Msme in Emerging Markets

7/27/2019 Msme in Emerging Markets

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Banking Practice

Micro-, small andmedium-sized enterprises

in emerging markets:how banks can grasp a$350 billion opportunity

Mutsa ChirongaJacob DahlTony GolandGary PinshawMarnus Sonnekus


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Copyright McKinsey 2012Any use o this material without specifc permissiono McKinsey & Company is strictly prohibited.


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ContentsExecutive Summary 1

The size o the opportunityFive leading practicesThe strategic choicesGetting started

Introduction 7

Our methodology

01 The size of the MSME opportunity 9

A huge opportunity A large and growing market or banks An innovation laboratory or Western banks A source o growth and employment or governments

A potentially proitable segment

02 Five leading practices 171. Seek a granular understanding o target MSME clients2. Radically lower operating costs

Distribution Product processes

People3. Manage risk innovatively New approaches to credit scoring Other elements o the credit process

4. Empower MSME clients5. Engage with government

03 Strategic choices 29Where to playHow to play

04 The emerging market MSME bank of the future 35The MSME bank o the uture

Economics o the MSME bank o the uture05 Moving to action 39

Acknowledgements 44

Technical annexure 45

1. MSME deinitions2. MSME banking revenue pools3. Banking revenue growth4. Sectors5. Client bank interviews6. Bank economics model

Case studies 54

References 58


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1

This paper argues that the time is right or banks to step up their eortsto serve micro-, small and medium-sized enterprises (MSMEs) inemerging markets. There are three reasons or our optimism. First, anestimated 60 per cent o global banking revenue growth over the nextdecade will lie in emerging markets. Second, more and more banks inemerging markets are inding ways to overcome the diiculties o servingthe important MSME segment. Third, innovations in technology, riskassessment and business models are increasingly acilitating their eort.

It is not just banks in emerging markets that should grab the opportunity.Western banks will ind innovative practices that they can use to rereshand adapt their traditional banking models back home.

The size of the opportunity

Emerging market MSMEs looks a very attractive segment. We estimatethat bank revenues could jump rom $150 billion in 2010 to ~$367billion by 2015 a growth rate o 20 per cent per annum (Exhibit 1).

Three actors will be responsible or this expansion: high GDP growth in

emerging markets, increased penetration o the large number o unservedand under-served MSMEs and an increased take-up o more advancedand higher revenue banking products.

Executive summary

Exhibit 1

2010Regions

SOURCE: McKinsey Global Banking Pool (GBP); IMF Financial Access Survey; Honohan 2008; McKinsey analysis

2015Growth 2010151CAGR%

1 201015 nominal GDP growth plus growth in financial inclusion (growth 200510 extrapolated to 2015) plus growth based on convergence between developed andemerging markets product penetration (refer to technical annex)

19

20

18

18

14

20

21

MSME bank revenues, $ billions

MENA 6

Sub-Saharan Africa 5

Latin America 27

South Asia 20

East Asia 62

Grand Total 150

Eastern Europe 30

366

49

15

12

59

64

167

7

19

9

33

44

105

217

MSME banking revenues are $150 billion today and are expected to more than doubleover the next 5 years (20% p.a. growth)


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2Micro-, small and medium-sized enterprises in emerging markets: how banks can grasp a $350 billion opportunity

Executive summary

The inherent challenges o serving MSME bank clients low revenue perclient, high risk o credit losses and the need or a physical presence to lendto MSMEs are no longer the obstacles they used to be. Revenue growthshould thereore be proitable. Our research revealed that a ew leadingemerging market banks are making returns on equity (ROE) o over 30 percent in the MSME segment, and many others are earning 2030 per cent.

Five leading practices

We believe winning banks will do one or more o the ollowing ive things:

Develop a granular understanding of their markets. With MSMEclients typically widely dispersed banks must identiy clear geographicconcentrations o these businesses. It is equally important to understandthe size o the potential banking revenue pool in the sectors in whichMSMEs operate and the nuance o the inancial needs o each sector.

Radically lower operating costs. Given the low level o bank revenueper MSME client, banks have to ind a highly eicient way o servingthem. This requires bold new thinking in distribution (both remoteand physical channels), product design and sta deployment.

Manage risk innovatively. A people- and judgement-intensive approachto risk is likely to be too costly. Banks must develop new and creativeways to assess credit, such as psychometric testing, cash low estimates,or qualitative credit assessment (QCA)1. All associated credit processes(e.g., loan origination, monitoring and collections) must be streamlined.

Empower MSME clients. Financial and business illiteracy in emergingmarkets leads to poorly presented business cases, the single mostimportant reason why banks decline credit applications. Banks shouldtake the initiative to address this problem, or example, by organisingseminars or existing MSMEs or providing start-up packages or new ones.

Engage with government. Governments can be useul allies inovercoming challenging business environments so banks must work

with them by, say, establishing risk-sharing acilities and credit bureaus, orseeking out inormation that identiies under-served and unserved clients.

1 A McKinsey & Company proprietary risk-scoring approach where qualitative actors are added to risk models by a process o statistical,regression analysis, to establish whether the qualitative actors increase the predictive power o existing risk scoring models.


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3

We believe these practices are complementary and that those banks adoptingone or more o them will more likely be winners in the race to capture theemerging market MSME segment. We calculate that applying these practicescould increase a banks ROE in the MSME segment rom ~14 to ~33 per centand raise proits ater tax rom ~$50 to ~$130 million per annum (Exhibit 2).2

The strategic choices

Based on the size and growth o the MSME banking opportunity, we seethree groups o emerging markets countries:

Red hot countries have ast-growing, large and partly unserved MSMEbanking markets, such as China, India, Brazil, Indonesia, Russia andMexico. Banks should invest disproportionately in these territories.

Warm countries should see moderate growth in inancial penetration3o, say, 1.02.0 per cent per annum, yet they still represent an excitingopportunity or banks. These include Thailand, Nigeria, Vietnam,Argentina and Chile.

In cool markets, inancial penetration is increasing at less than one percent per annum. Countries in this group are either close to saturation

point (e.g., Poland and the Czech Republic) or are yet to create theconditions in which MSMEs will really thrive (say Pakistan or DRC).

2 Reer to Our methodology (page 8) and Technical annexure (page 45).

3 Proxied by per cent o the population with access to fnancial services.

Exhibit 2

SOURCE: McKinsey analysis

Traditional bank (from)

Year-5 comparison for start-up bank, $ millions1

Leading edge bank (to) Key levers

Seek granular understanding of your MSMEclients e.g., Micromarket analysis Sector targeting

Radically lower operating cost e.g., Lean/light branches Internet/mobile distribution Optimal staff loading ratios

Manage risk innovatively

e.g., QCA Psychometric testing

Impact2

Per cent

Cost-income

Indirect impact of empowering clients

and engagement with government not

quantified

ROE

1 Rounded to nearest $10 million, 2 Rounded to nearest 5%

Net profit 50

Tax

Operating cost

390Revenue

240

Risk cost 90

10

130

430

40

70

190

14

63

33

44

10

-20

-20

160

Applying the 5 leading practices can have a dramatic impact onbank economics, increasing ROE from ~14 to ~33 per cent


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Executive summary

We have also developed archetypes based on barriers to distribution andthe management o credit risk. Game changers are countries in whichboth distribution and risk management are challenging. Leapfroggershave high credit bureau coverage but under-developed physical distribution.Creative credit countries typically have good distribution and lowcredit bureau coverage. And fortunately flexible countries haveadvanced distribution networks and credit risk methods (Exhibit 3).

Getting started

We see two main types o business models, though in some cases theycould be combined. One is a credit-led proposition with low-cost physicaldistribution. Face-to-ace contact with clients is critical, in addition to astrong end-to-end credit process. The other is apayment-led propositionwith direct channel distribution. Banks that want to emphasise paymentsolutions in their MSME proposition will ocus more on direct channelssuch as mobile, ATM and contact centres. In both models, all ive leadingpractices should be applied, though their emphasis will be dierent.

No single agenda is equally relevant to the diverse range o institutions incumbent banks, start-up banks and other inancial players thatcan capture the MSME opportunity. Nevertheless, the CEO o any bankbold enough to embrace the challenge aces the same key choices:

Exhibit 3

To understand how best to approach their chosen markets, four emerging countryarchetypes will inform how banks behave

Behaviouralcreditmodelsneeded

Increasing need for direct channels

SOURCE: McKinsey Global Banking Pool (GBP); World Bank Doing Business; IMF Financial Access Survey 200610; McKinsey analysis

Growth

5-year historic increase inshare of population withaccess to financial servicesCredit bureau coverage

Per cent of adults>3%Between 1.5% and 3%


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5

Is the emerging market MSME segment part of your banks strategy?

Is the emerging market MSME segment part o your growth agenda?Does this segment have synergies with your current set-up and otherbusiness unit?

Is your home market attractive enough or do you need to go cross-borderto capture the opportunity?

What is your banks level o ambition or this segment in terms o earningsor market share? Is it commensurate with the size o the opportunity?

How quickly can the MSME segment make a meaningul contributionto your banks inancials?

Does your bank have the required capabilities, and which ones

will you have to build?

Does your bank understand the MSME opportunity at a suicientlygranular level to attack it eectively?

Does your bank have an appropriate, end-to-end risk managementprocess or MSMEs, leveraging the latest innovations?

Does your bank need to change its game in distribution to capturethe opportunity proitably?

Does your bank have a value-maximising coverage model to capturethe opportunity ully?

Does your bank have the innovative mindset required to serve MSMEsproitably and at scale?

Is your bank ready to execute at scale?

Does your bank have the plan, processes and tools required to executeat scale?

Does your bank have the talent and leadership to execute against theMSME aspiration? Does your bank attract people with the required skillsand have a actory or developing relevant talent?

It is not just banks in emerging markets that should grab the opportunity.

Western banks will nd innovative practices that they can use to

reresh and adapt their traditional banking models back home.


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7

Introduction

4 In this article, MSME reers to micro-, small and medium-sized enterprises earning a turnover o up to $3.5 million the average upperbound across emerging markets.

5 See or example Murdoch, Jonathan, The microfnance promise, Journal o Economic Literature, December 1999; IFC, Scaling-upSME access to fnancial services in the developing world; Stein, Peer, Tony Goland and Robert Schi, Two trillion and counting assessing the credit gap or micro, small, and medium-size enterprises in the developing world, IFC: World Bank and McKinsey& Company, October 2010.

6 McKinsey & Company, September 2011.

The question o how to serve micro-, small and medium-sized enterprises(MSMEs4) in emerging markets is not new. Many practitioners including commercial banks, non-proit microinance organisationsand venture capitalists have searched or a winning ormula overthe years, with mixed results. Academics and policy makers5 havewritten volumes on how to provide inancial services to the millions oMSMEs around the world that remain unbanked or under-banked.

Why are we writing about this now?

We believe there is an interesting opportunity or banks and others toachieve a step change in their approach to MSMEs, in light o several actors.

First, we see increasing evidence that MSME inancing has gonebeyond social objectives and the role o microinance institutions.In this article, we present evidence that an increasing number oprivate sector banks across emerging markets is attacking thissegment, and that many o them are doing so proitably.

Second, banks around the world are looking to emerging marketsor new growth opportunities. For example, in a recent publication,The State of Global Banking in search of a sustainable model6,

McKinsey estimated that 60 per cent o global banking revenuegrowth rom 2010 to 2020 will come rom emerging markets. Andwithin emerging markets, MSME is an under-served segment.

Third, innovations in technology, risk assessment and businessmodels are happening at such a pace that we believe a breakthroughmodel, the MSME bank o the uture, is inally within our grasp.

The time is ripe not only or emerging market banking executives tolook anew at the opportunity, but also or those in advanced marketbanks to view emerging markets as an innovation rontier with manyleading practices that can be applied in their own markets.

This article lays out our perspectives as ollows. In Chapter 1, we outlinethe size o the MSME banking opportunity across emerging markets. Inthe Chapter 2 we discuss ive leading-edge practices in MSME banking inemerging markets. In Chapter 3 we present the strategic choices or bankskeen to play in this arena. Based on these premises, in Chapter 4 we oera possible version o the MSME bank o the uture and its economics. Weclose in Chapter 5 with critical questions to address when moving to action.


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Introduction

Our methodology

The article combines several different sources of information and ideas. We conducted exclusive in-depth

interviews with 29 leading banks across six emerging market regions Latin America, Asia, Sub-Saharan

Africa, North Africa, the Middle East and Eastern Europe. These interviews provided insights into how

banks perceive the MSME opportunity in their markets, how they are set up to attack it, challenges they

face in doing so, and innovative practices they are seeing in the MSME segment.

We estimated the size of the MSME banking opportunity across emerging markets using the McKinsey

Global Banking Pools, a proprietary dataset developed and tested over several years, and covering 79 of

the largest economies across advanced and emerging markets. In addition, we also gained insight from

existing literature and by analysing third-party datasets such as the IFC/World Bank enterprise survey,

which include MSMEs across the emerging markets, and the FinScope survey of 6,000 MSMEs in South

Africa.

The research also draws on the experience of McKinseys network of MSME banking experts from across

the emerging markets.

Finally, we tried to imagine what a large-scale bank serving MSMEs would look like, and built a financial

model for that bank linked to operational drivers such as number of clients, products and channel mix.

We estimate that banking revenues rom MSMEs in emerging markets will grow

20% per annum rom $150 billion in 2010, to over $350 billion in 2015.


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9

A huge opportunity

A large and growing market for banks

The opportunity or banks to serve MSMEs7 in emerging markets is large. In2010, banking revenue rom MSMEs in emerging markets totalled $150 billion,or one sixth o all emerging market banking revenues. By 2015, we estimatethis igure will grow by around 20 per cent per annum to approximately $367billion (Exhibit 4). Our interviews with 29 leading banks in emerging marketswere consistent with this: almost two-thirds believe that MSME lending willincrease by over 20 per cent per annum or more over the next ive years, andanother 10 per cent believe it will increase by at least 15 per cent per annum.

7 In this article, MSME reers to micro-, small and medium-sized enterprises earning a turnover o up to $3.5 million the average upperbound across emerging markets.

01.The size of theMSME opportunity

Exhibit 4

2010Regions


2015Growth 2010151CAGR%

1 201015 nominal GDP growth plus growth in financial inclusion (growth 200510 extrapolated to 2015) plus growth based on convergence between developed andemerging markets product penetration (refer to technical annex)

19

20

18

18

14

20

21

MSME bank revenues, $ billions

MENA 6

Sub-Saharan Africa 5

Latin America 27

South Asia 20

East Asia 62

Grand Total 150

Eastern Europe 30

366

49

15

12

59

64

167

7

19

9

33

44

105

217

MSME banking revenues are 150 billion today and are expected to more than doubleover the next 5 years (20% p.a. growth)


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1. The size of the MSME opportunity

Strikingly, this projected $217 billion revenue growth by 2015 is

larger than the combined growth o $140 billion in global salesand trading ($64 billion), global asset management ($63 billion)and global investment banking ($13 billion) (Exhibit 5).

Three important actors are driving the projected growth in MSMEbanking revenues:

Big increases in nominal GDP, averaging 14 per cent acrossemerging markets, account or $153 billion or roughly 70 percent o the growth. These GDP estimates are based on aconsensus base case. The scenario o, say, a disorderly break-

up o the euro or a iscal crisis in the U.S. is not incorporated.

Exhibit 5

279

221

90

367

Revenue 2010

$ billions

150

Global investment banking3 76

Global asset management2 157

Global sales and trading1 215

Emerging market MSME revenue4


64

217

13

63

Revenue 2015

$ billions

1 Secondary market transactions

2 Includes corporate pension funds, institutional funds, mandates, third-party-managed insurance funds3 Includes all advisory and discretionary fee-based services such as M&A, ECM, DCM, structuring4 Projected growth based on nominal GDP growth to 2015, in penetration in financial services and increased share of wallet

Banking divisions

7.0

3.2

5.4

Growth

$ billionsCAGR

Per cent, annual

20

140

Projected emerging markets MSME revenue growth is likely to be larger than the combinedgrowth of some other banking service lines

In 2010, banking revenue rom MSMEs in emerging markets totalled

$150 billion, or one sixth o all emerging market banking revenues.


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Increased penetration o the large number o unserved and under-served MSMEs accounts or $49 billion or about 23 per cent o thegrowth. Our research8, undertaken with the International FinanceCorporation (IFC) in 2010, revealed that an estimated 5060 per cento emerging market MSMEs are either under-served or completelyunserved (Exhibit 6). Some markets have millions o un-served MSMEs(e.g., China, India and Nigeria); in others unserved MSMEs run intothe hundreds o thousands (e.g., Thailand, Brazil and Mexico).

A bigger take-up o more advanced and higher revenue-type products,such as trade inance, actoring and cash management, accounts orroughly $14 billion or six per cent o the projected revenue growth. Theshare o these products in GDP varies signiicantly between emergingmarkets and advanced markets even ater taking the bigger penetrationo unserved and under-served MSMEs into account. Our estimateassumes that emerging markets will close 15 per cent o the gap in thenext ive years as MSME product needs become more sophisticatedand banks transer product knowledge rom advanced markets.

An innovation laboratory for Western banks

MSME banking in emerging markets is also relevant or Western banks, whocan adopt leading practices rom emerging markets in their own markets.In the recent publication, The State of Global Banking in search of asustainable model9, McKinsey points out that banks simultaneously acestricter regulation, evolving technology, and shiting customer preerences.

Exhibit 6

5060% MSMEs in emerging markets are unserved or under-served

SOURCE: IFC/Worldbank MSME database 2011

Total no. of unserved

or underserved

MSMEs:

200250m

5060%

90

High-income OECD

34m MSMEs

2935%

Latin America

2025m MSMEs

3847%Sub-Saharan Africa

2530m MSMEs

6175%

4150%

Middle East & North Africa

911m MSMEs

East Asia

100125m MSMEs

5567%

South Asia

3441m MSMEs

4453%

Central Asia & Eastern Europe

911m MSMEs

4454%

Per cent of formal and informal MSMEs that are unserved or under-served

8 Stein, Peer, Tony Goland and Robert Schi, Two trillion and counting assessing the credit gap or micro, small, and medium-sizeenterprises in the developing world, IFC: World Bank and McKinsey & Company, October 2010.

9 McKinsey & Company, September 2011.


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10 China, Indonesia, Singapore, Brazil, Mexico, Argentina, South Arica, Nigeria and Kenya.

I banks in advanced markets are to secure a sustainable uture, weargue, many will have to transorm their business models in ways moreradical than they have contemplated to date. Western banks can drawlessons rom the results o innovation in banking in emerging markets.

Banking would not be the irst global industry to undergo a metamorphosisin the ace o switly changing regulatory and technological realitiesand customer behaviour. In the 1990s, the telecom sector underwent atransormation as deregulation, the introduction o mobile technology andnew consumer preerences posed a challenge to existing business models.In response, some incumbent companies embraced the new environment(e.g., a major traditional European telecom company acquired a mobile phonecompany) and others reduced cost and sta numbers by 3050 per cent.

In the 1970s, the automotive industry began a transormation in responseto the downturn in global demand and the advent o Japanese competition,which emphasised practices such as just-in-time inventory management.Productivity improvements, ierce competition and signiicant merger andacquisition activity all ensued. We believe banking is at a similar crossroadsand that emerging markets could be an incubator or innovative practicesyet to sweep the sector.

A source of growth and employment for governments

Governments stand to beneit rom growth in the MSME segment. MSMEsare a major contributor to GDP and employment. For example, our analysis onine emerging markets10 has shown that MSMEs account or approximately40 per cent o GDP and 65 per cent o employment. Indeed, MSMEs areincreasingly attracting government attention as a source o economicgrowth and employment, especially in the prevailing economic climate.


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However, in surveys o MSMEs, access to inance is consistently citedas one o the top three obstacles to unlocking the segments growthand employment potential (Exhibit 7). With MSMEs such a priority,banks should be able to count on the support o governments.

Indeed, we already see several governments acilitating bank lending toMSMEs. For example, the UK government has created a variety o enhancedincentives or banks to lend to MSMEs: the Enterprise Finance Guaranteeund (2 billion) which provides a 75% government guarantee on long-term(10-year) SME loans to banks; the Enterprise Capital unds (200 million)which are government-sponsored venture capital unds supporting thekey sectors within the SME segment; and the Financial Literacy Initiative,

which is investing 10 million towards building skills and changing themindset o MSMEs and potential MSME owners.11 Brazils governmentreduced tax bureaucracy or MSMEs by simpliying the tax iling (romeight documents to a single document), and uniying ederal, state andmunicipal taxes under the Simple National tax reduction programme12. ByJuly 2011, 3.6 million small enterprises had been granted tax exemption bysubscribing to the programme.13 Chinas government encourages banks tolend to MSMEs by sharing inormation on MSME locations, industry andcreditworthiness with a major bank. Nigerias government recently launcheda $500 million und to share risks with banks that lend to agriculture, asector with many small enterprises. Banks should proactively engagegovernments on issues they need to resolve to acilitate MSME lending.

Exhibit 7

Across emerging market regions, access to finance is a top 3 obstacle to growth

SOURCE: IFC/World Bank Enterprise Survey 200610; World Bank GDP 200810

1 Exception is MENA,

2 Average medians; averages are GDP weighted

Number of countries

For ~15

40% of SMEs site finance is the most important obstacle to growth

Share of respondents per region, per cent2

Most commonly

reported obstacle

Second obstacle

Third obstacle

Corruption

Access to finance (availability and cost) 14

Crime, theft and disorder 17Electricity 27

Courts

Inadequately educated workforce

Transportation of goods, supplies and inputs

Tax rates

Access to land

Practices of competitors in the informal sector

11

13

19

10

1712

19

1317

3929

38

18

Most serious obstacle

to growth of SMEs

Sub-Saharan

Africa East Asia

Latin

AmericaSouth Asia

Central Asia and

Eastern Europe

3

4

4

4

4

6

7

1

1

1

4

1

4

2

6

5

5

4

4

2

3

7

6

9

2

1

7

7

5

1

3

7

2

3

38 4 9 17 31

11 BBC News report on SMEs, 14 January 2011.

12 General Micro and Small Enterprise Law and under the Complementary Law no. 123 o Dec/2006.

13 Innovating gaining market share and ostering social inclusion success stories in SME Development; UN, ECLAC, IDB, December 2010.


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Exhibit 8

Economic profit1All the banks we interviewed are serving MSMEs profitably

1 ROE less country-specific cost of equity (cost of equity used for the countries: Angola 15.4%; Brazil 11.8%; Colombia 12.4%; Czech Republic 10.5%; Ethiopia 17.4%;

India 13.2%; Indonesia 12.9%; Kenya 13.9; Malaysia 10.7%; Mexico 11.6%; Morocco 10.2%; Nigeria 15.3%; Russia 12.3%; Saudi Arabia 10.9%; Singapore 9.9%;

South Africa 13.0%; United Arab Emirates 11.1%; China (used bank specific average 14.1%)

2 Average of all banks excluding the 83% ROE outlierSOURCE: Emerging bank interviews; McKinsey analysis

MSME segment ROE, Per cent, n = 27 respondents

xx

Low ROE


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With the exception o just two banks, all those we interviewed weremaking an economic return (ROE adjusted or cost o capital) inthe MSME segment. Such returns ranged rom 528 per cent,with one outlier reporting an economic proit o 71 per cent.

Contrary to popular belie, the MSME segment can thereore deliverhigh levels o proitability. Those banks that have recognised this andare tackling the challenges o doing business in emerging marketsare making a healthy economic proit. How have they done it?

Based on the successul banks we interviewed and worked with,we have identiied ive leading practices in the MSME space.We turn to these leading practices in Chapter 2.

What the banks and MSMEs say

We interviewed 29 leading banks serving MSME from across emerging markets, conducted desk research

on publicly available MSME surveys14, and collated results from our interviews with MSMEs in Asia and

several African countries. Our insights gleaned are as follows:

What MSME clients want

Simple products and services. Products need to be simple and easy to use (application formsno longer than one or two pages), and quick turnaround times of one to four days.15

Unsecured loans even at a high price. Frequently without collateral, MSMEs often require access

to unsecured credit and are willing to pay a higher interest rate to obtain it. Several banks are already

piloting unsecured credit offerings and the high take-up rates confirm MSMEs do indeed value this.

Trustworthy, convenient channels. Trustworthy typically means face to face, especially at

the beginning of a relationship. Many banks interpret face to face to mean a branch, but it could

also be an agent who visits the MSME owner at his or her premises.

What banks say about the opportunity

MSMEs are strategically important. This segments share of bank profits is typically five percentage

points higher than its share of bank revenue, assets and liabilities.

MSME loan books forecast to grow strongly. While the typical MSME loan book is currently less

than $5 billion, two-thirds of banks agree it is likely to grow by more than 20 per cent a year over the

next five years. In addition, more than 90 per cent of banks expect losses on loans to be less than

five per cent per annum.

Poor data and poor business cases constrain lending growth most. Around three-quarters of

the banks we interviewed listed poor business cases as a critical reason for credit declines, and more

than two-thirds cited poor information availability as a critical constraint to lending.

14 FinScope survey o 6,000 MSMEs in South Arica; IFC/World Bank enterprise survey o MSMEs across emerging markets.

15 More complex or high turnover MSMEs may demand more complex products, e.g., cash management and trade fnance.


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16Capturing the emerging market MSME banking opportunity


Channel innovation will be a defining feature of the future. New technology means banks are likely

to pursue significant channel innovations to reach MSMEs. Of the banks we interviewed, 60 per cent

believe the Internet is most likely to reduce operating costs by 10 per cent or more over the next five

years, and a third cited mobile.

Use of tools is uneven. More than 70 per cent of banks interviewed have an influential credit

scoring tool combining qualitative and quantitative information; nearly two-thirds, however, have no

meaningful sales tool.

Regional differences and similarities

In our interviews, some themes were consistent across regions, and others varied. In all the emerging

market regions, banks see MSMEs as strategically important to their business, cite poor business cases and

poor information as the major constraints to lending, and estimate expected losses in the MSME segment

to be less than five per cent.

However, banks outlook for growth in the MSME segment differed. While more than seven in 10

respondents from Africa, Asia and Eastern Europe expect growth in MSME lending in the next five yearsto be more than 20 per cent, only four in 10 respondents from Latin America, North Africa and the Middle

East agreed. There were also regional variations in perceptions of the big technological influences to

come in the next five years. More than 60 per cent of respondents from Sub-Saharan Africa cited mobile,

compared to 20 per cent in other regions. Meanwhile more than 60 per cent from Eastern Europe and

Asia cited automation of credit scoring as a large cost reduction lever, against approximately 20 per cent

in other regions.

In all the emerging market regions, banks see MSMEs as strategically important

to their business, cite poor business cases and poor inormation as the major

constraints to lending, and estimate expected losses in the MSME segment

to be less than ve percent.


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02.Five leadingpractices

We believe banks will improve their chances o capturing the emerging marketMSME opportunity on a signiicant scale i they do ive things (Exhibit 9):

1. Seek a granular understanding o target MSME clients

2. Radically lower operating costs

3. Manage risk innovatively

4. Empower their MSME clients

5. Engage with governments.

These ive leading practices each address challenges that make MSMEsdiicult to serve proitably on a signiicant scale. They are not mutuallyexclusive and they complement each other. For example, a granular

understanding o target MSME clients will help deine the most optimalapproach to distribution and help reduce risk cost. Distribution andrisk are particularly interlinked. All things equal, the deeper a bankreaches into the business community and the more it develops closepersonal interactions, the better will be its perormance on risk.

Exhibit 9

SOURCE: United Nations; IFC; Financial Inclusion Expert Group; World Bank Doing Business; McKinsey analysis

Leading practicesChallenges

2Bank revenue per client averages $2,100, so traditionaldistribution is unprofitable

1Urbanisation lower than in advanced markets e.g., 30% in India,40% in Africa, 45% in China versus ~80% in Europe

3Only 530% of emerging market SME borrowers are covered bycredit bureaus

5

Emerging market nations rank in lower half of World Bank Doing

Business indicators

4

Financial literacy in BRICS countries (most developed emergingmarkets) of ~50 to 60% compared to G7 countries of above 60%

Radically loweroperating cost

Seek granular understandingof target MSME clients


Engage with government

Empower your MSME clients

Low bank revenue per client

Dispersed clients

Poor data availability

Poor business environment

Business/financially illiterate clients

We see 5 leading practices that will make the difference in the race to capture theemerging market MSME banking opportunity


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2. Five leading practices

Distribution is arguably secondary to risk processes and the banks approachto risk management should thereore drive the design o the distribution model.

The ive practices are relevant across a wide spectrum o MSME bankingmarkets and strategies, and banks serving MSMEs successully display oneor more o these leading practices.

We explore each in turn over the next pages.

1. Seek a granular understandingof target MSME clients

In emerging markets, MSME clients are typically more dispersed

than they are in advanced markets. For example, the share o peopleliving in cities and towns is approximately 30 per cent in India, 40per cent in Arica and 45 per cent in China, compared to 80 per centin Europe. In addition, the MSME sector mix in emerging marketsis disproportionately weighted towards agriculture and inormalretail and wholesale. This has two implications or banks.

First, banks need to be able to identiy geographic locations withhigh MSME concentrations, or example, using micromarket sizingtechniques. The municipality is a good level at which to perorm thisanalysis as in the case example rom South Arica set out in Exhibit 10.

Exhibit 10

Banks should have a granular understanding of the geographic

location of their MSME clientsNumber of companies per municipality

SOURCE: Lightstone

1 A metropolitan municipality represents large densely urbanised

regions that encompass multiple cities, hence it represents a metropolis

Number of companies

per municipality:

Metropolitan municipality1

High (< 50,001)

Medium (5,00150,000)

Low (05,000)

NORTHERN CAPE

NORTH WEST

Durban

East London

George

Hibiscus CoastKing Sabata Dalindyebo

Port Elizabeth

The Msunduzi

uMhlathuze

Nelspruit

Polokwane

Thulamela

Witbank

Local Municipality of Madibeng

MafikengRustenburg

City of Matlosana MPUMALANGA

KWAZULU NATAL

LESOTHO

WESTERN CAPE

EASTERN CAPE

MatjhabengFREE STATE

Bloemfontein

LIMPOPO

GAUTENG

City of Tshwane

Ekurhuleni

Emfuleni

Mogale City

City ofJohannesburg

City of Cape Town

Tlokwe City CouncilSteve Tshwete

Stellenbosch


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19

It is equally important to understand the size o the banking revenue poolin the sectors in which MSMEs operate. In emerging markets, ive sectorscomprise around 75 per cent o the MSME banking revenue pool: retail(approximately 20 per cent), manuacturing (30 per cent), hospitality (nineper cent), general services (nine per cent) and agriculture (eight per cent).The size o these sectors diers by region and by country (Exhibit 11).

Exhibit 11

Equally important is to understand the size of banking revenuepools in the sectors in which MSMEs operate

SOURCE: IFC/World Bank Enterprise Survey 200610; McKinsey Global Banking Pool (GBP); McKinsey analysis

Grand total2

Central Asia and Eastern Europe

Sub-Saharan Africa

Latin America

South Asia

East Asia

Total$ billionsRegion

1 Middle East and Northern Africa (MENA) region not shown separately due to unavailability of sector breakdown2 Middle East and Northern Africa (MENA) account for $7 billion of grand total

Emerging market MSME banking revenue by sector1, Per cent

62

20

26

5

30

150289915

21

61520 6 77

3 8 9 7

15 11 20 17 5 9 7 6 5 5

24 16 10 11 6 11 12 1

60 12 3 1 16 4 3

14 12 18 9 11 9 5 3 9 9

17 14 12 8

Agriculture

Chemicals and pharmaceuticals

Textiles

Retail

Heavy manufacturing

General manufacturing

Heavy industry: construction,transportation, mining

Unknown

Hospitality

General services

8

In emerging markets, ve sectors comprise around 75 per cent o

the MSME banking revenue pool: retail (approximately 20 per cent),

manuacturing (30 per cent), hospitality (nine per cent), general

services (nine per cent) and agriculture (eight per cent).


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An understanding o the nuance o the inancial needs o each sectorcan provide a basis or sector targeting. Some sectors are asset-rich,such as agriculture and manuacturing, while others are liability-rich, suchas services and textiles (Exhibit 12). Armed with this knowledge, banksare able to develop tailored propositions speciic to particular sectors.

For example, in India, one bank in the agriculture sector provides securedlending to acquire arm equipment and machinery (or example tractorsand ploughs), while another provides tailored input inance to help armersmanage the seasonality o cash lows. Two examples rom the retail sectorinclude a South Arican bank that launched an automated cash acceptanceterminal on client property allowing small cash deposits to accumulate

into bulk deposits similarly a Mexican bank provides unsecured loansto a group o retail microentrepreneurs to be paid back bi-weekly. Thesuccess o this method lies in the bundling o loans and the promise olarger loans, which exerts peer pressure on the group or repayment.

Some banks combine sector-specialised oers with micromarket strategies.For example, a bank in Indonesia set up a subsidiary initially targeting sel-employed retailers such as mom and pop stores and within 10 yearsit had set up 1,300 outlets in micromarkets where many o these clientswere located. The bank used a community model in which it recruitedrelationship managers (RMs) rom the local area to serve clients withina three-kilometre radius. The RMs oten had personal knowledge otheir retail clients character and were amiliar with their business cash

low and sources o borrowing, thereby enhancing their understandingo the risks and opportunities. This approach has underpinned strong,targeted client growth and helped keep risk costs impressively low.

Exhibit 12

It is critical for banks to understand the size of the sectors in which MSMEs operate

SOURCE: IFC/World Bank Enterprise Survey 200610; McKinsey Global Banking Pool (GBP); McKinsey analysis

13

12

Retail 25

Grand total 150Unknown 15

Heavy industry: mining,transport and construction 5

Textiles 16

Chemicals and pharmaceuticals 6

Agriculture 18

General Services 12

Hotels, restaurants and food service

28General manufacturing

Heavy manufacturing

Served clientsMillionsSectors segments

Assets (loan book)

$ billionsLiabilities (deposits)

$ billions

10

9

8

11150

12

13

13

22

22

30Asset-rich

Asset-rich

Deposit-rich

Deposit-rich

Banking revenue$ billions

Loan-to-

deposit

ratio

Emerging market MSME clients

168

145

101

157

2322,272

87

222

350

467

341

1,816408

105

114

69

69

106

182

242

177

344 1

2.6

1.4

1.2

0.8

2.4

2.1

0.9

1.4

0.61.3


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21

In another example, a bank in Brazil recognised the importance oacquiring a detailed understanding o its clients. The banks modeltargets speciic sectors like retail and manuacturing, and ocuses ongetting to know the client at close quarters, paying close attention tothe business in the irst ew months o the relationship. For its Head oSME, the most important thing in SME lending is going to where theclient is and seeing the business with your own eyes. Over time, clientsare migrated to lower cost, remote channels, but the understandingbuilt early on is invaluable when loans are subsequently extended.

2. Radically lower operating costs

Banks must strike a balance between creating value or shareholders andadding value to MSME clients at an aordable price. In emerging markets,MSME bank revenue per client is typically low, estimated at an average o$2,100 per annum16 (compared to an average $21,000 per client in advancedmarkets). Assuming a 50 per cent cost to income ratio, this only allows or anaverage cost per client o up to $1,050 per annum across emerging markets.At the lower end o the MSME spectrum, where revenue per client can beas low as $100 per annum, the Western RM model is simply inappropriate.

Banks must thereore meet their client needs at the lowest possibleoperating cost, leaving no room or excessive credit losses and engagingin some bold thinking about distribution, products and people.

DistributionFundamental innovation in both physical and virtual distributionchannels can radically reduce costs or banks and clients alike.

Low-cost branches and correspondent banking should be at theheart o any traditional bricks-and-mortar inrastructure:

Low-cost branches. One Indonesian bank relies on 1,300 verylow-cost branches or serving MSMEs. The bank's outlets are small(less than 100 square metres) and have two to our permanent sta,compared to an average o eight to 10 sta in a standard branch.

Correspondent banking. This model is popular in Latin America, wherebanks use retailers to extend their distribution reach. For example, abank in Colombia has 700 branches and 900 correspondent outlets.In Brazil, correspondent outlets outnumber bank branches by sevento one; in Colombia by two to one. This approach is easible even incountries where large networks o ormal retail outlets do not exist inNigeria, or instance, one bank is planning to roll out 20,000 agents.

Technology is a major battleground and innovation is rie. Almost 60 percent o the banks we interviewed believe that the Internet will have thegreatest impact on lowering MSME operating costs over the next 10 years.For example, a bank in Nigeria is introducing a process that enables MSMEclients to apply or rolling credit, be assessed and obtain approval all online.

16 These estimates are derived rom dividing the total emerging market MSME bank revenue pool by the total number o banked MSMEs inemerging markets.


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Technology-led innovations are already transorming emerging marketsin a number o ways:

Contact centre model. One o the banks we interviewed uses a ullcontact centre model or its smallest MSME clients in Brazil. Oneo the large Arican banks is building a section in a contact centrededicated to MSMEs staed by bankers rather than call centreagents. This model has proved to be very successul in advancedmarkets. In the U.S., or example, a major credit card company hasadvanced unsecured credit to up to our million small businessclients in 10 years without any branches or checking accounts.

Mobile. In Kenya, 60 per cent o MSMEs use M-Pesa, a mobilephone-based product, oering clients payments and deposits/

savings unctionality. M-Pesa is a runaway success and has soar captured over 16 million individual and MSME users.

Laptop and POS-enabled agents. A large Arican bank deploysMSME relationship oicers armed with POS machines to collect cashin person rom retail sector MSMEs in their marketplace. The oicerscollect cash up to a maximum limit (or security reasons) and depositit at the nearest bank where it is credited to clients bank balances inreal time. Not only does this maximise cash balances or the bank, itenables the local branch to recycle cash into the local micromarketrather than requesting top-ups rom distant bank depots. MSME clientsaccess their cash via cards and mobile phones, which is both convenientand secure. A bank in Colombia and a microinance organisation

in Kenya are lending to MSMEs using agents with laptops; in theKenyan case, M-Pesa is used to transer the loan and repayments.

Product processes

Banks can reap enormous beneits by creating products anchored inlean, automated processes. Even simple things can make a dierence.For example, an Arican bank made savings o around $15 million byreducing its application orm to two pages. An Indonesian bank signsup clients through a credit process that asks a ew, simple questions,sends the answers to a centralised credit scoring centre, then returnsan answer so that credit can be disbursed within three to our days.

The most innovative MSME banks have long abandoned product processeswith complex 20-page application orms borrowed rom the corporatedepartment and asking or inancial statements, a credit score, and collateralbeore being run through a multivariate credit-scoring model. Complicatedproduct processes in this segment are neither necessary nor economical.

People

Banks should match the number and tenure o bankers assigned toMSMEs according to the revenue potential o their three or our targetedsegments, always striving or a similar cost-income ratio. For example:

For the highest revenue sub-segment, say turnover o between $1.5and 3.5 million, a bank might employ an experienced, well-qualiied RM

with a loading o 100 to 120 clients. The RM knows the clients well andvisits them several times a year. Such an enhanced service should becombined with sound perormance management and key perormanceindicators (KPIs). For example, with roughly 250 working days per year,and on the assumption that the RM can reasonably make three outbound


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23

client meetings or calls per day, total outbound client contacts shouldtotal 750 per year. Assuming 120 clients, the RMs KPI could be builtaround an average six outbound contacts or visits per client each yearand the associated sales and risk cost targets or that size portolio.

For the middle revenue sub-segment (turnover o between $0.5 and1.5 million) the bank may have a lesser skilled banker with a loading oup to 200 to 250 clients. The banker will only know some o his or herclients on a irst-name basis perhaps ocusing on those with creditexposure. In this model, much o the client service will be reactive, butthe banker still has some scope or outbound contact ocused on highrevenue or high risk clients, at a rate o, say, one or two clients per day.

For the lowest revenue sub-segment (turnover o below $0.5 million),bankers serve their clients almost entirely on a reactive basis, witha sta/client ratio o anything up to one sta member per 1,000clients. Only the very largest clients, or ones with large loans,would receive outbound attention, but they would orm a smallpercentage o the bankers portolio. Ideally, the remaining clientsshould be empowered to use the sel-service channels.

On the ace o it, banks serve small business clients in advancedmarkets in a similar way. However, two dierences should be noted.Literacy levels are lower in emerging markets than in advancedmarkets, requiring ace-to-ace contact with clients, especially in the

When business gets personal: reconciling dual MSME client needs

In emerging markets, MSME owners are often affluent and there can be a significant overlap between the

two segments. For example, MSMEs account for 5070 per cent of affluent clients in the Chinese business

of one prominent, multinational bank. Recognising these links offers financial upside for the bank. Results

from a 2008 Asia-Pacific SME banking survey found that the share of wallet for personal banking in

China, India, Indonesia and Thailand is significantly higher when SME owners use their primary business

bank for personal banking. How can banks marry the needs of the individual and his or her business?

As discussed above, an RM who knows all his small business clients individually can only be justified in

the highest segment. One option is to assign a super RM to these clients who is empowered to deal with

both business and personal financial needs. Benefits to the client include a single point of contact, less

duplication and access to the most appropriate packages. From the banks perspective, the credit process

is more insightful as banks are able to monitor both business and personal accounts for anomalies. In

addition, client loyalty can be heightened, allowing flexibility around pricing and leading to greater client

openness to cross-sell.

Another option is to deploy dual RMs who coordinate and refer the two sides of the clients needs. In this

case it is the quality of these interactions that makes the difference: failure to refer can lead to missed sales

opportunities. In one successful variant of this model, a bank we studied offers a dedicated business RM to

MSMEs above a revenue threshold of $1 million. This RM is the relationship owner as far as the MSME

client is concerned. The MSME division then deploys personal bankers to service the same clients personal

needs. These personal bankers are called on only occasionally by the business RM as specialists to service

a clients individual needs; they do not own the client relationship.


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early stages o the relationship. Also, emerging markets have lowersta costs and this approach can thereore be economical.

3. Manage risk innovatively

In high-revenue-per-client segments, such as corporate banking, bankstake a people- and judgement-intensive approach to risk. This simply doesnot work in emerging markets where costs must be kept low. Furthermore,MSMEs rarely possess the inormation required or a traditional credit scoringmodel a credit rating, inancial statements or collateral. For example, onaverage, only 30 per cent o MSME borrowers in BRIC countries are coveredby a credit bureau, compared to 95100 per cent in advanced markets.17

New approaches to credit scoring

In the words o one Latin American bank we interviewed: The biggestchallenge with MSMEs by ar is lack o inormation that and better riskmodels would do most to help us increase our MSME lending. Banksmust think beyond standard risk models to design simple, data- andIT-enabled approaches.

So ar, ew have done this. The bank interviews show that 72 per cento banks actively use a credit scoring model though the tools are basedprimarily on traditional inormation sources such as documented evidenceo cash lows, collateral, and a credit bureau score. Some 69 per cent orespondents indicated that these were quite poor or even unavailable.

However, a ew banks are beginning to break the mould in credit scoring,introducing new and creative ways to assess a clients credit (Exhibit 13).

17 IFC Doing Business indicators, 2010.

Exhibit 13

Cash flow

Has documentary evidence ofcash flow e.g., financialstatements, salary slip

CapitalHas some personal capital toput down as deposit

Collateral/guarantorHas assets as collateral or aguarantor

Credit ratingHas a verifiable credit historye.g., credit rating agency score


Principles of credit evaluation Banks lend based on evidence

from at least 2 pillars

These pillars are in two

categoriesTypical, one of which is a

must have:

Cash flow

CapitalAdditional, 1 of which can

replace 1 of the above:

Guarantor/collateral

Track record (e.g., credit

score)

Typical(1 required)

Additional

(1 of which

can replace

1 of above)

High

Low

Pillars of typicalcredit appraisal

Likelihood of MSMEmeeting requirement

Teach clients how to make a basic

cash flow estimateRely on proven member-ship of a

value chain

Use track recordlend after MSME hasopened an account and made 6 monthsof deposits (however small) ~50% ofSMEs already banked in any case

Innovations banks can make incredit underwriting for MSMEs

Use insurance of loans instead ofcollateral

Use a debtor/customerin the valuechain as collateral

Use psychometric testing orqualitativecredit assessment

Banks are beginning to break the mould in credit scoring, introducing new and

creative ways to assess a clients credit


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25

Some are using psychometric testing, which uses the test score toseparate good risks rom bad and can lower deault rates by 2540per cent. The psychometric test measures attributes such as theentrepreneurs psychological proile, ethics and integrity, intelligenceand business skills. The test is sel-administered in 3040 minutes ona touch screen computer or ease o client use without any bankersupervision, the cost o the assessment is 45 per cent o traditionalassessment measures. The test has been piloted in seven countries innine languages, and a ew o the banks we interviewed were alreadyusing it. Being computerised, simple and low cost, it is ideal or use bysmall-scale entrepreneurs lacking the traditional credit scoring inputs.

Other banks are using approaches which combine quantitative andqualitative assessment, such as Qualitative Credit Assessment (QCA),

a McKinsey tool. QCA is a 1525 question assessment that banksMSME clients can navigate through in 3060 minutes. Each o the 1525questions is then aggregated to provide a score, with the weight o eachquestion in the score determined by the questions predictive power.QCA has been used by over 20 banks across all the emerging marketcontinents, and has achieved risk cost reductions averaging 35 per cent.QCA typically covers non-conventional variables in our areas: MSMEmanagement (identiying the strength and integrity o the entrepreneur);MSME eatures (such as ownership structure or relationship with thebank); MSME competitiveness; and MSME company operation (includingrelationships with suppliers and customers). To assess the entrepreneursintegrity, or example, a question could provoke our possible responses:

the entrepreneur only volunteers positive inormation; the entrepreneuralso provides negative inormation but only with probing; the entrepreneurvolunteers negative inormation without probing; or the entrepreneur alsoprovides negative inormation with curiosity about how the bank canassist him or her in addressing it. QCA questionnaires can be tailored torelect actors relevant to a banks country and target client segments.

Another approach is to dispense with collateral altogether and toadvance unsecured credit instead. Priced correctly, this can deliverexciting returns rom loans and some banks are seeing a high take-up. Others no longer ask or inancial statements and rely on thebankers estimate o cash low either through observation o thebusiness or analysis o payments into a transactional account.

Banks should match the number and tenure o bankers assigned to MSMEs

according to the revenue potential o their three or our targeted segments,

always striving or a similar cost-income ratio.


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Other elements of the credit process

Credit scoring is only one element, and to succeed in the MSME segment,banks must review all parts o their credit process (Exhibit 14). Indeed, manybanks we interviewed acknowledge that there is scope or improvementin credit origination, underwriting, monitoring and collections.

Take collections, or example, where a 10 percentage point improvementcan translate into a 1020 per cent reduction in losses. Banks can alsoset up their game by prioritising continuous credit monitoring, ensuringthat the relationship manager does an early pre-workout, segmentingworkout cases and allocating them to the right collection/workout oicer.

In origination, an important challenge is to limit or even eliminateclient raud. Cross-selling to existing, non-credit clients, sourcingnew clients with the help o current clients, using pre-deined raudknockout criteria, or looking out or raud in inancial statements usingBenords Law18 can all help. Residual raud risk can then be pricedin, ideally using the probability o raud or a particular client.

4. Empower MSME clients

Emerging markets suer disproportionately rom inancial and businessilliteracy. In Nigeria, or example, just six per cent o the banked populationis inancially literate, compared to 6070 per cent in advanced markets.

18 Benords Law states that any genuine (i.e., non-abricated) set o fgures has the frst digit o each number distributed in a particular,non-uniorm way. For example, the digit 1 is the frst digit o a number in 30 per cent o cases, and larger numbers appear with lower andlower requency to the point where the digit 9 is the frst digit o a number in only approximately fve per cent o cases.

Exhibit 14

Banks should review their entire credit processes end-to-end

if they wish to succeed in the MSME segment

OriginationCredit

managementCredit monitoring Collections

Underwriting

Assessment Decision Disbursement

Tools Knock-out criteria

Limit cal-culation

Credit application

Checklist of supporting documents

Scoring model e.g.,

QCA

Psychometric testing Credit pricing model

Covenants

Credit reviews e.g.,

Pro-longations

Re-payments

Portfolio monitoringdashboard including

Portfolio data e.g., NPLs

Individual loan data e.g.,per cent of credit limit

utilised Macro data e.g., interest

rates and exchange rates

Sector trends e.g.,sector growth, sectorshare prices

Segmentation

Scripts

Principles

on how

to lend to

MSMEs

Use simple80:20 filters toget 80% insightinto whetherclient has achance ofsuccess

Know the clientwell e.g., visitpremises

Commercial staff accountable for both revenueand risklend as if its their money

Tools give a credit recommendation, humanbeing makes a decision

Covenantsshould stand thetest of timeunchangingtruths

Credit is a day-to-daydecision it doesntend the day the credit isgranted

Maximise NPVrecovered bybanksometimes partialrepayment now isbetter than fullrepayment afterlengthy courtbattle



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27

Poor inancial literacy increases transaction costs, notably the investment intime required to explain products, services, interest rates and other issuesto bank clients.

About three-quarters o the banks interviewed told us that poorly presentedbusiness cases, a consequence o poor inancial literacy, is the number onereason why banks decline credit applications or MSMEs. Such businesses,they added, oten have limited knowledge o supply chain management,sourcing, marketing, pricing and other quite undamental practices.

It is thereore as much in their own as in their clients interest or banks tohelp develop MSME inancial literacy and business skills. This will helpexisting MSME clients survive where they might not otherwise have doneso and new clients prosper, so ueling the banks revenue growth.

Most banks have a start-up package to help new MSMEs and give theseclients added support. For example, one Arican bank runs businessseminars or their MSME clients to introduce them to business skills, such asinventory management, supply chain management, and inancial reporting.

5. Engage with government

Banks need to start engaging much more with governments inemerging markets in an eort to improve the business environment.

For example, ranked by ease o doing business, BRIC countries, on

average come 101 compared to 24 or their G7 counterparts, accordingto IFC Doing Business Indicators. Legal processes can be costly anddiicult to enorce. For example, it takes on average 630 days to enorcea loan contract in emerging markets in the case o a deault, comparedto 530 days in advanced markets. Poor inrastructure can be anotherobstacle. Internet penetration averages 18 per cent in emerging markets,compared to 72 per cent in advanced markets. Similarly, limited accessto transport and electricity raises the cost o bank operations.

We see three ways in which banks could engage much more activelywith government to improve the business environment:

Participate in risk-sharing facilities. All 24 o Nigerias banks participated

in a central-bank-led $500 million und to share around 50 per cent othe risk o unpaid agricultural loans. Launched in 2011, it is expected thatthe und will create additional loans to agricultural producers o $3 billionover 10 years, including our million armers and agricultural MSMEs.

Set up credit bureaus. The presence o a credit bureau roughlyhalves the likelihood o MSMEs reporting inancing constraints (rom49 to 27 per cent), signiicantly increases the chance o loans beinggranted (rom 28 to 40 per cent), and radically cuts deault rates(rom 2.2 to 1.3 per cent or large banks; rom 2.4 to 0.5 per cent orsmall banks). There is still signiicant scope or banks to work withgovernment to create credit bureaus in emerging markets only530 per cent o MSME borrowers are covered at the moment.

Leverage government information. Banks can identiy under-served and unserved clients by harnessing government supportto understand where MSMEs are located and whether they havecredible and viable businesses. A bank in China has reached


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our million MSME clients, leveraging inormation on credible andviable businesses held by Chinese municipal governments.

Using a detailed inancial model o a typical MSME division, we believethat applying the ive leading practices can have a dramatic impact onbank economics. Relative to the base case ROE o ~14 per cent and netproit ater tax o ~$50 million per annum, our analysis suggests the iveleading practices could increase a banks ROE rom the MSME segmentto ~33 per cent, and raise proits ater tax to ~$130 million per annum(Exhibit 15). Under conservative assumptions, we estimate that having agranular understanding o clients and targeting them more precisely and

eectively (with sector-speciic products, or instance) can raise revenuesby around 10 per cent; radically lowering distribution, people and productscosts can reduce operating costs by around 20 per cent; and signiicantlyimproving risk practices can reduce risk costs by about a ith.

According to McKinseys Global Banking Pools model, such an ROEcompares avourably with the returns oered by, or example, developedmarket corporate loans (around 15 per cent) and developed markets retaillending (around 13 per cent)19.

19 ROE calculated using McKinsey Global Banking Pool data: net proft ater tax (which is calculated using the eective tax rate or banks inthe country, cost to income determined by research into listed banks and central bank data; and risk costs which are typically determinedrom central bank inormation), divided by cost o regulatory capital, assuming tier 1 and tier 2 (equity and subordinated debt) capitalrequired by Basel I and II.

Exhibit 15


Traditional bank (from)

Year-5 comparison for start-up bank, $ millions1

Leading edge bank (to) Key levers

Seek granular understanding of your MSMEclients e.g., Micromarket analysis Sector targeting

Radically lower operating cost e.g., Lean/light branches Internet/mobile distribution Optimal staff loading ratios


e.g., QCA Psychometric testing

Impact2

Per cent

Cost-income

Indirect impact of empowering clients

and engagement with government notquantified

ROE

1 Rounded to nearest $10 million, 2 Rounded to nearest 5%

Net profit 50

Tax

Operating cost

390Revenue

240

Risk cost 90

10

130

430

40

70

190

14

63

33

44

10

-20

-20

160

Applying the 5 leading practices can have a dramatic impact onbank economics, increasing ROE from ~14 to ~33 per cent


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29

03.Strategic choices

As well as understanding and adopting the leading practices, banks mustmake strategic choices about entering the MSME segment. In particular, theyhave to decide where to play and how to play. These two strategic choices willdetermine the mix o leading practices and the extent to which each is applied.

Where to play

Emerging markets are extremely varied, and banks must understand therelative size o the opportunity across each market. Doing so will help large,multinational banks deine where they pursue the MSME opportunity. It willhelp banks based largely in one market understand i the country they arein oers an exciting opportunity or not.

Emerging markets can be split into three country groups according to theirsize and growth (Exhibit 16):

Exhibit 16

Across emerging markets, banks have many high-growth, large markets to compete in

1 Based on 5-year growth of deposits per capita according IMF Financial Access Survey 2006102 Number of MSMEs who are under-served and unserved with regard to credit as per IFC/World Bank Enterprise Survey 2010

Nigeria

Bangladesh

Mexico

Thailand

Brazil

Indonesia

India

0.5

46.5

4.5

3.0

2.5

2.0

1.5

1.0

0

Growth in financial inclusion

Yearly increase in per cent of population with access to financial services1

PolandSouth Africa

Kenya

Ethiopia Peru

Malaysia

Venezuela

Russia

Turkey

Tanzania

Colombia

Republic of Korea

Egypt

Pakistan

VietnamQatar

UAE

Angola

Czech Republic

Cote dIvoireUganda Ghana

EcuadorSaudi Arabia

Chile

Morocco

Argentina

SOURCE: IFC/World Bank Enterprise Survey 200610; McKinsey Global Banking Pool (GBP); IMF Financial Access Survey; Honohan 2008; McKinsey

Size: number ofunserved MSMEs2

0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.4 3.6 3.8 4.0 4.2 4.4

Current SME revenue pool, $ billions

China

Cool Warm Red hot


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3. Strategic choices

Red hot countries have both ast-growing and large MSMEmarkets. Growth in inancial penetration (deined as the percentageo the population with access to inancial services) has been 2.0 percent per annum or more over the last ive years; or many countriesin this group, the MSME revenue pool exceeds $5 billion. Many redhot countries, including China, India, Brazil, Indonesia, Russia andMexico, still have large numbers o unserved MSMEs. Turkey, Malaysia,Poland and South Arica also all into this group by virtue o the growtho their unbanked populations. Banks should take ull advantage ored hot countries and be willing to invest on a signiicant scale.

Countries that are warm are achieving a moderate growth ininancial penetration o 1.02.0 per cent per annum but still representan exciting opportunity. The larger markets in this group include

Thailand, Nigeria, Vietnam, Argentina and Chile. Banks that call thesemarkets home should take ull advantage; multinational banksshould consider them a second-tier priority ater red hot countries.

Markets in the cool zone or example, Pakistan, the CzechRepublic, Morocco, the UAE, Kenya, Ethiopia and Saudi Arabia areincreasing inancial penetration at less than 1.0 per cent per annum.Some markets are cool because they are close to saturation point(e.g., the Czech Republic), while others have yet to establish theconditions that will allow banks to ully capture the MSME opportunity(e.g., Ethiopia, Pakistan). Domestic banks can pursue proitableMSME niches within cool countries, and multinational bankscan approach these markets opportunistically as part o a broader

portolio o markets weighted towards red hot and warm countries.

How to play

To understand how best and most proitably to approach their chosenmarkets, banks must consider the countrys characteristics in twokey respects:

How easy is it to reach MSME clients? Branch density, measuredas bank branches per 100,000 inhabitants, is a useul proxy.

How easy is it to manage credit risk? Here, credit bureau coverage is auseul proxy, measured by percentage o adults covered. This measure

correlates well with other dimensions o credit management, such asthe ease with which collections can be made and contracts enorced.

Emerging markets are extremely varied, and banks must understand the relative size

o the opportunity across each market.


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Based on these two measures, we have identiied our emergingcountry archetypes that will inorm how banks play (Exhibit 17):

Game changers are countries where it is relatively diicult both to reachclients and manage risk: game-changing approaches to both distributionand risk are thereore required. Examples o countries in this group areIndia, Thailand, Nigeria, Peru, Russia and Egypt.

Leapfroggers have relatively good credit bureau coverage, but poorphysical distribution relative to the population size. Some major emergingmarket countries are in this group, including Brazil, China, Mexico andSouth Arica. Here, banks should leaprog traditional branches using directchannels or innovations in low-cost physical distribution.

Creative credit countries typically have good distribution but sparsecredit bureau coverage. This group has relatively ew countries andincludes Turkey, the UAE, Chile and Saudi Arabia. Banks operating in thesecountries must pay extra attention to risk management because o the lacko inormation.

Fortunately flexible markets such as the Czech Republic and Polandscore well on distribution and credit risk. Banks here will ind it relativelyeasy, i never straightorward, both to reach clients and assess the risks olending to them. Successul players are using remote channels to controldistribution costs and advanced risk management approaches to lowerrisk costs.

Exhibit 17

To understand how best to approach their chosen markets, four emerging countryarchetypes will inform how banks behave

Behaviouralcreditmodelsn

eeded

Increasing need for direct channels

SOURCE: McKinsey Global Banking Pool (GBP); World Bank Doing Business; IMF Financial Access Survey 200610; McKinsey analysis

Growth

5-year historic increase inshare of population withaccess to financial servicesCredit bureau coverage

Per cent of adults>3%Between 1.5% and 3%


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33

In both game changer and leaprog countries, innovation in distributionis critical. One option is to partner with retailers and telcos, which reacha larger share o the population in many emerging markets than banks(Exhibit 18). Many orward-thinking players are orging such partnerships to:

Share physical inrastructure, or example retail outlets or correspondentbanking, as in Latin America

Use mobile as a distribution channel or inancial services e.g., M-Pesain Kenya

Use account data rom telecom companies to assist with credit scoring.

To get started, banks must also make a choice about which business model

to adopt. We believe the various business models we have seen can besynthesised into two main types:

Credit-led propositions with low-cost physical distribution. Credit isa key MSME need. Well-priced and managed, it can be proitable and acompelling part o a banks proposition. A strong but simple end-to-endcredit process is important. For credit-led propositions, some orm oace-to-ace interaction is required, typically implying some level o low-cost physical distribution. The elements o this model could include:

Low-cost outlets with locally hired RMs who know the MSMEclient intimately and visit him or her regularly

Roving RMs/bankers who provide unsecured credit at the

MSME location Contact centres used to lower costs ater the initial ace-to-acestage o a banking relationship.

Exhibit 18

An important option to consider is partnering with retailers and telcos

SOURCE: McKinsey Global Banking Pool (GBP); World Bank Doing Business; IMF Financial Access Survey 200610; Honohan 2008; McKinsey analysis

Modern retailcoverage

Per cent of adultswith access tomodern retailservices

Financial services coveragePer cent of population with access to banking services

UAEKuwaitKenya

Angola

Morocco

Poland

Malaysia

South Africa

Colombia

TurkeyMexico

Russia

Indonesia

Egypt

Nigeria

Argentina

ThailandPeru

Czech Republic

United Arab Emirates

Potential for retail playersPotential for mobile players

Mobile coverageNo. of mobile

subscriptions percapita

Financial services coveragePer cent of population with access to banking services

Kuwait

UAESouth Africa

Colombia

Turkey

Mexico

Russia

Indonesia

BrazilEgypt

Nigeria

Argentina

Peru

Angola

Morocco

Poland

Malaysia

101520253035404550556065707580859095

100105

10 20 30 40 50 60 70 80 90 10010152025303540

6570758085

9095

10 20 30 40 50 60 70 80 90 100

India

China

Republic of Korea

Brazil

India

China

Russia

Kenya

Size: current SME revenue pool$ billions

45505560


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Payment-led propositions with direct channel distribution. Convenient,secure payments are also a key MSME need. Banks wishing to emphasisepayment solutions or MSMEs can put much greater emphasis ondirect channels, as done by M-Pesa with mobile across Arica.

Over time, these business models may merge as banks oer both credit-led and payment-led propositions. In practice, banks may pursue a dualapproach, using low-cost physical channels primarily or credit while tryingto oer most o their transactional services through remote channels. In bothmodels, all ive leading practices can be applied, with dierent emphases.

The business model choice should be made in relation to the bankingopportunity. With healthy projected growth rates or a number o products,there is scope to pursue either model, or indeed a dual model (Exhibit 19).

Having explored these strategic choices and understood the ive leading-edgebehaviours, we are ready to envision the emerging market MSME bank o theuture this is the ocus o the next chapter.

Exhibit 19

The projected growth is well distributed across products

SOURCE: McKinsey Global Banking Pools (GBP); IMF Financial Access Survey; McKinsey analysis

367

Current banking revenue$ billionsProducts

1 Simple lending medium- and long-term financing (1236 months), overdrafts, guarantees2 Specialised lending equipment leasing, factoring, trade finance, project finance, LBO financing, loan syndication3 Cash management short-term minimal interest bearing, check payments, payment systems, i.e., B2B4 Long-term deposits interest-bearing deposits with restriction liquidity

Total$ billions

Growth in market

$ billionsCAGR

Per cent

80

8

44

18

150

188

31

106

42

Simple lending products1

Specialised lending2

Cash management3

Long-term deposits4

Total 217

24

61

108

24

19

31

19

18

20


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35

04.The emerging marketMSME bank of the future

The MSME bank of the futureTo make the MSME bank o the uture come to lie, we characterised andmodelled a hypothetical bank to help readers understand what it could lookand eel like.

The successul emerging market MSME bank o the uture will oer simple,tailored products; lexible, convenient channels; ast, easy credit; and supportor the MSME owner to build his or her business and all at a very low cost.

A typical client might be a start-up commercial armer in Arica or Asia with asimple, single-account product that oers ast and easy access to his moneyand helpul inormation about his business and agriculture through his mobile

phone (Exhibit 20)20. Clients will be able to enquire about loans and insuranceonline. Unsecured loans will be oered up to a certain level, say $10,000, andree business seminars will be available on topics relevant to MSMEs, suchas pricing, marketing, supplier management and inancial record keeping.

20 One Arican company, Mi-Fone, has launched a smartphone costing $50, showing that this technology will be increasingly aordable to abroad range o MSMEs and can become a more widespread channel in emerging markets.

The MSME bank of the future will offer simple, tailored products; flexible, convenient channels; fast, easy creditExample advertisement


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4. The emerging market MSME bank of the future

21 The median emerging markets by number o MSMEs include Morocco (~2.0 million MSMEs), Argentina (~2.1 million MSMEs), Saudi Arabia(~1.8 million MSMEs) and Poland (~2.1 million MSMEs).

22 IFC/World Bank enterprise survey, 200810.

23 Total loan and deposit size based on McKinsey Global Banking Pool data, and a number o MSMEs based on IFC/World Bankenterprise survey.

24 Based on estimates or emerging markets rom McKinsey Global Banking Pool data.

From the banks perspective, the MSME bank o the uturecould have the ollowing attributes (Exhibit 21):

Around 40,000 clients at start-up, growing to 200,000 within ive years.In a typical emerging market, 200,000 MSME clients roughly equal a10 per cent market share21. Clients might be segmented as ollows: 10per cent highest revenue sub-segment (annual turnover o between$1.5 and 3.5 million); 20 per cent middle revenue sub-segment (annualturnover o between $0.5 and 1.5 million); 70 per cent lowest revenuesub-segment (annual turnover o below $0.5 million). This client mix isrepresentative o the distribution o MSMEs according to IFC data22 andin line with our experience o banks already active in emerging markets.

Average loan balances ranging rom $31,000 or the lowest revenuesub-segment to $210,000 or the highest revenue sub-segment, withaverage deposit sizes between $7,000 or the lowest and $45,000or the highest23. Interest margins are assumed to be around ourper cent on loans, and around three per cent on deposits24.

Exhibit 21

The MSME bank of the future may look like this


Client profile

Bank life-cycle

Channel

Staff profile

Service model

Risk

Business model

Revenue

Cost

Segment split, per cent

No. of branches

No. of ATMs

Transaction by channel, per cent

No. of transactions per client per year

Clients per front office staff

Front-to-back office ratio, per cent

Expected loss, per cent

Target market share

No. of clients year 5, 000s

Withdrawal/deposit

Payments

Start-up attacking bank

Focus on medium and small clients

200,000 clients; 5 years to capture

Initial infrastructure required

Focus on direct channels (payments)

~550 transactions per client per year (if holding product)

Better service for medium segment

Use of innovative risk tools

Dual credit and payment focus

Start-up

Transaction-led

10%

Core banking system

Online/mobile system

200

1,000

2%

Dual Credit-led

Mature

1070 20

50

6020 20

546262 104 180

200130 50 20

50 0

3367Front Back

Deposits Withdrawals Payments

Branch ATM Direct

Branch ATM Direct

100

100

100

100Micro Small Medium

Micro Small Medium

1,3001,000 200100Micro Small Medium

Msme in Emerging Markets

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