Worldwide, micro, small, and medium enterprises (MSMEs) are an anchor of the economy. In the US, 33.2 million MSMEs contribute 45% of GDP. China has over 140 million MSMEs, contributing 60% of GDP. India’s 47 million registered MSMEs, primarily micro enterprises, currently employ 204 million people and contribute approximately 30% to GDP and 46% to total exports. Clearly, there is a long way to go for India to reach where China and the US are.
Credit is the life force of these small businesses. Every activity of the business needs it. It's used for working capital, machinery, and new products. The gap in India’s MSMEs financing is estimated to be $530 billion. Globally, this number is in trillions. Credit to small businesses in India is at 14%, compared with 50% in the US and 37% in China.
Small business lending is a compelling opportunity for most growing economies and so it is for India. There have been a lot of efforts to fill this gap, through both traditional and new-age ways. The government introduced TReDs (Trade Receivables electronic Discounting System), credit guarantee schemes, and aggregation platforms. India is building the networks to connect lenders, platforms, borrowers, and many others. And yet, there have been few large success stories. Why? And what can fintechs and government/regulators do to create more success stories?
Why is lending to small businesses difficult?
MSMEs are not always the most lucrative customers for banks. They take smaller loans and often operate on tight budgets. They have high turnover – as many as 30% shut shop within a few years of starting.
MSMEs are not the easiest to find and often function unnoticed. Underwriting is difficult because they don’t have much collateral. Their business cycle depends on collections, not neat monthly inflows.
Finally, banks find it easier to serve corporates, who have deeper pockets, or retail borrowers, who are numerous and have a good record of repayments.
Fintechs have tried technology-first ways to solve MSME challenges, but with limited success. Customer acquisition cost is high because MSMEs are not easy to find digitally. Fraud issues get magnified in digital processes. Technology helps with underwriting and servicing, but gains do not offset other challenges.
What can fintechs do?
MSME lending is a problem worth solving, but there is no silver bullet. Fintechs have yet to try many ideas. Government and regulators can do much more to help. Here are a few ideas that can help.
Verticalization: Merchant banking started in the UK after the industrial revolution. It served the growing industrial MSMEs. Over time, merchant bankers became more and more specialized. In India, fintechs could specialize by MSME verticals since these tend to be geographically concentrated.
Get hands dirty: Pure technology solutions may not succeed with MSMEs. The magic solution might lie in human-in-loop products for acquisition, underwriting, and servicing. The humans could well be made more efficient and effective with technology.
All needs are not equal: There might be specific parts of MSMEs’ credit needs that might be easier to serve. Fintechs can tailor the underwriting to meet the different borrowing needs.
Embedded finance: Technology solutions built for small businesses can embed lending, insurance, and other products. These technology solutions could include accounting, CFO services, and customer management. Embedding would reduce customer acquisition costs and increase retention. Good solutions can become a moat over time.
Regulatory frameworks: Initiatives like Mudra loans and expanded SIDBI branches announced in the Union Budget for FY25 can aid MSMEs in accessing credit and support during stress periods. However, in our experience, it was the digital invoicing and tax reforms that revolutionized MSME finance in Mexico. Wider adoption of GST and further reforms hold a similar promise for India. So do simplification of KYC, onboarding, collections/loan resolution and other requirements.
Impact of new initiatives: The Union Budget for FY25 introduced several initiatives that are expected to bolster MSMEs. These include a Credit Guarantee Scheme in the manufacturing sector to facilitate term loans for purchasing machinery and equipment, a new assessment model for credit by public sector banks, and enhanced scope for mandatory onboarding in TReDS. The establishment of e-commerce export hubs aims to provide MSMEs and traditional artisans with access to international markets, significantly increasing their growth potential.
Missing women entrepreneurs: An RBI Innovation Hub study found that credit is the main limitation for women entrepreneurs. A tailored solution – for example, consisting of collateral-light lending, back-office support, and empathetic lifestyle tools – can access this high-potential segment.
Conclusion
Small businesses are the future wealth creators in the economy, and so are the fintechs. Fintech founders should grab the unique chance to help fellow entrepreneurs at MSMEs. The government and regulators should take targeted actions to unleash the massive potential here. Fintechs will then go to MSMEs to flourish and not to die!
Sandeep C. Patil is Partner and Head of Asia at QED Investors