For the traditional banker, serving the United States’ 5.5 million small businesses is very good business. Generating $33 billion a year from checking accounts, simple credit, deposit products, and other services, this market provides many banks with returns on equity of over 30 percent. The contrast with consumer banking, where only the top customers produce profits, is marked. More than three-quarters of all small business customers are profitable over a three-year period. And again in contrast with consumer banking, small business is an area where banks hold a full 90 percent of the market.

As competition begins to hot up, every player needs to examine its own competitive position and those of its rivals

But this is only part of the picture. If we step back and take into account the activities of institutions other than banks, a more complex landscape emerges. Software firms, payroll processors, office product retailers, credit card companies, and a host of others are already serving or are poised to serve the financial needs of small businesses. Any organization seeking to capture or defend small business markets must base its strategy on this broader view. As competition begins to hot up, every player needs to examine its own competitive position—its skills, technology, cost structures, customers, geography, and aspirations—and those of its rivals before it can appreciate what strategic options are available to it. Uncertainty abounds, and many fundamental questions must be answered: Which customers should I target? What products should I sell? How should I sell them? Where can I form alliances?

Despite the uncertainty, the small business market offers tremendous promise. It is much larger than it at first seems. Small business owners have many financial needs beyond those currently served by banks: for payroll, tax services, life insurance, property and casualty insurance, and employee health benefits. Instead of producing a total of just $33 billion in yearly revenues (or $6,000 per business), small businesses actually generate close to $80 billion a year ($14,000 per business). That makes them equal in size to the US residential mortgage market, and twice as big as the credit card market.

According to this broader view, banks hold only around 40 percent of the small business market. But we could step back still further. If we include the retail accounts of the owners and employees of small businesses, which we believe can be influenced by the small business market, another $122 billion in revenues is added to the picture, making a total of $200 billion per year.

Many banks are going after this market with great fervor. In 1996, Mellon increased its reported small business loan portfolio by 136 percent to $1.4 billion, while Union Bank of California achieved a 35 percent rise to $1.3 billion. Over the next ten years, Wells Fargo Bank plans to lend $25 billion to small businesses, using an innovative approach involving nationwide direct mail. Banks such as Wachovia are bundling products and services to capture a larger share of the small business market.

First Union is exploiting its size to act as a group buying agent for small businesses; it provides third-party discount services on major purchases such as long-distance phone service, overnight package delivery, and car rentals. Barnett Bank is teaming up with Staff Leasing to offer small businesses relief from the administrative burden of workers’ compensation and compliance with unemployment and payroll tax regulations. KeyCorp has created PRISM Small Business to offer retirement plans to companies with fewer than 100 employees. In addition, it recently went into partnership with the OfficeMax retail chain to locate small business branches within OfficeMax and CopyMax stores.

Outside the banking industry, interest in small businesses is equally intense. With over 1.6 million small business cardholders, American Express has formed or is forming partnerships with credit providers such as Wells Fargo, BancOne, and AT&T Capital to serve this market. Automatic Data Processing (ADP), the dominant provider of payroll processing, is expanding steadily from its traditional base of large corporate clients, having already gained more than 250,000 small business customers. It also owns Peachtree Software, the second-largest producer of accounting software, as well as a federal savings bank in Pennsylvania. The innovative software firm Intuit is now the largest provider of small business accounting and financial management software. Its recently released QuickBooks 5.0 is a complete accounting and book-keeping program that offers online bill payment features and online banking capability with almost 30 banks.

All of this activity testifies to the potential of the small business market. Competitive intensity is sure to increase. In the short term, the margins on most conventional products will shrink. While no dominant player has yet emerged, we believe that the range of feasible strategies is becoming clearer. One set of strategies builds on an organization’s distribution capabilities in pursuit of more effective ways to reach small business customers. Another set focuses on the manufacturing of specific groups of products which are then sold via multiple distribution channels. Finally, changes in the market are providing opportunities for players to integrate information and product services for small businesses and other financial institutions.

Distribution strategies

Financial institutions that adopt distribution strategies play the role of retailer, selling a selection of products direct to customers. The wider the range of product they can offer, the better their performance. In a sense, these strategies parallel current attempts by many banks to cross-sell products and use databases to drive marketing. As in retailing, a number of viable value propositions exist. A financial institution can serve the broad market, focus on a few choice customer segments or geographies, or provide everyday low prices.

Broad-line distribution strategy

This strategy offers personalized service and advice and the convenience of one-stop shopping across the full range of small business services. It relies on a strong brand name and on a highly trained (and often highly paid) "financial consultant" who brings in new customers and serves them across all their financial needs, business and personal. Costs are high because of the wide range of products and the relationship-intensive channels used to deliver them, but these costs are more than offset by better customer retention and the premiums paid for the advice of skilled financial consultants and supporting specialists. As in retailing, broad-line players are able to capture scale economies in processing and technology, and to exploit their strong bargaining position with product suppliers.

Until recently, regulation prevented companies from selling the full range of insurance, tax, brokerage, and bank products to small businesses in the United States. Now that the regulatory environment has begun to be relaxed, national and super-regional banks with strong name recognition would be good candidates to attempt this strategy. So would national brokerages such as Merrill Lynch, Dean Witter, Smith Barney, and Paine Webber, and national insurers that have strong agency forces and handle both retail and commercial products, such as State Farm and American Express Financial Advisors. With its strong brand name and 8 percent share of the small business insurance market, State Farm could be a formidable competitor.

Many institutions are likely to try this strategy, but few will succeed in the long term. It is very "open," with no inherent structural advantages to provide protection from competitors. It also requires a superior sales staff that can consistently deliver value and attract and retain customers.

Customer segment strategy

For companies with the brand recognition and skills to sell a wide range of products to the small business market, focusing on selected customer segments will often be a sounder strategic choice. However, it is not without challenges of its own. For the strategy to succeed, a customer segment must be both cohesive and large enough to justify the costs involved in creating tailored multi-product offerings. It must also show real brand loyalty. As few segments can support more than one or two players, it is essential to choose and attack your segment quickly.

Focusing on customer segments demands expertise in dealing with multiple suppliers and building a highly skilled salesforce

As with broad-line distribution, this strategy demands expertise in dealing with multiple suppliers and building a highly skilled salesforce. Unlike the previous strategy, however, it relies on a unique understanding of a particular segment and the ability to deliver a truly customized, differentiated suite of products. Examples include Mellon’s recent partnership with the American Dental Association to provide a full range of financial services to dentists across the United States, and Corus Bank’s partnership with the Currency Exchange Association of Chicago to serve more than half of that city’s currency exchanges. Banks, brokers, or insurers that possess both strong marketing skills and existing relationships with similar affinity groups would be the best candidates for this strategy.

Local advisor strategy

A successful distribution strategy can also be built on a geographic basis. A local advisor would mimic the broad-line distributor in the breadth of its offering, but focus on a single locale—probably a non-metropolitan area—where it has strong ties to the community. Manufacturing very few, if any, of the products it sells, it would ruthlessly outsource as many products and functions as possible so as to concentrate its efforts on providing friendly, high-quality customer service. To stay competitive with other distributors, it would need to offer customers the convenience of remote access via ATMs, bill payment, and telephone service.

Smaller banks, regional brokerage firms, independent insurance agencies, and financial planners are the most likely candidates for such a strategy, though some larger competitors may also be well placed to succeed as local advisors. Operating almost 800 branches in smaller communities throughout the Midwest, Norwest could be seen as a prototype for this approach.

Discount distributor strategy

A final distribution strategy focuses on value for money rather than on a customer segment. Like a Target discount store in the world of retailing, a discount distributor for the small business market would offer customers standard products and simple, no-frills service at rock-bottom prices. It would serve not just the price-sensitive segment of the market, but also businesses too small to attract the attention of relationship-oriented financial service companies.

The discount distributor would concentrate primarily on the cost side of the equation, using the potent economics of electronic and remote channels to gain an operational cost advantage. To process a bill payment through a bank branch costs approximately $1.93, for example, while at an ATM it costs only 67 cents, and by computer a mere 19 cents. A company pursuing this strategy would need continuously to improve its operations, driving costs inexorably downward by using creativity and cutting-edge information technology to obtain more functionality with fewer resources. It would purchase most of its products from external vendors, buying in bulk to obtain low prices that will attract customers. The one area of major investment will be advertising and direct mail—the only ways for the company to communicate its offering to the price-sensitive segment in its entirety .

Market demand for this strategy is currently low because of the cross-subsidies present in today’s banking industry. The huge profits they reap from a few customers allow banks to charge artificially low prices to the mass of customers. Soon, however, these cross-subsidies will be challenged by competitors that cherry-pick the most attractive customers. In order to remain profitable, banks will have to raise prices for their other customers, thereby opening the door to the discounters. If price wars ensue, their lower cost structure will ensure that the discounters win.

This strategy is viable only for large banks, discount brokers, and insurers with superior processing capabilities and experience with large, modern IT infrastructures. It requires substantial upfront expenditure on technology, thus excluding many institutions without the capital or talent to devote to this effort.

Manufacturing strategies

Many of the distribution strategies are enhanced by the existence of financial institutions that focus on making products rather than on distributing them directly to end users. There are two types of manufacturing strategy, one focused on high-volume, simple products and the other geared toward low-volume, customized products. Though neither holds out as much promise for banks as do distribution strategies, they still have potential, particularly for early adopters.

Simple product strategy

Focusing on manufacturing simple products or services in quantity, the category killer offers ubiquity, a recognized brand, and high quality. Consider the Fidelity Magellan fund, which achieved superior returns throughout the 1970s and 1980s, building a strong brand and dominant position in retail asset management for its parent Fidelity organization. Countrywide Credit plays a similar role in the mortgage business, where it enjoys a cost advantage over competitors in mortgage origination. Having invested heavily in information technology, it can process loans twice as fast as an average player. The credit-scored direct small business loan is one example of a product targeted by several category killers today.

As market awareness of its offering grows, the category killer will leverage all possible channels to gain volume, delivering its products directly via its own salesforce and other distributors. Volume brings economies of scale and cost advantages over competitors, while deeper experience in making and servicing a product helps a manufacturer further refine its skills. As a result, it may make even better products or develop new forms of product.

On the other hand, the category killer has to cope with the complexity of selling its product through multiple channels. It also runs the risk of falling victim to its own focus. Lacking the diversification that a range of products represents, it may find that if its product loses favor, its economics will crumble.

Many standard small business products and services are amenable to a category killer approach, among them numerous credit, leasing, and insurance products, as well as some investment offerings. Companies adopting this strategy will probably leverage existing strengths in retail banking and middle-market products, or expertise from within their current small business operations. Examples include Wells Fargo for lending, Erie Insurance Group for property and casualty insurance, American Express for credit cards, and ADP for payroll processing.

Specialist strategy

The other role available to the manufacturer is that of a specialist providing tailored products and services to meet complex needs, such as trusts and estate planning, taxes, environmental liability insurance, and the buying and selling of businesses or partnerships. These all take time, skill, and effort to provide, but command large margins because there are few providers to choose from and any errors will be costly. Specialists will direct their marketing efforts toward a small set of distributors, trade organizations, and specialty publishers, rather than toward final customers. Broad-line and local distributors will have to maintain relationships with one or more of these specialists if they are to offer a complete range of services to their most valued customers.

As long as the source of its value remains complex, and therefore hard to emulate, the specialist will enjoy many advantages in the market. The primary risk it faces is that of losing its skill advantage to a category killer. With advances in technology, some specialty skills can become commoditized, as seen in small business loans with the advent of credit-scoring. Those following the specialist route might include independent certified public accounting firms, trust companies, and specialty insurers, law firms, and investment banks.

Service strategies

Finally, there are two strategies based on service. One focuses on serving the manufacturing and processing needs of smaller distributors, the other on serving all the payment needs of small business customers in an integrated way.

Product aggregator strategy

If they are to compete with large national players, small distributors and local advisors need access to a broad assortment of up-to-date, competitively priced products. There is a service role to play in providing that access. While such a "product aggregator" strategy is not new to banking, it is still rare in the highly fragmented small business market, where little outsourcing takes place, especially among smaller banks. In cash management, for example, small banks typically outsource only 30 percent of their needs, compared with 55 percent for larger banks.

The product aggregator will act as a wholesaler, drawing together the demand generated by many small distributors and negotiating with manufacturers to obtain the latest products at competitive prices. It may also manufacture its own products to supply to distributors, and provide processing and IT services to small distributors. Solid account management and top-quality service will be crucial, since the product aggregator’s offerings—account statements, customer service call centers, ATM operations, payroll, 401(k) products, transaction processing, and so on—will be highly visible to customers.

Two ownership models exist for this strategy. A product aggregator might be an independent entity that exploits the skills it has gained by serving small local advisors to move into product manufacturing and wholesaling as its customer base expands. The second model resembles the role that Ace Hardware plays in the hardware business: a cooperative buying group of small distributors banding together to obtain a wide range of products and negotiate processing contracts. Such a mutual organization may also allow participants to share best practices and market information, commission market research, create benchmarks, and develop customer databases for the benefit of all members.

Large product aggregators benefit from several kinds of economy of scale. First, they are much more efficient; witness the steady consolidation in the merchant card servicing and check processing businesses. Size also allows these players to invest in technology to cut costs and improve service. In addition, they can buy equipment, advertise, and source products such as PC banking, insurance, and investments more cheaply than their smaller rivals.

Banks with large-scale processing or correspondent operations, such as First Chicago NBD, National City, and Chase Manhattan, could become major players in this area; so could big technology outsourcers with extensive processing operations, such as EDS, Fiserv, and NYCE. Companies such as Deluxe and Harland may also choose to broaden their services beyond checks and database marketing, leveraging salesforces that already have relationships with many of the community banks. Moreover, such associations as the Independent Bankers Association of America are aggressively pursuing this strategy for their members.

Integrated payment provider strategy

The last strategy serves the small business owner who seeks the benefits of sophisticated integrated financial management, but cannot afford to hire a dedicated financial manager. The integrated payment provider (IPP) offers sophisticated cash management, tax payment, and electronic bill payment services, as well as intelligent online access to many financial products and services, including investments, loans, basic financial advice, and small business publications. Cheap, convenient electronic applications and transactions drive this strategy’s economics and value proposition. As well as being much cheaper than transactions conducted by ATM, telephone, or teller, electronic interactions are more reliable, faster, and capable of providing far more information.

An IPP gives small businesses a platform for secure electronic transactions. It maintains and updates a library of products, services, and business information. And it can automatically manage authorized payables and receivables, payroll and tax payments, and other types of accounts. It could, for example, optimize a small business’s cashflow by balancing payables, receivables, supplier discounts, past-due accounts, deposit accounts, and lines of credit, shifting money where it can be most effective. In an online loan application, it could release credit and financial statement information to multiple providers, selecting the one that fits the customer’s preferences and offers the best value.

Successful IPPs will require many organizational capabilities. Superior technical expertise in software and networks will be vital. Strong marketing skills will be needed to translate a litany of technical specifications and features into simple, compelling value propositions for the customer. While small businesses may be familiar with accounting software and information databases, they will initially be wary of letting a third party handle their cashflows. The IPP must create a culture that attracts and retains the experts needed to run the network. Losing key individuals to competitors could wipe out any lead that one IPP manages to build up over another. Finally, the IPP will need deep pockets to support large upfront investments and fund operations until a critical volume of customers has been amassed.

The IPP strategy poses a serious potential threat to banks: it may ultimately control the way in which small business customers are presented with the product offerings of financial service providers. The SABRE airline reservation system has demonstrated that an institution’s position on a list of similar products is crucial to obtaining business from that list. The worst outcome for a bank would be to end up as just another name among hundreds of financial service providers.

At present, many different players hold various pieces of the IPP approach. No one player will be able to create an IPP solution alone. It is more likely that a consortium of participants—banks, insurers, software houses, service providers, processors, and telecommunication companies—will be established to experiment with the opportunities in electronic commerce.

All players will have constantly to adapt their strategies and business systems to the intensifying competition

The strategies outlined here are simply a sketch—a jumping-off point into the small business market. All players, whether banks, insurers, technology providers, or credit card companies, will have constantly to adapt their strategies and business systems to the intensifying competition and shifting dynamics that look likely to persist for the foreseeable future. The successful companies will be those that make an early start on assessing and understanding the many pitfalls and organizational issues along the way. Adapting to new markets is a process of trial and error that gives the advantage to early movers—those willing to experiment and learn. To wait carries great risks.