prasenjit Chakravarti David Chubak Marco De Freitas Benjamin Ellis Daina Graybosch Tommy Jacobs Piotr Kaminski Rami Karjian Akshay Kapoor Catharine Kelly Nick Malik Robert Mau James McKay Howard Moseson Sudip Mukherjee Fritz Nauck Sandra Nudelman Marukel Nunez Pradip Patiath John Patience Greg Phalin Leonardo Rinaldi Pablo Simone Vik Sohoni Dorian Stone Sarah Strauss Ameesh Vakharia Tim Welsh

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