They could be even bigger drivers of growth and jobs if their large and persistent credit gap of over 60% could be bridged. This gap stems from multiple challenges across the MSME lifecycle. The underwriting scorecards for most financial institutions are built on limited data sources.
For example, they do not fully leverage information about the seasonal or real-time cash flows that allow for accurately assessing a borrower’s creditworthiness, while documentation collection and customer management processes are often cumbersome and costly.
MSME borrowers need credit to overcome working capital cycle mismatches and gain the scale necessary to boost productivity. In the absence of sufficient formal funding, over half these enterprises turn to informal and more expensive sources of credit.
Even those that do qualify for loans don’t get products appropriate for their cash flow and payment cycles, which vary in predictable ways across sectors such as dairy, food processing, construction and logistics.
Fortunately, change is underway, with much more granular and timely data and documents available through various Digital India initiatives, such FASTag, Digilocker, GeM and ONDC. Lenders can now access high-quality and high-frequency customer data that has predictive power for transaction patterns, cash flows, procurement practices and more.
Standards and protocols such as the Account Aggregator system facilitate the consent-based exchange of customer data for faster and more reliable banking processes.
The Union Budget 2024 adds tailwinds for financial institutions with a number of actions to help accelerate lending to MSMEs. The new credit guarantee scheme facilitates liquidity for manufacturing MSMEs without requiring collateral or third-party guarantees.
Banks have been asked to go beyond traditional evaluations based on MSME assets or turnover, and instead develop in-house credit assessments using digital footprint scoring. This will help include MSMEs that lack formal accounting systems.
The budget has doubled the limit for ‘Tarun’ Mudra loans (from ₹10 lakh to ₹20 lakh), thus helping entrepreneurs with a successful repayment record to secure larger funds to grow their business.
Plus, it has halved the turnover threshold for buyers on the Trade Receivables Discounting System (TreDS) platform from ₹500 crore to ₹250 crore, enabling more participation.
In this supportive environment, how can financial institutions lend responsibly and grow profitably? McKinsey’s work with leading financial institutions globally and in India points to three distinctive capabilities that have proven impact: data-driven, informed decision making, enhanced SME-specific propositions leveraging digital public infrastructure, and greater inclusion of MSMEs using the full capabilities of government programmes.
In our experience, these capabilities can increase frontline productivity by around 20-25%, unlocking scope for business growth, reduce credit risk by 15-20%, double auto-renewal rates, improve turnaround times by 50%, and double growth in the value of transactions through supply-chain solutions.
However, too few institutions have built and driven these capabilities to scale, and as a result, the system is not at full potential. In this context, we would urge all financial institutions, large and small across the private and public sector, to adopt three practices:
Use transaction data to build stronger credit underwriting capabilities for automated decision making and higher approval rates. Along with traditional credit bureau scores and GST information, they can also tap alternate sources such as FASTag and utility bills to accurately assess creditworthiness.
Develop a new and better ‘digital SME proposition,’ with seamless customer journeys. This can be built by using the Account Aggregator framework for consent-based data that looks at cashflow-based lending and alternate data, particularly for customers with a low or nascent footprint with credit bureaus.
Developing a standard set of protocols and application programming interfaces could allow seamless data sharing among financial institutions and government departments, enabling quick and accurate inputs. Omnibus consent mechanisms could shorten turnaround times for credit decisions, simplifying the borrower’s experience.
Expand the borrower base by tapping the full capabilities of government programmes. The adoption of TreDS and credit guarantee schemes as well as innovations in receivables-financing could help extend credit to many more MSMEs and unlock their potential.
These actions will avoid the boom-bust cycles of typical lending programmes and act as a sustainable driver of growth and value for the financial system. Most importantly, these capabilities will help deserving MSMEs get the credit they need to create a multiplier effect for growth and jobs in our country.
Prachi Shah and Anurag Chadha have contributed to this article.
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