The approach to risk management can differ significantly if the credit is for a small-to-medium enterprise as the risk is not primarily that of the enterprise but that of the promoter. So what should banks really do?

SMEs reportedly contribute to more than 50% of global GDP and 80% of employment, yet tend to be the less sought-after segment when it comes to banking credit. Some 40% of US companies are SMEs, while in India and China they account for more than two-thirds. However, SME credit does not commensurate with the opportunities they supposedly provide. And the reasons are palpable: measuring credit risk for an SME is not as straightforward as it may sound, especially in an economy that has a proliferation of smaller enterprises in sectors such as trade and services.

So what makes SME lending so very different? The answer lies not so much in the credit amount, but in the assessment of the risk there-in. For most banks, the distinction of risk assessment for large corporate customers and small enterprises is blurred. Since SMEs turnover less than $25 million, the credit could be too small for a corporate bank. Furthermore, applying a credit framework meant for large customers to an SME segment is not only inappropriate but can be quite ineffective for a bank looking to grow business. Given that this calls for a continued engagement for a volume-not value-driven portfolio, it becomes almost impossible for any risk-operating model that does not lend itself to a focused SME-lending framework to thrive.

By definition, SMEs tends to be promoter driven, therefore, the risk of the enterprise is almost the same as that of the promoter. From the borrower’s perspective, the distinction between debt and equity is somewhat blurred, and there-in lies the problem. SME lending is more akin to a venture-capitalist approach: score the obligor, not the facility. In the past, with a neighbourhood banking function, where everybody knew everyone, lending was based on the ‘banker’s instinct’ where you look someone in the eye and take a call. This is no longer viable due to the size and scale of the demand or the need for an institutionalised credit risk that banks require if they are serious about lending in the SME sector. The coverage model for an SME book, therefore, needs to be complemented by a strong risk-management framework. In essence, there are five key pillars for any successful SME lending book.

Pillar 1: Borrower assessment

No matter how good the industry sector is or, for that matter, the order book of the enterprise can be, the quality of risk is always, almost inevitably, as good or bad as that of the SME’s primary shareholder or promoter. This understanding forms the bedrock of any solid riskmanagement function for an SME-focused bank. Unlike in a typical corporate risk assessment, which is driven by financial parameters, credit-risk measurement tends to be more of an obligor scoring process. It is driven both by the profile of the promoter and that of the industry as the vagaries of the enterprise are tightly intertwined with those of the sector in which it operates. Financial measurement tends to be based more on the cash-flow analysis and review of bank statements, as the financial statements of SMEs are generally considered less reliable. This is also because, more often than not, SME customers tend to be less organised in their financial reporting than their corporate counterparts.

Pillar 2: Underwriting norms

The flexibility in underwriting for SME credit is directly proportionate to the degree of security provided – by virtue of the collateral that is made available. This, in turn, implies that the combined value of the borrower’s score and the collateral would help define the relative risk-tier position of the customer. An obligor with a better score drives a lower probability of default (PD). Similarly, a higher collateral level minimises loss-given default (LGD). A tier rating that combines both, when the customer has a better score and a higher collateral, tends to be rated in a higher tier, followed by those with a lower score. A customer with a lower score and without a collateral would be rejected.

The underwriting norms, including the financing amount, tenor, pricing and documentation requirement, are all a derivative of the tier structure. This underwriting framework not only prevents the assessment from being subjective but makes it agile enough to be a large-volume, SME-approval factory. More importantly, credit approval processes – as discussed in the next section – need to have a light touch, and the framework makes it less dependent on people.

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The best customer experiences are delivered when both physical and digital channels co-exist, effectively complementing each other. This also implies that banks would need to connect with third-party applications to create new ‘application eco-systems’ with a lower cost of delivery.a lower probability of default (PD). Similarly, a higher collateral level minimises loss-given default (LGD). A tier rating that combines both, when the customer has a better score and a higher collateral, tends to be rated in a higher tier, followed by those with a lower score. A customer with a lower score and without a collateral would be rejected.

The underwriting norms, including the financing amount, tenor, pricing and documentation requirement, are all a derivative of the tier structure. This underwriting framework not only prevents the assessment from being subjective but makes it agile enough to be a large-volume, SME-approval factory. More importantly, credit approval processes – as discussed in the next section – need to have a light touch, and the framework makes it less dependent on people.

Pillar 3: Credit process

A primary success factor and the key differentiator for any successful SME lending is its ability to drive effective turnaround time (TAT) and quick approvals. The sensitivity of a timely approval is so high that borrowers will invariably be willing to pay higher interest to a bank with a better TAT performance. The turnaround is highly dependent on the number of touchpoints, simplified documentation and degree of automation. While many suppliers and fintechs have promoted the automation standards, a pragmatic credit policy with a well-balanced credit authority matrix remains a pre-requisite for fast approvals.

Pillar 4: Risk organisation

There is always a balance to be found between the size and scale of the bank in terms of its geographical spread, number of customers, types of products, and the roles being performed by the risk organisation. The critical factor here being the segregation of roles between policy development, risk appraisals and portfolio review. While the ownership of the client relationship always remains with the front-end business executive, it is not unusual to see a risk implant attached to the team, facilitating quick pre-qualification before going the whole nine yards. More importantly, a differentiated SME business risk organisation from that of a corporate risk appraisal desk is critical – both for ensuring the quality of assessment and the turnaround time.

Pillar 5: Portfolio monitoring

Arguably, the most critical, yet less obvious role of an effective SME credit-risk function is that of its proactive portfolio monitoring and its ability to pick up on the early warning signals. The SME segment, by its very nature, is a high risk-return game and it is imperative to have checks and controls in place. Predictive analytics and Big Data tend to play an extremely potent role in this, enabling early restructuring of debt and minimising impact. In many economies, regulatory requirements related to priority-sector lending and caps or limits on lines of credit to specific industries are not unusual. Proactive portfolio-monitoring activity is, therefore, not only important in managing credit risk but also in ensuring compliance and associated regulatory risk.

While the income for an SME portfolio can be quite lucrative when the market is in an upswing, the non-performing assets (NPA) levels can also be dangerously high in a slowing economy. In the end, the credit risk is not only about your level of exposure but more about to whom are you exposed.

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