MSME Credit Assessment Gets a Makeover with Finance Ministry Launching a New Model

By Mr. Ram Kewalramani

With the country moving towards a more inclusive growth agenda, the Micro, Small, and Medium Enterprises (MSMEs) in India will play a critical role in helping India achieve the targeted growth rate of the nation.

According to EY, the burgeoning gap between the demand and supply of credit to MSMEs is said to be approximately US$250 to 300 billion.

This credit gap presents opportunities for banks and FinTech companies to collaborate and enable the provision of affordable and easily accessible credit facilities.

The finance ministry calls for the rollout of new MSME credit assessment models

The exclusion of MSMEs from structured lending frameworks stifles their development.

While we have made significant progress in unlocking easy access to credit, we still have to address some critical challenges to ensure that the formal use of financial products or services is meaningful and affordable.

Considering how MSMEs are contributing towards wealth creation at a grassroots level and are the driving force behind India’s ascent to become a global powerhouse—the financial services industry, together with the government and regulatory bodies, needs to address the case of MSME funding with greater urgency.

We will need the support of regulatory initiatives to improve the operational environments and create a nationwide digital ecosystem that will play a pivotal role in reaching the credit-starved segments of society.

In line with the Union Budget 2023-24, Public Sector Banks (PSBs) have been tasked by the Ministry of Finance to roll out pilot initiatives focused on a restructured credit evaluation approach for MSMEs.

During the pre-budget consultations, the Federation of Indian Micro, Small, and Medium Enterprises presented the issue before the Finance Ministry.

As a result, the Indian Banks’ Association (IBA) will lead the charge in developing this new framework, which will require PSBs to build in-house capabilities to assess MSME creditworthiness.

How will this new MSME credit assessment model help?

The shift to digital platforms by MSMEs brings numerous advantages, including the ability to establish a verifiable and traceable digital history of their financial transactions.

As a result of this, the traditional cash flow figures are being replaced by digital transactions, making it easier for banks and FinTech lenders to make data-backed decisions while lending to MSMEs.

The new credit assessment model will move away from third-party ratings and evaluate MSME creditworthiness by leveraging the digital footprints of these small businesses, many of which operate without formal accounting systems.

It will bring forth a much-needed upgrade from the traditional assessment of credit eligibility, which is largely based on external evaluations such as the business’s asset ownership or turnover criteria.

In recent years, what has truly supported widespread financial inclusion is the advent of the digital infrastructure centred around a digital identity and a robust payment system. These developments have unleashed the potential to assess credit, set up recovery mechanisms, and underwrite risk effectively—in turn, reducing the friction in distributing credit to underserved segments like MSMEs.

With this new credit assessment model, banks that have for years relied on external credit evaluations now have the opportunity to get a more holistic view of an MSME’s financial health through a comprehensive assessment of digital transactions and business records available online.

This allows them to overcome the challenges of over-financing or under-financing MSMEs and ensure credit is delivered effectively to those who need it most.

FinTechs and their data-driven lending model

Lending to underbanked MSMEs has been a longstanding challenge. The lack of access to adequate and affordable credit faced by most MSMEs is a result of:

• Information asymmetry
• MSMEs essentially have a ‘thin file’ character
• They have varying degrees of quantity and quality of firm-level financial data

FinTech lenders are adopting innovative approaches to credit scoring and underwriting to expand access to credit. Utilising external data, such as credit scores and payment histories, banks also have the opportunity to improve their credit decisions. This not only minimises the risk of default but also ensures competitive pricing based on a borrower’s risk profile.

Backed by FinTechs’ data-driven lending technology, banks can monitor invoice finance portfolios of corporates in real time, transforming the supply chain financing ecosystem. Further, machine learning algorithms enable banks to detect early warning signals of potential payment delays or defaults. These predictive insights provided by FinTechs can help banks with proactive risk management.

AI is shaking up traditional lending practices

AI empowers banks to delve into customer data like never before.

According to Gartner, 20% of all test data for consumer-facing use cases will be synthetically produced using generative AI by 2025.

With AI, we are uniquely positioned to tap into vast datasets to gain deep insights into customer behaviours and trends. This level of foresight can be a game-changer in delivering personalised credit solutions.

Understanding customers at such a granular level also means better risk assessment. AI can spot irregularities or potential issues in real time, reducing fraud and improving security. Out of the financial services companies using AI, nearly 56% of them have implemented the technology in risk management.

New-age FinTechs, have shown remarkable agility in adapting to the needs of MSMEs and are building AI-powered credit solutions that are inherently more favourable towards small businesses. By leveraging the latest technological advancements, they have introduced proactive credit risk assessment models, flexible financing solutions like small business loans, and streamlined operations—providing a more MSME-centric experience.

(The author is Mr. Ram Kewalramani, Co-founder at CredAble, and the views expressed in this article are his own)