Fuelling the Indian entrepreneur – Opportunities in SME

1. Fuelling the Indian entrepreneur – Opportunities in SME Bancon 2010 Panel Discussion Presentation by Ramnath Balasubramanian, McKinsey & Co December 3rd, 2010 CONFIDENTIAL AND PROPRIETARY Any use of this material without specific permission of McKinsey & Company is strictly prohibited

2. SME sector in India • 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 India has more than 8 million SMEs contributing significantly to the country’s GDP, exports and employment • Number of • Companies • CAGR • (no. of co.’s) • Turnover cutoff • Rs. crore • % • 1,500 • 22 • Large corporates • >500 • Mid corporates • 4,000 • 19 • 125-500 • 18 • 200,000 • Medium SME 10-125 • SME • 22 • 1,500,000 • Small SME 2-10 • 6,500,000 • 25 • Micro SME <2 SOURCE: Prowess database; market interview; India Budget 2006-07; team analysis

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 Mix of SME revenue pool SME revenue pool INR '000s crore INR '000s crore, percent • 65-75 • Investment banking • 32 • 1 • 1 • 100% • 3 • 3 • CMS • FX and rates • Trade finance • 16% • Deposits • Lending • FY 2009 • 2015E • 2015E • FY 09 • FY 15 SOURCE: RBI data; Prowess data; market interviews; McKinsey analysis

4. 6 • 10 • 15 • 1 • 14 • 2 • 13 • 3 • 12 • 11 • 5 • 2 • 4 • 9 • 3 • 1 • 5 • 6 • 9 • 4 • 8 • 8 • 7 • 7 Over 70% of SME advances revenue is concentrated in the top 15 cities and 9 industries • ESTIMATES • SME advances revenues • SME advances revenues Percent Percent • Mumbai • Whole Sale Traders • Delhi • Remaining cities • Textiles • 14 • Chennai • Remaining sectors • 30 • Kolkata • 25 Cluster cities • IT and professional services • 11 • Bangalore • Hyderabad • Retail traders • Ahmedabad • Metal works • Coimbatore • Pune • Food processing • Top 15 cities • Top 9 • sectors • 75 • Chandigarh • 70 • Real estate • Ludhiana • Jaipur • Transport and logistics • Vadodara • Ernakulam • Auto and Auto ancillary • Surat SOURCE: RBI; McKinsey analysis

5. SME is a relatively profitable segment, but returns could vary based on operating model and ability to manage risks • ESTIMATES Percent of average advances Risk-adjusted ROA for high performing SME Bank • Three key drivers of profitability of 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 • Lending • NII • Risk cost • RiskadjustedNII • Deposit • NII • Fee • Income • Opex • Risk-adjusted ROA Risk-adjusted ROA for under-performing SME segment • Lending • NII • Risk cost • RiskadjustedNII • Deposit • NII • Fee • Income • Opex • Risk-adjusted ROA SOURCE: Central bank data; expert interview; 2008 Asia Pacific SME Banking Report

6. SMEs’ financial needs can be broadly classified into three categories + • Complexity of cash management needs • “Enabling • day to day • business” Conducting daily transactions Managing and investing high cash flow • “Creating flexibility and acquiringassets” • Lifespan of assets and liabilities • Traditionally served • Core • financial • needs • 1 Managing and financing working capital Acquiring and maintaining assets • Complexity of risk protection • “Managing business-related risks” Single “isolated” risks Multiparty and complex risks • Stake-holders related • needs SME owner and shareholders • “Serving stakeholders’ financial needs” • 2 SME employees and management SME suppliers and/or customers • Rarely served • Lifecycle-based long-term financing needs • Life-cycle related • needs • “Supporting • strategic • growth” • 3 Starting the business Changing the business – SOURCE: McKinsey

7. % SMEs are extremely loyal to their primary bank with ~70% of SMEs have banking relationships of more than 6 years • Tenure of relationship with lending bank (percent) • Top 15 cities • Cluster cities • 10 or more years • 6-9 years • 3-5 years • Upto 2 years • Similar trend observed for transacting bank as well SOURCE: McKinsey SME survey

8. There are 7 key elements of a successful SME business • 1 • Appropriate customer segmentationand value proposition to ensure different types of SMEs are served according to their needs • 2 • Business modelchoice– in terms of traditional lending based vs. liability led vs. technology led (e.g., supply chain financing) • 3 • Servicing model to ensure rapid turn-around times at low cost to serve (e.g., internet, loan factories) • 4 • Relationship management and branch architecture to cover and provide specialised services to SME • 5 • SME-specific risk rating tools in a relatively data-scarce environment using qualitative credit assessment based techniques • 6 • Suitable operating architecture in terms of centralisations vs decentralisation of mid and back-office functions • 7 • Putting in place the appropriate organisation construct and business performance management system to ensure the right focus on the segment SOURCE: McKinsey

9. Deposit and cash flow packages • Volume correlated products • Sector specific offers ¹ • 1. Segmentation and value proposition Value proposition: Bundled offers can help drive cross-selling • Description • Examples • 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 businessand individualoriented products that are tailored to a specific sector(e.g., doctors, lawyers) ¹ 1 Limited number of sector specific offers available including non-profit, agricultural and professional services SOURCE: McKinsey; mystery shopping; company websites

10. 100 Traditional 800 Supply chain 100 ~65 ~75 ~55 ~300 • 2. Business model Business model choice : Supply chain based approach • CLIENT EXAMPLE • Example of channel financing strategy deployed by a successful bank • Impact achieved Profitability of supply chain lending vs. traditional lending • 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 Basis points, indexed Risk adjusted revenues Cross-sell opportunities on supply chain finance Basis points, indexed Risk adjusted lending revenue Trade services cross-sales Cash management cross-sales FX cross-sales Total revenues SOURCE: “Serving Asian SMEs” KIP team, 2008; expert interviews

11. 5 • Impact achieved • 2. Business model Business model choice : Integrating business and personal wealth needs of SMEs • ASIAN CLIENT EXAMPLE • Example of integrated business and personal relationship approach Additional profits from cross sale of SME banking products to wealth management SME customers Indexed • 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 • ~100 Current profit from SME owner’s WM • ~245 Net interest income • ~75 Net fee income Operation cost • ~145 Risk cost • ~65 Profit • ~110 • ~210 Additional profits from increased WM penetration of SME and wallet share of SME owner’s WM Indexed • ~100 Current profit from SME owner’s WM • ~195 Increased wallet share of SME owner’s WM • ~180 Increased WM penetration of SME Operation cost • ~110 Profit • ~265 • ~365 SOURCE: “Serving Asian SMEs” KIP team, 2008; expert interviews

12. Quantitative rating • (statistical score) • Qualitative credit • assessment • Combined rating • 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) • One overall rating and Probability of Default • Method of combination chosen based on the relative performance of the two underlying ratings • 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 Effective mitigation of risk in SMEs will need a combined quantitative and qualitative credit assessment approach SOURCE: McKinsey Risk Management Practice

13. 6. Risk management A combination of quantitative and qualitative modelshas consistently yielded better results across markets • Quantitative model only • Quantitative model + separate QCA Predictive power (GINI) in points, sample cases • 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) • India • Taiwan • Hong Kong • China • North America SOURCE: McKinsey Risk Management Practice

14. In summary • 1 • SME is a large, fast growing and attractive opportunity for banks and financial institutions and a significant contributor to the economy • 2 • Needs of SMEs are evolving rapidly - financial institutions will need to look beyond core financial needs for this segment • 3 • The segment is very local and can be very profitable for banks – but managing profitability will require a very sound business model • 4 • Financial institutions will need to create a differentiated model to serve this segment and build excellence in one or more of seven dimensions SOURCE: McKinsey

15. Backup

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 • KBFs – transacting bank • Factors • Factor importance • Factors • Factor importance • Proximity to branch • Proximity to branch • Competitive prices • Competitive prices • Brand name/reputation • Brand name/reputation • Trustworthiness of • the bank • Trustworthiness of • the bank • Turnaround time • Turnaround time • Level of documentation • Level of documentation SOURCE: McKinsey SME survey