Bridging The $540 Billion Credit Gap for Indian MSMEs

The world of Micro, Small, and Medium Enterprises (MSMEs) in India is a vibrant one, contributing over 30% of the nation’s GDP and generating around 110 million jobs. Yet, these businesses face a staggering credit gap of $540 billion.?

A mere 14% of India’s 63 million MSMEs can access credit, a shocking statistic given that these enterprises are touted as the backbone of the Indian economy.

What is preventing MSMEs from securing the financing they need to thrive and expand? Addressing this gap is crucial if India is to reach its $5 trillion economic goal, but assigning blame solely to lending institutions oversimplifies the problem.

As per Redseer, Of the total 64 million MSMEs in India, roughly 12%—about 7.7 million—are recognized as digitally mature brands, while the rest are at different stages of their digitization journey.

While banks and Non-Banking Financial Companies (NBFCs) have an undeniable role in MSME financing, the issue is multifaceted, with both systemic challenges and evolving solutions.

Also, read our take on the 'Credit Gap in India’s MSME Sector: Causes and Effects of Lending Bias'

The Often Rigid Lending Practices

Despite the priority sector lending (PSL) requirements set by the Reserve Bank of India (RBI), MSMEs often face difficulties navigating traditional lending frameworks. Digitized MSMEs have a current working capital demand of around $220 billion, with eCommerce making up about 70% of this. Infact, this demand is expected to grow to $570 billion by FY27 as the number of digitized SMEs is projected to double in five years.

While MSMEs have made great strides in accessing market capital, they continue to face challenges, including collateral requirements, loan approval processes, and a difficult approach towards NPAs (non-performing assets). These factors can stifle small businesses, especially when cash flow disruptions—often due to delayed client payments—occur.

Grievance Redressal: A Missing Link

Compounding the issue is the lack of an effective grievance redressal mechanism within the banking sector. In terms of grievances, the average ratio of complaints lodged by individuals to those filed by proprietorships is over 297:1. This absence of transparency leaves many businesses feeling abandoned.

The Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) was established to provide collateral-free loans to MSMEs. However, this scheme is riddled with limitations. While loans up to ?10 lakh are mandated to be collateral-free, anything beyond that is at the discretion of the banks. As a result, many MSMEs are compelled to provide security for larger amounts, which is often a barrier to accessing the funds necessary for growth.

Addressing The Current Schemes

Despite several government initiatives and pilot projects aimed at helping MSMEs, the results haven't quite met expectations. For example, the National Mission for Capacity Building of Bankers for Financing MSME Sector (NAMCABS), which is meant to improve bank officials' understanding of MSME financing, had only 3,950 participants in its programs during 2023-24. This small number isn't enough to address the broader issues in how banks engage with MSMEs.The limited participation could also be due to a lack of awareness about such schemes.

Gaps on a Global Level

1. Impact of Global Markets: Indian MSMEs have recently faced increased challenges as major retailers in the US and Europe cut back on purchases due to inflation and economic uncertainty.
2. Rating System Challenges: The absence of a standardized rating system for MSMEs hampers lending. Unlike the CIBIL ratings for individuals, MSMEs registered on the Udyam portal lack a comparable private rating, making it challenging to assess their creditworthiness. According to Mahavir Pratap Sharma , the past Chairman of the MSME-dominated Carpet Export Promotion Council (CEPC), MSMEs registered on the Udyam portal should get a private rating akin to the CIBIL ratings for individuals. “The D&B rating of a US retail shop will tell you what its average payment days are. With the amount of data that we have in India today, we should be able to get a similar system,” says Sharma.
3. Growing Credit Gap: The credit gap for MSMEs was pegged at $240 billion in 2019 and has only increased since.

Moving Towards a Solution

While these challenges are significant, it's important to acknowledge the progress being made by the lending community and the government in narrowing the credit gap. Banks, NBFCs, fintechs, and microfinance institutions (MFIs) are working to overcome traditional hurdles and offer more flexible, tailored solutions.

More Tailored Initiatives

Financial institutions are developing specialized products to meet the unique needs of MSMEs. For example, banks like SBI are transitioning towards cash flow-based lending, eliminating the need for collateral for loans up to ?5 crore. Such moves signal a shift towards more flexible lending models that accommodate the dynamic nature of MSME operations.

With a strong push from the government, local entrepreneurs are now finding support through various initiatives designed specifically for their needs. Programs like the Credit Guarantee Scheme have been reimagined to offer financial backing without the usual roadblocks, allowing small businesses to expand without the stress of securing hefty collateral.?

At the same time, the rise of MUDRA loans is providing essential credit to micro-businesses, ensuring that even the smallest enterprises can access the funds needed to thrive.

But the story goes beyond just financial aid. Communities are embracing digital transformation, with schemes like the MSME Champions Portal offering real-time support and technological resources to help businesses adapt. Initiatives like the MSME Technology Centers are fostering a culture of growth by equipping entrepreneurs with the skills and tools to innovate.?

The Lending Market Sentiment on The MSME Credit Gap?

At the recent Indian Merchants Chambers’ Banking & Finance Conference, several CEOs of NBFCs spoke on the topic “Digital Lending – Bridging the credit gap” & creating a financial landscape that includes everyone’.?

• K V Srinivasan , Whole Time Director & CEO of Profectus Capital Pvt. Ltd , highlights that MSMEs face challenges beyond capital, particularly in maintaining financial discipline. He points to generational changes and the importance of governance, as well as the need for greater awareness around government subsidy schemes.

• Shachindra Nath , Founder & Managing Director of U GRO Capital , shares optimism about the future of SME financing, predicting that SME credit will eventually grow to match consumer credit levels. He emphasizes the need for a level playing field and a shift in how credit officers approach digital underwriting.

• Sudipta Roy , MD & CEO of L&T Finance , expresses concerns about the complexities of SME underwriting compared to consumer financing, noting that more sophisticated approaches like AI may be necessary to capture the nuances in the data.

• Govind Sankaranarayanan , Co-Founder & COO of Ecofy , focuses on the potential for green financing and the use of technology like IoT devices for more accurate underwriting and monitoring of businesses.

• Raman Aggarwal , Director at the Finance Industry Development Council (FIDC), calls for borrower-specific regulations rather than lender-centric ones and stresses the importance of restructuring loans for borrowers with fragile cash flows. He also advocates for greater access to capital for smaller NBFCs.

• Subha Sri Narayanan , Director at CRISIL Limited , notes that data external to MSMEs can be useful for predicting repayment abilities and highlights the changing funding environment for SMEs post-pandemic.

An MSME Specific Bank?

As per the MSME propagators, the sector needs a dedicated MSME bank that offers more flexible lending terms, a user-friendly complaint system, and a focus on building relationships with small business owners.

This institution could also assist MSMEs in securing foreign currency loans, external commercial borrowings, and financing for medium-sized projects. By doing so, it would enhance the trade finance market and inject greater liquidity into the system, benefiting small businesses.

Although the exact amount of funding required for such a bank remains uncertain, experts note that SIDBI already has substantial cash reserves exceeding ?28,000 crore, which could effectively support this initiative. The potential of MSMEs is enormous, and with the right support, they can drive economic growth and innovation in India.?

The Collaboration At Its Best?

To effectively address the $540 billion credit gap, a collaborative approach between the government, financial institutions, and MSMEs is essential. Initiatives like the Open Credit Enablement Network (OCEN), which aims to democratize credit access through interoperable networks, hold promise for the future. By leveraging digital infrastructure, cash-flow-based lending, and embedded finance, the MSME ecosystem can experience significant growth.

Banks, NBFCs, and fintechs are already aligning to unlock the full potential of MSMEs, and with continued innovation and regulatory support, the sector is poised for a more inclusive financial future. While challenges remain, progress is undeniable. By fostering cooperation across the ecosystem, India can reduce the MSME credit gap, drive growth, and create a stronger, more resilient economy for all.