By: Joel Pruis
Basic segmentation strategy for business banking asks the following questions:
– How should small business be defined? Sales size of the applicant? Exposure to the financial institution?
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.
