What do cash flow based loans mean for the future of credit underwriting for MSMEs

By Sudarshan Chari

Credit and financing for MSMEs: It is now well established that MSMEs, about 70 million in the country, are key to overall GDP growth and meeting India’s employment needs. This is primarily the reason why financing for MSMEs continues to be a focal point when discussing India’s growth ambitions. Historically, the MSME segment has not been the easiest customer segment to serve given the huge variation in size, complexity and requirements. The segment could best be described as having the ticket size of a retail customer, but with the needs of an enterprise customer, and it is often these business needs that remain largely unserved or underserved.

It is evident from the figures reported by Transunion that there are around 7 million MSMEs (around 10% of the total) with formal access to finance, a total outstanding amount of around $275 billion as of March 2022 Financial institutions (FIs) are struggling to balance the right products, cost of service, limited returns and higher perceived risk for this segment – ​​given the vulnerability due to low capital, low fluctuating demand, an inefficient supply chain, concentration risks and the lack of a credible balance sheet. Credit growth has been weak, particularly with respect to the addition of NTC (new in credit) and therefore the gap between demand and supply of timely and adequate credit for MSMEs remains high .

However, there are green shoots in this ecosystem. Through what we call 3D impact – data, digital and the determination of all stakeholders (Government, RBI, Fin-techs and FIs) coming together to capitalize on this unique opportunity. This is not just an Indian phenomenon, but across the globe there is a move towards capitalizing on opportunities in the MSME space.

India is placed ahead of its global counterparts, thanks to the concerted efforts of the government which has improved access to digital data i.e. Bureau/CRILC/GST/Account aggregator platforms which can be leveraged for underwriting based on cash flow. This may very well be a watershed moment for MSME lending if all stakeholders in the ecosystem work together to meet the challenge. Given the advances in data capabilities, the rise in the use of digital platforms and payments, and regulator support, the solution around this space can be done by keeping the customer journey at the center.

There are approximately three factors that need to be considered to meet the needs of MSMEs: a) the overall course designed for convenience b) the time to access finance c) the risk underwriting that allows the financial institution to lend the right amount to the MSME. The first two can be addressed through a digital journey, but the third factor still relies on offline assessment and verification methods. Traditionally, similar methods have been applied to underwriting corporate and SME loans, relying heavily on financial statements.

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Over time, lenders have realized that financial statements alone may not be the best way to assess the risk of an MSME and that it is often necessary to look at differentiated metrics for the assessment. We need to embrace alternative data points (which are not static) like bank statements. The trend has led to the advent of cash loans in India – which are usually short-term working capital loans, granted after assessing an MSME’s cash flow – mainly using operating bank statements, GST data, transaction data available on B2B platforms and background i.e. personal desk score or CMR ranking. The fact that all of these data points have evolved over time and are now available digitally at source has helped to strengthen the case for cash flow based lending.

This has enabled banks to look beyond traditional products like cash credit or term loans to meet the needs of MSMEs. Domestic trade financing products like invoice financing and post-shipment financing are slowly emerging as preferred products within cash flow lending. This allowed overall flexibility in decision-making, based on duration, ticket size, redemption cycle, further considering industry specifics and economic cycle. Improved decision-making has resulted in another significant paradigm shift: lenders are increasingly willing to consider collateral-free lending in the MSME segment, which until now has been asset-backed .

The success of any initiative depends largely on the willingness of decision makers to support the cause. Whether it’s RBI’s nudge to look at cash flow based lending for MSMEs, the push for digital infrastructure in the form of an account aggregation framework and the launch of TReDs platform for cash flow based lending; all of this provided the impetus for the FIs to act. In addition, the government’s overall push for credit to MSMEs through revised definitions, the inclusion of lending to priority sectors or the overall digital push through UPI, GST and Udyog Aadhar has helped to emphasize a more precise execution. Above all, what has propelled change are new entrants in the form of fintechs and neobanks that are boldly challenging the status quo.

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The journey has only just begun and there is still some way to go before new lending models become scalable and sustainable. Digital platforms, enriched with contributions from various data partners, would complement the cash flow-based lending framework. This would enable a simplified customer journey and reduced TAT for the customer, it would simultaneously allow banks to adopt light origination and underwriting models to onboard customers. Eventually, the digitalization trend would help banks address some of the cost-of-service concerns and allow flexibility in pricing.

However, the real litmus test would be the pace of adoption of cash flow-based underwriting. This would require more than surface-level changes and would require fundamental changes in approach. Other data points based on financial data should be experimented with. In the long term, this would enable FIs to offer the right product at the right price.

Cash flow based lending has the potential to positively disrupt the MSME sector and can have a large-scale impact across the entire MSME value chain. Considerable potential can be expected in this area, not only in terms of underwriting, but also as banks evolve their supervisory frameworks and respond to customer demands on an ongoing basis. The faster the adoption of cash flow based lending, the better it will be for MSMEs, with network effects for the economy. This would have a cascading impact across the entire system, driving new data formats, use cases, and product innovations that will help strengthen the banking industry and propel the country’s growth.

Sudarshan Chari is Executive Director and Head of Corporate Banking at DBS Bank India. The opinions expressed are those of the author.