Access to Finance Problem of the Financiers

While enough literature is available pointing out to the lucrative business (and impact) that local financial institutions could target by reaching out to the micro and small businesses in any economy, there is very little written about how these "local financial institutions" can access funding to re-lend to this segment underserved segment. By nature, small businesses are risky and lack of formally verifiable income makes it difficult for banks to lend to small business. To some extent, it is right that banks avoid getting into financing such risky business on a large scale given that they can not put small retail deposits into trouble. This means that there is clearly a need to address the credit needs of smaller enterprises through a network of more nimble and differently designed financial institutions. In fact, in India some specialised lenders have come up over the years catering to different types of small businesses. Such financial institutions are recognised by the Reserve Bank of India as well.

They reach out to the "lucrative" MSME segment through customised appraisal mechanisms and lending processes and often due to their close ground presence manage to have a fairly good quality of loan book. Higher risk is adequately compensated by higher yield AND additional measures like closer monitoring prevents high default rates. This makes it look like an attractive proposition for people who want to invest (as debt or equity) in such businesses. In fact, a lot of these business have got significant equity interest. And that is where it starts to get interesting.

They have an interesting problem of being able to raise equity while not being able to raise enough domestic debt. A closer inspection would reveal that the equity raises have largely been from foreign sources and often result in companies facing hurdles around the guidelines that guide loss of shareholding vs FDI amounts invested. 

While the debt could have also come in from offshore sources, bringing debt into India from foreign jurisdictions faces lot of obstacles in terms of process (which has become significantly smoother over the years but it still continues to be a pain). These small financial institutions depend largely upon banks for debt funding and banks in India don't fund anything unless the borrower is large enough or unless they the borrower is classified as priority sector. If a corporate entity doesn't fall into any of those categories, their growth expectations are doomed because banks just wouldn't fund. 

Of course, banks have their own reasons. Most of these small financial institutions would be less than investment  grade (as per rating agencies) or just about investment grade. "Risking" money in something that the rating agencies don't call investment grade is criminal in a bank setup.What banks miss though is that there is a way to assess such companies by moving out of the branches and observing the operations of those companies, their people and their practices. A small group of debt funding companies (companies that I have worked for most of my career) understand that and provide funding to such small financial institutions based on strong/relevant evaluation practices. In my experience of working with such companies and debt funding of more than INR 9000 Crores, there has not been a single case of non performing assets, be it in the form of on balance sheet loans or in the form of off balance sheet transactions. 

Beyond banks, we also have other sophisticated financial institutional investors who can measure and establish appropriate risk mitigation strategies but even they don't because the size of funding that each individual small financial institution seeks is not economically interesting. Honest and successful efforts have been made by the organisations that I have worked with to bring such sophisticated investors to fund these smaller financial institutions but it still takes a lot of push to make such transactions happen. It is not the norm.

As a result, the growth of new small financial institutions which have the ability to cater to smaller enterprises and customers, enabling financial access for all have been very slow, painfully slow. Entrepreneur interest in setting up new financial institutions to reach out to smaller enterprises and households have waned in spite of all data/reports and literature suggesting that there is a large market to be addressed. The number of new NBFCs coming up in the Indian market have slowed down in the last 2-3 years. The only ones who continue to move ahead are the ones with significantly large equity backing. Crossing the Chasm before success is dependent entirely on equity.

A portfolio size of INR 100 Crores in portfolio outstanding seemed to be like something that could garner interest of banks. Such a portfolio size could also give rating agencies enough track record to consider a rating upgrade. It seems that the number of INR 100 Crore in portfolio size is becoming less important now. It is more important now to know how much of that INR 100 Crore is funded with equity because more often than not, debt wouldn't be easy to get for such companies anyways. 

In other words, bootstrapping as a strategy to enable access to finance for SMEs in India is a very challenging job! So, banks won't fund small enterprises because they are small and risky and no body would fund those who can fund small enterprises because they are not large and not priority sector. How do we then make it easier for small enterprises to access debt in India?

Photo Courtesy: rgbfreestock