By Avishek Gupta
Credit and Finance for MSMEs: India’s micro, small, and medium enterprises (MSME) sector is the source of innovation and livelihood for millions of people. The country’s 63 million MSMEs represent 30 per cent of India’s GDP and the largest source of employment. One in six of these MSMEs are nano enterprises: very small, informal businesses run by nano entrepreneurs. These nano entrepreneurs have often not had the benefit of receiving a college education, which prevents them from working in the formal economy. Typically they earn less than around Rs 25,000 a month, but they run smart businesses with big growth potential, and they represent a credit market of Rs 2 lakh crore.
Yet despite this sizable market, traditional lenders and institutions have steered clear of supporting nano enterprises. This is largely because it’s expensive for traditional lenders to evaluate and service nano enterprises, given their informal nature and smaller loan requirements. Also, nano enterprises’ lack of collateral and verifiable data pose risks for traditional lenders.
That’s where credit guarantees come into play. These guarantees act as a bridge towards better credit assessment of nano enterprises despite limited data and collaterals available with this segment. Hence, setting in motion a flow of capital that nano entrepreneurs can harness to grow their businesses.
Setting off the domino
In the Indian financial market, there are two major players: banks and nonbank financial companies. Large banks and financial companies have abundant liquidity and aim to tap into the Indian market, but their regulations and structures make them typically risk averse, focused on collateral-backed loans. These players are not designed to meet the small ticket borrowing requirements of nano entrepreneurs.
Fintechs and smaller nonbank financial companies (NBFCs), on the other hand, have direct connections with nano entrepreneurs or partner with grassroots organizations to reach these nano entrepreneurs. By adding a layer of technology on top of these connections, NBFCs and fintechs use alternate data models and are able to provide collateral-free loans to nano enterprises. Yet these NBFCs remain constrained in the capital they can access to offer nano loans, because the large institutional capital providers have low confidence in the MSME segment. The Covid pandemic has exacerbated large lenders’ reluctance to invest in these small businesses.
Credit guarantees address major lenders’ credit risk concerns by offering a partial risk protection against defaults. This allows fintechs and NBFCs increased access to liquidity so that they can lend proactively to the nano enterprise and MSME segment, thereby setting off a domino effect of business growth of the 63 million MSMEs, which has a compounding impact on businesses and the economy.
The compounding impact
The pandemic pushed 80 per cent of MSMEs to scale down their operations or shut down temporarily. At the same time, the perceived risk for lending to MSMEs increased, which reduced lenders’ ability to service nano entrepreneurs. Financial services companies dedicated to providing debt capital to retail NBFCs that lend to MSMEs, tightened their credit norms post pandemic to adjust for a heightened risk of lending to MSMEs. This impacted the livelihoods of nano entrepreneurs, their employees, and the community.
Through credit guarantees received from partner organizations, companies providing customized debt were able to directly unlock as much as five times additional liquidity and credit for microenterprises. Further, partial guarantees helped not just meet but also exceed the retail NBFC borrowers’ requests for capital and reduce perceived risk of the loans made to several such NBFCs. For guarantee providers, such pooling of portfolios across different partners enables enough risk diversification to improve their risk appetite. Further, their assessment on the quality and strength of their partners acts as a risk mitigant thereby allowing them to give a fillip in a certain direction, for instance, MSMEs, or exports, or agriculture.
The power of credit guarantees enables not just wholesale lenders to get additional funding from traditional lenders to continue lending to this segment, but also helps retail NBFCs that lend directly to nano enterprises. The risk protection from guarantees helps improve or maintain credit rating of the lenders while building a portfolio of MSME loans. Credit guarantees are an efficient means of unlocking additional credit to MSMEs, and other perceived high-risk segments.
Helping nano borrowers
Credit guarantees have massive potential to meet the needs of India’s MSME sector. Through guarantees, NBFCs and fintechs can lend to first-time borrowers, connecting this sector to formal financial markets and expanding the market further. As more unsecured credit becomes available for the MSME/ nano segment, these small borrowers will begin generating data and building credit histories with their successful repayments. NBFCs and commercial banks, in turn, will be able to use these records to recalibrate their underwriting and credit assessment models, reducing the risk perception of the MSME/nano segment. This will significantly reduce the need for third-party credit guarantee protection in the future for those who have built a repayment track record.
To achieve this goal, a few things must happen. Financial organizations need simpler and more accessible credit guarantee programmes. The market needs a mix of blended finance providers such as development financial institutions, impact investors and philanthropic organizations, to provide credit guarantees. Due consideration should be given to allow lower risk weightage for guaranteed portions of loans. With all these measures in place, credit guarantees can be an effective first domino that sets in motion a new credit market for nano entrepreneurs in India.
Avishek Gupta is Managing Director and CEO at Caspian Debt. Views expressed are the author’s own.