Unlocking the potential of commercial banking

RMA Journal, The, April, 2003 by John Walenta

Although it is possible to be successful by pursuing any one of these approaches, each model has its particular challenges. The main point is that each strategy is fundamentally defined along two dimensions: product breadth and risk appetite. A credit-led approach, for example, is one that by definition relies on the loan product to generate revenue with little or no support from other cross-sell products. This may be one of the most difficult strategies to pursue, because it fails to capitalize on the vast array of financial products and services that even small businesses require. It also leaves a bank to compete primarily on the price of credit and perhaps a high-touch service proposition supported by expensive relationship managers handling a modest account load.

The primary challenge for banks in this group is to maintain tight controls on expenses and adhere to strict pricing and fee guidelines. In many respects, it is this group of banks that has fallen somewhat short in achieving the full potential of the commercial segment. Although it's true that innovative approaches to small businesses and upper-middle-market companies offer instructive lessons in optimization, no one bank seems to fire on all performance cylinders simultaneously. Therefore, best-practice examples need to be drawn from many different financial institutions, each doing one or two things exceptionally well.

Asset-based lenders continue to maintain, in our estimation, one of the best business models in the commercial segment. Their approach is undoubtedly credit led but is characterized by fully secured facilities, often with credit stories that command higher pricing. Indeed, the sweet spot for most asset-based lenders is with levered companies--up to five times senior debt:cash flow--with credit spreads in the 350-500 bps range. Asset-based lenders do face a higher risk profile than traditional banks, but tighter deal structures, covenants, and much more intensive credit monitoring-including the right of cash domain--coupled with the juicier spreads tend to compensate. Additional success factors include rigorous discipline on pricing, significant investment in up-front credit analysis (including forensic audits and detailed inventory and receivables valuation), and sophisticated understanding of collateral value in the event of liquidation.

The last major business model is employed by mainly nonbank financials that offer a highly structured offering of both senior and subordinated debt, often with strips of private equity or a claim on equity upside through options partially paid in lieu of fees. The better-known names in this field include the old Heller Financial, now part of GE Capital, and smaller boutiques like Madison Capital and Antares Capital, subsidiaries of Massachusetts Life and New York Life, respectively. This is not a segment for the faint of heart, especially given the current dim prospects of takeout options in the IPO market. Fundamentally, success here rests on strict commitment guidelines and rigorous credit processes, both to make initial decisions and to monitor the ongoing progress of the portfolio.