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Banks and Small and Medium-Sized Enterprises Recent Business

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					Banks and Small and Medium-Sized Enterprises: Recent
Business Developments
by Sergio Schmukler, Augusto de la Torre, and María Soledad Martínez Pería


Executive Summary
 •    Banks consider SMEs to be core strategic businesses with a high profit potential.
 •    To serve SMEs, banks are now establishing separate dedicated units, standardized processes, and
      risk-management systems.
 •    The relationship manager’s role is crucial for attracting new customers, and selling products to existing
      SME customers.
 •    Banks are increasingly serving SMEs through different transactional technologies. which emphasize
      cross-selling.
 •    Large, multiple-service banks are the main players in the SME market.


Introduction
A common perception is that small and medium-sized enterprises (SMEs) cannot access appropriate
financing. This perception is often supported by academic and policy circles’ “conventional wisdom” that
                                                                                                       1
banks are generally not interested in dealing with SMEs, mainly due to SMEs’ perceived opaqueness
                         2
and higher informality. As capital markets do not compensate for these deficiencies in the banking sector,
the need to receive special assistance, such as government programs to increase lending, has been
            3
suggested. In recent years, SME financing initiatives included government-subsidized lines of credit and
                             4
public guarantee funds.
In the academic literature, there is evidence that banks (especially small and niche players) engage with
SMEs through relationship lending. Relationship lending can overcome opaqueness due to the primary
reliance on “soft” information gathered by the loan officer through continuous, personalized, direct contacts
            5
with SMEs. However, in a series of studies recently conducted by the World Bank, new stylized facts point
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to a gap between the conventional view and the way banks are actually interacting with SMEs.
First, new evidence suggests that most banks, including large and foreign banks, indeed serve SMEs, finding
                                 7
this segment very profitable. Second, different transactional technologies that facilitate arms-length lending
(such as credit scoring and significantly standardized risk-rating tools and processes, as well as special
products such as asset-based lending, factoring, fixed-asset lending, and leasing) are increasingly applied
                    8
to SME financing. Third, banks try to serve SMEs in a holistic way through a wide range of products and
services, with fee-based products rising in importance, placing cross-selling at the heart of their business
strategy.
Under this new model of bank engagement with SMEs, larger, multiple-service banks exhibit, through the
use of new technologies, business models, and risk-management systems, a comparative advantage in
offering a wide range of products and services on a large scale, becoming leaders in this business segment.


New Business Model
Banks’ high level of interest towards SMEs has, consequently, brought major changes to business models.
First, as SMEs have become a strategic sector, banks are changing their organizational set-up to approach
and serve this segment efficiently. Two main structures can be broadly categorized. The first combines
the work of a commercial and credit risk team established at headquarters, with relationship managers
distributed throughout the branches. The second consists of business centers or regional centers that
operate as mediators between headquarters and branches, with a team leader or regional manager

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who controls and trains the relationship managers of the corresponding branches. In addition, banks are
establishing separate, dedicated units with new strategies to cater adequately for the specific needs of
SMEs. These dedicated business units approach SMEs in an integrated way, offering them a wide variety
of products and services, including both deposits and loan products. In this set-up, relationship managers
(RMs) are instrumental in attracting new customers, and selling products to existing ones. RMs look for new
clients and prepare the information of each SME that is presented at the regional centers or at headquarters.
They develop a relationship with the client, and, in some cases, RMs are allowed to express their opinion,
make recommendations, or even present the case to the credit committee.
Second, the new model serves SMEs at all branches, and with standardized processes, facilitating the
reduction of the high transaction costs that dealing with each SME entails. In most cases, branches and
headquarters complement each other and undertake different functions. The initial stages of granting loans
to SMEs are decentralized in most banks, while later stages, such as risk analysis or loan recovery, are
usually centralized. In addition, banks exploit the synergies of working with different types of clients. Using
information from existing firm databases, such as credit bureaus, relying on existing deposit clients, and
attracting clients with bank credit are also common approaches that banks use to identify prospective SMEs.
Third, regarding credit-risk management, banks are reorganizing their systems, with a greater degree of
sophistication among international banks and the leading, large domestic banks. Typically, risk management
is a process that is organizationally separated from sales, and primarily done independently at headquarters.
In most large banks, credit-risk management is not automated. Furthermore, in most cases, credit-risk
management involves a credit-risk analyst, who is in charge of conducting both qualitative and quantitative
risk assessments on the SME. The quality rating of SME management and SWOT (strengths, weaknesses,
opportunities, and threats) analysis are the main components of qualitative assessments, while the financial
analysis and projections of the SME firm and the SME owner are the main quantitative assessments.
Qualitative assessments usually include an analysis of the SMEs’ products, their demand and market
structure, the quality of the owners and managers (including the degree of separation between management
and owners), the degree of informality, the years of activity in the sector, and the vulnerability to foreign-
exchange-rate fluctuations. Quantitative assessments entail an analysis of profitability, cash-flow generation
capacity, solvency, quality of assets, structure of balance sheets, and global guarantees. Moreover, scoring
models are still being developed, and primarily applied to small loans.
Monitoring of the credit-risk outlook is standardized at the majority of banks. Some monitoring mechanisms
used frequently are preventive triggers and alerts automatically generated to signal the deterioration of the
SMEs’ payment capacity. However, credit-risk monitoring still depends on the diligence of the relationship
manager or the credit-risk analyst. Some banks use a system that allows different individuals to provide input
on each enterprise (such as auditors, back-office staff, sales personnel, and risk analysts).
The business and risk-management models described above can be better pursued by large universal
banks, especially foreign ones, which can be more aggressive in reaching out to SME clients, and are better
suited to conduct lending based on automated scoring models for small loans (as they have the know-how
and models to do so) and template-type rating systems for larger loans (based on streamlined, standardized
versions of corporate rating).


SME Evidence
SMEs interact with banks using a variety of products, mostly checking and savings accounts, as well as
            9
term loans. Furthermore, SMEs do not exclusively obtain financing via “relationship loans.” SMEs access
                                                                                            10
financing products that do not depend on the bank processing soft information on the firm. An interesting
finding is that the provision of loans through public programs or guarantees is low. The highest usage of
public programs observed is in Chile, with 8% of SMEs reporting using them; other countries are reporting
                              11
percentages of around 3%.
Nonetheless, while SMEs increasingly interact with banks to purchase a range of products and services,
SMEs still appear unable to obtain access to crucial products such as loans secured by certain forms of
collateral (for example, accounts receivable, inventories, equipment, cattle, and intangible assets), or long-
term, fixed-interest rate loans in domestic currency. However, it is still unclear how much SMEs in developing

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countries would be able to rely on banks to obtain those products. As the US literature indicates (Carey
et al., 1993; and Berger and Udell, 1996), SMEs might have to rely on private placements and non-bank
institutions. Bank financing for certain SMEs, such as start-ups (in particular, those in high-tech or research-
based industries), is also likely to remain limited, as has proven to be the case in developed markets such as
the United States.


Case Study

                                                    12
Government Interventions in Colombia
While direct government funding programs have been described as relatively unsuccessful, policy
innovations could still prove important for SME financing. For example, in Colombia, several policy measures
targeted towards the micro and SME segments have been introduced since 2004. On the one hand, non-
financial instruments have been implemented, including training programs to increase competitiveness,
and promote technological development and exports. On the other hand, financial instruments have
been introduced, including the further expansion of existing government programs, and promoting the
development of alternative financing instruments (investment funds, factoring/supplier financing, fiduciary
structures, etc).
Colombian government programs include long-term development funds and partial credit guarantees.
Longer-term development funding is mainly provided in the form of rediscounting lines at below-market rates
                                                                     13          14                   15
by the state-owned, second-tier credit institutions, Bancóldex,           Finagro,    and Findeter.        Partial credit
                                                                                        16                         17
guarantees—typically around 50% loan-loss coverage—are provided by FNG, as well as by FAG for
the agricultural sector. The role of these institutions—particularly Bancóldex and FNG—has been cited as
instrumental in promoting access to credit for SMEs.
The authorities have recently embarked on an initiative to improve financial access, including for SMEs.
The low level of financial penetration in Colombia, both in response to pre-crisis levels and in comparison to
regional peers, has prompted the authorities to take measures to expand access to credit and other financial
services. Both demand- and supply-side barriers have been identified, and will be tackled via regulatory
reforms and the Banca de las Oportunidades initiative. Recent policy measures include the introduction of
correspondent banking arrangements, changes in the definition of the interest-rate ceiling, the passage of
legislation on credit reporting, and the strengthening of creditor rights via a new bankruptcy law. Additional
proposed reforms include changes to the civil code on enforcement procedures and to the financial system
structure, as well as plans for the introduction of a special savings account for low-income households.
In addition, the Banca de las Oportunidades initiative aims to design and propose measures to stimulate
financial access, particularly for low-income households.


Conclusion
In summary, the new evidence shows that the whole spectrum of private banks (large and small, domestic
and foreign) has started to perceive SMEs as a strategic sector. Banks are aggressively expanding, or
planning to expand, their operations in the SME segment. As a consequence, the SME market is becoming
increasingly competitive, although far from saturated. The evidence suggests that banks are learning how
to deal with SMEs, and, at the same time, making the investments to develop the structure to deal with a
growing market in the years to come. As banks have recently discovered a key, untapped segment, it is
likely that the models to work with SMEs will evolve significantly as the involvement with the SME segment
increases.
However, there are issues that remain for future work. Although banks appear to have become more
involved with SMEs, banks may not be able to measure comprehensibly their exposure to the segment in
terms of income, costs, or risk. Furthermore, banks are not adequately tracking their loan-loss experiences.
We might be witnessing a process in which banks are only now developing the structure to deal with SMEs,
and, through their interactions with the segment, they will be able to reduce the involved costs and risks.


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More Info
Articles:
 •    Berger, A., and G. Udell. “Universal banking and the future of small business lending.” In A. Saunders,
      I. Walter (eds). Financial System Design: The Case for Universal Banking. Burr Ridge, IL: Irwin, 1996:
      559–627.
 •    Carey, M., S. Prowse, J. Rea, and G. Udell. “The economics of the private placements: A new look.”
      Journal of Financial Markets, Institutions and Instruments 2 (1993): 1–66.
 •    Carter, D., J. McNulty, and J. Verbrugge. “Do small banks have an advantage in lending? An
      examination of risk-adjusted yields on business loans at large and small banks.” Journal of Financial
      Services Research 25 (2004): 233–252.
 •    De la Torre, A., M. S. Martinez Peria, M. Politi, S. Schmukler, V. Vanasco. “How do banks serve
      SMEs? Business and risk management models.” In Benoît Leleux, Ximena Escobar de Nogales, and
      Albert Diversé (eds). Small and Medium Enterprise Finance in Emerging and Frontier Markets. IMD
      and IFC, 2008c forthcoming.
 •    DeYoung, R. “Mergers and the changing landscape of commercial banking (part II)”. Federal Reserve
      Bank of Chicago, Chicago Fed Letter 150, 2000.
 •    DeYoung, R., and W. Hunter. “Deregulation, the internet, and the competitive viability of large and
      community banks.” In B. Gup. (ed). The Future of Banking. Westport, CT: Quorom Books, 2003: 173–
      202.
 •    DeYoung, R., W. Hunter, and G. Udell. “The past, present, and probable future for community banks.”
      Journal of Financial Services Research 25 (2004): 85–133.

Reports:
 •    Beck, T., A. Demirgüç-Kunt, and M. S. Martínez Pería. “Bank financing for SMEs around the world.
      Drivers, obstacles, business models, and lending practices.” World Bank Policy Research Working
      Paper 4785, 2008.
 •    De la Torre, A., J. C. Gozzi, and S. Schmukler. “Innovative experiences in access to finance: Market
      friendly roles for the visible hand?” Washington, DC: World Bank, 2009.
 •    De la Torre, A., M. S. Martinez Peria, and S. Schmukler. “Bank involvement with SMEs: Beyond
      relationship lending.” World Bank Policy Research Working Paper 4649, 2008b.
 •    Independent Evaluation Group. “Financing micro, small, and medium enterprises through financial
      intermediaries.” Washinton, DC: International Finance Corporation, World Bank, 2008.
 •    OECD. “The SME financing gap: Theory and evidence”. OECD Publishing, 2006.
 •    Stephanou, C. and C. Rodriguez. “Bank financing to small- and medium-sized enterprises (SMEs) in
      Colombia.” World Bank Policy Research Working Paper 4481, 2008.
 •    WEC. “Securing a place in an uncertain economic landscape.” World Economic Forum on Latin
      America, Cancún, Mexico, April 15–16, 2008.
 •    World Bank. “Bank financing to small and medium enterprises: Survey results from Argentina and
      Chile.” 2007a.
 •    World Bank. “Bank lending to small and medium enterprises: The Republic of Serbia.” 2007b.


Notes
1 Opaqueness means that it is difficult to ascertain if firms have the capacity to pay (for example, viable
projects) and/or the willingness to pay (due to moral hazard). For example, lack of audited financial
statements prevents banks from engaging in what is known as financial-statement lending, by which the
loan contract terms are set on the basis of the company’s expected future cash flow and current financial
condition, as reflected in audited statements (see Berger and Udell, 2006).
2 If firms do not reliably report their full financial activity on their financial statements, banks do not count, for
example, with complete information on warranties for lending. See OECD (2006) for more on the factors that
drive SMEs to operate in the informal economy, especially in emerging economies.




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3 The need to provide support to SMEs through critical government investments was stated at the World
Economic Forum on Latin America Summit in 2008. In addition, re-examination of tax regimes, regulatory
reforms, and provision of capital through public-private partnerships were mentioned. See WEC (2008).
4 Chile’s Fondo de Garantía para Pequeños Empresarios (FOGAPE) is a fund created to encourage bank
lending to SMEs through partial credit guarantees. The Colombian Fondo Nacional de Garantías (National
Guarantee Fund) provides similar partial credit guarantees. Structured finance transactions arranged by
FIRA, a Mexican development financial institution focused on the agricultural sector, are another example
of a government effort to provide financing to rural SMEs. Furthermore, the Mexican development bank,
NAFIN, has initiated a reverse factoring program to provide working capital financing to SMEs through a
process of online sale of receivables from large buyers. See de la Torre et al. (2008a).
5 See DeYoung (2000), DeYoung, and Hunter (2003), Carter et al. (2004), and DeYoung et al. (2004) for a
discussion of the comparative advantages that small community banks have in lending to small firms through
relationship lending.
6 See de la Torre et al. (2008b, 2008c) for a comprehensive analysis. Case studies are also available for
Argentina, Chile, Colombia, and Serbia, describing the institutional and macroeconomic contexts, their
banking industries and trends, and the data in detail. See World Bank (2007a and 2007b) and Stephanou
and Rodriguez (2008).
7 Using data from 91 banks in 45 countries, Beck et al. (2008) found that all banks in the sample have SME
customers, over 80% perceive the market to be big and prospects to be good, and more than 60% have
a separate department managing their relations with SMEs. On average, the share of bank loans to small
(medium) enterprises averages 11% (13%), compared to 32% in the case of large firms. The share of non-
performing loans for small (medium) enterprises is 7.4% (5.7%), compared to 4% in the case of large firms.
8 See Berger and Udell (2006).
9 Banks have developed a wide range of fee-based, non-lending products and financial services for SMEs.
Loans are not all always the main product offered to SMEs. Moreover, loans are often offered as a way to
cross-sell other lucrative fee-based products and services. See de la Torre et al. (2008b, 2008c).
10 De la Torre et al. (2008b) argue that banks are developing new technologies and business models to
serve the SME segment, reducing their dependence on “relationship lending” and the gathering of “soft”
information, which is costly and time-consuming.
11 See World Bank (2007a).
12 This case study can be found in Stephanou and Rodriguez (2008).
13 Bancóldex’s main aim is to provide low-interest lines of credit via first-tier credit institutions for exporters
and SMEs.
14 Finagro’s main aim is to provide low-interest financing for agriculture, livestock, forestry, and related rural
projects.
15 Findeter was set up in order to lend (via first-tier banks) to subnational entities for infrastructure and other
development projects.
16 FNG is a guarantee fund that “backs” credits to all economic sectors (except agriculture) with the primary
objective of facilitating access to credit for micro enterprises and SMEs.
17 FAG is a guarantee fund that “backs” working capital and investment loans for the agricultural sector that
are financed either with Finagro discounting, or with a credit institution’s own funds.


See Also
Best Practice
 •    Assessing Opportunities for Growth in Developing Countries of Micro, Small, and Medium-Size
      Enterprises
 •    Assessing Opportunities for Growth in Small and Medium Enterprises
 •    Assessing Venture Capital Funding for Small and Medium-Sized Enterprises

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 •  Managing Capital Budgets for Small and Medium-Sized Companies
 •  Raising Capital in the United Kingdom
 •  Understanding Equity Capital in Small and Medium-Sized Enterprises
Checklists
 •    Assessing Cash Flow and Bank Lending Requirements
 •    Maintaining the Banking Relationship
 •    Options for Raising Finance
 •    Retail Banks: Their Structure and Function
 •    Steps for Obtaining Bank Financing

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