They Fought Tooth And Nail On Home Loans - Now For Business Banking

There is a sense of deja vu within KPMG's description of the state of the small-business banking market in a report commissioned by the Australian Bankers Association and issued yesterday.

KPMG describes an industry dominated by the big banks but with the first signs of emerging competition from regional banks, non-bank lenders and brokers. It also depicts an industry that, despite the absence of established large-scale competitors to the four big banks, is surprisingly competitive.

The big four banks hold more than 80 per cent of the banking market for small and medium-sized enterprises, but interest margins have fallen 145 basis points, or nearly 35 per cent, over the past six years, and there has been a sizeable overall fall in SME fee income. By international standards, the cost of banking for SMEs is very competitive.

That picture of an already competitive market with declining margins and fees would be a disturbing one for the big banks, given that all of them are looking to the sector as their growth opportunity as the extraordinary levels of activity in the housing market subside.

While there are some structural differences between SME banking and the home-loan market, there are also some potential parallels that could complicate the bankers' ambitions.

Conventionally, SME banking has been seen as a segment of the system that was impregnable because servicing the market requires skills in analysing and pricing credit, and ubiquitous physical distribution networks that only the big banks had.

The ``monoline" suppliers of home loans who attacked the bank stranglehold on mortgage lending were targeting a product that could be commoditised. Each SME loan and banking relationship is unique and has to be uniquely evaluated. Or at least that has been the conventional wisdom.

KPMG, however, found that the regional banks are making inroads into SME banking, a number of non-bank lenders (such as Bluestone, GE Capital, Pepper Home Loans, Wizard, RAMS and Liberty) are entering the market, there are online SME products emerging and, KPMG says, in some regions banks are reporting that broker-originated loans now represent about 20 per cent of small-business lending.

The emerging landscape looks vaguely like the home-loan market in the mid-1990s, when the mortgage originators first appeared.

It took a while before the banks recognised the severity of the threat and responded by slashing margins. The subsequent proliferation of mortgage brokers helped the banks arrest the erosion of their position, but at another heavy cost to margins and with some weakening of their customer relationships.

As the housing bubble deflates, a lot of capacity and capabilities within both the banking system and the non-bank elements of the home-lending sector will be searching for replacement activity. SME banking has already been identified as the next big thing.

As the big banks step up their own competition to drive their share and offset the loss of housing-loan volumes, the regionals, non-bank lenders and brokers will also be switching their gaze.

The non-banks and regionals will be helped by a trend KPMG uncovered among SMEs towards multiple sources of banking services, although that tends to mean two providers rather than one. KPMG also found that SMEs are embracing electronic banking channels, with 72 per cent of small businesses using internet banking - a 35 per cent increase within three years.

SMEs tend to favour the big four banks because they offer full suites of products, have convenient networks, and offer the prospect, at least, of a ``relationship". It is also expensive and inconvenient to change providers.

The smaller players will focus on niches in the SME market that are more easily attacked than those needing full-service offerings, and attempt to unbundle SME banking in much the same fashion as they have unbundled and cherry-picked the retail-banking market.

If the mortgage brokers, and perhaps financial adviser groups (who are facing a significant squeeze on their fee income streams as the wealth-management sector matures and changes shape) can establish footholds within the banks' traditional territory, they will accelerate and intensify the competitive pressures.

The experience in the home-loan market indicates that competitors don't have to grab big slabs of market share to exert tremendous leverage over the big banks' pricing.

One suspects that both their own underrated competitiveness and their desire to prevent non-banks getting any sort of beachhead in a new core market explains why margins and fees for SME banking have been falling in recent years, ahead of any meaningful presence in the segment of non-bank competition.

The big banks have been able to offset the squeeze on home-loans margins with the massive volume gains provided by the housing bubble, gains at least partly attributable to the impact of the non-bank activity in the sector.

If there is a similar supply-led eruption of competition in SME banking, one could expect the volume gains to offset the margin squeeze in the near term.

SME lending is, of course, more complex and risky than home lending, and intense competition does tend to lower credit quality. The big banks will no doubt remain conscious of the trade-off between simple volume and pricing sensibly for risk.

bartho@theage.com.au