Manuel Bueno

SME Banking: The Next Frontier in Low-Income Finance

In two recent posts I have talked about emerging business models for serving Small and Medium Enterprises (SMEs) in banking and the recent clash between commercial and microfinance banks in their future competition for SMEs. On December 2009, the IFC released a SME Banking Knowledge Guide that, in my opinion, confirms the rise of SME Banking as an important tool in stimulating private sector development. I strongly believe that SME Banking represents the next frontier in BoP finance in terms of its social impact and the sophistication required for profitably serving this population. SME Banking will increasingly shift the boundaries of the finance market at the BoP level as two types of organizations, microfinance firms and commercial banks, fight to capture this market by taking recourse in their respective competitive advantages (as I briefly outlined here).

The SME Banking Knowledge Guide is a superb book that systematizes much of what I have said in my two previous posts and adds lots of interesting insights on top of them. Mainly directed towards practitioners, either from other development institutions or commercial banks, this reading is recommended to anyone who is vaguely interested in this aspect of finance for low-income markets.

Why are SMEs important? Why do they suffer lack of access to financing options?

SMEs are often defined on the basis of their sales (below $2.5 millions, for a small enterprise, and $10 millions, for a medium enterprise) or the number of employees (less the 250 people). It is estimated that 95% of the registered firms worldwide are SMEs (OECD, 2006). SMEs serve as a middle ground for the economy and are active at nearly every point in the value chain as producers, suppliers, distributors, retailers, and service providers, often allied with larger businesses. 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), thus significantly contributing to employment and GDP as well as the development of the private sector.

However, SMEs also face severe constraints in their growth due to the reduced access to markets, skills and capital (Beck, 2007). Lack of access to financing option is a consequence of the generalized perception from commercial banks that SMEs are risky and costly to serve (especially because they rarely have any collateral to pledge in the loan). As a result, SMEs usually have to rely on more expensive or unreliable informal sources of capital, hence struggling to make the investments they need to increase their productivity, enter new markets and/or hire more people. In this line, long-term debt would enable SMEs to invest in expansion without losing ownership, while short-term and working capital loans would help SMEs grow incrementally. Additionally, bank deposit and transaction products would improve operational efficiency and enable SMEs to outsource financial functions. This finance gap is not covered by microfinance institutions, because they lack the skills and expertise required to deal with such sophisticated clients.

(Figure from SME Banking Knowledge Guide. Original source: Ayyagari, Beck, and Demirgüç-Kunt, 2003)

What can commercial banks offer?

Commercial banks have traditionally viewed SMEs as a challenge because of their lack of collateral, information asymmetry and the higher costs of serving smaller transactions. All of these hindrances make, at least in theory, SMEs better suited to relationship lending methods. This implies that the SME banking market would be better served by small local banks that specialize in niche market segments and rely on “soft” information gathered through personal contact

Nonetheless, and as I explained in a previous post, in the last few years commercial banks’ profitability margins have fallen. This has encouraged them to start exploring SME banking as an alternative. As a result, their perception of the market potential in financing SMEs has radically changed. Currently, commercial banks perceive the SME sector as strategic (Beck, Demirgüç-Kunt, and Martinez Peria, 2008). Moreover, commercial banks are now starting to figure out exactly how to use their competitive advantages to successfully cater to this segment.

Therefore, the SME banking industry is currently an industry in transition. Those banks that have been successful so far in servicing SMEs have experienced Return over Assets (ROA) of 3%-6% in their SME operations compared with a bank-wide ROA between 1%-3% (IFC, 2007). This has been achieved by developing customized risk adjusted pricing models that are able to predict risk without fully reliable financial information by exploiting other credit scoring tools and statistical inputs. Moreover, commercial banks have improved their efficiency by using mass-market approaches and by adapting the IT and Management Information Systems (MIS) tools to use more effectively the information generated in the transaction.

More importantly, commercial banks have discovered that SME credits 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). In other words, SME Banking is much more than SME lending. This approach greatly benefits SMEs as well. Deposit and savings products provide SMEs with basic financial management tools. Transactional products such as automatic payroll, payment collection, debit cards and currency exchanges will lower the cost of doing business for the SME. Commercial banks can also offer good advice to the SME related with producing reliable financial statements, developing business plans, and selecting appropriate financing products.

What value added does IFC’s SME Banking Knowledge Guide offer?

Apart from a detailed analysis of this market, IFC’s guide also offers a simple Do-It-Yourself framework for commercial banks to improve the operations and quality of their services targeted to SMEs. This framework is based on five stages of the banking value chain: (1) understanding the market, (2) developing products and services, (3) acquiring and screening clients, (4) serving clients, and (5) managing information and knowledge.

(Figure from SME Banking Knowledge Guide)

Additionally, for commercial banks that have not entered the market yet, but are thinking about doing so, IFC’s guide offers several lessons to take into account while still on the drawing board.