Source: Banking Frontiers
While MSMEs are recognized as the growth engine of the economy, their funding requirements are more often relegated to the bottom of the preferences. There are varied reasons for this. Bankers who handle MSME financing discuss the existing system and its shortcomings:
A recent report by rating agency CRISIL says the lending potential of MSMEs is Rs15 trillion from all sources. Another report produced jointly by ASSOCHAM and Ashvin Parekh Advisory Services puts the potential for bank lending alone at Rs 5 trillion. The CRISIL study also maintained that the market for financial institutions is slated to grow at a CAGR of 7% in the future. The latter report says that the MSME sector is underserved with only 40-70% of financial requirements being met by banks. At present, the sector accounts for over Rs 3.5 trillion in lending.
But how easy it is for these units to secure funding from the traditional sources? Again several studies suggest it is difficult for a majority of them to get finance on time. One reason often cited by MSME watchers is the lack of financial literacy among these entrepreneurs. For example, even established MSME do not rely on online lending. Similarly, many of them are unaware of the new age financial institutions that offer funding easily, instantaneously. They prefer traditional banks to alternative lending institutions to avail credit at low rate of interest in spite of the fact that banks have laborious documentation processes and strict criteria in sanctioning loans.
ACCESS TO CREDIT
There are multiple reasons why a large number of individual MSME units still find it difficult to access credit on time, says Manish Kothari, senior executive vice president and business head (Corporate Banking), Kotak Mahindra Bank. “The important among these are: (a) lack of formal data with these MSME businesses (since most of them are still unregistered and do business as a sole proprietor/partnership in an informal way) – which is needed to access credit from the formal channel, and (b) high cost to serve lower ticket to lending (to micro enterprise) – through the regular lending process the banks/ financial institutions”.
Sudip Bandyopadhyay, group chairman Inditrade group of companies, which has substantial MSME business, cites an ASSOCHAM study that states only 33% -34% of firms in the MSME sector have access to banks and institutional financing channels while the rest resort to informal channels like friends, family and other personal channels for raising loans. “So even if this number grows by around 7% annually, it still leaves a large population of the MSME segment unserved by the formal financial sector,” he adds.
He says this segment is underserved by formal credit sector mainly because some of these are exogenous to the MSME sector. “For instance, the financial sector faces a liquidity crunch from time to time and is, therefore, less forthcoming with credit to this sector. Then again, many banks may be selective in their lending to small scale units to preempt the build-up of no-performing assets. The second set of reasons arise due to collateral requirements which MSMEs find difficult to meet,” says he.
MSME is a very large segment of borrowers ranging from the informal, semi-formal to the formal sector, says Bhadresh Pathak, president, MSE Banking at Equitas Small Finance Bank. “Hence maintaining the financials of the business in an organized manner varies from some unorganized records to audited balance sheets. Still most of the informal units are not GST compliant and also do not route their trade transactions through proper bank accounts. Hence, assessment of income of these units for loan appraisal becomes difficult,” says he.
STRETCHED DEBT CYCLES
According to him, for the more advanced units that have formal financial statements and banking arrangement, there is a crunch in funding many times due to stretched debtor cycles. Many of the large companies do not pay the MSMEs within stipulated time frame by citing frivolous reasons and stretched debtors beyond 120 days generally are excluded from the working capital funding. “The government departments also delay their payments due to administrative reasons. Banks have their limitations to fund if there is a highly stretched working capital cycle,’ he points out.
Pathak says hitherto, PSU banks have been playing a large role in providing credit to MSMEs, but unfortunately 50% of the PSU banks are under the PCA framework till sometime back. NBFCs have their own limitations with respect to fund raising and cannot provide the working capital financing in its true form as they typically fund through loans against properties and that is not a correct way to lend for working capital.
“Another reason,” says he, “for shortage of funding is inadequate collateral security to provide for bank funding. Here again, enhancement requirements are not met in proportion to the increase in turnover and hence there is a shortage”
Manish Kothari cites lack of data on the part of MSMEs and high cost to serve them on the part of banks as reasons for their inability to access credit.
TOUGH TO UNDERWRITE
Anshul Swami, head, Retail, Inclusion and Rural Products at RBL Bank, which focuses more on the micro segment of the MSMEs and has specific products for these units, says the problem for MSMEs in accessing credit is because of the fact that financial institutions find it difficult to lend this segment.”It is not that these institutions do not want to lend to them. They are relatively a riskier segment and the risk will be priced. The larger issue is that it is difficult to underwrite and hence a lot of institutions have shied away. What they have done with a fair bit of success is if you are a MSME unit, and if you have a liability relationship, a loan is easier to come by,” says he.
“What is critical is that though they may not have financial statements or filing audited returns, if their banking is good, that solves 50% of the problems. Because as lenders we understand that these entities transact through cash in excess of 50% either receipts or payments. If there is a 50% to 60% chance of their banking being proper, this fact comes into play when you underwrite the loan. Now that GST has come into force, there is a clearer picture available,” he elaborates.
MSME lending continues to be an extremely cumbersome and time consuming process for both the MSMEs and the lenders, says Vinod Parmar, global head – Sales & Marketing at Vayana Network, the technology based third-party B2B trade financing platform. “Banks have typically extended the same due diligence, documentation and lending processes applicable to the larger or mid-market corporates in the case of MSMEs as well. However, larger corporates are far more financially and technically savvy; and have qualified these terms to run these processes independently. The MSMEs have no such luxury with the promoter himself or the CA among whom the entire process needs to be managed. Putting together the documents, details of assets to hypothecate etc is very time consuming and involves a lot of back and forth between the MSME and the bank. The only way to change this is to look at digital sources of date and easier models of due diligence,” says he.
LACK OF CLARITY
Kothari of Kotak Mahindra Bank believes lack of understanding of what (data/information) goes into processing of credit and the importance of formalization of a business – for banks/institutions underwriting comfort – is surely lacking, more so at the lower end of the MSME chain (micro & small enterprises).
Many cite the practice of not maintaining records or creating financials by these entities is due to lack of knowledge or financial illiteracy. It is because most of these institutions – especially micro enterprises – are run as one-man shows. The promoter or founder is the owner and he manages everything and feels managing the business is more important than anything else, says he. “So, they end up hiring small-time CAs to take up this task of managing books of accounts. This purely for the sake of filing the returns” he adds.
“Having said these, I do not think in the MSME segment there is that much lack of financial literacy. The entrepreneurs are well aware of the resources available to them. The government through MUDRA has more than adequately publicized the avenues available to them and ensured that everybody knows the inside out of the lending process, what are the minimum requirements to avail loans. The state level banking committees and the district collectors all are involved in driving the financial literacy program. A massive amount of awareness has already been created,” he points out.
Bhadresh Pathak of Equitas Small Finance Bank is of the view that people in the informal/ semi-formal economy or in rural areas may lack financial literacy whereas some who are in the manufacturing or hi-tech areas like software, analytics, fintech etc are still called MSMEs and are well informed and well educated. “Industry associations are definitely playing their role in educating their members. We are unable to get the desired results on financial literacy since spending financial literacy through associations or NGOs is still considered to be a social service and is voluntary. If the state governments introduce measures like subsidized online courses through industry collaboration, we can increase financial literacy to a large extent,” says he.
According to Sudip Bandyopadhyay, while availability of funds is certainly an issue, part of the reason that MSMEs do not use formal sector credit is the lack of awareness about it. ‘ Even ASSOCHAM has highlighted this aspect, saying the crying need is to spread awareness about formal financing opportunities within the sector to grow their credit exposure, limit risks and seek better spreads by developing and implementing sector-specific policies,” says he.
Lower financial literacy levels within MSME entrepreneurs is one of the major causes for funding challenges for them, maintains Vinod Parmar of Vayana Network. He says they heavily depend on advisors, CAs and at times even informal sources to guide them on how they should raise funds. While there are several initiatives undertaken by industry associations, trade bodies and at the government level, a huge catalyst to MSME lending would be to rely far more on digitally available data as against physical documents. “We are moving in the right direction with the advent of GST which is a strong source of digital trade data on MSMEs. At the same time measures are being put in place to ensure corporates make payment to these MSMEs on time to ease their cash flows. We are quite confident that over the coming 4-5 years we will see a phenomenal change in MSMEs’ outlook and preparedness towards borrowing,” says he.
Sudeep Bandyopadhyay feels NBFCs are increasingly becoming favorite source of funding for MSMEs, because of simpler processes and some level of handholding.
NOT TECH SAVVY
There is a perceptible inaction on the part of MSMEs in relying on technology. For example, many of them do not trust digital transactions. Does this lead to their lagging behind in securing timely funding?
Kothari believes this definitely is a reason, “since digital trail for such customers is quite poor – which otherwise banks could have used to access data digitally for these customers (as a part of the credit underwriting/monitoring process).”
Pathak, however, does not think entrepreneurs have any resistance to technology. “What is happening is that while they are tech savvy, they trust their influencers more than technology. Role of influencers like chartered accountants or successful people in the group/industry associations is more than technology due to a typical mindset. For example MSMEs don’t share their data easily on their own with fintech platforms. They still require some physical consultant who advises them what to do even while making use of electronic platforms. They will still require some physical consultant who advises them what to do even while making use of electronic platforms. However, this mindset may get transformed with times. There is no great evidence to say as of now what MSMEs lag behind in securing timely funding only because they don’t access digital means to secure the same,” he maintains.
Parmar too is of the view that MSMs have traditionally been relying on people and paper driven processes and transactions. “This is on account of a couple of reasons. One, the entire institutional approach in dealing with MSMEs continues to be paper driven, and secondly, tendency of low compliance in recording business transactions and confirming them. However, a growing number of MSMEs are keen to change from paper to digital. With the right incentives to digitally record and transact, MSMEs are quick to adopt mechanisms which will help them access financing easily,” he avers.
Swami ventures a comparison between pre-demonetization, there is significant penetration of digital transactions,” says he, adding: “However that directly does not impact the ability of these enterprises to adopt digital transactions. But they have advantages in adopting digital transactions. One is that information is created, which helps banks and NBFCs to address their needs in a more proactive and easier manner. Having said this, there is still heavy reliance on cash by this segment. Demonetization addressed the issue for a while, but cash still continues to be a significant factor.”
CONTINUED USE OF CASH
He says the problem lies in the continued use of cash. “If everyone uses cash, the micro entrepreneur too will be forced to do so, because he has no escape from not accepting cash. He is not going to push digitization. But I think there is some level of proliferation of wallets, which has really become popular among the micro enterprises. For example, Paytm or BHIM UPI, which are aggressively used in small shops and similar enterprises. If you look at the trading segment in India, including in the metros, there is a huge reliance on cash even today. Even when the options of Paytm or BHIM UPI are available, it is far more convenient to use cash. The actual cashless economy will usher in only when the trading segment adopts cashless transactions,” he adds.
A majority of MSMEs prefer banks to alternative sources of funding, like P2P platforms or shadow banking institutions. One reason is the low interest rates offered by the banks. Is the reliance on banks narrowing their options and also delaying fund flows?
Bandyopadhyay points out that about a fifth of MSMEs’ credit requirements are met by banks and the balance comes from informal leaders and NBFCs. However, bank credit to SMEs has been on the decline while that of NBFCs has been raising, despite marginally higher rates by the latter. “The reason for this trend is probably because NBFCs make the entire process simpler, using technology and algorithms to substitute for conventional forms of credit appraisal documents. Also, I believe that they tend to do a lot more handholding and are more approachable; this compensates for the higher rates charged,” he says.
ROLE FOR FINTECHS
He says while banks must ensure more prudence that will prevent the build-up of bad loans in the future, a good way to improve finance for MSMEs is to develop the debt market and allow fintech companies greater leeway in disbursing credit. “This way money can be raised from the debt market to service MSMEs that cannot access the debt market directly. If the government and the RBI work together to achieve this goal, it will not only result in better access to formal credit for MSMEs, it will also enable greater economic growth,” says he.
Swami says MSMEs are not approaching new-age lenders like P2P platforms for sure. “May be a small minority should be doing so. MSMEs largely approach public sector banks and NBFCs. They also private sector banks. The literacy or the awareness about P2P platforms and the newer ways of acquiring funding is not much compared to the awareness about funding options that banks and NBFCs have. There are SME focused platforms, which are essentially meeting places of lenders and borrowers. What is significant about such platforms is that 90% of the business they do is lending further down using information supplied on the supply chain and the entities that stand to benefit are small to medium enterprises in MSME segment. The micro segment is something very few of these platforms cater to. And their quantum of lending, compared to established players, is still very small. They are also mostly urban focused entities,” he explains further.
CHEAPER SOURCE OF FUNDING
Pathak points out that banks provide a cheaper source of funds in a systematic manner. “The cost of funds on P2P platforms is too high for running a viable business. MSMEs may rather raise unsecured loans through friends or relatives since it has a personal element of trust. While relying on banks is narrowing options, good NBFCs can help in meeting some secondary requirement outside the working capital assessment,” says he.
Use of technology in decision making, he says, can create ease of delivering credit. “We can automate routine work flows that consume time by digitalization. We can also use advanced analytic tools to make decisions and open up new ways of doing credit. Every constituent of the system needs to have out of box thinking on how to make processes more efficient. Even the regulator has a large role to play in creating ease of doing business by making amendments that don’t increase systematic risk,” he adds.
Kothari, however, says there are quite a few fintechs (digital only +digital & physical combination) that are providing credit to the MSME customers – especially at the micro end (<Rs 10 million turnover businesses). Similarly, NBFCs is a large provider of credit to this segment. In fact, a lot of the larger MSMEs use NBFC/ fintech funding as an add-on to bank funding.
Parmar of Vayana Network says there has been a very little uptake or scale of MSMEs’ interest in alternative sources of funding. This is mainly because banks and financial institutions continue to the most efficient option with their wide reach, presence and lower rates. He says while alternative sources claim to be using digital models to originate demand and assess risk, majority of the experience continues to be offline and paper-driven impacting the TATs adversely. Also banks and NBFCs offer funding to MSMEs at anywhere between 12%-18% p.a. and hence are still the preferred sources whereas alternative sources offer it at 20-30% p.a.. According, to him the best option would be for a fintech company to be the perfect digital bridge between the MSMEs and the banks and NBFCs where they can draw money on a real-time basis against confirmed trade transactions.
3 CORRECTIVE STEPS
Parmar also lists 3 corrective measures: “First, get them access to finance, ideally at their doorstep. Second, make it convenient for them by eliminating the amount of activity they need to do to get financed. And third, make financing available at a fair price. If these can be taken care of, through a mix of digital mode and institutional support, MSMEs will be well served and there will not be any need to create other alternative mechanism.”
One of the contentious issues that MSMEs often quote while approaching a lending institution is the documentation process. Swami explains the pros and cons: “In terms of documentation, there are two parts. One is KYC, which the regulator defines. This is mandatory and no relaxation is possible. Then comes the financial information. There is also a third part, which is a check through the bureau for repayment history. When it comes to documentation of the financial information, the micro segment especially may or may not have the required documents. “Generally, what happens is that the micro enterprises may not have audited financials, mainly because of the small size of their operations. The best thing for a bank or a NBFC to do, and all these institutions are doing this, is to help the enterprises understand their business cash flow by visiting their premises and then asking them or helping them to derive the cash flows- like monthly cash flows or quarterly cash flows or yearly cash flows. This ensures that he is able to generate these in future. Basis those cash flows, we at the bank can assess the ability of the customer to repay a particular loan. Of course, you take some haircuts here and there and net off some expenses of the customer. Then you are able to give a loan with which he can meet his working capital needs. Therefore he can start having a credit history. He starts with a small loan, then increases loans through trust and confidence created. Besides, the banks and financial services institutions should encourage the customers to have banking habits as well.
“For the sector to become creditworthy, it is essential that the individual customers of this segment should start banking. If they start banking no other documents are required. If they are at a slightly higher end and is supplying to customers, they are invariably becoming part of the GST Network, which will also take care of the documentation part.
“I will say it is all part of a continuum. The level of discomfort a customer had in approaching a bank and sharing income details is gradually reducing. But it is a continuum, it is not at any stage of perfection.”
Anshul Swami points out that if MSMEs’ banking track is good, that solves 50% of the problems as these entities transact through cash in excess of 50%
Pathak is of the view that every bank is endeavouring to simplify the processes. More successful banks have simplified and quickened the processes with robust risk mitigation too. The scope is to simplify and also mitigate risk would always remain high and it will only differentiate successful organizations from the not so successful ones, says he.
Kothari says there is always scope to improve. Today banks are specifically working towards using digital/ analytics as a medium to improve upon the customer experience for MSMEs – across the end-to-end processing chain. (verification, credit underwriting, loan processing, payments, collections, etc.), says he.
Bandyopadhyay too says banks are working towards simplifying procedures. Fintech companies have demonstrated how it is possible to minimize documentation and collateral requirements. “However, as banks face stringent regulations and are already carrying the burden of larger historic NPAs, simplifying documentation and collateral requirements may involve some regulatory changes by the RBI and government. Strengthening and streamlining the credit guarantee system could help ameliorate the situation,” he says.
Parmar believes there is scope for banks to simplify the processes. Both the assessment and post-assessment activities can be made completely digital by relying on their legitimate trade data corroborated by the MSMEs, their banking records, eKYC and GST filings, says he, adding: “The current process can be simplified with easy to understand terms of services or agreements that can be digitally signed. Over the last 3-4 years, connection to internet and digital sources has become very ubiquitous. Over 80% of the MSME base today is well connected to the tech and digital fabric of the country. If we can put together a robust mechanism of capturing data and providing to banks it will dramatically change the MSME financing experience,” he explains.
It is often made out that MSMEs in general and the micro segment among them in particular are prone to delinquency and defaults, several factors in their business models contributing to such behavior. But many bankers believe most of these entities are often sole proprietors/ owners of the business and they are essentially entrepreneurs and passionate about their enterprises. They do not default intentionally. One of the top reasons for defaults according to them is the delayed payments from their suppliers. The second is the fact that they themselves are not organized or disciplined. So, they will use the loan availed for purposes other than intended.
Says Swami: “I can say with conviction that in general there is no intention to default on the part of these entrepreneurs. In fact, as you go rural, the intention is miniscule. In urban lending, comparatively yes, there are intentional defaults.”
He also mentions that another critical reason is loan stacking. For example, if an entrepreneur takes a loan now, he will go for another loan immediately for some other purpose. So, the burden of repayment goes up and automatically that leads to defaults.
That may also be the result of the fact that there is no finality on their business models. “We do not have issues on their hoarding loans. They have their own methodology of defining their business, but often these calculations go wrong.
“There can also be diversion of funds. But that is more on the higher end of the customers. There may be instances of an entrepreneur wanting to set up another unit or purchasing another business, this causes stresses, especially when taken up without adequate planning,” adds Swami.
Kothari says defaults are there and the reasons being (a) impact of formalization of the economy post demonetization & GST, since, for a lot of these businesses, their margins are primarily through the tax saved by not declaring their business income/doing business only through cash/informal channels; and (b) inability to support their business financially during times of volatility in the market (across commodity prices, interest rates, currency, industry growth, etc) – due to low capital in the business and lack of availability of free cash.
Pathak points out that defaults can occur on the account of stretched working capital cycle and bad debts, diversions of funds to non-productive avenues, being unable to compete due to technology, labour issues, cost of production etc. project failures or over runs.
Says Bandyopadhyay: “It appears that taking multiple loans is highly correlated with defaults in the MSME space. A TransUnion CIBIL report suggests that the risk of default on loans taken by borrowers who have stacked their loans has increased in the last 3 years and therefore lenders must establish prudent processes and policies to detect and mitigate risks arising from loan staking behaviour.”
Parmar says having dealt with thousands of MSMEs on the network, his experience shows that MSMEs are well aware of their borrowing obligations; and are keen to settle the same on time. “The business against which they borrow is usually their primary source of livelihood and default is always a last resort. Lack of cash flows is a major reason for MSMEs defaulting. They have very little control and hold on when their trade receivables as per promised terms are actually received whether it is a corporate or a government customer. Lack of financial literacy also leads to the MSMEs being less prepared in terms of cash flow planning. The third reason, is that MSMEs are at times forced to divert money received for business to personal or family exigencies that are less productive from which it is difficult to recover.”
SCALING UP MICROS
It is estimated that a major portion of the MSME sector comprises micro-enterprises. Scaling them up or even making them viable is a major task given the problems they face in securing funding. Parmar observes that these micro units are even farther when it comes to financial literacy and access to financing. “We have a number of tier 2/3 suppliers and distributors on our network and it is our observation that the anomaly is quite deep in case of micro enterprises. The only way to address this is to work with a combination of trade references and digital data – capturing, understanding and assessing the track record of business and transactions that these micro enterprises have done. A broader correlation amongst these and their GST filings should form the basis for assessment for lending decisions,” says he.
Kothari feels the only way providing funding to micro enterprises can become viable (from accost to serve perspective) is when a large part of the end-to-end credit processing – factors like sourcing, verification, credit underwriting, documentation. Payments, collections, serving and monitoring – happens digitally. That is the only way to bring down the costs for reaching out and making the funding available, he says, “I guess the entire ecosystem (banks, NBFCs, fintechs, technology companies, government, regulator, etc.) needs to play an active role here – in some of the other part of the end-to-end credit processing chain,” he emphasizes.
Pathak is of the view that the lack of collateral security and lack of proper financials are two biggest reasons that work against scaling up the micro units. Unsecured funding is a speedy option but it is not very viable in view of high cost, says he, adding the legal system is very time consuming and in the circumstances risk aversions becomes more than necessary.
He says the issue can be tackled in two ways: (1) by making secured funding more liberal by use of behavioral scores of existing borrowers so that the collaterals can be leveraged to a higher extent; and (2) by bringing down the cost of unsecured lending through effective legislations helping unsecured creditors in a very quick and efficient manner. He believes while GST has come out as a single largest factor in making economy more formal, the sector will capitalize on this aspect more in the coming times as the learning curve has just got over.
Bandyopadhyay is hopeful that the advent of fintech companies that are specialized in microfinance will cater to this segment better than multi-strata lenders, who lend to commercial borrowers across the spectrum. “Microfinance is a large, untapped market and fintech companies realize that an initial investment of time and effort, and finance of course, could pay off in future; especially if they retain the business of these micro-enterprises as they transform into small, then medium and eventually large enterprises,” he adds.