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Access to finance is a key constraint to the growth of micro and small businesses across economies. Data from 119 developing countries shows that MSMEs perceive access to finance as the most significant obstacle, which hinders their growth. In India, where MSMEs account for about 99% of all enterprises, comprising 63 million MSMEs across various industries and diverse geographic locations, financing of MSMEs has been regularly identified as a priority amongst Indias economic goals Even as the financial infrastructure has improved over the years, the access to finance for SMEs remains a challenge across countries.

MSMEs, particularly the micro and small businesses, face a funding gap, as they generally have a harder time obtaining credit from formal financial institutions. This is largely due to information asymmetry, lack of a previous credit history, and formal documentation, etc, which leads to unwillingness of lenders to provide financing to these borrowers. Even if they get financing, it typically takes time in approval and requires hard collateral like movable property and other onerous documentation.

Impact of the pandemic

At the same time, the access to finance challenges has been exasperated for these firms. As per RBIs data, credit growth to micro and small industries decelerated to 0.5 per cent in March 2021 from 1.7 per cent a year ago. Despite having multiple Central, State, Bank schemes targeting financial assistance, availing credit from banks remains a pain point for all MSMEs.

Digitization of MSMEs and ecosystemIn the online economy, the rapid development of digitization, automation, processes, etc., has offered a promising potential to unlock the bottlenecks faced by MSMEs. Historically, MSMEs have significantly low adoption of technology such as use of online channels for sales, digital accounting, payment transactions through multiple online channels or even for business communication.

The Government of Indias push towards digitization has been a significant contributor in the growth of digital infrastructure. A case in point is the growth in the number of POS terminals in India over the last 4 years from 1.4 million in 2016 to 4.43 million in 2020. Although digitization is an ongoing process, the COVID-19 pandemic has compelled an even larger segment of MSMEs to transform their businesses through digital means. Beyond providing greater ease and convenience for their customers, improving reconciliation, & accessing new markets, MSMEs are creating a large digital footprint of financial and non-financial data.

At the same time Indias fintech ecosystem continues to evolve and push traditional boundaries. These entities have removed administrative layers to make transactions more effective, making delivery of loans more decentralized. More collaboration between Fintech and traditional lending institutions can help spur world-class infrastructure and capabilities.

Power of Alternate DataIt is well known that in the absence of collateral, under-writing the MSME customers often entails higher operating cost for banks. However, smaller firms have fewer assets to provide as collateral for loans. A World Bank report further suggests that 80% of these firms capital stock consist of movable assets and are less likely to have access to fixed assets like plot or building. Policy makers have been advocating and nudging financial institutions to institute frameworks that can lower collateral requirements for SME borrowers.

Many fintechs and other financial institutions are utilizing technological tools to conduct online due diligence of MSMEs by analysing data from several sources using automated algorithms and managing risks more effectively. Beyond the transaction and financial data, this also includes social & mobile data, utilities data, macro data, and other environmental data, and generating a comprehensive credit score for the customer leveraging AI/ML based risk models. This has the potential to move from assessing physical collateral to assessing information collateral.Re-imagining financing structuresIn recent years, policymakers have also increasingly begun to push innovative lending models for MSMEs and believe that some of the structural barriers can be addressed by bringing greater innovation in loan and product structures. Cash flow-based lending models envisage a shift in banks appraisal system from parameters such as balance sheets, tax returns, credit bureau to evaluation based on historical cash flows and repayments predicated on future cash flows. Such structures are highly suitable for MSMEs with volatile cash flows & seasonality in business, etc. Many small businesses associated with online marketplaces, aggregators and platforms are utilizing the power of cash-flow based lending.

Innovative supply chain financing solutions are allowing MSME vendors and distributors to manage their receivable and payable cycle efficiently by integrating with corporates ERP and enabling financing from financial markets. Banking surrogates-based products are being utilized to disburse loans to micro enterprises in the range of Rs 1 lakh Rs 5 lakh. Similarly, sector-based lending is providing in-depth view and comprehensive understanding to new-age lenders, utilizing sector specific statistical scorecards. This allows them to take care of sector specific peculiarities and apply different yardsticks, risk-reward ratios for different sectors.

When financial institutions are too selective and cautious in their loan decision-making to MSMEs, it can be assumed that there are significant inefficiencies in the system. This will create a negative impact on the economic growth of the country. Revitalizing MSME financing with the help of innovative financial structures using digital tools and cash flow based lending will bolster the MSME sector and ensure stated policy objectives are fully realized.

Shobhit Mathur and Amar Shankar, Partners, Government and Public Sector, EY India

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Revitalizing MSME financing: COVID and beyond - Economic Times