Manuel Bueno

Emerging Business Models for Serving SMEs in Banking

Some time ago during a BoP conference in Madrid I had the chance to talk with Felipe Acosta, commercial director from Codensa. I remember asking him, “Now that you seem to have figured out individual credit, are you thinking about going for Small and Medium Enterprises (SMEs)?” He replied “You are crazy! It’s so much more complicated that not even many banks get it right!” What Felipe said is the common view about offering financial products to SMEs: fraught with risks and not really profitable. That view, however, is starting to change.

Why are SMEs so important? A firm is normally considered a SME when it has sales below 2.5 (for a small enterprise) and 10 million dollars (for medium enterprises) respectively. According to Ayyagari, Beck, and Demirgüç-Kunt (2003), SMEs account for close to 60% of manufacturing employment in developing countries. Furthermore, SMEs often drive innovation, spur economic growth and facilitate the provision of goods and services – above and beyond other economic actors (Barreiro, Hussels and Richards, 2009).

The problem is that often SMEs have difficulty securing financing because they do not have the necessary systems in place to provide transparent information to investors or lenders and cannot supply the high collateral requirements that banks require for their higher operational risk. In essence, they slip between the cracks of the financial system, because they are too large for microfinance institutions and too small for commercial lenders.

Why are financial institutions perceived as not being interested in SMEs? The conventional view highlights SMEs opaqueness as a crucial factor. As a consequence of SME informality and its lack of full financial reporting, financial institutions find it very hard to ascertain whether SMEs have the capacity or the willingness to pay. The appropriate business model to profitably deal with such opaqueness has been argued to be “relationship lending” which relies primarily on “soft” information gathered by the loan officer through continuous, personalized, direct contacts with SMEs, their owners and managers, and the local community in which they operate, to mitigate opacity problems (Berger and Udell 2006). Nonetheless, relationship lending has a strong disadvantage in the high labor costs required to collect and keep updated such information. Furthermore, big financial institutions are perceived as less capable to process, quantify and transmit such type of information through their formalized communication channels. Therefore, traditionally small or niche banks have tended to take a more predominant role in this market.

This state of affairs has been changing in the last few years as the competitive pressure on most financial institutions in developing countries has increased. Banks have seen their margins in other markets fall due to the intensified competition coming from non-financial organizations such as utilities (like Codensa) or Mobile Phone Banking firms. This reduction in lending margins across segments has prompted banks to increase fee-based revenue and product cross-selling, with SMEs becoming a natural target for expansion. For many large banks, SMEs have now become a strategic client.

How are these financial institutions adapting their business model to serve SMEs? From a purely market-based perspective it is obvious that they should not resort to the relationship lending prevalent at smaller institutions. To facilitate arms-length lending (the opposite of relationship lending), many of these banks have greatly invested in the development of transactional technologies such as credit scoring and standardized risk-rating tools and processes. Moreover, they have started to develop specially targeted products such as asset-based lending, factoring, fixed-asset lending, and leasing (de la Torre, Martinez Peria and Schmukler, 2008).

Some of these technologies benefit from the effects of economies of scale and scope which are present in larger banks. For example, credit scoring models rely on statistical properties to assess risk and need a large number of clients and loans, which tend to increase with bank size. When credit scoring does not adapt to the client (credit scoring tends to work best for micro and very small enterprises), large banks can tap into more sophisticated risk management systems. In this case risk management is done primarily at headquarters by a credit analyst with independence and strong approval and veto powers. Finally, large banks can also take recourse to their service platforms, technical expertise, and IT and back-office infrastructures. These advantages can be very useful with relatively bigger sized (and thus more profitable) SMEs.

However, it should be noted that lending is just one part of a larger overall package devoted to SMEs. The cross-selling of services and products is at the heart of the banks’ SME business strategy to profitably serve this segment. In fact, credit generates only part of the revenue (38%).The rest is divided between deposits (29%) and other products (32%) (Beck, Demirgüç-Kunt, and Martinez Peria, 2008). Moreover, lending is often not even the first product to be offered to SMEs and, when it is, it is normally used by the bank as an entry door to offering other more lucrative fee based products and services, including payments, saving, and advisory services. As these later products and services gain importance, the negative institutional environment relevant to credit contract writing and enforcing becomes less of a constraint.

At the organizational level, the refinement of lending practices and the thrust to cross-selling has resulted in important changes. Most banks have built separate, dedicated units to manage their relations with SMEs. These units are separated from other consumer and corporate units and approach SMEs in an integrated way. Additionally, headquarters and branches have specialized in different aspects of the service to SMEs playing to their particular strengths and centralizing functions that are subject to economies of scale. The account manager in a branch reaches out to new SMEs and manages the daily operations with existing SMEs, relying on the business center for specific back-office work. Headquarters design the array of products to be offered to SMEs to exploit cross-selling potential and use existing databases to perform data mining and screen SMEs.

Many of these changes in bank business models to serve SMEs are very recent and are still being tinkered with. SMEs in developing countries remain sorely underserved compared with their peers in developed countries. Nonetheless, this is a very important trend to notice. As financial institutions at the BoP suffer growing competition from other industries, they will increasingly have to make fuller use of their capabilities and start catering to traditionally underserved customers with better targeted sets of products and services, such as student loans or, in this case, SME financial services.