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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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ICRA 2004SME Symposium
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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA 2004SME Symposium
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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA 2004SME Symposium
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ICRA Advisory ServicesA Division of ICRA Limited
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 Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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 Advisory ServicesA Division of ICRA Limited
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 Advisory ServicesA Division of ICRA Limited
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 Advisory ServicesA Division of ICRA Limited
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 2004SME Symposium
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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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 2004SME Symposium
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ICRA Advisory ServicesA Division of ICRA Limited
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 Advisory ServicesA Division of ICRA Limited
ICRA Study: Inadequate business analysis of SME borrowers by banks 2
How good arethe existing
systems
Extent of compliance
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 Advisory ServicesA Division of ICRA Limited
ICRA Study: Inadequate analysis of Management risk associated with SME borrowers 1
Management Analysis How good arethe existing
systems
Extent of compliance
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
How good arethe existing
systems
Extent of compliance
Quality of appraisalFinancial Resources
Promoters Assets and Net worthTax Details
typical credit appraisal system for SME lending should
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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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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ICRA Advisory ServicesA Division of ICRA Limited
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)
Site Inspection report
(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
Site Inspection report
(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
ICRAs Key Recommendations for streamlining SME credit in Sri
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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
ICRAs Key Recommendations for streamlining SME credit in Sri
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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