India's Growing Credit Gap: Digital Lending to serve Women and MSMEs

I know its hard to imagine that there is a dearth of loans being disbursed by our financial institutions, especially when we are fielding unwarranted Personal Loan calls all day long. But economists estimated that India has roughly a gap of ? 25 Trillion in terms of need for credit, versus actual credit disbursed. In FY 22, Banks and NBFCs disbursed ?90 Trillion, and this year they are set to close the financial year with a 100 trillion. That means 25% of the market is still not having their needs met.?

And we shall look into the high margin world of lending, but I cannot start my newsletter without first welcoming all of you. I just wanted to thank you for your support, in subscribing to The Fintech Chronicler, and as always, hoping you have a great start to the week. Also, I would love to hear from you. What is it that you like about my newsletter, and what would you rather I change? And when it comes to lending, did you know about these 5 headlines from the last week, which could possibly impact you?

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Now lets get back to India and our lending opportunity.

India's Credit History

The problem isn't with disbursing of loans for banks and NBFCs. It is with identifying the right set of people to lend to, who would not turn delinquent, either wilfully or otherwise. And every lender is fighting to get to those customers with the appetite plus ability to repay. In fact, a lot of headway has already been made, with the gross NPA of the industry standing 1.3%. But to reach that last quarter of underserved market, Digital can be a major amplifier. Especially thanks to the numerous data points, and alternate source of information that one can collect, and use to build a persona of their target users.

So what has the past of Credit in the country looked like?

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During the Mauryan period, when Kautilya wrote in his treatises, a standardised system of lending money out. RNapatra, RNapanna, and RNalekhaya were the three distinct loan deed formats. This was way back between the years 321 and 185 BCE. In the Mauryan period, an instrument known as an adesha directed a banker to pay the stipulated quantity on a note to a third party, akin to a modern Bill of Exchange. Moreover, many merchants frequently used Letters of Credit. Dastawez, another type of money loan popular during the Mughal era, came in two flavours: Pay on Demand (dastawez-e-indultalab) and Pay after a tenure (datawez-e-miadi). They also had an instrument called Hundi, which acted a lot like our modern day credit card systems.

Then came the Imperial impact on Lending when Great Britain colonised India. The financial sector grew more standardised and organised. They helped establish the country's first bank – Union Bank of Calcutta. Allahabad Bank opened its doors in 1885, and continues to welcome customers to date. The Oudh Commercial Bank was the first wholly Indian bank to open, and upon its demise paved the way for the Punjab National Bank to open in 1894. As part of the Swadeshi movement, many new regional banks opened from 1906 to 1911. Four nationalised banks and one private sector bank were founded in what is now known as the unified Dakshina Kannada District, often known as "The Cradle of Indian Banking."

And yet, if you have the privilege of having elders from two generations ago, they’d tell you, “Karz me rehna buri baat h” (translates to “Its not good to be in debt”). That could be attributed to India’s small money lenders, who true to their Shylock nature, would extract every pound of flesh from defaulter. To combat that, with the establishment of the Reserve Bank of India, we paved the way for Banks and later NBFCs to lend in their current form.

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The Rise of Digital Lending : BNPL

Now lenders have to play a delicate balancing game, of whom to lend to that they can get the max interest out of, and how much of a risk they can take on their plates, lest the borrower is unable to pay back even the principle. To help them make this decision, we have credit bureaus, who score borrowers on the basis of their past behaviour.

I wont get into the nitty gritties of how banks use Credit Bureaus but you can read an older edition of my newsletter of mine here and here. But even without reading the article, you would have spotted a flaw in the above model. Namely that banks only lend when they know someone can and has paid back their dues in the past. But what about new or first time borrowers? And who ever said the past will always repeat itself?

But that is not all. The new age buyer has a vastly different mindset and behaviour than that of the older generation. This is especially true in India, where half the population comprises of Gen Z and Millennials (yours truly included).

The above study by Experian was also illuminating on how needs of the new generation are changing, as is their relation with money. Most of the Internet users today (75%) belong to this category, where they are used to getting things at the click of a button. SO, expecting them to plan out a big purchase well in advance, having waited months to apply and get the loan, is well, silly!

And that is why option like BNPL literally grew wings and took off.

Lenders started to pay attention. And realised they didn’t really have the tools to cater to this segment. So they took the next best course fo action. Tied up with these BNPL companies. So much so that 44% of the digitally sanctiones loans were co-lent with these Fintech platforms.

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RBI's Digital Lending Norms, and the brakes on BNPL

The Reserve Bank of India (RBI) updated its regulations for digital lending in India in September 2022. The new rules included limiting first loss default guarantee (FLDG) arrangements, restricting loan disbursement and repayment fund-flows, prohibiting credit on e-wallets, and regulating the collection of fees by lending apps. This move sent several new age Fintech companies scrambling to change their business model, or/and update the terms of their usage. Most of them stopped onboarding new customers immediately, which given the fintech winter, also impacted their valuations and ability to raise subsequent funding rounds.

The RBI, India's lending authority, recently urged digital lenders to be transparent while offering their products online. Banks and NBFCs are responsible for regulatory compliance whether or not a third party facilitates loans (including those relating to client protection and product transparency). The RBI governor recently met with a few major fintech firms and assured them that the RBI will continue its consultative and collaborative approach to financial services innovation.

FLDG: Banks and NBFCs, two types of regulated lenders, can use FLDG to decrease credit risk by engaging with fintech firms to discover new loan customers. Under FLDG arrangements, fintech businesses give lenders with collateral (cash, lien-marked fixed deposits, etc.) and pledge to compensate lenders for client defaults in their loan portfolio. The RBI's concerns about FLDG comfort posing ecosystem-wide risks are valid. Financial institutions trusted uncontrolled fintech businesses' FLDG guarantees, which caused this.

Nonetheless, the market effects of FLDG bans necessitate a reevaluation. Reducing FLDG agreements without alternative channels will inhibit digital lending, weaken India's efforts to expand financial services, and raise consumer borrowing costs. Regulated lenders may have problems locating customers through fintech firms and digital lending platforms, which may increase expenses for everyone. Lenders may modify their loan product offers, affecting loan size, length, and cost.

Loan distribution and repayment fund-flow issues: the RBI's new digital lending regulations ban pool accounts. Payment aggregators helped market participants transmit funds. For example, a digital lending platform may partner with a payment aggregator to offer multiple digital payment choices for loan repayment. A payment aggregator would then put all repayment funds in an escrow account and pay the lenders.

However, RBI appears to have mandated that all fund-flows be conducted directly between the consumer and the lender, making such arrangements illegal. Repaying consumer loans without payment aggregators could be difficult.

The Central Bank of India limits personal digital wallet loans. Digital lenders and customised products have affected many people (which involved usage of their prepaid wallets or cards to make retail purchases through flexible credit options).

Considering everything, the new digital lending criteria limit fintech companies' capacity to provide digital lending products to Indian consumers. Fintech firms' creative digital user experience is crucial to the industry's success, thus regulatory clarifications are needed.

Now lets turn our attention to 2 underserved target markets, with a huge potential.

Underserved segment: Women

About 45.3% of India's female population lives in poverty. The practise of being married at a young age has a negative impact on the lives of 750 million women around the world, 223 million of them are located in India. Beti Bachao, Beti Padhao, the Kishori Shakti Yojana for adolescent girls, and the Pradhan Mantri Matru Vandana Yojana, a maternity benefit programme, are just a few of the policies that the Indian government has implemented to improve the future of girls and to ensure their full and equal development and recognition.

In fact, the Pradhan Mantri Jan Dhan yojana which saw 46crore bank accounts being opened, had about 56% accounts opened by women. And yet, beyond receiving the Direct Benefit Transfers, these accounts do little else. Overall too, women borrowers are less than 10% of the female adult population, in contrast to 23% for men.

According to a study done in the year 2020, men in India are able to access credit equal to 52% of their deposits, but women in India are only able to obtain credit equal to 27% of their savings. This gap could be due to women simply not applying for loans, which would build their credit histories, or it could be due to financial institutions not extending credit to women on an equal basis.

One other aspect is that women most often do not see their contribution as equal to that of the men in the house either. This is further accentuated in agrarian setup, where the women despite doing equivalent work as the men, are seldom paid the same hourly wages, hence restricting their ability to borrow either.

Fortunately there are some solutions cropping up for First Time women borrowers. Reading this case study by IFC, where women were given small ticket loans, as low as ?20,000 helped them not only out of poverty, but also set up a small business to support their family.

I have had the privilege of witnessing how Self-Help Groups in the hinterland of Tamil Nadu have helped women out of poverty, and becoming financially independent. From holding each other accountable for their spending habits, to saving, and setting up goal based Investment targets, these women have it all covered. I felt I was learning from them instead, on how to be responsible with my money!

But the only drawback was the limited scope of investing. For example, most of these groups would invest in Post Office Fixed deposit schemes. When asked why, it wasn’t better rate of return but the fact that post offices were more welcoming than Banks!

Some Fintechs are trying to solve for this. The hook for them , especially apps like Basis, is education. So instead of pitching products to them, give them the tools to build their castles! What is not to love in that.

Target Segment : MSME

The Reserve Bank of India (RBI) reevaluated and updated the country's Priority Sector Lending (PSL) rules in 2020 to increase access to finance for micro, small, and medium-sized enterprises (MSMEs) and other underserved sectors. With these rules in place, PSL now encompasses startup bank financing of up to Rs 50 crore.

But, by the middle of 2021, a loan deficit of Rs 30 lakh crore still saw??MSMEs struggling. There was a 40% gap between the amount of credit the industry needed and the amount that was actually provided by traditional lenders like banks, according to a study. Five out of every six MSMEs also lacked exposure to these avenues. The disparity in available credit is the result of a number of factors.

1. Small and medium-sized enterprises (SMEs) are classified as high-risk borrowers

MSMEs are considered high-risk by banks and other credit institutions. MSMEs' "inability to pay" and "unwillingness to pay" were lending risks in 2019. Financial institutions are wary of lending to micro, small, and medium-sized firms (MSMEs) due to the risk of business failure and inability to repay loans.

2. Limited scope With no way of knowing the creditworthiness of the borrowers

Lender-MSME partnerships suffer from information asymmetry. Many Indian MSMEs don't keep accurate financial records like tax returns, profit and loss statements, balance sheets, etc., therefore institutional lenders like banks don't know the MSME sector's health.

Banks lack SME credit score data. They also discount MSME business ideas and financial success.

3. No tangible assets to use as collateral

Most Indian SMBs have few assets. They can't borrow since they have no collateral. Because to this and a lack of credit history, traditional lenders cannot mitigate capital risk and reject many applicants.

4. Customer Acquisition Costs

The cost to?lend?to MSMEs grows when these businesses either can't or won't keep adequate records and collateral. Due to the high "cost to serve," many financial institutions avoid extending credit to these businesses.

5 – Trust

India's millions of MSMEs make it hard for lenders to distinguish between borrowers. This misperception makes banks wary of lending.

MSMEs' high loan-non-repayment risk also hurts their reputation. MSME supply chain purchasers often clear transactions in 30–90 days. As customers pay slowly, they do too. In 2021, late payments cost MSMEs 10.7 lakh crore, making banks more apprehensive of lending to them.

So, that brings us to the question. Can Tech really solve for these inherent biases in the system? And if so what kind of Financial service + Tech integration should we be looking at.

The first step would be to remove information asymmetry regarding MSMEs business worth. And the easiest way would be to record their transactions as they happen. Yes, I am talking about Payment Gateways as well as ERP tools that help small businesses to plan and manage their inventories. This is one of the reasons why Pine Labs has been on an acquisition spree of late.

Using this information along with their bank statements, it shouldn’t be too hard for lenders to estimate the runway that MSMEs have and what would be an amount they would be able to repay over a tenure of 6-9 months.

But how can lenders know about the business in the pipelines? Well, this is where the India Stack can help, with protocols such as OCEN and ONDC, sitting on top of Account Aggregation. And while at present, the number of buyers on OCEN is restricted to just Government bids, I’m convinced this will scale to touch every aspect of manufacturing in the country. Coming to Account Aggregators, while today its just a pipeline for financial data alone, imagine how powerful it would be for lenders, if they could use it to also access utility consumption details of Businesses. That could act as a leading indicator of the growth of the business, something they can use to place their bets on these small businesses.

So that is a wrap for this rather long edition of the Fintech Chronicler. If you liked it then do consider sharing it with others. And don’t forget to hit the bell on my profile that way you’d be the first to know when I put out more such content about the Fintech and Crypto space. If you felt it wasn;t good enough, then drop me a comment and let me know. I will work harder to ensure I produce quality and well researched articles next time on.