Digital lending: Shot in the arm for MSMEs?

• Digital payments have gained strong traction in India post-2016, and are expected to be valued at US$ 135 billion in 2023.
• One key area where fintech is expected to play a huge impact is digital lending, especially for Indian MSMEs that face a funding gap of US$ 240 billion.
• Digital lending startups help address several pain points for MSMEs seeking loans through lower transaction times, less procedural hassles and lower costs.
• To grow sustainably, digital lenders must ensure that their data security, risk identification and mitigation framework is in tune with global best practices.

The Supreme Court has removed the ban on cryptocurrency this week, which had been instituted by the RBI in 2018. This can be seen as another ominous sign of the inevitability of India’s progression into digital transactions. In fact, the digital surge could be coming much faster than we would have anticipated till around two years back. 

Factually, the cash economy in India is still too deeply entrenched to be shaken up in a hurry. However, in a recent report, the Reserve Bank of India (RBI) concluded that there has been a noticeable rise in digital payments throughout the country. The cash in circulation has grown at a lower rate between 2016-17 and 2018-19, as compared to 14% between October 2014 and October 2016. If the rate of increase would have remained 14% subsequently, the notes in circulation (NIC) would have been valued at Rs 26,04,953 crore in October 2019. However, the actual amount shows a shortfall of NIC by Rs 3.5 lakh crore.

While the change is small today, there is little doubt that digital currency in India is well on its way to reach tipping point. Over 1,000 fintech startups have sprung up in just around 2 years with a total funding of around US$ 2.5 billion. Digital payments are expected to double to US$ 135.2 billion in 2023 from US$ 64.8 billion in 2019 according to an Assocham-PwC study. The strong surge in digital payments has major consequences for businesses as well as the overall economy.

One major impact area in this regard is lending for MSMEs. So far, the formal sector has fallen woefully short when it comes to serving their financing needs. This has led to a colossal funding gap estimated at around US$ 240 billion (Rs 16.66 lakh crore) as concluded by an IFC Intellecap report. Moreover, the report notices an increase in the credit gap from US$ 200 billion in 2012. As a result of this, around 40% of the MSME lending comes from the informal sector, with unfavourable terms and several other hassles.

A number of factors are driving a new wave of opportunity for MSME lending. Firstly, Indian MSMEs are digitizing and getting formalised at a quick pace, especially post-demonetisation. The launch and rise of the unified payment interface (UPI) platform has been a major catalyst along with the introduction of Goods & Services Tax. Rapid digitization post-2015 has equally played a pivotal role, with a 95% drop in data costs, eight-fold increase in MSME data consumption, and 85% total MSME smartphone adoption, as affirmed by an Omdiyar-BCG report.

The technology-led aggregator model also ensures benefits in unit economics for lending akin to other fast-growing sectors like food delivery, travel and cab hailing. Digital lending is asset light, without the need for extensive infrastructure of branches and huge manpower. Due to lower fixed cost, these fintech lenders can aggregate huge volumes of low value loans and also keep their products attractive.

MSME lending is projected to grow 10-15 times larger by 2023 to reach US$ 80-100 billion, still only half way through the current demand, as a result of this exercise. Policymakers are looking for ways to support this industry. Recently, the RBI increased the limit from Rs 10 lakh to Rs 50 lakh for P2P lending to support the industry, after the industry demanded a hike in this limit to Rs 1 crore. This has built the brass tacks for a revolution in digital payments, building an ever growing treasure trove of MSME financial data that is easily and quickly available and also verifiable.

For MSMEs, digital lending can help address some of the most crippling pain points of lending – approval time, documentation requirements, high interest rates, low sizes of loans, etc. Digital loans can be processed within a single day. Also, with the availability of data on MSME credibility, a lot of the documentation is automated. With the implementation of e-KYC and recognition of the Indian credit rating system, the growth has received a further boost.

Various models have emerged in the digital lending ecosystem, which include:

• P2P lending: Connects borrowers and lenders via a digital marketplace model.
• Invoice financing: Provision of short term working capital credit to MSMEs based on unpaid customer invoices.
• Crowdfunding: Borrowers make presentations of their business case, growth potential and fund requirements to a large group of investors to get external credit.
• Pay later loans: Lenders disburse instant, small-ticket sized loans with the ‘buy now and pay later’ model for meeting customers’ purchases
• Mobile lending: Lenders offer mobile loans to customers by assessing their creditworthiness through mobile phone data like call patterns and mobile e-money usage.
• Digital mortgage: Lenders facilitate mortgage purchases through end-to-end digitisation of the traditional mortgage loan process, from application to disbursement, through digital channels.
• PoS lending: A partnership model with FS (financial services) lenders where these players finance online shoppers’ purchases by utilizing both conventional data like bank statements and unconventional data like online transaction history.
• Supply chain financing: Marketplaces that tie up with direct lending NBFCs to target merchants selling their goods and services online, by leveraging the huge amount of merchant data residing on these channels.

Although the industry is growing fast, it can prove highly vulnerable if there is a rise in defaults. A report by NASSCOM titled “Fintech Lending, unlocking untapped potential” affirms that this entails a significant risk to business viability, especially since they are collateral-free loans. The experience of NBFCs provides some background in this regard, as their bad loan ratio has risen from 3.6% to 6.6% in the past five to six years. The rise of fintech firms has ushered in a new era with the use of advanced algorithms to screen individuals and businesses for risk of defaults. These algorithms are also capable of learning from default data as it becomes available and improving their efficacy.

To take the lead in this space, Indian digital lending players have to stay abreast of the latest technologies and ensure that their risk identification and mitigation strategies are best in class. Consistent innovation in these models, with due regard to data security standards will be key in determining how the Indian digital lending space evolves and the role it plays in addressing the funding requirements of MSMEs in the country.