How to make the SME Segment Profitable for

How to make the SME Segment Profitable for Commercial Banks Greg Rung May 2005

Opening Remarks • Talented speakers… • … have already said a lot • This proves the quality of the conference… • … and shows a common vision, ie need for economies of scale

SME Banking Framework: Shifting the Productivity Frontier What are banks trying to do? Productivity Frontier (Future state of Best Practice) How? Generating Growth: Through profitable marketing strategies Improving Asset Quality: Through enhanced risk management Lower unit costs per transaction or service Limited services to limited number of customers UNPROFITABL E Broader service offerings & higher asset quality Increasing Operating Efficiency: Through technological innovation

Scope Taken out of this presentation but important: • Right environment is needed: credit bureaus, appropriate tax systems • Leasing is definitely part of SME banking • Elements on program lending, scoring… What is left? • Holistic • Hybrid • Project/change management • Execution

Key messages / Presentation Outline • SME banking, although difficult, can be highly profitable • Differences across markets tend to disappear with the globalization of the financial services industry. • In practice, it means that targeting SMEs impacts the entire value chain • Based on this, several types of strategies can emerge • Implementation is critical

SME Banking Can Be Highly Profitable In the US, the SME segment generates higher returns Market Size Insurance Consumer Credit SME Banking Mortgages Credit Cards ROE

SME Banking Can Be Highly Profitable (Contd) In a number of Emerging Markets, some banks also generate high returns in the SME segment Example of a bank in South East Asia

Differences across markets… Leading wholesale banks in US and Europe Credit portfolio is: -Managed actively (ex: secondary market activities) Main European Banks and some others -Managed like a profit center -Credit rating is used for key business decisions (pricing, capital allocation) -Linked to overall balance sheet management -Credit portfolio exposure, risk and profitability are measured -Some processes often remain lengthy and costly Most other banks -Credit assessment done in a “traditional” way. Many processes remain lengthy and costly -No systematic rating, implementation of RAROC concepts nor link between credit worthiness and pricing

… Tend to Disappear with the Globalization of the Financial Services Industry - Growing competition - Opportunity to charge higher interests and transaction fees to SMEs - Need to diversify portfolio to lower overall risk - Information technologies lowering costs Banks have an incentive to tap new markets : Large Cos and “A” Clients SMEs, Microenterprises & Mass-market Current Clients Underserved Market

In Practice, Targeting SMEs Impacts the Entire Value Chain Marketing strategy Products and services offerings Risk management Organization IT / Systems Delivery channels

1. Marketing Strategy • In addition to conducting competitive analysis (on products, terms & conditions; from other countries), … • … segment the market and build up in-depth knowledge of SME clusters, especially through third-party data providers • Find ways of retaining existing credit-worthy customers… • … & reducing cost of acquisition of new targeted customers • Manage information transversally (e. g. , get, compile and analyze default information, if available by industries & companies)

2. Products & Services Offerings Maximize client retention and profitability by offering product packages as well as cross- and up-selling Credit § Loans § Guarantees § Credit Cards § Overdrafts Payments § Domestic payments § International payments § Check processing Deposits § Checking accounts § Savings accounts § Money market accounts Value-added § Insurance § Brokerage § Information & tools

2. Products & Services Offerings (Contd) Focus on deposits even if lending is necessary U. S. Small Business Profit Distribution Deposits 70 -85% Source: FIC Loans 10 -15% All Others 5% Small Business Profitability 100%

2. Products & Services Offerings (Contd) The deposit/loan ratio largely determines small business ROE Small business unit ROE Small Business Profitability 40% Bank B Bank C Bank A 20% 0% 1: 1 2: 1 3: 1 Deposit-to-loan ratio Source: First Manhattan Consulting Group 4: 1 5: 1

2. Products & Services Offerings (Contd) Number of products The more products sold, the greater the profit contribution Contribution Source: Oxford Information Technology, Ltd.

3. Risk Management / Analytics Efficiency Gains with Credit Scoring Enter Data Generate Score Apply Decision Strategy Auto decline High risk Review Medium risk Auto accept Low risk

4. Delivery Channels • Goals: cost efficiency, differentiation in the market and client satisfaction. For that: • Review existing delivery channel mix & utilization… • … as well as current and potential level of automation • Focus the branch network on marketing, sales and client relationships • Design multi-channel networks mixing branches – business bankers/agents – ATMs – mobile kiosks – call centers – electronic banking – smart cards – mobile banking

4. Delivery Channels (Contd) Pre-Sale Prospecting Channel • Buyer Identification • Buyer Solicitation Information Provision • • Features Pricing Selection Availability Post-Sale Advice and Consultation • Aggregatives • Optional Categorizatioin • Alternatives Order Capture • Specifications • Feature • Entry Order Processing Customer Support • Transaction Processing • Billing • Complaint Handling • Account Reconciliation Direct Mail Phone Center VRU Branch Online Channel Efficiency (Capacity to Cost Ratio) Source: Business Banking Board Research High Low

4. Delivery Channels (Contd) In emerging markets, personal contact is critically important… Banco Solidario (Ecuador), reaches 45% of its customers through bankers in the field – similar situation for Bank Dagang Bali (Indonesia) which has very few branches Vs Bank BRI (Indonesia) received an award from the Indonesian Museum of Records for establishing 4, 658 branches throughout the country (92% of Bank BRI’s portfolio is microloans) Source: FIC

4. Delivery Channels (Contd) …as is word of mouth • 45 % of Banco Solidario’s new customers are referred by existing customers • At Bank BRI, a senior manager states, “All new customers are referrals. Good [loan] customers never just walk into the bank” Source: FIC

5. Organization Align organizational requirements – Separate organizational responsibilities for SME Finance (part of retail rather than corporate banking) – Market versus product focus – Clarify responsibilities for sales vs. credit vs. collections – Clear responsibilities and incentives for deposit raising and cross-sales (including personal financing needs of the owner) – Centralized processing of credit applications – Clear processes for collections

6. IT / Systems • As for the organization, client-driven vs. product-driven • Develop efficient integrated information systems by leveraging appropriate technologies… • … towards Customer Relationship Management (CRM) capabilities… • … and multi-channel management

Based on This, Several Types of Strategies can Emerge Focus of the strategy Key components Risk management - Use sophisticated credit scoring models - Build informal networks to gather asymetric information on potential borrowers - Develop deep understanding of industrial sectors Margin management - Use of technology to reduce delivery and service costs - Redesign organization structure to manage operational costs Superior value proposition - Gain in-depth understanding of customer needs and behavioral drivers to develop and deliver differentiated value proposition

Conclusions • SME banking is hybrid • It generally involves a specific strategy and a total redesign of the value chain • Quality of execution is key

Example of Project Module 1 : Standardization of Product Offering Analyse performance Analyze de performance Get infor. Collecte mation on existing des contrats products Benchmarking Define a Elaboration revised d’une gamme de product produits offering cible Plan Implementation d’implémentation

Example of Project (Contd) Module 2 : Improvement of Loan Appraisal Fi Process and Scoring Data warehousing Scoring tool Analysis of current situation • Data available • Scoring tools in place • Loan appraisal forms • Methodologies/ processes Define missing data Development of scoring tools n d d at a a n d fo llo w • Back-u testing p • Definition of new procedures • Communic ation • Training • Follow-up

Example of Project (Contd) Module 3 : Improvement of Collections Analyse the portfolio Analysis ofde performance Benchmarking Analysis of the processes • Identify quick wins Elaboration • Improve processes d’une gamme de • Set-up a call center produits cible • Training

Possible Next Step if Interest: Diagnostic Gather data on – – Customer segmentation Sales organization CRM Risk-based pricing Calculate key indicators – Fee vs. interest income ratio – Profitability by customer segments Portfolio-at-Risk % loans with early defaults % Non Performing Loans Ratios on Collections Efficiency Ratios on Provisions and Write-offs Understand profitability drivers Gross Margin – Centralization of creditapproval – Accuracy of Risk Reporting – Efficiency of Collections – – – Processes streamlining – Scoring/Rating tools – Branch as a distribution channel – Organization of back-office – Overhead/Net Income – Staff productivity – Branch productivity Overhead Costs – Product mix and impact on funds – Governance/Disclosure – Treasury Management / ALM – Ratio loans/deposits – Ratio interest bearing / non interest bearing deposits – ALM key ratios Cost of Funds Cost of Risks – Formulate a diagnostic on current situation and ways of improving net margin – Draft a proposal

Contact Details Greg Rung Email: grung@ifc. org

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SME Banking Is Difficult… SME market knowledge is difficult to acquire – “A Corporate” market composed of a few hundreds of large wellknown companies, vs. – A mass market composed of hundreds of thousands of SMEs in different Industry Sectors and Geographic areas SME Risk is difficult to manage for traditional banks – Financial information on the business is scarce and often non reliable – SMEs are often under-capitalized – SMEs are often unable to provide adequate collaterals – SMEs lack Financial Management culture SME banking has high cost-to-serve – One Corporate transaction can generate the same Net Banking Income as 50 SME transactions… – … But is not much costlier to the Bank than 1 SME transaction

… In Countries with the Adequate Environment Banking Regulations Judicial System – Should enforce creditor rights – Should allow quick and efficient dispute resolution Payment Systems – To improve productivity – To develop value–added products with good service quality Communications, Infrastructure – Easy contact with customers and branches across country Credit Information – Credit-Information Sharing

3. Risk Management / Analytics • Use of advanced, cost effective tools & processes for comprehensive risk management… • … from data capture & management to data analysis and monitoring. . . • … by possibly leveraging information derived from historical performance of SME clients… • … and scoring experience of consumer credit underwriting (models, application processing, reporting) • This supposes good coordination between portfolio management and collections departments, in particular

3. Risk Management / Analytics (Contd) Example of a Simple Scorecard Age of Owner 18 – < 21 6 21 – < 25 10 25 – < 30 18 30 – < 40 26 40 – < 50 35 Marital Status Single 14 Married 30 Divorced 5 Other 14 NI 14 # of Dependents 0 14 Own 40 1 14 Rent 15 2 25 Parents 20 3– 4 10 Company 18 4 – High 5 NI 20 NI 14 <1 1–<3 3–<6 6 – < 10 18 20 25 30 Prof. Services I. T. Other Services Retail 38 35 30 27 10 – < 15 33 Catering. 20 15 – High 40 Building 10 8 – < 15 38 NI 20 Residential Status Years at Address Industry Heavy Manuf. Others Industry - continued 8 27 Years in Business Total Assets <. 5 16 . 5 – < 2. 5 20 GT 100, 000 LT $100, 000 27 18 Yes No Negative File Information – 30 15 50 – High 42 NI 27 2. 5 – < 5 27 5–<8 34 NI 10 No Investigation 0 © 1995 Fair, Isaac and Co, NI 0 NI 10 NI 25

3. Risk Management / Analytics (Contd) Evaluating the Credit Applicant CHARACTERISTIC JUDGMENT CREDIT SCORING Age Marital status # of dependents Residential status Time at address Industry Time in Business Total Assets Negative file information + – + – – + + 26 14 25 18 25 20 20 27 15 OVERALL Decision + 190 Accept ODDS OF REPAYMENT Accept ? © 1995 Fair, Isaac and Co, 95%