By Avishek Gupta
Credit and financing for MSMEs: India’s micro, small and medium enterprise (MSME) sector is the source of innovation and livelihood for millions of people. The country’s 63 million MSMEs represent 30% 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 advantage of receiving a university education, which prevents them from working in the formal economy. Typically, they earn less than around Rs 25,000 per month, but they run smart businesses with great growth potential, and they represent a credit market of Rs 2 lakh crore.
Yet despite this large market, traditional lenders and institutions have avoided supporting nanoenterprises. This is largely because it is expensive for traditional lenders to assess and service nanoenterprises, given their informal nature and low lending requirements. In addition, the lack of warranties and verifiable data from nano-companies presents risks for traditional lenders.
This is where credit guarantees come in. These guarantees act as a bridge to better credit assessment of nano-companies despite the limited data and guarantees available with this segment. Hence, setting in motion a flow of capital that nano-entrepreneurs can leverage to grow their businesses.
Trigger the domino
In the Indian financial market, there are two major players: banks and non-bank financial companies. Big banks and financial firms have ample liquidity and aim to tap into the Indian market, but their regulations and structures generally make them risk-averse, focusing on collateral-backed lending. These actors are not designed to meet the small borrowing needs of nanoentrepreneurs.
Fintechs and smaller non-bank financial companies (NBFCs), on the other hand, have direct links with nanoentrepreneurs or partner with grassroots organizations to reach out to these nanoentrepreneurs. By adding a layer of technology on top of these connections, NBFCs and fintechs use alternative data models and are able to provide unsecured loans to nanobusinesses. Yet these NBFCs remain constrained in the capital they can access to offer nanoloans, as large institutional capital providers have low confidence in the MSME segment. The Covid pandemic has exacerbated the reluctance of large lenders to invest in these small businesses.
Credit guarantees address the credit risk concerns of major lenders by providing partial protection against payment defaults. This allows fintechs and NBFCs to have increased access to liquidity so that they can proactively lend to the nano and MSME segment, thus triggering a domino effect of business growth of the 63 million MSMEs, which has a cumulative impact on businesses and the economy.
The cumulative impact
The pandemic has caused 80% of MSMEs to reduce their activities or close temporarily. At the same time, the perceived risk for lending to MSMEs has increased, which has reduced the ability of lenders to serve nanoentrepreneurs. Financial services companies that are dedicated to providing loan capital to retail NBFCs that lend to MSMEs, have tightened their lending standards post-pandemic to accommodate increased MSME lending risk. This has impacted the livelihoods of nanoentrepreneurs, their employees and the community.
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Through credit guarantees received from partner organizations, companies providing personalized debt were able to directly unlock up to five times more cash and credit for microenterprises. In addition, the partial guarantees have helped not only meet, but also exceed the capital demands of NBFC retail borrowers and reduce the perceived risk of lending to many of these NBFCs. For guarantee providers, such pooling of portfolios between different partners allows sufficient risk diversification to improve their risk appetite. In addition, their assessment of the quality and strength of their partners acts as a risk mitigant, thus allowing them to nudge in a certain direction, for example, MSMEs, exports or agriculture.
The power of credit guarantees not only allows wholesale lenders to obtain additional funding from traditional lenders to continue lending to this segment, but also helps retail NBFCs who lend directly to nano-enterprises. The risk protection of guarantees helps to improve or maintain the credit rating of lenders while building an MSME loan portfolio. Credit guarantees are an effective way to unlock additional credit for MSMEs and other segments perceived as high risk.
Helping nano borrowers
Credit guarantees have huge potential to meet the needs of India’s MSME sector. Through collateral, NBFCs and fintechs can lend to new borrowers, connecting this sector to formal financial markets and further expanding the market. As more and more unsecured loans become available for the MSME/nano segment, these smaller borrowers will start to generate data and build a credit history with their successful repayments. NBFCs and commercial banks, in turn, will be able to use these records to recalibrate their underwriting and credit scoring models, thereby reducing the risk perception of the MSME/nano segment. This will greatly reduce the need for third party credit guarantee protection in the future for those with an established repayment history.
To achieve this goal, certain things must happen. Financial organizations need simpler and more accessible credit guarantee programs. The market needs a combination of blended finance providers such as development finance institutions, impact investors and philanthropic organizations, to provide credit guarantees. Particular attention should be paid to allowing a lower risk weighting for the secured portions of loans. With all these measures in place, credit guarantees can be an effective first domino that triggers a new credit market for nanoentrepreneurs in India.
Avishek Gupta is Managing Director and CEO of Caspian Debt. The opinions expressed are those of the author.