Evolution of SME lending in India
While the base of the pyramid is served by microfinance institutions and corporates are served by banks, the MSME segment has always had few alternatives
There are around 60 million micro, small and medium enterprises (MSMEs) operating in India today, contributing around 30% of India's gross domestic product and employing more than 111 million people. But a major barrier to their growth has been the ease of getting credit—today, around 40% of total MSME credit demand is still served by informal sources of credit. As per the IFC Report 2018, the huge financing gap is pegged at INR 45 lakh crore out of which 40% will be served by informal credit, 25% through personal loans and only about one-fifth of the total credit demand will be fulfilled by formal credit.
While the base of the pyramid is served by microfinance institutions and corporates are served by banks, the MSME segment has always had few alternatives. Often, they do not have property or collateral to mortgage and many of them have insufficient or do not have any credit history. The lack of proper documentation in many cases and a weak balance sheet hasn't helped the case either. In addition, long approval and disbursal periods are especially challenging for small businesses, and only few traditional financial service providers have cost structures that allow them to make small loans that are appropriate for micro and small enterprises. This constrains MSME growth since firms must either make do with low levels of working capital or rely on informal financing, which is expensive, or supply chain financing, which limits their vendor choice and bargaining power.
This is the context within which a new era of lending has dawned. Alternate finance companies armed with technology and venture capital money have taken the challenge head-on. These companies have ridden the wave of India's technology leapfrog to start lending to the unaddressed sector. As per the BCG-Omidyar report on Credit Disrupted-Digital MSME Lending, 47% of MSMEs have adopted digital tools for business processes, payments and online sales. These tools provide a certain degree of comfort in making a lending decision and often, cash flow footprints play a key role in providing a working capital loan to an SME. Similarly, the cost of data has fallen by 95% in the last three years leading to smartphone proliferation. New-age lenders are now using data from smartphones, utility payments, bank statements and triangulate it with social media activity to arrive at a credit decision that would not have been possible for most of the new-to-credit entrepreneurs earlier. For instance, digital lending players address the challenge by underwriting based on the digital payments data which gives a good measure of the intensity of business throughput as well as allows for automated and daily repayment through POS machines itself. This enables businesses with a low asset base or inadequate credit history to avail timely funds.
Nano-businesses are now aggressively ditching moneylenders that charge up to 90% annualized interest rates on loans towards loan aggregator platforms which provide them with a host of loan offers from different banks and non-banking finance companies (NBFCs). The cost of credit here is cheaper and more transparent with pre-defined payment terms. On average, India has seen more than 50 alternate lending companies crop up each year between 2014 and 2016, according to Tracxn. These companies come armed with venture capital that allows them to use technology and scale much faster than the time a bank would normally take in deciding to open an SME branch in a semi-urban area.
Moreover, the emergence of digital KYC, data from ministry of corporate affairs portal, EPFO data, utility payments data as well as GST returns data is facilitating loan processing time reduction and enhancing customer experience across all touchpoints. This revolution could boost the MSME digital lending annual disbursements to reach INR 6-7 lakh crore by 2023. Now, retail and e-commerce companies can simply use their transaction data through point-of-sale terminals to show cashflows and obtain funding for a period of 12-36 months at competitive rates. Meanwhile, new-age NBFCs are also aiming for a share in this market by bringing in high-end algorithms to quickly sift through eligible borrowers and funds are disbursed quickly—in less than three days in most cases.
While the new-age models could be seen as threatening the dominance of banks as preferred lenders, there's scope for further disruption. A new era of co-lending is upon us where banks will proactively partner with alternate lenders and NBFCs which will lower the cost of acquisition in a big way for all parties involved. Moreover, lenders are tying up with fintechs as well as new-age lending NBFCs to ensure that they retain their market share while improving the experience for SME customers. It's time for lenders to not be gatekeepers of credit and become business growth partners for millions of Indian entrepreneurs. Also, with the formalisation of account aggregators, lenders will get instant access to customer's digitally verified asset data of the customers directly from sources such as banks, mutual funds, equities, GST and income tax, which can eliminate paper and fraud risks associated with them leading to further reduction in loan processing time and delivering superior customer experience.
Moreover, digital MSME lenders are creating a strong positive social impact on the MSME sector by way of lending to new-to-credit borrowers and first-generation entrepreneurs thereby enabling customers to improve their livelihood. Further, these players are also furthering financial inclusion by an increasing focus on lending to small and medium businesses in tier II and III cities. With continuous thrust of measures by the government for the MSMEs and NBFCs, growing acceptance of digital modes of payments, further opening up of GST returns data combined with payments and digital trails, SME lending could galvanize India's economy and provide it the much-needed competitiveness and vibrancy that one would come to expect from one of the fastest developing economies of the world.