How digital can bridge the gap in MSME lending

According to the Indian Ministry of MSME’s Annual Report for FY18, there were a total of 63.3 million MSMEs (Micro, Small, and Medium Enterprises) in India. Further, MSMEs (broadly defined as businesses with annual revenue up to INR 250 Cr – approximately US$ 35 million) accounted for 30% of India’s GDP, 45% of India’s total manufacturing output, and 40% of India’s exports in FY18. These MSMEs largely operate in the informal sector and comprise a large number of micro enterprises and daily wage earners.

Despite such a significant contribution to the economy, MSMEs have been facing several bottlenecks inhibiting them from achieving their full potential, including an inability to access timely and adequate credit. According to International Finance Corporation (IFC) estimates, the potential demand for India’s MSME finance is about US$ 370 billion as against the current credit supply of US$ 139 billion, resulting in a finance gap of US$ 230 billion (equivalent to 11 percent of GDP).

So what’s the reason behind this huge credit gap? Why are banks not targeting this vast market? Why is Bank credit to MSMEs as a percentage of GDP less than one-sixth of the levels seen in South Korea and China, and one-fourth in Thailand and Malaysia? Indian Banks have historically been reluctant to lend to MSME borrowers for a number of reasons, especially the relative difficulty in assessing credit quality. The traditional underwriting methods followed by banks and other financial institutions involve the review of extensive documentation including financial statements, Credit Bureau scores, documents for the property to be kept as collateral and many more. In many situations this documentation simply isn’t available. But even when it is available, the cost involved in evaluating the material is far greater as a percentage of the low amount than it is for larger companies. Put simply the cost is too high and the return is too low – the loans are not profitable enough. Another reason is the high business failure rates in the MSME sector. Financial institutions are doubtful about their survival and growth and therefore under-financing happens. Concerns over rising non-performing loans (NPLs) in the Indian banking sector and the implementation of more stringent capital adequacy norms has also prompted banks to become extremely cautious in lending to business ventures perceived to be ‘riskier’. A large number of MSMEs are therefore unable to gain access to formal credit sources despite being creditworthy.

To fill the gap, MSMEs have resorted to informal sources for financing. According to a recent survey of MSMEs by BCG and Omidyar Network, the challenges faced by them in accessing formal credit included long processing times, lack of transparency in timelines and insufficient loan sizes. These pain points are substantial enough to compel many MSMEs to continue to seek out informal sources, often at much higher interest rates. In fact, according to the same report nearly 40 percent of Indian MSMEs are forced to borrow from informal sources that charge an average of 2.5 times higher interest rates than those in the formal sector.
However the situation is changing rapidly and MSME sector is at the cusp of a significant transformation in terms of formalisation and digitization driven by recent telecom and technology advancements coupled with few major government initiatives.

In India, mobile internet tariffs have fallen by 93 percent in the last three years, making it the cheapest globally. These low costs have led to an eight-fold increase in data consumption across the country – including among previously non-digital MSMEs. Smartphone penetration rates have doubled in the last three years, to roughly 337 million users. This increased access to and consumption of digital data is expected to have a significant impact on overall levels of digitization among MSMEs in the country.A range of recent programs from the Indian Government have added further momentum to these developments. The government launched the Unified Payments Interface (UPI) real-time system for mobile transactions, followed by a demonetization effort that triggered rapid growth in digital payments across India. This was followed by the Goods and Services Tax (GST) to simplify business taxes and increase tax reporting, which has already compelled millions of MSMEs to formalize – roughly 9.2 million MSMEs in India are now GST registered. The shift to online tax reporting through GST has created a trove of digital data from MSMEs. This data is verified, granular, current and electronically accessible, which means that it can be used to make decisions. Another important factor driving India’s digital evolution and its shift toward a cashless economy is ‘’India Stack’’ – which is a set of APIs that enable instant communication between servers and devices. Both India Stack and additional APIs now serve as a rich source of public and private data.

All these developments together have created a potentially massive opportunity for both traditional lenders as well as fintechs – to address the huge MSME credit gap by offering loans in a significantly quicker and more efficient manner at a far lower cost and lesser risk.

Digitally available data can now provide a more accurate portrait of a MSME borrower’s creditworthiness and the associated risk for credit underwriting insight. With increased formalization and digitization, bank statements have become more granular and complete, enabling lenders to generate much more detailed insights into borrower behaviour. New sources, such as transaction data (e.g., point-of-sale credit card trails) and other surrogate data (e.g., telco, utility payments) are giving lenders an even deeper view. As a result, the relative importance of different sources in digital underwriting is undergoing a shift, with decreasing reliance on audited financials and increasing focus on new data sources.

Fintechs, powered by technologies that harness big data analytics and machine learning, have been quick to spot this opportunity and they have already made inroads into the MSME segment. They use non-traditional data to assess creditworthiness, their application processes are completely streamlined, with little or no paperwork, and the loans are disbursed fast – in days or hours. They thus provide quick and easy access to finance to MSMEs, without the hassle of the traditional loan application, and customers don’t need to have built up a long credit history.

With Fintechs having made quick inroads, how should banks and traditional lenders respond to this opportunity?

In one way, this probably has been a blessing in disguise for banks. The initial success of Fintechs has rekindled Banks’ interest in the MSME segment. Some of them have already started testing the waters by partnering with Fintechs to capitalize on the strengths of Fintechs – alternate credit scoring models and greater digital reach.

However, from a long term perspective given the huge size of the opportunity, it may help traditional lenders to assess the likely impact of disruption and re-orient their business models. Banks probably realise that they do possess some inherent advantages like the expertise to navigate the regulations and licensing discipline of the finance industry, a reputation for trustworthiness and the capital to weather intense competition. What Banks would do well to focus on is exceeding the standards set by Fintechs – by building strong digital foundations. This means re-engineering and integrating back-end systems to enable next-generation online and mobile experiences. Traditional lenders should therefore be investing in the latest technology to streamline customer interactions while taking advantage of real-time data.