Unlocking the potential of commercial banking

RMA Journal, The, April, 2003 by John Walenta

A survey of commercial and middle-market banking practices among small and large financial institutions in North America indicates that many banks and nonbank financials are starting to work hard to differentiate their commercial and middle-market services and their approaches to market.

For many financial institutions, the commercial banking segment (1) historically has garnered far less appreciation or attention from executive management than either the retail or large corporate lines of business. Retail banking has been a cash cow for most banks for much of the past decade. Large corporate--for better or for worse--is more "headline grabbing," whether for mammoth deals during the boom or for equally mammoth credit losses during the bust. Commercial lies somewhere in between, causing neither excitement nor alarm. Many banks do not know quite what to do with it. At the bottom, small-business end, it blurs into retail. At the top end, it blurs into large corporate. Too few banks see it for what it really is--a series of distinct subsegments, each with attractive RAROC (risk-adjusted return on capital) and growth prospects. The net effect of this inattention is that many banks have under-invested--sometimes significantly--in their commercial banking infrastructure, never quite believing in the potential of commercial customers to be a sustainable source of attractive profits with manageable risk.

This internal view has been reinforced by external market conditions as well. To be certain, commercial banking has not been susceptible to the same forces transforming large corporate, such as the disintermediation of credit, convergence of lending and investment banking, and use of credit as a loss leader. Yet, as banks have refined their approaches to large corporate and retail, attention has started to shift to the small-business, commercial, and middle-market segments. Commercial can be an attractive business but--and this is the key point--not as currently configured. Only by applying the same management rigor that has been seen in other, higher-profile lines of business can the inherent profit potential be realized.

A survey of commercial and middle-marker banking practices in North America recently completed by Oliver, Wyman & Company revealed that, despite its reputation as being an unexciting, undifferentiated segment of the financial services industry, many banks and nonbank financials are starting to work hard to differentiate their commercial and middle-market services and their approaches to market. Within banks, the greatest amount of optimization activity has occurred around the two boundaries where commercial meets small business and where upper-middle-market meets corporate.

* Many financial institutions have been able to generate--on a sustained basis--above-hurdle-rare risk-adjusted returns on capital of around 15-20% and cost-to-income performance in the 3040% range. This sector has also provided good opportunities for significant earnings growth as basic deposit and loan balances have increased annually in the mid to high single digits for much of the past decade.

* Banks are working aggressively to reduce cost-to-service for lower-end commercial accounts through standardized product offerings and streamlined credit processes that allow account loads to increase dramatically-sometimes to as many as 400 names per relationship manager. Many customers actually prefer this simpler coverage approach, while those who require a more customized or personal service proposition are given that option--only appropriately priced.

* Efforts to serve growing upper-middle-market companies better have been confined largely to creating dedicated capital market SWAT teams that identify opportunities for derivatives, M&A, equity, and fixed-income offerings. As companies grow in size, stand-alone lending returns start to come under increased pressure, making effective cross-sell in the upper middle market almost as important as in large corporate.

* Effective and efficient credit processes provide one of the most important levers for sustaining solid returns: the best-performing financial institutions are able to limit expected loss (EL) charges to between 40-60 bps.

* Regardless of specific segment strategies and tactics, the best-performing commercial businesses can achieve superior returns by moving toward best-of-market practice along the three dimensions of relationship management productivity, pricing, and cost efficiency.

Business Models and Strategies

Oliver, Wyman has identified five basic business models, or approaches to market, employed by banks or nonbank financials competing for commercial business customers:

1. Credit led.

2. Super-community

3. Super-regional multi-product.

4. Asset based.

5. Structured credit.

The core principles of each approach are shown in Figure 1.

The traditional full-service banks and their nimble counterparts, the super-community banks, have considerable overlap in their basic strategies but with important distinctions. The super-community banks tend to have a more limited product suite and rely on a distributed front-office model, with as many back-office functions as possible consolidated and streamlined for efficiency. Some super-community banks, like Fifth Third and BB&T, have grown significantly through acquisition and have become quite adept at expense reduction while retaining the benefits of a strong local branch presence. Full-service banks, composed of the larger U.S. regionals and the Canadian Schedule I's, offer the broadest array of products, although cash management, forex, and derivatives typically constitute the mainstay of their offerings.