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

2. 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

3. SME Banking Framework: Shifting the Productivity Frontier Broader service offerings & higher asset quality Lower unit costs per transaction or service Productivity Frontier (Future state of Best Practice) Limited services to limited number of customers UNPROFITABLE 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?

4. 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

5. 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

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

7. 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)

8. 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

9. … 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

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

11. 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)

12. 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

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

14. The deposit/loan ratio largely determines small business ROE 1:12:13:14:15:1 40% 20% 0% Small Business Profitability Bank A Bank B Bank C Source: First Manhattan Consulting Group Deposit-to-loan ratio Small business unit ROE 2. Products & Services Offerings (Contd)

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

16. Efficiency Gains with Credit Scoring Enter Data Generate Score Apply Decision Strategy Auto declineAuto acceptReview High risk Medium risk Low risk 3. Risk Management / Analytics

17. 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

18. 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-SaleSale Post-Sale Source: Business Banking Board Research 4. Delivery Channels (Contd)

19. 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)

20. …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

21. 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

22. 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

23. Focus of the strategyKey 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

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

25. 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

26. 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 Fi n d d at a a n d fo ll o w - u p Scoring tool Development of scoring tools Back- testing Definition of new procedures Communic ation Training Follow-up Define missing data

27. 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

28. 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 Gross Margin Calculate key indicators Understand profitability drivers – Formulate a diagnostic on current situation and ways of improving net margin – Draft a proposal

29. Contact Details Greg Rung Email: grung@ifc.orggrung@ifc.org

30. out

31. 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

32. … 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

33. 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

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

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