Inside Financial Services

Welcome to the Golden Age of Small-Business Banking

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Along with 300 or so other attendees, I spent part of last week at the American Banker’s annual small-business banking conference in Phoenix. It’s a very worthwhile event, made all the more so by the fact that not many investor types like me tend to show up. (I think I was the only one this year.) That means IR representatives tend not to come either or, if they do, they keep their guards down. That’s good. I’m always interested to hear what banking executives have to say when they’re not being chaperoned.

This year’s conference was especially timely. Small-business banking is a hugely important market for most banks, especially now. It’s a large income contributor (a number of banks that spoke said small business accounts for 40% of their retail banking earnings). It’s also one of the few segments that’s growing. The bad news, though, is that at most banks the small-business market can be devilishly difficult to serve. It often gets lost between the retail and corporate business, for one thing. Plus, the segment is extremely heterogeneous, so it’s tough to come up with strategies that apply broadly.

My biggest takeaway from the conference is that the banking industry has entered what might be thought of as a golden era for small-business banking. Senior managements have finally discovered how crucial the segment is to their banks’ growth and profitability. What’s more, this is the point in the cycle when lending to small business is the most profitable. But succeeding in the segment won’t be easy.

Here are some highlights of what I heard:

1. Defining the market is difficult. Different banks have different definitions of what counts as a small business. Most use a cut-off in sales, with $10 million and under being the most common. But Peter Carroll, a managing partner at Oliver Wyman, says his firm used a different definition, which had nothing to do with sales, when it did an in-depth study earlier this year. In this case, Oliver Wyman simply defined a small business as one that didn’t have a CFO. Which, when you think about it, makes some sense.

Table 1 shows a Census Department breakdown of the small business by sales, with small business defined by number of employees. Table 2 shows another breakdown, using the Oliver Wyman definition.

Table 1: U.S. Small Business, by Payroll Size
(millions, except where noted)

Number of Employees

No Payroll
< 100 >100



Sales (trillion)

Source: Census Dept.

Table 2: U.S. Small Business
(i.e., those without CFOs)
by Annual Sales

Sales ($)
<100k 100k-250k 250k-500k 500k-1m 1m-2m 2m-5m Portion of Total (%) 34 20 13 12 10 7 Source: Oliver Wyman Regardless of the exact definition, the small-business market includes a huge number of enterprises, the vast majority of which are tiny by any standard. This creates a challenge for banks. Most have responded by further subdividing the market and developing different strategies for each subsegment. I’ll get to the detail in a minute. 2. The small-business market is heterogeneous. Small businesses and their owners tend to be more different from each other than they are than similar, and so are tough to pigeonhole. But small-business owners do have common traits that set them apart from the population at large. They tend to be older, wealthier, and better educated. Here’s some data from the Oliver Wyman study. • 66% of small-business owners are between 45 and 64 years old; • 76% have a bachelors or masters degree; • 74% have household incomes over $75,000. Those might be the sort of numbers you’d expect. But consider these facts, too: • 20% of small-business owners own not just one business, but two or more; • 33% have full- or part-time employment outside the business; • Only one-third rely entirely on the business for their household income. 3. Small-business owners tend to be stable bank customers. Once a small business is established, it tends to be established. The Oliver Wyman survey did not include any business that had been operating for less than a year. Even so, consider that • 81% of small businesses were started by their current owners (another 4% were inherited); • 84% have been in business for 5 or more years (35% for 20 or more years); • Only 11% planned to sell or close in the next 3-5 years 4. The profitability of small business banking is driven by deposits, not loans. Oliver Wyman’s data is consistent with similar studies I’ve seen from First Manhattan and Novantas. Over the full economic cycle, two-thirds of small-business economic profits come from the spread earned off of deposits, Wyman estimates. The second-largest profit generator is the merchant-acquiring business. Wyman concludes that there’s little profit to be made through the cycle in direct lending to small business (excluding credit card loans). In fact, only 38% of small businesses have a business loan of any type. 5. The profitability skews of individual businesses are huge. Oliver Wyman’s survey of small businesses included enough questions that it’s possible to make a reasonable estimate as to how profitable a given surveyed enterprise would be to a bank. Again, the data is consistent with what we’ve seen at other firms. Not surprisingly, there’s tremendous variation in the profitability among small businesses, just as there is among retail customers. The highly profitable relationships are spread throughout the size spectrum and industry classification. That said, the bigger the company, the more likely it will be profitable for a bank, but there are simply fewer of them. The sweet spot (measured by profit and number of companies) is in the $2 million-to-$5 million revenue range. Overall, small-business relationships that can be considered very profitable (that is, they provide annual profit greater than $500) make up about 23% of all small-business relationships, while profitable relationships ($0-$500 of annual profit) comprise and 42%, and unprofitable relationships make up 35% of the total, according to Oliver Wyman. 6. Service models and execution are the keys to profitable growth. Banks’ strategies for wooing small business vary widely, probably more so than for any other segment. Some smaller banks just treat all business customers the same. This often results in an over-allocation of expenses to the micro-businesses (less than $1 million in annual sales) or disinterest in the business. Joe Barlow Research reports that the largest banks have a disproportionately high market share of loans to businesses with less than $1 million in revenue, because of their streamlined, credit-card-like underwriting process. In contrast, community banks have a disproportionate share of loans to small businesses with between $1 and $10 million in revenues, largely because of the speed of decision-making and ability to deliver the entire bank, with little product or channel conflict. Some community banks, particularly those with less than $30 billion in assets, have business models wherein the branch manager is the primary small-business banker in the area. However, more community banks segment the market so that, for instance, branch employees are primarily responsible for very small businesses and start-ups (those with less than $500,000 in sales), a sales force is responsible for companies between $500,000 and $2.5 million in revenues, and relationship managers are in charge of customers with $2.5 million to $10 million in annual sales. This tiered approach may be the best model on paper, but it’s difficult to execute, given the silos in banks, incentive structures, and varying reporting requirements. The Golden Era I do believe the industry has entered a Golden Era for small-business banking, but not all banks will profit equally. There are many challenges, including: • Choosing the right business model; • Choosing the right incentive plan; • Ensuring product and delivery channels work together; • Ensuring senior management’s commitment to small business. As an investor, I prefer banks that have historically had a commitment to the small-business market (they don’t have to re-train a bunch of commercial real estate lenders) that are also in the midst of credit recoveries. Some of my favorites are Western Alliance (WAL) and Taylor Capital (TAYC). Small-business banking can be a great opportunity, but it involves the proper matching of resources with potential reward. The winners in this segment in coming years could be very big winners for investors. What do you think? Let me know!

5 Responses to “Welcome to the Golden Age of Small-Business Banking”

  1. JRG

    According to Wyman’s statistics 80% of small businesses are under $1MM in sales and 67%are under $500M in sales. If banks focus on the over $1MM sement( under the assumption where this is where the profitability is) segment the majority of small businesses will be underserved particularly in terms of credit needs. The under 1MM segment is where jobs will be created and this segment needs credit to grow. What will likely happen is over competition for the larger small businesses and banks will end up with 90/10 rule- 10% of the customers make 90% of the profits (similar to the middle market). What needs to happen is a complete rethinking of the small business delivery model and a focus on getting credit to small businesses under $1MM. This is where the need and the opportunity is. The answer may not be with a traditional bank delivery model but with some form of speciality provider.

  2. David Foster

    Tom, what do you think about the role of Business Development Companies as an alternative to banks for small-business and mid-market lending?

  3. whp

    A large and sophisticated buyer value and market segment study done by a major consulting firm and top ten bank in the 1990′s led to the development of a very efficient credit and deposits delivery model. This same study highlighted that there was a very large market for credit that was unprofitable due to the expensive and traditional approaches to underwriting and servicing small business credits. Once this change is made, the small business segment can be a major generator of profits. The credit business model is a derivative or a credit card/factory approach, but has multiple methods for underwriting depending on the type of credit. Not all small business needs can be fit into a credit card.

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