Why is SME and small Corporate an ‘under-served’ segment in Banking?

Anyone who follows or reads about Fintech companies will know that they excel at finding profitable niches in financial services and exploiting them. Once they have identified a specific vertical they can profitably serve, they need to draw clients away from their one-stop-shop bank by mitigating the inconvenience of using one extra service.

FinTechs use the anabolic steroids of cheap capital (from venture / private equity), cloud, API, micro-services, automation, new technology (e.g. Machine Learning), cleverly segmented pricing and smart user experience design. Banks are not just seeing a key natural market intermediated, they are having their historic and long-standing inadequacies called out by the interlopers.

That SMEs and small Corporates is an under-served segment in banking has become a hackneyed notion such that it is now an accepted truism. It is never questioned; it seems to require no explanation and has become almost passé. But is it actually true? If it is true, how has this continued to be the case for so long? Why haven’t the incumbents plugged this gap through replication or acquisition? Will it continue to be the case? What would the banks need to do to re-capture the market?

I’m not sure everyone fully understands what has led us to this point in providing banking services to companies. And there may not be any need for Corporate clients to have significant knowledge of Corporate banks – some Corporates just accept that the pricing is better from a FinTech, and that’s all they choose to know.

For those who would like to know more about Corporate banking, information is scarce. There is no Unified Field Theory; no simple explanation that will provide an answer to these questions. However, there are some things which it is worth understanding (a little) before we try to become Fintech’s Mystic Meg. In my view, these are:

  1. Basel Accord on Bank Stability (and specifically Basel III)
  2. Banking Reform (Ringfencing in the UK)
  3. Bank investments
  4. Bet you thought I was going to say Brexit? Well, not this time Buster.

Basel Accord

The Basel Committee was formed in the 1970s from the top 10 central bank governors in the world. They meet under the auspices of the Bank for International Settlements (BIS) which is headquartered in Basel in Switzerland (hence the name).

This committee has issued many papers and guidelines, all aimed at reducing the systemic risk in banking. It is arguable whether some of these changes have made the financial markets more or less stable as banks’ treasuries and traders have sought to circumvent the Basel rules with unintended and often disastrous consequences (which might be funny if they weren’t so tragic).

  • Basel I. Published 1988, and with revisions through the 1990s. Minimum capital to risk-weighted assets of 8% set globally. Netting of derivative exposures. Use of internal (value at risk, VAR) models. Note, VAR is based on the normal distribution function, not on the real-world of ‘fat tails’ where disastrous outcomes are more likely to occur than is predicted by VAR models. Arguably this approach to market VAR led to a number of big collapses such as Long Term Capital Management.
  • Basel II. Published 2004. Capital pillars for credit, market and operational risks. Focus was on the management of credit risk. Banks sought to move credit risk to off-balance sheet vehicles which they could ‘tranche-up’ and sell down. The profitability of doing this led to ‘originate to distribute’ and (arguably) ultimately to the Global Financial Crisis in 2007-09.
  • Basel III. Various rules on structuring banks’ balance sheets including types and amounts of liquidity banks can use to fund operations.
    1. Basel III hasn’t led to any cataclysmic disasters (not yet, anyway) but it has heavily contributed to Corporate banking being very low-margin business. This is because:
      • Lending requires capital to be held on a risk-weighted basis to prevent excess leverage and as a buffer against losses. This is the very definition of fractional reserve banking. The capital required for credit risk also has a quality measure included.
      • Non-Retail (i.e. business, Corporate and financial institution) lending has a high risk weighting, so lending to these entities requires substantial capital to be held. Return on capital for Corporate loans are often low single-digit %s
      • Retail mortgages have a very low risk weighting, practically zero in many cases, so require almost no capital to be held against them. Returns on Retail mortgages can be far in excess of 15%.
    2. Banks can fund their lending activities using various sources of capital including equity (Tier-1 capital); various types and categories of debt; or funds borrowed from their depositors. Where the bank holds short-term customer deposits, they are required to use a proportion of the deposit as a liquidity buffer to buy (usually) government bonds. This is to mitigate the risk that customers and clients would all want their money back at the same time (such as in a stressed economic scenario). As with lending, Corporate deposits suffer by comparison with Retail:
      • Retail demand deposits are considered ‘sticky’ and unlikely to be withdrawn in distressed circumstances for the bank. Practically none of the bank’s Retail balances in current accounts have to be used to buy government bonds, so it can all be used to fund the lending business.
      • Corporate current account balances have varying levels of assumed stickiness, but even in the most favourable treatment of current account balances, the bank must retain 25% of the balances in government bonds. In the worst treatment the requirement is to hold 100%, making those deposit balances worse than useless (especially with negative returns in e.g. euro denominated bonds).
    3. The reality has become even worse than that for Corporates. Historically, banks could allow clients to ‘offset’ current balances with current liabilities (overdrafts) in different accounts and only pay / receive interest on the ‘net’ balance. This was called ‘notional pooling’. The new Basel III rules are that the capital calculations for both lending and deposits must be done on the gross loan and deposit balances. No netting is allowed for the purposes of calculating how much capital to hold.
      • In Retail, this is a trivial exercise – virtually no capital is held on either the deposit or debt. Netting is rare in Retail, but even were it to exist the impact would be miniscule.
      • In Corporate, however, the capital needed for BOTH lending and deposits is non-trivial and netting of these balances was widely used. There are now costs to netting which didn’t exist previously. Giving the Corporate client any benefit from netting results in value destruction.
    4. In summary then,
      • Corporate banking lending and deposit businesses may have (if they are lucky) returns on risk-weighted-assets (a measure of their capital) of around 6-10%. They have to work really hard to get to the upper end of those numbers.
      • Retail banking returns are frequently >25% or higher, and would barely fall away even if you fell asleep while you were driving the Retail bus.

    Banking Reform (“ringfencing”)

    The Financial Services (“Banking Reform”) Act 2013 followed on from the Independent Commission on Banking set up in the aftermath of the Global Financial Crisis. UK Banks were required to split their banks into low risk (Retail & Small Business Banking) and high risk (Investment Banking) businesses.

    But hang on, I hear you cry! If we have Retail and Small Business vs. Investment Banking, where does Corporate Banking fit? Are they classified as low risk, as Corporates still need to borrow money and place deposits; or are they high risk, as Corporates might require more sophisticated capital raising and risk management (some of which can only be sourced from Investment Banks)? The answer is YES. To BOTH.

    Medium-sized Corporates (classically defined as ~250 employees and / or ~£50m turnover) are low risk most of the time AND high risk some of the time.

    UK banks have different proportions of low and high-risk business lines (the more global the bank, the more high-risk business they will be doing). Different banks will manage those clients very differently for products and relationships. The legislation has had to include significant contortions and provisions to avoid these clients falling between its cracks.

    In the end, whilst the average man on the street may be a bit safer, there appears to have been two main impacts on banking Corporates:

    1. Reduced competition for the banking business, including worse pricing. Different banks now have to approach these businesses with different return hurdles, depending on which balance sheet they are using. Those with higher return hurdles will have had to worsen their price, or may not choose to bid for the business at all.
    2. Reduced the functionality available. Some banks have sophisticated banking and cash management platforms, but now only offer these to large Corporates and Financial Institutions (some only for Corporates >$500m turnover). There are now fewer banks out there who can fulfil the needs of a medium-sized Corporate.

    Arguably Banking Reform wasn’t really necessary inaddition to Basel III; one or the other would have done. And if that view is correct, then to remain internationally competitive, Basel III should have had supremacy in the UK. Small amounts of the Banking Reform legislation could have been injected into regulation over time, with much of the rest never seeing the light of day. But that wasn’t to be; we now have both Basel III AND Ringfencing, and both are trying to strangle Corporate banking at the same time.

    Bank investment

    But hold on, can it possibly get worse for Corporate banking? Yes. Yes, it can. Step into my office and I’ll tell you how

    Imagine there is a bank business that includes two product lines. One is Retail, 80% of your whole company’s turnover and profits, and has a (more than) 25% return on capital. This is the ‘star’ performer. The other business line is a ‘dog’; Corporate-focused and only about 20% of the profits with a 7% return on capital. That means it’s 4x smaller than the ‘star’, but consumes roughly the same amount of capital. For reference, bank shareholders ‘expect’ a return on capital of at least 12%.

    As further context:

  • The bank has paid some celebrities multiple millions of pounds [Simon Cowell, Ant & Dec, etc.] AND paid major marketing agencies even more than that to promote the brand. Everyone knows this mostly benefits the Retail business;
  • The Retail marketing spend is “above the line”. Costs are deducted from the Corporate overhead as indirect costs, as it is argued it benefits the whole banking group. Retail are the biggest beneficiary, but none of the cost is in the Retail divisional bottom line in segmented accounts.
  • The marketing budget for the Corporate business is below-the-line, i.e. deducted from the revenues as direct costs reflecting the direct marketing of a relationship-driven business.
  • No-one recognises the difference in marketing spend treatment, the fact that the Corporate business pays for marketing twice. No-one attempts to create a like-for-like analysis to show the impact this has on the ‘return’ calculations.
  • Non-spend marketing such as the potential for negative PR is also skewed. e.g. a weekend IT failure in the Corporate business will go largely unnoticed, whereas a weekend IT failure in the Retail business could be on the front page of the Daily Mail by Monday.
  • The bank is allowed to spend and invest a fixed sum on technology. After paying to maintain the 40-year-old platform and undertaking changes required by regulation, the bank is left with an amount for ‘investment’ for both Retail and Corporate. Corporate banking divisions face at least 2 more major issues gaining access to the residual amount left for investment:

  • The bank can invest in the stellar business rather than invest in the Corporate business. Looked at another way, money invested in a sub-hurdle business feels like throwing good money after bad; or
  • The bank can spend the money on neither and can instead ‘outsource’ product development spend to:
    • a central, group-level, possibly international product team which will create products for all businesses and countries in the group;
    • an innovation team;
    • an internal FinTech venture fund; or
    • a strategy consultant, who will suggest buying a FinTech.

    In the case of #1 choosing which business to invest in (star or dog), these decisions happen every day; no tears are shed, I’ve got the T-shirt. Banks are required to allocate shareholders’ capital efficiently and for the best possible returns, and at the same time mitigate risks. Senior managers making this decision will naturally want to align themselves behind, and investment will be skewed towards the ‘star’ Retail business. That’s just office politics 101.

    In #2 outsourcing product development:

    1. allocating funds to a central international product team seems rational on the face of it. However:
      • each country will often start from a different point in product maturity and each is subject to different regulations and relative competitiveness.
      • The necessary first step is to allow countries to level-up with each other and to work collaboratively.
      • Even if this is undertaken, countries with significant proposition gaps or infrastructure issues will fall further behind the local market and group peers.
    2. Internal bank innovation teams want to do what is ‘cool’ rather than what is necessary. And there is nothing ‘cool’ about filling-in basic product gaps or in implementing solutions which conform to a market standard. Whether the output of an internal bank innovation team is useful is arbitrary. I have always described their activity as ‘decorating the bedroom whilst the kitchen is on fire’.
    3. The venture fund has incentives and objectives which are even further away from what the business actually needs and have even less interest in improving the Corporate bank’s profitability. Their aim is to learn from and participate in equity upside, which can sometimes mean investing in the esoteric. They benefit from attaching the bank’s name to cool FinTech businesses, lending them legitimacy. I refer you to my bedroom comment above.
    4. Buying a FinTech
      • May be naïve and wasteful,
      • Unless buying something esoteric that the product team would never develop. But in this case, it is no longer an alternative form of product development. See my bedroom comment above.
      • If the bank is buying something like a payments company, for example, a large part of the valuation and therefore price is in their licence to operate and banking connections.
      • The Bank already has a licence and likely has a correspondent bank network. Discounting the value of these to near zero, the residual valuation is in innovation and technology. However, these could often have been built by the incumbent product team and/or bought from a software vendor.
      • The payment company (in this case) will struggle to ever be absorbed by a large bank. The bank’s governance and compliance processes will also squeeze out ‘interesting’ practices and stifle future innovation.
  • Why Corporate Banking success can be difficult to measure

    1. Corporate Banking is a useful source of revenue diversification away from Retail mortgages. It will also have lower operational risks from e.g. IT failures (see TSB, NatWest, etc.), although this will rarely be included in the valuation discount rate.
    2. Income is under-stated. Retail costs such as marketing are absorbed by head office, whereas the equivalent Corporate costs are absorbed in costs of sale. This is in the nature (and name!) of above / below the line marketing, but banks rarely seem to adjust for these factors when comparing returns.
    3. In the UK is already one of the most mature, transparent and technologically advanced markets in the world. The product development agenda needs to adjust for that, and you cannot compare or import practices from other jurisdictions.
    4. Is expensive – the upfront investment costs are large. This is a double-edged sword as:
      • Full-service Corporate banking is difficult to do well and has high barriers to entry, so *should* be defensible;
      • You need to have a scalable, rich set of ancillary functionality to augment the meagre returns from lending and deposits.
      • Some banks (Metro, Starling, etc.) have received funds from the RBS Capability and Innovation Fund to improve their businesses and build their ancillary revenues.
      • These banks and the public body measuring their success (Banking Competition Remedies Ltd) may have under-estimated how difficult it will be to take significant market share from the incumbents.
    5. The annual investment costs inherent in product development could (and probably should) be like Retail marketing costs, i.e. moved ‘above the line’ to head office.
    6. Corporate banking, particularly in the UK, is often where Subject Matter Expertise resides in areas such as payments, FX, cash management, lending, deposit-taking, etc. The product teams understand Fintechs because they understand (i) how to ‘bank’ them as companies, and (ii) how to provide them with wholesale services. The wider bank, including Treasury, the Investment Bank and the Retail division, typically fails to take full advantage of this natural asset. By moving the Corporate Banking product development investment costs ‘above the line’, even on a notional basis for the purposes of management accounting, the intellectual capital becomes a group asset, rather than a business unit asset.
    7. Invest more in Product improvements than in Marketing.
      • I didn’t say that; Jeff Bezos did. To be more specific, he said that the proportion was historically 70 : 30 Marketing : Product, and that this proportion should be flipped.
      • Banks might argue they already spend at least this much already on technology. But I don’t think Mr Bezos would ‘count’ spend on items such as meeting regulatory requirements or keeping the business running, which a bank does count. These are Opex items, not Capex.
    8. Corporate Banks regularly cite “Relationship” as key differentiator in their banking model, and spend huge sums on maintaining those relationships (which is effectively marketing cost). But if all banks are making this claim, and assuming Corporate Banking requires (by definition) a relationship banking model in order to operate, then how can it be a differentiator?
    9. Relationship is often a buffer for poor products, poor service (including lack of self-service) and weak automation. Fix those issues (by making the products and services better) and you can cut out a huge swathe of support, operations, credit and relationship staff. Human contact would fall, but who wants to socialise with a banker anyway? Keep your rugby tickets and just give me a better service and a lower price.
    10. Product development is often seen as zero-sum because the improvements may cannibalise legacy revenues from products that rely on client stickiness / inertia.
    11. Corporate products are also part of a package – developments must be bid for separately because they would be delivered separately. But there is often a story; there may be little point in doing one of the projects in isolation if there are other major proposition gaps because the benefits in isolation will never be realised.

    Will Corporate Banks heed any of the lessons of the Fintech era and be able to keep pace?

    Best guess: NO. The change in thinking, different vision and the buy-in to the investment required is simply too great for senior management to contemplate.

    The future Corporate banking model needs to be innately efficient. This means light-touch (‘relationship -lite’) so fully or semi-automated, self-service, robo-advised, integrated directly into a corporate’s operations and yet remain a full-service experience. This will give Corporate banking a chance of hitting the key banking metrics of cost : income ratio close to 50%, and have a (properly measured / adjusted) return on capital above investors’ hurdles (say >12-15%).

    Who is most likely to create a model like this? In my view, in the future there will be one of three corporate banking models in the UK:

  • Full service. Built out of existing banks. Trying to be full service, but unlikely to succeed in that aim as gaps will likely exist. One or two may emerge, but with gaps. This model is unlikely to be the winner for the reasons already stated in this paper.
  • Disaggregated. Corporates buy-in what they need from specialists and forego any relationship experience for the sake of price. Possible, but relies on corporates knowing exactly what they need and being able to coordinate competitive bids themselves.
  • Banking-as-a-service. Platforms equivalent to Amazon become a marketplace / venue where Amazon sells its own products and those of others. Most likely winner. Unlikely to actually *be* Amazon, but I’m ruling nothing out.