After a pandemic-induced dry spell, MSMEs are back in action. A look at their credit demand is proof enough. Loan queries grew 1.6 times since the pre-COVID era and the government has predicted that the sector’s lending potential may reach Rs. 3 trillion next year. These numbers indicate that MSME credit demand is only set to rise.

And lenders—private banks in particular—have welcomed this trend. The enterprises have enjoyed a steady rise in credit disbursal in the past few quarters. The aggregate bank credit deployed in August ‘22 to the MSME sector amounted to Rs. 18.15 lakh crores, a 24% increase compared to disbursal during the same month last year. This, despite a cloudy forecast that has loomed over our economy for months.

It makes us wonder: Why are banks now embracing this otherwise credit-starved market? For the most part, the nature of MSMEs remains the same. They’re still considered risky and mostly happen to be informal and unorganized. In fact, the Ministry of Micro, Small and Medium Enterprises recently emphasized the need for the formalization of enterprises in the sector for better access to credit. So what’s changed?

The answer lies in the slow-but-sure developments in the lending ecosystem.

FinTech and LSPs to the rescue

MSMEs, especially those in the rural landscape, have long been excluded from credit access. IFC reports that of the 15% of MSMEs who have availed of credit, only one-fifth are financed by formal institutions. The ecosystem has its hopes turned to FinTechs who’ve risen to the occasion, filling the gap. The trend of raising money through digital lenders has seen a steady increase—especially in the form of small-ticket loans. This comes as a relief to the sector, as they now have easier access to cash-flow income, which was harder to receive from legacy lenders without pledging collateral.

And then there are FinTechs who have set sights on fixing the sector’s credit gap in collaboration with traditional lenders, with some even pledging to deploy credit to rural MSMEs.

The rise of alternate data for risk assessment

Lenders have previously been reluctant to finance thin-file borrowers. They’ve relied on traditional assessment methods like CIBIL scores to underwrite applicants. But the increased availability of digital footprint and additional sources of data have helped lenders underwrite even thin-file or new-to-borrower MSMEs. This is mostly the result of advanced and more comprehensive alternate data models as well as cash-flow-based financing products that allow MSMEs to build a credit history while availing of small-ticket
size formal finance.

With more data available to underwrite and rigorous models trained for effectiveness,lenders can now process loans quicker, with more accuracy and minimal documentation.

Looking beyond top borrower cohorts

The economic slowdown has caused legacy lenders to shift focus from their top borrower cohorts to the promised land that is MSME. As per MicroFinance Institution Network, there are 5.8 crore micro-finance borrowers. This is a sizable pool with diverse needs and a relatively larger average ticket size. It’s a sector that’s been underserved for decades and thus, offers an excellent growth opportunity for lenders looking for their next phase of growth. Add to this equation the growth of alternate data-based underwriting, and MSME borrowings seem like a great place to cash in on long-term profits.

A better appetite for risk, powered by co-lending

In 2020, the RBI revised the co-organization of loans framework to make co-lending more flexible. As a result, we’ve seen NBFCs and Banks collaborate to deploy large-ticket loans to otherwise risky borrowers. This welcome partnership has been further accelerated by digital loan service providers who have made financing more accessible to previously underserved pools, including MSMEs. Now, banks and NBFCs can jointly finance a larger number of relatively bigger loans to medium enterprises.

Even with these developments, the MSME credit gap is anything but bridged. The time is ripe for lenders, FinTechs and regulators to work together on product and policy innovation to get the maximum out of this momentum. Generally, credit is always the hardest to deliver where it’s needed the most. This is a challenge worth its weight in gold and portends an exciting future.