We are at a rare moment in history. Lending to micro, small and medium enterprises (MSME) is at the cusp of witnessing the same transformation that retail lending went through over the last decade. Structural changes on both the demand and supply sides for MSMEs are creating a massive flywheel effect. Demand is growing with rising access and supply is growing with lower cost of origination, and rising confidence in underwriting and collections.
Addressing MSMEs’ credit needs is today a national priority, more than ever. With increasing formalisation of the economy, the pricing advantage that MSMEs had in the parallel economy is eroding. Further, the gradual shift of consumer demand towards organised channels is creating additional growth challenges. Not to mention, the additional cost of building greater sophistication in reporting and compliance. This is a concerning situation for a segment that contributes ~40% of India’s GDP and employs ~120 million Indians.
As MSMEs become more organised, the demand flywheel for formal credit will accelerate. MSMEs recognise that access to formal credit, which is much cheaper than informal sources of credit, can help in protecting their business margins. For a cold storage provider (see graphic), as the contribution from informal sources of funding goes down, the pressure to under-report income decreases dramatically while protecting the business’ return on capital.
Against this backdrop, potentially less than 10% of the 50 odd million MSMEs have access to formal credit as of today. Bridging this gap is a national priority.
The supply side flywheel has been jammed primarily because of three reasons (so far):
- High cost of origination and servicing (small ticket sizes, last mile access with high presence in tier III/IV cities and rural areas leading to overall unviable economics);
- Low confidence in underwriting in the absence of reliable data;
- Poor ability to manage portfolio health and collections due to lack of on-going visibility into the health of MSMEs
All three factors have witnessed significant disruption in past couple of years. As access to organised market places and digital channels increases, the cost of accessing for MSMEs is coming down. Aadhaar has reduced the cost of disbursing a small ticket loan by 25% (leveraging AEPS). While still early days, wide scale adoption of GSTN should further provide reliable transaction and invoice data. Telecom data and other utility data also needs to be significantly digitised and made accessible to lenders to further increase credit access. All this has to be under a well-regulated consent architecture. The impact is significant:
- Lower cost of acquisition, on-boarding and servicing: Deploying the full stack of digitized customer journeys can reduce the cost of processing to approximately 33% of the original cost. Cost of servicing through digital channels is typically observed to be 1/10th of physical channels. This allows financial institutions to fundamentally service lower ticket sizes while maintaining unit profitability
- Better risk assessment and pricing: Across Bureau, MCA, GSTN, and other surrogate data providers, there exist more than 100 data points which can be accessed and analysed instantaneously. Similar sources could be also used to set up alarms and triggers on portfolio health which can help contain credit losses in the long term
Loans of ticket size less than one crore constitute around 60–70% of the total MSME lending. Our experience suggests that the customer journey in this segment can be fundamentally re-imagined to create a win-win for both customer and banks/NBFCs. The day is around the corner when an MSME looking for working capital loan of, say, Rs 50 lakh, gets an instant paperless loan sanction using data such as Aadhaar, PAN, TIN and GSTN. Subsequent renewals are done from home/office (no branch visit) with no document submission.
The next frontier is pre-qualified and pre-approved loans for MSMEs. With consent architecture in place, we could go a step further and offer pre-approved business loans to new MSMEs. This concept is limited to personal loans and credit cards today in India. It is time to replicate this revolutionary idea for MSMEs.
The journey has just begun and a more concerted effort is required. The constructive nudge from the government to increase MSME participation in banking will further help accelerate MSME accessibility to formal credit.
To help small businesses borrow from banks, the ministry of MSME is working on a portal that will certify the credit worthiness of small players based on pre-identified parameters which can be submitted to banks when loans applications are submitted. It is imperative that all regulated entities which are bringing capital have a level playing field access to the Aadhaar stack to ensure that they can go about originating credit efficiently.
Government’s concentrated effort on installing POS in large numbers has been a great initiative in breaking the vicious cash cycle for small kirana shops and merchants. New age lenders are already beginning to use the POS transaction data to provide OD/CC limits to small merchants, thereby introducing them to formal credit.
While the market is huge and there is ample room for growth, pioneers will establish the much needed competitive advantage. We believe the competitive advantage will reside in lowering unit costs of end-to-end customer journeys (from origination to collections and servicing) for MSMEs and using conventional plus surrogate data to sharpen risk assessment and pricing.
-Yashraj Erande &Abhinav Bansal. Erande is partner and director, and Bansal is principal, BCG. Views are personal