Finance+ +ICRA

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ICRA 2004SME Symposium

Printed 13-May-04Page 2

ICRA Advisory ServicesA Division of ICRA Limited

ICRA was appointed by IFC to conduct a diagnostic analysisof select Banks in Sri Lanka with respect to SME lending

The terms of reference for the study -

Evaluate the Credit Strategy for the select banks

Evaluate the Credit Strategy for the select banks

Evaluate existing credit risk management systems, processes

and procedures

Evaluate existing credit risk management systems, processes

and procedures

Conduct a survey on prevailing Credit Risk Culture and HR

skills

Conduct a survey on prevailing Credit Risk Culture and HR skills

Evaluate Corporate Governance

Evaluate Corporate Governance


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The characteristics of the banks selected for the study

Private domestic banks incorporated in Sri Lanka

Private domestic banks incorporated in Sri Lanka

A reasonably high credit exposure to the SME sector

A reasonably high credit exposure to the SME sector

High performing banks

High performing banks


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Focus of ICRAs Presentation

Challenges in SME lending

How do Sri Lankan banks meet these challenges?

Good practices in SME lending


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In general, the banks have a higher level of NPA in the SME portfolio relative to other segments in their portfolios

5

10 10

20

15

17

0

5

10

15

20

25

Bank A Bank B Bank C

Bank NPA (%) NPA in the SME portfolio (%)

Note: Figures are disguised, and reflect relative levels only


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Despite higher level of NPA in the SME segment, thecontribution from the SME segment is comparable to theaverage contribution from all borrowers

In 2002 Domestic Operation

Parameters Bank as a Whole SME Banking

Yields on Performing Credit 17.0 19.0 Less: Loss of Income on NPAs 1.5 2.5

Yield on Credit Portfolio 15.5 16.5 Less: Cost of Funds 8.0 8.0 Less: Provisions on NPAs 0.5 1.5

Contribution 7.0 7.0

In 2002 Domestic Operation

Parameters Bank as a Whole SME Banking

Yields on Performing Credit 17.0 19.0 Less: Loss of Income on NPAs 1.5 2.5

Yield on Credit Portfolio 15.5 16.5 Less: Cost of Funds 8.0 8.0 Less: Provisions on NPAs 0.5 1.5

Contribution 7.0 7.0

Contribution is before incorporating fee income and organisation expensesContribution is before incorporating fee income and organisation expenses

Note: Figures have been disguised but are representative


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The banks plan to grow their SME portfolio by 15-20% p.a. over the medium term, as there are several benefits

Advantages in expanding credit in the SME segment

Higher Interest

Income

Ability of borrower to tap capital markets or

alternative funding sources is limited

Stable InterestIncome

Utilization of limits is generally higher in caseof SMEs vis a vis large borrowers

ALM lessComplex

Lower fluctuations in utilization of limits makesasset-liability management a lesser issue for abank

Diversification of

Risk

Small size of each SME account enables a bank

to diversify portfolio risk


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The competition in the banking sector is getting intense

Number of entities100% = 11,002,539

Large corporates

Middle Market

Small Business

Fiercely competitive

Limited Access to Finance

Under served

0.1% =11,002 entities

1.3% =143,033 entities

98.6% = 10,848,504 entities

In USA, SMEs became of interest to banks after a recent focuson segmentation showed their profit contribution


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The SME segment generates above market returns whencompared to other product areas

5 10 15 20 25 30 35 40

ROE (%)

R e v e n u

e s

( $ B N )

50

100

200Small

Business

Insurance800

Credit

Cards

Mortgages

MutualFunds

ConsumerFinance

U.S. Market Size and Profitability

Source: IFC Symposium, China


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ICRA Study: Account-wise profitability indicates the true position of profitable segments

R e t u r n o n

C a p

i t a l

% of loan assets

0%

20%

40%

60%

80%

100%

120%

140%

0.1% 21.6% 42.7% 50.7% 60.7% 82.1%

40% of the assets generate below25% RoE

Hurdle rate

SMEsLarge Credits


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Key challenges in SME lending

Promoters of SMEs have limited financial and managerialresources

The ability of promoters to submit an accurately filled outproject/ loan application is also limited

In general, the financial statements of a typical SME do notreflect its true financial position

The quality of collateral offered by an SME may not be of high quality

SMEs have low sustenance power. A business recession or adelay in credit sanction has a greater adverse effect on an

SME units performance than on a large borrower


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ICRA Study: Reasons for sickness in the larger SME units

% of accounts in sample

0%

10%

20%

30%

40%

50%

60%70%

80%

M a n a g e m

e n t

M a r k e t i n g

T e c h n o l o

g y P r o d

u c t

D i v e r s i o n

L a b o u r

W o r k i n

g C a p i t a l

O t h e r

r e s o u r c

e s P o w

e r

R a w

M a t e r i a l s

O t h e r s

Total adds up to more than 100% on account of multiple reasons for an account to fall sick Note: These are findings of a study conducted in India


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ICRA Study: Reasons for sickness of smaller SME units

0%

10%

20%

30%

40%

50%

60%

70%

80%

M a n a g e m

e n t

D i v e r s i o n

P r o d u c t

T e c h n o l o

g y

P a y m e n t s

P o w e r

R a w

M a t e r i a l s

L a b o u r

O t h e r s

% of accounts in sample

Total adds up to more than 100% on account of multiple reasons for an account to fall sick

Note: These are findings of a study conducted in India


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ICRA Analysis: Causes for high NPAs in the SME sector in Sri Lanka...

Inadequate focus on evaluating the Management Risk of SME borrowers or institutionalising insights into borrowers

Inadequate focus on evaluating the Management Risk of SME borrowers or institutionalising insights into borrowers

Inadequate credit monitoring. A Bank identifies a pooraccount only after the borrower has delayed/ defaulted on a

loan obligation

Inadequate credit monitoring. A Bank identifies a pooraccount only after the borrower has delayed/ defaulted on aloan obligation

Inadequate origination efforts by banks in finding qualitycustomers, and a high dependence on walk-in customers

Inadequate origination efforts by banks in finding qualitycustomers, and a high dependence on walk-in customers

Source : ICRA analysis

Inappropriate pricing of credit risk associated with theborrowers from the SME segment

Inappropriate pricing of credit risk associated with theborrowers from the SME segment

ICRA Study: Banks primarily depend upon existing


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ICRA Study: Banks primarily depend upon existing customers and walk-in clients to meet the growthobjectives in the SME segment

*Largely driven by

existing/walk-in/

references Till recently, branches are primarilydepending upon existing customers and walk in customers to meet the growth objective.

As a result,Choice of good customers getslimited and it narrows down market size Competition is also narrowing down the

market further Untapped market


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Differences in risk assessment methodology for small business credit

Classic credit analysis essentially works for L&M businessescentralization of information feasible

financial statements dependablemarket intelligence easily accessible

Risk assessment of SME segments predominantly driven bylocal market situationknowledge of the borrowers standing in the business communityunderstanding the terms of tradeintangibles in management risk assessment

Classic credit analysis essentially works for L&M businessescentralization of information feasible

financial statements dependablemarket intelligence easily accessible

Risk assessment of SME segments predominantly driven bylocal market situationknowledge of the borrowers standing in the business community

understanding the terms of tradeintangibles in management risk assessment


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ICRA Study: Inadequate business analysis of SME borrowers by banks

How good arethe existing

systems

Extent of compliance

Quality of appraisalBusiness Condition

MarketCompetition & Substitute Product*Market ShareCompetitive Advantage

Future ProfitabilityIndustry Scenario & TrendDemand Scenario ForecastPrice Volatility

Business CyclicalityCredit officers do not delve intothe specific aspects of market asexpected by the system

f


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ICRA Study: Inadequate business analysis of SME borrowers by banks 2


systems


Quality of appraisalCustomers & Suppliers

Customer TypeDomestic

Export

Major customers

Customer concentrationSelling ArrangementsMajor Supplier Supplier Concentration Credit officers mention only the

customer profile for a particular borrower. However, risksoriginating out of customer baseis not analysed in detail.

ICRA S d I d l i f M i k


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ICRA Study: Inadequate analysis of Management risk associated with SME borrowers 1

Management Analysis How good arethe existing

systems


Quality of appraisal

Integrity

Payment Track Record of GroupCompaniesDiversion of FundBusiness CommitmentDispute amongst Owners

Payment Track Record is mapped by theCRIB Report.

Integrity of the management is analysedas a part of the internal risk rating report.

Management is one of the key parameters for assessing the creditworthiness of the borrower. Itsimportance increases in the SME segment as the

financial statements of these companies are lessreliable.

ICRA S d I d l i f M i k


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ICRA Study: Inadequate analysis of Management risk associated with SME borrowers 2


systems


Quality of appraisalFinancial Resources

Promoters Assets and Net worthTax Details

typical credit appraisal system for SME lending should


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yp pp y ginstitutionalise the information gathered during market enquiry

Information Capture Market Enquiry

Information Analysis

Sanction Decision

B k d diff i k i d l f diff


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Bank needs different risk scoring models for different lending segments

CorporateCredit

RetailLoan

ProjectFinanceSME

Quality of financial

statements

LessReliable

MoreReliable

No PastTrack

Record

PartialInformation

Global or National or

Regional

MarketSituation

Regionalor Local

Local Global or National

High value &Low Numbers

Lower value &Higher Numbers

Type Low value &High Numbers

High value &Low Numbers


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How does a bank use the output of a risk scoring model?

Exposureat

Default X

Probabilityof

Default

Risk scoring model

LossGiven

Default

Expected Loss

X =

A T Di i l S t ll fl ibilit i


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A Two Dimensional System allows more flexibility in Measuring Risk

Probability of Default (PD)

Loss GivenDefault (LGD)

CollateralType

1

2

3

4

5

6

7

8

9

10

LGD

5%

-

-

-

20%

-

-

-

-

75%

BorrowerRisk Score

1

2

3

4

5

6

7

8

9

10

PD

.05%

-

-

-

10%

-

-

-

-

100%

Exposureat

Default(EAD)

x= xExpectedLoss(EL)

As per norms spelt out by the Basel Committee maximum


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As per norms spelt out by the Basel Committee, maximumconcentration in a risk grade should be 30%

01 2 9

Low risk

Highrisk

30

25

20

15Distribution acrossrisk grades

10

5

3 4 5 6 7 8

Risk grade

Banks use the following framework for risk grading the


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Banks use the following framework for risk grading theborrowers

PD - Probability of Default

Financial Risk

Management Risk

Industry Risk Borrower

Risk Score

Gets linked to PD

Project Risk

Account Operations #

# For existing accounts

The Borrower Risk Score generated by Risk Scoring Model


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The Borrower Risk Score generated by Risk Scoring Model should indicate the Relative Risk of Default

Relative Risk of Default

1 3 5 7 10RS 1 RS 2 RS 3 RS4 RS 5 RS 6 RS 7 to RS 9

Strong Credit Quality Weak Credit Quality

GreenZone

Low Risk Risk scores between 1 & 3 Good quality credit

YellowZone

Risk scores > 3 & up to 5 No immediate concern

Amber Zone

Requires intensivemonitoring

Risk scores > 5 & up to 7

High Risk

RedZone

NPA/ Could turn NPAover the medium term

Risk scores greater than 7

A Transaction Risk Score Model helps a bank to


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A Transaction Risk Score Model helps a bank toimplement risk pricing

PD - Probability of Default

BorrowerRisk Score

TransactionRisk Score

Security

Gets linked to PD

Financial Risk

Management Risk

Industry Risk

Project Risk

Account Operations

The principal building blocks of Credit Risk


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The principal building blocks of Credit Risk Management

Implementing Credit Risk Management

Risk ScoringRisk ScoringMeasuring risk using risk

scoring models

RiskQuantification

RiskQuantification

Linking risk scoring to risk quantification

Risk PricingRisk PricingEstimating historical recovery rates and loan loss rates of the

bank

Risk ControlRisk Control Managing portfolio proactively


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ICRA Study: Tools for monitoring individual accounts

Proposed toolsExisting tools

Site Inspection report(Only at the time of fresh/

renewal loan application)

Account Review(Only at the time of fresh/

renewal loan application)

Site Inspection report

(Only at the time of fresh/ renewal loan application)

Account Review

(Only at the time of fresh/ renewal loan application)


(periodicity should be linked torisk score)

Annual review. Use Risk

Scoring Models to identifydeterioration at individual account level

Account profitability report tomeasure risk adjusted return onindividual accounts


(periodicity should be linked torisk score)

Annual review. Use Risk

Scoring Models to identifydeterioration at individual account level

Account profitability report tomeasure risk adjusted return onindividual accounts

Credit monitoring strategy should factor in the Borrower


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g gy Risk score

Action post reviewPass through risk scoringFrequency of review based

on sanction termsIncrease exposure tonurture the accountHold position

Change termsExit

Adverse changein risk scoring

Favourable

changein risk scoring

Individual a/creview

Increase exposure

aggressivelyHold position

ICRA Study: Additional MIS reports that can enable


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y p proactive portfolio monitoring

High risk credit report - all credits greater than cut off risk scoreor accounts with delay in payments of interest/ principal

Fast slippage report- accounts which slip by more than onegrade between two financial years

Red alert report - accounts with risk score greater than cut off and having insufficient/ weak security or accounts with risk score greater than cut off and delay in payments of interest/

principal

Segmented Profitability Report

ICRAs Key Recommendations for streamlining SME credit in Sri


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ICRA s Key Recommendations for streamlining SME credit in Sri Lanka...(1)

Banks need to streamline their loan origination policies to provide clear guidelines for Credit units

Define minimum eligibility criteria for accepting a loan application based on therisk appetite of the bank

Introduce Customer Contact Report

Capture information on rejected customers

Banks need to design their loan application forms and appraisal formats insynchrony with their risk scoring models. This will help in reducing the

workload of the credit officers

Banks need to streamline their loan origination policies to provide clear guidelines for Credit units

Define minimum eligibility criteria for accepting a loan application based on the

risk appetite of the bank

Introduce Customer Contact Report

Capture information on rejected customers

Banks need to design their loan application forms and appraisal formats insynchrony with their risk scoring models. This will help in reducing the

workload of the credit officers



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y g Lanka...(2)

Banks need to validate their risk scoring models

Banks need to streamline their Risk Pricing frameworks by considering theimpact of security and estimating Loss Given Default.

Banks should use Transaction Risk Scoring Model to do business withSME customers whose borrower risk scores may be higher than the

threshold

Banks need to strengthen monitoring at the individual account level to enable proactive monitoring:

Site inspection reportDesign an annual review formatAccount profitability report

Banks need to validate their risk scoring models

Banks need to streamline their Risk Pricing frameworks by considering theimpact of security and estimating Loss Given Default.

Banks should use Transaction Risk Scoring Model to do business withSME customers whose borrower risk scores may be higher than the

threshold

Banks need to strengthen monitoring at the individual account level to enable proactive monitoring:

Site inspection reportDesign an annual review formatAccount profitability report



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y g Lanka ...(3)

Banks need to strengthen portfolio monitoring to be able to quantify the risk-return relation in the credit portfolio and identify any deterioration

Banks need to formulate a NPA recovery policy which guides the creditofficer to zero in on the method recovery. Banks also need to articulate / finetune their Rehabilitation policy, OTS policy and Sale of Asset policy

Banks need to organise high-level training programmes for their creditofficers to improve the quality of appraisal and enhance ability to offer new

products and services

Banks need to strengthen portfolio monitoring to be able to quantify the risk-return relation in the credit portfolio and identify any deterioration

Banks need to formulate a NPA recovery policy which guides the creditofficer to zero in on the method recovery. Banks also need to articulate / finetune their Rehabilitation policy, OTS policy and Sale of Asset policy

Banks need to organise high-level training programmes for their creditofficers to improve the quality of appraisal and enhance ability to offer new

products and services

In conclusion, the Credit management system for successful SME


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financing has to address specific needs at each stage of the credit cycle

Credit Decision

Portfoliomanagement Operations

Appraisal

Sanction

Accept

Good account

The Credit Cycle

Reject

Marketing

Reject

MonitoringNPA ?

Recovery

In conclusion - What will it take for a bank to be


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successful in the SME Segment?

Profile the target customer sub-segments within the SME segment

Assess the market for different sub-segments

Identify key success factors for lending to different customer segments

. SWOT analysis of the bank from the perspective of different segments

Set business targets

Formulate a client acquisition strategy

Design appropriate credit risk appraisal systems

Design appropriate credit monitoring & MIS systems

Identify HR / technology requirements


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Thank You


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Symposium on making SME Finance ProfitableHosted by:

International Finance Corporation & Government of The Netherlands

Banks Approaches to the Challenge of Successful SME Lending

January 23, 2004 Colombo

Documents

Finance+ +ICRA