In late September,  McKinsey issued some research that generated this headline in mainstream news outlets (such as FT where you may get a paywall).

“McKinsey warns banks face wipeout in some financial services.”

The key is here:

“McKinsey said banks last year made $1.75tn of revenues from origination and sales activities, on which they earned a 22 per cent return on equity, while they made $2.1tn of revenue from balance-sheet provision at a return on equity of only 6 per cent.”

Generating revenues from origination and sales activities means being a service business. This was a subject we addressed back in July when we wrote that banking is a service business so study Zappos more than Lending Club.

In this research note we dig deeper into one market where banks can still play a central role in origination and sales activities, on which they can earn that 22% ROE.

The market is staring Banks in the face. It is huge. You know, like an elephant. It is called Working Capital Finance.

Lets give that a number. PWC sizes Working Capital Finance at $309 billion. 22% ROE on that number sounds interesting.

The starting point for banks to focus on this massive opportunity is a simple organizational change – appoint a senior executive who is 100% focused on small business. This avoids small business being the ignored middle child that:

• Does not offer the lending scale per unit of a Global 2000 (oldest child)

• Does not offer the lending scale in aggregate of the consumer (youngest child).

Being a service business does not mean being an old fashioned bank to which customers have to go loaded with piles of paperwork. There is plenty of opportunity to create new digitized services through what we call Rebundling (described in this post).

Take Supply Chain Finance as an example. Banks can always do balance-sheet via lending networks to get that 6% ROE, but earning that 22% in Supply Chain Finance requires being excellent at onboarding small business customers (the ones doing the actual borrowing in a Supply Chain Finance network i.e. the customers that really matter).

The problem is that Banks see Supply Chain Finance as something to offer their corporate clients. Banks like serving corporate clients and dislike serving Small Business clients.

This means that in reality banks end up doing balance-sheet lending either to the Corporate (which lends to its suppliers) or via a Supply Chain Finance network where the bank has to compete with other lenders because they have been disintermediated from the customer relationship. That means the bank becomes dumb money that can only earn 6% ROE.

Banks lost out in this market because they did not focus on small business. That is easy to change – appoint a senior executive who is 100% focused on small business.

That person has to be focused on using technology to create a compelling customer journey for small business. Banks used to understand small business. That knowledge was stored in the minds of old-fashioned bankers who worked in branch offices who saw small business owners every day and built personal relationships with them. The business model was broken (too labor and paper intensive) but the habit of “walking a mile in their shoes” is a habit that Banks will need to relearn in order to earn that 22% ROE. Working capital finance is the subject that keeps those small business owners “up at night” and so understanding that customer journey and figuring out how to insert themselves profitably into that customer journey should be strategic priority for Banks.

By Bernard Lunn