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What does cash flow-based lending mean for the future of underwriting credit for MSMEs

Credit and finance for MSMEs: The faster the adoption of cash flow-based lending, the better it would be for MSMEs, with network effects for the economy. It would have cascading impact on the overall system leading to new data formats, use cases and product innovation which will help strengthen the banking sector and propel the country’s growth. 

What does cash flow-based lending mean for the future of underwriting credit for MSMEs
Over a period of time, lenders have realized that financial statements alone are not perhaps the best way to assess the risk of an MSME.

By Sudarshan Chari

Credit and finance for MSMEs: It is now well established that MSMEs, approximately 70 million in the country, are key to overall GDP growth and to meeting the employment needs of India. This is primarily why MSME financing continues to be a pivotal point when discussing India’s growth ambitions. Historically, the MSME segment has not been the easiest customer segment to serve given the considerable variation in size, complexity and requirement. The segment could be best described as having the ticket size of a retail customer, but with the needs of a corporate customer, and it is often these business needs that remain largely unserved or underserved.

It is evident through the numbers reported by Transunion that there are around 7 million MSMEs (roughly 10 per cent of the total) with formal access to finance, a total outstanding of roughly $275 Billion as of March 2022. Financial institutions (FIs) have struggled to find a balance between the right products, cost of service, limited returns and higher perceived risk for this segment – given the vulnerability due to low capital, fluctuating demand, inefficient supply chain, concentration risks and lack of a credible balance sheet. Credit growth has been meagre especially when it comes to the addition of NTC (new to credit) and hence the gap between the demand and supply of timely, adequate credit to MSMEs remains high. 

However, there are green shoots in this ecosystem. Thanks to what we call 3D impact – Data, Digital and Determination of all stakeholders (Govt, RBI, Fin-techs and FIs) coming together to leverage this once-in-a-lifetime opportunity. This is not just an Indian phenomenon, but across the globe there is a shift towards capitalizing on the opportunities in the MSME space.

India is placed ahead of its global counterparts, thanks to the concerted efforts of the government which has improved access to digital data, that is, Bureau/CRILC/GST/ Account aggregator platforms that can be leveraged for cash flow based underwriting. This can very well be a water shed moment for MSME lending if all stakeholders within the ecosystem work together to take up the challenge. Given the advancements in data capabilities, uptick in use of digital platforms and payments and support from the regulator, the solutioning around this space can be done keeping the customer journey at the center. 

There are around three factors that need to be addressed to meet MSME needs: a) the overall journey that is designed for convenience b) time to access finance c) risk underwriting that enables the financial institution to lend the right amount to the MSME. The first two can be addressed through a digital journey, but the third factor still relies on offline methods of assessment and verification. Traditionally, similar methods have been applied to underwrite a corporate and SME loans, largely relying on financial statements.

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Over a period of time, lenders have realized that financial statements alone are not perhaps the best way to assess the risk of an MSME and there is often a requirement to look at differentiated metrics for evaluation. We must adopt alternate data points (which are not static) like bank statements. The trend led to the advent of cash-flow lending in India – which is typically short-term working capital loans, provided after evaluating the cash flow of an MSME – primarily using operating bank statements, GST data, transaction data available on B2B platforms and past track records, that is, personal bureau score or CMR Rank. The fact that all these data points have evolved over time and are now available digitally at source has helped to boost the cause of cash flow-based lending. 

This has allowed banks to look beyond traditional products like cash credit or term loans to cater to MSMEs. Domestic trade finance products like invoice financing and post-shipment finance are slowly emerging as the preferred products within the cash flow lending framework. This has allowed overall flexibility in decision making, based on tenor, ticket size, repayment cycle, additionally factoring in sector specifics and the business cycle. Improved decision making has laddered up to another important paradigm shift – lenders are increasingly willing to consider collateral free loans in the MSME segment, which has so far been asset-backed. 

The success of any initiative largely depends on the willingness of decision markers to support the cause. Be it RBI’s nudge to look at cash flow-based lending for MSME, the push for digital infrastructure in the form of an account aggregator framework and the launch of the TReDs platform for cash flow-based lending; all of these have provided the impetus for FIs to act upon. Additionally, the government’s overall push for MSME credit through revised definitions, priority sector lending inclusion or the overall digital push through UPI, GST and Udyog Aadhar have ensured that there is due focus on sharper execution. Above all, what has propelled the change is the new entrants in the form of fintechs and neobanks who are boldly challenging the status quo. 

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The journey has just begun and there is way to go before the new lending models become scalable and sustainable. Digital platforms, enhanced with input from various data partners, would complement the cash flow-based lending framework. This would enable a simplified customer journey and a reduction of TAT for the customer, it would simultaneously allow banks to adopt light touch origination and underwriting models to onboard customers. Eventually, the trend towards digitalization would help banks to address some of the concerns around cost of service and allow flexibility on pricing. 

However, the real acid test would be the pace of adoption to cash flow-based underwriting. This would need more than surface level changes and require fundamental changes in the approach. One would need to experiment with alternate data points relying on financials. In the long term, this would enable FIs to offer the right product at the right price. 

Cash flow-based lending has the potential to positively disrupt the MSME sector and can have a wide-scale impact on the entire MSME value chain. One can expect far-reaching potential from this area, not only in underwriting but also as banks evolve their monitoring frameworks and meet customer requirements on an ongoing basis. The faster the adoption of cash flow-based lending, the better it would be for MSMEs, with network effects for the economy. It would have cascading impact on the overall system leading to new data formats, use cases and product innovation which will help strengthen the banking sector and propel the country’s growth. 

Sudarshan Chari is the Executive Director & Head Business Banking at DBS Bank India. Views expressed are the author’s own.

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