MSME Lending Gap

How can Public Sector Banks help MSME

unlock their True Potential

In India, Public Sector Banks have not played a 06 July 2023

major role in the growth of the MSME Sector. This
is due to many structural reasons that we will Report by: Projects Team
explore further in the article. We will also be Gautam Kapoor,
looking at if there is a credit gap in the MSME Vishwas Vaish
sector and why that exists from both the lenders’ _____________
and borrowers’ perspectives. And finally, we will
be looking at how Public Sector Banks can help
MSMEs grow further and unlock their true
potential.
 MSMEs: Unlocking their Potential
Poornatha

Lending Gap in the MSME Sector

In India, there are about 64 million MSMEs. Only 14% of people can get credit, compared to
30% or more in wealthy countries. A 3.8x debt-to-equity ratio is needed to meet their expected
total financial demand of USD 1,955 Bn (INR 1,61,33,700 Cr). Their overall debt demand,
therefore, totals USD 1,544 Bn (INR 1,27,41,900 Cr). Out of this, 47% of the demand is unmet.
This is demand from businesses that are not profitable or prefer to obtain finance from
unofficial sources. However, it still leaves us with a sizable total addressable market of USD 819
Mn (INR 6758 Cr). Only USD 289 Bn (INR 23,84,900 Cr) of this demand is now serviced by
conventional lending sources, such as commercial banks, public banks, and NBFCs.
NBFCs make up approximately 12% of this supply. However, their percentage has been rising
over time. Private banks account for 45%, state banks for 43%, and NBFCs for 12%. This results
in a staggering USD 530 Bn (INR 43,73,800 Cr) credit gap, leaving much room for lenders in this
market. The whitespace is more available for businesses that borrow small amounts, such as
INR 1 million or less. According to estimates, almost 70% of their credit demand is unmet, and
their credit gap is close to USD 120 Bn (INR 9,90,300 Cr).

Figure 1: Credit Gap in the Indian MSME Sector (Source: Avendus)

Now that we have understood the scale of the credit gap let's move on to why there is such a
massive one from both the perspective of the lender and the borrower.
From the lender's perspective, the following reasons act as a hindrance to lending to MSMEs
1. MSMEs are viewed as having high-risk borrowing: Banks and other financial institutions
typically view lending to MSMEs as hazardous. According to the UK Sinha-led Expert
Committee on Micro, Small, and Medium Enterprises, lending to MSMEs carries a risk
because of those businesses' "inability to pay" and "unwillingness to pay." Banks will

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always view MSMEs as high-risk borrowers and be wary of adding them to their loan
books if they think that these borrowers won't be able or willing to repay their debts.
2. Inability to assess the creditworthiness of the borrowers: Information asymmetry is a
significant issue in bank-MSME transactions. Due to the fact that many Indian MSMEs
don't keep thorough financial records, such as tax return filings, P&L statements,
balance sheets, etc., institutional lenders like banks have very little or no access to
information on MSME finances. Additionally, banks lack sufficient knowledge about
MSMEs’ credit histories and ratings. Additionally, they don't spend much time
monitoring MSMEs' financial health and business strategies. Due to the significant
information gaps caused by all of this, banks are reluctant to lend to MSMEs since they
cannot evaluate their creditworthiness.
3. Lack of tangible assets and incapacity to offer security: In India, most MSMEs
frequently lack significant physical assets. Because of this, they are unable to offer
collateral when applying for loans. Because of this and the lack of credit history,
traditional lenders cannot balance the risk to their capital. As a result, they have to turn
down many loan requests from MSMEs.
4. High Cost to Serve: The expense of providing loans to MSMEs is increased by their
incompetence or unwillingness to maintain suitable accounts and collateral. Many
lenders are reluctant to establish credit connections with MSME customers because of
this "cost to serve".
5. Lack of confidence: Due to the thousands of MSMEs now functioning in India, lenders
frequently cannot distinguish between one MSME borrower and another. This
ignorance typically manifests as a lack of trust and a refusal to lend. The substantial risk
of loan default posed by MSMEs contributes to low trust. This is due to the fact that
their customers don't pay them promptly. Delay payments to MSMEs in 2021 were
worth Rs 10.7 lakh crore. Buyer payments in MSME supply chains may take 30 to 90
days to clear. Banks do not trust MSMEs since they frequently receive late payments,
making it difficult to repay loans.
Now that we have discussed why lenders are unwilling to provide credit to MSMEs let’s discuss
why borrowers are unwilling to obtain credit from formal sources of credit.
1. Poor Credit Depth: In semi-urban and rural areas of India, few lenders are prepared to
offer loans to MSMEs at reasonable rates. MSMEs have nowhere to turn because there
aren't any choices for them to get crucial finance. Additionally, the credit gap in India's
MSME sector keeps widening due to limited financing access.
2. Complicated Borrowing Procedures: A sizable share of MSMEs are found in smaller
towns and cities. Many MSME owners lack basic financial literacy and do not understand
loan possibilities, paperwork requirements, or borrowing procedures. Larger banks don't
spend the time necessary to clarify or even simplify these issues for MSME owners, who
become discouraged by the idea and decide against seeking loans.

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3. Long Disbursal Timelines: Since many MSMEs have slim profit margins, they urgently
need working capital to cover daily expenses. However, traditional financial institutions'
approval and disbursement times are excessively long, rendering them inappropriate for
the operating capital needs of MSMEs. These protracted disbursement times deter
potential MSME borrowers from completing the process.
4. Gender Bias: In India's patriarchal society, women are frequently seen as having less
entrepreneurial potential than males. Additionally, women have less collateral
registered in their names, making it more difficult to obtain bank credit. Even if they run
similar businesses and submit similar loan applications and presentations, a male MSME
borrower is more likely to be approved for a loan than a female borrower due to the
persistent and long-standing gender imbalance issue. These factors collectively account
for the 2X higher loan refusal rate for Indian women business owners, at 16%. They also
provide an explanation for why women-owned firms account for at least Rs. 12 lakh
crore of the Rs. 30 lakh crore total credit gap faced by Indian MSMEs and why 90% of
female borrowers depend on "informal" sources of funding.

How can PSBs serve MSMEs better?

When we look at this industry, we can see that the government has implemented a number of
new rules to close the credit gap. The Prime Minister announced the Pradhan Mantri MUDRA
Yojana (PMMY) scheme in 2015 to provide loans to small and micro non-farm firms and non-
corporate sectors of up to INR 1 million. In order to assist MSMEs impacted by COVID-19, the
Indian government introduced the Emergency Credit Line Guarantee Scheme (ECLGS) in 2020.
Non-Banking Financial Institutions (NBFCs) have expanded their branch networks over the past
five years to serve consumers all over India to take advantage of the positive market trends and
governmental efforts. For their customer-centric strategy, being close to small ticket clients was
crucial.
Adaptable NBFCs have the mentality to service non-prime consumers by travelling far into the
country's hinterlands. They have a strong focus on putting the needs of their clients first, and
they use exclusive underwriting processes to lessen the risks involved in underwriting this
market. Additionally, successful NBFCs have strong balance sheets and solid capitalization,
which is supported by ongoing stock infusions. They are, therefore, ideally suited to assist
debtors of low ticket amounts.

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Figure 2: Growth in the number of rural branches of NBFCs (Source: Avendus)

Now let us move on to what are the various initiatives PSBs can take to help MSMEs.
1. Co-Lending: This is a type of financing in which two or more financial organisations work
together to offer loans to their clients. The PSBs can use this strategy to reach borrowers
who might not have access to regular banking services, which enables them to achieve
their Reserve Bank of India-mandated priority sector lending commitments. These
commitments include lending money to MSMEs, small and marginal farmers, and
economically disadvantaged groups of the population. PSBs have partnered with NBFCs,
fintech firms, and other financial institutions to benefit from co-lending. Through this
relationship, tailored loan solutions can be provided at lower origination, underwriting,
and servicing costs, hastening and streamlining the customer's loan experience. Since
NBFCs are present in Tier 2, 3, and 4 cities throughout India, they can exploit their
understanding of the surrounding area's topography to their advantage.
2. Distribution: PSBs have expensive branches in major cities all over the nation; this
operational philosophy is inappropriate because these PSBs cannot access areas where
most micro-businesses are located. They must adopt the low-cost, more regionally
focused branch model used by NBFCs. This would result in improved underwriting
knowledge and greater pricing power.

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3. Underwriting: Unlike NBFCs, PSBs favor safer consumers and are unwilling to
comprehend and evaluate an unregulated business. One tactic PSBs can use to speed up
the underwriting process is automated scoring, which is based on a quick analytics-
based eligibility assessment. Vendor agreements to extract filings from the ITR website
come in second. The third is using technology to recognize cash flow patterns for more
accurate loan pricing.
4. Collection: In contrast to NBFCs, which have their own collection teams on the ground,
PSBs outsource the collection process to outside firms, which enables them to build
strong client relationships. Nimble NBFCs establish an internal infrastructure specifically
for collections. To achieve good collecting efficiency, all communication channels are
used, including WhatsApp, field trips, SMS, calls, etc. First Payment via QR codes, OTP-
based collections, and WhatsApp-linked collections are some tactics NBFCs might use to
improve the collecting process. Second, are documents and signatures that are entirely
digital. Third, machine learning is utilised to continuously monitor delinquencies and
spot them early.

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References:

1. Avendus. (n.d.).
https://www.avendus.com/crypted_pdf_path/msme-lending-report-formattedvf-img-
642a719b97ccc-.pdf
2. Iyer, A. (2018, May 22). How important are public sector banks to MSMEs? |
Mint. Mint. https://www.livemint.com/Money/Dr4WfrCxdSOLClQbgsQtIN/How-
important-are-public-sector-banks-to-MSMEs.html

3. MSME ecosystem - MSME saksham. (n.d.-b). https://www.msmesaksham.com/the-

msme-ecosystem.html
4. Yubi. (2023). Lending Bias & Credit Gap in India’s MSME Sector. Yubi. https://www.go-
yubi.com/blog/credit-gap-msme-sector-causes-effects/
5. Soni, S. (2023, April 3). $530 billion massive credit gap in India’s MSME sector out of
$819 billion addressable demand: Report. Financial
Express. https://www.financialexpress.com/industry/sme/msme-fin-530-billion-
massive-credit-gap-in-indias-msme-sector-out-of-819-billion-addressable-demand-
report/3031372/
6. Sengupta, A., & Bfsi, E. (2022, December 14). MSMEs growth doubles in last 2 years,
credit gap remains:
Report. ETBFSI.com. https://bfsi.economictimes.indiatimes.com/news/financial-
services/msmes-growth-doubles-in-last-2-years-credit-gap-remains-report/96221758
7. Khetarpal, S. (2023, March 4). How co-lending is changing the way public sector banks
lend. Financial Express. https://www.financialexpress.com/industry/sme/msme-fin-
how-co-lending-is-changing-the-way-public-sector-banks-lend/2999466/

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