The Modi government has been very proactive in addressing India’s massive SME financing gap, but it will take years for policy measures to make a significant difference. Melodie Michel reports.


“Dear small business brothers and sisters, (…) the strength you give to the economy is one of its most overlooked secrets,” Indian Prime Minister Narendra Modi wrote on March 31, in an impassioned open letter to his country’s micro, small and medium-sized enterprises (MSMEs).

The letter was published the day after the launch of the Micro Unit Development Refinance Agency (MUDRA) Bank, the latest in a series of measures implemented by Modi to improve access to finance for MSMEs.

And improvements are sorely needed: an International Finance Corporation (IFC) report from November 2012 stated that out of the US$650bn MSME funding demand, only 22% was met by the formal financial sector (85% of which is formed by banks). The IFC estimated that 38% of the overall demand (US$198bn) was actually viable under banks’ compliance standards, but that “financial institutions [had] limited their exposure to the sector due to a higher risk perception and limited access of MSMEs to immovable collateral”.

In its recommendations, the report reads that with appropriate policy interventions and support to the MSME sector, a considerable part of the currently unmet demand could be made financially viable for the formal financial sector. Two years later, and a year after Modi became prime minister, it is clear that this support has become one of the government’s top priorities.

Take MUDRA Bank for example: after ‘banking the unbanked’ at the end of 2014 – a push for financial services in remote locations that has led to the opening of 95 million new bank accounts – the government is now pledging to ‘fund the unfunded’. MUDRA has been allocated US$3.2bn of capital for refinancing, as well as US$480mn for credit guarantees.

“It is dedicated to SMEs with the purpose to extend refinance, even to non-banking financial companies, so the ultimate loans become cheaper. If it becomes cheaper, we will pass on some of that advantage to SMEs,” says Sanjay Agrawal, senior president, business banking, at YES Bank.

“Our new prime minister has taken the initiative of covering all locations by banks. The banking records are being created, and if we have a banking record, it will be easier for us to lend. Slowly, the organised flow of credit can reach the ultimate borrower.”
However, some have expressed concern over the scale of the change that MUDRA can realistically bring to the system. “The MUDRA Bank will be good and dedicated, but it’s small,” says Samir Bhatia, founder and CEO of online SME financing platform

While recognising that the initiative should “bring much relief to the MSME sector”, Chandrakant Salunkhe, founder and president of the SME Chamber of India and the SME Export Promotion Council, tells GTR that previous government initiative in that arena haven’t always been as effective as planned: “Public banks in India are required to meet prescribed targets in SME lending, being the priority sector of the government, but quite often this target is not accomplished due to many reasons. And though there are certain government initiatives for reaching out to international markets, they are not really very effective. More awareness programmes and handholding are required to achieve effective results in this regard.”


Middle men


Though government measures are definitely heading in the right direction, the issue of SME lending has much deeper roots, which will take time and education to move. Indeed, the main reason why small businesses don’t have easy access to the banking system is that they are not in a position to put forward a bankable proposal.

Bhatia was a banker for about 20 years before launching SMEcorner in January 2015, and his main takeaway from that experience is that SMEs do not know how to raise money. He explains that they usually go to a third-party provider to put together an application, for a hefty fee.

“The middle men or advisers take a lot of commission in the form of processing fees, or say they had to pay somebody in the bank to get the loan approved, and there is no price discovery. They also get a commission from the bank, so those guys actually make a commission on both sides. There is a clear conflict of interest and vested interest, and the middle man is most likely going to recommend the bank that is paying him the most commission as opposed to the cheapest or the fastest bank,” he tells GTR.
Though widespread, this system is anything but transparent, and unaffordable to the smallest businesses.

For that reason, sites like SMEcorner – through which SMEs can enter their requirements online for free and are then contacted by an underwriter who helps them build an application to submit to relevant lenders – could be game changers.

The site matches SMEs with loans for a variety of purposes: working capital, trade finance, letters of credit, guarantees, and even unsecured loans from non-bank providers, as a large number of applicants don’t have the collateral needed for bank funding.
“It is absolutely free to the SME; it’s one application form and takes about seven minutes to fill out online. It captures the basic information, which is then analysed by our underwriting team, which calls the potential borrower and discusses.

“What usually happens is that they themselves don’t know how much they can get, in what form they can get it etc, so we need to provide a lot of guidance. We ask them what their turnover is, what their profit is, how much cash they generate, what their existing loans are, and what type of security they can offer. We then do the documentation work for the bank: pick up financial statements, bank statements etc, and then forward them to the banks that are most likely to lend. We get paid by the banks, through a one-time fee which is a percentage of the amount disbursed,” Bhatia explains.

Three months after its launch, SMEcorner had partnered with 16 bank and non-bank lenders and received “a few hundred” applications.

But the best efforts from these providers won’t change the fact that Indian SMEs’ funding needs are often too small to make business sense for banks. Combined with a largely cash-based economy that makes it impossible for banks to measure receivables, this means unorganised players including family friends and ‘trade’ – businesses with extra cash lending to others at interest rates of about 24% per annum – still have good days ahead of them.

“Everybody has to play their own role in terms of education. As far as regulators are concerned, they are doing enough for SMEs. They are giving licences to banks and non-banking financial companies, as well as permission to open new banks dedicated to SMEs.

“As far as banks are concerned, we are trying to bring down our costs so we can lend to these SMEs and it makes economic sense for us. There are also financial consultants who are now focusing on SMEs because they feel that there are opportunities, but still, it is concentrated largely on towns with populations of more than 100,000 people. All these issues will take a long time to get resolved; it’s unlikely that all SMEs will be covered in the next five years,” says Agrawal at YES Bank.


The e-commerce revolution
The sector where SME lending changes are most likely to accelerate over the coming years is e-commerce. The industry has grown by almost 35% a year in India over the past few years, from US$3.8bn in 2009 to an estimated US$12.6bn in 2013 (PwC, 2014). But because it is still in its infancy, it is not yet fully covered by banks’ comprehensive compliance requirements – meaning there is room for flexibility.

“We are doing a lot of opinion building on the e-commerce space because it is exploding in India. Most of the sellers registered today are the newer generation in the family, where the father is doing the manufacturing business and the children want to do the more glamorous e-commerce side. These entrepreneurs have less experience, and the banks really want to finance them, but it’s challenging because it’s a new industry.

“We go and meet the policy heads of banks, taking them through the profiles of these sellers to see if they can set up a small product programme, a small amount for six months, see if it works and if it does, expand it. Over time I think that will become a very large market for banks,” says Samir Bhatia, a former banker who recently founded SME financing platform