MSME Lending - The $500B+ Market

I have been fascinated by the evolving landscape for fintech in India. A couple of days ago I wrote a post on how Neo Banks can provide a superior experience to millennials. While I was researching about Neo Banks for millennials for my long post, I read few notes on opportunities for fintech in MSME space. I found it equally exciting and decided to partner with a few knowledgeable folks from the industry to understand this space better and share my learnings with others via a blog post.

Before I begin my post, I want to thank Gautam, Manish, Sandeep, Shreyance, Sidak and Vidhu for helping me understand this space and also contributing to this post! I am an absolute novice in this space and got to know about MSME lending space in a lot of more detail from them.

MSME sector snapshot

There are around 60 million MSMEs employing over 120 million people in India. MSMEs account for about 30% of GDP and 45% of India’s overall exports. However, a whopping 95% of the 60M MSMEs fall into the Micro segment and the rest into the Small segment. A fraction of the % also fall in the Medium segment. The ministry of finance has recently revised the definition of MSME as a part covid economic stimulus package - Atmanirbhar Bharat Abhiyan

60% of MSMEs are from rural regions and bulk of the MSMEs are concentrated in 10 states with Uttar Pradesh and West Bengal being the top 2 states and Tamil Nadu is distant 3rd

It is also interesting to see the sectoral clusters that are formed across India from the below snapshot of machinery demand pulled from IndiaMART investor presentation. It is important to note that each cluster will have its own nuances for lending needs.

20% of MSMEs are into manufacturing and the majority chunk is into services. As per 6th economic census 2014, below are the top categories of establishments under MSMEs

As it can be seen clearly MSMEs are one of the pillars of the Indian Economy and growth in this sector is precursor to overall growth of the economy. Additionally MSMEs also contribute indirectly to the growth of many downstreams consumption based businesses and services.

95% of the MSME firms fall in micro category. This is in a way problematic as it suggests that micro firms have failed to grow into smaller and medium firms and so on over time. One of the reasons for this is the lack of participation by MSMEs in the massive government capex spends as the contract clauses are too restrictive for them to participate. This is however changing with recent focus on ‘vocal for local’ initiatives. Another reason for low share of medium enterprises is the mismatch of incentives for good micro firms to upgrade themselves to smaller or medium segments.

Both the government and the private sector alike have put a lot of focus to understand the challenges that are hindering the growth of this sector and enable the required levers for MSMEs to propel forward and grow both on domestic and export fronts

Growth challenges for MSME

MSME faces significant growth headwinds on multiple fronts as shown in the below table

Among all the challenges mentioned above, lack of access to adequate and timely credit is one of the biggest hurdles to the growth of this sector. It is important to note that solving for credit access will indirectly also contribute to improving other aspects like awareness, sector formalization and adoption of digital transactions.

Access to credit

MSMEs need credit for 2 broad needs - working capital and capital expenditures. Lack of access to finance continues to remain the biggest challenge for this sector and it is independent of the category of the MSME - Micro, Small or Medium. Total addressable credit demand from MSMEs is around $500B and growing annually by 20%. Supply from formal financial sources is pegged at $165B and there is a massive unmet credit demand of $400B!

It is no surprise that a bulk of this gap is currently met via informal financial lending routes. Within the informal financial sector, non-institutional sources include family, friends, and family business, while institutional sources comprise moneylenders and chit funds. Informal financing is preferred due to ease of access, speed of disbursal and minimal documentation despite being more expensive than the formal one. Another additional reason is also the self-selection of MSMEs based on their past track record to approach informal routes rather than formal routes. For instance, sick industries, newly launched industries as well as companies that chose not to register with MSME would have no option but to approach informal sources for lending.

The average ticket size and duration of a loan from chit funds is INR 2.5 Lakh and 25 months respectively. The interest cost in a chit fund is typically in the range of 12% - 14%, cheaper than bank and moneylenders. However the processing time is anywhere between 1 to 3 months. While banks charge 12% to 20% and processing time of 2-3 weeks. Moneylenders on the other hand offer it instantly but interest rates vary between 36% to 200%. 

Banks are the dominant source of formal financial lending to the sector owing to their wide regional footprint, regulatory mandate around priority sector lending and in the general attractiveness of the sector from increasing their balance sheet. NBFCs too ha been participating in SME lending and their share is growing rapidly. This is for various reasons - earning higher interest spread, faster disbursement and use of new-age credit assessment models and processes. 

Despite the massive potential of growth in lending, it has challenges both on supply and demand side.

Barriers to lending

Lender Challenges - Financial Institutions

Financial institutions struggle to fund the aspirations of MSME entrepreneurs due to below reasons - 

• High NPA - MSMEs have one of the highest NPAs across various lending categories. However NPAs are the lowest for Micro enterprises among MSMEs. Banks thus tend to lend more to Micro and SMEs with each having a share of about 20%. 

• Inability to pay stems from the issues related to delayed buyer payments, business & market risks. Additionally there are intention issues due to political issues (eg: loan waiver news), corruption and general perception towards such loans (backed by govt schemes) as being ‘free money’

• High cost to serve - Assessing creditworthiness of MSMEs is a challenge due to the lack of information around financial performance. This leads to a high-touch servicing approach which increases the cost of servicing. GST + Aadhaar + TReDS (explained later) details has significantly lowered the cost of servicing but there is still a challenge in lending owing to the fact that over 85% of MSMEs are not registered on MSME Udyog Aadhaar. This is important especially in small ticket loans where high cost to service makes the business proposition unviable.
• Lender coverage - Atleast 50% of MSMEs are located in rural parts and in states which do not have good lender coverage. These lead to two problems - Over supply of financial services to select geographies leading to severe competition among lenders to credit. MSMEs in remote and rural areas feel disadvantaged and are prone to migrating to urban areas where services are better leading to further concentration of employment in urban clusters

Despite the challenges, Banks and NBFCs prefer to invest to MSMEs for various reasons - 

• Better margins (more than offsetting the higher cost of servicing)
• Better cross-selling opportunities
• Diversification of risk on bigger base and lower loan ticket sizes
• Lower chances of prolonged legal conflicts with borrowers
• Benefit of government subsidies and support
• Among the better avenues to lend under priority sector lending

Borrower Challenges - MSMEs

Majority of unregistered MSMEs are nano / household type enterprises that don't find any tangible benefits with registration. They feel the cost of managing the official machinery, paperwork, costs and rent seeking required by registered MSMEs is far higher than the benefits that they can achieve. Additionally the documentation and time required to apply for even small loans deters them to approach banks and makes them prefer informal channels. BCG in collaboration with Omdiyar Network ran a quantitative survey with MSMEs to understand their challenges in getting credit

For MSMEs access to credit is not difficult given the ticket size and the support from the informal credit sector. But this comes at a steep price that can adversely impact their financials.

Other MSMEs who achieved a certain business scale and want to register also struggle due to the lengthy process of registration. This devoids them from access to formal credit channels and govt support in terms of waivers, tax benefits, training and expansion support. They additionally struggle to raise capital from banks due to lack of adequate collateral.

Summary

Most of my posts tend to be long and spill over to multiple posts. This one is no different! In this post, I covered MSME landscape and the barriers to lending both from financiers and the borrowers i.e. MSMEs. I will cover solutions that can help in overcoming the barriers and unlock the massive $500B credit opportunity for Fintech startups, banks, NBFCs and MSMEs!

Please reach out to me if you find anything incorrect or not been attributed to right source. I will get it corrected quickly

Link to next post on this is now out! Check it out here - https://www.dhirubhai.net/pulse/msme-lending-disrupted-deepak-malani

References

Do read through the link if you want dwell deeper into this segment!

• Making Indian SMEs globally competitive - https://164.100.117.97/WriteReadData/userfiles/MSME.pdf
• RBI Expert Committee on MSMEs - https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/MSMES24062019465CF8CB30594AC29A7A010E8A2A034C.PDF
• Invoice discounting presentation axis bank - https://www.gtreview.com/wp-content/uploads/2016/08/Online-marketplace_A-new-digital-revolution-in-financing-solutions-for-MSMEs.pdf
• RBI govt note on MSME challenges - https://www.bis.org/review/r200306e.htm
• MSME Debt challenges - https://www.intellecap.com/wp-content/uploads/2019/04/Financing-Indias-MSMEs-Estimation-of-Debt-Requireme-nt-of-MSMEs-in_India.pdf
• Credit Disrupted - https://www.omidyar.com/sites/default/files/file_archive/18-11-16_Report_Credit_Disrupted_Digital_FINAL.pdf
• Neo Banks - A Global Deep Dive - https://s3-us-west-2.amazonaws.com/medici-prod/root/Medici/public/ckeditor_assets/attachments/478/NeoBanks-_A_Global_Deep_Dive.pdf
• SME Neo Banks in various countries - https://www.dhirubhai.net/pulse/neobanks-smes-pricing-competition-brings-value-small-marcel-van-oost/?trk=related_artice_Neobanks%20for%20SMEs%3A%20pricing%20competition%20brings%20value%20for%20small%20businesses_article-card_title