46 The Future of Retail Banking Stepping Into the Breach: How to Build Profitable Middle Market Share The $50-billion U.S. middle market banking segment, comprised of companies with between $10 million and $500 million in annual revenues, is undergoing a dramatic competitive shift. The distressed condition of many specialty finance and monoline lenders is clearing wide swathes of opportunity and tipping the balance of power toward commercial banks. Regional banks have stumbled as well, creating opportunities in the broader commercial sector, while some megabanks have retrenched in certain geographies and sectors. It is a great moment for gaining share in the market. Best-inclass lenders reap ROEs of 20 percent or higher. However, getting to best-inclass is not as simple as picking up where specialty lenders left off. To step successfully into these profitable gaps in the middle market landscape, banks need to reinvent the business model and redefine best-in-class execution. We see nine imperatives for banks seeking an edge in this market. Build relationships Banks pursuing profitable middle market share must follow a path we see as critical across the entire banking spectrum. What we are calling relationship banking has a basic premise: in order to attain sustainable, profitable growth, expand relationships with your best customers. To step successfully into profitable This approach, while not new, is in stark contrast to the expand-at-all-costs approach of the past gaps in the middle market several years. It is also particularly relevant for landscape, banks need to reinvent commercial banks with large national clients. the business model and redefine These larger clients – and even some more local businesses – have needs that go beyond the best-in-class execution. lending products that are usually a bank’s entrée into serving them. And while lending is critical to securing relationships in the first place, it is not nearly as instrumental in driving profits as other products, such as cash management services (Exhibit 1). 47 Stepping Into the Breach: How to Build Profitable Middle Market Share To begin, banks need to make clear distinctions between how they serve local middle market clients and large national corporate clients. A one-sizefits-all approach to relationship banking is not sustainable. Banks suffered steep losses in the smaller middle market segment during the crisis, often driven by an overreaching attempt to lend in geographies and industries where they did not have sufficient experience or knowledge. For smaller clients, best-in-class banks will return their focus to their home turf, looking to build scale on a local level with in-footprint clients. Competitive advantage in the smaller middle market segment will derive not from over-extension and volume, but from targeted lending in areas banks know best. For larger, national-scale clients, banks need to leverage lending interactions into deeper and more lasting relationships based on products and services that are both stickier and more profitable. (Although they are demanded more by large corporate customers, some middle market businesses may also need specialized finance products such as FX and interest rate derivatives.) Redesign client coverage and account planning Regardless of client size, an important foundation of relationship banking is seamless coverage and rigorous account planning. Exhibit 1 While credit is important to securing middle market relationships, cash management drives economics 68 percent of middle market relationships involve credit Upper middle market bank relationships1 Percent of total Cash management only But cash management still drives profitability Average revenue per mid-market client indexed (100 = lending only) 3,000 32 800 1,000 100 Credit only 25 Credit & cash management 43 2008 1 Lending only Percent of lending clients 30 Lending + cash manage ment (or other corporate banking product) 50 Lending + investment banking 10 Lending + cash manage ment (or other CB products) + Investment banking 10 Survey of 1,608 U.S. corporations with annual sales over $100 MM; of these, corporations with sales from $100 MM to $500 MM considered upper middle market Source: Phoenix-Hecht, 2008; McKinsey analysis 48 The Future of Retail Banking There is great opportunity in targeting profitable industry sectors or verticals that are aligned with a bank’s existing capabilities and geographic footprint. Banks should also consider which products are most profitable and build capability to serve sectors that rely heavily on those products. For example, cash management, that profitable standby, is in high demand with professional services, retail, insurance, government and non-profit clients (Exhibit 2). Cash-centric clients spend two times more than their credit-intensive peers and also use more products (8 for cash-centric versus. 6.2 for other segments). Understanding customer needs is also crucial for banks in designing relationship manager (RM) coverage. Our research has shown that larger and smaller clients value different RM attributes. As an example, smaller clients place a higher value on product knowledge, whereas larger clients tend to value industry and local market knowledge (Exhibit 3). To capture the combined value of geographic footprint, product knowledge and industry expertise, best-practice commercial banks support their re- Exhibit 2 Industries with higher cash management use are more profitable High Cash management usage Cash-centric (20% of companies, 25% of profits) Complex cash and credit needs (27% of companies, 29% of profits) Retail Attorneys Consulting Technology Insurance Some manufacturing Healthcare (provider/doctor groups) Hotels Transportation Wholesale trade Publishing International trade Governmentt/public sector (e.g., municipalities, school districts) Financial intermediaries Non-profit/membership organizations Restaurants Healthcare (hospitals) Sophisticated opportunists (44% of companies, 35% of profits) Large/public companies across industries Large government/public sector entities Agriculture Mining Transportation Real estate development Low Construction Entertainment (e.g., film finance) Credit-centric (44% of companies, 35% of profits) Low Source: McKinsey analysis Credit usage High 49 Stepping Into the Breach: How to Build Profitable Middle Market Share gional coverage with a meaningful degree of industry and product overlay. They deploy front-line teams by geography and use industry sectors or verticals to cover specialized sectors. Across regions, generalist RMs are the primary customer contacts, working closely with product specialists who provide targeted support. Industry verticals have dedicated expert RMs and support teams. Beyond coverage, it is very important to develop and institutionalize an account planning process that prioritizes customers in each target group and results in a holistic approach to customer-level profitability. A rigorous planning process starts with the selection of potential clients and the scheduling of meetings. Next, a relationship manager should conduct a needs assessment for identified clients by each product and prepare action plans, finalized with a direct manager and product specialists. With action plans complete, next steps should be defined through activity plans that create a visible interface and a transparent schedule for participants in the account plan. Finally, reporting mecha- Exhibit 3 Large and small middle market customers value different areas of expertise Most important attributes of relationship manager Percent of respondents by revenues $2 – 5M Knowledge of credit needs Other 8 35 8 4 29 22 9 $500M – 2B 25 16 23 7 5 17 22 17 $100 - 500M 35 17 24 Industry knowledge $25 - 100M 32 48 Product specialist Local knowledge $5 - 25M 29 33 5 Source: McKinsey Corporate Banking Survey, March 2009 (based on 400+ responses from McKinsey’s proprietary panel) 29 4 50 The Future of Retail Banking nisms should be established to follow up on, track and review results of action plans before closing. Capitalize on disruption in the monoline space Many players in sub-segments of the commercial space, such as monolines, are experiencing severe disruption. Savvy financial institutions will step in and take share by meeting pent-up credit demand. For example, at one large regional bank, current cross-sell rates for lease products to middle market and corporate banking customers were 3 to 7 percent, compared to 10 to 30 percent for a best-in-class institution. This leaves significant opportunity for deeper product penetration (Exhibit 4). In particular, the vendor channel represents an attractive growth opportunity for well-capitalized banks due to competitor dislocation and certain captive finance companies scaling back their presence. Enhance product offerings To take full advantage of market opportunities, banks need to honestly assess their product capabilities, identify gaps based on the needs of client segments, and develop competitive offerings. For example, a bank could develop a standardized cash management product for the low-end middle market or a suite of derivatives, FX and other specialized finance products for larger firms. However, banks will need to go a step further and improve the functionality and efficiency of delivery for the product suite, which could mean upgrading systems, platform integration and reporting. The key drivers of customer satisfaction are access to systems, delivery of information, reliability of systems, effective issue-tracking and rapid resolution. Revamp end-to-end underwriting and credit adjudication Weaknesses in commercial lending and underwriting processes have contributed to both significant levels of customer dissatisfaction and unprecedented losses. This dissatisfaction can be addressed though the adoption of two important principles: • Functional excellence reduces excessive touch points, unclear accountability, over-stressed roles and sub-optimal spans of control by creating specialized roles for each component of the credit process (e.g., client service, transaction management, credit and portfolio management). 51 Stepping Into the Breach: How to Build Profitable Middle Market Share • Expert choreography improves process efficiency by eliminating wait time, reducing unnecessary duplication of work due to lack of expert coordination; defining clear, differentiated “flight paths” based on deal complexity (e.g., auto-decisioning for select customers); and creating process champions. Streamlining credit delivery can lead to a 30 to 50 percent increase in productivity. At one U.S. regional bank, an analysis revealed that almost 75 percent of an 11-day approval process was spent on hold time. Reducing even a percentage of such delays, which are partially caused by approvers working on higher-priority items, would speed delivery and leave clients more satisfied. Reduce risk-weighted asset leakage The current regulatory environment, in combination with limitations in balance sheet capacity, make it more important than ever for banks to reduce capital Exhibit 4 There is significant opportunity to grow lease cross-sell into existing customer base Representative bank cross-sell rates by division compared to competitor benchmarks Representative bank Division Current cross-sell rates of lease products into banking customers Factors impacting cross-sell Percent Small business 15 30 Small businesses likely to have one primary banking relationship Highest propensity to lease (80%) 7 Middle market Relatively more difficult to penetrate due to high volume of potential customers 15 30 Smaller number of customers/RMs make identifying customers for cross sell easier High propensity to lease (70 80%) 5 Best in class Value potential $15 million for each additional percent age point increase in cross sell $5 million for each additional percent age point increase in cross sell Relatively easy to cross sell if credit relationship in place Corporate Most price sensitive 10 20 3 Source: McKinsey analysis Large corporate customers have multiple, diversified relationships, and are most likely to lease with one of their banks $4 million for each additional percent age point increase in cross sell 52 The Future of Retail Banking wastage. Our experience shows that risk-weighted asset (RWA) optimization can reduce leakage by 15 to 25 percent and increase revenues by 8 to 12 percent in the relevant books of business. There are four major sources of capital wastage. The first are internal models that calculate capital requirements based on regulatory approaches that do not maximize capital efficiency. Second are poor credit processes – lacking state-of-the-art monitoring and workouts – that lead to higher regulatory risk parameters and capital requirements. The third source is problems in collateral management: lack of updated collateral values and errors in timeliness and booking of credit lines and collateral. Finally, data quality issues directly translate into higher capital requirements; for instance, regulators may impose additional capital requirements for low data quality. These problems can be addressed with a capital-optimized business model built around six actions: Stemming the tsunami of commercial loan losses Default trends in commercial loan portfolios typically lag consumer loans by 12 to 18 months and are emerging as the next major casualty of the global credit crisis. Banks that are already reeling from a liquidity and capital crunch will likely face high default volumes and major losses in their commercial portfolios through 2010. The signs pointing to this tsunami of losses are clear. Delinquency and charge-off levels in commercial real estate (CRE) and commercial and industrial loans (C&I) are four to eight times higher than historical averages; at some banks they are even worse. The Federal Reserve’s stress tests in March and April 2009 projected losses over the next two years, under adverse economic scenarios, at 10.6 percent of CRE outstanding and 5.8 percent of C&I. This translates to $600 billion for the 19 banks tested. Over the next four years, we expect combined losses in these two areas to be in the range of $500 billion to $1.2 trillion, depending on the severity of economic scenario. Many institutions are unprepared to deal with this level of losses, having allowed their loss mitigation capabilities to atrophy. The situation calls for immediate action. Banks must redesign commercial loss mitigation structures and supporting mechanisms and use proven and effective best practices. Banks need to catch problems early instead of waiting for them to trickle down. They need to assign their best people to workouts rather than reserving them for business growth initiatives, and sharpen the accountability and transparency of loss mitigation efforts. Additionally, compensation philosophy should be based on well-defined targets, rather than vague or broad top-down targets. Finally, banks need effective reporting on both activities and outcomes so early interventions can succeed. Best-in-class banks can reduce commercial loan losses by 10 to 15 percent by following through on three imperatives: • Strengthen early-warning mechanisms. The key to successful loss mitigation is identifying and working on at-risk loans early. Failure to do so ensures that many loans will be dead on arrival at the loss mitigation group. Early de- Stepping Into the Breach: How to Build Profitable Middle Market Share • Establish clear rules regulating client acquisition to avoid exposure to clients likely to be unprofitable, given operating and capital costs. • Provide commercial guidelines and tools that direct the front line toward highest RWA-return products and maximizing collateral without jeopardizing RWA return. • Instill risk-adjusted pricing, e.g., through a regulatory capital-compliant risk-adjusted pricing tool per client and transaction, and introduce a segment-specific pricing process. • Offer clients solutions for improving their financial profile and thereby their credit rating. • Set up market placement enablers through product, system and organizational features to selectively leverage possible market placement opportunities (e.g., syndication, securitization). tection triggers allow banks to quickly identify and prioritize high-risk loans, based on the external economic outlook and metrics specific to the debtor. Banks should also identify high-risk portfolio areas and sectors and develop specific action plans for them. • Install world-class workout and restructuring processes. To effectively manage large volumes, institutions must ensure that their processes and procedures are scalable, structured and consistent. This requires clear decision rules to quickly move high-priority loans from the business to the loss mitigation group. Workout groups need checklists for file preparation and execution. Leaders must also ensure that different groups adopt the same practices and monitor each group’s activities to identify outliers with low recovery rates or high average resolution times. And once these groups are spotted, the root causes of these problems must be addressed; for example, leaders must understand each group’s criteria for selecting workout strategies. • Enhance organizational capacity, structure, reporting and capabilities. The average caseload per loan workout officer has increased by a factor of three to five. Banks must increase their capacity and ensure that they distribute the workload equitably. To manage the complexity and severity of the loan losses, they can create groups that deal with different sizes of loans and staff them with loan officers with the necessary skill sets (including skills from different sectors, e.g., CRE, structured finance and retail). These employees also need the right tools, so they can select strategies that maximize value, set priorities and monitor recoveries and costs. To improve performance management, banks should develop key performance indicators and link compensation incentives (and future employment) to value creation. Finally, given the heightened demand for transparency – from internal and external stakeholders – banks should develop structured, consistent and action-oriented reporting dashboards on portfolio trends, efficiency and effectiveness. 53 54 The Future of Retail Banking • Optimize product mix and design by using more capital-efficient product types for both short- and long-term financing that deliver similar value to clients (e.g., overdraft instead of short-term structured solutions). Broaden and intensify portfolio management In the wake of the financial crisis, management of risk in the loan portfolio has taken on heightened importance. Banks must develop more rigorous portfolio management processes to track aggregate exposures by company, sector, region and industry. They must instill processes in their risk paradigm and scenario analysis to test implications on various events and develop contingency plans to respond to different scenarios. Further, banks must identify and monitor high-risk client segments and accounts, based, for example, on the likelihood of events that could impact the industry and cause the client to fall into delinquency, such as production disruptions, demand fall-offs and supplier or key customer bankruptcies. Furthermore, loan portfolio management should inform and drive proactive actions. As an example, banks should identify single-product relationships and work to either deepen the relationship or end it, if there are no signs of cross-sell efforts succeeding. Strengthen loss mitigation Loss mitigation capabilities atrophied over the course of the last boom cycle and must be transformed. Delinquencies and charge-offs have increased six to eight times in commercial real estate and commercial and industrial loans, across segments, creating a drag on capital and earnings. There are three areas where banks need to focus: early warning; workout and restructuring processes, and organization/capability incentives and tools. (See “Stemming the tsunami of commercial loan losses,” page 52.) Unleash talent Performance management in commercial banks needs improvement. Much ink has been spent describing how incentives have led to behavior adverse to the interests of banks and their shareholders. A good example is relationship managers who are incented to sell loans by volume, without consideration or accountability for the long-term profitability or health of the loan. A less egregious, but still important Stepping Into the Breach: How to Build Profitable Middle Market Share example is that relationship managers are not incented strongly enough for cross-selling. Banks need a complete redesign of incentive plans across the enterprise: for the front line, product specialists, loss mitigation and support functions. Both quantitative and qualitative aspects need to be considered. Pay packages must account for profit, health and volume of products sold and overall client profitability. *** There is clear opportunity for banks seeking a stronger foothold in the profitable middle market. Distressed and dislocated players are leaving a wide open field, but simply stepping into the breach would be a mistake. Winners in the space will be those institutions that reinvent their business model not only to grab share, but to build sustainable, profitable relationships. 55 About McKinsey & Company McKinsey & Company is a management consulting firm that helps many of the world’s leading corporations and organizations address their strategic challenges, from reorganizing for long-term growth to improving business performance and maximizing profitability. For more than 80 years, the firm’s primary objective has been to serve as an organization’s most trusted external advisor on critical issues facing senior management. With consultants in more than 40 countries around the globe, McKinsey advises clients on strategic, operational, organizational and technological issues. McKinsey’s Consumer & Small Business Banking Practice serves leading North American banks on issues of strategy and growth, operations and technology, marketing and sales, organizational effectiveness, risk management and corporate finance. Our partners and consultants provide expert perspectives on a range of topics including corporate strategy, business model redesign, product and market strategy, distribution and channel management, the impact of financial services regulation and performance improvement. The following McKinsey consultants and experts contributed to this compendium: Whit Alexander Daina Graybosch James McKay Greg Phalin Philip Bruno Tommy Jacobs Howard Moseson Leonardo Rinaldi Robert Byrne Piotr Kaminski Sudip Mukherjee Pablo Simone Liam Caffrey Rami Karjian Fritz Nauck Vik Sohoni Prasenjit Chakravarti Akshay Kapoor Sandra Nudelman Dorian Stone Catharine Kelly Marukel Nunez Sarah Strauss Nick Malik Pradip Patiath Ameesh Vakharia Robert Mau John Patience Tim Welsh David Chubak Marco De Freitas Benjamin Ellis Contact For more information, contact: Nick Malik Christopher Leech Marukel Nunez Director Director Principal (212) 446-8530 (412) 804-2718 (212) 446-7632 nick [email protected] chris [email protected] marukel [email protected] Financial Services Practice November 2010 Designed by Hudspith Design Copyright © McKinsey & Company www.mckinsey.com/clientservice/financial_services