Redefining MSME Financing

Although 94 per cent of 29.8 million MSMEs in various industries (employing 69 million people and accounting for 45 per cent of Indian industrial output and 40 per cent of exports) are unregistered, the contribution of the sector to India’s GDP has been growing consistently at 11.5 per cent a year, which is higher than the overall GDP growth of eight per cent. However, financing the MSME sector has never really kept pace, as they receive less than five per cent of the total banking credit. 

The MSME sector has a total finance requirement of Rs 32.5 trillion, including Rs 26 trillion of debt demand and Rs 6.5 trillion of equity demand. The viable and addressable debt demand is estimated to be Rs 9.9 trillion, which is 38 per cent of the total debt demand. The viable and addressable equity demand is estimated to be Rs 0.67 trillion. 

Only seven per cent of MSMEs seek external sources of credit, while the rest manage with self-financing or with funding from informal sources. The remaining 64 per cent are generally considered unviable due to inadequate/ ”poor” credit profiles; preference for alternative funding; etc. However, in actuality, these present a rich potential for NBFCs if adequate safeguards can be built in to protect asset quality. After all, credit is not just the real fuel that can propel this sector’s growth but is really the lifeline for its survival. 

Poor infrastructure and inadequate market linkages are key factors that have constrained the growth of the sector. Lack of adequate and timely access to finance has been the biggest challenge. The financing needs of the sector depend on the size of operations, industry, customer segment and the stage of development. Financial institutions have limited their exposure to the sector due to a higher risk perception and limited access of MSMEs to immovable collateral. This has created a demand-supply gap for approximately 11.3 million enterprises. 

While a large number of these already receive some form of formal finance, they are significantly underserved, with only 40-70 per cent of their demand currently being met. The equity gap in the sector is a combined result of demand-side challenges such as the legal structures of enterprises, as well as supply-side gaps, such as a lack of investment funds focused on MSMEs. Equity requirements for the MSME sector are concentrated in the growth- stage enterprises (~70 per cent). 

MSME businesses display diverse unique characteristics and are often underbanked vis-à-vis their vast potential. They have varied credit product needs and a two-pronged approach – a horizontal and a vertical strategy – is required to differentiate between small enterprises and mid-sized ones. The relationship approach always works best, but an early warning mechanism should be in place . And the age of specialist financiers has come that could result in a focused and developmental approach to funding this critical cog in the Indian economic wheel. 

When it comes to relationships, there is a need to go beyond the traditional confines of corporate or retail/ consumer banking simply because MSME financing incorporates characteristics of both segments. In terms of risk management, there is a need to develop a better understanding of financing patterns of service enterprises in the sector. There is an opportunity to expand the scope of the sector’s credit information bureau to collate and process important transaction data. There is also scope to strengthen the recently established collateral registry and create stronger linkages with other financial infrastructure. There is a need to facilitate greater debt access to non-banking finance companies. 

India today needs financiers who will focus on a few sectors and MSMEs therein rather than spreading them selves thin. A deeper understanding of MSMEs will lead to greater focus. The time has come for specialist financiers for pharma or textile or food/beverages MSMEs in the manufacturing side or even agri-allied or auto-allied or retail-oriented MSMEs.

A specialised business vertical for MSME financing can assist in enabling infrastructure in terms of encouraging securitisation of trade-receivables in the sector through conducive legal infrastructure. It can encourage NBFCs to syndicate finance and provide advisory support to MSMEs in rural and semi-urban areas. It can also incentivise the formation of new MSME-specific venture funds by allowing existing government equity funds to make anchor investment in venture funds. Liquidity management can be aided in terms of improving debt access to non-banking finance companies focused on these enterprises and providing regulatory incentives for participation in the sector. It can also help develop an IT-enabled platform to track MSME receivables to facilitate securitisation of these trade receivables, or alternatively expand the scope of IT platforms to facilitate securitisation. It can provide credit guarantee support for MSME finance. 

In terms of risk management, it can develop a better understanding of financing patterns of service enterprises in the sector. It can expand the scope of the sector’s credit information bureau to collate and process important transaction data, including utility bill payment. It can also strengthen the recently-established collateral registry, create stronger linkages with other financial infrastructure and facilitate greater debt access.

One potent approach in addressing the MSME sector today needs a two-pronged strategy – what we can define as a horizontal strategy for the micro and very small businesses and a vertical, industry-based strategy for the small and medium businesses. In case of very small enterprises, the horizontal approach lends itself to faster customer acquisition, an assembly-line approach to credit underwriting and an efficient risk portfolio management. 

The small and medium enterprises exhibit a more predictable demand for debt, and several of these units are able to access multiple sources of capital. An industry-based vertical approach to address the credit needs of this part of the MSME space will augur well both from a banker and borrower perspective. The ability to understand specific industries and their key success factors will provide distinctive competence to the bank to dominate these turns and at the same time achieve an attractive risk- return balance. The borrower, on the other hand, benefits from the focused approach of the banker and is relatively better equipped to develop and grow the business. The relationship approach – both ways with clear unit metrics with a lucid understanding of industry segments – is indeed an ideal recipe for this sector.

Only an in-depth, on the ground understanding of the diverse dynamics can help financiers spot early warning signals, which are so critical to a successful MSME lending strategy. It is a known fact that 80 per cent of MSMEs have faced a downturn at least once, if not on more occasions, during their lifecycle. But a temporary blip cannot lead to pulling the plug in terms of financing. Of course, there could be instances of entrepreneur promoters lining up their own pockets after attracting funds or channelising them into unrelated untested gambles.

Remember, most MSMEs have sole banking partners and rely heavily on them to fulfill all their financing needs unlike corporates, which have multiple access to finance partners. Ratings agencies have their own limitations in terms of spotting trouble, and it is better to build one’s own credit risk mechanisms on the ground to successfully operate in this sector and even lead the pack over a period of time.

The growth of a nation largely depends on the development of small and medium entrepreneurs. Companies that are in the development phase today will power employment and derive revenues tomorrow. In a developing nation like India, small and medium-sized entrepreneurs have a very important role to play in the overall economic development of the country. The country’s SME sector, which is all set to become the largest SME nation internationally, is crucial to India’s economy and provides employment to millions. Every step has to be taken to ensure that MSME financing becomes a priority.