Making SMEs bankable and banking on SMEs

India is considered a "bright spot" in the gloomy, global economic scenario today. The country with a GDP growth of 7.6% (in 2015-16) has topped the World Bank's growth outlook for the financial year 2015-16 for the first time. A closer look at the performance of the Indian economy in past few years certainly showcases some glimpses of structural reforms with a shift of focus towards high potential sectors – manufacturing MSMEs, and start-ups. It is clear that as an economy, we are banking upon the MSME sector and the start-up community to push the frontier of nation's growth. (world bank)

Over the years, manufacturing MSMEs have shown steady growth and the sector has come a long way. Today, the sector has created a position for itself and is now known for the manufacturing of a variety of sophisticated and niche products like electronic control systems, electro medical equipment, microwave components, etc. The manufacturing MSME sector contributes 8% to India’s GDP, 45% to India’s total output and 40% towards total exports (Govt. of India data). These numbers may seem magnificent but if compared with other countries, like China where SMEs contribute 60% to nation’s GDP, it reveals that India that has largest SME base (38 million) after China (52 million) has untapped potential that needs to be explored. But, what is stopping our manufacturing SMEs in utilizing their full potential, becoming bankable?

Challenge in procurement of good quality raw materials: On an average, raw material procurement amounts to about 70% of the recurring costs of a manufacturing SME. Add to that the highly biased and unstructured nature of the market. An SME has to compete with large and established enterprises, which get easy access to high quality raw materials owing to the volume/quantity of purchasing power.

Owing to their small size and lower demand for raw material, SMEs have to spend huge amount for sourcing good quality raw materials from trusted suppliers. This raises two prime concerns for the SMEs:

• Limited access to high-quality raw materials
• High procurement cost

Lack of access to working capital: Although they contribute significantly to the economic growth, SMEs still struggle to get sound financial backing. In fact, majority of the banks fail to analyse the credit worthiness of the SMEs – that is, whether the SMEs have the capacity to payback the debt in loan on time. Unless the SMEs have strong financial backing with easy access to long term working capital, the sector cannot be termed as a bankable one. Thus in order to have a SME sector that can be banked upon, India need to make it bankable and financially stable.

There are various reasons why SMEs do not get enough financial support:

• Ticket size of loan & high transaction cost– The SME sector suffers from challenges of small ticket size of loan, low revenue per client, and incur high transaction cost due to which the traditional banking institutions refrain from financing these small ventures.
• Higher risk perception – Banks consider SMEs as a high risk sector owing to low or nil credit rating, higher rate of diversion of the funds, and low turnover, among others.
• Lack of collaterals - SMEs often fail to raise enough funds due to lack of collateral. Banks and other financing institutions prefer to give loans to entities with best collaterals and security such as residential property, thus crushing the efficiency and scope of growth of the small firms.

Government initiatives to help SMEs

While the challenges are deep-rooted, the government is resolving to address the key issues. For instance, the establishment of MUDRA bank, under the Pradhan Mantri Mudra Yojana (PMMY), to disburse loans of smaller amounts is a great move. As of May 2016, the Mudra bank has managed to disburse Rs 1.32 lakh crore to about 3.48 crore beneficiaries and has set a target of Rs 1.8 lakh crore has been set for the current financial year, 2016-17. The PMMY has managed to reinstall an air of optimism in the SME sector with its effort towards refinancing micro units - small individual and enterprise borrowers – who seldom get loans from banks.

However, the demand of such loans is humungous in the market to be absorbed by a single entity. The International Finance Corporation (IFC) has reported that the MSME sector has a severe capital shortage of Rs. 32.5 trillion along with a debt shortfall of Rs. 26 trillion.

Financial Institutions as custodians

Given the situation, various NBFCs (Non-banking financial companies) and private banks have come forward with specialized loan services for SME players. This is seen as a welcome move by the SME sector and many players are opting to secure working capital loans from NBFCs or private banks as against the private lending concept that comparatively has the highest rate of interest in the market. Presently for many SMEs, lending from private banks and NBFCs is proving to be a viable and convenient option. Over the past few years, NBFCs have become a major source of working capital for small and mid-sized companies.

New-age Lenders – Fin-tech/ Digital Finance Firms

Avant-garde NBFCs like Vistaar Finance and others, with their online presence also made it easier for the asset light SMEs and entrepreneurs to receive loans. These NBFCs analyse the credit worthiness of the sellers using analytics and other scanning metrics like their sales and fulfilment records and can disburse loans in less than 48 hours.

The new age NBFCs, with help of technology are creating disruption in the industry, and for good. The trend is picking up at a faster pace as the SMEs find this option very convenient to access funds easily and quickly. In fact some of the banks like Bank of Baroda is also partnering with new age lending players in order to expand their reach especially in the SME sector.

How can SMEs and banks work together?

Major efforts are under way in making the India SMEs bankable as the sector is being exposed to innovative credit facilities, online lending platforms which offer alternative modes of financing for small businesses.

• Focus on bright ideas and not size of assets - There is a need for banks and financial institutions to evaluate the credit worthiness of SMES on the basis of the merits of the project and ideas rather than focusing on size of collaterals – this would be a game changing scheme in the MSME sector, that is known to drive innovation and competition into key economic sectors.
• Performance driven incentives by government: Again, we need to focus on improving the performance of our SMEs and ensure that a good idea or product should not face mortality due to lack of funds. The government, along with public banks must introduce performance incentives basis business activities of SMEs. Incentives can be given in form of lower rate of interest on loans, or sponsoring SME’s participation in global trade fairs or rebate on certain taxes, or in any other way that promotes ease of doing business.
• Resolving the information asymmetry – One of the major reasons why banks refrain from lending to SMEs is lack of reliable financial information. Efforts need to be made in supporting SMEs in generating reliable financial information. India can take cue from the Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR), under United Nations Conference on Trade and Development recommendation for implementation of a standard accounting system for SMES. Such a standard system promises flexibility to accommodate growth, reduces information asymmetry and also evaluates an SMEs accountability and ability to furnish information based on their business skills.
• Working with third party players other than rating agencies: The main purpose of collecting information is to analyse the credit worthiness of a player. The same can also be analysed by tying up with companies that are directly working with SME players. This can help banks get an insight into payment history, behaviour and performance of an SME player which can play crucial role in deciding the credit worthiness of SMEs.

The MSME sector has still a long way to go before it is identified as a bankable and dynamic sector. Although the government has come up with substantial policies and reforms to boost the SME sector, there is a need to address the challenges that affect the SMEs at the grassroots level. Unless SMEs are made truly stable and profitable, banking on them remains a question. To augment the government initiatives further, prominent industry bodies and other stakeholders should join hands to promote more activity in the sector and help create more demand for its goods and services.