Segmenting a market carefully in any line of business not only has implications for creating new opportunities but in managing risk. The key issue is that different segments carry different risks. The approach, therefore, to managing risks in each has to be very different.
Markets evolve over time ... paradigms shift. The behaviour of clients changes over time. It follows that market participants need to adapt and change too.
A close examination of the manner in which banks have been handling the SME and other segments throws up some interesting issues.
Banks divide the corporate lending market into segments based on the annual turnover of companies. The common segments in the UAE are: SMEs (annual sales between Dh30 million and Dh200 million); “emerging corporates” or “commercial banking” clients (sales of Dh200 million to Dh500 million); large corporates (Dh500 million plus); multinationals and government related enterprises (GRES).
Each of these segments is handled differently, differing on the quality of relationship managers involved, intensity of relationship and risk management, appetite for lending, pricing, flexibility of credit facility structures and so on. The segmentation is based on a simple premise — that size and risk are inversely proportional. And size and opportunity are directly proportional!
In other words, the bigger the company, the less risky it is as a borrower and that it presents greater avenues to banks to cross-sell different products and make more money. So, SMEs are considered the riskiest borrowers and GREs the least so.
How does it work then? If when a client is “on-boarded” by a bank, its turnover is say Dh100 million and grows to Dh300 million, it will automatically be moved up from SME to the next segment. Obviously moving into the MNC segment is unlikely and GRE impossible.
What does this all mean and why does it matter? Account classification matters enormously for three reasons, all of which seriously affect risks bank take; and the returns they make.
Firstly, pricing of credit facilities falls with increasing size, in general. The larger they are the safer they are, is the common belief — they therefore deserve cheaper credit. Secondly, banks are prepared to lend more merely because clients are bigger.
More leniency creeps in; norms are relaxed as are pricing and credit structures to accommodate size. There is more scope for manipulation of the system in the mid segments of risk and reward. It is in emerging corporates or commercial banking that the trouble starts. Lastly, the level of scrutiny, due diligence and watchfulness of clients by banks appears to reduce with the increasing size of borrowers.
There are other factors involved in how banks view risk. Risk rating models purport to spread the net as wide as possible to account for non-size related issues, but are fraught with loopholes. Too much reliance on rating models, too little on market analysis and basic due diligence have also contributed to poorer risk management.
Here and now, size matters. And far too much.
The takeaway of all this: the larger the company, the better the risk profile. Therefore, the more money it deserves at cheaper rates, the more flexible the banks can be regarding credit facility structures. And, lastly, the less closely they need to be watched and analysed.
This approach is now dated and fallacious. It has become clear that so many of the assumptions of yesteryear have changed and that both market segmentation policies and the analytical approaches to various segments need to change.
Firstly, a company’s size depends on the nature of its business — volume based involves large sales volumes as well. A commodity trader with four employees can turn over Dh500 million. Does that make him a better risk than a highly specialised advertising agency with blue chip-clients but turning over Dh25 million?
Second, and sadly, turnover can be fabricated, as has become far too commonplace. Owners create paper transactions to fabricate large and growing sales, to access more (and cheaper) bank credit. Size here matters as much that of a balloon does.
Thirdly, size does not result in better corporate governance, financial discipline, transparency and so on. There is no correlation, even if legally mandatory. Corporate governance, or the lack of it, has a huge bearing on the risks it poses to lenders.
Lastly, no correlation can possibly be made between size and integrity. Integrity or the age-old banker’s yardstick — “the willingness to pay” does not evolve with size. Size may eventually buy respectability inasmuch as a Mafioso goes “legit”, but a thug he still remains ...
It is painfully clear that if banks keep segmenting according to the size of their clients, they are bound to go wrong more often than before. Size is illusionary at times and, in any case, an overreliance on numbers and pure desk-based analyses for an emerging market such as the UAE is now outmoded.
Banks need to refine the size-based model and perhaps develop a “Maturity Index” to add more contemporary, relevant, outward looking and judgemental aspects to their models.
I am not suggesting something revolutionary. What I am suggesting is that banks should consider creating an index or a rating system that encompasses more to do with their customers than mere size.
The Maturity Index should, for example, rate the following: the extent of corporate governance in the firm; management depth and independence; quality of staff; financial discipline and transparency; quality of processes, checks and balances; business continuity processes and succession planning; and cross-sell opportunities. Current rating models do take some of these into account — the problem is that the system is not only imperfect, but also that banks do not use ratings to determine the segmentation of their portfolios.
The rating from this index combined with size could determine how segmentation is handled. Perhaps it is time to segment the market according to sophistication and maturity levels?
The writer is Managing Director of Vianta Advisors.