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Enhancing MSME through Financing

Preprint · July 2021

DOI: 10.13140/RG.2.2.31351.14242

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JULY 2021

Enhancing
MSME
through
Financing

Prepared by Kisslay Anand

 1

ENHANCING MSME THROUGH FINANCING

Background

Micro, Small and Medium Enterprises (MSMEs) are the economic backbone of virtually every
economy in the world. MSMEs represent more than 95 percent of registered firms worldwide1,
account for more than 50 percent of jobs, and contribute more than 35 percent of Gross
Domestic Product (GDP)2 in many emerging markets. Moreover, the contribution of MSMEs to
GDP increases as economies develop – with MSMEs in the developed world contributing well over
50 percent of GDP. MSMEs generate most of the new jobs that are created; they help diversify
a country’s economic base; they promote innovation; they help deliver goods and services to the
bottom of the social pyramid; and they can be a powerful force for integrating women and youth
into the economic mainstream. And appropriate financial allocation decisions – that allow
productive MSMEs to expand and become large firms, distressed but productive MSMEs to
restructure, and unproductive MSMEs to exit so that their resources are reallocated to growing
firms – are critical to generate economywide benefits.

Overview of MSME in India

Sustainable economic development is at the top of the political agenda in India and the aim is
for growth to be ‘faster, sustainable and more inclusive’. Every year, around 12 to 13 million
young people3 enter the labour market. In order to absorb this influx of job seekers, between
120 and 130 million new jobs will need to be created by 2025 4 . The private sector,
particularly micro, small and medium-sized enterprises (MSMEs), is expected to be a key driver
here. The MSME sector, with roughly 44 million micro companies and thousands of small and
medium-sized businesses, has an enormous economic, social and environmental impact. A recent
IFC report corroborates the disproportionate geographic distribution of MSMEs in the country.
Low-income states (Bihar, Odisha, Uttar Pradesh, West Bengal, Chhattisgarh, Jharkhand, Madhya
Pradesh, Rajasthan, and the north-eastern states including Sikkim) have 32.6% of India’s total
MSMEs. Within the country, north-eastern states account for less than 3% of the country's
total MSMEs.

1
World Bank Group Report
2
IFC Report 2017-18
3
DC-MSME Report
4
Innovation Promotion in Micro, Small and Medium-sized Enterprises, GIZ India

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Classification of MSMEs

Micro Enterprises Small Enterprises Medium

• Investment upto INR 1 • Investment upto INR 10 Enterprises
crore and turnover upto crore and turnover upto • Investment upto INR 20
5 crore 50 crore crore and turnover
upto100 crore

Figure 1: Manufacturing and Service Enterprises

Most of the MSMEs in India are congregated together to form a cluster. The Ministry of MSME
defines cluster as a geographical concentration of MSMEs that face common opportunities and
challenges to growth. According to the 4th Census of MSME Sector, India is home to a total of
2,443 clusters covering 321 products5.

A lack of adequate finance is one of the biggest challenges facing the MSME sector. Financial
constraints hamper growth, competitiveness, response to shocks, as well as employment and
investment decisions at the firm level, thus affecting the performance of the economy at large.

MSME Finance Gap

The financing needs of the MSME sector is dependent largely on customer segment, industry and
size of operation. The current domestic market conditions are not conducive to provide enough
opportunities for the MSME sector for raising low-cost funds. Due to higher risk perception, many
financial institutions have reduced their exposure to the sector.

Despite increase in financing to MSMEs in recent years, the addressable credit gap in the MSME
sector is estimated to be INR 25.8 trillion (USD 397 billion), which formal financial institutions
can viably finance in the near term.

The micro, small, and medium enterprise segments respectively account for INR 8 trillion (USD
123.3 billion), INR 16.8 trillion (USD 258.6 billion) and INR 1 trillion (USD 15.6 billion)6, of
the debt gap that is viable and can be addressed by financial institutions in the near term. With
appropriate policy interventions and support to the MSME sector, a considerable part of the
currently excluded demand can be made financially viable for the formal financial sector. Micro
and small enterprises together account for 95 percent of the viable debt gap that can be
addressed by financial institutions in the near term.

5
MSME Sector Census
6
RBI Report on MSME

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Figure 2: Source: MSME AR 16-17

Status of Micro Enterprise Financing: The Middle Gap Finance Issue

There are number of financial and non-financial constraints plaguing the MSME sector. However,
financial exclusion that too of the microenterprises, is the most critical one. Access to capital
for MSMEs is indeed severely constrained which has been recognized even by the Prime Minister
Taskforce on MSME. However, this constraint is particularly acute for the microenterprises.
Having understood the key characteristics of typical microenterprises in the previous section, it
is now much easier for us to appreciate the financial constraints that such unit’s face.

The financial requirements of microenterprises usually range from Rs 30,000 to around Rs

250,000. This range of financial requirement is such that on one hand the banks often find it
difficult to provide credit of such small amounts and on the other hand this amount is too
large for microfinance institutions, as they typically deal in loans below Rs 30,000. Thus, this
segment of microenterprises gets completely excluded from the financial services both – from
the banks as well as from the MFIs. Thus, the financial gap to this segment has been termed as
the missing middle.

Microfinance Institutions The Middle Gap Banks

(Rs5,000 – 30,000) (Rs250,000 onwards)

MFIs are a significant credit provider to very small unorganized enterprises, many of which are
home based enterprises. However, the current guidelines issued by RBI does not allow MFIs to
lend more than Rs 50,000 to an individual under ‘qualifying assets and the proportion for

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‘qualifying assets’ must be 85% of the gross loan outstanding of the MFI. This severely restricts
MFIs’ role in microenterprise financing.

Even aside the regulatory issues, MFIs themselves have not been dealing in this segment as
MFIs do not offer loans exceeding Rs 50,000 and in fact most of their loans are under Rs 30,000.
These loans are co-guaranteed jointly by the group members and are not secured by any physical
collateral. The MFIs do not have the kind products, processes, appraisal systems and staff
expertise to deal in microenterprise financing.

Government Interventions for Strengthening

Finance for MSME
1. Mudra Banks

In April 2015, the Government of India launched the MUDRA (Micro Units Development and
Refinance Agency) Bank for primarily refinancing micro businesses with loan requirements in the
range of INR 50,000 to INR 1 million. All loans up to INR 1 million sanctioned on or after April 08,
2015 for non-farm income generating activities will be branded as MUDRA loans. Even though
the quantum of MUDRA loans disbursed in the coming years will be significantly larger — the
government has met the target of INR 1.8 trillion for FY 16-17 — the maximum additional credit
flow to the MSME sector is estimated to be INR 50 billion per annum only over the next three
years. This is because the additional loans will be constrained by size of the refinancing corpus
which is currently INR 200 billion spread over four years.

2. Payments Banks

Payment’s bank is a new model of banking conceptualized by the Reserve Bank of India (RBI).
These banks cannot offer credit but can operate current and savings accounts. On 19 August
2015, RBI gave ‘in-principle’ licenses to eleven entities to launch payments bank. As on date,
four payments bank have started operations. While payment banks cannot provide credit, these
banks will likely explore innovative partnerships with lenders to create joint value proposition
for each other. For instance, some Payments Bank can help rural suppliers on its ecommerce
platform in meeting their credit needs by connecting them with suitable fintech companies. The
credit from such fintech NBFCs may be routed to the suppliers through the Payment Bank.

3. Key Government Institutions

SIDBI, India's apex financial institution for the promotion and development of MSMEs was
established in 1990 by the Indian government to act as an intermediary organization that
provides key research and facilitation necessary for the growth of the sector. Ranked as one of
the top development banking institutions in the world, SIDBI directly lends to the MSME sector
as well as advises and supports lending to MSMEs by other financial institutions. As the country's
leading organization in steering the sector and ensuring innovative products and services reach
businesses through channels created by robust, multi-stakeholder strategic partnerships, SIDBI
does everything — from encouraging the promotion of a cluster-based approach, to innovation,

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and pioneering the well-known Credit Guarantee Fund Trust for Micro and Small Enterprises
(CGTMSE) guarantee program, and finally lending.

State Financial Corporations came to be organized in individual states after the enabling
Central Act came into force in August 1952. These are state-level organizations meant to provide
term finance to medium and small-scale industries. SFCs provide financial assistance by way of
term loan, subscription to equity / debentures, guarantees, discounting of bills of and seed /
special capital. They also operate a number of schemes on behalf of IDBI and SIDBI, in addition
to the schemes for artisans, and special target groups such as women and physically
handicapped.

State Industrial Development Corporations provide not only finance but also perform a variety
of functions, such as arranging for land, power, roads, licenses for industrial units, sponsoring
the establishment of such units, especially in backward areas, among others. They were set up
entirely by individual state governments, unlike SFCs that were set up jointly by state
governments with the RBI (responsibility now transferred to IDBI) and other financial institutions.

Alternative MSME Financing Options

I. Cluster-Specific Financing Schemes

Clusters need assistance with deciphering how to leverage technology to meet their specific
financing needs. Accordingly, SIDBI launched a platform that is available to 15 clusters and
highlights tailored policy and technology recommendations to improve credit access for clusters.
For instance, in the Kolhapur textile cluster (Maharashtra), this platform has encouraged the
consolidation of units and enabled the NPA-free cluster to receive increased subsidies for power
looms for micro and small enterprises.

SIDBI has begun a three-year pilot program focused on bringing together global thematic experts
to assess and meet financial needs at a cluster-level and help develop concrete solutions that
are owned and implemented by clusters without the aid of external organizations or partners.
Five clusters have been selected for this pilot: Agartala bamboo cluster (Tripura), Coimbatore
engineering cluster (Tamil Nadu), Ludhiana knitwear cluster (Punjab), Rajkot engineering cluster
(Gujarat), and Bhagalpur textile cluster (Bihar).

II. Marketplace or Fintech Models

The advent of Fintech (combining technology and innovative business models in financial
services) has gained considerable momentum in recent years, with global investments rising at
exponential rates. It holds the potential to revolutionise SME financing, as it can offer
unprecedented solutions to deal effectively with the main barriers that SMEs face in financial
markets: information asymmetries and collateral shortage.

On the one hand, digital technologies, such as online and mobile banking and payment solutions,
have had an important impact on traditional SME financing. They allow financiers to considerably
lower transaction costs when reaching out to unserved and underserved segments of the SME
population. They introduce accounting technology to help manage SME financial statements, as

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well as alternative credit scoring mechanisms using non-traditional sources of information, such
as payment history, usage and payment of utilities, online activities and mobile history. These
make lenders able to address information asymmetries in a cost-effective manner and enable
higher approval rates with a relatively low default rate.

1. Traditional P2P lending model

The overarching idea of P2P lending platforms is to provide an online market that allows lenders
to trade directly with borrowers. P2P lending platforms involve a range of features that go
beyond the quality assurance provided by most other peer-based platform markets. The P2P
lending process begins with a prospective borrower applying or registering for a loan on a
platform. Borrowers provide a range of credit information, which is posted on the platform after
it has been verified and approved by the platform. Prospective creditors can choose to fund
loans available on the market. Importantly, individual loan contracts are established between
borrowers and creditors, rather than with the platform. Funds and contractual loan repayments
are segregated from the platform’s own account, with the platform operator earning its revenue
from fees levied on the transacting parties, such as those for account setup, loan origination and
ongoing loan repayment.

Figure 3: Source (CGFS FSB Report)

2. Notary Model

In the notary model, the platform also offers a matching service as traditional P2P lending, but
the loan is originated by a partnering bank. The notary model is the most widespread model
used by FinTech lending platforms in Germany and Korea and is also common in the United
States. In this model, online platforms act as an agent that brings together creditors and
borrowers, with banks originating all FinTech loans and then selling or assigning them to
creditors (either directly to the creditors in smaller packages or to a platform subsidiary that
repackages them into multiple loans). The Notary Model is used in Germany because of
regulatory restrictions on non-authorised institutions issuing loans. In Korea, most FinTech
lenders set up a moneylender as a subsidiary which originates loans with the funds raised through
the lending platform from investors. The lending platform does not directly engage in lending,
to avoid any possible violations of finance-related laws. In some cases, banks may originate loans

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for an online credit platform, with the arrangement involving the platform passing on the funds
it has raised to the bank as collateral, which the bank then uses to originate the loans. In the
United States, some FinTech lenders partner with certain depository institutions to use that
institution’s charter to make loans nationally without obtaining individual state licences. The
issuing depository institution originates loans to borrowers that apply on the online platform.
The loans are subsequently held by the issuing depository institution for one or two days, and
then purchased by the platform lender or directly by an investor through the platform lender.
Alternatively, FinTech-facilitated loans may be retained by the issuing bank.

Figure 4: Source (Corporate Compliance Insights)

3. Guaranteed Return Model

In the “guaranteed return” model, the platform operator guarantees the creditors’ principal
and/or interest on loans.

Figure 5: Source (FSB Report)

4. Invoice Trading Model

Businesses use invoice financing (or factoring) services to manage cash flow, as it allows them
to sell invoices or receivables to a third party that provides them with immediate liquidity at a
discount. In the non-recourse factoring model, the factor not only acquires the receivables of a
business at a discount in return for liquidity but also assumes the default risk of the ultimate
debtor, whereas in the recourse model the default risk remains with the original creditor.

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Because of the credit risk involved, intermediaries providing non-recourse factoring may set a
minimum business turnover threshold for eligibility; in these cases, the model may be less
suitable for start-ups, freelancers and other self-employed.

FinTech “invoice trading” platforms appear to have targeted start-ups or the small business
segment by offering recourse factoring and providing more flexible services than traditional
players. These include automatic invoice processing; a shorter time frame between invoice
processing and liquidity provision; a smaller minimum turnover threshold or factoring of
individual invoices; and financing confidentiality for debtors. The ability to quickly obtain small
unsecured financing amounts means that such FinTech platforms are more likely to extend credit
to start-ups or very small business customers than traditional factoring providers. There are,
however, some invoice trading platforms that facilitate the financing of multinational
corporations’ receivables. In some cases, the receivables may be securitised before they are
traded.

LendingKart

•Founded: 2014
•Location: Ahmedabad
•Known for its credit evaluationplatform that helps its NBFC partners assess
creditworthiness and disburse loans within 48 hours even in Tier II and Tier
III cities, Lendingkart focuses on startups and SMEs offering loans from INR
0.1-1 million (USD 2-15 thousand)

Innoviti

•Founded: 2008
•Location: Bangalore
•Established originally as payments transaction platform to improve
operational efficiency, Innoviti’s SME lending business connects enterprises
to both banks and NBFCs, disbursing almost INR 3.8 billion (USD 60 million)
to 10,000 SMEs in 20 cities.

Faircent

•Founded: 2013
•Location: Gurgaon
•A peer-to-peer (P2P) lending platform, Faircent brings together individual
borrowers and lenders, curating the enterprises seeking loans to reduce risk
for investors. With 20,000 borrowers and 5,000 lenders, Faircent processes
INR 1 million (USD 15 thousand) in loans every month.

Figure 6: Marketplace Lenders in India

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III. Balance Sheet Lending

Balance sheet lending platforms originate and retain loans on their own balance sheet, akin to
the usual business model of a non-bank lender.

Figure 7: Source (IFC Report)

Balance Sheet lenders take on the risk of lending themselves, most often as NBFC. They lend to
borrowers directly from their own capital base, taking credit risk themselves. As, the lenders
taking on the risk of credit disbursal directly and not as an intermediary, they are able to offer
revolving lines of credit with more flexible terms to borrower.

Instacash

•Founded: 2014
•Location: Bangalore
•An online lending marketplace for SME loans, offering working capital loans to
small businesses looking to sell their goods on online marketplaces. Loans are
disbursed within 72 hours, and all borrowers are charged with a 2% monthly
interest.

Capital Float

•Founded: 2013
•Location: Bangalore
•Capital Float is an online platform that provides working capital finance to SMEs.
Borrowers can complete an online application within minutes, selecting preferred
repayment terms and receiving funds in their bank accounts within seven days.
Figure 8: Balance Sheet Lenders in India

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IV. Supply Chain Finance

Cash is the lifeblood of any company. It’s

more important than ever for businesses to
optimise this fundamental aspect of
financial performance if they’re to
maintain a steady course in these uncertain
times. Given that working capital is the
cheapest source of cash, nothing is more
vital than having a cash culture and good
liquidity on board.

Supply chain finance, also known as

supplier finance or reverse factoring, is a
set of solutions that optimizes cash flow by
allowing businesses to lengthen their
payment terms to their suppliers while Figure 9: Source (Understanding Supply Chain Finance, PwC 2017)
providing the option for their large and SME
suppliers to get paid early. This results in a win-win situation for the buyer and supplier. The
buyer optimizes working capital, and the supplier generates additional operating cash flow, thus
minimizing risk across the supply chain.

Founded in 2014, Mumbai-based SMECorner.com is an online lending marketplace for SMEs selling
on e-commerce sites such as Flipkart and eBay India. Offering tools such as a ‘Loan Eligibility
Calculator’ and ‘Loan EMI Calculator’ SMECorner.com helps SMEs become more aware of the
variety of financing options they have. With 32 banks and NBFCs as lenders, SMECorner.com has
disbursed more than INR 300 million (USD 4.6 million)7 till date.

Conclusion

Financing for MSMEs in the appropriate forms is important at all stages of the business life cycle,
in order to enable these firms to start up, develop and grow, and make contributions to
employment, growth and social inclusion. Access to finance improves post-entry performance of
start-ups and industries which are more dependent on external finance grow relatively faster in
countries with more developed financial markets, thanks to enhanced information sharing and
risk management, and a better allocation of resources to profitable investment projects8. On
the other hand, financing constraints that prevent firms from investing in innovative projects,
seizing growth opportunities, or undertaking restructuring in case of distress negatively affect
productivity, employment, innovation, and income gaps.

7
SMECorner.com Annual Report
8
Rajan and Zingales, 1998; Giovannini et al., 2013

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