Small businesses often vex retail bankers. Together, these companies represent 35 to 45 percent of total banking revenues in Europe from all business customers, while they account, at best, for 20 percent of all profits. But a solution may be at hand. A few mass-market retail banks have successfully turned small-business customers into a profit center. They have done so by defining the boundaries of the small-business segment clearly and then subdividing the territory into a handful of smaller groups based on banking needs.

To study how European banks approach small businesses, we looked at the operations of 15 financial institutions. To make more accurate comparisons, we defined small businesses as those with no more than 50 employees and an annual turnover of about €10 million ($11.4 million). This categorization, which includes such operations as farms, shops, hotels, restaurants, and small services firms, covers the bulk of owner-managed businesses that don’t have separate financial officers. (Companies with chief financial officers are normally too large to fit into the small-business segment; in addition, CFOs generally demand more sophisticated financial services than a bank’s small-business unit can provide effectively.) While this definition is appropriate for most European banks, in some cases the boundaries may need to be adjusted to account for the maturity of the local economy, the profitability of the local banking sector, or other factors that can affect both the needs of businesses of various sizes and the ability of banks to meet those needs.

We found that the small-business operations of many European banks serve a hodgepodge of clients beyond these boundaries. At one end of the scale are businesses so small that they would more appropriately be treated as retail customers. Banks persist in offering them unnecessary, expensive products and thereby give them more attention than is needed or warranted. At the other end of the spectrum, underperforming customers once rightly placed in the midsize corporate segment are rarely reclassified as small businesses even though many are no longer worth great effort. Moving such customers away from highly personalized services would significantly reduce the cost of serving them and may unleash new profits.

Defining the segment is only a first step; banks should then divide it into workable subsegments. Most mass-market retail banks use industry sectors or some measurement of size—annual turnover and the number of employees are common ones—to subdivide their small-business customers. But sector and size are only crude proxies for what drives profitability. As a result, these banks don’t tailor products sufficiently to capture the full profit potential.

True, some European banks—including Belgium’s Antwerpse Diamantbank (which serves the diamond industry) and Germany’s Deutsche Apotheker- und Ärztebank (which concentrates on doctors and pharmacists)—do cater successfully to single industry sectors. But the performance of such banks is built on their finely targeted products, outstanding knowledge of the industry in question, and dominance of their markets. Mass-market retail banks can’t duplicate these factors efficiently across the wide breadth of industries they serve.

For such banks, a more effective approach is to group small-business customers, regardless of sector, by some cross-cutting criterion—for example, business maturity, the required level of service, or product usage. Most successful banks follow two main rules. First, keep the number of subsegments small because the costs of creating overly differentiated products, services, and strategies can rapidly outweigh the commercial benefits. A division based on product usage, for instance, should rarely yield more than four subsegments. Second, the chosen criteria should make it possible to sell proactively to each subsegment instead of relying on an essentially relationship-based, reactive approach to sales. Grouping customers that require similar products, for example, makes it more feasible to discover useful information about these customers, to develop targeted marketing and sales campaigns for them, and to direct them to frontline bank employees with the appropriate skills to serve them.

One successful European bank chose to distinguish among its small-business customers that needed credit, held a significant amount of assets, or more closely resembled mass-market or retail customers (exhibit). For the latter, the bank developed a package that provides only for on-line transactions and strongly supports the cross-selling of basic financial services. Each manager for this subsegment serves as many as 700 customers, and most interactions take place by phone. Prices are intended to stimulate the utilization of inexpensive channels, to limit the frequency of transactions, and to promote the use of additional banking products.

For credit-oriented customers, the bank designated specific branches as bases for small-business credit specialists with portfolios of up to 150 clients. In addition to corporate-credit products, these salespeople are skilled in marketing personal-finance products aimed at owner-managed businesses and, to some extent, at employees. The key processes are aligned with the core credit products, and pricing is focused on the risks associated with each customer; these risks are assessed largely using automated systems. For customers with net assets, the bank designated financial advisers who have a thorough understanding of the available cash-management, savings, and investment options rather than their credit colleagues’ deep knowledge of financing. Each adviser serves 100 to 150 clients.

By moving from an approach focusing on small businesses in general to one that divided customers into subsegments, the bank’s small-business operation saw its return on risk-adjusted capital rise to 21 percent, from 9 percent. As a result, the bank emerged as one of the few mass-market institutions making healthy profits from small businesses. Other banks can emulate this approach by meticulously developing models based on differentiated services that match the business needs and profit potential of a small set of carefully defined subsegments.