Extending upmarket in US commercial banking

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The past few years have proven challenging for US midcap, regional, and superregional banks.1 Declining net interest margins on traditional lending and increased competition for lending—from larger incumbents and new entrants—have eroded balance-sheet businesses. Though near-term interest rate increases may offset this historic erosion somewhat, competition is likely to increase, as nonbank lenders have historically large balances to deploy and fintechs continue to innovate.

Despite the challenges of this environment, banks have the potential to enable future growth by directing the incremental revenues from rising rates into investments in new long-term strategies. Tactically, midcap and regional banks can simultaneously respond to new challengers and stand their ground against their larger incumbent competitors by expanding their offerings to include additional treasury management and, in some cases, capital markets products.

But sustainably adding these new products and growing fee income is not simply a matter of white-labeling an offering to the bank’s existing clients. In many cases, the clients best served by these products will be larger and have more sophisticated financial needs. To make the most of these offerings, midcap and regional banks may consider expanding upmarket to serve these larger clients.

Banks interested in expanding upmarket should explore five strategic actions:

  1. Take an end-to-end view of processes and policies to ensure they are properly calibrated for growth in the current economic environment.
  2. Select areas where the bank can create (or purchase) differentiated capabilities and expertise.
  3. Develop, train, and hire the right talent to enable growth.
  4. Align the product offering and product road map to the needs of target clients.
  5. Focus the entire bank on client experience.

Two ongoing challenges to midcap and regional lending models

While the US commercial banking environment became more challenging during the COVID-19 pandemic, two well-established forces had already been working against banks. The first challenge was an extended low-interest-rate environment. As the Fed kept interest rates low to blunt some of the pandemic’s economic impact, interest income per dollar of commercial and industrial (C&I) loans fell to its lowest point in 15 years (Exhibit 1). This pressure has been particularly acute for midcap and regional banks, whose historical “local banking” model has relied on rates to drive revenues.

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The second challenge is that nonbank entities continue to grab market share, both as owners and as lenders. Private equity (PE) acquired 3.5 times as many middle-market companies in the three years ended 2021 as in the three years ended 2011.2 The trend is likely to continue, given that this increased PE activity represents a fraction of the total market and researchers at Preqin report private capital firm reserves of $2 trillion.3 In addition, global private debt fundraising approached $200 billion in 2021, and the asset class is projected to grow at 17 percent through 2026.4 Differences in regulatory policies and risk appetite allow private capital to lend more money, on more favorable terms, than banks.

Private capital represents a threat to bank lending, especially for banks looking to extend upmarket using syndicated loans. As private capital becomes the direct lender for loans that would have historically been syndicated, a bigger share of syndicated loans are relatively large. These larger syndicated loans are more difficult to lead, leaving midcap and regional banks with fewer options to be the primary lender for larger clients. In 2004, over 60 percent of broadly syndicated loans5 were for amounts below $250 million, and more than 15 percent were for amounts above $500 million. By 2020, the distribution had reversed, with over 60 percent of syndicated loans at amounts larger than $500 million and under 10 percent at less than $250 million (Exhibit 2).

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However, private equity ownership has a mixed impact on opportunity for banks. On one hand, private equity financing may reduce the overall volume of commercial lending in the market, assuming portfolio companies rely on their owners for financing that they previously would have sought from banks. On the other hand, banks that develop strong relationships with the private equity owners may be able to increase their offerings to the portfolio companies, especially fee products. The private equity ownership share of firms with revenues of $100 million to $1 billion is modest, so significant room for expansion remains.

Expanding upmarket

Midcap and regional banks can counter their losses in profitability and share by developing and marketing fee-based products and services across two broad categories: treasury management and investment banking. Treasury management is an attractive area for expanding fee products and services, as businesses of all sizes need it. Investment banking can generate significant fee revenues, but it requires significant investments and a client mix that may not be feasible for midcap and some regional banks.

To maximize the returns of their fee products, midcap and regional banks can move upmarket to target larger clients. Doing so can create several benefits:

  • Favorable returns. Moving upmarket rewards sales effort with greater returns. Larger clients have more complex needs and purchase a greater number of fee products, so fee revenues grow larger on average as client size increases (Exhibit 3). 
  • Opportunities to differentiate. Moving upmarket creates space—and demand—for specialization. Whereas smaller businesses may simply choose the nearest bank, larger enterprises need a meaningfully better offer than they can get at their current bank to justify the cost of switching. These offerings could be in industry verticals (for example, healthcare) or in functional horizontals, such as payments. Functional horizontals require significant resources to build, making them less appealing than industry verticals for midcap and regional banks.
  • Revenue stability and growth. Upmarket specialization improves long-term stability in two ways. First, capturing larger clients creates a more robust fee base. Because fee revenues tend to be “stickier” than lending revenues, this fee base can be a more predictable source of revenues for the bank. Fee revenues also contribute to stability by making the bank less reliant on interest rate fluctuations.
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Second, banks that concentrate efforts in industry verticals can develop specialties, products, credibility, and a value proposition that can win well beyond the initial target clients. For example, expanded fee-based offerings developed to serve an industry specialty can be deployed to clients of all sizes across the bank’s portfolio. Banks that build these specialized products for larger companies not only increase their share of wallet at the top end but also can serve the needs of their existing clients, thereby increasing account stickiness and improving ROE. Companies use more complex treasury management products as they get larger, so banks looking to capture most of the client wallet and win with these larger companies will need to offer improved capabilities, such as integrated payables (Exhibit 4).

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Five strategic actions

As banks consider how best to move upmarket, they should assess where they are on the journey and what factors are most important to their trajectory (for example, capital considerations, costs to implement products, or risk appetite). As banks build their upmarket strategies, they should consider the following five actions.

1. Review processes and policies

Larger clients are an opportunity, but failing to deliver can have significant consequences that extend to existing customers. Before targeting larger customers, it is critical to take an end-to-end view of processes and policies to ensure they provide both the features that clients need and the capacity to take on the new volume. In one case, a bank targeted a large client and won their initial business, only to discover that no one at the bank knew how to send wires to a key supplier in another country. This resulted in significant delays for the target client as wires were sent with errors, requiring additional processing. Current clients suffered longer transaction times as resources were diverted to fix the errors. Ultimately, the target client left the bank, as did several other unsatisfied clients.

To set themselves up for success, banks can assess their current capabilities, routines, and approaches to identify and address inefficiencies and challenges. For midcap banks, this could include not only a review of the sales processes (such as sales team cadence and quarterly review metrics) and credit decisioning (including underwriter team volumes and length of credit memos), but also an assessment of operational considerations, such as handoffs across the loan life cycle and “time to cash” tracking from application to funding. Taking a holistic view allows teams to identify and resolve bottlenecks and to reduce wait times and duplicate work. Developing strong processes not only enables improved performance for the current book but also frees capacity to expand upmarket.

Regional and superregional banks could go further to include digital and analytics capabilities to enable more consistent routines and greater insights into pipelines and process flows. Several banks are beginning to implement “smart” relationship manager (RM) dashboards that track the sales funnel at enhanced levels and leverage known information about clients and behaviors to suggest the next product to buy. These banks have seen significant deal flow, but the complexity and necessary scale make RM dashboards most attractive for larger banks.

2. Target where to differentiate

Banks also can select targeted areas where they can create (or purchase) differentiated capabilities and expertise. Larger clients expect their bankers to be deeply knowledgeable about their industries and businesses. Developing that specialization requires consistent and concerted effort involving the investment of time, resources, and focus. This investment creates natural limits on the breadth of expertise a bank can credibly claim, which has implications for banks of all sizes.

Midcap banks typically have the resources to specialize in just one or two industry verticals. Because of this narrow selection, it is imperative that midcap banks select verticals carefully, considering the bank’s concentration limits and risk appetite, as well as its current book and footprint, to maximize the opportunity. Building a successful vertical at this size may require a midcap to expand its aperture beyond its native market to cover the industry nationally. Moreover, concentration may require these banks to develop capabilities to lead syndicated loans, typically by hiring an experienced team, in order to offer a full suite of financing across the target client base.

Regionals and superregionals have more resources and can typically take a broader approach to specialization, selecting multiple national industry verticals. For these larger banks, the question of coverage becomes paramount: as the footprint and number of specializations expand, the bank must consider how best to leverage its expertise and experience to deliver a truly differentiated offering.

3. Get the right talent

Many banks find their portfolios packed with small loans for small clients, creating a cycle in which RMs and underwriters become experts at servicing these smaller clients, so they feel most comfortable prospecting similar small clients. Breaking this habit requires banks to take a thoughtful, strategic view of their talent and build a plan to develop, train, and hire to build the right team for serving their target clients.

Relationship managers, as the face of the bank for clients, will need not only significant familiarity with the industry of the target clients but also deep understanding of the relevant bank products and services. A recent McKinsey survey of businesses highlights the need for knowledgeable RMs in addition to bank capabilities (Exhibit 5).

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Banks striving to expand the talent pool should develop an RM talent plan that covers changes in the go-to-market structure necessary to enable the targeted growth: definitions of roles for specialist and generalist RMs, choices of target verticals and how alignment will be determined, and responsibilities for tracking new team leads and sales.

Underwriter capability also is crucial, as understanding the risks and mechanics of larger exposures is fundamental to serving larger clients. Simply hiring new RMs is not enough, as one bank learned when it hired a team of industry expert RMs, only to discover that the underwriting team was unprepared to adequately assess the industry’s inherent risks. This sales/credit mismatch resulted in adverse selection in the market, leading to write-offs. As a consequence, the bank quickly exited the business and since then has passed on all like opportunities.

4. Match product strategy to client needs

Another key tactic is to align the product offering (and product road map) with the needs of target clients. Larger clients typically have more complex banking needs than smaller clients, with variation driven by industry and complexity. For example, among clients earning revenues of $20 million to $200 million, larger shares have purchased complex receivables than complex payables, but among clients with revenues greater than $500 million, four times as many have purchased complex payables than complex receivables. In addition, many products are undifferentiated, leading clients to treat them as commodities and choose on cost. Banks of different sizes have opportunities to turn client attitudes to their advantage by focusing on the products that matter and streamlining the products that don’t.

Viewing product opportunities by bank size, midcaps are unlikely to have the resources and culture to support investment banking products. However, they may find success partnering with local investment banking boutiques to offer these products to serve target segments. Leading syndicated or “club” loan deals is another way for midcaps to expand their offerings to serve larger businesses.

Regional and superregional banks can benefit from developing debt capital market (DCM) services or partnering with local boutiques to offer them. Delivered by a small team, DCM can provide critical support as existing clients grow. Equities require greater economies of scale, so they are challenging for banks of this size to offer.

5. Focus on client experience

Midcap, regional, and superregional banks can turn size to an advantage against larger banks by doubling down on attention, ease, and client experience. They can benefit from their ability to manage the full relationship, from commercial lending and treasury management to capital markets and even wealth management, to win against their larger, segmented competitors. Some banks have had success with a structured, one-team model in which the RM leads commercial relationships (for example, lending, treasury management, and capital markets) and a private banker leads executive relationships (such as personal banking and wealth management). By developing a 360-degree view of their client relationships, the RM and private banker can be responsible for ensuring that discounts in highly competitive offerings are offset against higher-margin offerings. Banks with siloed P&Ls have historically struggled to do this effectively.

In addition to a comprehensive approach to pricing, banks can benefit from the greater discretion available to support key clients in their “moments of truth.” Policies will vary by institution, but clients tend to remember key lending and liquidity decisions long after the crisis that required the bank’s flexibility. A systemic example is provided by the recent Paycheck Protection Program, in which over 60 percent of lending was performed by banks with assets of less than $50 billion.6

For midcap and regional banks, moving upmarket can boost revenues and profits. Banks must, however, ensure that this upmarket push builds on their core business capabilities and is not implemented as a substitute for serving existing clients. Commercial banking is a long game that can only be won on a solid foundation. Long-term success will come from enabling growth with appropriate coverage and skill in new areas, combined with diligent protection and expansion of the core franchise.

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