Credit and financing for MSMEs: As India focuses on post-Covid-19 recovery, reviving MSMEs is clearly seen as the key to wider job creation and the distribution of benefits to the economy. The lack of working capital so far has prevented many closed, marginally functioning and surviving MSMEs from regaining their full economic potential. Therefore, when the Reserve Bank of India called on financial institutions to adopt cash-flow-based lending, the industry applauded the dynamism the government wants to bring to meet the capital needs of MSMEs, which represent major players. elsewhere 95 percent of all businesses in India. It wouldn’t be wrong to say that since then “cash flow based loans” have literally been “trending” when it comes to any discussion of MSMEs.
However, loan uncertainty in an already muted business segment has already replaced the previous cheer as financial institutions, whether banks or NBFCs, take action to push the Politics. Several operational and technological constraints stand in the way. For starters, MSMEs tend to be treated as a generic pool based on their turnover, which is not appropriate for determining access to working capital. Their risk profiles and who they get funds from can be best understood by decoding who MSMEs buy from and who they sell to: –
Category 1: MSMEs who are vendors or suppliers to large companies or the government
This is a safer category of loan for banks, as there is regulatory support to force their buyers to repay MSMEs. Banks and NBFCs can easily lend through platforms such as the Trade Receivable Discounting System or TReDS. The risk of non-payment is minimal and the approach relieves banks of the heavy burden of origin, KYC and aggregation of invoices. And, their risk is not on MSMEs, rather than on business and government. In reality, this is another form of accounts payable financing for buyers – which is not to say that MSMEs do not benefit from an optional early payment at a discount.
Category 2: MSMEs that buy from large companies and sell to retailers or end customers
There are hundreds of thousands of dealers and distributors in industries such as FMCGs and other GICs, who currently use traditional Channel or Trade financing provided by banks through businesses to secure periods of credit. However, the concessionaires hardly profit from it; in fact, companies partly use prepayments to pay lenders. Since businesses have hard and flexible backstops to ensure payments keep coming in, banks and NBFCs prefer this route of lending. Additionally, with difficulties in determining the ‘qualified’ origin of potential borrowers, lack of data, KYC / documentation issues, and repayment risks, banks limit this to collateral-based financing within the branch and have long decision cycles.
The recent generation of technology and algorithm based lenders have attempted to use eKYC and data from ITR, bank statements, etc. to quickly approve direct working capital loans to this segment. However, their own limited book size and First Loan Default Guarantee (FLDG) on leverage (when borrowing from banks) make this a risky proposition where even a small percentage of NPA can sink the business. – as we have seen in many cases.
Category 3: MSMEs who sell their goods or services directly to end customers
It is the most underserved category, anchored neither by business nor by government. They form the lowest rung in access to finance and this is where new age fintechs and tech NBFCs in India have already taken action or are rapidly developing loan programs tailored to determined cash flows. through digital acceptance and payments.
The vast opportunity for banks and NBFCs to expand access to working capital lies in the second category where trade finance currently plays a limited role. And here fintech can do the trick. For example, the technology can offer real-time cash flow data instead of collateral to determine credit. Pre-validation by companies of their authorized resellers to minimize KYC requirements and use payment behavior analysis in addition to credit scores makes decision making more realistic. Integration of bank payment rails and open banking APIs to facilitate payments. Integrated corporate soft and / or hard backstops to help mitigate lender risk, and automating collections as an integral part of the ecosystem can boost lender confidence.
It also has benefits for businesses with early cash flow and lower DSOs, and for MSMEs with faster access to capital. An example of this is the Government of India’s success in collecting and enforcing taxes through electronic invoicing. Simple end-to-end automation of the invoice lifecycle (presentation, payment, receipt and reconciliation) can itself provide real-time, transparent and integrated sources of cash flow-based data. This will certainly allow banks and NBFCs to differentiate between the actual risks and the perceived risks of loans to MSMEs.
In conclusion, I would say that just as humanity has not shied away from using technology to carry on with its life despite COVID-19, neither should financial institutions shy away from using technology to get the job done. For all yet unfounded fear, this quote from the great Albert Einstein may be encouraging – A ship is always safe on land, but that is not what it is built for.
Mohan Krishnan is the founder of Global PayEX. The opinions expressed are those of the author.