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

Broader service offerings & higher asset quality

Lower unit costs per

transaction or service

Productivity FrontierProductivity Frontier(Future state of Best Practice)

Limitedservices tolimited numberof customersUNPROFITABLE

How?Generating

Growth:

Through profitable marketing strategies

Improving Asset Quality:

Through enhanced risk management

Increasing Operating

Efficiency:

Through technological innovation

What are banks trying to do?

Scope

Taken out of this presentation but important:

• Right environment is needed: credit bureaus, appropriate tax systems

• Leasing is definitely part of SME banking

• Elements on program lending, scoring…

What is left?

• Holistic

• Hybrid

• Project/change management

• Execution

Key messages / Presentation Outline

• SME banking, although difficult, can be highly profitable

• Differences across markets tend to disappear with the globalization of the financial services industry.

• In practice, it means that targeting SMEs impacts the entire value chain

• Based on this, several types of strategies can emerge

• Implementation is critical

SME Banking Can Be Highly Profitable

In the US, the SME segment generates higher returns

ROE

Market Size

InsuranceConsumer Credit

Credit Cards

Mortgages

SME Banking

In a number of Emerging Markets, some banks also generate high returns in the SME segment

Example of a bank in South East Asia

SME Banking Can Be Highly Profitable (Contd)

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 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

-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

… Tend to Disappear with the Globalization of the Financial Services Industry

- Growing competition

- Opportunity to charge higher interests and transaction fees to SMEs

- Need to diversify portfolio to lower overall risk

- Information technologies lowering costs

Banks have an incentive to tap new markets : Under-

served Market

Current Clients

SMEs, Microenter-

prises & Mass-market

Large Cos and

“A” Clients

In Practice, Targeting SMEs Impacts the Entire Value Chain

Marketing

strategy

Products and services offerings

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

Maximize client retention and profitability by offering product packages as well as cross- and up-selling

Domestic payments International payments Check processing

Payments

Checking accounts Savings accounts Money market accounts

Insurance Brokerage Information & tools

Loans Guarantees Credit Cards Overdrafts

Deposits

Value-added

Credit

U.S. Small Business Profit Distribution

Deposits70-85%

Loans10-15%

All Others5%

Small BusinessProfitability

100%

Focus on deposits even if lending is necessary

2. Products & Services Offerings (Contd)

Source: FIC

The deposit/loan ratio largely determines small business ROE

1:1 2:1 3:1 4:1 5:1

40%

20%

0%

Small Business Profitability

Bank A

Bank B

Bank C

Source: First Manhattan Consulting Group

Deposit-to-loan ratio

Sm

all b

usin

ess

unit

RO

E

2. Products & Services Offerings (Contd)

Contribution

Num

ber

of p

rodu

cts

$51,462

$54,343

$11,432

$10,871

$12,702

$7,149

$1,641

$477

$0 $10,000 $20,000 $30,000 $40,000 $50,000 $60,000

Eight

Seven

Six

Five

Four

Three

Two

One

Source: Oxford Information Technology, Ltd.

The more products sold, the greater the profit contribution

2. Products & Services Offerings (Contd)

Efficiency Gains with Credit Scoring

Enter Data

GenerateScore

ApplyDecisionStrategy

Auto decline Auto acceptReview

Highrisk

Mediumrisk

Lowrisk

3. Risk Management / Analytics

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

Prospecting

• Buyer Identification

• Buyer Solicitation

Information Provision

• Features• Pricing• Selection• Availability

Advice and Consultation

• Aggregatives• Optional

Categorizatioin• Alternatives

Order Capture

• Specifications• Feature• Entry

Order Processing

• Transaction Processing

• Billing

Customer Support

• Complaint Handling

• Account Reconciliation

Channel Efficiency (Capacity to Cost Ratio)

High Low

Channel

Direct Mail

Phone Center

VRU

Branch

Online

Pre-Sale Sale Post-Sale

Source: Business Banking Board Research

4. Delivery Channels (Contd)

In emerging markets, personal contact is critically important…

4. Delivery Channels (Contd)

Source: FIC

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)

…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”

4. Delivery Channels (Contd)

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

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

Based on This, Several Types of Strategies can Emerge

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

Elaboration

d’une gamme de

produits cible

Collecte

des contrats

Analyse de performance

Benchmarking

Plan

d’implémentation

Elaboration

d’une gamme de

produits cible

Collecte

des contrats

Analyse de performance

Benchmarking

Plan

d’implémentation

Define a revised product offering

Get infor-mation on existing products

Analyze performance

Benchmarking

Implementation

Example of Project (Contd)

Module 2 : Improvement of Loan Appraisal Process and Scoring

Data warehousing

Analysis of current situation

•Data available•Scoring tools in place

•Loan appraisal forms

•Methodologies/processes

Find data and follow-up

Scoring tool Development of

scoring tools

•Back-testing•Definition of new procedures

•Communication•Training•Follow-up

Define missing data

Example of Project (Contd)

Module 3 : Improvement of Collections

Elaboration

d’une gamme de

produits cible

Analyse de performance

Benchmarking

Elaboration

d’une gamme de

produits cible

Analyse de performance

Benchmarking

•Identify quick wins•Improve processes•Set-up a call center•Training

Analysis of the portfolio

Analysis of the processes

Possible Next Step if Interest: Diagnostic

Gather data on– Customer segmentation– Sales organization– CRM– Risk-based pricing

– Centralization of credit-approval– Accuracy of Risk Reporting– Efficiency of Collections

– Processes streamlining– Scoring/Rating tools– Branch as a distribution channel– Organization of back-office

– Product mix and impact on funds– Governance/Disclosure– Treasury Management / ALM

– Fee vs. interest income ratio– Profitability by customer segments

– Portfolio-at-Risk– % loans with early defaults– % Non Performing Loans– Ratios on Collections Efficiency– Ratios on Provisions and Write-offs

– Overhead/Net Income– Staff productivity– Branch productivity

– Ratio loans/deposits– Ratio interest bearing / non interest bearing deposits– ALM key ratios

Cost of Funds

Over-head Costs

Cost of Risks

GrossMargin

Calculate key indicators

Understand profitability drivers

– Formulate a diagnostic on current situation and ways of improving net margin

– Draft a proposal

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

Example of a Simple Scorecard

< .5

16

GT 100,000

27

Yes

– 30

Years in Business

Total Assets

NegativeFile Information

.5 – < 2.5

20

LT $100,000

18No

15

2.5 – < 5

27

N I

10No Investigation

0

5 – < 8

34

N I

0

8 – < 15

38

Single

14

0

14Own

40

< 1

18 Prof. Services

38

Heavy Manuf.

8

Marital Status

# of Dependents

Residential Status

Years at Address

Industry

Industry - continued

Married

30

1

14Rent

15

1 – < 3

20 I.T.

35

Others

27

Divorced

5

2

25Parents

20

3 – < 6

25Other Services

30

N I

27

Other

14

NI

14

3 – 4

10Company

18

6 – < 10

30Retail

27

4 – High

5N I

20

10 – < 15

33Catering.

20

15 – High

40

N I

14

18 – < 21

6

21 – < 25

10

25 – < 30

18

30 – < 40

26Age of Owner 40 – < 50

35

50 – High

42

N I

10

N I

25Building

10

N I

20

© 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

+–+–+––++

261425182520202715

AgeMarital status# of dependentsResidential statusTime at addressIndustryTime in BusinessTotal AssetsNegative file information

?ODDS OF REPAYMENT 95%

OVERALLDecision

+Accept

190Accept

© 1995 Fair, Isaac and Co, Inc.

3. Risk Management / Analytics (Contd)