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SME Banking

SME Banking

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Published by Suresh Kumar
SME Financing
SME Financing

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Published by: Suresh Kumar on Jun 19, 2012
Copyright:Attribution Non-commercial


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SME Banking Knowledge Guide
Fostering a dynamic small and medium enterprise (SME) sector is seen as a priority amongst economicdevelopment goals, in both developed and emerging economies. SMEs are a primary driver for jobcreation and GDP growth. They greatly contribute to economic diversification and social stability andthey play an important role in private sector development. SME development also represents a majorand difficult challenge. SMEs typically face more severe constraints to growth than large companies,their lack of critical size resulting in reduced access to markets, skills, and capital.
Lack of access to financing is consistently cited by SMEs as one of the main barriers to growth. Oftenconsidered by commercial banks and financial institutions as risky and costly to serve, SMEs arelargely underserved when it comes to basic financial services. With such limited access to financing,SME owners struggle to make the investments they need to increase productivity andcompetitiveness of their business, develop new markets, and hire more people.
Can small and medium enterprises be banked profitably, and is the market today an attractive one?How do banks overcome the challenges and capture the opportunities offered by the SME segment,particularly in developing countries? What is the difference between SME lending and SME banking?How can banks successfully expand their SME banking operations? These are the types of questionsexplored in this SME Banking Knowledge Guide. This Guide provides an overview of the current state of SME banking, and then breaks down the approaches that banks are using to unlock the potentialopportunity in a challenging, but growing market. It concludes with guidance for banks that want tobegin to strategically engage the SME market.
The State of SME Banking Today
SME banking is an industry in transition. From a market that was considered too difficult to serve, it has
now become a strategic target of banks worldwide. The “missing middle,” describing the gap in financial
services provided to SMEs, is shrinking. SME banking appears to be growing the fastest in emergingmarkets (low- and middle-income countries) where this gap has been the widest. More and moreemerging market banks are developing strategies and creating SME units.Competition in oth
er markets is one reason cited for commercial banks moving “downstream” to serve
SMEs. Also, governments around the world now recognize the importance of the SME sector and haveworked to support its access to finance, sometimes by addressing legal and regulatory barriers orbuilding credit infrastructure. But the key to the growth of SME banking may be that banks are startingto understand the particular needs and preferences of SMEs, and are developing tailored approaches toovercome the historical challenges of high credit risk and cost to serve. One sign that banks areunlocking some of the potential in the market is that they are reporting higher returns on assets fromtheir SME operations.Today, despite the significant challenges posed by the global economic crisis in 2009, and theuncertainty ahead, many banks seem to be holding fast to their strong commitment to the SME sector,especially in emerging markets. While the full impact of the crisis is not yet apparent, banks maintaining
their focus on SMEs often cite a strong belief in the importance of the SME sector to the nationaleconomy as a whole.
Bank Approaches to the Challenges of Serving SMEs
To effectively serve SMEs, banks have had to change the way they do business, and manage risk, at eachstage of the banking value chain. This begins with working to understand the market, and how it differsfrom both the retail and commercial segments. Next, in developing products and services, banks havebegun to understand that SME banking means much more than SME lending and are, therefore,prioritizing non-lending products in order to provide total customer value. Leading banks report thatmore than 60 percent of their SME revenues come from noncredit products. Banks have found ways tomanage both costs a
nd credit risk as they acquire and screen clients. A bank’s current portfolio provides
both a low-cost starting point for generating new business and a source of valuable data that can enableit to understand and predict the risks associated with SME clients. Developing this capacity to predictrisk without completely reliable financial information, by using tools such as credit scoring, has enabledbanks to more effectively screen potential clients. In serving SME clients, banks are improving efficiencyby using mass-market approaches for smaller enterprises and using direct delivery channels whereappropriate. They also build their revenue base by prioritizing cross selling to existing clients. Finally,banks are adapting IT and MIS tools, and building capacity to effectively use these tools for managinginformation and knowledge in their service of the SME market, especially in understanding profitabilityand risk.
How to Begin Engaging the SME market
Banks looking to enter the market or expand their SME operations will be able to draw from the lessons
of other banks’ experience to date. These lessons apply to operations in five strategic areas: (1) strategy,
SME focus and execution capabilities; (2) market segmentation, products and services; (3) sales cultureand delivery channels; (4) credit risk management; and (5) IT and MIS. Before putting these lessons touse, however, banks need to follow a process for market entry that begins with understanding thespecific opportunity in the SME sector and ends with developing a strategy and implementation plan.Two tools that facilitate this process are a market assessment and an operational diagnostic. A marketassessment is concerned with determining the size and nature of the opportunity as well as thecompetiti
ve landscape. An operational diagnostic helps highlight a bank’s strengths and weakness.
 In summary, serving SMEs is proving to be profitable and rewarding for individual banks, and assistingthe growth of SMEs will benefit national economies as well.
Small and medium enterprises are central to economic development, particularly in emergingmarkets. In order for SMEs to grow and their positive impact on the economy to continue, they needaccess to financial services, which has historically been severely constrained.
Many SMEs in emerging markets often rely on informal sources of capital, such as borrowing fromrelatives, to meet finance needs. However, when a small or medium enterprise does access formalchannels, it typically looks to a bank as its primary source of financial services. Banks have begun to turn
their attention toward this untapped market and their service of SMEs is a major factor in increasingSME access to finance.Commercial banks are distinguished in that they normally lend to, rather than invest in, SMEs. Unlikeother specialized finance providers, commercial banks offer a broad suite of products and servicesincluding deposit, credit, transaction and advisory services. They also focus on enterprises in the formalsector, rather than informal microenterprises which MFIs traditionally serve.Commercial banks have traditionally viewed SMEs as a challenge because of information asymmetry,lack of collateral, and the higher cost of serving smaller transactions. However, as corporate bankingmargins continue to shrink and increasing fiscal restraint lowers yields on government borrowings,banks have begun to explore the SME space.In the developed world, banks have made significant strides in serving the SME market in recentdecades. However, in emerging markets, many banks have only recently started to expand theiroperations into the sector, and the market is a long way from saturated. Many banks are stillexperimenting with different approaches toward SMEs, but the success stories thus far are highlighting anumber of key principles for profitably banking the SME sector.
SMEs and the “Missing Middle”
SMEs are firms whose financial requirements are too large for microfinance, but are too small to beeffectively served by corporate banking models. SMEs represent a large and economically importantsector in nearly every country in the world. A thriving SME sector is commonly considered a sign of athriving economy as a whole. In high-income countries, and some middle-income countries, SMEsaccount for over half of national output. Yet, historically, SMEs have lacked access to financial productsand services, especially in developing countries. Especially elusive to SMEs are longer-term debtinstruments. However, although banks have previously focused on high-value, low-risk corporate clients,there is an increasing consensus that the SME market can be a profitable segment to bank. Availabledata from banks, though limited, support this perception. By employing a range of measures, such asrisk-adjusted pricing, credit scoring models, and SME-tailored non-lending products, banks aredeveloping ways to mitigate risks, lower costs, and increase the overall benefit accrued from SMEbanking.SMEs, particularly in developing (low- and medium-income) countries, have historically lacked access tofinancial products and services. Micro Finance Institutions (MFIs) have emerged to serve the smallest of these enterprises, while banking institutions have typically concentrated on large corporations. SMEs fall
between these two markets where there is a finance gap commonly described as the “missing middle.”
However, in recent years, this has begun to change. SME banking, as an industry, is growing. Banks arenow demonstrating that the SME segment can be served profitably provided it is properly understood.

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