Who can potentially fill the colossal credit gap for MSMEs: Banks, NBFC or Fintech?

Mr Kamal, a freshly qualified mechanical engineer, is a budding entrepreneur who comes from a humble middle-class family. He aims to set up a decently sized workspace for starting his business but needs financial support. Upon approaching a bank, he is told to present a business idea, show income records, projections, provide collateral, and so on. He is in a fix as he may not give most of what is asked for, holds a zero credit history, and is denied the requisite loan/credit. 

Kamal’s story resonates with several aspiring entrepreneurs in the small business sector who may be put in the ‘credit unworthy’ situation. Given a chance, Kamal could have established a fairly operating business in a span of six months to a year. Else, he must approach an unorganised lender, prone to higher interest rates. Banks continue to be hesitant to fund new businesses than already established or large companies, not without a valid reason but due to the economies of scale, India’s financial and banking ecosystem and bad loan history itself. 

The story narrated above and similar ones that have occurred past several years have led to a whopping USD 240 billion credit gap for the Micro, Small, and Medium Enterprises (MSME) in India. In Indian rupees, this worked out to Rs.17.40 lakh crore and was published by IFC-Intellecap in its 2019 study report. Ironically, the Indian MSME segment contributes to more than 45% of its output yet faces a lack of easy access to funding. If this continues, India may witness the downfall of its MSME sector and, in turn, threaten the survival of several industries.

A credit gap refers to the difference between the total external credit demand created and the cumulative supply of finance from all the formal sources. The normal banking channels finance about 16%-20% of the MSMEs in India, a minimal number. It means that any formal banking system does not finance a wider sect accounting for about 80% at all, says the report. 

The MSME sector plays a vital role in nation-building due to its significant contribution to the Gross Domestic Product (GDP), exports, and job creation. Despite their demonstrated growth record and contribution to the economy, financial institutions have underserved businesses in this sector. 

In addition to financial resources, they need access to new market opportunities, customer databases, and emerging technology. These can help them increase their competitiveness, efficacy, and resilience in the new normal. MSMEs will also need access to services that could help them develop a resilient infrastructure to continue operating in the changing market climate.

Most of the business owners in the MSME sector face challenges, including being educated and financially literate. From not maintaining complete books of accounts to not affording collateral assets for loans, problems are aplenty. In a gist, due to the lack of collateral securities, vague credit histories, inadequate accounts and records, many MSMEs are unable to access financial product suites and services.

Since the segment is so diverse, financial institutions regard it as a high-risk investment. Not to forget, the majority of the companies are family-owned, and the promoters tend to obtain financing from unorganised sources, often at exorbitant rates. A lack of credit history hinders banks’ ability to determine the integrity of such units. 

Banks face difficulties due to poor bookkeeping and financial planning, precisely the ones mentioned as MSMEs’ problems. Fear of a poor credit rating and a reluctance to dilute equity holdings make it much more challenging to obtain structured financing and establish a better track record for potential needs. PSU banks are far better in MSME lending when compared to their private counterparts.

The question to be asked is how the MSMEs can come out of the situation. Various policy initiatives such as the industry cluster development, the Emergency Credit Line Guarantee Scheme (ECLGS), the All-India SME exchange, the skill development program, the implementation of Goods and Services Tax (GST), and the government’s GST-compliant MSME loans: “Rs.1 crore in 59 minutes” all have created a sustainable environment for MSMEs and opened up formal finance channels from commercial banks, small finance banks and NBFCs. 

Most of the schemes are at a snail’s pace in terms of adoption and reach. Immediate results cannot be expected from these but will benefit in the long span. An alternate and trusted source of financing is the need of the hour. Thus, come the digital lending platforms and fintech to the rescue. 

Fintech firms pose creativity, using new-age technology and adopt customised lending techniques backed by predictive analytics and artificial intelligence. It assists in real-time decision-making, enabling them to reach out to the last mile consumer. In recent times, some well-known fintech firms provide services such as translating scanned financial bank statements into customised formats for fast decision-making and providing borrowers with digital channels for easy access to credit. 

Their operations accelerated during the COVID-induced lockdown around the same time last year. Fintech-backed lenders are more convenient for their clients, and they respond to their needs with a sense of urgency that banks frequently lack. Fintech and digital lending platforms offer short to long term lending and offer working capital loans as well. Lending is done for a period as short as seven days.

Lending by fintech stands apart due to the extensive use of technology, making their product far more efficient in signing off the financial risk and having a good reach. It also helps them replicate or outperform the traditional informal lending sector. Moreover, these fintech firms have co-lending and securitisation to their support.

A report known as “Fintech for Asian SMEs” released by the ADB Institute in 2019 quotes that while new SME-focused fintech firms may take some market share from traditional banks, they are most likely to serve many borrowers currently rejected by the traditional firms. An increase in the overall size of the market will likely offset the market share lost to newcomers. Going by this claim, we can say that fintech and digital lending may take the lead in bridging the long-standing MSME credit gap in the years to come. 

However, to equally reap the short and long-term benefits of financing MSMEs, banks are rapidly adopting the digital environment, automating back-end processes, investments in capacity building with several trade associations and creating customised credit products, especially during the COVID pandemic. 

So, one cannot completely rule out banks’ contribution, including the NBFCs, since they have a more substantial presence in tier II and tier III cities, including rural areas across India. Digitisation in banks and relaxation of stringent credit lending norms can have multiplier effects in plugging the MSME credit gap. It equally calls for the expansion and promotion of digital lending and SME focussed fintech firms on operating in rural areas. 

On the other hand, a more passive way to bridge the colossal credit gap is by improving MSMEs’ liquidity position, making them self-sufficient to meet their working capital needs. It can happen through faster sales realisation and increased receptiveness towards invoice discounting over platforms like the government’s TReDS. Extension of the e-invoicing system under GST to MSME in the coming years will pave the way for private invoice discounting platforms and fintech to emerge as promising contributors in fixing the big MSME credit gap.

For any clarifications/feedback on the topic, please contact the writer at annapoorna.m@cleartax.in