Indian financial system has traditionally not been a level playing field between large enterprises versus small businesses. The MSMEs have had a raw deal on financing in India. This is because, by their very name, Micro, Small and Medium Enterprises (MSMEs) are generally small. So will the big firms keep getting bigger, to the point of “too big to fail”? Is small really not so beautiful? And how can Fintechs play a role in reversing this trend.
Let us first look at what problems MSMEs faced traditionally. MSMEs have generally been starved of funding due to reasons of scale, transparency and capital providers. Fintechs have the ability to make a significant difference to correct all the imbalances, thereby helping close the gap as detailed below. First on scale, MSMEs are small enterprises by their very nature. This makes them higher risk, according to most credit models, including the ones used by rating agencies. These models believe the small scale of business increases inherent risk, irrespective of their profitability, or payment track record, or the number of years of in business. While theoretically and even empirically this may be true, this does make scale an unfairly high determinant of credit quality. World over, there are enough examples of niche businesses that continue for decades in their chosen line of business, with specialized skills profitably. This would also be true of those small businesses in the supply chain of large enterprises, either as vendors or dealers, who would find it hard to access finance easily. In India, they find it hard to generate capital unless they provide hard asset collateral, which is commonly required for MSME borrowings. Thus, scale of business being small creates an unfair estimate of credit risk being higher, which then adversely impacts cost. The cost goes up, in line with perceived risk; contributing to lower margins and continued small scale.
Second, on transparency, MSMEs traditionally scored low. Sometimes this was due to hazy regulations, but most times due to lack of financial savviness of entrepreneurs in this category. Thus their accounts were hardly audited, or if they were, were applied uneven standards. The disclosure of even basic data, say balance sheet numbers, was both poor quality and outdated. All this made any decision making suspect, if based purely on financial data. This was despite India being one of the few countries, wherein public data availability has been recognized for long time as a virtue. So, all private companies need to file basic Profit & Loss, and balance sheet to the MCA periodically. However, the implementation of this was tardy earlier. Further, out of millions of enterprises, a large part were partnerships, where the disclosures were not again mandatory.
Given the lack of good quality transparent data and perceived higher risk due to small scale, the capital availability for MSMEs traditionally was very poor. Thus they got no finance and if they did, either at a high cost or with huge collateral, unless subsidized due to some scheme. The implementation of these schemes would typically have some lacunae again exacerbating the woes of the small businessman. Most of the financing was by banks, as capital markets found it hard to make small loans to businesses due to cost of issuance. Large companies with big finance teams that managed the accounting, ratings and investor coverage were able to get money cheap and from banks, local debt capital markets as well as overseas markets. Money being life blood of business, they continued to grow.
Enter the Fintechs, which have raised substantial amount of equity and generated a huge interest over last few years. The tech part of Fintech has been keeping up with continued improving access to data online, such as GST, KYC and variety of bureau scores. Temperamentally, Fintechs are more in tune with the instant gratification psychology at work today. Thus Fintechs have been able to create new disruptive business models of making credit available to MSMEs. GST in particular has been a paradigm change, as it helps in transparent business information on a real time basis, which can be relied upon. Such transparency neutralizes the scale disadvantage. Fintech-Bank alliances can do wonders to help improve access and cost of capital for MSMEs.
It is still early days where the Fintech funding models backed by new data and underwriting methodologies are being proven. Once found satisfactory, these can be scaled digitally in an exponential fashion. That would be the time when the MSMEs will have a fair chance of growing in size to be globally competitive eventually, thanks to the Bank-Fintech collaborations.
– Sanjay Phadke, EVP – Platform & FI Business Head, Vayana Network