Providing loans to Small and Medium Sized Enterprises (SMEs) is among the most challenging business segments for financial institutions and investment funds. This is true for both developed and developing markets. Analysts often complain that the available financial information is incomplete or outdated. Loans require significant collateral. At the same time, SME entrepreneurs face significant funding gaps, estimated by the IFC to be above USD 5 trillion in developing markets only.
Understanding the Risk Profile of an SME
The dilemma of the lack of financing has been discussed at conferences and in publications. As always, if it is difficult for all stakeholders to find a solution, it is worthwhile to look for more creative ways to address the problem. In the following, I have collected some thoughts on the topic.
- Managing a successful SME is a major achievement of an entrepreneur. It requires years if not decades of hard and committed work. Success is often a function of how the company navigates around obstacles and survives critical times. For every strong SME, many failed on the way.
- When assessing SMEs, analysts in financial institutions and funds are subject to a survivorship bias and excitement for exceptional situations. There are also start-up entrepreneurs with exciting business ideas, apparently disrupting a sector with a lot of noise. The successful SMEs are often the quieter ones, focused on their business without talking a lot.
- When approaching the assessment of an SME with the tools from textbooks, analysts immediately struggle, because the SMEs do not have the data and the track record of audited financials as shown in the case studies.
Assessing SME Credit Risk in a better way
This dilemma seems to be difficult to solve. Efforts have been made to support the preparation of financials or to provide training on business planning. The essential issue that cannot be addressed with standard tools is much simpler. Successful SME banking is based on knowledge and experience. There is no shortcut to building a trustful relationship.
- Financial services for SME clients require a specific understanding of the way those companies conduct business, the entrepreneur’s personality, strengths, and weaknesses.
- It can take several years to build an understanding of the client and the business potential. A good SME relationship manager in a financial institution has gained the trust of the entrepreneur and the management of the company.
- Trust comes from building a business relationship in steps. Identifying and applying, sector-specific client journeys, which involve less risky products and services help the borrower and the lender to get to know each other.
- A business relationship rarely starts with a large loan. The risk is very high for both sides. Of course, the entrepreneur needs funding, but also the ongoing support, advice, and access to a relationship manager, to discuss critical aspects and opportunities in the business.
- I have been involved a lot in lending activities in developing countries. Assessing the Credit Risk of an SME is not more complicated in a developing country than in the rest of the world. Everywhere, knowledge and relationships are key ingredients for success. The relationship manager of a cooperative bank in Western Europe as much as for his counterpart in a local bank in Africa. Their connection to the entrepreneur for years if not decades and their regular interaction is the key to success.
To support the relationship approach, lenders need to make some adjustments to their operating model, both, on a strategical, as well as tactical level:
- When structuring an investment approval process, it does not matter how many approval steps are included, whether a committee decides unanimously or with a majority. It is not a priority which ratios are the best to include in a standard template. Nothing replaces a thorough assessment, an experienced analyst, a decent understanding of business, and the skills to describe the risk profile in one well-written paragraph.
- Even if you have completed a great loan assessment, you will not be a successful SME lender if you forget the importance of monitoring. No loan defaults before disbursement. The actual work to collect and recover starts with regular borrower interaction and a smart early warning system. Neglecting the monitoring is like playing curling without the brooms.
Customer Centricity and Knowledge Management
This also means that a successful bank engages in a very customer-centric business model and is keenly focused on knowledge management
- Customer-centricity goes beyond asking customers what they want and delivering this. It requires a continuous assessment by financial institutions of who their customers are, what interests them, what they value, and what drives them. This focus also builds trust.
- Data and analytical capacity are two essential components to support the customer-centric approach. Financial institutions collect massive quantities of data throughout the various stages of the customer journey, including the sales cycle, onboarding, and customer service inquiries — across multiple channels. This data, despite having infinite potential, is of little use if it isn’t consistently processed and analyzed.
- Segmentation of customers is the initial step. This is done by demographic, sectors, and at an even more granular level by building out detailed individual customer profiles. These end-to-end customer profiles should include information about demographics, location, income, credit risk, exposures to other financial institutions, and household and professional relationships.
- This is combined with transaction and interaction history. Further, milestones, such as the first profitable financial year for an SME are included. Attitudes, such as the level of comfort with financial topics are assessed.
- The financial institution needs an organization/portfolio management system that operates complimentary to the core banking software. Through this system, the main concepts of data structure, process structure, risk appetite, and pricing are supported. The system provides the necessary analytics to guide the entire institution with flexible dashboards and reports for management, business/support functions, and individuals.
- The platform is designed in a flexible and adaptable way to allow growth with the institution and adjust to modifications. The platform can integrate relevant CRM functionalities, document management, and risk/scoring engines. The platform needs to be designed in an open concept to link with other service providers and to allow the offering of specific services to customers. One of these functions can be a business management app for customers to allow them to track invoices, inventory, and payroll.
Q-Lana facilitates SME Lending
At Q-Lana we aim to develop the most comprehensive, yet easy-to-use credit management platform. Q-Lana upgrades lending processes to create business opportunities and navigate through credit risk. Many of the concepts that I refer to in this article are supported by the platform. To read more about our work, please also check the blog (www.q-lana.com/blog)