51805 The SME Banking Knowledge Guide IFC AdvISory SErvICES | ACCESS To FInAnCE In Partnership with: 2009 © International Finance Corporation (IFC) 2121 Pennsylvania Avenue NW Washington, D.C. 20433, USA Telephone: 202­473­1000 Internet: IFC.org All rights reserved This information, while based on sources that IFC considers to be reliable, is not guaranteed as to accuracy and does not purport to be complete. This information shall not be construed, implicitly or explicitly, as containing any investment recommendations and, accordingly, IFC is not registered under the U.S. Investment Advisers Act of 1940. The denominations and geographical names in this publication are used solely for the convenience of the reader and do not imply any judgment on the part of IFC, the World Bank, or other affiliates concerning the legal status of any territory or the endorsement or acceptance of such boundaries. 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Contents List of Abbreviations 2 Foreword 3 Preface 4 Executive Summary 5 Introduction 7 SMEs and the "Missing Middle" 9 Definitions of the SME market 9 The economic importance of SMEs 11 Unmet demand for banking services 12 The SME banking opportunity 14 Bridging the Middle: SME Banking Today 17 Composition of the industry 19 The role of the operating environment 20 Challenges and Approaches along the Banking Value Chain 25 Risk management 26 Understanding the SME market 28 Developing products and services 32 Acquiring and screening SME clients 40 Serving SME clients 46 Managing information and knowledge 52 Engaging the SME Market 55 Lessons from SME banking today 55 Getting started: entering or expanding SME banking 59 Tools for initiating market entry or expansion 61 Appendix A: Sample SME definitions 68 Appendix B: List of bank case studies and vignettes 69 Appendix C: Partnering with IFC 70 Appendix D: About IFC 71 References 72 Endnotes 74 2 THE SME BANKING KNOWLEDGE GUIDE List of Abbreviations ANDE Aspen Network of Development IIC Inter-American Investment Entrepreneurs Corporation ATM Automated Teller Machine IT Information Technology BD Business Development LE Large Enterprise BRIC Brazil Russia India China ME Medium Enterprise CAGR Compound Annual Growth Rate MFI Microfinance Institution CFO Chief Financial Officer MIF Multilateral Investment Fund CRM Client Relationship Management MIS Management Information System EBL Eastern Bank Limited MOEA Ministry of Economic Affairs (Taiwan) EBRD European Bank for Reconstruction MSME Micro, Small, and Medium Enterprise and Development NGO Nongovernmental Organization EM Emerging Markets NPL Nonperforming loan EMPEA Emerging Markets Private Equity OECD Organization for Economic Association Cooperation and Development EWS Early Warning Signals P&L Profit and Loss FI Financial Institution PE Private Equity FELEBAN Latin American Federation POF Purchase Order Financing of Banks RM Relationship Manager FS Financial Statement (Management) FY Fiscal Year ROA Return on Assets GDP Gross Domestic Product SBA Small Business Administration GM General Manager SE Small Enterprise HQ Headquarters SME Small and Medium Enterprise IDB Inter-American Development Bank SRA Senior Resident Advisor IFC International Finance Corporation TA Technical Assistance IFC ADvISOry SErvICES | ACCESS TO FINANCE 3 Foreword Fostering a dynamic small and medium enterprise (SME) sector is seen as a priority amongst economic development goals, in both developed and emerging economies. SMEs are a primary driver for job creation and GDP growth. They greatly contribute to economic diversification and social stability and they play an important role in private sector development. SME development also represents a major and difficult challenge. SMEs typically face more severe constraints to growth than large companies, their lack of critical size resulting in reduced access to markets, skills, and capital. Lack of access to financing is consistently cited by SMEs as one of the main barriers to growth. Often considered by commercial banks and financial institutions as risky and costly to serve, SMEs are largely underserved when it comes to basic financial services. With such limited access to financing, SME owners struggle to make the investments they need to increase productivity and competitiveness of their business, develop new markets, and hire more people. For more than 50 years, IFC has helped expand access to finance for sustainable private enterprises in developing economies. Leveraging this track record and learning from the experience of banks successful at serving SMEs, IFC has been working with commercial banks to recognize and seize the untapped and profitable opportunity that the SME segment represents. With IFC and others' help, they are learning how to better understand and cater to SME financial needs, how to better manage SME risk, and how to process smaller transactions at lower cost and with better service quality. We are proud of our leadership in the SME finance arena. As of end fiscal year 2009, IFC had a committed portfolio of $6.1 billion in 200 financial institutions that primarily target small and medium enterprises in developing countries. About half of these institutions also received advisory services from IFC. In total, these institutions had an outstanding portfolio of 1.3 million SME loans amounting to $90.6 billion. The SME Banking Knowledge Guide synthesizes IFC lessons learned and aims to share what we believe are key success factors for profitable SME Banking operations. Is it primarily a technical publication, intended for bank directors, managers, and staff in developing economies, who see the untapped opportunity in their local markets but still wonder about the optimal way to approach the SME segment. It is also a useful tool for policy-makers and other financial sector actors who seek to better understand the essentials of SME finance. We hope that this guide will provide a useful reference to many financial institutions willing to engage more actively with small and medium enterprises across the world. Peer Stein Global Business Line Leader Access To Finance 4 THE SME BANKING KNOWLEDGE GUIDE Preface The objective of the SME Banking Knowledge Guide is to share and disseminate IFC's experience and knowledge with financial institutions considering or currently engaged in banking to small and medium enterprises. Financial services providers, who may find this Guide particularly helpful in developing or expanding their SME operations, include commercial banks, investment banks, leasing companies, private equity institutions, and microfinance institutions. Other organizations interested in SME access to finance issues, such as research institutes, government agencies, and nongovernmental organizations (NGOs), may also benefit from the content of this publication. The SME Banking Knowledge Guide draws widely from existing research and literature, as well as from numerous primary interviews with SME banking experts and practitioners worldwide. It is not designed to be prescriptive and does not advocate for a single approach to SME banking. Rather, the Guide seeks to support financial services providers in making informed choices by sharing the challenges, opportunities, and effective practices in SME banking from across the globe. This Guide leverages IFC's SME Banking CHECK Diagnostic framework used to assess SME banking operations, as well as its SME Banking Benchmarking exercise used to analyze good practice business models. In addition, practical examples of SME banking from a number of featured financial institutions are provided. Such examples may serve to highlight a good practice, or may simply serve to illustrate a learning experience. Financial institutions featured in this publication include Access Bank, Bank Muscat, Eastern Bank Limited, Hamkorbank, ICICI Bank, NBD Bank, Standard Chartered and Wells Fargo. Additional SME banking experiences are drawn from a variety of other banks and are cited throughout the text as appropriate. IFC, a member of the World Bank Group, creates opportunity for people to escape poverty and improve their lives. We foster sustainable economic growth in developing countries by supporting private sector development, mobilizing private capital, and providing advisory and risk mitigation services to businesses and governments. Our new investments totaled $15 billion in FY09, helping play a prominent role in addressing the financial crisis. For more information, visit www.ifc.org. Acknowledgment The IFC's Global SME Banking Program would like to acknowledge our donor partners, the Governments of Netherlands, Norway and Japan for their contribution and partnership in the program. IFC prepared this SME Banking Knowledge Guide under the supervision of a team led by Ghada Teima and with the support of Melina Mirmulstein and Anushka Thewarapperuma. The team would like to acknowledge the contributions of the IFC and World Bank peer reviewers: Ary Naïm, Ignacio Estevez, Neil Ramsden, Paul Rusten, Peer Stein, Sergio Shmukler, and Tony Lythgoe. We are also grateful to all the banks that shared their experiences in the Guide, as well as our regional colleagues who facilitated this process. We would particularly like to thank Dalberg Global Development Advisors' team of Peter Tynan, Yana Watson, and Jason Wendle, commissioned by IFC to produce this Guide. Dalberg is a strategy and policy advisory firm specializing in access to finance issues in emerging markets. IFC ADvISOry SErvICES | ACCESS TO FINANCE 5 Executive Summary Can small and medium enterprises be banked profitably, and is the market today an attractive one? How do banks overcome the challenges and capture the opportunities offered by the SME segment, particularly in developing countries? What is the difference between SME lending and SME banking? How can banks successfully expand their SME banking operations? These are the types of questions explored in the SME Banking Knowledge Guide. This Guide provides an overview of the current state of SME banking, and then breaks down the approaches that banks are using to unlock the potential opportunity in a challenging, but growing market. It concludes with guidance for banks that want to begin to strategically engage the SME market. The State of SME Banking Today SME banking is an industry in transition. From a market that was considered too difficult to serve, it has now become a strategic target of banks worldwide. The "missing middle," describing the gap in financial services provided to SMEs, is shrinking. SME banking appears to be growing the fastest in emerging markets (low- and middle-income countries) where this gap has been the widest. More and more emerging market banks are developing strategies and creating SME units. IFC's committed portfolio of investments in SME financial institutions has grown dramatically over the last five years -- by 271 percent -- totaling $6.1 billion as of end of Fy09. Competition in other markets is one reason cited for commercial banks moving "downstream" to serve SMEs. Also, governments around the world now recognize the importance of the SME sector and have worked to support its access to finance, sometimes by addressing legal and regulatory barriers or building credit infrastructure. But the key to the growth of SME banking may be that banks are starting to understand the particular needs and preferences of SMEs, and are developing tailored approaches to overcome the historical challenges of high credit risk and cost to serve. One sign that banks are unlocking some of the potential in the market is that they are reporting higher returns on assets from their SME operations. For example, leading banks reported rOAs of 3­6 percent for their SME operations compared with 1­3 percent bank-wide. Also, contrary to common perception, the SME market is served by a wide spectrum of banks, not just smaller banks with relationship-based models. Today, despite the significant challenges posed by the current (2009) global economic crisis, and the uncertainty ahead, many banks seem to be holding fast to their strong commitment to the SME sector, especially in emerging markets. While the full impact of the crisis is not yet apparent, banks maintaining their focus on SMEs often cite a strong belief in the importance of the SME sector to the national economy as a whole. Bank Approaches to the Challenges of Serving SMEs To effectively serve SMEs, banks have had to change the way they do business, and manage risk, at each stage of the banking value chain. This begins with working to understand the market, and how it differs from both the retail and commercial segments. Next, in developing products and 6 THE SME BANKING KNOWLEDGE GUIDE services, banks have begun to understand that SME banking lessons to use, however, banks need to follow a process for means much more than SME lending and are, therefore, market entry that begins with understanding the specific prioritizing nonlending products in order to provide total customer opportunity in the SME sector and ends with developing a value. Leading banks report that more than 60 percent of strategy and implementation plan. Two tools that facilitate their SME revenues come from noncredit products. this process are a market assessment and an operational diagnostic. A market assessment is concerned with determining Banks have found ways to manage both costs and credit risk as the size and nature of the opportunity as well as the competitive they acquire and screen clients. A bank's current portfolio landscape. An operational diagnostic helps highlight a bank's provides both a low-cost starting point for generating new strengths and weakness. IFC's SME Banking CHECK business and a source of valuable data that can enable it to Diagnostic Toolkit is an operational diagnostic built upon the understand and predict the risks associated with SME clients. five strategic areas of SME banking. Developing this capacity to predict risk without completely reliable financial information, by using tools such as credit In summary, serving SMEs is proving to be profitable and scoring, has enabled banks to more effectively screen rewarding for individual banks, and assisting the growth of potential clients. In serving SME clients, banks are improving SMEs will benefit national economies as well. Banks looking efficiency by using mass-market approaches for smaller to seize opportunities in the market can use this Guide as a enterprises and using direct delivery channels where means to learn from industry experience to date. By debunking appropriate. They also build their revenue base by prioritizing misconceptions of SME banking, establishing its business cross selling to existing clients. Finally, banks are adapting IT case, and sharing global good practices, the SME Banking and MIS tools, and building capacity to effectively use these Knowledge Guide hopes to support banks in building stronger, tools for managing information and knowledge in their service sounder services for small and medium enterprises worldwide. of the SME market, especially in understanding profitability and risk. The experience of individual banks such as ICICI Bank, Wells Fargo and Standard Chartered demonstrate innovative approaches to SME banking. Some of these innovations include multi-level service segmentation and creative involvement in equity financing of SMEs. How to Begin Engaging the SME market Banks looking to enter the market or expand their SME operations will be able to draw from the lessons of other banks' experience to date. These lessons apply to operations in five strategic areas: (1) strategy, SME focus and execution capabilities; (2) market segmentation, products and services; (3) sales culture and delivery channels; (4) credit risk management; and (5) IT and MIS. Before putting these IFC ADvISOry SErvICES | ACCESS TO FINANCE 7 Introduction Small and medium enterprises are central to economic development, particularly in emerging markets.i In order for SMEs to grow and their positive impact on the economy to continue, they need access to financial services, which has historically been severely constrained. Many SMEs in emerging markets often rely on informal sources of capital, such as borrowing from relatives, to meet finance needs. However, when a small or medium enterprise does access formal channels, it typically looks to a bank as its primary source of financial services. Banks have begun to turn their attention toward this untapped market and their service of SMEs is a major factor in increasing SME access to finance. In its broadest definition, the banking sector includes commercial and investment banks, leasing companies, microfinance institutions (MFIs), and other related institutions. The SME Banking Knowledge Guide pays particular attention to commercial banks, which are the most important financial intermediaries in most economies, as they link savings and investments. Commercial banks are distinguished in that they normally lend to, rather than invest in, SMEs. Unlike other specialized finance providers, commercial banks offer a broad suite of products and services including deposit, credit, transaction and advisory services. They also focus on enterprises in the formal sector, rather than informal microenterprises which MFIs traditionally serve. Figure 1 maps the scope of SME banking in comparison to other areas of SME finance. Motivation for the Knowledge Guide Commercial banks have traditionally viewed SMEs as a challenge because of information asymmetry, lack of collateral, and the higher cost of serving smaller transactions. However, as corporate banking margins continue to shrink and increasing fiscal restraint lowers yields on government borrowings, banks have begun to explore the SME space. Figure 1: SME banking covers a wide range of firm sizes and types of financing Financial Infrastructure Long-term · Credit Bureaus Finance Private Equity · Payment Systems · Collateral Registries Equipment Leasing Finance SME Banking Microfinance Working Trade Finance Capital Informal/ Formal/ Smaller Larger i Throughout the SME Banking Knowledge Guide, the term "emerging markets" refers to low- and middle-income, or "developing" countries. 8 THE SME BANKING KNOWLEDGE GUIDE In the developed world, banks have made significant strides in With an overview of the SME banking industry in place, serving the SME market in recent decades. However, in Chapter 3 explores bank approaches to serving SMEs at each emerging markets, many banks have only recently started to stage of the SME banking value chain. Each section within expand their operations into the sector, and the market is a Chapter 3 covers a specific stage of the value chain, and focuses long way from saturated. Many banks are still experimenting on the major challenges faced by banks. The chapter discusses with different approaches toward SMEs, but the success stories the approaches taken by the industry in general, and the thus far are highlighting a number of key principles for leading banks in particular, to address these challenges. The profitably banking the SME sector. In this period of industry end of each section covers "Steps to Excellence," or examples of transition, the SME Banking Knowledge Guide shares some of approaches that distinguish great practices from good ones. these success stories and highlights the emerging lessons from Three detailed case studies appear in Chapter 3, drawing the experience of banks serving SMEs. There is no single lessons from the experiences of Wells Fargo, Standard formula for effectively serving SMEs, but the principles in this Chartered, and ICICI Bank. Two other banks, Bank Muscat Guide can offer important insights to banks looking to and Access Bank, are also highlighted in shorter vignettes. strategically engage the SME sector. Finally, Chapter 3 also features a discussion of the more recent phenomenon of innovative banks engaging in equity financing of SMEs. Chapter Objectives Chapter 4 completes the Guide by providing tactical guidance Chapter 1 of the SME Banking Knowledge Guide provides an for banks looking to enter or expand their operations in the overview of the SME banking market, including common SME market. The chapter opens by summarizing the key definitions of the SME sector, evidence of their economic lessons that can be taken from the experience of banks serving importance, and a discussion of the unmet demand of SMEs. SMEs. These lessons are organized according to five strategic Evidence suggests that SME banking is a potentially rewarding areas that are critical to success in serving SMEs. Next, section endeavor for banks, both now and in the future. 4.2 describes how banks can get started and the key questions they need to ask in developing a plan to serve SMEs. Finally, Chapter 2 discusses the state of the SME banking industry, the Guide concludes by describing a market assessment overall trends, and key factors in the operating environment approach and the IFC's CHECK Diagnostic of SME banking that impact a bank's ability to serve SMEs. It features a special operations, two tools that can support the process of section that describes important sources of data on SME strategically engaging the SME market. The two case studies banking practices, and another that discusses the impact of the in Chapter 4 describe the experience of Hamkorbank and current financial crisis on the SME banking industry. In NBD Bank in expanding their own SME operations. discussing the operating environment, section 2.2 examines the role of government in supporting SME banking. A short case study of Eastern Bank Limited in Bangladesh illustrates that even in the most challenging operating environments, determined banks are seizing opportunities to successfully serve SMEs. IFC ADvISOry SErvICES | ACCESS TO FINANCE 9 SMEs and the "Missing Middle" SMEs are firms whose financial requirements are too large for microfinance, but are too small to be effectively served by corporate banking models. SMEs represent a large and economically important sector in nearly every country in the world. A thriving SME sector is commonly considered a sign of a thriving economy as a whole. In high-income countries, and some middle-income countries, SMEs account for over half of national output. Yet, historically, SMEs have lacked access to financial products and services, especially in developing countries. Especially elusive to SMEs are longer-term debt instruments. However, although banks have previously focused on high- value, low-risk corporate clients, there is an increasing consensus that the SME market can be a profitable segment to bank. Available data from banks, though limited, support this perception. By employing a range of measures, such as risk- adjusted pricing, credit scoring models, and SME-tailored nonlending products, banks are developing ways to mitigate risks, lower costs, and increase the overall benefit accrued from SME banking. SMEs, particularly in developing (low- and medium-incomeii) countries, have historically lacked access to financial products and services. MFIs have emerged to serve the smallest of these enterprises, while banking institutions have typically concentrated on large corporations. SMEs fall between these two markets where there is a finance gap commonly described as the "missing middle." However, in recent years, this has begun to change. SME banking, as an industry, is growing. Banks are now demonstrating that the SME segment can be served profitably provided it is properly understood. Definitions of the SME Market While there is general agreement that the SME market is significant in size and importance, there is considerable variation in their definition around the world. A common definition of SMEs includes registered businesses with less than 250 employees.1 This places the vast majority of all firms in the SME sector. SMEs are estimated to account for at least 95 percent of registered firms worldwide; in Europe, for example, this number is well over 99 percent.2 To narrow this category, SMEs are sometimes distinguished from microenterprises as having a minimum number of employees, such as 5 or 10. They can be further divided into small ii The World Bank defines low-income countries as those with gross national incomes (GNI) per capita of less than $935; lower-middle with GNI/capita of $936­3,705, upper-middle $3,706­11,455; and high-income countries $11,456 and above. 10 THE SME BANKING KNOWLEDGE GUIDE enterprises (SEs) and medium enterprises (MEs), though there There are a number of reasons why a rigid quantitative SME is even less consensus on where to divide them. Alternative definition is not suitable for describing the SME banking criteria for defining the sector includes annual sales, assets, and market as a whole. In developed (high-income) and some size of loan or investment. developing countries, much of the SME segment includes organizations with fewer than five employees. By many While the appropriate definition of the sector ultimately definitions, these would be classified as microenterprises. At depends on the local banking context, the most used SME the other end of the scale, a midsize business in a high-income classification at the World Bank provides an illustration of country might be effectively served like a large corporation in criteria similar to many used around the world. (Appendix A a low-income country. To further complicate matters, in provides other examples showing the contextual variation in developing countries, many SMEs operate in the informal SME definitions.) To qualify as a micro, small, or medium sector, and although they are excluded from most accounts of enterprise (often abbreviated MSME) under this World Bank the SME sector, they may represent a potential market for classification, a firm must meet two of three maximum SME banking. requirements for employees, assets, or annual sales (Table 1). For client reporting purposes, IFC's Global Financial Markets The SME banking sector is best defined conceptually by its Department uses loan size as a proxy, since some banks are position between large corporations and mostly-informal unable to report according to SME firm size. microenterprises. The development of a commercial banking sector in many countries began with addressing the needs of Many banks currently serving SMEs do in fact use annual large corporate clients. This model has historically consisted of sales figures, and average bank-reported maximum thresholds managing very high-value transactions for a small number of ($16 million, Table 2) are remarkably similar to the World low-risk clients. Outside of the commercial banking sector, Bank classifications ($15 million, Table 1). MFIs arose to offer working capital loans to microenterprises, typically ranging from median amounts of $150 in South Asia to $1,600 in Eastern Europe.3 SME finance is referred to as the Table 1: World Bank definitions of MSMEs "missing middle" because SME financial requirements are too (enterprise must meet at least 2 of 3 great for most MFIs and SMEs have been viewed as too small, characteristics) risky, or costly for traditional commercial banks. Firm size Employees Assets Annual sales SMEs do operate in different ways than large enterprises (LEs), Micro <10 <$100,000 <$100,000 and may be less sophisticated financially, lacking in business planning and cash flow management expertise. SMEs serve as Small <50 <$3 million <$3 million a middle ground for the economy, often transacting with large Medium <300 <$15 million <$15 million corporations and providing links to the formal sector for Loan size proxies Micro <$10,000 Small <$100,000 The SME banking market consists <$1 million (<$2 million for some Medium advanced countries) of firms whose financial Source: Ayyagari, Beck, and Demirgüç-Kunt (2005) requirements are too large for Table 2: Average sales ranges for bank definition of SMEs microfinance, but are too small to Firm size Minimum sales Maximum sales Small $200,000 $4 million be effectively served by corporate Medium $2 million $16 million banking models. Source: Beck, Demirgüç-Kunt, and Martínez Pería (2008) Figure 2: TypicalservICes | ACCess to FInAnCe IFC AdvIsory business landscape in 11 emerging economies Corporate & 0.1% multinationals Banks' primary Large target 0.9% enterprises microentrepreneurs. they are active at nearly every point in Medium 5­10% enterprises the value chain as producers, suppliers, distributors, retailers, THE SME and service providers, often in symbiotic relationships with FINANCE larger businesses.4 Small GAP 20% enterprises the sMe market includes a wide range of firm types and sizes. sMes are often family owned, and in most cases, the owner is Micro- Micro the primary financial decision maker. For example, sole 65­75% enterprises finance proprietorships alone make up at least 52 percent of sMes in egypt and 58 percent in taiwan.5 the sMe segment can be Percentages represent the number of companies visualized as a pyramid, with most firms falling into the smallest size category and the fewest firms falling into the largest size category (Figure 2). For illustration, a 2004 study Figure 3: Egypt's SME market illustrates the of egyptian sMes estimated that its market consisted of bottom-heavy distribution of firms by size 168,000 sMes, of which 98 percent had fewer than 50 employees (Figure 3). the same study estimated that the Makeup of Egypt's 168,000 firm SME market country had 2.4 million microenterprises. 2% 50­200 The Economic Importance of SMEs 8% the sMe sector is important to national economies because it 11% contributes significantly to employment and GdP, and because 15­49 # EMPLOYEES its growth is linked with the formalizing of an economy. In 28% many countries, the majority of jobs are provided by sMes. In the 30 high-income countries of the organization for economic 11% Cooperation and development (oeCd),iii sMes -- registered 10­14 enterprises with fewer than 250 employees -- represent over 11% two-thirds of formal employment.6 In low-income countries, this figure tends to be smaller, especially where the informal 76% 5­9 sector is large; but it is still significant. Figure 4 illustrates the 53% importance of the sMe sector to job creation using the median contributions of sMes to formal employment from a sample of % of firms % of total revenue low-, middle-, and high-income countries.7 Source: IFC (2004) SME Landscape in Egypt the sMe sector's contribution to GdP also confirms its economic importance. In high-income countries, and some middle-income countries, the sector accounts for over half of Figure 4: SMEs provide a significant portion of national output.8 In low-income countries too, sMes play a jobs worldwide sizable role, though the informal economy is more dominant. SME contribution to formal country employment Figure 5 displays the median contributions to GdP from a 55- (median values) country sample. 100% the fact that the role of sMes in an economy appears to 80% increase with country income level might indicate that sMes are themselves a driver of economic growth. While this remains 60% an open question, formalization has emerged as a potential channel through which a growing sMe sector is linked with 40% economic growth. the data demonstrate an inverse relationship 20% iii note that a few of the 30 oeCd countries are classified as upper-middle 0% income. For a complete list of countries, see: www.oecd.org/membercountries Low-income Middle-income High-income Source: Ayyagari, Beck, and Demirgüç-Kunt (2003) 12 THE SME BANKING KNOWLEDGE GUIDE Figure 5: GDP contribution of the SME sector increases, and informality decreases, with income GDP contribution of SME and informal sector 100% between the size of the SME and informal sectors in a country. 31% Residual In Figure 5, the informal economy and the SME sector together 80% 37% 36% generate about 65­70 percent of GDP across all country 60% income levels. What changes is the division of this amount 30% 13% Informal between SMEs and informal enterprises. In other words, 40% 47% higher-income countries -- where SMEs contribute more to SME 51% sector GDP -- have smaller informal sectors. If informality has 20% 39% created inefficiencies related to operating "underground," then 16% 0% the transformation of informal firms into registered SMEs can Low-income Middle-income High-income boost economic growth. Source: Ayyagari, Beck, and Demirgüç-Kunt (2003); "Residual" Bank service of the SME sector is economically valuable includes sources such as large enterprises and public sector because of the sector's importance in each country. In low- income countries, the role of banks may be critical if the Figure 6: Finance is more likely a constraint for prospect of bank financing can create enough incentive that smaller firms in lower income countries informal firms will register as SMEs in order to receive loans. In addition, the data indicate that as a country develops, the Average percentage of firms citing access to/cost of SME market will only increase in size. 100 finance as major constraint to current operations 80 0 10 20 30 40 50 Unmet Demand for Banking Services 60 46 Despite the recognized importance of the SME sector, evidence 40 31 indicates that SMEs continue to be undersupplied with the financial <20 employees products and services that are critical to their growth. In global 20 27 surveys, including the World Bank's Enterprise Surveys and Investment Climate Assessments, SMEs report that the cost of 0 14 finance is their greatest obstacle to growth and rank access to finance as another key obstacle.9 While these constraints are more acute in 43 developing countries (Figure 6), SMEs in any environment are nearly one-third more likely than large firms to rate financing 28 20­99 employees constraints as a "major" growth obstacle.10 In low-income countries, 23 this means that nearly half of small firms report being severely constrained by financing difficulties. 11 Complaints of financial constraints by firms may not be completely reliable indicators of what SMEs actually face, but data from these 30 surveys also show that SMEs actually use external financing to a 22 much lesser degree than large enterprises. For example, even 100+ employees though bank financing is consistently the most important source 18 of external financing for small firms,11 large firms are 150 percent more likely than small firms to use bank financing for a new 7 investment (Figure 7). This differential use of bank financing could indicate a lack of High income countries SME demand, in addition to a lack of supply. However, Upper middle income countries microeconomic studies of SME behavior suggest otherwise. At least in the SMEs observed, these studies clearly locate the Lower middle income countries finance gap on the supply side. One such study showed that Low income countries when SMEs were offered temporary access to subsidized credit, Source: World Bank Enterprise Surveys, Dalberg analysis; countries they used this credit to expand production, rather than to weighted equally within income groups to calculate group average IFC ADvISOry SErvICES | ACCESS TO FINANCE 13 substitute for more expensive borrowing. The additional credit received by SMEs was directly linked with expanded business operations and increased sales and profits. The actions of these firms strongly support the common complaint by SMEs that finance is a major constraint to their growth. 12 This claim is also supported by measurements of the impact of financial constraints on firm growth. Not only do small firms have more difficulty accessing finance, but they are more negatively affected by this difficulty than larger firms. One study has estimated that the negative growth impact of financial constraints on small firms is two-thirds greater than the negative impact of financial constraints on large firms (Figure 8). SMEs are particularly in need of bank services because they lack the cash flow to make large investments, they cannot access capital markets as large firms can, and they often lack qualified staff to perform financial functions.13 Here, bank-provided long-term debt can enable SMEs to invest in expansion without losing ownership. In addition, short-term and working capital loans help SMEs grow incrementally. Lastly, bank deposit and transaction products can improve operational efficiency and enable SMEs to outsource financial functions. Figure 8: Small firms are more negatively impacted by financing constraints than large firms Long-term financing products, such as term loans with longer maturities and fewer restrictions on usage, provide SMEs with Impact of financing constraints on 3-year investment capital for strategic business expansion -- for example, sales growth, by firm size through research and development, or property and equipment purchases. SMEs may have difficulty obtaining these types of loans Lacking access to lease financing Lacking access to Figure 7: Large firms are significantly more likely to export finance use bank financing for new investments Need special connection Percentage of firms using types of financing with banks for a new investment 30% High interest rates SE 25% ME 20% +150% Bank paperwork/ LE bureacracy 15% Financing obstacles 10% overall 5% +167% -12 -10 -8 -6 -4 -2 0 0% Banks Leasing Equity Trade Credit TYPE OF FINANCING Small firms Large firms Source: World Bank Investment Climate Survey data from 71 Source: Beck (2007); estimates impact of a 1 level (of 4) reported mostly developing countries, cited in Beck (2007) increase in degree of financing constraint on 3-year sales growth 14 THE SME BANKING KNOWLEDGE GUIDE because of inadequate financial records or assets to use as collateral. suggests that banks are finding effective solutions to challenges While some banks offer unsecured loans to SMEs, based on cash such as determining credit risk and lowering operating costs, and flow rather than collateral, these loans often come with shorter are profitably serving the SME sector. For these banks, unmet maturities; in general, collateral requirements have been the norm. SME demand for financial services has become an indicator of Partially due to this, long-term finance is one of the most commonly opportunity to expand their market share and increase profit.15 cited needs of SMEs, and in many aspects, long-term loans are Many banks now report that they perceive significant opportunities where the "missing middle" problem has been most acute, especially in the SME sector. Survey data from multiple studies show that in developing countries.14 Figure 9 depicts the problem SMEs have rather than overlooking or avoiding the market, banks have begun faced when looking for long-term finance. to target SMEs as a profitable segment. For example, a recent Bank products can also enable SMEs to take on more and larger survey of 91 banks in 45 developed and developing countries -- contracts. A small or medium enterprise may have a potential order Bank Financing for SMEs around the World 16 -- found that these from a customer in place, but need cash up front to complete the banks overwhelmingly perceived the SME sector as a large market order. Banks can provide short-term working capital to such SMEs with good prospects (Figure 10). to purchase supplies, pay employees, and meet obligations to clients. The recent increase in banks' commitment to the SME sector has Providing help with order fulfillment can extend across borders as been tested by the current (2009) global financial crisis.iv However, well, with trade financing assistance. For example, with a letter of even in Latin America, a region that has expressed some credit, exporting SMEs can offer customers better payment terms uncertainty about the future for SMEs, a 2008 survey of banks because a bank pays the enterprise based upon documentation of found that about three-quarters of large and midsize banks, and the sale and extends credit to the customer of the enterprise. half of small banks, still consider SMEs to be a strategic part of Finally, SMEs have important operational needs that banks bank business. In addition, about 90 percent of large and midsize can meet with nonlending products that include deposits and banks report having an active policy to finance SMEs.17 While savings, transactional products, and advisory services. Some of these numbers represent a slight decrease when compared with a these products can effectively enable SMEs to outsource 2006 version of the survey, they indicate that targeting SMEs has financial functions to the bank. become the rule, rather than exception, for most banks. · Deposit and savings products The potential profitability of serving SMEs has been enhanced Deposit and savings products provide businesses with basic by the development of new business models to engage small financial management tools to help organize revenues and enterprises. SME banking had been assumed to require difficult- savings. Additionally, mutual funds and other investment to-scale relationship lending methods. However, many SME products provide businesses with opportunities to obtain banking operations today make use of sophisticated high-volume earnings on excess capital. approaches, use statistical inputs in credit risk assessment, and cost- effectively provide nonlending products at scale.19 Banks have also · Transactional products been able to develop synergies with existing bank operations, for Transactional products facilitate SME access to and use of example, by integrating the service of SMEs with that of the personal available cash. Automatic payroll and payment collection, banking of the owner through retail or private banking portfolios. debit cards, and currency exchange are transactional bank (Approaches to profitability are discussed in Chapter 3). offerings that lower the cost of doing business and streamline potentially complicated processes. risk-adjusted pricing models have also been important tools enabling banks to profitably serve SMEs. rather than avoid · Advisory products risk, banks have found ways to incorporate the risks of serving SMEs can benefit from help in producing reliable financial SMEs into their pricing of financial products. Some banks are statements, developing business plans, and selecting able to use risk calculations to develop multiple pricing appropriate financing products. These advisory services can approaches within the SME segment.20 SMEs have proven improve SME access to finance by enhancing its capacity to willing to pay these risk-adjusted prices because they value the apply for credit. services provided and because alternative providers are often more costly. As a result, banks have been able to successfully serve this new and untapped market. The SME Banking Opportunity The SME market has been perceived in the past by banks as iv At time of publication (2009) the global financial crisis that can be dated to 2007 risky, costly, and difficult to serve. However, mounting evidence had not yet been resolved. Box 2.2 discusses SME banking in light of this crisis. IFC ADvISOry SErvICES | ACCESS TO FINANCE 15 "SMEs are the fulcrum of the economies we work in, and the fulcrum of our banking strategy. Banking SMEs may be riskier than banking corporations, but we price for the risk, and banking SMEs is more profitable...There is a lot of capacity in the SME market." --Retail banking head at an African bank Figure 9: In developing countries especially, many Figure 10: Most banks report that the SME market is SMEs have had few options for investment capital large and that prospects are good Impact of financing constraints on 3-year sales What is your view of the size and prospects growth, by firm size of the SME market in general? Investment size Commercial Private equity bank debt Big market 82% 83% $2M 3% 18% "Missing middle" ­ debt and equity Family and friends Money lenders Small market $25K 14% 0% 0% 0% Bleak prospects Good prospects Microfinance Developed countries Developing countries Source: Dalberg (2008) Aspen Network for Development Entrepreneurs: Background Analysis Source: Beck et al (2008) Around the World 16 THE SME BANKING KNOWLEDGE GUIDE "The cash-hungry SME market has Having developed a strategic focus on the sector and applied become the banking sector's latest new banking models, banks are reporting income growth rates and returns on assets in SME banking that exceed those of sweet spot."21 their overall banking operations. Data collected in IFC's (2007) study, Benchmarking SME Banking Practices in OECD and Emerging Markets, illustrate such cases of SME banking revenue generation and profitability. The study profiled 11 Figure 11: Benchmarking banks generally report "good practice" banks from OECD and emerging markets, faster income growth in their SME operations... and received data from a number of these banks on income and rOAs for operations in the SE and ME segments. Figure Income growth rates for panel banks 11 illustrates that SME banking operations for these banks have been growing rapidly and are profitable. Income growth-Bank Income growth-SME Describing these trends, one bank explains, "SMEs represent 240% 10 percent of our portfolio numbers, but they generate 50 233% percent of our banking income." The data needed for a more 50% generalized quantification of SME profitability is elusive because many emerging market banks cannot precisely allocate 40% costs across segments and products. However, other banks are 30% also demonstrating that SME operations can lead to income and profit generation. An additional 12 banks that completed 20% the IFC SME Banking Benchmarking Web Survey v in 2008 10% reported on average 28 percent higher operating incomes and 35 percent higher operating profits as a percentage of assets for 0% Bank Bank Bank Bank Bank SME lending than for bank lending as a whole (Figure 12). M1 S1 S2 S3 S4 ME segment SE segment Figure 12: Web-surveyed banks also report greater profits for the SME segment Average operating incomes and profits for credit products ...and higher ROAs for SME banking than for bank operations as a whole % of Assets ROAs for panel banks 11 70% 10 11.0 ROA-Bank ROA-SME 9 60% 6% 8 8.6 +28% 50% 5% 7 40% 6 4% 5 30% 3% 4 3 20% 3.5 2% 2 +35% 2.6 10% 1% 1 0 0% 0% Total bank SME segment Bank Bank Bank Bank Bank Bank M1 M2 S1 S2 S3 S4 Operating income Operating profit ME segment SE segment Source: IFC (2009) SME Banking Benchmarking Web Survey Report Source: IFC (2007) Benchmarking SME Banking Practices in OECD and Emerging Markets v IFC's SME Banking Benchmarking Web Survey is a tool available to all banks in emerging markets interested in benchmarking themselves against SME banking practices of their peers. Bridging the Middle: SME Banking Today The SME banking industry is young and growing. While the full effect of the current financial crisis on this industry is uncertain, the general orientation of emerging market banks toward SMEs does not appear to have changed (Box 2.2). Contrary to conventional wisdom, it is not exclusively small banks that successfully serve SMEs. Many large banks have also moved "downstream" to serve SMEs and are now dominant players in their markets. Also serving the market are a few MFIs that have moved "upstream," although this remains relatively rare due to their bottom-of-the-pyramid mission. The significant gap in SME access to finance between high- and low-income countries has been attributed to factors in the operating environment, such as regulation and macroeconomic conditions. However, these factors have generally not prevented the growth of the industry. Most governments have policies to support SME finance, though there is no single framework for effective support. While banks have served small businesses to some extent for generations, SME banking has only recently emerged as a distinct industry. In the United States, where SMEs represent nearly 98 percent of all employer firms, the Small Business Administration began tracking lending to SMEs in 1994. Since then, the number of small business loans (defined by the SBA as loans <$1 million) has multiplied more than four times, to over 27 million loans valued at over $700 billion (or five percent of GDP), in 2008.22 The significant expansion in lending to small businesses in the developed world over the last couple of decades may be one reason why only 30 percent of OECD (developed) countries report a gap in debt financing of SMEs. This is compared with 70 percent of non-OECD (developing) countries responding to an OECD survey of government policy experts (Figure 14).23 While banks around the world are optimistic about the SME market, these results indicate that the opportunity, in terms of unmet demand, may be larger in developing countries. The remaining debt financing gap in the developing world may reflect that the SME banking industry is even less mature in low- and middle-income countries, where banks have been more averse to risk. In India, one of the largest and most dynamic SME banking markets in the developing world, the total outstanding national SME loan portfoliovi is still only $88 billion,24 less than that of Taiwan, at $95 billion.25 The nascent stage of the SME market may explain why 74 percent of banks rated "perceived profitability in the SME segment" as their top reason for involvement with SMEs.26 vi Note that loan portfolio data does not fully reflect the size of the SME banking market, as revenues from nonlending products are often greater than those from loans. However, as many banks themselves are not able to identify their total SME revenues, complete data on market size are scarce. Box 2.1: Important sources of cross-country data on bank perceptions and practices The following studies provide both depth and breadth (in terms of country coverage) of understanding of the SME banking industry, and have served as a guide for discussions of bank trends and approaches. STUDY SAMPLE / SOURCE DATA TOPICS COVERED / HIGHLIGHTED FINDINGS Around the World Survey · 91 banks surveyed in 45 countries · Topics include drivers, obstacles, business Beck, Thorsten, Asli Demir- (38 developing and 7 developed) models (including definitions of SMEs, credit güç-Kunt, and Maria S. · On average banks accounted for risk structures, organizational setup) lending Martínez Pería (2008) Bank 32 percent of total banking system practices, perceptions of the market Financing for SMEs Around loans in countries surveyed · Attractiveness of SME market is a global the World: Drivers, Obstacles, · Emphasis on overall market share phenomenon Business Models, and Lending coverage means that large banks · Differences in lending patterns between Practices are more strongly represented in foreign/domestic, or state/private-owned banks the sample are small compared with differences between developed and developing countries Bank Involvement Study · 48 banks studied in 12 countries · Topics include drivers and obstacles, attitudes de la Torre, Augusto, Maria · Data compiled from in-depth World towards SMEs, products offered and used S. Martínez Pería, and Sergio Bank interviews with bank business by SMEs L. Schmukler (2009a) Bank In- managers and IFC's Benchmarking · SME lending is not only the domain of volvement with SMEs: Beyond study of leading banks relationship-lending niche banks; large and Relationship Lending · 1000s of SMEs, from survey of Latin foreign banks not only target SMEs, but have American SMEs advantages in doing so. Benchmarking Study · 11 "good practice" banks studied · Topic is leading bank practices, structured in IFC (2007) Benchmarking SME · Banks serve SMEs in 8 countries: parallel with the five strategic areas of the Banking Practices in OECD Australia, Brazil, India, the Neth- CHECK Diagnostic and Emerging Markets erlands, Poland, Thailand, the UK, · Less than 40 percent of revenue is generated and the USA by credit products · Data often split between SE and ME · Segmentation of the SME market is important business models, 17 in total Benchmarking Web Survey · 12 banks (self-selected) from devel- · Topics are the same as with the Benchmarking IFC (2008­2009) SME Banking oping countries completed a Web study, but these banks are all from emerging Benchmarking Web Survey survey to compare themselves with markets other banks · SME banking reported to be more profitable · Study is ongoing as more banks on average than overall bank operations complete survey Figure 13: Outstanding US small business loan Figure 14: Non-OECD (developing) countries volume grew 18% from 2005 to 2008, totaling perceive a larger gap in SME debt financing over $700 billion Percentage of countries identifying a financing gap US outstanding small business loans 800 30 100% 750 80% 27 700 M I L LI O N S O F L O A NS 60% 650 $ BI L L IO N 24 40% 800 550 21 20% 500 18 0% 450 Is there a gap? ...in debt ...in equity 2005 2006 2007 2008 financing? financing? 400 15 OECD countries Non-OECD countries Volume ($) loans <$1M # loans <$1M Source: US Small Business Administration, midyear call report data Source: Source: OECD (2006) IFC AdvIsory servICes | ACCess to FInAnCe 19 Composition of the Industry A classic view of the sMe banking market is one served by small local banks that specialize in niche market segments. these banks employ a relationship-lending approach that relies on "soft" information gathered through personal contact. However, in response to perceived profitability, as well as competition in other banking segments,27 many larger banks -- including private and government-owned domestic banks, and foreign banks -- have begun to move downstream in the direction of the sMe segment. Figure 15: Large banks perceived as key players in the industry While this phenomenon has been observed in the developed world as well, it is especially striking that many of the strongest players in low- and middle-income countries today are large Bank response to "Who are the main players in SME financing?" banks, often headquartered in high-income countries. A number of multinational banks based in London have large sMe banking operations in Asia, Africa, and the Middle east. In Brazil and India, some of the largest domestic banks are also 100% some of most active in the sMe market. 88% Large banks Figure 15 highlights the perception that large banks are 75% dominant players in the industry, as reported by the banking 100% industry in four countries. Although large banks are not primarily suited for relationship lending, they do have certain advantages in serving the sMe sector. they often employ 92% state-of-the-art business models, develop customized statistical 50% credit scoring approaches, leverage connections with large Public banks multinationals to reach sMe suppliers, and provide 0% sophisticated and technology-based nonlending products at 0% scale.28 Large banks are, however, not the only new arrivals to the 62% sMe space. successful MFIs have begun to look "upstream" to 38% serve sMes. two of the most prominent MFIs in Bangladesh Niche banks began serving sMes by offering relatively large loans to the 0% bottom of the sMe market. they did so in much the same way 13% as large banks initially made relatively small loans to the top of the sMe market. to begin serving sMes, MFIs often start 54% with microentrepreneur "graduates", namely clients who began as individual microborrowers who have grown in sophistication 0% Other financial and size to qualify as small enterprises. intermediaries 38% For certain MFIs, the ascent to sMe banking has been 0% facilitated by a relaxation of regulatory restrictions on loan size and maturity. others have converted into regulated banks in order to serve the market. For example, an international 23% Argentina network of MFIs commercialized its operations in Malawi in 13% Chile 2002, and over the course of the past few years, has migrated Small banks upstream to serve sMes as well.29 However, most MFIs have 0% Colombia not become formal financial institutions. MFI forays into sMe 0% Serbia Source: de la Torre et al (2009a) Bank Involvement with SMEs 20 THE SME BANKING KNOWLEDGE GUIDE banking have been relatively minimal. They have been limited upon successful SME operations to expand into the retail by a lack of financial and human capital, and by organizational segment. missions which remain targeted on poorer individuals.30 In addition to commercial banks that have moved downstream The Role of the Operating Environment and MFIs that have moved upstream, the SME banking industry also includes banks that have been founded specifically While the SME banking industry appears to be growing to target the SME sector. Examples of these include a number rapidly in emerging markets, access to finance is generally still of banks founded in russia and Eastern Europe/Central Asia easier for a small firm in a developed country than a firm of any shortly after the fall of communism. Some banks, such as size in a developing country. Developing country banks Hamkorbank in Uzbekistan (profiled in Chapter 4), have built surveyed in Bank Financing for SMEs around the World, report Box 2.2: SME banking during a global economic crisis SME banking has not been immune to the effects of the current global financial crisis. Yet while momentum may have slowed, and the full impact of the crisis is not yet known, early signs suggest that the overall trend is toward continued growth and value in the SME market segment. The current (2009) crisis was triggered in 2007 in high-income countries and has resulted in a contraction of credit around the world. Unlike banks in OECD countries, many banks in emerging markets have generally avoided bad loans and other "toxic" assets, and therefore, did not feel the immediate effects of the crisis. However, these banks are still affected by the liquidity crunch and by the impact of the crisis on the real economy. Some emerging market banks have reported a drop in demand, and some have had to pull back on many types of lending out of concern for rising defaults. In March 2009, the OECD Turin Round Table on the Impact of the Global Crisis on SME and Entrepreneurship Financing and Policy Responses cited working capital as a critical need of SMEs during the crisis. This is illustrated by reports that, for example, many manufacturing SMEs in China have been unable to withstand even a few months of slowdown in orders from the West. In response to this need, many governments have worked to support lending to SMEs, mostly through credit guarantees. While the Round Table cautioned that government policies must not impair fair competition, it noted the importance of providing credit guarantees to the SME market. The head of a leading international bank's global small business operations welcomes this support, "This crisis is completely different from those in the past as far as SMEs are concerned...SMEs used to be the first ones to be hit...now governments have provided a credit backstop." While the financial crisis continues, and a complete picture of its impact on SME banking is yet to be seen, the orientation of many emerging market banks toward SME banking does not seem to have changed significantly. This is despite the fact that some banks are scaling back aggressive SME loan growth targets, citing a lack of demand from SMEs. Says one executive regarding operations in Asia, Africa, and the Middle East, "Our loans have withstood the current stress. Profitability will get impacted but I don't think the default rates will go up like [in past crises]." Banks interviewed in Ghana and India, even in the midst of the crisis, report seeing SMEs as the economic future of their countries and express their desire to be positioned accordingly. In Latin America, even though 50 percent of banks in a 2008 study believe the SME situation in their country will be the same or worse in two years, only 23 percent plan to reduce their exposure to SMEs in response to the crisis. The sentiment expressed by an executive at one pan-African bank is not uncommon, "Our SMEs often sell to the developed world. Now people are not buying their products. This has definitely affected us. But the impact is not a threat to our profitability at the moment." Sources: Bank and expert interviews; Summaries and reports from the Turin Round Table, OECD (2009); Latin America study: IIC/MIF, IDB and FELEBAN with D'Alessio (2008) IFC ADvISOry SErvICES | ACCESS TO FINANCE 21 more collateral requirements, less lending for investment, and regulatory obstacles, on the supply side, can directly reduce higher interest rates than developed country banks. These the profitability of SME banking by making it difficult to differences dwarf those between lending to the small, medium, charge market rates or to recover nonperforming loans. Often or large enterprise segments, and they point to the historical government measures intended to support SMEs may in fact impact of the operating environment on the banking industry have the opposite effect. For example, interest rate ceilings, a in general, and SME banking in particular (Figure 16 and policy that is intended to make lending more affordable for Figure 17). However, bank innovation, sometimes combined SMEs, can actually discourage competitive and commercial with improvements in the operating environment, has enabled pricing and reduce the supply of credit. On the demand side, the growth of SME banking in spite of these historical regulatory obstacles can impact the willingness or ability of challenges. SMEs to borrow. SMEs that cannot navigate complex regulatory hurdles to formalization may choose to remain Three commonly cited challenges to SME banking in the informal, and as a result, may not be bankable. Similarly, operating environment are (1) regulatory obstacles, (2) weak mandating audited financial statements may prevent SMEs legal frameworks, and (3) macroeconomic factors. These from even applying for loans. challenges may impact SME banking on the supply side by hampering effective banking operations, or on the demand Even when regulations are not a problem, weak legal side by inhibiting SMEs. frameworks can deter banks from serving SMEs. Ineffective Figure 16: The finance gap is greater between Figure 17: Developing country banks charge higher countries than between firms of different sizes interest rates despite lower default rates Portion of loans that require collateral Interest rates and nonperforming loans by segment and country development 100% SE 18% 80% ME 16% 60% LE 14% 40% 12% 10% 20% 8% 0% Developed countries Developing countries 6% 4% Portion of loans going to finance investments 2% 80% 0% SE SE ME LE SE ME LE 60% ME Developed countries Developing countries 40% LE 20% Best client rates Premium for worst clients 0% Developed countries Developing countries % Nonperforming loans Source: Beck et al (2008) Around the World survey, bank figures Source: Beck et al (2008) Around the World survey, bank rates averaged by country development and client segment averaged by country development and client segment 22 THE SME BANKING KNOWLEDGE GUIDE Figure 18: Developing country banks rank macro- Figure 19: Countries with credit bureaus are economic factors the top obstacle to banking SMEs associated with lower SME financing constraints Percentage of banks citing a factor as "top obstacle" Percentage of small firms reporting high financing constraints 0% 10% 20% 30% 40% 50% 60% Macroeconomic 50% factors 40% 30% Regulation 20% 10% Competition in the SME segment 0% Without credit bureau With credit bureau 0 10 20 30 40 50 Legal & contractual environment Probability of factors Macroeconomic obtaining a bank loan for a small firm Bank specific factors 50% 40% Regulations Nature of lending technology to SMEs 30% 20% Competition in the SME segment Lack of adequate demand 10% 0% Without credit bureau With credit bureau Developing countries Developed countries Legal and contractual environment Source: Beck et al (2008) Around the World survey Source: Love and Mylenko (2003) Bank specific factors IFC ADvISOry SErvICES | ACCESS TO FINANCE 23 contract enforcement is a leading example. A lending portfolio is in essence an array of contracts of varying lengths. If weaknesses in the legal and judicial system make it difficult to enforce these contracts, this increases the transaction cost of Thriving in a difficult climate -- Eastern Bank lending. Higher transaction costs in turn make the smaller loans required by SMEs less attractive to banks. Legal Limited targets Bangladesh's missing middle frameworks also impact the demand side: SMEs that lack In 2005, the banking industry in Bangladesh faced effective and enforceable rights to their own assets may not be political turmoil, high inflation, corruption, rising able to secure sufficient collateral to qualify for a bank loan. interest rates, and a history of state domination and Macroeconomic factors comprise a third category of challenges low financial sector penetration. Undeterred by these in the operating environment. These factors include overall potential obstacles in the operating environment, instability, high interest rates (i.e., high cost of capital to lend), Eastern Bank Limited (EBL) viewed the lack of banks and exchange rate risk.31 The impact of the last of these has providing SME finance as a growth opportunity and set been illustrated in the current financial crisis. Banks that have about establishing a formal SME banking unit. borrowed from international lenders in foreign currency, such With ongoing support from IFC, EBL launched its SME as U.S. dollars, have seen the value of their outstanding local- division midway through 2006, opening 12 SME centers currency-denominated loans drop when the dollar strengthened despite the deepening political crisis which engulfed against emerging market currencies. It should be noted, the country. EBL also partnered with an international however, that factors such as these may impact all banking investment manager to create the country's first joint operations, rather than only the service of SMEs. SME-specific venture private equity fund primarily targeting SMEs. macroeconomic factors do exist on the demand side, to the In 2007, amid political unrest, loss of trade confidence, degree that SMEs are more vulnerable to economic shocks. natural disasters, and inflation, EBL persevered. The In practice, these three sets of challenges do appear to have bank launched new loan and asset products tailored contributed to the "missing middle" financing gap, at least in to SMEs, opened new SME centers, and prepared to some countries. Cross-country evidence on legal frameworks deploy an Electronic Loan Processing System to reduce shows that the finance gap between SMEs and large firms turnaround time on SME loan applications. EBL's SME appears greater in countries with worse protection of creditors loans grew 54 percent, deposits more than doubled, and less effective judicial systems.32 Likewise, researchers observe and the rate of nonperforming assets was cut in half. that the lack of competition associated with unfavorable regulatory environments is often accompanied by barriers that In 2008, EBL grew its SME loan portfolio by 51 disfavor small enterprises with limited resources. For instance, percent and total SME revenues by 37 percent. It also the minimum amount required to obtain an SME loan in increased its offering to seven SME-tailored products, Bangladesh, until recently, was equivalent to 100 times GDP including the country's first SME loan product for per capita.33 Finally, macroeconomic factors were the most women entrepreneurs. As EBL continues to push commonly cited "top obstacle" to SME financing by banks in the boundaries of SME banking in Bangladesh, it the Bank Financing for SMEs around the World survey shown in provides an inspiring illustration of what determined Figure 18. and creative banks can achieve despite adverse conditions, if committed to serving the SME sector. Unlike macroeconomic factors, legal and regulatory obstacles were only cited as top obstacles by a combined 25 percent of banks. This may be a surprising result given that these challenges EBL's SME loan portfolio as a percentage of total has can pose real difficulties for banks. However, banks and banking grown rapidly 9.3% experts have noted that legal and regulatory hurdles in general 7.8% have not prevented them from serving the market.34 In the same 6% survey, 54 percent of the banks in low- and middle-income countries viewed their country's prudential regulations positively compared with only 22 percent negatively; and more than two- thirds thought that documentation requirements for SME lending 2006 2007 2008 were "appropriate and beneficial."35 Prudential regulation, of 24 THE SME BANKING KNOWLEDGE GUIDE course, does play an important role in protecting economies from exceptions to international regulations designed with large the effects of excessive risk taking. loans in mind.40 These survey results, however, do not negate the fact that legal Governments may also take action to support SME access to and regulatory challenges are very high in some countries. finance by providing public goods and services targeted at Operating environments (and barriers to financial access) vary incomplete markets and market failures. This can be helpful, significantly: there are no minimum balance requirements for particularly in countries where transparent information is opening a commercial checking account in South Africa or difficult to obtain. On the demand side, governments might Swaziland, but the requirement in Cameroon is cited at $700, provide training to SMEs in financial statement preparation. which is greater than the national GDP per capita.36 Banks On the supply side, governments can work to build or support serving SMEs in most developing countries may be undeterred the credit information infrastructure of the country, including by regulatory obstacles or weak legal frameworks, but legal and credit bureaus and collateral registries. Building this kind of political institutions in the poorest countries may not have infrastructure is perceived by experts as a potentially important reached a minimum threshold of reliability.37 These factors role for any government. This view is supported by evidence on might also limit the scale of SME banking in some middle- the positive impact of credit registries on access to finance.41 income countries. Large majorities of banks in both Colombia The case is less clear for direct government intervention in the and Serbia report that "regulations" and the "legal and banking market, but most governments do appear to intervene contractual environment" are each significant (or greater) in some form.42 Such interventions can include direct lending obstacles to their exposure to SMEs.38 through government-owned institutions and directed credit A fourth challenge in the operating environment is defined not programs, where the government provides capital to banks by the presence of a specific obstacle, but by the absence of an specifically for lending to SMEs. The inspiration for these important catalyst to SME banking, the credit information interventions may come from underdeveloped markets where infrastructure. Where reliable financial statements are lacking, banks had not previously been interested in SMEs. As banks are the information on prospective SME borrowers provided by targeting SMEs as a profitable sector, these government credit bureaus and collateral registries can be instrumental in interventions may risk distorting the market and generating banks' abilities to approve loans. SMEs find it more difficult to unintended consequences.43 Loan guarantees, where the obtain loans in countries where this information is lacking. government shares a portion of the credit risk on SME loans, Figure 19 illustrates this association using data from a sample have become a very common intervention, but studies of these of 5,000 SMEs in 51 countries. programs have reported mixed results as to their effectiveness.44 Although there are different policy perspectives on the relative Government Support of SME Finance merits of government intervention, banks themselves appear recognizing the importance of the SME sector, governments supportive of many such policies, particularly those that enable have undertaken a variety of measures to support SME access better risk management. For instance, nearly 70 percent of the to finance. These measures range from (1) reforming existing developing country banks in the Around the World survey legal/regulatory barriers, (2) taking actions to develop the stated that the existence of a credit bureau in their country SME finance market broadly, and (3) intervening in the market facilitated SME lending.45 This illustrates, first, that directly to jumpstart or incentivize lending to SMEs. The governments are taking measures to lower some of the barriers impact of these policies on the operating environment for SME to SME banking and, second, that banks are receptive to these banking varies by country context.39 While some measures measures. Every country context is unique however, and while appear to be more beneficial than others, there is no single governments can provide welcome and beneficial interventions, framework for effective government support to the SME each must be assessed on a case-to-case basis. banking sector. reforms that support SME access to finance may include identifying and decreasing legal and regulatory obstacles, such as those described above. In one country this may involve streamlining accounting requirements or formalization processes for SMEs. In another country, it could mean reducing capital requirements for SME portfolios, perhaps by providing Challenges and Approaches along the Banking Value Chain There are many challenging aspects to SME banking. To understand how to address each challenge, it is helpful to analyze these challenges in the context in which they occur. The banking "value chain," or chain of activities, provides a framework for this disaggregated analysis. Shown in Figure 20, the value chain facilitates a discussion of the challenges in serving the SME market by banking activity. For each stage in the value chain, challenges, as well as effective bank practices and examples of steps to excellence taken by leading banks, are described. Risk management, especially credit risk management, is a critical cross-cutting component of the SME banking value chain. Highlighted observations from the five value chain stages are (1) Understanding the market is critical and serves as a foundation to being able to address the unique needs of SMEs, (2) Nonlending products should not be overlooked, as they may generate more revenues than SME loans, (3) A bank's current portfolio is a critical potential source of new business, (4) Segmenting service approaches, i.e., the level of relationship management by client value can help banks balance customer service and operating cost concerns, and (5) IT systems are merely tools; effective information management means knowing how to maximize the use of these tools. To frame the discussion of how banks approach the challenge of serving SMEs, we adopt a standard banking value chain framework consisting of five discrete stages and one cross-cutting task. The five stages of this banking value chain are (1) understanding the market, (2) developing products and services, (3) acquiring and screening clients, (4) serving clients, and (5) managing information and knowledge. Cutting across each of these five stages is the ongoing and critical task of risk management. At each stage of the value chain, there are actions and considerations particularly relevant to the SME sector. Figure 20 provides a condensed overview of the key activities within each stage of the banking value chain in the context of serving SMEs, i.e., the "SME banking value chain." Section 3.1 begins by highlighting key risk management considerations along each of the sequential stages of the value chain, with particular emphasis on credit risk management. Each of the five sections thereafter (3.2­3.6) covers a stage of the SME banking value chain in detail. Each section discusses challenges faced by banks, describes how banks are approaching this stage, and provides examples of leading banks moving toward excellence in SME banking. Complementing this discussion, Chapter 4 provides greater detail on the lessons that have emerged from bank experience along the SME banking value chain and on how banks can strategically engage the SME market. 26 THE SME BANKING KNOWLEDGE GUIDE Figure 20: Key activities at each of the five stages of the SME banking value chain Risk management Understand the Develop products Acquire & screen Serve SME Manage information SME market & services SME clients clients & knowledge · Define the SME · Design & bundle lending · Market product & service · Meet the needs of · Model & manage risks sector & non-lending products offering existing clients using portfolio data to clients · Research SME · Ensure profitability of · Cultivate new · Use current customer needs & preferences product offering · Build a growing & business through data to adapt service diversified portfolio cross-selling approaches · Sub-segment the · Develop SME-specific market lending technologies · Distinguish profitable · Monitor loans · Analyze & respond to from unprofitable profitability data at prospective clients · Use teams segment, product & client organized for level front & back-end servicing Risk Management customers who also transact in higher volumes. That said, SME transactions may involve a much higher degree of risk management is always a critical bank function, but it customer interaction than retail banking because SMEs have becomes especially critical in a relatively new industry such as more extensive and varied needs. Managing the risk of excessive SME banking because there is less information on how to cost to serve means managing the prospect of higher transaction mitigate risks for this sector. The risks themselves are not costs incurred on a lower revenue base. unique: as in all banking, they include credit, market, strategic, and operational risk. However, managing these in the context Leading banks are finding ways to manage both these risks of smaller clients, with potentially higher frequency and lower through a comprehensive set of risk management practices value transactions, adds to the complexity. There are two main undertaken at each stage of the SME banking value chain. categories of risk to prioritize: credit risk and the risk of Figure 21 provides highlights of these practices. These and excessive cost to serve the client. other risk mitigating practices also appear throughout the five value chain sections that follow. Managing the risk of excessive Credit risk is the risk of lost revenues and assets from delayed cost to serve SMEs is closely linked with selecting effective and payment or nonpayment of loans or other credit products. It is efficient approaches at each stage of the value chain, which is an important concern in SME banking because unlike larger discussed in these sections to come. The remainder of the corporations, SMEs often cannot provide verifiable financial present section provides additional detail on credit risk information. As a result of this information asymmetry, most management. bank loans to SMEs are secured, or in other words, require collateral. Since SMEs often lack the collateral required, this Managing Credit Risk limits the size of the market. Emerging market banks report that over 80 percent of SME loans are secured.46 As a result, Credit risk management has attained unique prominence in banks that can find other ways to manage credit risk without discussions of SME banking because one of the primary requiring collateral have a potential competitive advantage barriers to serving SMEs has been the actual or perceived risk when serving SMEs. of default. Credit risk relates only to lending, which is just a subset of SME banking, so managing credit risk is not a The risk of cost overruns results from bank uncertainty standalone component of the SME banking value chain. regarding the best operating model for serving SMEs. Whereas However, it warrants special attention because effective corporate clients are characterized by low-volume, high-value management of credit risk can be the gateway to successfully transactions, SMEs often require more transactions at lower serving new SME markets. values. In this way, SMEs are similar to individual retail IFC ADvISOry SErvICES | ACCESS TO FINANCE 27 Figure 21: Common approaches to risk management Risk management Understand the Develop products Acquire & screen Serve SME Manage information SME market & services SME clients clients & knowledge · Quantify risks in · Develop loan pricing · Lend to current clients · Dedicate staff to · Establish centralized Approaches to managing credit risk target market by models that match first, learning from spot signs of SME teams to monitor loan leveraging existing client risk profile portfolio information default early & data for risks & early research & other bank directly engage warning signs, & to incor- data where possible · Incorporate innova- · Use internal rating & with SME to mini- porate data into improved tive forms of collat- scoring methods to mize losses credit policies · Sub-segment the eral, such as accounts assess loans/clients SME market by risk receivable · Provide advisory · Use portfolio data to profile, & target ac- · Use transparent ex- services to assist customize models for cording to bank risk · Prioritize role of ternal data such as SMEs in cash flow statistical credit scoring appetite non-lending prod- credit bureau reports management ucts in establishing · Enhance predictive customer relationship · Separate sales from capabilities by gather- & providing credit approval ing information on local predictive data for more rigorous SME success factors underwriting · Inform pricing & · Use sophisticated · Focus customer ac- · Dedicate pro- · Enhance profitability operational ap- but standardized quisition on clients cesses & staff to analysis capabilities to Approaches to managing risk of proach by understand- products to minimize "close to" the current SME segment disaggregate revenue ing level & nature of transaction costs portfolio to streamline & costs by key units excessive cost to serve unmet SME demand, operations (branch, product, client) including service pref- · Increase the overall · Separate business erences value of each SME development from · Use direct chan- · Learn from & apply client by offering & relationship manage- nels like branches cost-saving innovations · Segment the market bundling a wide vari- ment for efficiency & call centers to discovered at branches in order to identify & ety of products & reduce relationship limit effects of cost services · Use automated screen- management cost drivers linked to SME ing processes to reduce characteristics underwriting costs · Adjust level of personal service to SME size or value In the first stage of the value chain, understanding the SME At the second stage of value chain, developing products and market, banks can use initial assessments to quantify the risks services, a bank can manage risk by building product-specific in the target market, which they can then factor into future profitability models. These models help a bank gauge the pricing models. Banks can also work to identify the success potential profitability of an SME portfolio and determine the factors in the SME market they serve, as an input to risk required product offering and pricing structure to generate forecasting. For example, if targeted SMEs are heavily those prof its. Combined with effective credit scoring dependent on international trade, their ability to repay loans capabilities, this enables risk-based pricing of products. A may be correlated with the exchange value of the local currency. profitability model will also shed light on the role of nonlending Therefore, currency fluctuations could be monitored as an products. A leading misconception among lenders is that the input to risk forecasting for those SMEs. Finally, in gathering SME customer base should be built by increasing the number and analyzing information about the market, banks can and value of asset products. rather, increasing sales of segment the SME sector according to risk profile, and adjust nonlending products can boost profits and reduce risk as a their approach to different segments accordingly. percentage of SME banking revenues. 28 THE SME BANKING KNOWLEDGE GUIDE During this stage of product and service development, banks management depends on a bank's information systems to can also manage credit risk through innovative approaches to detect early warning signals. Efficiency in bad debt management collateral. SME lending does not always mean cash-flow-based has a strong impact on the bank's bottom line, since one loan lending. Collateral is often needed as an incentive for repayment written off can typically destroy as much value as is created by and as remuneration in case of default. However, innovative many good loans. A key to this type of credit risk management approaches to collateral, such as accepting accounts receivables, is to view recoveries not as a legal burden, but as a proactive may enable a bank to manage credit risk while avoiding customer relationship function. prerequisites that limit potential clients. Bank activities in the fifth stage of the value chain, managing With or without collateral, however, effective underwriting is information and knowledge, feed into credit risk management needed to manage credit risk during the third stage of the value in other stages. An important function in the fifth stage is chain, acquiring and screening SME clients. Effective portfolio monitoring, which includes using information underwriting involves performing a thorough risk analysis of collected on the SME loan portfolio to detect early warning prospective borrowers, as well as understanding business signals of nonperforming loans and to initiate proactive drivers, cash-flow generation, and default probability, all of corrective action. As with parts of the underwriting process, which can be streamlined so that underwriting does not portfolio monitoring can be automated for greater efficiency. become cost prohibitive. Mass-market approaches are often Another credit-risk-related function of managing information effective for small enterprises and can save time by combining and knowledge is analyzing portfolio data in order to develop decentralized client contact with centralized credit decision and refine centralized processes and credit scoring models. process control. This is often enhanced by an automated credit Internal rating and scoring tools ensure consistency and scoring tool. Internal rating and scoring tools can be built from objectivity of risk appraisal. Well-designed tools are detail- bank data, and can increase the accuracy and efficiency of oriented, objective (no subjective criteria like "quality of screening. At the same time, because information asymmetry management"), and are calibrated to an estimated probability is a concern, credit underwriters need to be able to use and of default. cross check informal sources of information as well. Having previewed each of the five stages of the value chain in At stage four of the value chain, serving the SME client, a critical discussing management of credit risk, it is useful to step back aspect of managing credit risk is addressing problem loans and look at each of these stages in greater depth. before they go bad. Proactively addressing problem loans often makes the difference between a profitable and a loss-making asset portfolio. It includes the ability to react quickly to arrears, Understanding the SME Market to maintain a good commercial relationship with the client as Growing any portfolio of customers requires that banks be long as possible, and to minimize losses when they cannot be demand-driven, i.e., responsive to the needs and preferences of avoided. As the last line of defense to manage credit risk at the clients. SMEs differ from both large businesses and individual individual loan level (Figure 22), nonperforming loan customers in their needs and preferences, and in what it takes to serve them. Since a small business in one context may be a relatively large corporation in another, definitional clarity is Figure 22: Managing nonperforming loans is an essential to effectively understand the market. For example, in important last line of defense the process of conducting an initial market survey, a bank looking to serve SMEs in Eastern Europe found there was little First line of defense Early warning signals Recovery process agreement within the bank itself as to what exactly qualified as an SME and, therefore, how to profile their needs. Before Credit Approval Monitoring NPL Management attempting to determine how to satisfy SME demand, the bank needed to step back and achieve consensus on how to Loan restructuring define the market. After doing so, it was able to target its efforts Collection at filling information gaps on SME demand. Selling Loans Even when the SME sector is clearly defined and its needs profiled, the range of businesses that make up this market may warrant further segmentation. As a result, banks face the IFC ADvISOry SErvICES | ACCESS TO FINANCE 29 First Mover Advantage: Bank Muscat Targets Oman's Unbanked SME Market "We saw that no one was trying to lend to SMEs in Oman, so we said, `Why don't we be the first?'" In 2006, Bank Muscat had successfully captured a 40­45 percent commercial banking market share in Oman, but noticed that no one was targeting the SME sector. Its own small portfolio of SME loans was performing poorly. So, it asked itself, "Do we want to drop this market or do we want to learn how to do this well and make money on it?" Recognizing the opportunity to establish itself as the first bank to serve SMEs in the country, Bank Muscat chose the latter. Bank Muscat knew it needed to build knowledge of the sector, so it gathered market research, including a World Bank study identifying a potential client base of 15­20,000 SMEs and competition limited to equipment and leasing companies. It sought investment and advisory assistance from IFC, including help conducting a market survey and additional challenge of identifying how (which dimensions formulating strategy. Bank Muscat also sent a team to matter) and where (which thresholds to apply) to sub-segment observe the operations of top SME banks in Europe. Based the SME market. Examples of dimensions might include size of on these inputs, it restructured its operations, segmenting annual sales, industry, or growth stage. Thresholds, then, are its lending into Program Lending, which offers highly the categorical limits that divide SMEs within a dimension, structured products to smaller SMEs, and SME Finance, such as the number of years in business required for an enterprise which provides more customized service to larger SMEs. to qualify for classification in the "mature" growth stage. The bank is now in the process of upgrading its Client Relationship Management (CRM) and MIS capabilities so Segmentation within the SME sector is important because not that it can use current portfolio information to increase all SME clients have the same banking demands, nor do they sales and to develop its own credit scoring models. respond well to the same banking practices. For example, Standard Chartered Bank finds that it can profitably offer Over two years, Bank Muscat has mutiplied SME loans, "riskier" loan products to businesses that have been operating deposits, and customers for a certain length of time. However, there are no universal Total assets (loans) 356% rules of thumb for where to draw the line between SME clients, Total liabilities (deposits) or even along which dimensions these lines should be drawn. 285% Customer base In some geographies, the stage of growth may be less important than the industry sector of the SME for determining the 220% riskiness of the loan. Taking into account their target market 189% 178% and organizational capabilities, banks must learn from experience which characteristics are most meaningful for SME 140% sub-segmentation. 100% FY 2006 FY 2007 FY 2008 30 THE SME BANKING KNOWLEDGE GUIDE Figure 23: Bank sales thresholds for SME Figure 24: Banks are generally set up to serve definitions vary widely SMEs as a single segment Bank definitions of SMEs Banks' setup to serve SMEs Medium enterprise Small enterprise 30% 81% 25% 60% 20% 15% 30% 10% 10% 9% 9% Small enterprise Medium enterprise 30 5% Not setup 1 separate 2 segments to serve structure serving small & 25 SMEs separately for SMEs* medium separately 0% 0.1 0.25 0.5 2.5 1 5 10 15 20 25 30 35 40 45 50 20 ANNUAL SALES THRESHOLD ( $ MIL L ION S ) Developed countries Developing countries 15 Source: Beck et al (2008) Around the World survey; each data Source: Beck et al (2008) Around the World survey point shows the percentage of banks whose maximum sales threshold falls between the current and previous category on the *One separate structure may serve only small, or medium, or 10 x-axis. small and medium combined 5 0 Approaches 0.10.250.5 1 2.5 5 10 15 20 25 30 a 40 45 example, service to the middle market may resemble35corporate50 banking approach that is modified for the particular needs of In most developing countries, information on SMEs may be medium enterprises. Serving the small enterprise segment, limited or unreliable. Here, a critical first step in developing an conversely, often requires mass-market approaches similar to understanding of the SME market is defining and categorizing those found in retail banking. SMEs. The most rudimentary approaches to setting SME 85 definitions have used bank lending exposure, but this can be a The fact that sub-segmenting SME clients is rare may suggest that most banks have amassed relatively little information on 68 poor proxy for the size of (and approach to serving) an enterprise. Instead, most banks incorporate some measure of the nature of the market. This is consistent with the fact that 51 enterprise assets or sales, with a considerable range of reported the industry is relatively new, and many banks have only thresholds. For example, some banks define small enterprises recently begun to develop concrete strategies for serving SMEs. 34 as having under $100,000 in annual sales, while others use Even the leading banks in IFC's (2007) study, Benchmarking thresholds all the way up to $20 million (Figure 23). SME Banking Practices in OECD and Emerging Markets, 17 generally reported that their current SME business model was More important than the precise criteria used is the degree to less than two years old. 0 which the SME definition helps banks structure their approach Not setup t to serving SMEs. Most banks -- 90 percent of the 91 banks in Because of this lack of institutional knowledge -- and the the Around the World survey -- report serving at least part of difficulty of obtaining reliable information on SMEs -- banks the SME market separately from other customers (Figure 24). must be creative in developing their understanding of the However, relatively few banks go on to sub-segment their SME sector. They may need to conduct primary research through clients and serve these segments according to their needs. market surveys or direct observation and interaction with SMEs in their places of business. They can also mine the Top banks report considerable advantages in using multiple potentially valuable data to be found in their existing portfolios. business models for different segments of the SME market. For SME owners may already be individual retail clients and have IFC ADvISOry SErvICES | ACCESS TO FINANCE 31 a history with the bank, or SMEs may be located in the supply chains of a bank's larger corporate clients. In fact, some banks have found it instructive to sub-segment their SME client base Serving the female-headed SME segment: by the corporate clients that they supply. Access Bank Plc Nigeria Steps to Excellence "Successfully reaching the women's SME banking experts cite the importance of making a cultural market in Nigeria is key to achieving shift away from traditional banking practices when serving the SME sector. Successfully navigating this shift requires a sound our retail and small business goals." understanding of the SME market. A few banks have begun to A key niche market in SME banking that is often neglected demonstrate excellence in this area. While these standouts are is that of SMEs headed by women entrepreneurs. Women often large banks, lessons from their experience are applicable worldwide are starting and growing businesses at a to banks of all sizes. remarkable rate; female-headed SMEs represent an estimated minimum of 38 percent of all registered small Banks most effectively serving SMEs usually have a strategic and medium enterprises. Though they are active in SMEs focus on the sector at the highest levels of bank decision around the globe, especially in emerging markets, making. When senior management champions the strategic women's contributions are often overlooked due to importance of the SME sector, banks are able to justify up- limited market data about this segment. front investments in understanding it. For example, ICICI Bank (profiled in greater detail in the following section) In 2005 Access Bank Plc, a leading African bank determined that SMEs were central to the future of India's headquartered in Nigeria, realized that to stay ahead it economy, and to the bank. It strategically separated a banking needed to differentiate itself from its competition. With unit with a mandate to serve SMEs and subsequently invested the help of IFC, Access Bank saw an opportunity in the heavily in understanding the industries where Indian SMEs women's market to expand its SME and retail strategy, were most present. It sorted through 165 industries to identify positioning itself uniquely from other banks. 12 priority industries at a national level. Then ICICI worked to develop deeper expertise in serving SMEs in these IFC made a $15 million loan to the bank in 2006 to enable industries. it to extend credit lines to women entrepreneurs in the SME sector. In addition, IFC provided advisory services for When Wells Fargo (also profiled below) decided to focus on turning Access Bank into the "bank of choice for women" serving small business in the United States, it started by in Nigeria. IFC experts worked with bank staff to design carefully learning from its current portfolio. While this may and implement a strategy to attract and segment the have slowed the early growth of its small business portfolio, the women entrepreneurs in the SME market, and to design insights it gained from this deliberate analysis of its client base products that address challenges commonly faced by helped lay the foundation for its data-driven business model to women borrowers. serve the small end of the SME spectrum in the United States. This model is one reason why Wells Fargo is now the number As of June 2009, Access Bank had opened over 1,300 one small business lender in the country. new accounts and disbursed over $33 million in loans Banks that prioritize the SME market are also dedicated to to women entrepreneurs, with an average loan size maintaining their understanding of the market as it evolves. of $98,000. Over 650 women have been trained in After determining that SMEs were key to increasing overall business and management skills. The bank has enjoyed bank revenues, a bank operating in West Africa made it a an enhanced reputation in the market and has won policy to conduct a market assessment at the end of every year several awards recognizing its innovation in the women's in order to identify and target new opportunities. A market market, including the African Banker Award in 2007 and assessment is, in fact, one of the key steps a bank can take to the Global Banking Alliance Most Innovative Bank Award improve its understanding of the market. The process to in 2008. Through this program, the bank is capturing conduct such an assessment, including detailed specifications a key market niche in Nigeria's dynamic and growing of the information to be collected, is described at length in SME sector. The success of the program has led to its section 4.3. replication in other countries as the bank rolls out subsidiaries in Africa. 32 THE SME BANKING KNOWLEDGE GUIDE with multiple institutions, to bring all their business to one Figure 25: Leading banks' understanding of the institution. Products and packages that increase "share of market is reflected in segmentation approach wallet" and meet a range of customer needs help banks establish Segmentation approaches of Benchmarking banks a portfolio of high-value, loyal clients. The second challenge is to ensure overall profitability across 6 the offering, recognizing that SME-specific data is difficult to gather, particularly at the product level. This challenge is also complicated by the fact that the role of one product in securing the rest of an SME's banking business may be uncertain. Furthermore, while revenues from a particular product may be 3 easy to observe, the costs to provide it may be difficult to 2 disaggregate. 1 segment 2 segments, 3 segments,e.g. This assessment is made even more difficult when information small and small, top small, about the SME portfolio only reflects a fraction of the product medium medium offering. For example, a bank serving SMEs in the Middle East found it difficult to assess SME profitability because centralized Source: IFC (2007) Benchmarking SME Banking Practices in OECD and Emerging Markets data was only available for loan products, while the profitability of nonlending products was tracked at the branch level and was often not disaggregated for SMEs. Another bank explains that "as much as 44 percent of income generated from new small Leading banks' ongoing commitment to understanding the business clients was credited to other business units within our market is reflected in the fact that they are much more likely to bank."47 Surveys of banks in Argentina and Chile found that separate their approach to SMEs according to multiple sub- "almost half of the banks do not keep track of the...revenue segments. Of the 11 leading banks benchmarked by IFC in 6 share arising from deposits/account management, credit, and 2007 (Benchmarking SME Banking Practices in OECD and other transactions, and fee-based services to SMEs."48 Emerging Markets) most banks actually divide SMEs into three 5 segments by size or revenue to the bank. Only three banks A third challenge in developing a product and service offering treat the SME sector as a single segment (Figure 25). A select 4 is to strike the right balance between increasing one's offering few banks have developed other useful means of segmenting 3 to appeal to a broader market and recognizing one's limitations the market, such as by membership in an industry determined in the bank's capabilities. This is particularly true with lending to have high potential. 2 products, where new product designs have the potential to make financing available to SMEs, for example, that cannot 1 provide collateral in traditional forms. New means to secure Developing Products and Services lending, or new ways to0 1 unsecured 3 increase providesegment loans, cansegments, e.g. small, top s 2 segments, small & medium market size by tapping into the vast unmet demand of SMEs A bank's product and service offering includes, but is not lacking collateral and by fostering the growth of SME clients. limited to, lending, deposit, and transactional products. The However, the design of new lending products -- including breadth of the offering is important because it impacts a bank's their pricing, contract, and monitoring structures -- must SME market share by drawing in new clients or securing more reflect a careful assessment of the cost and risks to offer them. business from existing clients. The design of products and services also impacts the profitability of serving the SME market. Lastly, effective product development can influence Approaches the size of the addressable market itself by enabling banks to Developing an effective product offering may begin with reach clients that would otherwise be uninterested or unable to understanding the scope of products and services banks can meet requirements for service. offer SMEs. While lending is a central offering in SME banking, There are three main challenges in developing a product and the ways in which banks can meet SME needs extend far beyond service offering geared toward the SME client. The first lending. Figure 26 illustrates some of the bank products and challenge is to develop a set of products that are bundled in a services used by SMEs. Although this data is specific to Latin compelling way that persuades the SME client, who may bank America, it provides an overview of products that is largely IFC ADvISOry SErvICES | ACCESS TO FINANCE 33 relevant across regions worldwide. It shows that SMEs use a Products and packages that increase current account more than anything else, that many rely on banks for payment and other transactional services, and that financing itself can come in many forms besides standard loans. "share of wallet" and meet a range of This list of products is consistent with what banks may offer SMEs throughout the world, though in fact it understates the customer needs help banks establish a potential offering by not including such product categories as advisory services, which are increasingly common, or equity portfolio of high-value, loyal clients. financing, which is only recently emerging. Deposit and transaction products are worth highlighting as Figure 26: Lending products only represent a fraction they are often overlooked, despite demand expressed by SMEs. of the ways in which banks can meet SME needs Deposit products offered by banks have not traditionally been tailored to SME needs, but have been provided as a standard Financial products and services used by SMEs in Latin America set of current and term deposit accounts. Transaction products have similarly been limited, as banks have traditionally viewed 0% 20% 40% 60% 80% 100% them as low margin and therefore less attractive. However, Current account Deposit products Current technology developments such as internet banking, electronic Saving account clearing, and document management have increased the appeal Term deposits Saving of transaction banking products to SMEs, while generally Other investment prods. Term lowering costs for banks over the medium-term. Transaction Mutual funds Other investmen products are particularly valued by SMEs who are less likely None Mutu than corporate clients to have the in-house capabilities to Internet banking manage wage and supplier payments, taxes, receivables, and Payment of taxes Internet other critical transactions. Payment Transaction and other products Insurance Payment of wages In Banks have found that SMEs are more likely to be loyal clients Payment o Payment to suppliers when they feel the breadth of their needs have been understood Payment to s Transfer and met.50 Increasing wallet share and customer loyalty, Other payments therefore, depends in many cases on raising the number of Other p Debit card products used by each SME customer. Banks may track this De statistic as a key measure of their overall effectiveness. For Automatic debit Credit card for executives Automa example, Wells Fargo has targeted eight products per customer Foreign exchange Credit card for ex for each of its customer segments. While a large part of Collection of receivables Foreign e expanding wallet share involves integrating cross selling into None Collection of rec the strategy for acquiring and serving clients (discussed in the upcoming sections), developing the product offering plays an Loans, various types Lines of credit Loans, vario important role as well. To effectively maximize and retain the Lines business of SME clients, banks are (1) developing a wide range Overdrafts Financing products Ov of products suited to different SME needs and (2) learning to Credit card Cre bundle products and services. Leasing Check discounting IFC's (2007) Benchmarking study of leading banks found that Check disc Foreign trade financing many had originally started with a limited product offering, Foreign trade f Letter of credit especially to small businesses, but expanded their range as Letter Factoring their understanding of the market grew (Figure 27). In F None addition, they reported plans to continue adding new products in response to SME needs. At the time of the study, the median Source: FRS Surveys reported in de la Torre et al (2009a) Bank offering of these banks had grown to 18 products for small involvement with SMEs; Dalberg analysis49 businesses and 37 for midsize businesses. 34 THE SME BANKING KNOWLEDGE GUIDE OECD banks from this study reported providing about three new lending technologies into their loan offering, in particular credit and three deposit products to each of their SME clients those that address the problem of collateral. -- in emerging markets, that figure is closer to two of each Traditionally, SMEs have lacked the types of collateral needed type.51 By selling products in packages, or bundles, some banks to secure loans when available information about their credit have found that they can use one product that meets a top worthiness was not sufficient. This has been especially true in priority need to secure the sale of another, such as using a loan the developing world where property rights are weak and to gain an SME's deposit business. Bundling also appeals to collateral requirements may be very high -- for example, banks the commonly reported desire of SMEs to minimize the time in El Salvador normally set collateral-to-loan ratios at 140 it takes to conduct banking business. percent or greater.53 Even when such collateral is available, its While bundling can increase market share, its impact on use may place finite limits on SME growth, ultimately reducing profitability depends on the cost and revenues associated with the market for lending. each product. Many banks are limited by the lack of data, but To overcome this, banks have found new ways to lend using leading banks are working to track and analyze the information nontraditional, growth-oriented means of securing loans. At they need to assess the profitability of all the products offered the simplest level, this can mean using collateral that is linked to SMEs. They report, for example, that revenue from credit directly to the investment or expansion of an enterprise, as in products represents only a fraction of total income from SME equipment leasing, or asset-based lending where accounts clients (Figure 28).52 Since deposit and transaction products receivable become collateral. A more sophisticated product is can often be provided at lower costs than loans, this explains factoring -- a form of trade credit where a financial institution why it might be worthwhile to provide a low-value loan to an actually purchases an enterprise's accounts receivable at a SME if it is linked with other, more profitable products. discount that includes interest plus service costs. Factoring Cross subsidization of this sort is one way that banks have been combines a credit and transaction product that enables SMEs able to increase the size of the addressable SME market and to better manage cash flow and outsource financial functions. lend to SMEs that previously may not have warranted a loan. It may be particularly suited to emerging markets where weak Another way they have opened up the market is by incorporating legal environments make actual lending contracts less secure.54 Table 3 details these and other bank lending technologies Figure 27: Leading banks have increased their Figure 28: In leading banks serving SMEs, credit product offering to SMEs accounts for a minority share of revenues Median number of products offered Revenue breakdown by product type to SMEs by product type 32% Credit Credit 38% 16 Deposit Deposit 9 42% 29% Other Other 10 12 32% 4 24% 4 OECD Emerging Markets SE segment ME segment Source: IFC 2007 cited by de la Torre et al (2009a) Bank Source: IFC (2007) Benchmarking SME Banking Practices in OECD involvement with SMEs; Percentages do not add up to 100 and Emerging Markets percent because of non-response IFC ADvISOry SErvICES | ACCESS TO FINANCE 35 Table 3: Lending technologies Screening and Technology Information source underwriting policies Contract structure Monitoring mechanisms Small business Hard information Based on the SME's score in No collateral required, Observation of timely credit scoring (data points) about a statistical model higher interest rates repayments the enterprise Financial Audited financial Based on the strength (and Contracts may vary but Ongoing review of statement statements credibility) of the SME's future cash flow is primary financial statements lending financial ratios source of repayment Greater likelihood/level of collateral Relationship Soft information on Based primarily Variety of structures Continued observation lending the SME, owner, and on the decision or of the enterprise's community, gathered recommendation of the performance on all over time loan officer dimensions of its banking relationship Factoring Value of collateral: Based on the quality of the Factor purchases the Lender owns the accounts accounts receivable enterprise's clients accounts receivable receivable outright, thus taking over credit and collections Asset-based Value of collateral: Based on value of collateral Primary method of Problematic, as value lending accounts receivable or repayment is asset collateral of the assets must be inventory regularly updated Leasing Value of the asset Based on value of the asset Lessor purchases asset and Observation of timely leased rents to borrower, who may repayments often purchase at end of lease Fixed-asset Value of collateral: Based on the assessed Collateral (asset) worth Observation of timely lending real estate, market value of the over 100 percent of loan, repayments equipment asset, and coverage ratios throughout amortization measuring the SME's ability schedule; lien prevents to service debt borrower from selling asset Source: Berger and Udell (2006) "A more complete conceptual framework for SME finance" identified by researchers in describing a framework for SME standardized loan products. In addition to limiting the types lending that extends beyond relationship lending methods. of loans offered, some banks will standardize lending terms -- such as maturity, maximum amount, and collateral required Even when a new lending technology can increase the size of -- as well as interest rates, fees, and commissions. To further the accessible market, banks must assess the risks and costs of reduce the time it takes to deliver these loan products, banks employing this technology. For example, factoring is an may incorporate a checklist of criteria by which to approve effective solution only if the customers of the SMEs are likely SMEs for these loans. to pay their bills, and if the bank itself has the necessary competencies to efficiently conduct collections operations. Standardization enables banks to offer a range of products to Similarly, the cost of monitoring the assets used for asset-based SMEs that can be sophisticated in their original design -- lending may make it unprofitable for smaller clients. tailored to different SME growth stages, for example -- but inflexible and, therefore, efficient in their application. While Thus, for many banks, effective product design includes banks use less standardization when serving medium appropriate standardization. Banks must balance SME demand enterprises, most report that flexibility remains limited.55 for products that "fit" with the cost to provide them. For example, banks often find it cost-effective to offer enterprises under a predetermined size a fixed set of highly structured, 36 THE SME BANKING KNOWLEDGE GUIDE Steps to Excellence provides one such example. Another is purchase order financing (POF), a new financing product that some banks Banks that are moving toward excellence in developing now offer SMEs. POF is similar to factoring in that the products and services for SMEs take different approaches, but source of repayment to the bank is the customer of the SME seem to share the same attitude. Specifically, they tend to take bank client. However, with POF, banks provide up-front, a holistic view of the bank's role in meeting the needs of the pre-shipment financing to enable SMEs to complete orders. SME client, realizing that lending is only the tip of the iceberg Because the contract term is short and easy to monitor, banks in terms of what banks can offer. One of Australia's top banks waive collateral requirements. SMEs are then able to take on serving SMEs has successfully formalized this attitude in its new orders beyond their current financial capacities. For "total customer value" model, whereby it assesses and can international trade, POF can be an improvement over letters measure the complete value of its relationship with an SME of credit which often require coordination with overseas client across all products and services. Similarly, ICICI Bank banks and can be costly and time-consuming to provide to in India refers to "complete relationship value" when discussing small enterprises. its product and service offering to the SME sector. In designing and selecting a product offering, banks Because of this perspective, top banks invest in learning the demonstrating excellence are keen to ensure that SME- needs of SMEs, that of both existing and potential clients. tailored products are cost-effective and are aware of the point For example, the bank might analyze what current products at which the reward for providing a service is no longer worth are most popular among different client segments, thus the investment. Leading banks offer standardized small enabling the bank to target other clients in the segment with business loan products with clear guidelines for qualification, the appropriate products. Once they learn what SMEs need, such as a minimum number of years in business. Such effective banks are able to develop and quickly roll out new guidelines save time and money in loan processing, and the products. Especially responsive banks are ready to develop design also ensures the profitability of the product by limiting new products even if they fall outside the traditional SME exposure to excessive credit risk. bank offering. ICICI Bank's movement into equity financing IFC ADvISOry SErvICES | ACCESS TO FINANCE 37 A New Venture: Banks and SME Equity Finance in Emerging Markets Pioneering banks in emerging markets are redefining "bank their credit officers may lack.61 Additional risks include financing of SMEs" by engaging in equity and quasi-equity regulatory limits, such as capital adequacy ratios, and investments. By leveraging the insight gained from their internal bank credit rules that require credit-like information understanding of the SME sector, and their access to capital, on clients. Banks may address these risks by working through banks with SME operations are hoping to carve out profitable partnerships that leverage the complementary strengths of roles for themselves in the rapidly growing emerging the bank and its partners. markets private equity space. If successful, they will contribute to providing the long-term risk capital needed For example, a bank may not be well equipped for some for high-growth SMEs, which also have positive effects on aspects of the due diligence process or to provide technical the broader economy. assistance to SME investees. However, it may be able to offer origination services, leveraging local branch network and Trends in Bank Participation in SME Equity client portfolio to provide reliable information that is difficult to obtain in the emerging markets. The bank may Equity financing in emerging markets has been a growing also be able to provide working capital loans to investees industry, and most equity investors -- 78 percent in a 2009 during the lifespan of the investment. A number of models survey56 -- plan to increase their private equity exposure in that take these strengths into account have emerged around emerging markets over the next five years. Within this the world.62 In one such model from Africa, a domestic bank market, the SME segment appears particularly attractive. serving SMEs has partnered with an international equity In Kenya, for example, most new PE funds are reported to fund manager to provide long-term growth capital -- in the be focusing on SMEs, with investment deals that range from form of equity, quasi-equity, and debt -- to domestic SMEs. $50,000 to $2 million.57 Bank involvement in this dynamic The fund manager leads the due diligence process and space ranges from passive participation, such as investors in secures the services of a technical assistance provider to SME equity funds, to active participation, such as setting up enhance the capacities of investee SMEs, while the bank equity funds like ICICI Bank's SME-focused PE fund. Along identifies deals and provides portfolio monitoring and this spectrum, some banks act as shareholders of investment analysis (Figure 29). firms and others provide advisory services to match their SME clients with overseas investors.58 Not only are domestic Figure 29: SME equity risk capital partnership between banks in emerging markets interested in investing locally, a bank and an international investment manager but large multinationals are also investing in SMEs in these markets.59 International SME growth capital has been a burgeoning area of bank- investment manager Deal facilitated equity finance, especially in Africa, where growth origination Due capital markets have been underdeveloped. In Ghana, in diligence 2009, a leading pan-African bank announced it would build on its successful SME banking operations by creating a Domestic bank growth capital subsidiary. Banks in Nigeria entered the 3rd party TA growth capital market spurred on, in part, by a program provider that had required them to set aside a portion of profits for SME equity investments. Some worked through existing Venture Working investment managers, but others partnered together to Technical capital capital create new growth finance firms, or opened equity investing assistance subsidiaries. In cases like these, banks are actually at the forefront of an emerging industry.60 SME Models for Partnership and Risk Mitigation SME Although the potential for returns to the bank, and SME SME impact, are exciting, banks need to mitigate certain risks in equity investing. In particular, (1) equity investments might SME be used to prop up bad loans, and (2) equity investing requires a different set of investment skills that banks and Source: Dalberg research and analysis 38 THE SME BANKING KNOWLEDGE GUIDE "SME banking is not about providing a loan. It is about the complete relationship value that you can offer the SME. This spans the opportunity on the liability side and the opportunity on the transaction side." -- V. Chandok, Senior General Manager, ICICI Bank Bank Footprint 3 Keys to ICICI's Success Branches 1,438 ATMs 4,713 1. "Beyond-lending" approach ­ ICICI recognizes that SME needs go far beyond loans. As 95 percent of the bank's Employees 35,000 SME customers are non-borrowers, ICICI's strategy Retail deposit clients 14,000,000 includes profitably serving the complete needs of its SME deposit clients 900,000 SME customers through checking accounts, transaction banking services, cash management services, trade SME loan clients 46,000 services, etc. Total assets $74 billion 2. Effective segmentation ­ By effectively dividing its SME Banking Overview customers according to industry and business linkages, ICICI is able to customize its service approach and In the Indian market, where 70­80 banks are accessing the manage risk. SME space, ICICI claims a market share of 4­9 percent depending on customer classification. While ICICI cites classic challenges in serving SMEs, such as credit risk 3. 360-degree credit risk evaluation ­ ICICI Bank uses evaluation and the cost of acquiring clients, it has witnessed trade references, business profiles, transaction histories explosive growth since the re-launch of its SME strategy in and other non-traditional mechanisms to help 2003. In the past four years, both its SME loan portfolio compensate for SMEs' lack of financial statements. and overall SME revenues have nearly tripled. ICICI Bank Background "Beyond-lending" Approach With assets of $74 billion , ICICI Bank is India's largest vii ICICI Bank credits at least part of its success to its dedication private sector bank and second largest bank overall. to the SME client group and its "beyond-lending" approach Founded in 1955, initially as a development financial to serving SMEs. By offering SME clients products and institution, ICICI Bank is headquartered in Mumbai and has services that meet a full gamut of needs, ICICI Bank has been locations in all of India's 28 states as well as 18 countries able to increase its total SME client base to nearly abroad. ICICI subsidiaries include asset management and 1 million enterprises, only 5 percent of which are lending insurance companies. The bank itself is divided into groups clients. This has been done with the use of technology- that include Retail, Wholesale, International, and Rural/ enabled low-cost alternative channels. These channels and Micro. ICICI serves SMEs through a designated SME unit, applications help the bank serve SMEs in their day-to-day which is housed in its Retail Banking Group. It defines SMEs business and meet their transactional needs more efficiently as businesses with roughly less than $10 million in total net with low turnaround times. In re-launching its strategy in worth. 2003, ICICI investigated the sector and discovered that "SMEs are starved for services beyond financing, but they look to vii The INr (rs) to USD ($) exchange rates used are 51.4 rs/$ for 2009 financiers for help with all their problems," says SME Banking figures, 43.5 for 2007, and 43.7 for 2005. Head Vijay Chandok. ICICI was well positioned to begin IFC ADvISOry SErvICES | ACCESS TO FINANCE 39 meeting these needs with products such as cash management addition, through its subsidiary ICICI Venture, the institution and advisory services. Today, most of its SME revenues come began providing equity and quasi-equity funding to firms from deposit and other nonlending products, while lending that include growth-oriented midsize businesses. ICICI revenues are growing quickly as deposit-only clients begin Venture is currently in the process of closing India's first to take loans. mezzanine fund. On top of this, ICICI Bank has announced plans to develop a $150 million private equity fund focusing Effective Segmentation on Emerging Corporates which will be launched by its subsidiary ICICI Investment Management Company Limited, To strategically serve the market, ICICI divides its SME clients targeting sectors including Infrastructure, Healthcare, into three groups: (1) Corporate Linked Businesses, which are Education and other consumption- and corporate-driven SMEs linked to ICICI's current corporate client group, either as industries. These initiatives further demonstrate ICICI's vendors or distributors of goods and services, (2) the Cluster commitment to the "complete relationship value" it offers Banking Group consisting of pre-selected and pre-defined SMEs. customer industry clusters that represent promising opportunity markets within India, and (3) the Business Banking Group that includes the remaining clients. ICICI's SME loan portfolio has nearly tripled since 2005 This segmentation enables ICICI to address challenges such 3 8 as risk management and knowledge development. For example, corporate-linked SMEs represent lower-risk clients 2.5 C O R P O R AT E L O A N S ( $ B ) because ICICI has a degree of familiarity with the corporate 6 SME LOANS ($B) customer and can provide lending products based on this 2 background information. Similarly, by selecting 12 industries, out of a possible 165, to focus on at a national 1.5 4 level, ICICI can target its knowledge development toward CAGR 27% understanding the most promising groups of SMEs at a 1 2 deeper level to learn how to better meet their needs and 0.5 assess their strength. 0 0 360-degree Credit Risk Evaluation FY 2005 FY 2007 FY 2009 For its entire portfolio of SMEs, ICICI Bank uses a "360-degree" approach to evaluating credit risk. Credit SME loan portfolio score cards based on industry, linkages, or market segments Domestic Corporate loan portfolio are developed and approved by the central risk department Source: ICICI Bank to facilitate the client approval process at the branch level. ICICI Bank combines this numbers-based credit scoring process with analysis of SME value propositions, and the Most SME revenues come from nonlending products human touch of relationship manager site visits and personal references, to develop a multi-faceted credit risk 300 approval process. Combining standardized credit metrics and relationship-based techniques means that ICICI Bank can offer products and services to SMEs that would normally S M E L O A NS ($ M ) fall through the cracks of traditional methods (such as 200 requiring audited financial statements) while still maintaining profitability. 100 Next Steps: Equity Investing in SMEs ICICI Bank recognizes that its investment in understanding the SME sector can pay dividends in areas outside the scope of traditional banking. One result of this is that ICICI is 0 FY 2005 FY 2007 FY 2009 seeking to become a leader in India's emerging SME private equity industry. Initially, this meant facilitating deals between its SME clients and external PE funds, which often Net revenues from lending and trade products involved a mix of bank debt and equity from the funds. In Revenues from other products Source: ICICI Bank 40 THE SME BANKING KNOWLEDGE GUIDE where SME banking is a new phenomenon and financial literacy among SMEs may be lower. Standard Chartered, operating in 30 mostly developing countries, notes that, "When we enter an SME market we often find that we are the first bank that our clients have ever worked with." SME finance specialists focusing on low-income countries have noted that SME demand may be artificially muted because SMEs do not know how they can utilize bank financial services or assume they will be ineligible. Secondly, in addition to the challenge of providing information to SMEs, banks must also find ways to acquire information from SMEs, as in the case of borrower screening. One clear way to manage credit risk is at the point of loan origination, but SMEs complicate this process when they are unable to provide reliable financial information. This may pose a particular challenge to commercial banks moving downstream, which are used to working with audited financial statements from corporate borrowers. In the SME market, these statements are often unaudited, incomplete, or missing entirely. In the least developed markets, this problem is further compounded Acquiring and Screening SME Clients by a lack of information bureaus to provide credit history data. When building an SME client base, a bank should aim to draw from its existing individual clients where possible and to build Outreach Approaches a new client portfolio that is diverse in terms of SME size and sector representation. Diversity enables banks to stagger loan To grow their portfolios, many banks have adopted SME- maturity cycles and to manage the risks of economic shock to specific approaches to customer acquisition, starting with a certain industry or business segment. Two main challenges dedicating staff (and sometimes branches) solely to the SME that banks face in acquiring clients are (1) cost-effectively sector. To address the challenge of cost-effectively marketing marketing their product offering, and (2) managing credit risk to and acquiring prospective clients, banks note the importance by effectively screening for profitable borrowers despite of (1) taking a proactive approach, (2) dedicating an SME sales incomplete information. force separate from relationship management, and (3) employing multiple acquisition channels to reach clients. First, outreach to SMEs can be difficult because many SMEs lack basic knowledge of how they can benefit from banks. As IFC (2007) Benchmarking banks report taking a proactive such, they are less likely to be actively seeking bank products approach to generating sales, which means focusing on and services. This is particularly true in developing countries outreach rather than responding to walk-ins. Since the primary "In some cases, the problem of the SME finance gap may not be a shortage of supply, but that the demand side cannot define their needs, and don't believe they have access or could have access to financial services. They don't know the right vocabulary." --Emerging market SME finance specialist IFC ADvISOry SErvICES | ACCESS TO FINANCE 41 decision maker is often the owner of an SME, he or she may be less likely to take time away from work to shop for banking services. In such situations, especially in emerging markets, Figure 30: Relationship managers (RMs) and business bank sales staff rely on direct visits to SMEs' premises to present developers (BDs) rank as top acquisition channels the bank's offering to prospective clients. According to a bank, Importance of SME acquisition channels (5 = highest) "We make sure our sales staff have their feet out on the street."63 Although labor-intensive, such outreach is necessary to deliver 5 information to and build trust among SMEs, especially those who have not previously dealt with commercial banks.64 4 Because there may be no substitute for personal contact, banks streamline sales for efficiency by dedicating a group of sales staff 3 to business development, as distinguished from traditional relationship management (as well as from back-office staff). In this "hunter and farmer" model, relationship managers (rMs) 2 focus on cross selling and customer service, while business developers (BDs) work at efficiently generating new business. 1 Standard Chartered, for example, cites this as a means to balance the importance of personal contact with the necessity of lowering costs. Benchmarking banks rank rMs and BDs roughly equally 0 RMs BDs Postal Call Referrals as the top two client acquisition channels (Figure 30). mail center However, in addition to building a proactive, dedicated sales staff, banks have also diversified the channels through which ME segment SE segment they acquire clients. In particular, for smaller businesses with a Source: IFC (2007) Benchmarking SME Banking Practices in OECD lower relationship value, banks may use mass communication and Emerging Markets techniques such as direct mail and telemarketing to reach new clients. Wells Fargo has worked to master this approach on its way to becoming the top provider of loans under $100,000 to small businesses in the United States. Figure 30 shows that Benchmarking banks rank these tools as more important for Figure 31: Cost-effective outreach can involve small businesses than the middle market segment. starting with prospective clients closest to the bank Finally, another way that banks build recognition, and at the Business same time work to expand the potential demand for banking prospects services, is by providing SMEs with financial advisory services Cold development and workshops. Large banks that take this approach include c lients in supp one of Australia's largest banks, which created a Cash Flow to ly ch k ed a Solutions Group to both educate SMEs and to advise them of ent referrals Lin in the bank's transactional products; and ICICI Bank in India, Cli which partners with IFC and IBM to provide an online SME ta Toolkit, among other resources, for SMEs. Banks like these see nt re il clie rre n their investments in SME knowledge as supporting a critical Cu ts sector of the national economy and a critical market for their long-term strategies. Current SME clients Relationship Steps to Outreach Excellence management Banks and industry experts report that one of the most cost- effective ways to reach new clients is through existing clients.65 Based on this principle, banks moving toward excellence have 42 THE SME BANKING KNOWLEDGE GUIDE Figure 32: Most banks use independent credit underwriting Bank reported credit risk structures 0% 50% 100% found ways to structure their approach to customer acquisition Argentina to maximize quick (and inexpensive) gains generated from Credit underwriting separate Chile the current portfolio, starting inward and moving outward in focus. from sales? Colombia In banks that have 50 0 separated sales and service, this requires 100 Serbia strategic coordination between rM and BD functions. When a Argentina bank can effectively identify prospective SME clients in the Benchmarking, OECD existing portfolio, rMs may be best positioned to cross sell to Chile Benchmarking, EM these clients, including retail customers that also own/manage Colombia SMEs. To ensure this capacity, branches should be equipped as Argentina one-stop shops that offer the full range of the bank's products. Serbia Credit underwriting done Chile rMs may also be able to identify leads through client referrals. primarily at HQ? BDs are then able to follow up on these leads, as well as leads Benchmarking, OECD Colombia identified through SME prospects' supply-chain connections Benchmarking, EM Serbia with existing clients. For example, business developers at a bank Ghana inArgentina take a "portfolio approach" by targeting entire groups Benchmarking, OECD of SME suppliers and distributors of large multinationals in the Chile bank's corporate portfolio.66 Working from the inside out Benchmarking, EM (Figure 31) generates momentum upon which BDs can build as Colombia they reach new prospects that lack an existing connection to the Yes No Serbia bank. The role of the rM in serving the SME client is further Source: de la Torre et al (2009a), citing World Bank surveys in explored in section 3.5. Benchmarking, OECD 4 countries and IFC's (2007) Benchmarking study of OECD and emerging markets (EM) Benchmarking, EM Screening Approaches One advantage of an effective outreach strategy is that with a Figure 33: A number of Benchmarking banks have found effective ways to lend without collateral surplus of potential clients, banks can be more selective in screening clients. However, determining credit-worthiness is Unsecured lending as a percentage of loan portfolio still made difficult by SMEs' lack of reliable financial information. Some of the most common approaches to 100% effectively screening clients include (1) separating credit underwriting from sales and other bank functions, (2) utilizing credit rating and scoring tools, and (3) relying on transparent 80% external data on the enterprise or owner.67 Separating credit underwriting from sales diminishes or 60% eliminates the role of the rM (or BD) in credit approval. As a result, a bank is not dependent on an individual rM's ability 40% or incentive to screen loan applicants. Banks often do this by using a centralized credit underwriting unit, but may instead have decentralized credit underwriting teams that sit within 20% branches, or they may use fully automated scoring tools developed by a central team but executed locally. 0% In surveys representing the SME banking markets of Argentina, ME segment SE segment Chile, Colombia, and Serbia, most banks reported either separating underwriting from sales or centralizing it at headquarters (Figure 32). Leading banks, from IFC's (2007) Source: IFC (2007) Benchmarking SME Banking Practices in OECD and Emerging Markets Benchmarking study, are even more likely to separate under- 100 80 IFC ADvISOry SErvICES | ACCESS TO FINANCE 43 writing from sales, but at least some do so in a decentralized and its owners. In addition, they determine how to combine manner. and weight data collected through multiple methods, based upon factors such as a firm size or exposure. Some banks have Banks around the world have overwhelmingly rated the even addressed the lack of information bureaus by working to "financial assessment of the business" as their most important develop new rating agencies or negotiating new SME scoring basis for the underwriting decision.68 However, especially with techniques with existing bureaus.71 the small business sector, traditional means of making this assessment, such as financial statement and ratio analysis, are One sign that a bank has found ways to overcome information limited by the reliability of the information provided. Banks asymmetry is that it provides a larger share of unsecured loans may supplement financial statement data with credit rating and because it does not need to fall back on collateral requirements. scoring tools, an approach that complements the independent Figure 33 shows the unsecured lending of IFC (2007) underwriting structure. These tools can range from risk-level Benchmarking banks. Most devote a much larger portion of ratings of loans based on credit analyst expertise to statistically their portfolio to unsecured lending than the industry averages validated scorecard approaches. Both rating and scoring use data of about 19 percent in developing countries and 42 percent in on a set of variables to assess a loan or customer, but scoring developed countries.72 explicitly employs a statistical model to assign a quantitative value. This value represents the risk of default associated with Unsecured lending is an important measure because it is the various firm, loan, or owner characteristics taken into heavily demanded by SMEs. One of the emerging market account. The score is most often used as an input to credit Benchmarking banks commenced operations with a fully approval, but advanced banks also use it for applications that unsecured loan offering in a country without a fully developed include risk-based pricing. credit bureau. In only a few years, it had gained a 33 percent market share.73 Eighty-two percent of banks in developed countries and sixty- five percent in developing countries report that scoring plays a role in loan approvals, usually as just one input.69 One reason for this discrepancy may be that scoring models must be developed from historical data, and such data -- whether the type of external data used in generic models or bank-specific data -- often has a shorter history in emerging markets. Even without scoring models, banks can address the information asymmetry question by relying on transparent external data. Sources for this external data include credit bureau reports on the firm or the owner, whose finances are often inseparable from those of the firm. In developing countries with poor credit bureau coverage, banks may develop their own databases of external information. Banks that can invest in a more hands-on approach may directly assist SMEs in the preparation of financial statements or gather information by directly visiting firm premises or speaking with customers and suppliers.70 Steps to Screening Excellence Banks demonstrating excellence at screening for profitable client relationships are committed to overcoming information asymmetry as a means to gain market share. These banks see finding new ways to approve loans as key to their competitive advantage. They effectively employ proxies for missing information, such as data collected on noncredit clients' transaction behavior, or qualitative information on the firm 44 THE SME BANKING KNOWLEDGE GUIDE "Many small business owners have told us that we were the first to recognize their business in a meaningful way, by giving it a line of credit." -- M. Bernstein, Head of Small Business Banking 3 Lessons from Wells Fargo's Experience Two-thirds (or $28 billion in 2008) of Wells Fargo's revenues come from its Community Banking Group, which serves 1. Prioritize up-front learning ­ By balancing its goals of retail consumers and small businesses with revenues up to customer acquisition with the need to understand $20 million, though most are considerably smaller. Some market risks and demand, Wells Fargo built a solid SMEs, generally incorporated and with at least $10 million foundation and identified prime opportunities. in revenues, are also served through its Wholesale Banking Group. 2. Match service approach to client types ­ Wells Fargo recognized that many of its SME clients shared more SME Banking Highlights commonalities with retail clients than corporate and Wells Fargo has consistently been the number one provider capitalized on these similarities. of loans under $100,000 to small businesses in the United States, with over $23 billion in total loans originated 3. Experiment with marketing approaches ­ In acquiring nationwide in 2007, representing a 16 percent market share. its large portfolio of clients, Wells Fargo has found that The bank attained this status through its direct lending "constant testing, measuring, and learning is key to program, which started streamlining loans of this size in effective small business marketing." 1995. Today, it supplies 2 million small business clients with products that include unsecured lines of credit, often approved with the assistance of statistical scoring and priced Wells Fargo Background to match risk. Its loans under $1 million constituted a 10 percent market share in 2007. In addition to lending, Wells Wells Fargo's $1.3 trillion in assets makes it one of the five Fargo places a high value on cross selling, and increasing largest banks in the United States. The bank was founded in deposit and transaction products per SME customer is a core 1852 with its first "store" (branch) opening in San Francisco part of its strategy. that same year. Wells Fargo served the American expansion westward and, after its December 31, 2008, merger with Wachovia, now operates stores in 39 states. Prioritizing Up-front Learning During its entry into the SME market space, Wells Fargo made Bank footprint (post merger) the strategic decision to limit its initial pursuit of market share in favor of an up-front learning approach. Over the course of Branches 11,000 five years, Wells Fargo built a foundation of SME client ATMs 12,300 understanding. Wells Fargo focused on learning from its Employees 281,000 current clients and cross selling those existing clients on its product and service line. This enabled the bank to use client Clients 70,000,000 feedback throughout its process of developing an SME Small business clients 2,000,000 business practice area. It also provided the bank with statistical Assets $1,300 billion data to identify and successfully target the untapped small end of the business market by taking calculated risks. Today, IFC AdvIsory servICes | ACCess to FInAnCe 45 clients under $2 million in annual sales provide a large part of branches strategically target mass-market clients along Wells Fargo's total SME revenues, deposits, and loan volume. the most effective delivery channels. At the same time, The bank found unique advantages in serving these clients, Wells Fargo initiates direct contact with SMEs through including the ability to diversify its loan portfolio through a conferences and workshops that educate small businesses high volume of small loans to businesses of all types about financing options, business development, throughout the United States and Canada. management, and other issues important to SME success. These efforts establish the bank's commitment to the Matching Service Approach to Client Types sector and help bring new clients into the bank. In addition, they provide useful feedback that the bank can To determine its service approach, Wells Fargo divides its use in finding new ways to meet customer needs. small business banking clients into two types: (1) mass- market clients and (2) relationship-managed clients. Mass- market clients are those with under $2 million in annual Future SME Banking Plans and Objectives sales, though the group average is much closer to $300,000. Wells Fargo's plans for the future include widening its lead They make up the vast majority of Wells Fargo's SME client as the #1 lender to small businesses in the United States base, and the bank is distinctive in its commitment to this and increasing its cross selling to SME clients. The recent market segment. merger with Wachovia has increased Wells Fargo's geographical reach and customer base, and will serve as By dividing its client base between mass-market and the launching point for its next phase of SME-financing relationship-managed clients, Wells Fargo is able to reserve growth. Additionally, by improving its cross selling to SME the more expensive relationship-managed model for clients, the bank will increase customer retention and higher-grossing clients. The bank determined that its mass- profitability. market clients are better and more quickly serviced by branches dedicated to their needs, and through call centers and an extensive online platform. Even before its merger with Wachovia, Wells Fargo had 1.1 million active online small business clients using its Internet-based product and Wells Fargo's loans <$100,000 have grown steadily advisory service offerings. Wells Fargo observed that its 23.4 mass-market clients do not require the level of customized 25 150 21.3 attention that their larger relationship-managed S M AL L B U SI N ES S L O A N S ($ B) T OTAL BU S IN E SS LO A N S ($ B) counterparts do; instead, they look for convenient banking 20 18.1 120 CAGR 17% options and timely access to an easy-to-understand 14.5 portfolio of product offerings. 15 103 90 Mass-market clients would often be interpreted by banks 84 86 10 79 60 as high-risk or high-cost. However, Wells Fargo has been able to partially mitigate these risks and costs through knowing the market by using statistics-based portfolio 5 30 monitoring mechanisms. 0 0 Experimenting with Marketing Approaches 2004 2005 2006 2007 In reaching clients, Wells Fargo has experimented with Total business loans new ways to offer its solutions to SME needs. The bank Small business loans (<$100,000) was one of the first in the industry to target small business clients using a similar approach to credit card companies. Source: Latest available Community Reinvestment Act data Direct mailings and telemarketing calls from local bank 25 46 THE SME BANKING KNOWLEDGE GUIDE Serving SME Clients Serving SME clients includes meeting the needs of existing clients, cultivating new business through cross selling, and managing risk by addressing problem loans. The results of effective service are mutually beneficial relationships between the bank and a loyal customer base. Long-term SME clients provide stable and growing revenues and are excellent sources of information for banks. Banks are often able to charge such clients lower interest rates, reflecting the lower risks of serving them.74 Two key challenges in effectively serving SME clients are that (1) SMEs have unique demands and value personal and attentive service, in some cases even more than corporate clients, and (2) meeting these demands can be costly given the frequency of contact required and the potentially lower revenue earned per client. Given these two challenges, banks must balance the importance of keeping operating costs down with the risk of under-investing in service, which could lead to customer attrition, higher default rates, and lost sales opportunities. Banks that have begun to serve the SME market have found that SMEs place a high priority on being perceived as a valued customer by the bank. "They do not want to be treated like an account number," explains one bank. SME banking specialists point to the importance of "respect" to the SME client, citing that traditional commercial banking approaches have conveyed to SMEs that they are insignificant. At the same time, SMEs value simplicity, convenience, and quick service. "They do not want to have to wait too long, or to be asked to produce a bunch of paperwork that they do not have." 75 While banks may not be able to afford the level of dedicated services offered to their largest clients, they cannot treat SMEs entirely as retail customers -- with limited personal contact. "We have found that SMEs actually value relationships more than any other segment, whereas large corporates take it for granted. SMEs are willing to pay a higher price for this relationship. They do not want to be treated like an account number." --Senior GM of a leading Indian bank IFC AdvIsory servICes | ACCess to FInAnCe 47 Figure 34: Branches are the primary delivery channel for nonlending products Decentralization of SME banking functions to branches 0% 20% 40% 60% 80% this is further complicated by the fact that sMes may come to a bank with a broader set of needs than a large corporation Sale of nonlending products would. According to one bank executive, "they look to financiers for help with all their problems." Loan approval Approaches Risk management Banks serving sMes have found ways to cost-effectively meet and even capitalize on the unique demands of sMes. they do this by (1) using direct delivery channels, (2) segmenting and Nonperforming loan recovery redefining relationship management, and (3) turning demands into opportunities through cross selling. Developed countries Developing countries In contrast to wholesale banking, where most transactions are channeled through a relationship manager, sMe banking Source: Beck at al (2008) Around the World survey often relies heavily on a bank's branch network as a direct delivery channel. More than half of the banks in the Around the World survey reported decentralizing at least the sale of Figure 35: Banks that segment their approach can nonlending products primarily to their branch network (Figure provide multiple levels of personal service 34). Branch service of sMes provides clients with the Average client-to-RM ratios reported availability of personal contact while utilizing economies of by Benchmarking banks scale and freeing dedicated rMs from involvement in every 1 10 100 1000 transaction. It also meets a clear sMe demand for proximity. In a study in egypt, for example, 71 percent of the sMes 30 surveyed cited proximity of the bank branch as their reason for 75 selecting the bank.76 27 Leading banks report that effectively using branches requires 58 specialized staff to serve sMes, and profit sharing schemes 158 between branches and rMs.77 In addition to specialized staff, 50 PA N E L B A N K S a number of banks dedicate entire branches to serve sMes in 200 order to improve service and efficiency. these include four of 50 ten IFC (2007) Benchmarking banks in the small business 110 segment, three of which made these the primary point of sMe service.78 200 Banks also employ low-cost delivery channels such as call 5000 centers and Internet banking. For example, 73 percent of 35 Benchmarking banks have dedicated in-bound and out- 85 bound call centers. remote and technology-based banking approaches like these meet sMe demand for convenience 70 and time savings. recall that Internet banking was the most 120 used transaction-based product in a survey of Latin American sMes (Figure 26). At the same time, these channels can 40 reduce the labor needed to serve sMes. While a rM may 70 serve 30­100 clients, at least one bank reports that each member of its telesales team can serve 5,000 clients Senior RM or ME segment (Figure 35). Junior RM or SE segment the ability to use multiple delivery channels makes it possible Telesales team for banks to segment their service approach, and redefine the Source: IFC (2007) Benchmarking SME Banking Practices in OECD and Emerging Markets 48 THE SME BANKING KNOWLEDGE GUIDE "Cross selling is the cornerstone of our sales model; we take every opportunity to sell products that match our clients' needs." --Benchmarking panel bank role of relationship management from its traditional meaning This enables the rM to focus on client service and cross selling, in corporate banking. Banks use client size or income of the which are often one and the same. An effective rM can convey bank as a means to determine whether and what type of rM a sense of importance to a small or medium enterprise and should be assigned to an account. For example in the United increase sales volume by becoming its trusted partner. The States, Wells Fargo defines clients with under $2 million in ability to understand and offer solutions to a full set of SME annual revenues as its "mass-market" segment and primarily needs can be the difference between a profitable and serves these SMEs through direct channels like branches and unprofitable service model. Deeply understanding the customer call centers. Other banks may use client income to the bank to also enables rMs to foresee and even prevent problems with divide SMEs between junior and senior managers. existing loans. For this reason, most banks also include loan monitoring as a key responsibility of rMs. (For instance, 100 For clients that warrant a dedicated rM, the "hunter and percent of Benchmarking banks do so for the medium enterprise farmer" model described earlier helps banks increase the segment.) number of clients a rM can serve, by freeing these managers from client acquisition responsibilities. Also, whereas a Steps to Excellence traditional rM might dedicate more time to evaluating collateral or collections, these functions are now often Excellence in serving SME clients means ensuring that clients performed by dedicated teams. feel valued, regardless of their size, while also ensuring the cost to serve matches the client's value to the bank. This includes (1) finding and "institutionalizing" ways to convey customer worth without investing additional labor in individual SMEs, Figure 36: Standard Chartered uses four and (2) further refining service segmentation. Going further, relationship management approaches based on banks can reconcile the tradeoff between service and efficiency customer value by (3) moving SME operations from a product orientation to a customer process orientation. There are many ways to do this. Banks could institutionalize a customer process orientation by designating space or special Dedicated relationship queues within branches for SME clients or clearly branding manager SME-specific solutions in marketing materials and Web sites. Increasing customer value A successful Australian bank serving SMEs uses its Web site to Virtual relationship convey the importance of small business clients by providing manager an online business training platform ("the SB Hub") and clearly advertising that its SME services are specialized by Portfolio manager industry. It offers a section on the Web site for each of the following SME groups: · Accountants No manager · Agribusiness · Childcare SME client base · Financial planners · Franchising · Pharmacies Source: Standard Chartered Bank IFC ADvISOry SErvICES | ACCESS TO FINANCE 49 The bank also illustrates another way to institutionalize client (Figure 36). These include intermediate options such as value through customer process orientation, by specifically "portfolio manager" and "virtual relationship manager." hiring former small business owners and managers as SME As noted in the examples above, researchers of the industry have banking specialists. One expert estimates that 40 percent of the proposed that banks shift from "product orientation" to "customer bank's rMs come from the ranks of SMEs themselves. These process orientation." These experts observe that banks typically tactics convey the bank's commitment to SMEs and improve its offer SMEs products that solve isolated problems, rather than ability to meet SME needs, without necessarily increasing the aligning their services to the business processes of the clients.79 cost of individual client interactions. Instead, they argue, banks should follow the example of other Standard Chartered Bank also illustrates excellence in industries and develop "customer-centric business processes." balancing costs and service by refining its segmentation of By mapping all of the business processes of SMEs and relationship management. rather than use just one model for determining which ones can be met in-house or through small businesses and another for medium, Standard Chartered cooperating partners, banks can identify new revenue streams. calculates clients' total value to the bank and assigns them to At the same time, the alignment of bank business processes one of four different relationship management approaches with client processes will generate cost-saving efficiencies. "Small and medium-sized enterprises only get offered products which solve isolated problems, e.g., liquidity, financing, and investment services. However, these services do not reflect the intrinsic requirements of business clients such as procurement, sales and marketing, order fulfillment." Heckl and Moormann (2007) 50 THE SME BANKING KNOWLEDGE GUIDE "No bank that is ambitious can ignore the SME market. Given a reasonably stable political situation, we are confident we can move into an emerging market and profitably bank SMEs." -- Mandeep Vohra, Head of Small Business, SME Banking Bank Footprint 3 Lessons from Standard Chartered's Experience Branches >1,500 1. Separation and dedication ­ By explicitly separating its ATMs 5,500 SME business and dedicating staff and strategic Employees >70,000 resources across its global operations, Standard Countries >70 Chartered can locate opportunities, reduce costs, and increase customer satisfaction. Countries w/ SME operations 30 Clients 14,000,000 2. Differentiation ­ On the front-end, Standard Chartered SME Clients 550,000 serves SMEs as one segment, but on the back-end, its Assets $435 billion differentiated policies enable them to streamline underwriting and service processes in line with customer value. SME Banking Overview SME banking has become an increasingly important part of 3. Gender inclusiveness ­ Standard Chartered is Standard Chartered's operations, contributing 19 percent committed to meeting the needs and aspirations of ($600 million) of Consumer Banking income for the first women in its staff, communities of operation, and half of 2008, compared with only 9 percent ($110 million) client portfolio, including female-headed SMEs. five years earlier. The bank has taken a proactive approach to entering new markets, with dedicated SME operations in 30 countries and counting. As its operations have grown, Standard Chartered has seen liabilities growing faster than Standard Chartered Background assets, noting that in many cases the segment "has more Standard Chartered Group was formed in 1969 from a surplus funds than it requires funding." Its current liability- merger between the Standard Bank of British South Africa, to-asset ratio is over 1.5. founded in 1863, and the Chartered Bank of India, Australia and China, founded in 1853. Operating in over 70 countries, it derives over 90 percent of its profits from the "emerging Separation and Dedication trade corridors" of Asia, Africa, and the Middle East. Standard Chartered credits its successful SME operations in Standard Chartered divides its operations between part to its fundamental separation of the SME segment as Wholesale and Consumer Banking. SMEs are managed a distinct business. This separation occurs at the highest within Consumer Banking, but are divided into two level as SME operations are coordinated by a global segments: small enterprises, with annual sales under $10 strategy and continually analyzed for potential million, and medium enterprises, with annual sales under improvements. Global coordination enables the bank to $25 million. IFC ADvISOry SErvICES | ACCESS TO FINANCE 51 leverage "consistency and scale," while still benefiting Outputs of the bank's strategic focus in this area include a from local knowledge. It also translates into a visible growing offering of tailored products for women, including dedication of resources to the SME segment. Standard loans designed and marketed for female entrepreneurs. It Chartered assigns SME-specific sales, service, and risk teams, has dedicated 700 female employees, or 38 percent of the and works to demonstrate the value it places on SMEs in its SME team, to SME banking. At a local level, in Bangladesh, communication and marketing materials as well as its Standard Chartered has received recognition for developing finely-tuned SME-specific product offering. One output of a business installment loan called "Orjon" specifically for this strategy has been the development of the "Business female heads of SMEs. Installment Loan," which is an unsecured medium-term loan product with standardized ranges (by country) for Next Steps: Global Customer Relationship Management loan amount and SME-size requirements. It can be To better leverage its international presence, particularly approved quickly with minimal paperwork. For example, in facilitating international trade, Standard Chartered is in Singapore, a small enterprise can be approved for up currently in the process of developing a fully integrated to $100,000 in 24 hours by providing only six months of global customer relationship management (CRM) system. bank statements. This will enable the bank to fully institutionalize and streamline services to its clients across borders, with SMEs Differentiation operating and trading internationally, as well as across Standard Chartered has developed an innovative approach service lines, such as private wealth management and to the challenge of matching customer service with cost SME lending. efficiency. Where some leading banks offer one level of service for small businesses and one for medium businesses, Standard Chartered's SME income ($ million) has Standard Chartered has identified four levels. It generally grown nearly sixfold in five years provides a dedicated relationship manager to businesses with over $10 million in annual revenue, but for smaller 600 firms, it uses the value of the customer to the bank to determine one of the three other services levels: no RM 40 Foreign Exchange (entirely mass-market services), a portfolio manager who Lending manages smaller firms in groups, or a virtual RM, who 180 provides service primarily from a call center. Trade & Working CAGR Capital 40% Gender Inclusiveness 150 Cash Management & Payments Standard Chartered is committed to gender inclusiveness, both internally with its staff (46 percent of whom are All SME products female) and externally with customers (including women 230 who own or manage SMEs). Standard Chartered has formed a Group Women's Council to promote best practices in 110 gender diversity and inclusion, supporting its employee, H1 2003 H1 2008 customer, and community strategies. Source: Investor presentations by SCB; Note that this includes organic and inorganic growth "Standard Chartered's strength is the diversity of our people -- mirroring our customers and the communities we operate in. We believe that we also have the potential to lead the way on gender diversity." -- Joanna Fielding, CFO, Standard Chartered Bank (China) Ltd. and chair of Group Women's Council 600 500 52 THE SME BANKING KNOWLEDGE GUIDE Managing Information and Knowledge Sustainable SME banking requires banks to effectively manage information and knowledge ­ banks must consciously learn from experience and feed this learning back into its strategic planning cycle for the SME business. This learning is especially critical because SME banking is a young and dynamic industry. There are few experts, and fewer "tried and true" approaches. Considerable opportunities await banks that are able to make new discoveries about the market. The primary tools that facilitate these types of discoveries are a bank's information technology (IT) and management information systems (MIS). In fact, the technological capacity to analyze data on large volumes of clients has been an important catalyst in solving the problem of profitably banking SMEs. Effective management of information and knowledge involves strategic employment of these tools to improve bank operations. A fundamental source of bank learning can be the wealth of data provided by its current portfolio of SME clients. Proper Figure 37: Even among leading banks, profitability analysis of this data can produce useful information on "what's analysis can be a challenge working" in a bank's SME operations. Combined with the Profitability analysis capabilities of Benchmarking banks experience of bank staff in serving the SME market, this information can become institutional knowledge of "how to" sustain and grow profitable operations. Thus, two main Client segment challenges to managing information and knowledge are (1) developing the infrastructure (tools and systems) to collect and Individual client Client segment analyze information, and (2) developing the capacity (skills SE segment and processes) to turn information into knowledge and adjust Branch Individual client accordingly. operations Business unit first TheBranchof these challenges may be technically complex as it includes integrating data systems across bank functions and Product geographic Business unit distance. This challenge may also be the most obvious, as the hardware and software needed for effective Client segment Product management information systems may be clearly lacking, especially in emerging markets, or clearly not coordinated Individual client Client segmentbank locations. For example, when branch data between ME segment systems are not centrally integrated, many banks cannot fully Branch Individual client identify their SME portfolio. Business unit second TheBranch challenge of turning information into knowledge, which includes identifying the appropriate business Product Business unit requirements of these systems, may be easier to overlook; 0 5 10 however, SME banking specialists cite this challenge as more Product critical. They emphasize, "IT systems are really just tools. Full FS P&L Income only None Banks may invest large amounts of money in systems but a 0 5 10 system will not be useful if they do not know what information Source: IFC (2007) Benchmarking SME Banking Practices in OECD they should be getting out of it." Knowing how to effectively and Emerging Markets employ IT and MIS may be ultimately more difficult than getting the systems in place. IFC ADvISOry SErvICES | ACCESS TO FINANCE 53 "IT systems are really just tools. Banks may invest large amounts of money in systems but a system will not be useful if they do not know what information they should be getting out of it." Approaches Steps to Excellence Bank approaches to managing information and knowledge Excellence in managing information and knowledge is can be divided according to key functions. Some of the most demonstrated when information is directly linked with important of these functions are (1) risk modeling and improved operations at all levels of an organization. In other portfolio monitoring, (2) client relationship management, words, the information for key decisions must be available and and (3) profitability analysis. the staff must know how to use it. This can be accomplished by working backwards, from the targeted improvement to the Banks typically are most advanced in their abilities to track data to be collected. For example, Standard Chartered Bank is and monitor loan data. Such portfolio data is necessary for risk looking to capitalize on its presence in 30 countries and expand assessment, to spot early warning signals (EWS) of default, its trade service business by more effectively serving clients and for the development of internal credit scoring models. As across borders. It is in the process of rolling out a CrM system is the case with knowledge management in general, leading that is fully integrated across countries, so that rMs in different banks dedicate specific teams to closely monitor, analyze, and countries can provide consistent service to SMEs operating in apply loan information. This could mean a credit risk both. Standard Chartered also links its knowledge management department with the authority to adjust credit policies in directly to specific performance measurements, such as the response to trends in portfolio data. Or, at a more specialized turnaround time for the entire process of lending. The goal of level for example, a few banks employ "EWS teams," and cite continually improving on this metric provides a framework for them as key to their portfolio management.80 gathering the information and developing knowledge on how It is often more difficult for banks to centrally track and use to do so. This goes beyond data analysis to learning how to information on clients. This information is cited as key to "migrate best practices" from one part of the bank to another. cross selling, as well as to improvements in products and Some investments in knowledge development take a long time services. Most banks have systems to track important client to pay dividends. When Wells Fargo started what is now the data, but it is often segregated by distribution channels, number one small business lending operation in the United branches, or bank areas. For example, the investment States, it spent a number of years conservatively growing its account of a retail customer may not be linked to the loan portfolio, with a focus on collecting the data it would need to provided to the small enterprise he or she owns. To address determine statistical relationships. This meant identifying issues like these, banks are moving toward centrally early on which data would be useful and then patiently integrated CrM systems that are accessible throughout the collecting and analyzing it. Eventually, it had developed organization. statistical models that gave it a competitive edge for years on A third important function of information management is end. This did not end the learning process, however. Looking detailed analysis of profitability. As discussed previously, back today, its head of small business banking remarks, "We applications of this analysis include looking at a client's total used to depend almost exclusively on statistical models. Now profitability across all products to learn about the effectiveness our loan officers are directly reviewing more of the data." of a bundling strategy or the efficiency of its service approach. At a practical level, though IT systems are just tools, banks Banks also need to be able to look at the profitability of a should not underestimate the importance of developing these particular client segment, a branch, an individual product, or tools to effectively manage knowledge and information. SME the small or medium business unit as a whole (Figure 37). banking is a volume-driven business and often requires retail However, even some of the leading banks serving SMEs lack tools. Given this, banks' senior management must envision IT one or more of these capacities. investments as part of the core business and understand what 54 THE SME BANKING KNOWLEDGE GUIDE can be expected from IT and MIS in terms of client service, needs and fully integrated so that data is singularly located. It product offering, cost efficiency, and overall competitive should ensure collection and secure storage of client and advantage. Hardware architecture should ensure, among other account behavior data to allow development of CrM and risk things, efficient and real-time communication with bank management tools. With the necessary IT systems in place, an branches, centralization of client and accounting data for real- effective information management strategy can enable banks time consolidation, and adequate breakdown of processing to stay ahead of the market, and ensure future growth and between de-centralized and central servers. Software profitability. architecture should be flexible enough to answer growing client Banking the SME Market While there is no single formula for successful SME banking, there are lessons and good practices that apply to five strategic areas: (1) strategy, SME focus, and execution capabilities; (2) market segmentation, products, and services; (3) sales culture and delivery channels; (4) credit risk management; and (5) IT and MIS. Banks that want to implement these lessons, as they enter or expand their operations in the SME market, need to follow a market entry process that begins with understanding the specific opportunity in the SME sector and ends with developing a strategy and implementation plan. To understand the opportunity and survey the competitive landscape, banks can conduct a market assessment. To identify strengths and weaknesses, and help lay out the implementation plan, banks can use an operational diagnostic such as IFC's SME Banking CHECK Diagnostic Toolkit. The CHECK evaluates operations in the five strategic areas of SME banking. As this Knowledge Guide has described in detail, many banks have developed approaches that enable them to take advantage of the opportunity offered by the SME market. As a result, the path for other banks seeking to either enter or expand within the SME market has been helpfully illuminated. Banks looking to strategically engage the market can (1) integrate the lessons of current bank experience, (2) follow a clear process for initiating market entry or expansion, and (3) employ existing tools to understand the opportunity and evaluate their SME banking operations. Lessons from SME Banking Today The experience of banks serving SMEs along each stage of the value chain points to a number of emerging lessons for banks that want to strategically engage the SME market. This has led IFC, over time, to define its own framework -- IFC SME banking CHECK Diagnostic Toolkit (the CHECK) -- to benchmark SME banking operations. Success at SME banking requires a bank to develop its own approach in response to its specific opportunities and capacities. However, banking performance ultimately depends on revenue generation (greater income), asset quality (lower risks), and operating efficiency (lower costs). In the case of SME banking, five strategic areas form a foundation for strong performance along these measures (Figure 38): · Strategy, SME focus, and execution capabilities · Market segmentation, products, and services · Sales culture and delivery channels · Credit risk management · IT and MIS 56 THE SME BANKING KNOWLEDGE GUIDE Some of these strategic areas concern bank activities along the required to implement, and the management systems to be entire value chain, while others focus on specific stages. Figure set up. An important part of this strategy is to create a bank 39 maps the five strategic areas to the corresponding stages of definition of the SME sector based on the target market the SME banking value chain. Taken together, these five areas segments. provide a framework for distilling the lessons learned by banks · Adapt the bank's organization to serve SMEs. Focusing and observers of the industry. By incorporating these lessons, on the SME market has implications for a bank's structure, banks can more effectively design and execute their own staff, and systems. A strong SME focus may be achieved by approach to serving the SME market. dedicating units and staff to the SME segment for all key functions -- from origination to back-office. Strategy, SME Focus, and Execution Capabilities · Ensure bank leadership owns and executes the SME Banks with successful SME operations have developed business strategy. Successfully serving SMEs requires a strategic models that explicitly recognize the unique characteristics of investment of resources and effort by the bank, which will their SME market. This recognition, and how it plays into require the buy-in and leadership of senior management. banks' service of SMEs from planning to execution, is the basis Management will ultimately be responsible for putting in place of the first strategic area. An SME-tailored approach is evident the necessary procedures, processes, and incentive structures for in everything from a bank's product offering to whether SME the bank to effectively execute on its SME strategy. owners feel valued when they walk into a branch. A key lesson from the experience of successful banks is that banks must · Acquire the necessary skills. SME banking involves higher leave behind traditional methods in order to adjust to the volumes than corporate banking, and deeper levels of service market. This means they must: than retail banking. The skills needed -- such as sales management, SME knowledge, and client service -- often · Define an SME-specific strategy. An SME-specific strategy do not match those of a traditional banker. Effective banks and implementation plan reflects an understanding of a prioritize hiring, training, and developing staff with the bank's goals and aspirations, target market segments, value required SME-specific skills. proposition and competitive advantage, internal capabilities Figure 38: Five strategic areas form the foundation for SME banking performance SME Banking Performance Revenue Asset Operating Generation Quality Efficiency Markets Sales Credit risk IT and and and delivery management MIS products channels Strategy, SME focus, and execution capabilities Source: IFC SME Banking CHECK Diagnostic Toolkit IFC ADvISOry SErvICES | ACCESS TO FINANCE 57 Market Segmentation, Products, and Services · Offer a range of products, beyond lending. Loans are often not the major drivers of SME banking profitability, Effective SME banking models are not based on a single but may be best used as a means to attract and retain clients. approach to serving all SME clients. Instead, effective models Strong revenues come from providing a suite of effectively recognize the diversity in the market and segment clients bundled, value-added products -- including deposit and accordingly. Commonly, they incorporate more retail-inspired transactional products -- reflecting a sophisticated vision of products and services for smaller SMEs and more corporate the client's needs. banking services for larger, more sophisticated SMEs. reflecting their understanding of SME needs, leading banks · Build product development skills. These skills are needed look far beyond immediate lending revenue when determining to create a strong value proposition in the product offering to a customer's value to the bank and offer a range of products targeted clients, and on the bank side, to leverage simplicity that reflect this understanding. Key lessons in the second and standardization for cost effectiveness. strategic area include: Sales Culture and Delivery Channels · Determine priority target segments. Banks may be able to serve some segments of the SME sector more profitably Leading banks have shifted from a traditional relationship based on the nature of the opportunity, the competitive management approach in the delivery of banking services to landscape, and the bank's own strengths and weaknesses. SMEs. They have instead, adapted mass-market approaches Analysis of the bank's current mix of clients may also help it with a heavier emphasis on sales volume. This is often decide which segments to serve. demonstrated by separating the sales function from client service, as well as from underwriting. Lessons from these · Use segmentation to adapt processes. To maximize service banks include: quality and cost-effectiveness, banks must become adept at segmenting by client type and value to the bank. · Position the organization to emphasize sales. Sales Opportunities, risks, and financial needs can all vary by orientation is reflected in the management culture of such characteristics as industry, ownership structure, successful SME banking operations, in hiring criteria, maturity of business, and reliance on international trade. and in the organizational structure. responsibilities for Figure 39: Locating the five CHECK strategic areas on the SME banking value chain Understand the Develop products Acquire & screen Serve SME Manage information SME market & services SME clients clients & knowledge 1. Strategy, SME focus, & execution capabilities 2. Market segmentation, products & services 3. Sales culture & delivery channels 4. Credit risk management 5. IT & MIS 58 THE SME BANKING KNOWLEDGE GUIDE business development and back-office functions are environment, through an automated decision-making separated, with mechanisms to find the right balance system (see below). between sales and risk. · Invest in underwriting capability. Learning how to · Proactively acquire clients. The importance of sales determine the credit risk of SMEs in the absence of performance in SME banking means that acquiring clients has complete information is a process that takes time and to be proactive; banks cannot wait for walk-in clients. Success requires accumulation of data. Underwriting loans to in this approach requires the collection and mining of internal SMEs may often require a combination of data types, and external market data, and following a well-organized including informal sources. As a bank builds knowledge process to make sure all potential clients are contacted. (and statistical models) of the sector, its ability to predict credit risk improves. · Ensure efficiency of the branch network as a delivery channel. SMEs select their banks most often on the basis of · Automate portfolio monitoring. Effective data systems branch proximity. Since branches are an important, but can enable banks to reduce costs by monitoring portfolios potentially costly delivery channel, banks need to maximize based on automated early warning signals. efficiency by focusing branches on sales and client service, · Prioritize efficiency in bad debt management. Banks centralizing back-office functions, and specializing branches that can respond quickly to signs of problematic loans -- or staff for the needs of priority target segments. by viewing this as an important function of good customer · Utilize low-cost delivery channels. Low-cost delivery service -- can prevent significant losses. channels -- such as direct marketing, Internet banking, call · Develop and use risk modeling tools. Leading banks centers, card centers, and point-of-sale banking -- are have developed statistical models that enhance their ability efficient and cost-effective ways to serve clients. Leading to estimate risk for SMEs. These tools, often built from banks are able to develop these channels and create incentives accumulated portfolio data, help ensure consistent and for clients to use them. objective credit underwriting and are also used for pricing, · Maximize cross selling and leverage SME networks. incentives, delegated lending authorities, profitability Cross selling increases revenue per client. It is a cost-effective measurement, and economic capital allocation. way to boost sales because it relies on existing relationships rather than attempting to sell to "cold prospects." The IT and MIS networks linking SMEs and theirs owners, clients, suppliers, and employees are sources of sales synergies. Cross selling To effectively serve SMEs, banks have had to reconfigure or emphasizes a customer-centric rather than a product-centric overhaul their IT and MIS systems so that the information approach to profitability. they collect and analyze is useful for making business decisions and supports responsive procedures and processes. For example, among other things, IT systems need to enable banks to assess Credit Risk Management profitability at the client segment, product, and customer Banks with successful SME operations have left behind levels. This informs key decisions about what type of products traditional approaches to credit risk, moving from minimization a bank should offer and what clients it should target. Key to management. Banks have found that they can include risk lessons emerging from bank experience with IT and MIS are: premiums in their prices, and they do not need to rely solely on · Understand and value the role of IT and MIS. Because relationship lending or collateral to secure loans. Leading SME banking is a volume-driven business, IT and MIS have banks are finding ways to use available SME data to make up become critical for client service, product development, cost for the lack of complete financial information. The lessons of savings, and overall competitive advantage. In leading credit risk management, the fourth strategic area, include: banks, management views IT investments as essential to the · Segregate risk management from sales functions. Banks core business. have used a number of models to segregate loan origination, · Build adequate hardware and software architecture. Among underwriting, and disbursement. These models vary, but other functions, a bank's hardware architecture should facilitate have in common the fact that specific staff and processes the central storage of client and accounting data, and efficient are dedicated to risk assessment and are separated from communication between branches. In particular, centralized and sales. Segregation can also be achieved in a decentralized IFC ADvISOry SErvICES | ACCESS TO FINANCE 59 Leveraging outside assistance: NBD Bank partners with IFC and other International Financial Institutions (IFIs) Founded in 1992, NBD Bank is a regional Russian bank focused on SMEs. The bank has demonstrated sustainable growth despite facing extreme financial crises, including the 1998 Russian crisis and the current (2009) global crisis. In addition to rigorous underwriting standards involving deep analysis of firms, NBD works to grow sustainably by partnering with IFIs such as IFC. Smaller banks may face a problem in funding long- term loans to SMEs with capital from short-term deposits. Since Russian legislation allows corporate customers to remove term deposits at any time, consolidated client data is essential to understanding clients and NBD needed to minimize its vulnerability to liquidity identifying opportunities in the current portfolio. This also shortages. It has worked to raise long-term capital, requires that software components be integrated to avoid targeting IFIs as a stepping stone to raising funds in duplication of data. commercial capital markets. NBD has reached out to IFIs such as the European Bank for Reconstruction · Prioritize analytical capabilities. Data architecture is and Development and the Netherlands Development essential to supporting a performance-oriented culture; a Finance Company, and has partnered with IFC since quantitative approach to risk management; and CrM 2001. IFIs account for 40 percent of its current funding capabilities, which include segmentation, direct marketing, base. Some have provided syndication loans, where IFI funds are supplemented with those of commercial and optimization of distribution channels. For these investors. purposes, banks must be able to retrieve and analyze data, and make data extracts and analysis available to operational IFC's support of NBD Bank extends beyond providing staff. capital, and includes IT and MIS training and assistance with energy efficiency investments. In the latter case, IFC helped NBD identify potential projects, Getting Started: Entering or Expanding calculate potential energy savings generated in SME Banking order to measure increased client profitability, and ultimately open a new business line in the process. The key takeaways of section 4.1 synthesize the collective As with many banks, partnership with IFC makes it lessons that have emerged from SME banking experience easier to raise money from other sources, eventually today. However, the question remains as to how banks should replacing IFI investments. implement these lessons. What are the steps toward successfully NBD Bank's SME loan portfolio has grown from entering or expanding one's SME banking operations? Banks $170 million in December 2006 to $250 million in can answer this question using a simple five-point "getting December 2008. started" process when seeking to enter or expand in the SME market. The process begins with (1) understanding the opportunity in the SME market and (2) surveying the 60 THE SME BANKING KNOWLEDGE GUIDE competitive landscape to identify how well SME banking Assess Own Capabilities and Competitive Advantage needs are being served. Once equipped with a clear sense of the SME market opportunity, banks can (3) assess their own The next step for a bank is to turn this critical lens on its own capabilities and competitive advantage, and (4) identify operations and assess its capabilities with regards to its potential barriers to entry, risks, and key success factors. competitors'. Awareness of where the bank excels -- not simply Finally, in order to proceed in a stepwise and sustainable does well but truly excels -- will be important for prioritizing manner, banks should (5) develop a strategic implementation which SME segments to target, which products to offer, and plan that identifies the resources required, and prioritizes how to provide them. Questions to ask include: management and operational action that needs to be · What are our bank's key capabilities and competencies? undertaken by the bank, in a sequenced timeline. Where do we demonstrate true excellence? · Based on this, and our knowledge of competitor strengths, Understand the SME Opportunity what are we well positioned to offer? As mentioned previously, and discussed at length in the section · Where will we have to strengthen and improve our operations, to follow, the first step is to develop a clear, quantifiable view of and how will we accomplish that? the SME market size, segmentation, growth trajectory, defining characteristics, needs, and preferences. This detailed knowledge · What are the internal hurdles that we face as a bank as we at the segment level enables a bank to start identifying which seek to enter/expand SME operations, and how will we segments to prioritize and how best to serve them. Questions overcome them? to ask includeviii: · What is the size and growth trajectory of the target SME Identify External Barriers, Risks, and Key Success Factors market by segment? An important step, though often overlooked, involves proactive · What are the defining characteristics, banking needs, and risk assessment and planning. Thinking beyond simply the preferences by segment? prospective SME clients, competitors, and the bank's own capabilities, it is critical to also explore exogenous factors and · Based on this, what are the SME banking segments that understand how they might impact success. Navigating emerge as potentially high-priority segments? financial, regulatory, and legislative environments is often facilitated by forward planning. Questions to ask include: Survey the Competitive Landscapeix · What are the hurdles to clear for successful market entry? Before target segments can be identified, informed intelligence · What are the external risks to be proactively mitigated? regarding the competitive landscape should be overlaid on the SME market data. Questions to ask include: · What are the top 1­2 external risks that our bank faces in seeking to enter or expand SME banking? · Which competitors serve which segments of the SME market, and with what products and services? · recognizing that excellence in each stage of the value chain is the goal, what is the shortlist of things that our bank must · How are SME banking needs being met, and what are get right to succeed in serving the SME market? competitors' stronger and weaker areas of service? · Where SME needs are being met, are their preferences Develop a Strategic Implementation Plan addressed? Do competitor services to SMEs demonstrate innovation and excellence? The last operational step is the development of an actionable plan to execute upon entry or expansion in the SME market. Three · What needs and preferences remain unmet? aspects of this plan are particularly salient: resource requirements, timing, and sequencing. Success requires recognition that not everything can be undertaken simultaneously and that a phased approach is often the best for enabling real-time learning and viii Note that these questions are not exhaustive. course correction. Questions that a bank might ask when ix The primary tool to enable banks to understand the SME opportunity and survey the competitive landscape is a market assessment. Section 4.3 describes developing a strategic implementation plan include: an SME market assessment and the key questions it answers in greater detail. IFC ADvISOry SErvICES | ACCESS TO FINANCE 61 · What resources will be required to execute against the SME Quantifying and Qualifying Demand banking opportunity successfully? The first objective of a market assessment is to quantify and · What are the tradeoffs and opportunity costs of deploying qualify the demand for SME banking products. This involves resources against this effort? sizing, segmenting, and describing the SME market, as well as characterizing the financial needs of potential SME clients. · How should we time and sequence of our market entry or Key information to obtain, using as many data sources as expansion plan? possible, includes: · What mechanisms can be created to ensure the bank learns · SME definitions ­ Collect various definitions of SMEs used as it grows in SME banking? in the country of operation such as the definitions used by government ministries, mortgage legislation, and business regulatory authorities. If possible, include differentiations Tools for Initiating Market Entry or by size and any variation across industries. Expansion · Size of the market ­ Determine the number of SME A number of tools can guide banks through the process of enterprises, contribution to national employment and GDP initiating market entry or expansion. Two tools that are (annual revenues), total deposits and loans with banks and especially useful are (1) an SME market assessment, which other FIs and estimates of financing potential. enables banks to understand the opportunities and the competitive landscape, and (2) an operational diagnostic, · Market composition ­ Breakdown the market size statistics which helps highlight bank strengths and weaknesses in order by sub-segment, including size of company, industry, to assess capabilities and develop the market entry plan. IFC geographic location, legal status, ownership structure, and has developed methodologies for each of these types of tools number of years in business. based on its experience in assisting financial service providers around the world serving the SME sector. Appendix C describes · Market trends ­ Identify any important trends in the SME how banks looking to serve SMEs can partner with IFC. For sector, including growth trajectory, structural changes, the operational diagnosis, IFC created the SME Banking product, service and delivery channel evolution, and CHECK Diagnostic Toolkit (the CHECK). expected regulatory changes. To illustrate the use of these tools, IFC's SME market · SME financial needs ­ To complement data on total SME assessment and the CHECK are explained below. These deposits and loans, define a sample of representative SMEs explanations explore in greater depth some of the primary for each priority market segment. Survey or interview these lessons and steps in the "getting started" process discussed in SMEs, gathering information on, for example, the firm's previous sections. general manager, overall characteristics of the firm, attitude toward banks and other financial service providers, financial management needs and current tools used, processes and SME Market Assessment tools to make payments to suppliers and employees, A market assessment is the primary means through which management of receivables and debtors, and use of business banks can accomplish the first two steps of the "getting advisory services. started" process: understanding the SME opportunity and In addition to gathering the above information about the surveying the competitive landscape. The assessment can market as a whole, a bank can complement this broader market be divided into three components: (1) quantifying and segmentation with data mining of its existing client portfolio. qualifying customer demand, (2) evaluating the competitor This includes estimating how many current banking clients landscape, and (3) estimating the value to the bank of might also be potential SME clients. According to one leading serving the SME sector. The third component, estimating bank, "The bulk of our Private Banking clients are SME the value of the opportunity, may also interact with the owners."81 Having identified the size of existing SME clients, CHECK Diagnostic because a bank's strengths and the bank can segment and profile these clients according to weaknesses can indicate how costly it will be for it to seize both business characteristics and financial needs in the same an opportunity. way as the overall market analysis. 62 THE SME BANKING KNOWLEDGE GUIDE sample of SMEs regarding their financial needs, as part of the demand assessment, can also be used to gain perspectives on competitor banks. Key information and topics to address in evaluating the competitor landscape include: · Competitor client servicing approach ­ review competitor banks' SME definitions, delivery channels (for example, standard retail branches versus special SME counters versus fully SME-dedicated business centers), existence of specialized staff to serve SMEs, marketing materials for SMEs, and general attitudes toward/support of SMEs. · Competitor product range ­ review the product range offered by competitor banks. Questions might include: Mining internal data is especially important because existing SME clients can represent a significant source of demand for · What, if any, special products are offered to SMEs? new products, and the bank may enjoy a competitive advantage with these clients. For example, often only a very small percentage · What types of credit products are offered? of SME bank account (deposit) holders are holders of loans, and · What are the features -- for example, installment frequency SMEs that borrow tend to take out loans from the banks where options, loan size and maturity limitations, interest rates they already hold deposits. Consider IFC's assessment of the and fees -- of loan products? Egyptian market,82 which found that 68 percent of SMEs were bank (deposit) account holders, but only 8 percent of SMEs (12 · What are the loan application procedures and requirements, percent of account holders) held loans. An additional 18 percent and what do they indicate about the bank's approach to (27 percent of account holders) expressed a desire to borrow in credit risk management? the next two years, representing potential unmet demand among · What deposit, transactional and other products existing bank clients (Figure 40). are available? This assessment also found that over three-quarters of the · SME perception of competitor banks ­ In addition to Egyptian SMEs that held loans obtained them from the same interviewing the sample SMEs regarding their financial bank where they held deposits, which supports the notion that needs, these interviews can also examine how SMEs perceive unmet SME client demand, identified from a bank's current the other financial service providers in the market. For portfolio, represents a significant opportunity that may be example, foreign banks may be successful despite offering realized at low cost. more expensive banking products. Questions around why SMEs might be willing to pay higher prices at these banks Evaluating the Competitor Landscape might include: Where quantifying demand is concerned with market size, the · Are certain types of businesses, for example, export- second objective of a market assessment -- to evaluate the oriented SMEs, more attracted to foreign banks? competitor landscape -- is concerned with market share. A bank should understand the degree to which its competitors are · Are SMEs particularly attracted to certain products? already meeting the needs of SMEs, as this will shape its If so, which ones? opportunity to engage the market. In addition, it is valuable to · What other factors about the nature of these banks are learn as much as possible about how competitors go about important? Such factors could include the presence of serving SMEs. This will help the bank identify what competitors multilingual or female staff, flexibility of hours, and ability do well, and where they fall short, and will provide insight to the to make SMEs feel valued. bank's own strategy for customer service and product offering. · SME perception of the assessing bank ­ To complement Techniques for this evaluation include commissioning interviews the perspectives collected on competitor banks, a bank of competitor banks and "mystery shopping" -- which involves should investigate SME perceptions of its own services. In visiting competitor branches and recording observations guided such interviews, the bank could provide SMEs with a list of by a set of targeted questions. The interviews conducted with a IFC ADvISOry SErvICES | ACCESS TO FINANCE 63 banks that include itself and ask such questions as whether each bank: Figure 40: Existing clients represent a key source of · Has a good reputation? unmet demand for loan products · Has products suited for SME needs? Egyptian SMEs by bank product usage · Has a wide network of ATMs? 100% · Has staff that understand the business needs? 80% Gathering data comparing bank service with competitor 60% 68% service, and revealing SME awareness of bank offerings, will illuminate the nature of the immediately addressable market 40% opportunity and highlight areas of strength or weakness. In 20% 18% other words, if very few SMEs have a positive awareness of a 8% bank, capturing large segments of the market may be more of 0 a challenge. More broadly, each of the activities of the All SMEs SMEs without SMEs with competitor landscape evaluation will deepen a bank's bank accounts bank accounts competitive and client intelligence, and enhance its ability to position itself strategically and develop a tailored customer No expressed demand for loan products experience for the SME client. SMEs expressing intention to borrow (potential unmet demand) Valuing the Opportunity SMEs holding loans After investigating client demand and competitor supply, the Source: IFC (2004) SME Landscape in Egypt final objective of the market assessment is to integrate the available information into an estimate of the potential value of the opportunity to the bank, in terms of increased revenues and profits. A simplified version of this process -- with Figure 41: Projecting the number of "first-contact" illustrations from IFC's (2004) SME Landscape in Egypt report SME clients to be captured by fictional bank XYZ -- might include the following steps. Alexandrian SMEs estimated by 1. Quantify prospective new clients ­ Determine the number 2004 IFC Egypt market assessment of potential SME clients in the targeted market and estimate the fraction of them the bank could reasonably serve. For 5000 example, IFC's Egypt market assessment estimated that there 4000 were 5,000 SMEs with 10­200 employees in the Alexandria area and that market penetration by banks was only 40 3000 percent (2,000 SMEs).83 This suggests 3,000 potential new 2000 ("first contact") clients in the area, not counting those that already had bank accounts. The attitude of surveyed SMEs 1000 toward banks, the capabilities of competitors in this area, and X% the strengths and weakness identified by an operational 0 diagnostic could help a bank determine how many of these SMEs with Existing market Untapped 10­200 penetration market might become its clients. Figure 41 illustrates this employees calculation. Unlikely to capture 2. Identify the number of prospects among existing clients ­ Bank XYZ likely to capture Identify the total number of SMEs in the bank's current portfolio and estimate the number that might be interested in additional products or services. In Egypt, 27 percent of SMEs 64 THE SME BANKING KNOWLEDGE GUIDE with deposit accounts expressed interest in obtaining a loan in the next two years.84 If internal data gathering produced a similar figure, this fraction of a bank's existing clients might be added to the number of "prospects" as well. Moving to the next level: Hamkorbank 3. Estimate the type and volume of products to be sold ­ restructures for sustainable growth Estimate the volume of each type of product likely to be demanded by targeted new and existing SME clients. Of As a bank that had targeted SMEs since its founding in existing clients with the intention to borrow, 30 percent of 1991, Hamkorbank was familiar with the SME market. Egyptian SMEs surveyed indicated they would be looking for However, as it expanded beyond the Andijan region equipment financing. But the primary need for an enterprise's of Uzbekistan toward a more national presence, it first contact with a bank was a current account in local currency needed to assess its operations and position itself for (cited by 99 percent).85 A bank targeting currently un-banked sustainable growth. In 2006, IFC, which had worked clients might then expect the bulk of its new business to revolve with Hamkorbank since 2001, combined an investment around deposit products. Where possible, projections of product in the bank with a technical assistance package that demand should take into account any variation by sub-segments included a senior resident advisor (SRA). The SRA of the market targeted. performed a CHECK Diagnostic that identified, among other things, ways the bank could improve its structure 4. Project revenues per product sold ­ Estimate the likely and streamline its processes to manage risk as it revenues for each type of product the bank plans to offer, expanded. using data from the current portfolio, assessments of competitor pricing, surveys of SMEs, or other sources of With IFC's help, Hamkorbank created a risk market data (for example, the median interest rate paid by management department to oversee monitoring of Egyptian SMEs in the 2004 study was 12 percent). Where operations, compliance functions, and credit policies revenue varies by transaction size, banks can use data such and procedures. This enabled the bank to more clearly as average loan/deposit amounts for targeted sub-segments separate the relationship management role at the of the SME market. Multiplying the projected sales volumes branch level from the centralized management of credit by revenues per product provides one expression of the value risk. Refined credit principles and guidance tools were of the opportunity to the bank. established at the head office and communicated to credit officers at the branch level. With these processes 5. Estimate the cost/profitability per client of providing these in place, Hamkorbank nearly doubled its number of SME products ­ To the extent possible, estimate the cost to loans and more than tripled its quantity of lending. provide each SME client with the new products and services and the resulting client profitability, adjusted for estimated Hamkorbank's SME loan portfolio has increased risks. This estimate provides an expression of the opportunity by 366% since 2006 value in terms of additional profit. Obtaining information 75 15 about competitor costs or disaggregating internal costs by TH OU S A N D S OF L OA N S client may be difficult. However, when properly identified, data from a bank's existing portfolio can help provide 50 10 approximations. USD $M In reality, there are a number of factors that add complexity to 25 5 valuing the SME opportunity. A service such as payment processing might appear costly to provide, but might help catalyze the sales of profitable overdraft accounts when properly 0 0 2006 2009 bundled. The effectiveness and cost of soliciting and retaining SMEs may be difficult to predict, as may identifying the fi xed costs associated with reaching a new market. However, the Number of SME loans (R/H axis) CHECK Diagnostic tool can enhance the market assessment by clarifying questions such as where new investment will be Volume ($M) of SME loans (L/H axis) needed. Furthermore, absolute precision in valuing the IFC ADvISOry SErvICES | ACCESS TO FINANCE 65 opportunity is not required to make high-level decisions about can also interact with a market assessment by shedding light whether and how to target the SME market. on the potential profitability of seizing a given opportunity. A bank can conduct the CHECK either on its own or with IFC SME Banking CHECK Diagnostic Toolkit support as part of an Advisory Services package. In either case, An operational diagnostic serves a number of purposes, but for the bank's level of expertise in the five strategic areas is rated. banks looking to enter or expand in the SME market, it The CHECK Diagnostic scoring tool facilitates this assessment provides a framework for assessing capabilities and developing by identifying a total of 22 core competencies within the a strategic implementation plan. The CHECK is one such strategic areas and 56 criteria for these competencies. diagnostic tool. It translates the emerging lessons on SME Table 4 lists these core competencies and criteria, along with a banking into a concrete set of evaluation criteria by which a description of the assessment for each of the five strategic areas. bank can examine its current or planned SME operations. The CHECK is normally conducted by experienced IFC specialists The CHECK was developed specifically for banks aspiring to and evaluates bank strengths and weaknesses in the five enter or expand their SME operations. It is particularly useful strategic areas critical to SME banking performance detailed because, for each of the 56 criteria on which a bank is rated, above (section 4.1). Identifying these strengths can help a bank the scoring tool provides detailed descriptions of the understand its competitive advantages. Or, if the diagnostic characteristics that differentiate bank capabilities. A bank is identifies a weakness in a competency known to be a key scored according to whether it matches the description of a (1) success factor for SME banking, then improvement of this formative, (2) emerging, (3) developed, or (4) state-of-the-art competency will be a top priority in the implementation plan. bank. In addition to addressing a bank's current state, these As noted earlier, an operational diagnostic such as the CHECK descriptions help a bank understand the potential focus of the 66 THE SME BANKING KNOWLEDGE GUIDE Table 4: Competencies assessed by the CHECK Strategic area Description Core competencies Criteria Strategy, SME focus Assess the bank's ability to design a business Strategy · Vision and execution driven SME strategy and to consistently execute · Strategy formulation capabilities this strategy. This involves the evaluation of · Commitment to SME banking the overall framework for strategy design, HR · Sustainable finance management, performance management, and the evaluation of the specific SME focus implemented Organizational set-up · SME definition in the bank's strategy and organization. · Organizational set- up Leadership and management · SME and retail experience · Strategic planning · Operational integrity HR management · Role · Hiring · Skill set · Career development · Performance culture Markets, products Assess the bank's ability to understand and Market coverage · Current client mix and services address the needs of a broad range of market segments from Consumer to Corporate, to identify Segmentation capabilities · Market intelligence new market opportunities, and to design and · Segmentation implement new products creating value for the · Analytics clients and the bank. Range of products · Product catalogue · SME-specific products Product development · Product design · Pricing · Product standardization Sales, culture and Assess the bank's ability to shift from a traditional Sales strategy and · Sales culture distribution channels corporate-lending culture, mainly based on organization · Sales organization individual relationship banking, to a mass-market · Sales skills culture focused on client acquisition, service, and retention. To efficiently manage the tradeoff Client acquisition · Branding between volume and risks, in SME Banking, sales · Lead origination performance is critical. It allows the bank to proactively cherry-pick the best clients rather than Branch network · Role of branches being solicited by nonpriority prospects. · Role of project managers · Network size and set-up · Relationship management Low-cost delivery channels · Low-cost delivery channels Cross and up-selling · Culture capabilities · Tools · Analytics Credit risk Assess the bank's ability to shift from a traditional Management and · Organization of the credit risk function management risk management approach, based on risk- organization · Credit policy avoidance, systematic collateralized lending, and relationship lending, to an industrial and Credit underwriting · Approval criteria objective approach to risk based on adequate · Credit administration risk assessment, mitigation and pricing. A good credit risk management framework should ensure Portfolio monitoring · Monitoring process that (1) credit risk is appraised in a thorough · Early warning signals and consistent way across the institution, (2) · Early arrears management segregation of duties between origination, · Portfolio reviews underwriting, and disbursement is adequate, (3) mechanisms are in place to efficiently manage and Bad debt management · Recovery process monitor the portfolio, and to learn from negative · Rescheduling experiences. · Provisioning · Analytics Risk modeling · Risk modeling culture · Systems IT/MIS Assess the ability of the bank to get the best of MIS strategy and · MIS strategy and technological culture available technology, with a view to (1) acquire technological culture competitive advantage in serving clients, (2) automate back-office tasks, (3) base daily decisions Hardware architecture · Hardware architecture on facts and data rather than on subjective assessment and (4) pilot the bank via powerful executive information systems. Software architecture · Range of functionalities · Future proofing Analytical capabilities · Client information · Data mining practices IFC ADvISOry SErvICES | ACCESS TO FINANCE 67 Table 5: Sample scoring table for the "Low cost delivery channels" criteria LOW COST DELIVERY CHANNELS Formative Emerging Developed State-of-the-art Branches are the The branch network is complemented by a A large number of ATMs The bank uses branches, only delivery network of ATMs. allow performance of basic call-centers, ATMs, and channel. Some of cash and account checking Internet banking as a set of them have an ATM, Basic Internet banking may be available, mainly transactions. distribution channels whose mainly used by as a demonstration of the bank's technical edge, cost is optimized by creating international card but is not seen as a potentially important distri- Internet banking is available incentives for clients to use holders. bution channel. The bank's Web site is primarily and is promoted to clients lowest-cost channels. used for PR support. as a way to reduce cost of account management for the bank. Call centers automate the processing of incoming calls from clients and prospects. Clients are well-equipped with credit cards and Inter- net banking. next level of operational improvement. The descriptions also Figure 42: Sample scoring of a bank on strategy, translate easily into the elements of a strategic implementation SME focus and execution capabilities plan. For example, Table 5 provides an illustrative scoring Strategy, SME Focus and Execution Capabilities table for the low-cost delivery channels criterion. A bank that is rated as "emerging" might decide that a key goal to track in its Strategy State-of-the- implementation plan would be that a given percentage of art Bank incoming client calls will be handled by call centers within the Your Bank next year. Human Organizational Resource After a bank is scored in all of the competencies within one of Set-Up Management the five strategy areas, a stellar graph is produced, which visually compares the bank's results with the state-of-the-art standard. For the first strategic area, the illustrative bank profiled in Figure 42 is ranked as between "emerging" and Leadership & "developed" in strategy and organizational set-up, but is still at Management a "formative" stage in its leadership and management. The process of assessing SME operations against these competencies can enable a bank to quickly identify and target areas where improvement is most needed. When IFC advisors conduct the CHECK, the final output of the operational diagnostic also includes an analysis of strengths, weaknesses, opportunities and threats (SWOT). Along with this, banks are presented with a thorough analysis of all the competencies in each strategic area and accompanying recommendations. 68 THE SME BANKING KNOWLEDGE GUIDE Appendix A Sample SME Definitions Table 6: The European Union defines SMEs as firms with between 10 and 250 employees Firm size Employees Annual sales Micro <10 <2 million Small <50 <10 million Medium <250 <50 million Source: Recommendation 96/280/CE, with the May 2003 update Table 7: Malaysia SMIDEC defines SMEs differently depending on the industry Firm size Manufacturing, Agro-based industries Service, ICT, or Primary Agriculture Micro <5 employees OR <$66,000 in sales <5 employees OR <$53,000 in sales Small <50 employees OR <$2 million in sales <19 employees OR <$200,000 in sales Medium <150 employees OR <$6.6 million in sales <50 employees OR <$1 million in sales Source: SMIDEC - Small and Medium Industries Development Corporation Table 8: Often no single SME definition exists even within countries Country Employees Annual Sales (Revenues) United States <500 for most manufacturing and mining <$7 million for most nonmanufacturing, but ranges up to $35.5 million Canada 10 to 250