India’s goal of being Atmanirbhar Bharat (self-reliant India) would not be possible without its MSME sector. The country’s 633.9 lakh micro, small, and medium enterprises are a cornerstone of its economy. These businesses, which represent 90% of India’s enterprises, produce 6,000+ products – small and large, simple and hi-tech, machine-made and hand-crafted.

In FY2020-21, MSMEs contributed 35.98% of India’s total manufacturing output, 30% to the GDP (in terms of Gross Value Added), and about 49% to overall exports. MSMEs are also valuable employment generators, employing 60% of India’s multi-million-strong workforce.

By FY2023-24, the sector’s lending potential could reach $3 trillion, representing a huge market for business finance. Then what’s stopping banks and alternative finance houses from lending to MSMEs? Why this “lending bias” against MSMEs? And what are the effects of this bias?

The difference between supply and demand for working capital credit for Indian MSMEs is extremely wide. Let’s see why.

Show Me the Money: Causes of Lending Bias in India’s MSME Sector

In 2020, the Reserve Bank of India (RBI) reviewed and revised the country’s Priority Sector Lending (PSL) guidelines to enable better credit penetration to credit-deficient areas of the economy, including MSMEs. Per these guidelines, the RBI expanded the scope of PSL to include bank finance for startups for up to Rs 50 crore.

And yet, by mid-2021, MSMEs were reeling under a credit gap of Rs 30 lakh crore. Per one report, just 40% of the sector’s credit demand was being satisfied by formal credit channels like banks. Moreover, five out of six MSMEs lacked access to these channels. There are several causes for these shortages and the resultant credit gap.

1. MSMEs are considered high-risk borrowers

In general, financial institutions like banks consider MSMEs a risky lending proposition. In 2019, the Expert Committee on Micro, Small and Medium Enterprises, headed by UK Sinha, said that this risk in lending to MSMEs stems both from MSMEs’ “inability to pay” and “unwillingness to pay”. As long as banks believe that MSMEs are unable or unwilling to repay their loan obligations, they will always consider these borrowers as high-risk and be cautious of adding them to their loan books.

2. Inability to gauge the borrowers’ credit-worthiness

Information asymmetry is a serious problem in bank-MSME relationships. Many Indian MSMEs don’t maintain comprehensive financial records, such as tax returns filings, P&L statements, balance sheets, etc. so institutional lenders like banks get very little – if any – visibility into MSME finances.

Banks also don’t have enough information about MSMEs’ credit history or scores. They also spend very little time monitoring MSMEs’ business models and financial performance. All of this results in serious information gaps that prevent banks from assessing MSMEs’ creditworthiness, making them wary of lending to them.

3. Lack of physical assets and inability to provide collateral

A majority of MSMEs in India often don’t own substantial physical assets. As a result, they are unable to provide collateral for accessing loans. This fact, combined with a lack of credit history, means that traditional lenders cannot offset the risk to their capital. Consequently, they end up rejecting many MSME loan requests.

4. High Cost to Serve

MSMEs’ inability or unwillingness to maintain proper accounts and collateral increases banks’ expense of supplying credit to these enterprises. This “cost to serve” prevents many lenders from entering into credit relationships with MSME borrowers.

5. Lack of trust

With lakhs of MSMEs currently operating in India, lenders often cannot differentiate one MSME borrower from another. This lack of knowledge usually translates into a lack of trust and an unwillingness to lend.

Another reason for low trust is that MSMEs bring a high risk of loan non-repayment. This is because they themselves don’t get paid quickly by their buyers. In 2021, delayed payments to MSMEs were valued at Rs 10.7 lakh crore. In MSME supply chains, buyer payments can take 30 – 90 days to clear. Since MSMEs get paid late, they struggle to repay their loan obligations, which explains why banks do not trust them.

Causes of credit gap from borrowers’ perspectives

Here are 4 causes:

1. Poor Credit Depth

Few lenders are willing to extend loans to MSMEs at affordable rates in semi-urban and rural parts of India. The lack of options means that MSMEs don’t have anywhere to go to access much-needed credit. And poor access to credit means the credit gap keeps getting wider and wider in India’s MSME space.

2. Complex Borrowing Processes

A large proportion of MSMEs operates in smaller cities and villages. Many MSME owners are financially sub-literate or illiterate, with little or no knowledge about credit options, documentation requirements, or borrowing processes. Larger banks don’t take the time to simplify – or even explain – these complexities to MSME owners who feel overwhelmed by the prospect and change their minds about applying for loans.

3. Long Disbursal Timelines

Many MSMEs operate with small financial margins and therefore need urgent working capital to meet their day-to-day expenses. However, traditional financial institutions take too long to approve and disburse loans, making them unsuitable for MSMEs’ working capital requirements. These long disbursal timelines also discourage potential MSME borrowers from going through with the process.

4. Gender Bias

In FY2021-22, the number of women-led MSMEs registered on the MSME Ministry’s Udyam portal increased by 75%. Moreover, women’s participation in India’s MSME industry is higher than their participation in any other part of the labour force. These positives notwithstanding, women MSME owners face many challenges when accessing bank credit. In addition to the challenges explored above, their gender also hinders their access to bank loans.

Per one study, 70% of Indian women-owned MSMEs face a credit gap. One reason is that in India’s patriarchal society, women are often considered less capable than men of launching and running successful businesses. Women also don’t have enough collateral in their name, making it harder for them to raise credit from banks. The ongoing and long-standing gender disparity problem also makes it likelier that a male MSME borrower will get a loan over a female borrower, even if they run similar businesses and make similar loan applications and presentations.

All these factors explain why Indian women entrepreneurs face a loan rejection rate of 16%, 2X the rate faced by their male counterparts. They also explain why, out of Indian MSMEs’ total credit gap of Rs. 30 lakh crore, women-owned businesses account for a gap of at least Rs. 12 lakh crore, and why 90% of women borrowers rely on “informal” sources of financing.

The Impact of Credit Gap on India’s MSMEs

The RBI’s PSL guidelines aim to enable better credit penetration to credit-deficient areas like the MSME sector. The Ministry of MSME has also introduced multiple measures to boost MSME credit in recent years. Examples include an Rs. 20,000 crores subordinate debt for stressed MSMEs, a Rs. 50,000 crore equity infusion through the Self Reliant India (SRI) Fund, and the elimination of the global tendering system for government procurement of up to Rs. 200 crore.

Eligible MSME businesses can also access an Rs. 3 lakh crore Emergency Credit Line Guarantee Scheme (ECLGS) (increased to Rs. 5 lakh crore under the Budget 2022-23). Women entrepreneurs can also participate in Stand-Up India to set up greenfield enterprises. Under this loan scheme, they can borrow between Rs. 10 lakh and Rs. 1 crore for their MSME businesses.

But despite these measures, the credit gap remains a substantial problem for India’s MSME sector. About 95% of the viable debt gap is due to micro and small enterprises. Since MSMEs are vital drivers of the country’s economy, a lack of credit prevents them from making tangible contributions to this economy, slated to be worth $5 trillion by 2026 and $10 trillion by 2033. It also hinders them from achieving their full potential.

In the months following the COVID-19 pandemic, about 67% of MSMEs were forced to halt operations temporarily. Almost the same number reported profitability declines. Many MSMEs struggle to mitigate the pandemic’s impact and meet their day-to-day obligations. The credit gap makes it harder for them to overcome these challenges and return to profitability.

The asymmetry between the MSMEs that need credit and those that receive it also affects financial inclusion in India. Smaller ticket sizes, the geographical dispersion of MSMEs, and poor credit depth all result in the exclusion of many MSME borrowers from the traditional lending ecosystem. Ultimately, such exclusion hinders universal credit access and makes it harder to bring all Indians under the financial services umbrella.

Yubi Is Helping Close India’s MSME Credit Gap with Technology

Traditional banks and NBFCs are not exactly well-placed to address the widening credit gap in MSME financing. The key to closing this gap lies with Fintechs like Yubi. Yubi is building cutting-edge technology to enable seamless credit flows to India’s MSME borrowers and close the widening credit gap.

Yubi’s unified lending platform YubiLoans, seamlessly connects lenders with MSME borrowers, allowing for easy discovery and loan disbursals. Borrowers can access 750+ lenders in Yubi’s network and choose the lender that offers the best loan terms and the most competitive interest rates. The platform’s automated workflows bring greater efficiency to the lending process and simplify previously-complex tasks related to onboarding, document, credit checks, etc. Lenders also benefit from YubiLoans because they can access 3000+ borrowers, which means they get 3000+ chances to add new high-quality customers, expand their loan books, and boost their revenues.

Regarding MSME financing in India, YubiLoans is leading the way with digitisation, automation, and world-class AI/ML technology. To know how YubiLoans is augmenting the flow of finance to India’s MSME sector, click here.