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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Efficiency Gains with Credit Scoring 3. Risk Management / Analytics Auto decline Review Auto accept Mediumrisk Highrisk Lowrisk ApplyDecision Strategy Enter Data GenerateScore

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

4. Delivery Channels (Contd) Post-Sale Pre-Sale Sale Channel Direct Mail Phone Center VRU Branch Online Channel Efficiency (Capacity to Cost Ratio) High Low Source: Business Banking Board Research

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

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

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

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

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

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

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

Example of Project (Contd) Module 2 : Improvement of Loan Appraisal Process and Scoring • Analysis of current situation • Data available • Scoring tools in place • Loan appraisal forms • Methodologies/processes Define missing data • Find data and follow-up Data warehousing Development of scoring tools • Back-testing • Definition of new procedures • Communication • Training • Follow-up Scoring tool

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

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

Contact Details • Greg Rung • Email: grung@ifc.org

out

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

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

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

3. Risk Management / Analytics (Contd) Example of a Simple Scorecard 18 – < 21 6 21 – < 25 10 25 – < 30 18 30 – < 40 26 40 – < 50 35 50 – High 42 N I 10 Age of Owner NI 14 Single 14 Married 30 Divorced 5 Other 14 Marital Status 0 14 1 14 2 25 3 – 4 10 4 – High 5 N I 14 # of Dependents Own 40 Rent 15 Parents 20 Company 18 N I 20 Residential Status < 1 18 1 – < 3 20 3 – < 6 25 6 – < 10 30 10 – < 15 33 15 – High 40 N I 25 Years at Address Prof. Services 38 I.T. 35 Other Services 30 Retail 27 Catering. 20 Building 10 Industry Heavy Manuf. 8 Others 27 N I 27 Industry - continued < .5 16 .5 – < 2.5 20 2.5 – < 5 27 5 – < 8 34 8 – < 15 38 N I 20 Years in Business Total Assets GT 100,000 27 LT $100,000 18 N I 10 Yes – 30 No 15 No Investigation 0 N I 0 Negative File Information © 1995 Fair, Isaac and Co, Inc.

3. Risk Management / Analytics (Contd) Evaluating the Credit Applicant C H A R A C T E R I S T I C J U D G M E N T C R E D I T S C O R I N G Age Marital status # of dependents Residential status Time at address Industry Time in Business Total Assets Negative file information + – + – + – – + + 26 14 25 18 25 20 20 27 15 OVERALLDecision +Accept 190Accept 95% ? ODDS OFREPAYMENT © 1995 Fair, Isaac and Co, Inc.

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