Credit and Finance for MSMEs: MSMEs tend to be treated as one generic pool based on their turnover, which is not appropriate to determine access to working capital. Their risk profiles and who they get funds from can be better understood by decoding who MSMEs buy from and who they sell to.
Credit and Finance for MSMEs: As India focuses on post-Covid-19 recovery, the revival of MSMEs is clearly understood to be key in wider employment generation and for distribution of the benefits to the economy. The lack of working capital so far has constrained many of the shuttered, marginally functioning, and surviving MSMEs from returning to their full economic potential. Therefore, when the Reserve Bank of India called out for financial institutions to adopt cash-flow-based lending, the industry applauded the dynamism that the government wants to bring in addressing capital requirements of MSMEs, which incidentally comprise 95 per cent of all businesses in India. It would not be wrong to say that ever since ‘cash flow-based lending’ has literally been ‘trending’ when it comes to any discussion on MSME.
However, the uncertainty of lending in an already muted business segment has already replaced the earlier cheer as financial institutions, be it banks or NBFCs, get to action the policy push. Several operational and technological constraints come in the way. For starters, MSMEs tend to be treated as one generic pool based on their turnover, which is not appropriate to determine access to working capital. Their risk profiles and who they get funds from can be better understood by decoding who MSMEs buy from and who they sell to: –
Category 1: MSMEs who are vendors or suppliers to larger Corporates or Government
This is a safer category for banks to lend since there is regulatory support to force their buyers to pay back the MSMEs. Banks and NBFCs can easily lend through platforms like Trade Receivable Discounting System or TReDS. The risk of non-payment is minimal, and the approach relieves banks from the heavy lifting task of Origination, KYC, and Invoice aggregation. And, their risk is not on the MSMEs, instead of on the corporates and the Government. In reality, this is another form of Account Payable financing for the buyers – which is not to say that MSMEs do not benefit from optional early payment at a discount.
Category 2: MSMEs who buy from larger Corporates and sell to retailers or end-customers
There are lakhs of dealers and distributors of sectors such as FMCGs and other CPGs, who presently use the traditional Channel or Trade finance provided by banks via corporates to get credit periods. However, dealers hardly benefit from it; in fact, the corporates partly use early payments to pay to lenders. Given corporates have hard and soft backstops to ensure payments keep coming in Banks and NBFCs prefer this route to lend. Also, with difficulties in determining ‘qualified’ origination of potential borrowers, the paucity of data, KYC/documentation challenges, and repayment risks, banks limit this to collateral-based finance within branch radius and have long decision cycles.
The recent generation of technology and algorithm-driven lenders have attempted to use eKYC and data from ITR, bank statements, etc. for quick approval of direct working capital loans to this segment. However, their own limited book size and First Loan Default Guarantee (FLDG) on leverage (when they borrow from banks) makes this a risky proposition where even a small percentage of NPAs can sink the business – as we have witnessed in many cases.
Category 3: MSMEs who directly sell their goods or services to end-customers
This is the most under-served category, anchored neither by the corporates nor by the Government. They form the lowest rung in access to finance and this is where fintechs and new-age tech NBFCs in India have already actioned or are fast developing lending programmes that are attuned with cash flows determined through digital acceptance and payments.
The vast opportunity for Banks and NBFCs to scale access to working capital lies in the second category where trade finance is playing a muted role, currently. And here, financial technology can do the trick. For example, technology can offer real-time cash flow data instead of collaterals to determine credit. Pre-validation by corporates of their approved dealers to minimize KYC requirements and use payment behavior analytics as an adjunct to credit scores makes decision making more realistic. Integration of payments rails and open banking APIs from banks to ease payments. Inbuilt soft and/or hard backstops from corporates to help mitigate lenders’ risk, and automating collections as an integral part of the eco-system can boost the confidence of lenders.
This has advantages for corporates too with early cash flows and lower Daily Sales Outstanding (DSO), and for MSMEs with faster access to capital. An example of this is the Government of India’s success in tax collection and adherence through e-invoicing. Simple end-to-end automation of the invoice lifecycle – presentment, payment, collection and reconciliation – itself can provide for real-time, transparent, and integrated sources of cash flow-based data. This will definitely empower banks and NBFCs to differentiate between actual risks and perceived risks of lending to MSMEs.
To conclude, I would say just as humanity did not shy away from technology in getting on with their lives despite COVID-19, financial institutions too must not shy from using technology to get to the task at hand. For any unfounded fears still, this quote from the great Albert Einstein can be encouraging – A ship is always safe at shore but that is not what it is built for.