7 ways to bridge the MSME credit gap by banks, other lending institutions

By Bhavik Vasa

MSMEs are the backbone of global economies and more so in fast-growing markets like India. They aid in generating a large number of employment opportunities, thus contributing significantly to economic growth and GDP. MSMEs feed larger enterprises and spawn more expansive and robust industrial output.

Today there are over 64 million MSMEs which collectively contribute over 30% of our country’s GDP and some 44% of exports while providing employment opportunities to over 164 million people accounting for 31% of the workforce. Yet, industry reports peg the MSME credit penetration in India at just 14% against the larger economies like the US and China, where the credit penetration is at 50% and 37%, respectively.

If India is to realize its ambitions to grow to a $5 trillion economy, it is more imperative than ever to ensure the growing credit needs for this already severely underserved segment are met. As per ‘India Digital SME Credit Report’, there is an existing credit gap of over $170 billion and the working capital requirement for MSMEs is expected to grow to over $570 billion by 2027.

This gap can be attributed to many reasons, including stringent collateral requirements, high interest rates, and the perceived risk associated with lending to smaller enterprises. Priority Sector Lending (PSL) seeks to help correct some of these problems.

All lending institutions such as Banks, Microfinance Institutions (MFIs), Development Financial Institutions (DFIs), Non-Banking Financial Companies (NBFCs), fintechs, and various government schemes play a crucial role in addressing the credit needs of smaller enterprises and priority sectors, thereby helping to bridge the credit gap. Some of the ways this is and can be supported include:

Statutory Credit Allocation
The central banks stipulate that financial institutions should lend a certain percentage of their portfolio to the priority sectors, including micro, small, and medium enterprises. For example, in India, the statutory requirement is that every bank should deploy at least 40% of its Adjusted Net Bank Credit to priority sectors as mandated by the Reserve Bank of India. This statutory requirement ensures MSMEs get at least a minimum quantity of credit and are not wholly squeezed out of credit markets by big and more established businesses.

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Lower Interest Rates and Favorable Terms
Loans under PSL are often made available at subsidized rates, vis-à-vis straight commercial loans. This brings down the cost of borrowing for MSMEs and, in general, their cost of capital. PSL loans also involve more liberal terms, such as longer tenor and less stringent collateral requirements, than are available in regular business loans. Hence, it is easier for MSMEs to avail themselves of and service them.

Improved Access to Credit
PSL policies make it easier for lenders to lend to MSMEs by offering them credit guarantees against the risk perceived in lending to such small-scale enterprises. Since priority sector lending encompasses the MSME sector, it sets a target for the delivery of financial services to all, even the very micro, business units. While Traditional Financial Institutions (FIs) make use of their network and infrastructure and offer a variety of credit products designed especially for the MSMEs, NBFCs use alternative data, are lenient in giving loans to them and the processing time is also quicker. Fintechs provide access to credit by using digital platforms, leveraging big data, and offering innovative solutions like peer-to-peer lending.

Development of Tailored Financial Products
Financial institutions design special financial products for MSMEs to comply with their PSL commitments. In these instruments, they address the problems and needs of smaller enterprises. These institutions could also offer advisory services to help MSMEs overcome the hurdles of credit availing and manage finances effectively.

Encouragement of Non-Dilutive Financing
Opening up the possibility for non-dilutive financing options, such as loans and grants, to set MSMEs on the path to access finance without diluting their equity so that they can have full ownership and control. Other innovative financial solutions, including invoice financing or supply chain financing, cash flow-based financing and revenue-based financing, which PSL enables, allow MSMEs to have immediate liquidity off the back of receivables/supply chain activities and without the need for traditional requirements like collateral or significant vintage.

Government and Institutional Support
PSL is often supported by policies and programs of governments in providing financial incentives and support to financial institutions in lending to MSMEs. Most countries have credit guarantee schemes that back a portion of the loans being provided to MSMEs, which reduces the risk for these institutions to lend more actively to this sector.

In 2022, SIDBI launched the “MSME Emergency Credit Line Guarantee Scheme” for additional funding with government-backed guarantees to support businesses affected by Covid-19. It helped the MSMEs to get liquidity and thus continue to run their operations during a period that was indeed very tough. Under the scheme, more than ₹3 lakh crore was disbursed to MSMEs, helping bail out several businesses spread across various sectors and recover from the pandemic shock.