ROLAND BERGER STRATEGY CONSULTANTS CONTENT. Fresh thinking for decision makers

ROLAND BERGER STRATEGY CONSULTANTS CONTENT Fresh thinking for decision makers Fueling engines of growth Without access to financial markets, small businesses need banks to fuel their growth And banks need small businesses to succeed Banks will have to transform their business so that they can keep building a strong SME portfolio AUGUST 2012

BACKBONE OF THE EUROPEAN ECONOMY In 2010, there were almost 21 million SMEs in the EU. Altogether these SMEs provided more than two-thirds (87.5 million) of all employment opportunities in the private sector in EU-27. 99.8% 66.9% 58.4% ENTERPRISES EMPLOYMENT GROSS VALUE ADDED Number of enterprises, employment and gross value added in EU-27, by size class, 2010 (estimates) To tap this market we have identified four levers, which banks can activate in order to meet the needs of SME s while complying with the Basel III regulation: Tailor flow and cash management products Offer products that consume less capital and liquidity Develop new partnerships Adapt the "originate to distribute" banking model for SMEs

CONTENT SME lending Across Europe small businesses are the engine of desperately needed economic growth. In OECD countries, these businesses, which have less than 250 employees and EUR 50 million in turnover, account for between 60 percent and 70 percent of job creation and can account for up to 99 percent of a country s enterprises. In 2010 there were 20.8 million SMEs in the EU, 92% of which had fewer than 10 employees, compared with 43,000 large companies. But at the very time small business growth is most needed in Europe, their source of sustenance is being squeezed. That s because small businesses have become the collateral damage of Basel III banking regulations, which set new liquidity and leverage ratios. Even though lending rates to small businesses actually stayed steady during the global financial crisis, most European banks are now pulling back on SME lending. Through 2010 small business loans remained a stable share of overall business loans in many countries, but since then loans to small businesses are declining. Small businesses have noticed and have been reporting having an even tougher time getting financing. In March 2012 17 percent of SMEs reported that access to financing was their main barrier, according a biannual survey of firms by the European Central Bank. About 20 percent reported that they saw a deterioration in the supply of loans between October 2011 and March 2012 and 23 percent pointed to a lower willingness of banks to provide loans. However we believe this thinking by banks is short sighted. By rethinking their small business approach and tapping into the SME market, European banks will be able to thrive in this challenging new reality boosting growth instead of just fighting to stay alive. NEW REGULATIONS ARE FORCING BANKS TO ADAPT QUICKLY In coming years Basel III regulations mean that banks of all sizes will have to hold more capital and more liquidity on their books and will be able to only lend a lower ratio of their deposits, constraining their ability to finance small businesses in both the short and long term. That s partly because costs of complying with these new financial regulations will limit the availability of overall financing and increase the cost of that financing, which will pose enormous problems for smaller clients. While the rules officially go into effect in 2019, financial markets are pushing banks to already implement the regulations as early as 2013 giving financial institutions little breathing room to think about expansion. For some countries the new rules pose particular challenges. In France, for example, because savings is often held in the form of life insurance and not deposits, banks there will be severely handicapped under the new regulations because they have a weaker deposit base. TOPICS IN THE EUROPEAN BANKING LANDSCAPE BERGER STRATEGY CONSULTANTS CONTENT Fresh thinking for decision makers ROLAND Well-engineered regulation? Basel III may step up capital requirements But it also offers misdirected incentives and is an invitation to opt for capital arbitrage Banks have little incentive to advance their risk and liquidity management models WITH COMPLIMENTS Fi nancial Services CC The tough environment has meant that banks are focusing on large client business, generally seen as more attractive because they provide banks with large amount of liquidity and generate revenue across multiple business lines. But ignoring with the large number of SMEs will be disastrous for European banks because small businesses have higher growth perspectives, and can be very profitable, especially as competitors are shying away from the market.

ROLAND BERGER STRATEGY CONSULTANTS SMES ARE DEPENDANT ON BANKS FOR THEIR FINANCING Debt structure of SME in France (%, 2010) 9 bank debt short term + For banks to capitalize on this market, while dealing with ongoing turbulence, they will need to change their business models and adapt product offerings especially as plain vanilla longterm loans, which have been at the core of the relationship between banks and their SME clients, are becoming too expensive under Basel III. Indeed, in 2010 medium and long-term debt provided SMEs in France 66 percent of their debt needs, compared with 17 percent for large companies. Instead banks will have to pay closer attention to the particular needs of small entities. Like other major corporate clients, small businesses need both short-term loans to cover treasury needs and long-term loans to finance investments, but they also need specific cash management solutions and services to help develop their own businesses. 66 66% = 75 bank debt mid and long term Three-quarters of financing sources are bank debts TAILOR CASH MANAGEMENT PRODUCTS In the past bankers tailored cash management offers to large corporate customers, rarely extending this offer to small businesses. But now banks must also offer solutions truly tailored to SME client needs. Small businesses, like all companies, must manage their cash flows both locally and internationally. Banks can help SMEs even out cash flows by finding new ways to gather liquidity and using that excess liquidity to provide loans. For instance, we helped one innovative player structure the current accounts of its clients so that money which remained in the account longer was more richly rewarded providing an incentive for clients to keep cash in the account. We also helped this bank leverage its private banking unit by capturing deposits of top SME managers and executives, who often have their personal finances tied closely to their businesses. Source: Banque de France, Roland Berger analysis Finding such tailored banking solutions for SMEs requires banks to think more strategically about how to best serve client needs, no longer simply segmenting their sales focus based on size and assigning junior employees to smaller companies. Instead, recognizing the potential of the SME market and diverse needs of their clients, banks should consider segmenting customers based on financing needs, business complexity and organizational structure. At the most basic level, for example, the needs of retailers, which maintain positive free cash flows, are different from utilities, which need to make long-term investments. By understanding long and short-term liquidity needs of clients, managers can best optimize the mix between financing and cash management to better serve customers and boost profitability. SELL PRODUCTS THAT CONSUME LESS CAPITAL AND LIQUIDITY The new regulatory environment affects various products in differing ways forcing banks to analyze their portfolio of products to better understand their impact on capital and liquidity. For instance, the capital requirements are becoming higher on non-secured financing such as a straight loan, but much more limited on secured financing such as leasing or a guaranteed loan. As a result banks must adjust their product mixes so that they can most efficiently use their capital and preserve liquidity. Doing so is now essential to their ability to succeed in the coming years. For example in the past banks have traditionally used Treasury facilities, which are basically like overdraft accounts, to accommodate SMEs when they had negative cash flow.

CONTENT SME lending But as these products are now more expensive for banks, they must consider factoring and other types of "short term" financing to help smaller entities with short-term cash needs. For long-term financing, banks should consider leasing instead of non-secured medium term debt. These products have lower capital requirements or consume less liquidity making them ideal vehicles to build their SME business. Under Basel III capital requirements are halved for car or equipment leasing arrangements. Adjusting the product mix is not only about protecting bank balance sheets, but also growing them. That means banks must turn their attention to products that generate fees in addition to interest income to boost revenue without affecting capital and liquidity, such as advisory services, private banking services and insurance. While in the past banks did not bother to systematically sell such products to SME customers, they are useful for smaller companies and have the potential to boost bank bottom lines. Restructuring their business by offering products previously only sold to large companies to SMEs, requires that banks adapt their management and structures. SME relationship managers must be trained and incentivized to put more emphasis on these types of products, helping clients find the one that best meets both the SME and the bank's needs. We have, for example, helped a bank organize dedicated trainings for SME relationship managers. These sessions focus on how managers can increase their expertise on cash management, because clients need their relationship manager to be able to answer their first line of questions, and how to become a strategic partner for SME clients, who need advice in the current uncertain European environment. Commerzbank in Germany, for example, introduced a USB key to help small businesses manage transactions for multiple accounts flexibly and securely on different platforms. Banks must also restructure their organizations, reintegrating specialized financial services businesses such as leasing within their retail banking activity so that they can benefit from the liquidity of the customers they serve. Otherwise leasing businesses not backed by retail banking will have to find alternative, usually more expensive, sources of funding such as highly remunerated retail deposits, which will weigh heavily on their cost of funding and price competitiveness. DEVELOP NEW PARTNERSHIPS Even though partnerships are not traditionally within the DNA of the banking sector, successful banks should no longer be going it alone when it comes to small business financing. Instead they should think outside of the box looking towards new types of investors such as investment funds, or so called "grey financing" players, and public entities, who don t operate under the same restraints as banks, to co-finance offerings. The former are less regulated than banks and the latter seek to boost their funding of SME loans to support public policy goals. Leveraging these new investors and taking advantage of these dynamics, will put banks in the position to boost small business lending. TOUGH TIMES FOR FINANCING 17% of all SMEs in Europe reported that access to finan cing was their main barrier. 20% reported a deterioration in the supply of loans between October 2011 and March 2012. 23% of all SMEs pointed to a lower willingness of banks to pro vide loans. Source: European Central Bank A diverse range of private investors including private equity funds or business angel investors are also starting to get into the small business lending game, investing directly

ROLAND BERGER STRATEGY CONSULTANTS VARIOUS EUROPEAN BANKS CREATED DEDICATED FUNDS FOR SME FINANCING in Mio Euro 156 UNICREDIT 300 DEUTSCHE BANK 500 COMMERZBANK Source: Roland Berger Analysis into SMEs or into dedicated funds set up by banks allowing them to boost loans without coming under capital and liquidity restraints. Commerzbank in Germany, for example, worked with both the German owned development bank, Kfw, and a private bank, Hauch & Aufhaeuser, to set up a small business fund. The fund gave out loans ranging from EUR 10 million to EUR 30 million for a duration of 8 to 14 years to large SMEs that have a maximum of EUR 500 million in annual sales. On the public side, both the European Union and its Member States have decided to implement specific public/private programs to stimulate SME financing. Institutions such as Oseo in France, and Kfw in Germany exist on the national level, while the European Investment Bank, the European Investment Fund and the European Bank for Reconstruction and Development carry out international initiatives. Even though these programs exist at all levels from regional to European wide, they are not frequently used either by banks or SMEs themselves who simply are not accustomed to turning to the public sector for such efforts. The EIB, for example, offers a variety of loans and guarantees to support SME lending. They provide loans, up to EUR 50 million, to commercial banks at lower rates to support lending for small and medium size enterprises with less than 3,000 employees. In 2010 the EIB lent out EUR 10 billion for SME lending, either financing the full loan amount themselves or working with partner banks. In addition the EIB that year spent EUR 2.75 billion to support structured finance mechanisms for SMEs and EUR 6.3 billion for risk sharing financing. In 2010, 130,000 small businesses also benefitted from EUR 1.9 billion worth of EIB guarantees for banks that issue SME-backed securities, as well as direct guarantees for loans and microcredit portfolios. To best make use of these programs, banks should properly equip and support relationship managers so that they can utilize them where appropriate. For example one bank in Italy developed a specific simulation tool, which automatically identifies the type of subsidy that better fits its client's project, giving the relationship manager a leg up on competition without such knowledge and helping them to find a solution with the lowest capital and liquidity standards. In 2010 the bank generated EUR 4.1 billion in loans to small and medium sized businesses, an 18 percent increase over a year earlier. ADAPT THE ORIGINATE TO DISTRIBUTE BANKING MODEL FOR SMES Corporate and investment banks have long been active in bundling retail loans such as car loans or mortgages, or creating loan funds, then selling these securities to asset managers, pension funds, insurance companies or other investors. However investors rarely thought about buying securitized SME loans. In Europe SME securitizations still represent a small piece of the overall securitization market: in 2010 they were just 10 percent, or EUR 37 billion, of the total securitization market. There is a need to develop a market for such assets, with the support of the local regulator, and to find structures attractive to local investors.

CONTENT SME lending The investor appetite will, however, certainly evolve and make SME assets look more attractive to investors such as insurance firms. Indeed, under the Solvency II regulation, insurers will have to apply a capital charge on their assets. The capital charge against nonrated SME debt carries a relatively lower penalty when compared to other assets. Banks can take advantage of that new dynamic by developing an originate to distribute model for small business lending and partnering with insurance firms looking towards new asset classes to boost their returns. When insurers buy the security or sometimes the loans themselves, banks can move the SME loans off of their books, lowering their risk levels and the amount of capital and liquidity they have to hold. In France one enterprising bank, Societe Generale, teamed up with the insurer Axa to create a dedicated SME loan fund to be sold to selected insurers willing to finance SMEs. Societe Generale originates the small businesses loans, maintaining the prime client relationship. Meanwhile investors can choose to invest in the fund through either a loan structure or a bond structure. THE SME SECURITIZATION MARKET IN EUROPE REPRESENTS ONLY A MINOR SHARE OF TOTAL SECURITIZATION SME securitization Other securitizations 6% 10% 7% 10% CONCLUSION A European Commission Report estimates that the number of SMEs and their value is set to rise, producing jobs, innovation and valuable services. Already between 2002 and 2010 SMEs produced 85 percent of net new jobs in the EU. But under today s regulatory and economic climate, maintaining SME financing at current levels to spur that growth will be challenging. Banks must better manage risks while contending with sluggish growth forecasts. Despite challenges, however, the shifting situation of banking is providing ambitious banks with a unique opportunity to develop their position in the SME market. By adapting products and service offers, banks can capture more small businesses so that they can boost growth while contributing to economic growth. 2001 2006 2008 Source: CCIP, FEI, Roland Berger analysis 2010 This new reality means that banks must also fundamentally transform their organization to rethink how they do business. Banks must change how they interact with clients, no longer simply segmenting them by size. Instead they must better address client needs by segmenting and targeting them by activities and financing needs. Relationship managers cannot be content with acting as financiers, but they must also guide clients through these tricky times, growing into the role of a trusted advisor. Even the metrics of their evaluation needs to shift to reflect the new regulatory environment. Instead of being evaluated based on revenues made with SMEs, relationship managers must also be looked at for generating risk and liquidity adjusted profit. In other words they must also be measured based on capital and liquidity consumption, rather than simply revenues. This transformation to a new banking model to boost SME lending will require strong commitments from banks. But those who make these changes will be well rewarded by taking advantage of the opportunities that small businesses now afford. And in the end by catering to this dynamic sector, banks will be able to fuel engines of growth across the continent spurring a fresh recovery. IF YOU HAVE ANY QUESTIONS, PLEASE FEEL FREE TO CONTACT US: Cecile Andre, Partner cecile.andre@rolandberger.com Christophe Angoulvant, Partner christophe.angoulvant@rolandberger.com think:act CONTENT Editors: Dr. Martin C. Wittig, Charles-Edouard Bouée Overall responsibility: Dr. Torsten Oltmanns Project management: Dr. Katherine Nölling Design: Roland Berger Media Design Roland Berger Strategy Consultants GmbH Am Sandtorkai 41 20457 Hamburg +49 40 37631-4421 news@rolandberger.com www.think-act.com

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