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By: Joel Pruis Part I – New Application Volume and the Business Banker: Generating small business or business banking applications may be one of the hottest topics in this segment at this time. Loan demand is down and the pool of qualified candidates seems to be down as well. Trust me, I am not going to jump on the easy bandwagon and state that the financial institutions have stopped pursuing small business loan applications. As I work across the country, I have yet to see a financial institution that is not actively pursuing small business loan applications. Loan growth is high on everyone’s priority and it will be for some time. But where have all the applicants gone? Based upon our data, the trend in application volume from 2006 to 2010 is as follows: Chart displays 2010 values: So at face value, we see that actually, overall applications are down (1,032 in 2006 to 982 in 2010) while the largest financial institutions in the study were actually up from 18,616 to 25,427. Furthermore the smallest financial institutions with assets less than $500 million showed a significant increase from 167 to 276. An increase of 65% from the 2006 levels! But before we get too excited, we need to look a little further. When we are talking about increasing application volume we are focusing on applications for new exposure or a new extension of credit and not renewals. The application count in the above chart includes renewals. So let’s take a look at the comparison of New Request Ratio between 2006 and 2010. Chart displays 2010 values: So using this data in combination with the total application count we get the following measurements of new application volume in actual numbers. So once we get under the numbers, we see that the gross application numbers truly don’t tell the whole story. In fact we could classify the change in new application volume as follows: So why did the credit unions and community banks do so well while the rest held steady or dropped significantly? The answer is based upon a few factors: In this blog we are going to focus on the first – Field Resources. The last two factors – Application Requirements and Underwriting Criteria – will be covered in the next two blogs. While they have a significant impact on the application volume and likely are the cause of the application volume shift from 2006 to 2010, each represents a significant discussion that cannot be covered as a mere sub topic. More to come on those two items. Field Resources pursuing Small Business Applications The Business Banker Focus. Focus. Focus. The success of the small business segment depends upon the focus of the field pursuing the applications. As we move up in the asset size of the financial institution we see more dedicated field resources to the Small Business/Business Banking segment. Whether these roles are called business bankers, small business development officers or business banking specialists, the common denominator is that they are dedicated to the small-business/ business banking space. Their goals depend on their performance in this segment and they cannot pursue other avenues to achieve their targets or goals. When we start to review the financial institutions in the less than $20B segment, the use of a dedicated business banker begins to diminish. Marketing segments and/or business development segmentation is blurred at best and the field resource is better characterized as a Commercial Lender or Commercial Relationship Manager. The Commercial Lender is tasked with addressing the business lending needs across a particular region. Goals are based upon total dollars generated and there is no restriction outside of the legal or in house lending limit of the specific financial institution. In this scenario, the notion of any focus on small business is left to the individual commercial lender. You will find some commercial lenders that truly enjoy and devote their efforts to the small business/business banking space. These individuals enjoy working with the smaller business for a variety of reasons such as the consultative approach (small businesses are hungry for advice while the larger businesses tend to get their advice elsewhere) or the ability to use one’s lending authority. Unfortunately while your financial institution may have such commercial lenders (one’s that are truly working solely in the small business or business banking segment) to change that individual’s title or formally commit them to working only in the small business/business banking segment is often perceived as a demotion. It is this perception that continues to hinder the progress of financial institutions with assets between $500 million and $20 billion from truly excelling in the small business/business banking space. Reality is that the best field resource to generate the small business/business banking application volume available to your financial institution is through the dedicated individual known as the Business Banker. Such an individual is capable of generate up to 250 applications (for the truly high performing) per year. Even if we scale this back to 150 applications in a given year for new credit volume at an average request of $106,929 (the lowest dollar of the individual peer groups), the business banker would be generating total application dollars of $16,039,350. If we imply a 50% approval/closure rate, the business banker would be able to generate a total of $8,019,675 in new credit exposure annually. Such exposure would have the potential of generating a net interest margin of $240,590 assuming a 3% NIM.   Not too bad.

By: Joel Pruis Basic segmentation strategy for business banking asks the following questions: – Is there a uniform definition of small business across the industry? – How should small business be defined?  Sales size of the applicant?  Exposure to the financial institution? – Is small business/business banking a retail or commercial line of business? No One Size Fits All The notion of a single definition for small business for any financial institution is inappropriate as the intent for segmentation is to focus marketing efforts, establish appropriate products to support the segment, develop appropriate delivery methods and use appropriate risk management practices.  For the purpose of this discussion we will restrict our content to developing the definition of the segment and high level credit product terms and conditions to support the segment. The confusion on how to define the segment is typically due to the multiple sources of such definitions.  The Small Business Administration, developers of generic credit risk scorecards (such as Experian), marketing firms and the like all have multiple ways to define small business.  While they all have a different method of defining small business, the important factor to consider is that each definition serves the purpose of the creator.  As such, the definition of small business should serve the purpose of the specific financial institution. A general rule of thumb is the tried and true 80/20 rule.  Assess your financial institution’s business purpose portfolio by rank ordering individual relationships by total dollar exposure.  Using the 80/20 rule, determine the smallest 80% of the number of relationships by exposure.  Typically the result is that the largest 20% of relationships will cover approximately 80% of the total dollars outstanding in your business purpose portfolio.  Conversely the smallest 80% of relationships will cover only about 20% of the total dollars outstanding. Just from this basic analysis we can see the primary need for segmentation between the business banking and the commercial (middle market, commercial real estate, etc.) portfolios.  Assuming we do not segment we have a significant imbalance of effort vs. actual risk.  Meaning if we treat all credit relationships the same we are spending up to 80% of our time/resources on only 20% of our dollar risk.  Looking at this from the other direction we are only spending 20% of our credit resources assessing 80% of our total dollar risk.  Obviously this is a very basic analysis but any way that you look at it, the risk assessment (underwriting and portfolio management) must be “right-sized” in order to provide the appropriate risk management while working to maximize the return on such portfolio segments. The realities of the credit risk assessment practices without segmentation is that the small business segment will be managed by exception, at best.  Given the large number of relationships and the small impact that the small business segment has on traditional credit quality metrics such as past dues and charge offs, the performance of the small business portfolio can, in fact, be hidden.  Such metrics focus on percentage of dollars that are past due or charged off against the entire portfolio.  Since the largest dollars are in the 20% of relationships, it will take a significant number of individual small business relationships being delinquent or charged off before the overall metric would become alarming. Working with our clients in defining small business, one of the first exercises that we recommend is assessing the actual delinquency and charge off rates in the newly defined small business/business banking portfolio.  Simply put, determine the total dollars that fit the new definition and apply the charge-offs by borrowers that meet the definition that have occurred over the past 12 months divided by total outstanding in the new portfolio segment.  Similarly determine the current dollars past due of relationships meeting the definition of small business divided by the total outstanding of said segment.  Such results typically are quite revealing and will at least provide a baseline for which the financial institution can measure improvement and/or success.  Without such initial analysis, we have witnessed financial institutions laying blame on the new underwriting and portfolio management processes for such performance when it existed all along but was never measured. So basically our first attempt to define the segment has created a total credit exposure limit.  Such limits should be used to determine the appropriate underwriting and portfolio management methods (both of which we will discuss further subsequent blogs), but this type of a definition does little to support a business development effort as the typical small business does not always borrow nor can we accurately assess the potential dollar exposure of any given business until we actually gather additional data.  Thus for business development purposes we establish the definition of small business primarily by sales size.  Looking at the data from your existing relationships, your financial institution can get an accurate indication of the maximum sales size that should be considered in the business development efforts. As a result we have our business development definition by sales size of a given company and our underwriting and portfolio management defined by total exposure.  You may be thinking that such definitions are not always in sync with each other and you would be correct.  You will have some companies with total sales under your definition that borrower more than your total exposure limits while companies with total exposure that falls under small business but the total sales of such companies may exceed the business development limit.  It is impossible to catch every possibility and to do so is an exercise in futility.  Better that you start with the basics of the segmentation and then measure the new applications that exceed the total exposure or the relationships meeting the total exposure cap but exceed the sales limitation.  During the initial phase, judgment on a case by case basis will need to be used. Questions such as: Is the borrower that exceeds our sales limitations likely to need to borrow more in the near future? Is the exposure of the borrower that meets our sales size requirement likely to quickly reduce its exposure to meet our definition? Will our underwriting techniques be adequate to assess the risk of this relationship? Will our portfolio monitoring methods be sufficient to assess the changes in the risk profile after it has been booked? Will the relationship management structure be sufficient to support such a borrower? As you encounter these situations it will become obvious to the financial institution the frequency and consistency of such exceptions to the existing definition and prompt adjustments and/or exclusions.  But to try and create the exclusions before collecting the data or examining the actual application volumes is where the futility lies. Best to avoid the futility and act only on actual data. Further refinement of the segment definition will also be based on the above assessment.  Additional criteria will be added such as: Industry segments (Commercial Real Estate, for example) Product types (construction lending) Just know that the definition will not stay static.  Based upon the average credit request changes from 2006 to 2010, changes can and will be significant.  The following graph represents the average request amounts from 2010 data compared to the dollar amounts from 2006 (noted below the chart). So remember that where you start is not where you have to stay.  Keep measuring, keep adjusting and your segmentation strategy will serve you very well. Look for my next post on generating small business applications.  Specifically I’ll cover who should be involved in the outbound marketing efforts of your small business segment. I look forward to your continued comments, challenges and debate as we continue our discussion around small business/business banking.  And if you're interested, I'm hosting a 3-part Webinar series, Navigating Through The Challenges Affecting Portfolio Performance, that will evaluate how statistics and modeling, combined with strategies from traditional credit management, can create a stronger methodology and protect your bottom line.

By: Mike Horrocks Earlier this week, my wife and I were discussing the dinner plans for Thanksgiving.  The yams, cranberries, and pumpkin pies were purchased and the secret family recipes were pulled out of the cupboard.  Everything was ready…we thought.  Then the topic of the turkey was brought up.  In the buzz of work, family, kids, etc., both of us had forgotten to get the turkey.   We had each thought the other was covering this purchase and had scratched if off our respective lists.  Our Thanksgiving dinner was at risk!  This made me think of what best practices from our industry could be utilized if I was going to mitigate risks and pull off the perfect dinner.  So I pulled the page from the Basel Committee on Banking Supervision that defines operational risk as "the risk of loss resulting from inadequate or failed internal processes, people, systems or external events” and I have some suggestions that I think work for both your Thanksgiving dinner and for your existing loan portfolios. First, let’s cover “inadequate or failed processes”.  Clearly our shopping list process failed.   But how are your portfolio management processes?  Are they clearly documented and can they be implemented throughout the organization?  Your processes should be as well communicated and documented as the “Smashed Yam Bake” recipe or you may be at risk. Next, let focus on the “people and systems”.    People make mistakes – learn from them, correct them, and try to get the “systems” to make it so there are fewer mistakes.  For example, I don’t want the risk of letting the turkey cook too long, so I use a remote meat thermometer.  Ok, it is a little geeky; however the turkey has come out perfect every year.    What systems do you have in place to make your quarterly reviews of the portfolio more consistent and up to your standards?  Lastly, how do I mitigate those “external events”?  Odds are I will be able to still get a turkey tonight.  If not, I talked to a friend of mine who is a chef and I have the plans for a goose.   How flexible are your operations and how accessible are you to the subject matter experts that can get you out of those situations?  A solid risk management program takes into account unforeseen events and can make them into opportunities. So as the Horrocks family gathered in Norman Rockwell like fashion this Thanksgiving, a moment of thanks was given to the folks on the Basel committee.  Likewise in your next risk review, I hope you can give thanks for the minimized losses and mitigated risks.  Otherwise, we will have one thing very much in common…our goose will be cooked.