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

© International Finance Corporation 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

© International Finance Corporation Globalization of the Financial Services Industry Commercial and Retail Market Underserved Market Current Clients Small Businesses, Microenterprises & Mass-market Large Co’s and “A” Clients 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?

© International Finance Corporation 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)

© International Finance Corporation 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

© International Finance Corporation 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?

© International Finance Corporation 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 Evolution from: Credit financial products financial services

© International Finance Corporation 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

© International Finance Corporation  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-driven products & 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 systems by 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 SME Finance: What do FIs need to do?

© International Finance Corporation 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)