SME FINANCING How to make it viable?. Facilitated Discussion What is an SME? How are SMEs defined by...

SME FINANCINGHow to make it viable?

Facilitated Discussion• What is an SME?

• How are SMEs defined by your institution?

2

What is an SME?

SMEs are firms whose financial requirements are too large for microfinance, but too small to be effectively

served by corporate banking

Broadly, SMEs are all those businesses that act as the bridge between the LSM / FMCG Sectors and the End-

Users / Consumers

3

Usually “One Man” autocratic rule (no check on decisions)

Lack of succession planning

Excessive reliance upon one major product / supplier / buyer

Limited range of management skills

Weak legal structure

Lack of transparency / true financial reporting

Diversification backed by money, not knowledge

Limited access to debt financing and capital (own + public)

GENERAL CHARACTERISTICS OF SMEs

• 84% have sales less than Rs 0.5m

• 93% have sales less than Rs 1m

• 19% are less than 5 yrs old

• Only 4% over 25 years old

• Can be classified into Large, Medium and Small-sized entities / businesses

Source: SMEDA

SMEs in PAKISTAN

5.2m in Total Population

30% of GDP

25% of Manufactured

Exports35% of Value Addition in

Manufacturing

65% Contribution

in Employment

The SME Market still remains fundamentally under-banked and underserved, particularly for the “S” segment

• Fewer than 150,000 SME’s (4% of SME’s) currently borrow from banks in Pakistan

• Less than 40% have any form of banking relationship with any bank

PKR Billion Dec-10 Dec-11 Dec-12 Dec-13

SME O/S 334 294 266 273

Total Industry O/S 3,488 3,546 3,943 4,182

SME Share (%) 9.6% 8.3% 6.8% 6.5%

SME NPLs 96.5 95.5 95.4 86.6

SME NPL Ratio 29% 35% 36% 32%

No. of SME Borrowers 211,000 168,000 132,000 137,000

Source: SBP

Source: SBP

40%

43%

17%

Manufacturing TradingServices

Composition of SME Financing

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Scarcity of Financial Solutions

Weak Management Fabric

SME’s

Ignorance/Conservatism

Marketing/Distribution

IMPEDIMENTS IN THE GROWTH OF SMEs

The Multi-Faceted Needs of SMEsCORE FINANCIAL

NEEDSNON-CORE

FINANCIAL NEEDSNON-FINANCIAL

NEEDS

Asset Products Private Equity Business Plans and Financial Forecasts

Liability Products Debt Structuring Sales / Marketing Plans

Transaction Services & Treasury Management

Investment / Real Estate Advisory

Market Mapping & Distribution

Wealth Management Consumer Finance for Employees Process / Technology

SOURCE : IFC

Most Product Opportunities are Non-Credit

35%

40%

Other Credit Deposits

SME Revenue Base - Not Just Financing!

Credit products contribute only 35% to

Total Revenue

Only 15% of Total Revenue comes from

Loans / Funded Asset Products

• SMEs have unique and multiple needs

• Almost 85% of Total Revenue from a typical SME relationship consists of NFI

• Banks need to change the way they look at SMEs

CHALLENGES AND WAY FORWARD• Definition of SME Deposit only Customers

• Simplification and automation of Credit Process to reduce Turn-Around-Time

• Target Market Identification and Program-Lending Approach

• Investment in Technology

SME Banking

SBP Definition - SMEsSMALL ENTERPRISE (SE)

Employing up to 20 persons Sales up to Rs 75mFinancing from ALL banks / FIs up to Rs 15mAudited Account NOT mandatory

MEDIUM ENTERPRISE (ME)Employing more than 20 and up to 50 persons (Trading) OREmploying more than 20 and up to 250 persons (Manf. & Services)Sales more than Rs 75m and up to Rs 400mFinancing from one Bank/FI up to Rs 100m and from ALL banks/FIs up to Rs 200mCopy of Audited Accounts MUST be obtained where exposure is more than Rs 10m or Pvt. Ltd. Cos.

SBP PRs for SME FinancingSUMMARY OF KEY CHANGES

SME specific Credit Policy duly approved by BoD

Insurance of hypothecated / mortgaged assets NOT mandatory for exposures up to Rs 1m

PGs of all sponsors required (except in 100% cash-backed / nominee directors)

Clean exposure (secured by PG only) up to Rs 5m

Subjective Classification NOT mandatory for SEs based on account turnover / clean-up if mark-up servicing on time

CORE FINANCIAL / CREDIT NEEDS OF SMES

SMALL BUSINESSES REQUIRE FUNDS FOR FOUR MAIN PURPOSES:

Initial Business Acquisition or Establishment—often referred to as “seed” capital

Capital for Expansion and to support purchase of new plant / equipment, etc.

Working Capital needs for raw materials and stock purchases, customer credit support, and the running expenses of the business; and

Emergency Funds sometimes required to cover short-term liquidity problems

How Many Squares?

B     

D     

CA     E HGF

LKJIM PON

19 20

21 22

23 24

25 26

2728 29

Macro Risk

Industry Risk

Company Specific Risk

Business Risk Performance Risk Financial Risk

Management / Borrower Risk

RISK EVALUATION FRAMEWORK

are generally smaller, less established, have lesser power to demand leniency from creditors and influence terms, tend to work on smaller margins; and therefore are more subject to market forces

have fewer assets to offer as collateral on a secured loan

are less likely to have structured financial data and audited financial statements

tend to be under-capitalized due to the difficulties in raising equity finance for small business

have a smaller pool of business management skills to draw on, particularly where financial management is concerned

GENERAL RISKS IN SME LENDING

Succession Risk

Management & Planning Risk

Lack of Documentation / Transparency

Single Buyer / Supplier Risk

Limited access to Debt Market (Limited financial capacity)

KEY TYPES OF RISKS ASSOCIATED WITH SME BUSINESSES

sound lending policies and principles are key to successful small business lending

proper cash flow-based credit analysis

“know your borrower” and their business

always view collateral as the “last” source of repayment

monitor the borrower and business progress over time

GENERAL GUIDELINES TO RISK MITIGATION

RISK MITIGATION IN LENDING TO SMEsExtent / Amount and Type of lending must be based on Cash FlowsAssessment of “True” Cash Flows / Income EstimationMarket ReputationHistory with other Banks / FIsCredit / Limit StructuringSuccession Planning & Management QualityIndustry / Market OutlookInterest Rate RiskCollateral considerationsClose and Frequent Customer Contact, especially after disbursement

KNOW YOUR BORROWER !Who is the Prime Obligor?

• Is Prime Obligor and the borrower same entity?

• Who are the owners/ share holders of the prime obligor/borrower?

• Are there more than one firms wholly or partially owned by the owners/share holders of the prime obligor / borrower?

• In case of loosely knit group do member firms / companies usually use each other’s credit lines and/or bank accounts?

• An organization chart in case of a loosely knit group indicating who owns whom is always helpful

• Who are creditors - 3rd party suppliers / family or friends / other related firms / partners?

Some months have 30 days and some have 31 days. How many have 28 days?

All of them!

THE BORROWER’S (FIVE C'S OF CREDIT)» Character» Capacity (to repay) / Cash Flows» Capital (own contribution)

» Conditions (industry / economy / overall environment in which the customer operates)

» Collateral

PRINCIPLES OF LENDING

Character comes before anything else and

Collateral is always the last

QUESTIONS THAT MUST BE ASKED...

Why us?

What is the purpose of the loan facility being requested?

How did the “need” for a loan arise?

Does the size of existing business support the requested loan amount?

What shall be the extent of equity participation?

What are the existing banking arrangements, if any, and what are the present financing sources / alternates available?

How shall the requested loan be secured / collateral options?

LOANS ARE ALWAYS REPAID

OUT OF CASH AND

NEVER PROFITS

SIGNS OF TROUBLE

Erratic / Irregular repayment behavior

Frequent requests for enhancement of credit facilities

Sudden decrease in account activity

Frequently bounced cheques

Frequent requests for allowing payments against cheques in clearing

Sudden change in the borrower’s lifestyle, especially after disbursal of funded facilities

BEFORE AFTER

CASH FLOW BASEDLENDING

WORKING CAPITAL AND CURRENT ASSETS

Gross Working Capital (GWC) = Current Assets… represents investment in current assets

Net Working Capital = Current Assets – Current Liabilities

Maintaining working capital balance requires permanent commitment of funds

… a business will always have a minimum level of Inventory, Accounts Receivable, and Cash—All this requires funding

BEHAVIOUR OF WORKING CAPITAL

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Fixed Assets 15 15 15 15 15 15 15 15 15 15 15 15

Current Assets 45 60 70 70 60 50 60 70 70 60 50 45

5

15

25

35

45

55

65

75

PKR

Mill

ion

Permanent Working Capital

Current Assets OR

Working Capital

FINANCING NET WORKING CAPITALTemporary or Seasonal WC needs should be financed with

short-term sources (Payables and/or Borrowings)Permanent WC should be financed with long-term

sources (Equity and/or Long-term Debt)

Working CapitalTrade

Payables / Creditors

Raw Materials

Work-in-Process

Finished Goods

Trade Receivables /

Debtors

Cash

WORKING CAPITALTRADITIONAL DEFINITION = CURRENT ASSETS - CURRENT LIABILITIES

Working Capital = 19,000 – 11,000 = 8,000

LIABILITIES (funds from) ASSETS (funds to)

Share Capital & Ret. Earnings 18,000 Fixed Assets 13,000Long-term Loan 5,000 L. T. Investments 2,000

Current Liabilities Current AssetsTrade Creditors 8,000 Stock 8,000Other Payables 3,000 Trade Debtors 9,000

11,000 Other Receivables 1,000Cash 1,000

19,000

34,000 34,000

Long-term Surplus Funds = 8,000

WORKING CAPITAL

BANKER’S DEFINITION = STOCK + TRADE DEBTORS – TRADE CREDITORS

LIABILITIES (funds from) ASSETS (funds to)

Share Capital & Ret. Earnings 18,000 Fixed Assets 13,000Long-term Loan 5,000 L. T. Investments 2,000

Current Liabilities Current AssetsTrade Creditors 8,000 Stock 8,000Other Payables 3,000 Trade Debtors 9,000

11,000 Other Receivables 1,000Cash 1,000

19,00034,000 34,000

Net Working Capital = 8,000 + 9,000 – 8,000 = 9,000

Bank Loan (RF) needed to support growing SALES!

WORKING CAPITAL

LIABILITIES ASSETS Share Capital & Ret. Earnings 25,000 Fixed Assets 14,000

Trade Creditors 8,000 Stock 8,000Trade Debtors 9,000Cash 2,000

33,000 34,000

Turnover / Sales increases by 2 times

Share Capital & Ret. Earnings 25,000 Fixed Assets 14,000

Trade Creditors (8,000 x 2) 16,000 Stock (8,000 x 2) 16,000

Trade Debtors (9,000 x 2) 18,000RF Requirement 7,000

Cash ?

48,000 48,000

Anticipating Working CapitalCASE STUDY – Khan & Sons

Capital & Retained Earnings 7,000 Fixed Assets 12,000

Long-term Liabilities 1,000

Trade Creditors (8,000 x 2) 16,000 Stock (2,000 x 2) 4,000

Trade Debtors (2,000 x 2) 4,000

Net Working Capital = 4,000 + 4,000 – 16,000 = (8,000)

RF 0 Cash 4,000

TOTAL 24,000 TOTAL 24,000

Anticipating Working CapitalCASH FUNDING NEED

Sales 1,000,000 Stock 175,000+ Trade Debtors 290,000- Trade Creditors (180,000)Net Working Capital 285,000

Net Working Capital / Sales(the min. amount of increased Working Capital required to fund a given increase in Sales)

Net Working Assets / Sales Ratio = 0.285 times OR 28.5%

If sales were to increase to PKR 1,500,000 what would be the Working Capital Need?

Projected Working Capital Need = 1,500,000 x 0.285 = Rs. 427,500

Recommended max. RF / Loan Amount = ? Rs. 142,500

“Finished files are the result of years of scientific study combined with the

experience of years”.

Count the number of times that the letter “F” appears in the following sentence

6

Assessing SME Credit Risk

Is SME Credit Risk different than Corporate Credit Risk?

Is it different than Retail & Consumer Credit Risk?

WHY?

WHY NOT?

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Understand the SME Market

Develop Products & Services

Acquire & Screen SME Clients

Serve the Needs of SME Clients

Manage Information & Knowledge

SME Risk Management

Managing SME Credit RiskUnderstanding the SME Market• Sub-segment the market by Size, Risk Profile, and Business Model –

SME is not a mass-market!

Develop Products and Services • Develop and introduce Products / Programs / Bundles for each sub-

segment• Take unconventional collateral to secure loans – encourage “cash flow

based lending”

Acquire and screen SME clients • Use alternate channels to market new clients• Use alternative approaches to screen clients

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Manage SME clients• Introduce Customer Relationship Management (CRM)• Develop (preferably automated) early warning systems for identifying

problem loans• Introduce Collections as a function

Manage information and knowledge• Gather and analyze data for development of risk-rating models and

scoring tools

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Managing SME Credit Risk

Segmentation

Small

Large

Rural Urban

Seasonal Financing

Travel AgentsFertilizer & Pesticide

Dealers

Portfolio Risk vs. Loan RiskUnlike corporate loans, no single SME loan can sink the bank

Credit Risk Management Procedures• Implement enough controls to be reasonably certain that loans

meet quality standards

• Streamline and simplify the decision-making process

• Once a certain level of quality is achieved, stop the analysis process

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Portfolio Risk Management Procedures

• Clearly defined credit risk policy and approval procedures

• Adherence to the approval procedure is more important than the quality of individual loans

• Bank is seeking overall profitability of the portfolio, not perfect performance of individual loans

• If the default rate of the portfolio is too high (more than 7% for SEs and more than 10% for MEs), review and adjust the policy and approval procedure

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Credit Risk Appraisal

SME Lending will typically comprise the following:

• Evaluation based on 5 “C”s of Credit – Character, Capacity, Conditions, Capital, Collateral

• Site visits for verification and subsequent monitoring

• In-built ‘Need Assessment’ mechanisms for products / programs

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Portfolio Monitoring and Quality Control

• Credit policy and procedures set by HO; loan review focuses on adherence to policy and procedures

• HO sets concentration limits by industry type, geographical area, loan tenor; collects industry information

• Loan documentation and disbursement NEVER handled by business

• Preferably and where possible, disbursements directly for purchases rather than to the borrower

• Monitoring/site visit requirements

• Collections support

• Separate loan workout / NPL recovery unit

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Portfolio Monitoring and Quality Control

47

Credit Approval Monitoring NPL Management

First Line of Defense Early Warning Signals Recovery Process

- Loan restructuring- Out of court

settlements- Debt-asset swaps

- Collections- Segmentation- Applicant Screening- Credit Factory for “S”- Product Bundles and

Programs

Collections & Recovery

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Soft Hardcore Recovery ARM / Workout

0 - 30 DPD 31 - 60 DPD 61 – 90 DPD

- Call Centre for SEs- Phone calls by

Collectors for SEs / RMs for MEs

- Dunning Letters

More than 90 DPD

- Visits by Collectors for SEs

- Visits by BM/RM for MEs

- Dunning Letters

- Visits by BM/RM for SEs

- Visits by TL for MEs

- Dunning Letters

PRE-REQUISITES- Ownership must remain with the loan extending unit / branch- Automation of the Collection function- Dedicated Collections Teams- Dedicated NPL Management Teams

- Initiation of legal proceedings

- Restructuring

COLLECTIONS: An Illustration

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2007-11 2012 2013-140%

10%20%30%40%50%60%70%80%90%

100%

34.00%

75.00%

97.00%21.00%

20.00%1.50%

43.50%

4.20%1.20%

0-30 DPD 31 - 60 DPD 61 - 90 DPD

98.50%99.20%

99.70%

- Ownership remains jointly with the loan extending branch and SME Unit- Introduction of CWX for SME- Small but dedicated SME Collections Teams- Allocation of Collections targets to Branches and SME RMs in KPIs- Negative weight of NPL Accretion for Branches in KPIs- Trophies and incentives for meeting Collections targets

Before After

Approaches to Lending

• Financial Statement Lending• Asset-Based Lending (and Leasing)• Relationship Lending• Credit Scoring

Note: These approaches are often used in tandem, and are rarely used exclusively

50

Financial Statement Lending

• Lending is based on the strength of the financial statements – balance sheet and income statement

• Looking to profits, cash flow of the business to repay the loan

Requirement: Quality financial statements, transparency

51

Asset-based Lending• Lending is based on the quality of the underlying collateral • Loan is repaid by the conversion of that collateral to cash

Requirement: High quality accounts receivable and inventory

Examples:

• Ship-breaking• Seasonal Financing (Rice, Sugar, Cotton, Wheat, Wool, Tea)• Factoring / Receivable Financing• Leasing

52

Approaches to asset-based lending:

Borrowing Base – lend a % of current assets

Example:

• Use month end list of accounts receivable

• Eliminate any items from clients with past due amounts > 90 days

• Eliminate known problem clients

• Lend 70% of the remaining balance

53

Asset-based Lending

Approach to asset-based lending:

• Assignment of contract and proceeds – often used for supply chain financing

• Borrower pledges sales contract to bank, buyer makes payments directly to the bank

• May also be structured to secure a term loan

54

Asset-based Lending

Issues / Risks:

• Control of proceeds / assets

• Enforceability of liens

• Acceptability of collateral to bank regulators

Relationship Lending• Loan is substantially based on “soft” information from the owner about

the business, and information about the owner, through a range of sources

• Information may come from customers, suppliers; also includes information about the business environment; plus lending experience and provision of deposit accounts and other services

55

Characterized by:

• Close monitoring• Re-negotiability • Implicit long term contractual relationship• Information is not from public sources• Information is subsequently kept private

SME & Commercial

SMECommercial Agri

Medium Small

- Relationship Management approach- Mix of Program and Transaction Lending - Target Market identification- Risk Acceptance Criteria- Sales driven through branches and RMs- Special Assets Management support- Scorecards and Risk Rating Models

- Program Lending approach- Target Market identification- Risk Acceptance Criteria & Scorecards- Credit Factory approach- Sales driven through branches and ADCs- Collections function for timely markup

recovery- Need-based NPL recovery teams- Scorecards

Centralized Trade ProcessingNPL Settlement Policy & Dedicated Team

Centralized Supply Chain, BIU / MIS and R&D functionsComposite KPIs including Productivity targets in addition to volume and revenue targets

An Illustration: APPROACHES TO LENDING

Credit Scoring

57

Concept: The Future is Like the Past

Credit scoring measures relationships between borrower characteristics and payment performance of past loans to predict future payment performance of loans to borrowers with similar characteristics

Quicker, More Consistent

Credit scorecards quickly calculate a consistent risk measurement of relatively small, homogenous transactions.

This risk measure can be used as a tool in making loan decisions, pricing loans, and can be associated with historic probability of default for risk classes.

58

Concept: Expert vs. Statistical

All models are based on the combination of statistical analysis and expert judgment.

The proportion in which these two elements are combined is based on the amount and quality of data available for modelling.

Little Historic Data Extensive Historic Data

More Expert Judgment More Statistical Inference

Credit Scoring

Credit Scoring

59

Concept: Application Scoring vs. Behavioural Scoring

Application Scoring• Uses “Approved” and “Reject” data sets• Can be used as a pre-screener, or credit approval tool for NTB / fresh

loan applicants as well as for pricing decisions• Predicts the probability of default for each applicant• Used in credit approval and pricing decisions

Behavioural Scoring• Uses “Good” and “Bad” data sets• Based on the most recent information• Dynamic tool used for managing existing borrowers• Used for decisions on enhancements, renewals, cross-sell, and re-pricing

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Concepts: Ranks Applicants by Risk

Scores are used to rank applicants from low to high risk and treat them differently based on risk

Risk Class Decision Policy Interest Margin

1 Approve 1.25

2 Approve 1.75

3 Approve 2.25

4 Review 3.00

5 Review 5.00

6 Review 7.00

7 Reject N/A

Credit Scoring

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IT Requirements for Scoring

• Statistical software is needed for model development only• No software is required to implement a scorecard as a decision

support tool• A web-based online application processing system is the most

appropriate long-term model deployment solution.

Credit Scoring

Possible Modelling Techniques

1.Logistic Regression or comparable statistical techniques (neural networks, decision trees)

2.Cross-Tabs (univariate ‘logistic regression’)3.Expert Judgment Only

Amount of Data

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Types of Risk Factors:

Financial: - Leverage- NOCG- Liquidity- Profitability- Activity- Cash-flow Coverage- Interest Coverage- YOY changes in

SalesProfitabilityWorking CapitalNOCG

Credit Scoring

Non-Financial: - Years in Business- Credit History- Banking History- Demographic Information- Succession Planning- Type of Industry- LTV on Collateral- Business Reciprocity in relation to

Limit and/or Sales

Summary of the Scorecard Building Process

1. Assemble project working group

2. Define scorecard “segment”

3. Define “bad” loan for selected segment

4. Assess quality/quantity of data

5. Build Model

6. Pilot Test Model

7. Validate Model

63

Credit Scoring

Group Activity: Build an Expert Scorecard

64

1. Define scorecard segment: Generic for SMEs or Segment-specific

2. Define ‘bad’ – still needed for monitoring and validation, even for expert scorecards

3. Assume no data at all

4. Look out for pitfalls - Inputs should be simple to collect, Categories are mutually exclusive, Limit the total number of factors

5. Select Risk Factors• if I could look at only 1 factor, …• Select factors that measure different aspects of credit risk:

Ability to repay Willingness to repay

• For small businesses, can look also at personal characteristics of owner• Rank them from high to low risk: 1 is the lowest risk, 5 is the highest risk• Assign relative weights to each risk factor in terms of importance

An Illustration of an Expert ScorecardFACTOR / VARIABLE SCORE RANGES

Years in Current line of Business

> 10 years15

5 – 10 years10

5 – 3 years7

< 3 years0

Age of oldest relationship with the bank

> 5 years10

> 3 – 5 years 8

> 1 – 3 years5

< 1 year3

No prior relationship0

Age of primary Sponsor 40 – 65 years5

> 65 – 85 years3

< 40 – 25 years2

Other0

Primary Security Cash / Near-Cash15

Mortgage12

Pledge10

Hypothecation5

Clean0

Location of Business Main Market / Industrial Area

5

Peripheral Market / Industrial Area

3

Remote Market / Industrial Area

2

Other

0

Credit Turnover in all accounts / banks

> 4 x of limit15

2 – 4 x of limit12

> 1 x of limit10

< 1 x of limit0

Payment History Clean

15

Up to 2 times in 30 DPD and once in 60 DPD

10

Once in 90 DPD

7

Other

0

Sales Trend – last 3 years Increase / Increase10

Decrease / Increase8

Increase / Decrease5

Decrease / Decrease3

Others / Not Available0

Financing to WC < 50%5

50 – 70%3

70 – 85%2

> 85%0

Total Business Liabilities to Sales

Up to 75%5

75 – 90%3

90 – 100%2

> 100%0

TOTAL SCOREDECISION Approved (More than 70%) / Review (Between 65% and 70%) / Decline (Less than 65%)

CUT-OFF 65%

SMEs Have a Range of Different Product Needs

Market Analysis and Product Development Link

Create competitive products

Design product with features attractive to SME clients, but which also generate revenue for the bank

Back with strong systems so the bank can effectively deliver on its

promises

Clearly understand market for SME banking

Understand bank’s and competitors’ position in SME segment

Understand what target clients want through market research

67

Individual Product Design Considerations

• Fulfill all needs (Must Have)

• Satisfy as many wants as possible (Nice to Have)

• Create features (where possible)

• Eliminate barriers and highlight benefits

68

Needs

SME Customers

Needs = "Must Have"

Description

Access to Credit

Clear, sensible credit policy Achievable conditions/security Loan officer professionalism

Transaction Services

Balances held on account Deposits Withdrawals & transfers

69

Wants

SME Customers

Wants =

"Nice to Have"

Description

Reliability

Bank will not panic in tough times Credit to grow with the business Bank will help capture opportunities

Convenience

Proximity to branch location Easy administration procedures No bureaucracy

Cost

Lowest possible interest rates/ fees Inexpensive collateral/ legal fees Modest compliance burden

Service levels

Friendly/ sympathetic loan officer Speedy decision turnaround No mistakes or problems "Generous" credit availability

70

Features

Financial Services

Features Description

Market Presence

Safe & regulated Reputation and brand name Competitive vs. other banks

Services/ Products

Resources: "we have the money" Product range: “one-stop banking” Location: “we have a branch nearby”

Credit Capacity

Procedures: application forms, visits etc. Credit policy: "we know what's prudent" Staff: ability/ authority to make decisions

71

Benefits

Financial Services

Benefits SME Perspective

Relationship

A bank that knows my needs & risks Because they know me, they tend to trust me I can avoid the costs/ time of switching

People

Knowledgeable about finance & banking I like working with them Responsive: they can get things done

72

What is a Product Program?

73

• A standardized set of rules of credit extension for a group of customers with similar characteristics or product needs

• Sign-off on a product program is considered approval of the

complete risk/reward characteristics of the product & the credit-cycle process

• Demonstrates that portfolio performance will be predictable in terms of revenues, delinquencies, & losses

What Does the Product Program Contain?

74

• Product description• Target market • Economic & competitive environment • Eligibility criteria (terms & conditions)• Account initiation • Account maintenance • Collection & write-off policy• Treasury, funding, & pricing considerations • Support systems & MIS reports • Product profitability & stress testing

MIS strongly supports the product program process

Product Program Features

75

• Standardized & ‘simple’ products• Critical mass/scale• Risk-reward balance• Predictability• Factory-style • Management by exceptions

Portfolio management is done through approved product programs

The Importance of MIS

76

Continuously processes & transforms data into information, which will be used in the decision-making process directed

towards optimizing results

Risk-Return Trade-OffProgram Lending serves as a base for effective credit cycle &

portfolio management; diversifying and controlling risks & assessing opportunities

Product Provision: Sources of Product Manufacture

77

More than 80 % of SME banking products already exist within the organization but require customization

Much of product manufacturing can take place outside SMEbanking: • Retail banking• Cards / Consumer Finance• Corporate banking• Subsidiary companies

Product management needs to remain with SME banking, but supported by multiple service-level agreements

Product Strategies for SME Finance

78

• Liability vs. asset-driven strategies

• Pre-approved sales vs. customized solutions

• Statement vs. non-statement

• Business banking vs. total customer relationship

• Supply-chain financing

• Small vs. Medium SME

• Alternative forms (factoring, insurance, leasing)

• Product program-based

• Non-financial advisory services

• Payment-card strategies

Liability-driven Strategies

79

• SMEs use a current account more than anything else • Focus is capturing as much of the cash flow as possible: cash

is the competitor • Heavy reliance on bank for payments & transactional

services • Deposit accounts & payroll accounts can be very ‘sticky

products’• Often useful entry strategy to develop understanding of

segment • Ownership of operating account can drive risk and reward

behaviors • Many market leaders started with liability strategies

Asset-driven Strategies

80

• Credit is a crucial requirement for SMEs in deciding on a bank• Useful to hook existing banked customers of other

competitors • Strategy is to hook new clients using accessibility of credit &

pricing or a combination • Can be secured or unsecured • Main types:

- Overdraft/ emergency facility- Working-capital finance - Term finance - Commercial mortgage

Statement vs. Non-statement-based Strategies

81

• High degree of SME variability in terms of quality of financial• information & transparency • That affects the risk & reward relationship • Potentially creates two different product sets: SMEs with

financials & SMEs without• Product design quite distinct for each, with different

processing, documentation requirements, collateral coverage, & pricing/margin levels

• Leading SME banks will separately manage both product portfolios

Business Lending vs. Total Customer Relationship

82

• Some players focus on the complete business & personal banking relationship

• Includes relatives & employees of the SME• A single customer-relationship-management model

potentially adopted across all products & services• Products include deposits, current accounts, payroll, &

retirement services

Supply-Chain Finance Strategies

83

• Target the suppliers & distributors of existing or potential large corporate clients

• Effectively transfer the risk profile onto the debtor, based on receivables from the corporate name

• Customized or product-program basis with potential range of products

Small vs. Medium SME Strategies

84

• Clearly segregate the product portfolio based on size & risk profile of the Small and Medium SME

• Give small SME a small number of standardized & simplified products, primarily retail-oriented

• Medium SME potentially requires different terms & pricing

Small Medium

Borrower Individual or Business Entity Business Entity

Sales Up to Rs 100m More than Rs 100m

EligibilityExisting

business for more than 5

years

Existing business for more than 3

years

Max. Loan Amount Rs 15m More than Rs

15m

Interest Rate K + 5% p.a. K + 3% p.a.

Upfront Fee 1% 0.5%

Security Mortgage or Cash/Near-cash

Any tangible asset

Factoring Strategies

85

• Complementary source of working capital for SMEs• Two types of factoring: debt & invoice financing• Entails purchase by the lender of a firm’s accounts receivables

& collection of invoices from the parties owing money • Very useful in markets where the financial infrastructure

presents gaps. Addresses problem of SME opacity by focusing on the quality of the obligor

• Reverse factoring has recently become more popular—lender purchases receivables from only high-credit, quality buyers, resulting in low-risk loans to high-risk (SME) suppliers

Payment Card Strategies for SMEs

86

• Cards can represent a potentially low-cost, scalable way of access for high volume SME payments

• Can be packaged as small unsecured credit line for small SMEs• Card products can be packaged with added value & extensive

information-system support• Usage data can be extremely helpful in building scorecards• Research indicates 5 main motivators:

- Simplified payments- Simplified administration - Broader scope of use - Speed of service- Convenient form of credit (secured & unsecured)

Product Bundling: Another Useful Technique

87

Types of Bundling

88

Types of Bundling: Illustration (Segment-based)

89

Segment RF CF / Pledge LG Trade

FinanceCurrent

A/C

Term Loan /

Equip. Leasing

Free Credit Card (for

Sponsor)

Treasury /

FX Products

Payments & Cash

ManagementFactoring

Cotton Ginning

Travel Agent

Steel Re-Rolling

Construction

Education

CONCLUSION

90

SME Lending can be very viable, provided…

• Target Markets for both S and M are identified clearly• Business Models of the various segments within the target

market are understood• Risk Acceptance Criteria are developed for each targeted

segment• Product Programs / Bundles are developed and introduced for

each segment• Cash-flow based lending is encouraged, especially for Working

Capital needs• Adequate framework for Portfolio Monitoring is implemented

with NPL workout support