India has 51 million SMEs contributing 37% of the non-agricultural GDP and employing 40% of the workforce. While they are heterogeneous in their organizational form and offerings, they share a common challenge; the availability of formal financing to the sector has not been commensurate with the importance it holds for the economy. According to the Transunion - CIBIL MSME Pulse Report, only about 5 million out of 51 million SMEs have access to formal finance. This is owing to several factors; fragmented/incomplete financial data that informs lending; inability of formal lenders to lend below a ticket-size given the (fixed) costs of due diligence; incomplete credit infrastructure coverage as credit bureaus cover a minor fraction of MSMEs and inflexible payment options. A study authored jointly by Omidyar Network and BCG (“The MSME Study”) just this week suggests that 40% of the MSMEs are constrained to borrow from informal sources at interest rates that are on average 2.5 times what formal sources would charge.
In terms of the macro-environment, The MSME Pulse Report released in June 2018 states MSME credit constitutes 23% of the total credit outstanding (ref. table 1 below for Y-O-Y credit growth) while NPA rates have stayed below 12%. However, it also points out that INR 11,000 Crores exposure that is presently standard belongs to entities one or more exposures of which are tagged as NPA by other FIs. Future NPAs will be driven by this segment. The relief in NPA classification announced by the RBI for MSME (aggregate exposure up to INR 25 Crores) offers additional 90 days for repayments; however, this regulatory relief will be fully withdrawn by May 2019. In the light of the aforementioned data, the proposed SME restructuring norms would be significant. However, it is a matter of debate whether regulatory relief in restructuring SME loans will contribute to or take away from the need to structurally reform MSME ecosystem. Illustratively, delays in settlement of account receivables from corporates contribute to the paucity of working capital for MSMEs. The TReDS mechanism designed as one solution to the problem requires buyer corporates to on-board in significant numbers for invoice-financing to take off. However, corporates appear to lack natural incentives to onboard on the platform.
Finally, in terms of the competitive landscape, the Report highlights that new private banks and NBFCs are increasingly gaining at the expense of PSBs, catalyzed by formalization and stable NPA profile of the asset class. (refer table 2 below for the shift in market share).
Digital Lending: Opportunity & Challenges
It is estimated that annually, 10 lakh NTC MSME borrowers would be seeking credit, driven by GST reform and MUDRA loan scheme. With the advance in financial technology, digital lending has emerged as a potential catalyst for serving these, and enabling access to the remaining 90% SMEs. It enables speed both in the process and substantive terms by removing friction in compliances like the KYC, leveraging alternate data points in assessing the creditworthiness of new or non-prime borrowers, and innovative approach to collection, among other things. This, in turn, has resulted in faster onboarding and TATs and improving financial access. The MSME Study projects that digital lending will increase by 10-15 times by 2023 (80-100 billion in annual disbursements) creating an opportunity for both traditional credit service providers and innovative startups.
The growth projections do face the risk of policy and operational headwinds. The Supreme Court Judgement in the Aadhaar case that struck down Section 57 “in the absence of enabling law” thereby disabling access of private parties to e-KYC at least for the foreseeable future. Furthermore, the NPCI has suspended the e-NACH feature that offered a direct debit facility to lenders, citing the need to adhere to the Aadhaar case. This presents a challenge of creating alternate KYC and direct debit work-flows with the same cost curves as previously while retaining the seamless UX and risk-level.
Unavailability of data, fragmented data and incomplete coverage of MSMEs is another important bottleneck that goes to the underwriting “segment” of the credit value chain. Illustratively, an industry report released in 2017 states that SMERA covered merely 0.1% of the MSME universe.
Furthermore, data relevant to MSMEs is either spread between several data silos viz, the MCA, the GSTN (invoice/trade data), bank statements; or remains in disaggregated form (utility/telecom/rentals). The Public Credit Registry mooted by the Reserve Bank of India appears to be one potential solution to the disaggregated data problem as it proposes to consolidate utility/telecom data among other things. However, the proposal is in the early stages and utility would be contingent on “access friction,” end-use restrictions if any and so forth. Furthermore, CIBIL has recently approached the regulator to modify the relevant laws such that telecom entities (and Insurance companies) would have obligation to share payment data with credit information companies, similar to financial institutions. Leveraging India Stack’s Digi-Locker is another solution to the fragmented data problem. Moreover, improving the visibility of entity-level data through having the sole ownership and partnership MSMEs to register with the MCA portal would also facilitate access to finance, as the MSME Study referred to above, suggests.
Finally, there are collections. Given the volatility in cash inflows, the standard EMI (fixed payout) model may not be suitable to many MSMEs. Lenders have evolved collection models that permit borrowers to pay a percentage of their daily earnings. They are also partnering with e-commerce and logistics platforms to establish a lien on the salary account of the end-user borrower.
While partnerships with e-commerce and logistics platforms and B2B platform do offer the lowest cost of collection on a unit basis (0.4-0.6%), not all services are amenable to be offered through a platform model. The MSME Study highlights that direct digital models of collection (ex, e-NACH) as of now have comparable unit costs to the manual processes (approx. 0.7%). Removal of friction around on-boarding on e-NACH offers significant potential for easing collections when the anchoring through the platform is unavailable.
To summarize, SMEs are a significant contributor to the nation’s GDP and employment. Formalization and advances in FinTech offer the opportunity for a million NTC MSME borrowers annually, and 10-15 fold increase in disbursements to the MSME space through 2023, as studies suggest. Leveraging this opportunity would be contingent on how the market innovates around the authentication & onboarding challenges the Aadhaar case has thrown down, as also the resolution of friction in the availability of “credit-smart” data and collection.