The MSME lending market is helping close the credit gap for small businesses in the world in 2022
Demonetisation and legislative measures like GST, which escalated compliance costs that small enterprises found difficult to bear, have wreaked havoc on MSME in recent years. The epidemic of the previous two years and the current rising inflation have further added to their financial and operational difficulties.
According to the MSME Ministry, there are 63.3 million MSMEs in the country. These businesses account for around 30% of the country’s nominal GDP and 48% of its exports. However, the great majority of them do not have appropriate official credit. As a result, small firms face a shortage of cash flow for working capital and capital investment due to a time gap between receiving payments from clients and the absence of necessary papers and collateral required for traditional forms of lending.
Obstacles and dangers
Even though the Centre announced several fiscal efforts to help MSMEs, such as the ECLGS (Emergency Credit Line Guarantee Scheme), only about 10 million small businesses have been able to use these loans. Worse, most small business owners are unaware of these loans, making it difficult to obtain financing. As a result, formal credit is only used to meet around 40% of the segment’s credit needs.
As a result, India’s MSME credit gap has been estimated to be as high as Rs 30 lakh crore, offering lenders a considerable opportunity. The RBI-appointed Expert Committee on MSMEs cited three causes for the big credit gap in its 2019 report. The first was the significant risk to lenders if MSMEs couldn’t or wouldn’t pay. The second factor was the high expense of supplying such tiny enterprises owing to a lack of information and collateral. The lack of lenders in semi-urban and rural regions was the third factor.
Given the importance of micro and small companies in driving national economic growth, a cooperation approach amongst new-age digital lenders might aid the country’s inclusive development aim. Micro and small businesses can benefit from digital financing by bridging the credit gap and accessing traditional loans. Furthermore, digital lenders’ specialized knowledge combined with last-mile connectivity assures low loan costs and returns for all stakeholders.
Model of co-lending
In this context, a symbiotic partnership between digital NBFCs and banks might assist small companies by meeting the credit needs of unserved or underserved MSMEs through the co-lending model (CLM). CLM permits traditional banks and registered NBFCs to work together to make loans jointly sponsored by both companies and disbursed in a 20:80 ratio, with banks contributing the more significant portion.
CLM is a win-win situation for all parties involved. While fintech businesses and digital NBFCs provide last-mile connections, allowing banks to scale out without incurring the high costs of opening physical locations, banks have strong balance sheets. They can give money at a lower price, making lending more accessible. Fintech businesses’ digital skills and improved understanding of underwriting and collections for these sectors boost operational efficiency while decreasing the cost of obtaining small-ticket consumers, allowing for lower interest rates on funds.
Fintech businesses provide last-mile connectivity for MSMEs while customizing creditworthiness assessments based on their digital lending methodology. Data from numerous sources is aggregated via analysis using AI (artificial intelligence), ML (machine learning), and other technologies with continually growing algorithms and a comprehensive grasp of each speciality market. Fintechs may provide risk-based interest rates with the use of AI-enabled technologies.
Furthermore, because their operations are digital and automated, digital NBFCs benefit from an omnichannel presence (online and offline) and fast processing. This guarantees that financing services are easily accessible and that processing times are shortened. Borrowers can, for example, apply for loans via a mobile app from the comfort of their own home or workplace and have them authorized in hours to days. Digital techniques can also be used to resolve post-disbursement difficulties and inquiries quickly.
Fintech companies may lack the substantial balance sheets needed to serve millions of borrowers. Banks, on the other hand, have strong balance sheets, but because of a lack of data, they cannot underwrite MSMEs. Such limitations can be circumvented by forming collaborations between fintech players/new-age digital lenders and established banks.
Furthermore, because many small and micro businesses struggle to offer appropriate security, CLM uses cash flow-based lending to extend loans. Due diligence is performed by analyzing structured and unstructured data for improved risk assessment, thanks to the benefits of cooperation between legacy and new-age lenders. Micro and small enterprises may get funding more cost-effectively and quickly; as a result, boosting nation-building efforts through increased job creation and inclusion.
How FinTech can help small businesses fill the credit gap
MSME (Micro, Small, and Medium Enterprises) sectors quickly establish themselves as a vital part of India’s economy, contributing significantly to the nation’s development.
“MSME has emerged as the economy’s development engine, with a large network of roughly 6.33 crore firms contributing 30% of our nominal GDP and 48% of exports,” said RBI Governor Shaktikanta Das, speaking at the Bombay Chamber of Commerce and Industry’s 185th Foundation Day Celebration last week. “As digital capabilities increase and connection becomes more ubiquitous, technical innovation and a technology-driven revolution are set to rapidly and fundamentally transform India’s economy,” he added.
“This might lead to more financial inclusion, less information asymmetry, and lower credit risk in the financial sector,” Das added. The pandemic-induced crisis has heavily struck the MSME sector worldwide; nevertheless, despite established growth records, the industry was underserved due to a lack of timely finance availability even before the problem. Credit is like blood to every business; it must function correctly.
Similarly, having access to finance promotes economic growth. More significantly, loan availability for MSMEs promotes social and financial inclusion and dignity for people who work in them. The MSME credit gap is estimated to be over $240 billion (Rs 17 lakh crore).
Why are FinTechs so popular?
Given the existing circumstances, the critical question is: how will FinTechs meet the credit needs of India’s SMEs? To address this issue, consider what banks and digital NBFCs have to offer when it comes to meeting MSMEs’ loan needs:
- The cost of obtaining and retaining a consumer
Digital NBFCs may attract consumers at a considerably cheaper cost because of technology-enabled processes and algorithms. The quickness and agility with which companies may form partnerships with internet markets help them cut expenses even further. On the other hand, banks have higher acquisition costs since their branch-led business still depends heavily on physical presence and requires more Opex.
- Customizations of products
Digital NBFCs can give more product customizations with greater flexibility tailored to the borrowers’ demands thanks to alternate data obtained from social media and solid technical connections with digital partners. While incumbents are not dormant and are investing in technology, transitioning from old and legacy underwriting and credit-delivery methods will take time. The process flow and accompanying retraining of their existing workforce, as well as the culture of rapid service that FinTechs are establishing, will be the more challenging adjustment (without any past baggage).
- Accessibility and processing speed
Adopting technical tools and systems to implement digital NBFCS include omnichannel presence and quick processing times. A borrower may apply from the comfort of their home via Whatsapp, Facebook, or a mobile application and receive an approval within a few hours. With the ease of employing digital media, even post-disbursal client service is possible.
Banks, with their vast balance sheets, are capable of serving millions of consumers. Traditional underwriting techniques, however, hinder them from adequately underwriting SME groups. FinTechs or Digital NBFCs, on the other hand, have a high cost of a capital disadvantage since they lack huge cash buffers (unless they utilize their equity capital to lend). This puts a stumbling block in their way of offering lower-cost services to MSMEs. This is also a result of our economy’s sluggish debt markets.
Although digital lenders do not have big balance sheets or capital reserves, they are at the forefront of using technology to expand their reach at a cheaper acquisition cost. FinTechs have recently attracted significant amounts of equity financing as they develop cutting-edge credit-decision capabilities to serve customers better. Lack of collateral has always been a problem for small company owners, as we’ve seen in the past, and here is where internet lenders saw an opportunity to serve an underserved market.
Can banks and fintech work together?
Because banks and digital NBFCs have distinct capabilities, combining them to serve customers better is more accessible.
The Co-Lending Model (CLM) was introduced to allow banks and registered NBFCs to co-lend to offer loans. In a co-lending model, the digital NBFC is tasked with finding loans jointly underwritten and distributed in a 20:80 ratio, with banks retaining the majority of the loans. Banks and their balance sheets can supply capital at a rate that makes loans accessible. At the same time, FinTechs and digital NBFCs aid with better last-mile connectivity and can enable banks to expand without incurring significant expenditures on physical branches.
As a result, rather than being an “either-or” issue, a symbiotic partnership between banks and digital NBFCs may lead to a win-win situation for everyone. And the critical goal should be “customer focus” to help MSMEs achieve financial inclusion and improved loan availability. That is where our chances for rapid economic growth and social inclusion lie.
Before we can address the MSME credit gap, we must first investigate it.
Significant progress has been achieved in granting credit to micro, small, and medium companies (MSMEs) during the previous decade, but work is still to be done. It is a complex problem to address on a global scale. Given the importance of MSMEs to India’s economy, we cannot afford to wait indefinitely to fix the problem.
It’s been over two decades in the making, with everything from credit default swaps to interest derivatives tossed in to make it happen, but with only little results. To prevent MSME financing from following in the footsteps of our CBM, efforts must be focused on addressing well-defined issues. Force-fitting accessible solutions to misunderstood problems like a “hammer hunting for a nail” approach will not work. Let us first measure and comprehend the MSME-funding situation to avoid misallocating stakeholders’ resources.
According to the MSME Ministry, credit availability is better than most people think: India has 63.3 million MSMEs. Firms with revenues of more than 250 crores make up the upper echelon. Single-person businesses like grocers may be found on the lower end. In contrast, everything in between, from commercial vehicle owners to village craftspeople, can be found on the upper back. According to popular narratives, only 6-10 million MSMEs have authorized access to finance. However, there is reason to believe that this figure is low. There are three sorts of debtors with credit bureau records.
To begin with, commercial borrowers get loans from legal organizations (proprietorships, partnerships, and private firms). Second, customers who take out personal loans. Borrowers from microfinance institutions are the third group. There are 9 million distinct commercial debtors, according to TransUnion Cibil data.
- Furthermore, commercial vehicle and company loans are anticipated to be held by 14-16 million people. These appear to be micro, small, and medium-sized businesses. There are 58.3 million unique micro-finance borrowers, according to MFIN. According to industry analysts, at least 25% of them are MSMEs. As a result, 34-36 million MSMEs already have official credit.
- The formalization of MSMEs’ balance sheets would be a primary driver of credit development among MSMEs with credit access. Many MSMEs borrow from informal sources for their ‘cash’ transactions in addition to bank loans. Goods-and-services-tax data systems only collect transactions in formal accounts. MSME demand for traditional credit might increase by 30-50 per cent (i.e., by $8-15 trillion) due to increased formalization, albeit this will be driven mainly by regulatory pressure and borrowers’ desire to take out traditional loans.
- The long tail of MSME credit demand comprises India’s 27-29 million MSMEs without access to formal finance. At most, such borrowers will have the debt capacity of a typical microfinance borrower, around 30,000 dollars. This amounts to a credit demand of fewer than one trillion dollars. Remember that borrower intent is a critical factor in narrowing the projected $8-15 trillion credit gap.
- NTC MSMEs (new-to-credit): Longer loan approval times, rather than outright refusal, are the issue they’re dealing with. India adds 0.6-0.8 million NTC commercial borrowers per year, according to data issued by TransUnion Cibil. An estimated 20–25 per cent of NTC consumers receive credit for goods like business loans, which are often unsecured, based on their tax returns and bank data.
- To underwrite loans, large lenders and certain fintech companies with established techno-analytical capabilities will use this data in addition to alternative data. Field investigations are a crucial component when lenders have to take fraud and credit risk into account. The lender’s expertise determines how well it can offer loans to new clients.
- While some need to refocus and readjust, others need to reinvigorate their focus: Modern lenders are using available credit and know-your-customer data to streamline the financing process for MSMEs.
Although the infrastructure for credit data now in place may undoubtedly be improved, it is not a limitation in and of itself. However, the selection of MSME credit packages must be increased. For instance, they often cannot access loan products with terms of less than three to six months.
MSMEs require more diverse loan choices. Additionally, lending collateral is frequently lacking for small enterprises. Renowned Indian non-banking finance businesses have done successful unsecured business financing. However, further regulatory inducement would be needed for banks to switch collectively to unsecured business lending.
For the 27–29 million MSMEs who don’t already have access to loans, public-private partnerships (PPPs) may be necessary. We could attempt the next. Digitalization may increase operational efficiency by lowering the acquisition cost of small-ticket borrowers and offering them reduced interest rates.
Microlenders may be well-positioned to service the MSME sector, but for efficiency to take effect, they need to use cutting-edge technology to enhance their analytical capabilities. Perhaps a PPP model that offers loans to underserved MSMEs using a standard “credit stack” outfitted with advanced artificial intelligence can be developed. We require much more than simply a super-app to give tail-end MSMEs access to loans.
Why NBFCs are still crucial for bridging the MSME credit gap
It is commonly known that over the past several decades, India’s MSME sector has become the backbone of the country’s economic system. It has also not gone ignored that there is a stark disparity between MSMEs who need financing and those who get it. By extending the accessibility of financial services and boosting the resilience of MSMEs, NBFCs have emerged as a crucial component of the system for bridging this gap.
NBFCs are gradually making inroads into the Indian financial sector. They overtake banks as the most significant money recipients on a net basis. A sign of the importance of NBFCs as loan providers in India’s financial system should be the double-digit credit growth they achieved when banks saw credit drop due to asset quality concerns. NBFCs have maintained a constant market share of 13 per cent in the MSME lending sector (as of 2020). Due to their improved capacity to reach remote locations, speedier decision-making, rapid service delivery, and experience in specialized markets, NBFCs are becoming more and more desired by borrowers.
More than 40% of MSMEs do not have access to traditional sources of financing, according to the World Bank’s program evaluation document for the Raising and Accelerating MSME Performance (RAMP) initiative.
A considerable proportion of MSMEs is excluded from the typical loan environment because they lack effective accounting systems, current financials, and proper documentation. Thin-file consumers frequently need more assistance and hand-holding from the standpoint of larger lenders. Serving these markets is not financially feasible due to the reduced ticket size and geographic dispersion of such MSMEs.
Serving the 60 million MSMEs in India that lack access to institutional financing is crucial if the country is to advance with confidence. As in their case, digitally-led NBFCs are still essential to this aim. Lending models like the cash flow-based model are being used to increase credit availability.
As a result, these NBFCs become the preferred lenders for potential borrowers who have the resources but are turned down based on the established credit scoring method. Partnership arrangements between NBFCs and larger banks, which have lower capital and more robust risk management procedures, are evolving due to the distribution power and superior client underwriting of the former.
Digital lenders that have created effective and scalable outreach to credit-starved MSMEs have further improved access to credit. These digital lenders’ data-driven credit algorithms enable improved risk calibration. This is seen by the lenders’ improved credit performance following the stress caused by Covid.
Digital SME financing and online NBFCs: A crucial step toward universal credit availability
Online NBFCs are advancing this goal of reach and access through tech-enabled solutions. They have expanded the possibilities for credit and made it accessible to underserved clients in various sections of the nation. Digital lenders are more suited to facilitating access to credit for MSME borrowers thanks to the use of alternative data sets, creative methods to credit screening, and the provision of customized solutions with a quick turnaround time. Through various strategies, they are exhibiting new confidence in lending to small firms.
Ecosystem-based financing is one such method. MSMEs in tier 3 and tier 4 cities, which may not have the same alternatives for bank branches as larger cities, may find it logistically simpler to access business loans that are fully digitalized. The ecosystem-based strategy for financing entails working with digital ecosystems like Amazon, Google Pay, and Zomato and utilizing the data about MSMEs that is accessible with these technological platforms. The method also enables using segment-specific data related to revenue, customer ratings and reviews, and transaction business volume to produce a composite credit model.
As a result, business owners in small towns now have easy access to loans previously only available to them at physical bank offices, which are liquid but inaccessible to MSME borrowers.
Solutions like E-NACH, CKYC/OKYC, E-Sign, and Video Sign have improved this access even more. Digital lenders’ alternative data sets for credit modelling avoid the requirement for collateral and supporting papers, which many MSMEs might not have. This is how an “ecosystem-based” lending method goes above and beyond accessibility. To close the MSME credit gap, considerable work is still to be done.
The responsibility for developing digital tools and strategies that use the digital footprints and ecosystems of MSMEs rests with start-ups and the innovation ecosystem. In any case, NBFCS (both online and offline) is properly taking credit for expanding to the outer reaches of the financial system.
Modern finance techniques may help Indian MSMEs transition to the formal economy.
Recent research from the India Brand Equity Foundation supports that MSMEs are vital to India’s economic success. Over 11 crore Indians are employed by India’s 6.3 crore MSMEs, which account for nearly 30 per cent of the country’s GDP.
Despite these optimistic figures, timely access to capital continues to be a significant barrier to expanding micro and small companies in India, as any small company owner would attest.
According to the World Bank, the MSME credit gap in India is reportedly USD 380 billion. Similar to the previous research, the International Finance Corporation (IFC) estimates that India’s MSME credit shortfall is Rs 25.8 trillion ($397 billion).
Micro and small businesses account for 95% of the addressable loan demand. Many MSMEs borrow from unofficial sources like local money lenders for their cash needs at astronomical interest rates.
For an entrepreneur who lacks the required paperwork or credit history to seek a loan, family and friends continue to be a source of finance. According to the IFC analysis, the legal credit supply barely covers Rs 10.9 trillion of the MSME financing needs, leaving a credit gap of over Rs 25.8 trillion that may be filled. Access to credit can aid MSMEs in the unorganized sector in assimilating into the formal economy, competing successfully with large companies, and gradually transitioning into the organized legal industry.
How might new financing practices close this gap and support MSMEs’ involvement in the formal economy?
- For MSMEs, cash flow-based funding
Lack of credit history is a significant barrier for an MSME when seeking a business loan from a bank or financial institution. Cash flow-based lending has enormous potential to provide MSMEs with loan access even without a credit history. Based on the company’s previous and anticipated cash flow, including revenue and profit margins, this lending model enables MSMEs to get tailored, short-term loans from financial institutions.
The sectoral and economic risks that can affect the borrower’s business are also taken into account by lenders using this approach. MSMEs without tangible collateral to give the lender might benefit from cash flow-based loans.
- Examining the bank statements for MSME
A bank statement showing the company’s financial health may be an effective instrument for authorizing and approving loans. The lender can determine that a borrower is “responsible” with money when money is in their bank account. It improves his capacity to pay back the loan even more. Consistent inflows of funds into the MSME borrower’s account may indicate that activities are profitable. Therefore, the likelihood of the MSME obtaining a loan is increased by a good view on the bank statement.
- Loaning without collateral to promote financial inclusion
Small company entrepreneurs have always faced difficulties getting loans because they lack collateral. The ability to cater to this underserved market is where digital lenders develop their companies, particularly those that provide unsecured loans.
To fulfil their working capital needs, develop their business, restock, pay staff wages, or manage their cash flow, MSMEs may get collateral-free loans with various repayment options. Unsecured loans make it possible for MSMEs that have never used credit or previously relied on unofficial routes to access the formal credit system as they require nothing in the way of supporting documents. The MSME needs business records, such as GST and PAN information, to determine the company’s credibility.
- Establishing the MSME’s credit history
As a result of their lack of credit histories, many small firms and first-time business owners are aware that they cannot obtain loans from banks or other official channels. The borrowers’ credit ratings increase due to regular repayments and debt accessibility. By getting a loan from a digital lender, MSMEs that have never taken out a loan can establish a solid credit history and later access traditional lending channels based on that history. Digital lenders, therefore, enable small enterprises to acquire loans quickly and also qualify for traditional credit in the future. In a poll earlier this year, 55.2% of the consumers who were questioned who had prior credit history showed improvement or consistency in credit behaviour.
MSME Lending: The Future
Digital lenders are now concentrating mainly on loan solutions for MSME borrowers after seeing the addressable gap and the commercial opportunity in MSME lending. This has made it possible for MSMEs to access formal finance online, regardless of where they are in the nation.
Due to automated credit underwriting techniques and quick online payments, digital lending facilitates speedier decision-making. In the past five years, established and newer lenders have used cutting-edge technology to address client pain points along the banking value chain. Innovative lending strategies for MSMEs are being promoted more and more by policymakers.
One step toward increasing inclusivity in financing is the Account Aggregator structure. Open Credit Enablement Network will be a disruptive force in the MSME loan market in the upcoming years. Access to formal and cheap credit will be made more widely available thanks to OCEN, a group of lenders, loan service providers, technology service providers, account aggregators, and underwriting modellers.
Through OCEN, the digital ecosystem will become more scalable and interconnected and open the door to developing specialized credit products for MSMEs. On the Loan Service Provider platform, small companies will access various loan products provided by multiple lenders. By acting as a sort of marketplace for loan products, OCEN will help India’s small enterprises access finance more efficiently and facilitate their entry into the official system.
Edited by Prakriti Arora