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Key Challenges In Assessing Credit Risk For SMEs: A Wake Up Call In Digitalisation Around 41 per cent of SMEs are out of funds or have less than a month of funds left to survive, while 49 per cent are planning to reduce their employee compensation and benefit costs

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The pandemic has wreaked havoc in India since early 2020. Apart from challenging the public health system and almost crashing it, the time has been especially difficult for small businesses, as they too battled for their very existence during this crisis. The second wave has been a major blow for SMEs; as per a recent survey conducted by LocalCircles, about 60 per cent of small businesses in India are likely to scale down, shut down, or sell themselves by the end of this year.

The survey also says that 41 per cent of SMEs are out of funds or have less than a month of funds left to survive, while 49 per cent are planning to reduce their employee compensation and benefit costs by July to be able to keep going. While these are especially challenging times, one of the most important issues faced by small businesses is access to credit and a steady flow of cash. Having said that, there are some key challenges that most financial institutions face while assessing credit risk for SMEs. A comprehensive and efficient method for doing this could enable financial institutions to mitigate the risks and serve SMEs better.

While financial institutions might point out several challenges, there are five key ones that, if addressed, would make credit risk assessment simpler.

Lack of financial data: Level of information, credibility, timeliness

For any small and medium business, getting their first business loan is their biggest challenge due to the sheer lack of financial information available about them as an entity. Unlocking their first line of credit and credit underwriting are interlinked, and in a traditional banking ecosystem SMEs keep struggling with this "Catch-22' situation. The fact that most small businesses do not have a detailed digital footprint that can be relied upon is a major challenge in risk assessment. Even if a small business has been able to create a digital footprint through alternative sources of data (GST, mobile data, social, etc.), the timeliness of this information, though crucial, is something that most SMEs struggle to produce. A robust automated solution is needed to assess and process the data available from alternate sources, which in turn would solve the problem of timeliness.

Forecasting cash flow

By nature, most small and medium enterprises will have seasonal ups and downs for numerous reasons. Their cash cycle will be dictated by factors beyond their control, hence it is critical for them to manage their cash flow correctly. However, uncertainty is something that cannot be ruled out completely. While forecasting short-term cash flow is definitely good practice, there could be n-number of issues, namely liquidity crunch, negative cash flow trends, unplanned or unexpected expenses, etc. Predicting the future financial health of an SME is crucial since cash flow is the strongest indication of a company's continuing viability. There are several tools in the market that help with cash flow forecasting, most of which are out-of-sample models, based on trends and probability.

Accuracy of credit risk model

The most significant variables of financial behaviour are analysed in order to predict the credit-worthiness of SMEs, the results of which are then used to construct a default prediction model. While the most popular alternative statistical techniques are used to develop credit risk models, the performance, in terms of prediction accuracy, differs for different models, as well as for different types of SMEs. Most small and medium businesses often lack financial reporting and do not have audited financial statements, this adds to the challenges in predicting the accuracy of a credit model. Some of these models would show lower ability to discriminate between defaulted and non-defaulted customers.

Proactive loan portfolio evaluation and categorisation of NPAs

When it comes to determining asset quality for financial institutions, problem loan management is one of the most crucial areas. Theoretically speaking, there could be various factors which may cause a good loan to turn into a problem loan, especially for SMEs, considering the nature of the sector and the several issues it has been facing of late. Fear of this has opened doors for informal lenders. As per a report titled, Credit disrupted: Digital MSME lending in India, roughly 40 per cent of India's MSME lending is done through the informal sector, where interest rates are at least twice as high as the formal market. Moreover, SMEs demonstrate deficiencies in the enabling environment for financial services: i.e. financial infrastructure covering accounting and auditing standards, credit reporting systems and collateral and insolvency regimes. However, early identification of problem cases, timely restructuring of viable accounts can help recovery of non-viable ones.

Agility of the business model

Small and medium businesses have been exposed to various challenges during the global pandemic, unpredictability of the business environment along with high malleability has added to their challenges of being assessed for credit risks. While some sectors have become more vulnerable than others during the pandemic, agility is critical to SMEs. In order to build a sustainable business model, they need to quickly adjust their operations, and cultivate skills in order to leverage their flexibility in responding to circumstantial demands. This scenario demands for a change in strategy, thus changing their business models in order to adapt to this changing environment.

Conclusion: Building for future growth

As per the same report, Credit disrupted: Digital MSME lending in India, MSME digital lending has the potential to increase between 10 and 15 fold to reach INR 6-7 lakh crore ($80-100 billion) in annual disbursements by 2023, which is a huge opportunity for financial institutions. As financial institutions, we need to wade our way through these challenges in order to facilitate digital lending, as it has a strong potential to address the sector's credit-related challenges.

Two to tango: Fintech and digitisation can together be a gamechanger

One of the most crucial steps in enabling SMEs is to digitise them. This is exactly where fintechs can help--easy access to products like bank accounts, cards, managing cash flows, etc. Being a digital-only platform, fintechs offer SMEs with tailor-made products and solutions that help create a digitised credit history for them, which further helps them get seamless access to credit. Digitisation brings higher transparency and efficiency in the ways of conducting business: this would be empowering for SMEs as a segment.

Gurjodhpal Singh & Kumar Shekhar

CEO, Tide India & VP, Member Operations, Tide India


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