The RSBF approach to micro and small enterprise (MSE) lending
RSBF proposes a customer-focused approach to MSEs using an analysis-based lending methodology and establishing MSE lending on a broad scale. Over the course of 21 years the RSBF has assisted institutions across Russia to successfully build up large-scale and profitable loan portfolios using this approach. While the approach involves higher transaction costs due to the initial processing procedures, it results in more robust portfolios and lower default rates. In our experience, MSE lending has to successfully address a large part of the potential market if it is to be sustainable; it should also cover the entire sector – that is, MSEs of all sizes – particularly in a highly competitive banking environment such as in Russia.
Furthermore, the quality of loans has to be sound to ensure that the expected interest income covers the transaction costs, including post-disbursement management. In our experience establishing close professional relationships between a bank and its clients plays a key role in this. Under normal circumstances it enables early warning signs to be recognised and solutions to be worked out with borrowers at an early stage, thus minimising defaults and losses.
Particularly in times of economic crisis, financial institutions will benefit from a more stable and loyal client base, better information about each customer and a more robust loan portfolio – all rendered possible by our cash-flow based lending approach. Especially in Russia, which has experienced a serious economic crisis twice in the last 15 years, the importance of building up sound portfolios should be self evident.
Clients also benefit from this approach, since the financial solution offered to them will be thoroughly tailored to their needs and based on the real capacities of their business’ cash-flow. This responsible approach in itself provides the client with protection against the consequences of inappropriate financing and helps prevent overindebtedness.
The informality of Russian micro and small businesses
MSEs in Russia are marked by a relatively high degree of informality – regardless of whether they are registered as legal entities or sole proprietors – so that excluding sole proprietors does not necessarily simplify loan assessments or reduce risks. In our experience, establishing a close professional relationship with clients has proven to be the best way of understanding their actual business situation, thus facilitating better credit decisions and fostering client loyalty – which in turn reduces or at least mitigates risks to a certain degree.
MSEs differ from corporate clients in that the loan amounts in question are typically smaller and they do not require as wide a range of other banking services. Typically, MSEs also operate less formally than corporate clients so that documentation is not always available or accurate. While interest rates and processing procedures/requirements are factors taken into consideration by all borrowers, corporate clients, who usually have a choice, are typically more price sensitive. On the other hand, MSEs are worried about the difficulties and red tape involved in getting a loan, and are usually more ready to pay a premium for access to reliable and fair financial services.
From a bank’s point of view MSEs are perceived as risky precisely because they operate less formally than corporate enterprises, but still require significant loan amounts. Typically, banks have difficulties assessing the creditworthiness of MSEs and either refrain from lending to them in the first place or they rely on very strict loan security requirements – which a large proportion of potential clients cannot meet.
The RSBF resolves these apparent contradictions by advocating an approach which focuses on eliminating the informational asymmetry between potential client and bank by "knowing your customer". Key components of this are a direct, on-going, close professional relationship between client and bank and an on-location analysis of the client’s actual situation.
Characteristics of the approach
Decentralisation: This approach precludes complete centralisation. Certain aspects of loan processing have to be decentralised to allow for the required data collection and to foster client relationships. While we advocate standardisation and centralisation wherever feasible, our approach involves operations not being fully centralised. It is one of our core principles that the credit analysts should visit clients in person to ascertain their actual situation and also to monitor them from time to time. This enables the required information to be collected and allows for an adequate risk assessment both before and after disbursement. Given the loan amounts in question for MSEs it is not usually cost-effective to have credit analysts from head office travel to clients for the on-location assessments. Instead we propose the establishment of credit analyst teams (departments) in strategic locations, which will be able to cover applications in their assigned regions.
Credit committees: Credit committees should physically meet to assess and decide each case. These credit committees should be lean enough to keep transaction costs under control and should be convened in the same geographical area as the respective client relationship manager, credit analyst and client in order to be able to assess cases under local conditions and keep processing times short. The decision-making authority of such credit committees depends on a variety of factors, such as the experience of its members and the bank’s risk appetite. Amounts exceeding local limits should be subject to review and approval by higher level specialised MSE credit committees.
Separation of sales and risk: In line with Basel II, we recommend clearly separating the sales and credit analysis functions as well as a separation of front office and back office functions. In addition to defining the credit and risk assessment approach for MSEs, an effective business model requires significant investments in terms of making changes to the organisational structure, procedures, processes, IT infrastructure and personnel.
Mass-scale: For Russia, we encourage an approach that goes beyond just "cherry picking" and simply using a regular corporate banking approach but dipping a bit lower. We advocate broad coverage of the MSE market in terms of economic sectors and enterprise size. In this way the cherries can be picked along with other fruit in the MSE market. The “corporate approach” usually has unjust requirements regarding the MSE’s documentation, formality and collateral, and as a consequence few clients qualify for a loan. The critical mass needed to create a profit-generating portfolio can never be reached.
Streamlining the lending process: Responsible MSE lending requires a high degree of standardisation, functional division and streamlining to be effective. In order to ensure sound quality, risk management and cost-effective processing, the RSBF advocates streamlined and standardised loan processing procedures with clearly assigned functions and responsibilities.
Customer-orientation/client segmentation: Products should be tailored to clients’ needs. This includes segmenting MSEs and developing product packages for the different sub-segments in order to be in a position to cater to all the financial needs of a client. This means that the MSE business model should be suitable for different types of MSE client in order to achieve the business volumes needed to generate the income levels required to justify the investments. This also means that the target group should be large enough to leave room for further business development over time. In practice this will mean differentiating certain aspects of the business model for different segments of the MSE target group: a microenterprise with an annual turnover of US$ 200,000 and requiring a loan of US$ 20,000 should not be treated in the same way as a small enterprise with an annual turnover of US$ 2 million and requiring US$ 200,000. While the core business model used will be the same for all MSEs, the degree of detail in data collection, loan review (risk assessment) process and other aspects, for example, loan security requirements, can be adjusted to the different MSE sub-segments to allow for a simplified and standardised approach while paying heed to the costs and different types and degrees of risk involved.
Monitoring: Systematic monitoring of individual clients and regular portfolio screening are part of enhancing the bank’s relationship with its clients and improving risk management. Not only because an individual assessment of each client permits loans to be tailored to the borrower’s specific situation, but also because close professional relationships between financial institutions and clients enable early recognition of risks and allow them to work out mutually acceptable solutions to difficult situations. In the mid- to long-term, loyal clients constitute a core portfolio of relatively low-risk clients who generate steady income at relatively low cost, since maintaining existing client relationships is typically less cost-intensive than acquiring new clients.
Training: Intelligent client acquisition, recognition of unmet client needs and understanding the situation of any given client all require good expertise. Consequently, systematic personnel selection, training and staff development form a core part of the RSBF’s approach.
Overview of the main elements of the lending technology can be downloaded here.