‘MSME lending not about credit assessment only, but also merchant’s intent, credit risk, loan recovery’

Credit and finance for MSMEs: In the lending and fintech environment, there are distinct types of players such as payment aggregators, surrogate players and lending-tech players. However, there are some challenges associated with all these models.

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Traditional lenders often lack the flexibility and speed needed by MSMEs.

By Vaibhav Lodha

Credit and finance for MSMEs: MSMEs are the backbone of any economy, accounting for a large portion of employment, production and exports in most countries. In fact, 33 per cent of India’s GDP comes from the MSME industry — this sector is also responsible for the generation of over 120 million jobs across various industries, all of which contribute to wealth creation.

It is therefore essential to ensure that these businesses have access to the financing and resources they need to grow and succeed. However, formal sources of credit only reach about 39 per cent of MSMEs, according to government data. This gap is caused not only by a lack of credit supply, but also because of the absence of easily available and accessible collateral-free sources of credit.

With traditional banks becoming increasingly risk-averse, fintechs are uniquely positioned to fill this role by providing the funds and financial services MSMEs need to stay competitive and remain profitable. Moreover, the use of technology can also help SMEs reduce costs and make their operations more efficient.

Fintechs & NBFCs: Simplifying borrowing for today’s MSMEs

Fintechs have revolutionized the lending process for SMEs. By leveraging technology, these companies are able to offer simple, easy-to-use services and highly competitive interest rates. This, combined with the lower overhead costs associated with online financing, makes fintechs an attractive option for MSMEs looking to access capital quickly. What’s more, in comparison to traditional banks and lenders, fintechs are also much faster in processing loan applications.

Also read: Fintech-led digital lending to surpass traditional lending by 2030: Report

Traditional lenders often lack the flexibility and speed needed by MSMEs. Moreover, many fintechs provide funding to businesses that lack sufficient credit history and/or collateral, which can be difficult to come by in these situations. Additionally, fintechs also provide specialized business loans tailored to specific industries, such as real estate, technology, and healthcare.

In the lending and fintech environment, there are distinct types of players such as payment aggregators, surrogate players and lending-tech players. However, there are some challenges associated with all these models.

Payments data-based lending and the challenges associated with collections

Payment Aggregators are third-party services that act as a bridge between buyers and sellers in the financial technology space. In the simplest terms, they gather payment information from buyers and connect them to the seller’s payment processor or merchant account. In this model, merchants are aggregated across spectrums, right from a fish vendor on the street to a Ferrari showroom.

  1. While payment aggregators have merchant transaction data, through which they offer credit to merchants, the data is never exhaustive and/or exclusive. The same data is reflected in the bank statements of merchants and can easily be tampered with, as well.
  2. The number of daily transactions is not reflective of a merchant’s true business potential as cash and multiple payment services are quite often a norm.
  3. For payment aggregators, it’s hard to create one coherent policy that could service a roadside vendor to a large format retail store.
  4. Since large sums of money are already spent to acquire these merchants, some of the companies have tried to retrofit credit products in this space but it increases the risk beyond acceptable and profitable limits.
  5. A substantial number of acquired merchants for this segment are the long tail merchants who are roadside vendors or small stores, based on their transaction history and without complete credit assessment it is also hard to give them credit which can create a meaningful impact on their business.

Also read: Explained: How fintech can be a game changer for MSME lending and finance

Surrogate players and the need to maintain relationship with merchants

Companies offering physical products, business management solutions or solving for trade problems of SMEs, have also started to venture into lending to merchants with the purpose of scaling their business as:

  1. They have access to a part of the merchant data but it’s often only fractional and cannot be easily extrapolated to their business performance.
  2. In often cases, since lending is not their core business, they tend to write off a high number of loans to maintain healthy relationships with merchants.
  3. Based on the player category in this space, it has also been observed that merchants can tinker with data to create favourable lending lines.

Lending-first approach for the win

Despite numerous advances in the fintech sector, the lending-first approach remains unbeatable. This approach to financing involves lending decisions based on factors such as credit score, banking, GST, business performance, physical stock, transaction flow data, savings, network diversity and geographical patterns. By focusing on these factors, lenders can reduce the risk of default and ensure that borrowers are able to meet their obligations. This allows fintechs to provide reliable and safe financing options to MSMEs, providing them with the capital they need to succeed in the global market.

Moreover, the lending-first model allows for managing risk as:

  1. The credit-worthiness is observed in its entirety, just not transaction data or surrogate data
  2. Only those merchants/customers are on-boarded where there is upfront interest in availing credit, enabling for strong unit economics
  3. It has the ability to create specific products for each category or scale of merchant
  4. It allows for physical checks to ensure the data uploaded digitally reflects the true reality of the business on the ground
  5. Lastly, the business is robust for any changes in the market, policy, regulatory or app store changes.

Today, the world of finance is undergoing a radical transformation and fintechs are leading this charge by making the traditional financial system more accessible and efficient. It is safe to say that for fintechs to be successful, they must focus on the “lending first” approach as this strategy places the consumer at the centre of the lending process and allows them to receive access to finance quickly, securely, and efficiently. It is important for businesses to understand the need for responsible lending. Lending is not about credit assessment alone, it is about understanding the intent of the merchant, managing credit risk and focusing on the loan recovery process.

With the wheels set in motion by fintechs, the MSMEs of India can play a vital role in the country’s goal of touching a $5 trillion economy by 2027.

Vaibhav Lodha is the Co-founder of the non-banking financial company ftcash. Views expressed are the author’s own.

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First published on: 01-04-2023 at 16:00 IST