Credit Gaps in MSMEs and SMEs – How Embedded Finance Is Better Positioned to Solve This Problem?

MSMEs and SMEs face constant credit constraints and unfilled gaps. Know how embedded finance is the best way to solve this problem.

With the pandemic ravaging India, the financial year has begun poorly. Due to the slump of the Nomura Business Resumption Index, small businesses are being affected by mini-lockdowns across India. The government has announced a plan to assist the stressed SMEs and MSMEs but it shows a limited impact. 

The Emergency Credit Line Guarantee Scheme (ECLGS) was generous in duration and scope. However, despite this, fewer than 10 million of India’s 63.3 million MSMEs and 42.5 million SMEs have taken advantage of the ECLGS thus far. 

Therefore, it is not the schemes themselves that are the problem. The issue lies in the fact that, while the RBI mandates credit to MSMEs and SMEs, formal lending meets only 40% of their credit needs. Unmet credit demand by MSMEs and SMEs is an estimated Rs 30 lakh-crore, creating an opportunity and challenge for new financing methods.

Indian MSMEs and SMEs contribute 31% to the GDP according to the IFC. Though our economy’s backbone, they are credit-scarce. India still has a $380 billion and $340 billion credit gap for MSMEs and SMEs, respectively, to fill.

Why do SMEs and MSMEs face persistent credit constraints? How can credit distribution models contribute to financial inclusion? The solution to these challenges lies in a proactive, partnership-based method – “Embedded Finance”.

In this article we’ll see how including MSME and the SME in the financial inclusion game can be challenging and how embedded finance can fill the credit gap.

MSME and SME Financial Inclusion: A Systemic Challenge

U.K. Sinha, Chairman of the Expert Committee on MSME in 2019, identified three causes of credit gaps: 

  • Due to the inability and unwillingness to pay, lending to the MSME and SME sector is high risk.
  • Creditworthiness can be hard to assess due to lack of collateral, asymmetric information, etc. 
  • Lending in rural and semi-urban regions differs widely. 

Let us explore other systemic challenges that obstruct the way of formal credit distribution infrastructure: 

1. Unavailability of focused products

Working capital gap fills with credit for MSMEs. It requires minimal funds ( ₹5-15K) for short periods (2-10 days), called Packeted loans. However, transactions are highly rapid and volumetric. Therefore, a sachetised loan must use a technology-driven approach to be profitable, which sometimes requires acquiring a large number of customers with low transaction values and successfully retaining them through a multitude of touchpoints. 

By leveraging machine learning models, banks can better understand borrowers and cross-market them. However, a bank-driven credit model cannot meet these needs due to its size and speed. Additionally, most risk managers disapprove of its use. 

Since banks require considerable time and money for underwriting, the lending process focuses on large loans. Therefore, for lenders to offer sachetised products, they must rethink their onboarding, decision, and loan servicing technology stacks entirely.

2. Inaccessible APIs

Technology companies can tap into lenders’ infrastructure by providing Open APIs, enabling collaboration, and building on top of lenders’ infrastructure. There are no APIs available for lenders, however. Thus, digital platforms with reach are unable to connect their customers with lenders.

3. Lenders avoid taking risks

Lenders prioritise thick file clients – Traditional lenders tend to be risk-averse and will not accommodate customers with few credit bureau reports. As a result, enterprises are evaluated based on their past loan performance rather than their future potential. 

Alternative data is a rare consideration with banks to identify creditworthy customers. SMEs and MSMEs thus find themselves in a vicious circle. Banks turn them down with a lack of credit history. And, they can’t build one because they cannot avail of formal credit. 

Lenders favour assets – Creditworthiness is determined by borrowers’ assets rather than their cash flow. MSME and SME financing has thus been largely reliant on asset-based financing like gold loans and loans against property. However, not all MSMEs’ secure their assets with term loans. Consequently, smaller businesses are left out, particularly in terms of sachetised loans to cover capital deficits.

4. Inaccessibility of data 

A variety of digital tools are helping MSMEs and SMEs acquire rich data sets. A few of them are khata-apps, online catalogues, online accounting, and B2B eCommerce. Smartphones also offer rich alternative data. Cash-flow based underwriting can leverage this data using proven credit models and technologies. 

Comparing these datasets to traditional methods, they are significantly more effective. Lenders, however, struggle to understand and accept these datasets. Traditional methods involve lenders manually underwriting borrowers, an inefficient process that excludes a large segment of the small business market.  

5. Financial institutions lack visibility into these sectors

Small businesses are typically owned and operated as partnerships or sole proprietorships. Because there is no central registry of small enterprises, institutions must make rough estimates of their industry, sector, or geographical location. The absence of this data hampers the ability of financial institutions to make credit available to such enterprises.

While systemic challenges are one thing that creates credit gaps in MSMEs and SMEs, some practical hurdles are blocking the road for recently digital painted MSMEs and SMEs. Those difficulties include:

  • Unawareness of digital solutions 
  • Financial literacy about credit is low 
  • Business identity is difficult to establish 
  • Language barriers

But what can help to answer these both systemic and practical challenges? The answer to this is embedded finance. So, how can Embedded Finance solve this problem?

How Can Embedded Finance Fill the Credit Gaps In MSMEs and SMEs?

In addition to sophisticated technology infrastructure, embedded finance uses the expertise of financial institutions to distribute financing at scale and increase access to credit for small businesses. Keep reading to know how Embedded Finance overcomes the above challenges:

1. Underwriting of Platform Data  

Platform data enables cash flow-based underwriting via embedded finance. Data available through different digital platforms helps to determine creditworthiness. For example, accounts receivable data from the Khata app is used in determining creditworthiness, while past orders data from the B2B E-Commerce app helps in better decision making.

2. Collaborate with digital platforms to tailor user experiences 

By integrating digital platforms with embedded finance, tailored loan applications imply a better user experience. In this way, a customer’s experience is made seamless, simple, and guided. It allows MSME and SME businesses to apply for credit in context, reducing the effort involved in digital discovery.

3. Connecting digital platforms to customers

Through their digital platform, embedded finance companies facilitate loans, applications, and repayment. It enables an anchoring system to educate small businesses and navigate them to the digital sector. In addition, digital platforms provide MSMEs with demographic data that is not centrally accessible. 

We can use this data to understand the heterogeneity of the SME and MSME sector and then design solutions to fit the needs of each segment. It is essential to create deep partnerships between financial institutions, digital platforms, and fintechs to assist SMEs and MSMEs with financial inclusion. 

Technology-driven distribution and innovation of credit products are crucial for this process. A digital strategy and alternate data underwriting are essential for lenders to lower their acquisition costs and recoup them by driving repeat business. 

In addition, banks must leverage partnerships with Embedded Finance infrastructure providers to rapidly adapt to the heterogeneous needs of MSME and SME sectors.

A crucial component and game-changer in the field of Embedded Finance, GLasS offers a clear understanding of the process and products that make lending and borrowing easier. A plug-and-play service, Glass will allow companies to embed its API directly into their products. You can rest assured as it handles all lending compliance issues. 

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