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Alternative Finance: Redefining Lending Paradigm for MSMEs in India

By Jyoti Wadhwani:

Senior Analyst (Economist), Guest Contributor, WASME

Introduction

MSMEs in India play a crucial role in contributing to the overall economic growth. In India, MSMEs account for more than 80% of total industrial enterprises and employ an estimated 117 million people. Moreover, MSMEs make a significant contribution of more than 40% to industrial output and exports. However, there is a huge and unidentified potential in this sector which is yet to be harnessed to make it an economic powerhouse of employment creation and innovation. As per the MSME census of 2006-07, it has been found that more than 92% of MSMEs in India did not have access to finance from institutional sources. Besides, the bank credit to this sector has remained largely flat over the past two years at INR4.7 lakh crore (as of September 2017). Undoubtedly, access to finance has been the biggest challenge for the MSMEs in India to grow, innovate and create jobs. Notably, over 50% of the MSMEs in India are rural enterprises widely distributed across the low-income states, making them an important sector for promoting inclusive economic growth and poverty reduction. (World Bank, Aug 17).

Indian MSMEs face several constraints to access credit from the formal financial system

In the light of above, it is evident that the present banking system in India is needed to go through radical transformation to cater to the financing needs of MSMEs. The traditional banking though very predominant in India even today, involves lengthy procedures to grant loans to the MSMEs. Hence, MSMEs fail to obtain timely credit during their various crucial stages of growth. Besides, the quantum of credit approved is also based on the collateral offered to the banks, thereby limiting the required access to credit. Apparently, concerns over rising non-performing loans (NPLs) in the Indian banking segment and the implementation of more stringent Basel III capital adequacy norms, banks have become extremely cautious in lending to risky ventures and individuals.  Moreover, the lack of credit information of the MSMEs also prevents banks from extending financial aid. Unsurprisingly, the restrictive banking system in India has led to a much wider funding gap, restraining the MSME sector’s growth prospects.

Finance gap in the MSME sector in India

As per report of the International Finance Corporation 2012, the MSME segment in India is characterized as largely undercapitalized segment. It has identified that there is a considerable demand-supply gap of INR3.57 trillion which though viable and addressable by the formal financial institutions, remains unmet. The finance gap is composed of debt gap of INR2.93 trillion and equity gap of INR0.64 trillion. Geographically, it indicates that there are more service sector enterprises across India than manufacturing units (71:29). However, given that manufacturing enterprises are more capital intensive they have higher working capital requirements. Hence, share of the debt in the manufacturing sector is also significantly higher at 73% of the total gap. In order to address these financial gaps, several policy interventions have been made by the fiscal as well as the monetary authority of India to extend financial support to the MSMEs. Besides, the credit rating agencies (CRA’s) are also playing an important role in assessing the credit worthiness of the MSME with help of government subsidies, in order to encourage MSMEs to enter the formal financial system. Nonetheless, there is still a need to enable an environment for greater financial inclusion of MSMEs, assisting them to conduct business in a more smooth and proficient manner.

In this article, we consider some of the alternative financing solutions which can pave way for a more sustainable growth of the MSME sector in India.

Alternative sources of financing for small businesses- finding grip in India

Notably, the new alternative sources of funding in India are at their nascent stage and yet to become proven and sustainable models. However, given the large unbanked population, there is a good space for these financing channels to flourish and establish. Some of these innovative and transformative approaches are discussed below:

Factoring Mechanism: Factoring is a very effective tool as it helps in managing the cash flows of the company who have deficient working capital arrangements. The tool involves selling of accounts receivable (debtors) to a third party (factor) at a discounted rate. The companies facilitating factoring services pay cash against the credit sales of the client and obtain the right to receive the future payments on those invoices from the debtors. This tool proves to be very effective for MSMEs in addressing liquidity issues and finance operations which otherwise may result in loss of opportunities from the revenue that it may be able to garner. In India, the potential for this tool is very huge, as the use of this facility though suitable is overlooked. However, there are several service providers in India at present after the regulatory obstacle was addressed by The Factoring Regulation Act in 2011, which came into effect in February 2012. This Act now regulates the factoring business in India and focuses on promoting the factoring concept and spreading awareness. However, the factoring market is not yet robust compared to other international markets and this could be attributed to lack of awareness, low customer reach by factoring companies, etc. It is essential to encourage use of this tool as it results in higher utilization of resources, higher profits margins and more importantly enables smooth functioning of business operations. Markedly, international factoring also appears to be an attractive tool for exporters compared to traditional letter of credit.

Private equity: Another financial solution would be to cater to the equity needs of the small businesses which would be essential to expand the business and bring about sustainable growth. Though private equity (PE) investments have gathered momentum in India they are skewed towards the larger businesses while private equity investments in small businesses are yet to establish a firm footing. The venture capital funds and angel investors have shown interest in MSMEs; yet there is still a significant push needed in the MSME space. The listing of companies on the MSME exchange has been an important initiative taken by the regulatory authority. However, currently there is a real challenge of market making which is absent and the underwriters to support public issues of MSMEs.  Alternatively, the heavy reliance of MSMEs on debt has been creating pressure on their balance sheets. Besides, the present environment is confronting many regulatory actions like demonetization and implementation of GST which have slowed the growth in industrial segment and banks are reeling under the pressure rising NPAs.  In such circumstances, raising fresh loans from banks, MSMEs are likely to face several challenges with increased uncertainty over future cash flows. It is thus important for the MSMEs to shift their focus from debt alone to funding mix with equity capital to grow in healthier manner. This alternative source offers plenty of positives in terms of strengthening the balance sheet, increased capacity to withstand volatile business environment, higher flexibility in deciding the return on investment, etc. Moreover, raising funds through private equity is easier as opposed to public issue and requires minimum regulatory compliance.

Crowd funding: Crowd funding also called as democratized funding is web-based tool which involves seeking mainly smaller funds from multiple lenders through a social platform to fund new ventures. It is a big opportunity for small borrowers who are unable to raise funds through traditional means due to credit scores or higher interest rates. This concept is also in its nascent stage in India as yet. SEBI, the regulatory authority in India has been actively considering this concept and has proposed a framework to encourage and streamline the crowd funding market. A solid regulatory framework is expected to go a long way in enabling a sustainable business model in an emerging market like India.  This concept is likely to gain traction in India given that it requires huge social media penetration. Interestingly, India has outpaced the US to gain the leading position for Facebook (a social networking platform) users. This Facebook usage could prove to be a useful tool because in crowd funding the “single most predictive factor for the rate of emergence is social media penetration”, as mentioned in the World Bank report titled ‘Crowd funding’s potential for the developing world’. Presently, the US, UK and China are big key players in the crowd funding market. In India, there are merely 10 crowd funding platforms as of 2013, as per World Bank notes.

Peer to Peer (P2P) lending: P2P lending, a form of crowd funding, has become increasingly popular globally post financial crisis of 2008. P2P based lending platform seeks to connect interested investors and borrowers with matching requirements without any involvement of a formal financial institution, unlike other Fin-tech companies which act as intermediaries between the banks and borrowers. It caters to the borrowers without the need for collaterals and at affordable rates which are lower than the bank rates. Meanwhile, the investors holding idle cash have the options to fetch lucrative returns.  However, this lending concept is at its initial stage in India and still remains unregulated. However, these start-ups have been the recent buzz in the financial market. Several start-ups have been catching up in India to cater to the needs of the MSMEs. These start-ups not only aim to provide affordable credit in a simplified manner but also ensure real-time loan approvals for applicants within a fixed timeframe.

Fin-tech start-ups: Fin-tech start-ups have also gained momentum in India recently. This technology based firms act as intermediaries between the banks or NBFCs and borrowers and charge a processing fee for the transaction from both. Given the rich build of database in India these start-ups differ from traditional financing in terms of credit information of the borrower. They arrive at holistic credit scores that are more inclusive of myriad data points compared to the conventional credit bureaus which consider around merely 30 parameters, thus helping the enterprise to build a credit history.  It thus involves a more comprehensive credit evaluation of the small borrowers. This not only assists in faster processing of the loan applications but also helps small enterprises to get more competitive and make most of the business opportunities.

The technical challenge of MSMEs

The new and fast trending online lending platforms though could bring about an impressive push to the MSME sector growth; they are currently facing several challenges at their initial stages. Of the more than 50million MSME’s in India only 10million are active internet users. Hence, it becomes crucial for these enterprises to get more digitally active to be fully aware of the available alternative financing solutions and to reap their advantages. Interestingly, Google India has taken this initiative by launching ‘Google my business’ app to promote usage of the internet by MSMEs and aim to make 20 million MSMEs technology oriented. (Forbes)

Alternative financing-a boon to emerging market like India

Alternative financing in India though it is yet to establish its roots in India; it is certain to give positive push to growth of the MSMEs. The key hurdle i.e. inaccessible timely credit at competitive cost which has been a major challenge faced by MSMEs over the past several years, the alternative platforms aim to provide simplified and customized access to finance along with more active participation and guidance in the overall growth and operations of the enterprises. Besides, in the era of rapidly changing technology, it is also essential for enterprises to overcome the risk of becoming technologically obsolete. Hence, alternative sources are expected to be the key drivers, providing convenient and cost effective funding during the crucial stages of growth of the small and medium enterprises, thereby aiding sustainable growth. These alternative solutions are known to be popular among advanced countries suggesting that these alternatives are more likely to thrive if implemented in India as they help in bringing the borrowers and investors closer. However, these innovative methods would prove to be fruitful if established with strong legal framework involving greater transparency which would not only encourage borrowers but also build greater confidence among investors.