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There are two things you should know about MSME lending. One, it’s mandatory for financial institutions to route a substantial part of their credit deployment to the smallest businesses. Two, it’s risky.
The first part is pretty well documented. Priority sector lending norms have been around for long enough. They have seen their fair share of applause and criticism, including the charge that regulatory mandates do not necessarily translate into more funding on the ground.
Let’s talk about the second one. Here are some facts to get us started - officially, there are around 70 million or so MSMEs in India. About half of them (at least) don’t have any access to formal credit. But, if the latest data by CIBIL is to be considered, there are only 7 million or so live MSME borrowers in the country. This means a credit coverage of just ~10%!
We’ve written a lot about this credit gap, the rural-urban divide, new-age solutions like QR code-based financing, and the potential for API-driven credit infrastructure to get MSMEs the credit they deserve.
Ultimately the credit gap exists due to two main reasons - the lack of access to financial services in the interior hinterlands of the country and second, the mistrust between lenders and small borrowers because of the lack of reliable credit historiesand formal data to help lenders underwrite these loans.
But, something seems to have changed. The MSME credit demand is now 2X compared to the pre-pandemic levels, according to the latest CIBIL report on the MSME segment. At the same time, total disbursements to the sector increased 43% year on year in the last quarter of FY22.
This means that the demand for credit has jumped in the MSME segment, and lenders are now walking the talk.
It gets better. The increased credit appetite has also meant that average ticket sizes of loans to the MSME segment have steadily climbed. The report suggests that it could be due to increased credit demand, lower interest rates, and, most importantly - higher risk appetite of private banks.
The average ticket size for medium, small and micro loans now stands at Rs 1.4 crore, Rs 59 lakhs, and Rs 9 lakhs, respectively. This is much higher than one would imagine, given that MSME classification caps the total turnover at Rs 5 crore a year at the highest end.
Pricing in the risk
CIBIL has its MSME scoring benchmarks that rate the creditworthiness of a borrowing entity on a scale of CMR 1-10. CMR 1 implies the least risky segment, while CMR 10 implies the riskiest borrower pool. This kind of segmentation helps lenders incorporate risk-based pricing and calibrate their overall portfolio to ensure that returns from credit disbursement match the risk levels of that segment.
The above chart shows how these segments are distributed. The riskiest CMR 7-10 segment accounts for 15% of the total MSME pool.
In the micro-segment, the riskiest pools saw more credit disbursements than in previous years. This is accompanied by all lenders - private banks, PSUs, and NBFCs upping their share of lending to the CMR 7-10 segments in the MSME space.
Meanwhile, this trend doesn’t directly mean new riskier segments are being given credit. This can be gleaned from approval rates. The approval rates have remained consistent for private banks while they have dropped slightly for public sector banks and NBFCs. This indicates a tightening of customer selection criteria and lenders choosing to play the risk game by taking calculated risks.
All good news. But if the lenders are becoming more risk-friendly, there must be some method to this madness. During periods of economic uncertainty, lenders are known to tighten the purse strings and reduce riskier bets. Increased MSME exposure, especially to the riskiest segments, doesn’t fall into this equation.
What changed? How did a borrower segment so far considered risky and mostly unviable suddenly become attractive?
Risk as a growth strategy
“Nothing great comes without risk,” goes the adage. It’s clear that this boost in credit disbursements towards riskier borrower pools - if sustained - indicates a shift in the way financial institutions want to build their business going forward. Let me briefly describe the three biggest ones:
1. The profitability equation
In 2021, NIM - an indicator of overall margins from lending business - was 3.3% for scheduled commercial banks, mainly comparable to the 2015-16 levels. The situation hasn’t improved much since and going forward, lenders will look to expand their books to more profitable segments - even if this means opening themselves up to the idea of lending to thus far unserved or underserved segments.
Lending to sub-prime borrowers can bring in more profits through higher interest rates. If solid underwriting and collections intelligence back it up, it can boost a lender’s net profitability over time.
2. Peaks/slowdown in top borrower cohorts
The impact of an inflationary economic slowdown is seen first in the top borrower cohorts. This prime borrower pool starts cutting discretionary spending, reducing overall credit exposure and aims to reduce their overall debt.
At the same time, the pool of borrowers tends to grow much slower if the slowdown persists, limiting opportunities for lenders to tap into newly affluent but new-to-credit customers.
We wrote this detailed piece about how banks and FinTechs primarily target this borrower cohort and crowd each other out.
On the other hand, the MSME segment's needs are more diverse. They tend to demand higher credit to meet working capital requirements, and export/manufacturing related enterprises desire more capital even if there’s a slowdown back home.
Improved risk and underwriting infrastructure
Improved underwriting capabilities are one of the primary reasons for increased credit disbursements to new borrower pools. Earlier lenders hung up on traditional credit scores and formal financial trails to assess a borrower’s creditworthiness and are opening themselves up to more unique, holistic underwriting workflows.
This includes alternate data - utilizing a combination of the borrower’s social and behavioral data to assess their intent and ability to pay. This is usually done through device data analytics that helps lenders generate scorecards that feed into their rule engines and help bolster their existing underwriting process.
For instance, relying on traditional credit scores could close more than 50% of the borrower pools to a lender. Still, alternate data underwriting could add millions of new borrowers to that pool and reduce delinquencies by restricting credit to fuzzy candidates even in the top tier of credit scores.
This becomes even more useful for MSMEs as many other factors can help a lender more precisely assess borrowers. For instance, there are now social scores, geo-location intelligence, and Account Aggregation, to name a few.
It’s clear that if credit access has to improve at the bottom of the pyramid - it must be a mix of courage and guile. Courage on the part of lenders to make bold decisions and guile on the part of the risk and business heads to ensure that the bets are calculated, thought-through, and not irrevocably threatening to the business sustainability.
If you’d like to read more on this subject, I highly recommend checking out our in-depth whitepaper - Embracing Risk: How can lenders turn risk into a growth strategy?
That’s all from me this week. As always, leaving some reading recommendations below.
Deep dive: How risk-based pricing can help lenders save billions in credit losses See you next week! Mayank