At the Licensed Finance Company (LFC) and Specialised Leasing Company (SLC) Director’s Forum organised by the Central Bank of Sri Lanka, MTI Consulting (via CEO Hilmy Cader’s presentation) brought to light several key issues that require pre-emptive action before a complete post-consolidation stage is reached. One such key issue is the inadequacy of the existing finance sector business model and the need for a new reformed model based on both the structure of the industry and its dynamics, and the reasons for the existence and the success of LFCs and SLCs. A quick look at the performance of the finance company sector illustrates diminishing incremental growth over the last few years. Despite the strong growth in deposits, the year on year change in assets, borrowings and capital has been declining steadily since 2011.
Profitability wise, the finance sector has been plagued by a rapidly declining ROE (currently 7.4% compared to 28.8% in 2012) and a gradually declining ROA (currently 2% compared to 5.3% in 2012). Matters are further compounded by the sharp rise in non-performing accommodations (a current gross NPL ratio of 7.9% compared to 5% in 2012), which is a detriment to the success of the entire sector.
Reasons for SLC and LFC existence and success
Before establishing a new model for the post-consolidation period, it is first important for us to keep in mind the reasons for both the existence and the previous success of LFCs and SLCs over the years. Firstly and perhaps most importantly, is the limited access to bank funding. It is the bottom of the pyramid that is most attracted to finance company funding, due to their inadequate financial literacy and unwillingness to progress through a bank’s formality and documentation process – that perhaps contributes to their willingness to pay higher interest rates. It’s nothing new that LFCs and SLCs have possessed a greater ‘hunger’ for sales when compared to their banking alternatives. Banks have always been very comfortable warming up the chairs in their branches as business always came to them; however the success of finance companies has been driven by their willingness to go out and hunt for sales. Finance companies possess a greater degree of flexibility and fluidity in their conduct of the business, compared to banks. Of course, we must acknowledge that there’s another side to this point with regard to risk, governance and compliance. Furthermore there has been a significant automobile boom in Sri Lanka that has acted as one of the key drivers for finance companies as almost 90% of these vehicles require funding and leasing due to a consumer’s inability to purchase it outright. In addition to this, the last three or four years has seen a pawning rush – lead initially by banks and then followed up by finance companies.
The post-civil war era has seen euphoric borrowing and spending in great quantities that have once again been largely enabled by finance companies. However the probability that these amounts can be paid back and the question as to whether the increasing NPAs are an early sign of things to come is what we must keep in mind when moving forward. On a very positive note, there are finance companies that have run focused and successful micro-finance operations – going down to grassroot levels in order to benefit from this blue ocean and develop this market. Compared to banks that have not been as relatively successful as their counterparts, it’s easy to see that LFCs and SLCs have done it far better by developing a more efficient MFI model.
Will these reasons hold true in the post-consolidated period? In the future it’s likely that interest rates will fall leading to lower spreads, and that the access to banks would increase in great scale. Furthermore there are a lot of learnings we can get out of the Singaporean and especially the Malaysian experience, where finance companies have all but disappeared. Of all these reasons, it is of my opinion that three such reasons will prevail in the future. Namely the hunger for sales that banks will not be able to replicate, the flexibility and fluidity of finance companies, and the strength of their microfinance operations. The other reasons apply only to past success but may not be significant triggers for the future.
The framework of a new business model
We need to look at four key areas of a business model. Namely who the customer is and their needs, the value proposition finance companies will provide to satisfy their needs, how the value proposition will be taken to the market and finally to perform all of this, how the entire operation will be enabled.
The financial service market can be broken down into three segments – those dealing with banks, those dealing with finance companies and, those who rely on the informal or grey sector (which includes informal lending and trade integrated credit). Of course these three segments are not mutually exclusive and there would be a considerable overlap between most of them. Customer needs too can be broken down into three broad based categories of why they borrow or require funding – borrowing for lifestyle, borrowing for livelihood (which is more towards the bottom of the pyramid), and borrowing from an enterprise point of view. From a finance sector point of view, lending for lifestyle is perhaps the largest category compared to the other two, as we see far more consumption based loans provided compared to those provided for enriching standards of living and enabling enterprises.
So with a combination of both these segmental breakdowns, what should finance companies focus on? They must first take into account what banks will do in the future and where the strengths of the banks lie. Currently banks focus much of their energy on the lifestyle and enterprise market segments. However observing where banks have been opening branches, the types of products they are now offering and the desperation in their advertising, it is quite evident that they are trying to move downwards and cater to the type of consumers finance companies usually have. Similarly LFCs and SLCs have been, for the lifestyle segment, focusing on moving higher up and grabbing the customers banks usually get. We see that in the end, the lifestyle and enterprise segments are a red ocean – that is considering the competition within, the price cuts and the other activities which all manifests in the marketing and advertising. From a market point of view finance companies have done quite well in the livelihood segment and the lower end of the enterprise segment by increasing their penetration levels within (though higher penetration for them is still possible). Most importantly, the informal and grey market is still available and its consumers have limited access to finance and are currently paying exorbitant interest rates. For the economic needs of a country, it is this segment that needs to be empowered and provided finance in order to lift them out of stagnation. Thus this segment is a blue ocean.
LFCs and SLCs now have questions to answer. Will they continue fighting in the red ocean? Or will they begin wading into the blue ocean for the benefit of the country? Yet there still are challenges for finance companies to tap into this market. Following banks, finance companies tend to be too product-centric – developing a product first and then looking for consumers – as opposed to being more need-centric and developing new solutions in relation to needs. Furthermore the aggressive sales techniques associated with finance companies cannot be applied to the segment at the bottom which requires a more developmental approach. The channel cost too is a challenge – the cost of accessing the market – as finance companies still prefer to use traditional branches instead of cost-effective third parties for a greater outreach, which ideally needs to be addressed before the bottom of the pyramid can be personally catered to.
By and large, the only reason finance companies get customers today is simply because they provide funding. Yet looking ahead, in terms of assets, what is required of finance companies particularly as they proceed down the socio-economic ladder is not just funding, but linking customers to either a supply chain or a demand chain and providing advisory services as well. Finance companies tend to follow the banking mentality of – “Our job is to provide the finance and their job is to run their business” – which direly needs to change. Similarly on the liabilities side, finance companies shouldn’t simply just provide a favourable interest rate but additionally provide savings planning services, linking customers to purchase benefits, access to products, preferential rates, etc. Managing this value proposition however goes beyond having basic product and brand managers towards employing economic segment managers who understand the nature and the complete value chain of industries their consumers, especially those at the bottom of the pyramid, are involved in. There needs to be greater and deeper consumer insights. As in the past five years, finance companies have been far too involved in their sales push rather than identifying their consumer needs. In order to do so they should look outside the industry, analyse how other industries identify their customer needs and then find out how these learnings can apply to them. This value proposition further involves understanding the entire end-to-end value chain and building research and development labs that focus on new product development.
In the past three years, finance companies have almost doubled the number of their branches. Yet is this based on a rational need? After all, the entire cost incurred is fixed and in some case, completely irreversible and has been entirely possible due to the healthy margins of finance companies and in most cases their corporate ego to outdo each other’s rapid expansions. Yet there does not seem to be any consumer relevance with regard to this. To move forward a more scientific approach for channel management is required – econometric analysis in terms of transaction cost, transaction time and delivery time in making channel decisions.
LFCs and SLCs must look outside the industry and not look at their banking counterparts. Perhaps this rapid expansion is because of their constant learnings derived from the banking industry. Looking outside the industry, finance companies have a lot to learn from the consumer goods industry where several companies reach 75,000 to 80,000 outlets every week or fortnight – delivering the products and collecting the payment – without a single branch outside of their head office. Furthermore unlike finance companies where a majority of the employees are situated in the branch network, these consumer goods companies have only one-tenth of the sales force finance companies possess.
There are several challenges in enabling these operations. Headcounts have ballooned in finance companies and in many cases these are fixed costs. In some cases, the HR cost alone, excluding administration, is 40% of the net interest earned. Reversing these issues will prove to be quite a challenge to move towards a post-consolidation era. Furthermore a lot of organisation structures and systems are quite stretched, as higher growth rates led to less focus on controlling the structure, systems and processes of the finance company. Though the going may be good at the moment, it would take a couple of years to understand its effects. The danger also lies with the solution to these issues – finance companies often resort to quick fix solutions that are far less effective than those that tackle the fundamentals of the problem.
If LFCs and SLCs are to cater to the bottom of the pyramid, they must implement a ‘high touch’ approach compared to a more formalised banking approach which would then require relevant and significant investments in technology rather than the expansion of a traditional branch network. Finance companies need to rethink their need for a Colombo HQ based model if they are to tap into the lower socio-economic population.
Cross industry learnings
I will conclude with a few case studies LFCs and SLCs can learn from. e-Choupal in India provides illiterate farmers in rural areas with access to the internet so that they can directly negotiate the sale of their produce with ITC Ltd. Dhainik Bhaskar, a newspaper in India used an entire force of undergraduates and graduates to rapidly get their distribution off the ground and thus became the market leader on the first day of publication. If anything, it is high time for finance companies to look outside their industry and identify the key learnings that they can augment and apply to themselves – if they are to cater to the other segments of the market in the post-consolidated era.