Fuelling the Indian entrepreneur – Opportunities in SMEBancon 2010 Panel Discussion

December 3rd, 2010

CONFIDENTIAL AND PROPRIETARYAny use of this material without specific permission of McKinsey & Company is strictly prohibited

Presentation by Ramnath Balasubramanian, McKinsey & Co

McKinsey & Company 2 |

India has more than 8 million SMEs contributing significantly to the country’s GDP, exports and employment

Turnover cutoff

Rs. crore

>500

125-500

Micro SME <2

Small SME 2-10

Medium SME 10-125

Large corporates

Mid corporates

SME

Number of Companies

CAGR(no. of co.’s)

%

1,500

4,000 19

200,000 18

1,500,000 22

6,500,000 25

22

SOURCE: Prowess database; market interview; India Budget 2006-07; team analysis

▪ Contributes to ~39% of country’s manufacturing output

▪ Contributes to ~34% of exports and ~20% of imports

▪ Provides employment to ~68 mn people in rural and urban areas of country

SME sector in India

McKinsey & Company 3 |

SME banking revenue pool will grow at a CAGR of 16% over the next five years with growth being uniform amongst various products

ESTIMATES

SOURCE: RBI data; Prowess data; market interviews; McKinsey analysis

SME revenue pool

INR '000s crore

Mix of SME revenue pool

INR '000s crore, percent

75

65

32

2015E2015EFY 2009

16%

58 55

23 23

10 10

6 10

32

31

Lending

Trade finance

Deposits

FY 15

100%

65-75Investment banking

CMS

FX and rates

3 1

FY 09

McKinsey & Company 4 |

Over 70% of SME advances revenue is concentrated in the top 15 cities and 9 industries

SME advances revenues

1 Whole Sale Traders

2 Textiles

3 IT and professional services

4 Retail traders

5 Metal works

6 Food processing

7 Real estate

8 Transport and logistics

9 Auto and Auto ancillary

Percent

SME advances revenues

Percent 1 Mumbai

2 Delhi

3 Chennai

4 Kolkata

5 Bangalore

6 Hyderabad

Top 9 sectors

Remaining

sectors

70

30

7 Ahmedabad

8 Coimbatore

9 Pune

10 Chandigarh

11 Ludhiana

12 Jaipur

13 Vadodara

25 Cluster

cities

Remaining

cities

75

11

14

Top 15

cities

14 Ernakulam

15 Surat

SOURCE: RBI; McKinsey analysis

ESTIMATES

McKinsey & Company 5 |

Risk-adjusted ROA for high performing SME Bank

SME is a relatively profitable segment, but returns could vary based on operating model and ability to manage risks

5.0

4.02.74.6

1.71.02.7

Risk-adjusted ROA

OpexFeeIncome

DepositNII

RiskadjustedNII

Risk cost

Lending NII

Percent of average advances

SOURCE: Central bank data; expert interview; 2008 Asia Pacific SME Banking Report

ESTIMATES

0.5

4.00.92.7

0.91.82.7

Risk-adjusted ROA

OpexFeeIncome

DepositNII

RiskadjustedNII

Risk cost

Lending NII

Risk-adjusted ROA for under-performing SME segment

▪ Ability to manage risk (loan losses)

▪ Cross sell deposit and fee income-related products to SMEs

▪ Manage operating costs of serving SME segment

Three key drivers of profitability of SME segment

McKinsey & Company 6 |

SMEs’ financial needs can be broadly classified into three categoriesT

rad

itio

na

lly

se

rve

dR

are

ly s

erv

ed

+

–

“Enablingday to daybusiness”

Conducting daily transactions

Managing and investing high cash flow

“Creating flexibility and acquiringassets”

Managing and financingworking capital

Acquiring and maintaining assets

“Serving stakeholders’ financial needs”

SME owner and shareholders

SME employees and management

SME suppliers and/or customers

“Supportingstrategicgrowth”

Starting the business

Changing the business

“Managing business-related risks”

Single “isolated” risks

Multiparty and complex risks

Lifespan of assets and liabilities

Lifecycle-based long-term financing needs

Complexity of risk protection

Complexity of cash management needs

Core financial needs

Stake-holders related needs

Life-cycle related needs

1

2

3

SOURCE: McKinsey

McKinsey & Company 7 |

SMEs are extremely loyal to their primary bank with ~70% of SMEs have banking relationships of more than 6 years

Top 15 cities Cluster cities

Tenure of relationship with lending bank (percent)

SOURCE: McKinsey SME survey

6%

23%

19%

52%

Upto 2 years

3-5 years

6-9 years

10 or more years

Similar trend observed for transacting bank as well

7%

24%

11%

58%

McKinsey & Company 8 |

There are 7 key elements of a successful SME business

SOURCE: McKinsey

Appropriate customer segmentation and value proposition to ensure different types of SMEs are served according to their needs

Business model choice– in terms of traditional lending based vs. liability led vs. technology led (e.g., supply chain financing)

Servicing model to ensure rapid turn-around times at low cost to serve (e.g., internet, loan factories)

Relationship management and branch architecture to cover and provide specialised services to SME

SME-specific risk rating tools in a relatively data-scarce environment using qualitative credit assessment based techniques

Suitable operating architecture in terms of centralisations vs decentralisation of mid and back-office functions

Putting in place the appropriate organisation construct and business performance management system to ensure the right focus on the segment

1

2

3

4

5

6

7

McKinsey & Company 9 |

Value proposition: Bundled offers can help drive cross-selling

Deposit and cash flow packages

Volume correlated products

Sector specific offers ¹ ¹

1 Limited number of sector specific offers available including non-profit, agricultural and professional services

SOURCE: McKinsey; mystery shopping; company websites

Combination of business account and/or personal account in one single package (or two business or personal banking products tied-up) with a fee discount

Interests/loan size relationship benefits on business/individual account, e.g.,

▪ Business offset services reduce amount of interest on business loan based on balance in personal deposit account

▪ Loan size determined based on deposit balances with bank

Combination of business and individual oriented products that are tailored to a specific sector (e.g., doctors, lawyers)

Description Examples

1. Segmentation and value proposition

McKinsey & Company 10 |

Business model choice : Supply chain based approach

CLIENT EXAMPLE

Example of channel financing strategy deployed by a successful bank

▪Needs-based segmentation,focus on SME within large corporate’s supply chain

▪Performance managementand incentive system driving cross-unit collaboration

▪Use of proprietary scoring model and client profitabilityin credit assessment and pricing

▪Streamlined, seamlessIT-platform across segments and products, leveraging full transaction information

Traditional

Supply chain

SOURCE: “Serving Asian SMEs” KIP team, 2008; expert interviews

Impact achieved

Basis points, indexed

Profitability of supply chain lending vs. traditional lending

100

800Risk adjusted revenues

Cross-sell opportunities on supply chain finance

Basis points, indexed

Risk adjusted lending revenue

Cash management cross-sales

FX cross-sales

Total revenues

Trade services cross-sales

100

~65

~75

~55

~300

2. Business model

McKinsey & Company 11 |

Business model choice : Integrating business and personal wealth needs of SMEs

ASIAN CLIENT EXAMPLE

Example of integrated business and personal relationship approach

SOURCE: “Serving Asian SMEs” KIP team, 2008; expert interviews

▪ Identified overlap and cross-sales potential for both wealth mana-gement and SME banking

▪ Developed of SME owner specific wealth management offering based on insights from SME interaction behavior

▪ Refined organization model with aligned performance management and incentives to further cross-unit collaboration

▪ Installed referral system and eventual collaboration model to facilitate cross-unit sales

Impact achieved

Additional profits from cross sale of SME banking products to wealth management SME customers

Indexed

Additional profits from increased WM penetration of SME and wallet share of SME owner’s WM

Indexed

Net interest income

Net fee income

Operation cost

Risk cost

Profit

Current profit from SME owner’s WM

2. Business model

~210~110

~65

~145

~75

~245

~100

~365~265

~110

~180

~195

~100

Increased WM penetration of SME

Operation cost

Profit

Current profit from SME owner’s WM

Increased wallet share of SME owner’s WM

McKinsey & Company 12 |

Effective mitigation of risk in SMEs will need a combined quantitative and qualitative credit assessment approach

SOURCE: McKinsey Risk Management Practice

Quantitative rating (statistical score)

▪ Statistical techniques

– Logistic regression

– CHAID

– Neural networks

▪ Focus on quantitative or quantifiable data

– Financials

– Credit bureau information

– Demographics (e.g., age)

– Account information (e.g., balance, monthly turnover)

Combined rating

▪ One overall rating and Probability of Default

▪ Method of combination chosen based on the relative performance of the two underlying ratings

Qualitative credit assessment

▪ Appraisal of the business

– Operating environment

– Cash flow forecasting

– Asset valuation

– Management, etc.

▪ Presented as a series of questions with pre-defined answer options (check boxes)

6. Risk management

McKinsey & Company 13 |

Predictive power (GINI) in points, sample cases

SOURCE: McKinsey Risk Management Practice

Quantitative model only

Quantitative model + separate QCA

A combination of quantitative and qualitative modelshas consistently yielded better results across markets

65

54

7572

35

75808281

52

North America

ChinaHong KongTaiwanIndia

The QCA (Qualitative Credit Assessment) adds unique insights to credit assessment

▪ Quantification of inherently qualitative factors such as management quality

▪ Validation of financials and other fraud indicators

▪ Flexible approach to limited data availability (e.g., by quantifying also degree of uncertainty around a data point)

6. Risk management

McKinsey & Company 14 |

In summary

SOURCE: McKinsey

SME is a large, fast growing and attractive opportunity for banks and financial institutions and a significant contributor to the economy

Needs of SMEs are evolving rapidly - financial institutions will need to look beyond core financial needs for this segment

The segment is very local and can be very profitable for banks – but managing profitability will require a very sound business model

Financial institutions will need to create a differentiated model to serve this segment and build excellence in one or more of seven dimensions

1

2

3

4

McKinsey & Company 15 |

Backup

McKinsey & Company 16 |

Proximity to branch and competitive prices appear as the top two buying factors

Key Buying Factors (KBFs)

Percentage of respondents stating in top 5 factors

KBFs – lending bank

Factor importanceFactors

KBFs – transacting bank

Factor importanceFactors

33

37

38

56

57

62

Level of documentation

Turnaround time

Trustworthiness of the bank

Brand name/reputation

Competitive prices

Proximity to branch

34

34

37

52

55

59

Level of documentation

Turnaround time

Trustworthiness of the bank

Brand name/reputation

Competitive prices

Proximity to branch

SOURCE: McKinsey SME survey