Access to finance is a significant challenge for MSMEs (Micro, Small, and Medium Enterprises) in India like other emerging and developing economies. Despite the Indian central banks policies and guidelines requiring banks to allocate a portion of their credit for the priority sector, which includes MSMEs, information asymmetry and lack of risk assessment methodology and technology hinder the lending process. This issue is particularly exacerbated in rural areas. To address these challenges, there is a need to balance priority sector lending while managing non-performing assets, implement scalable and automated loan level monitoring, and improve operational efficiency in risk management. The use of advanced credit decision support technology and contextual data can help transform MSME lending in India and other emerging economies. 

This blog is brought to you by UPLINQ, a Member of the SME Finance Forum. The second that part of that blog series is available here.

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Indian MSMEs are a vibrant and fast-growing sector of the economy. Like many other emerging and developing markets across South and South-East Asia, Africa and LATAM, MSMEs employ a large majority of population and contribute a signification portion of GDP.  In India, MSMEs employ more than 110 million people and contribute almost 30% of the GDP.  
 

To provide support to MSMEs, the Reserve Bank of India (RBI - the central bank) has many policies and guidelines in place. RBI regulations require banks to allocate 40% of their adjusted net bank credit (ANBC) for the priority sector, comprising agriculture, small and medium enterprises, exports, and economically vulnerable groups such as small farmers, micro-enterprises, and disadvantaged segments. Priority sector lending (PSL) norms were introduced in 1972 to boost credit access to and development of economically weaker sections. These norms are applicable to all the commercial banks, small finance banks (SFBs), cooperative banks and foreign banks. A sub-target of 7.5% of ANBC towards lending to the Micro-enterprises is stipulated for Domestic commercial, foreign banks with 20+ branches, Regional Rural Banks and Small Finance Banks. 

Despite these guidelines, access to financing is a significant challenge for MSMEs and directly impacts their survival and growth potential.   
 

What’s driving that? 
 

Information asymmetry and lack of expertise and technology to harness sources of external, market and contextual data in a regulatory compliant way is a big stumbling block. This means archaic credit models using traditional data or narrow, rules based decisioning is the norm. PSL lending hasn’t kept pace with innovations and therefore suffering from a higher probability of default assessment. This further limits the availability of capital due to provisioning requirements.   

This issue of access to financing due to information asymmetry and lack of formal credit reporting is further exacerbated in rural areas. 32 million MSMEs out of the total 63 million are based in rural areas providing employment to 50 million people. While the rest of MSMEs in Urban areas employ close to 61 million. Given these numbers; the dependence of families and communities on the sector is undeniable.  To provide support to rural and urban MSMEs, there are several areas that need to be tackled:

• Balancing priority sector lending while keeping a check on non-performing assets

• Scalable and automated loan level monitoring to meet regulatory compliance 

• Operational efficiency in risk management while enhancing SME lending experience and turnaround time  

Managing Priority Sector Lending (PSL) and Non-Performing Assets (NPA)  
 

Non-Performing Assets (NPA) is one of the reasons cited by banks for shying away or keeping their hands tight when it comes to MSME lending. The challenge in meeting PSL targets is also due to the size of the loan. Small-ticket loans means higher origination expenses and therefore lower margins. Banks can make more money with fewer number of higher ticket loans which would also mean less burden on loan servicing and recovery. Hence, banks lack incentive for such lending. Therefore, it is both the profit dynamics and the loss potential that is guiding the decision making of the bank in finding it hard to lend to this segment.  

Although the overall bad loans of Indian banks will decline marginally; the bad loans in the MSME sector could rise double digits as per 2023 report by ASSOCHAM / CRISIL. 

• Gross NPAs in the MSME segment will rise from 9% in March’22 to 10-11% by March’24.   

• Highest NPLs are in the lower end of microenterprise and in medium sized enterprises. 

Other than lending, PSL norms also require banks to ensure that the loans are for approved purposes and banks are required to submit data on lending to RBI.  This outlines the need for an automated risk assessment technology with built-in monitoring to facilitate loan approvals and meet regulatory compliance. We are going to dig deeper in the second article in this 2-part series. 

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This blog is brought to you by UPLINQ, a Member of the SME Finance Forum