The Importance of the SME Segment to Banks in Developing Countries A Perspective

1. The Importance of the SME Segment to Banks in Developing CountriesA Perspective New Technologies for Small- and Medium-Size Enterprise Finance Washington, DC Hany A. Assaad December 4, 2002

2. Globalization of the Financial Services Industry • Globalization and technology are fundamentally changing the financial services industry worldwide • Competition has accelerated and is fierce for “best credits”/corporates in most countries • New competitors have entered the market • Margins and fees are narrowing significantly • Development of securities markets is disintermediating banks • Impact on domestic Financial Intermediaries (FIs) of deregulations, mergers/acquisitions/consolidations, global networks/alliances, universal banking

3. Globalization of the Financial Services Industry • In Emerging & Transition Economies: • Historically: • limited competition, banks not under pressure to target the underserved • Today: • growing competition, FIs have incentive to tap new markets • Need to diversify portfolio • Is the SME market profitable? Commercial and Retail Market Large Co’s and “A” Clients Current Clients Small Businesses, Microenterprises & Mass-market Underserved Market

4. FIs facing the choice: The SME Market • Too many FIs are focusing on the top tier corporate sector • In many transition and developing countries, banks are awash with deposits • SMEs are perceived as high risk and high cost • For many governments the development of SMEs is crucial for economic and social development (growth, employment, innovation)

5. Impediments to target the SME Market • Many FIs lack strategies & skills to tackle impediments associated with SME finance • Evaluating SME risk is “too labor-intensive” to be profitable • Inappropriate products & services (rigid, supply-driven) • Inflexible credit criteria – one size fits all • The need for collateral-based lending • SMEs have small transaction sizes and in many countries cash transactions  costly for FIs

6. Characteristics of SMEs • SMEs constitute the most dynamic segment of many transition and developing economies (more innovative, faster growth, possibly more profitable) • Formal vs. informal, wide variety of industries and activities • Only a small portion (~5-10%) of small businesses want to grow – the rest want to remain a certain size • Many SMEs are in the service industry low level of fixed assets • SMEs have on average a lower ratio of fixed assets to total assets and a higher level of working capital  long-term debt is not the solution • Accurate accounts or financial position are difficult to get • Failure rate of is high in early years of new businesses • Small firms and micro-entrepreneurs tend to limit their financial service provider to one financial institution  relationships with FI are important  captive clients for range of financial services • In many communities, reputation of the entrepreneur is important  reputation collateral?

7. Evolution from: • Credit financial products financial services Paradigm Shift in Financial Services for Small Businesses • Shift from product focus to customer focus • Shift from providing credit to a “package” approach, i.e. distributing a range of financial services and serving as a payment intermediary • Application of consumer finance techniques to the small business sector • Portfolio approach with mass-customized financial services • Rely on financial, information and communication technologies to develop new products and services and manage information-intensive distribution, service delivery and portfolio management

8. Pre-requisite: The Enabling Environment • Countries that encourage entrepreneurship and SMEs seem to have higher economic growth  many governments and development institutions have programs to encourage the development of the SME sector as part of strategies for economic growth and poverty alleviation • Under-developed financial and legal systems and corruption have a significant negative influence on the size, growth and profitability of SMEs  breadth and depth of financial system contributes significantly to the development of SMEs • Protection of creditors’ rights • Property rights and collateral enforcements

9. SME Finance: What do FIs need to do? • Segment the market and build up in-depth knowledge of SME clusters, identify good potential customer groups, understand their needs • Reduce cost of acquisition of new customers & retain credit-worthy customers • Develop wide range of demand-drivenproducts& services, offer a range of tailor-made (mass-customized) financial services (credit, savings, transactions/payments, life cycle products) • Maximize profit contribution per customer not per product • Develop multi-channel networks for delivery of products & services • Use of advanced, cost effective tools for comprehensive risk management • Reduce cost of delivering the best possible service = quality at low transaction cost • Align organization structure to target market and train staff • Develop efficient integrated MIS systemsby leveraging on appropriate technologies and focusing on maintaining cost of technology • Focus the branch network on marketing and sales and client relationships • Good governance and transparent reporting and adhere to highest environmental & social standards

10. Conclusion • Opportunity: • Large underserved market Potential for significant growth • Leverage financial, information & communication technologies to reduce transaction costs and improve portfolio risk management thus expanding services to SMEs profitably • Benefits to the FIs: • Potentially profitable(e.g. ROAA of 3% and higher for leading US small business lenders) • Risky but manageable(e.g. write-offs below 4% for leading US small business lenders)