Financing is a perennial challenge for Micro Small and Medium Enterprises (MSMEs) across the world, more so in developing nations.

According to the International Finance Corporation (IFC), almost 65 million firms, or 40 per cent of formal MSMEs in developing countries have unmet financing needs that amounts to $5.2 trillion annually, equivalent to 1.4 times of the global MSME lending. Including informal enterprises can increase these numbers substantially.

The UK Sinha Committee constituted by the Reserve Bank of India estimated the credit gap for MSMEs in India to range between $267 and $334 billion in 2019. The gap remains despite several measures taken by the government to strengthen formal channels of financing. In December 2021, the share of bank credit to MSMEs was a meagre 13 per cent.

In the wake of the pandemic, the government introduced a slew of measures to keep Indian MSMEs afloat. Additional loans, equity infusion, credit guarantees, etc. supported them on crutches of short-term financial relief. Thrown at the deep end, some sank, but many MSMEs learnt to swim.

ICRIER’s recent report titled ‘MSMEs Go Digital’ identified the first signs of a structural shift towards digitalisation. Lockdowns and restrictions on mobility, encouraged many MSMEs to opt for online channels. e-commerce companies reported an 80 to 90 per cent increase in seller registrations on their platform towards the latter half of 2020, most of whom belonged to smaller cities.

The success reflected in rising percentage of online sales, improving topline and profits. Benefits of digitalisation accrued to other aspects of business modernisation including inventory management, product cataloguing and most importantly access to new sources of finance through online lending platforms.

Online lending platforms driven by their data analytics and machine learning approaches are able to offer customised loan products to the MSME sector. They are lean, decentralised and effective channels for targeting underpenetrated markets. Mostly collateral free, online loans to MSMEs can range from short-term working capital to long-term business loans that are approved through automated processes even when borrowing firms don’t have a robust credit history. Some prominent examples of online lending platforms serving MSMEs include Lending Kart, LenDen Club, Cash Suvidha, Indifi, Flexiloans, Aye Finance, etc.

Interestingly, many platforms tie up with e-commerce companies creating a support ecosystem for MSMEs that sign up for online sales on e-commerce platforms. A few years ago, e-commerce companies were largely facilitating finance for their MSME sellers through banks and other financial services firms. But competition from online lenders offering faster and efficient access to finance has opened up a whole new window of opportunity for struggling enterprises.

Tripartite tie-ups

The tripartite arrangement between the e-commerce platform, online lender and the MSME is a win-win situation. For e-commerce companies, channelling finance to a seller enhances their ability to produce and offer high quality products for buyers on their platform that in turn strengthen network effects.

For MSMEs, it is access to cheap and quick loans that help manage inventory, expand market reach, hire new employees, modernise business processes, etc; and for the online lending platform it is a business opportunity, the risks of which are partly mitigated by data-driven determinants of credit worthiness and partly by security that the e-commerce platform may offer. Online lending platforms interviewed as a part of the ‘MSMEs Go Digital’ study emphasised on the symbiotic virtues of this arrangement.

According to RBI data, digital lending increased 12 times between 2017 and 2020. Online seller finance, a subset of digital lending, is thriving. But there are risks. The 2021 report by the RBI’s Working Group on Digital Lending, I, highlight the role of technological innovations in enabling financial access, albeit, at the cost of greater reliance on unregulated third-party lending services which lead to mis-selling, privacy breaches and other unethical business practices.

According to the working group, 600 out of 1,100 lending apps reviewed could be termed ‘illegal in nature’. This report provided a framework that balances the twin objectives of innovation and systemic integrity. Some of the proposed measures include a verification process, self-regulation, baseline technology standards, regular auditing, new legislation targeted at illegal lending, etc.

The current landscape is a mix of regulated and unregulated entities – deposit taking and non-deposit taking NBFCs, peer to peer lending platforms, etc., that create opportunities for regulatory arbitrage. For the market to remain competitive a balanced approach and pre-emptive regulation will be necessary.

Moreover, these first-generation online lenders are still to witness a complete cycle of growth and are at a distance from market maturity; a journey that will include episodes of defaults, non-performing loans, capital risk, etc. Adaptive policy can help navigate through these challenges.

Growth of MSMEs and their digitalisation are heavily dependent on credit availability and credit dissemination, especially to underserved markets. A recent paper by Jing Cai and Adam Szeidl, find that MSME financing must not be viewed as financed firms stealing business from the unfinanced ones, but through a broader lens of social returns on capital, demonstrating an increase in gains to consumers from financing of MSMEs that manifest in the form of introducing new products, lowering prices, etc.

It is therefore in the interest of policy makers to provide every available support for financing to reach MSMEs. Digital lending platforms are well placed to address this credit gap. For this, policy makers and regulators must remain adaptive and agile.

The writer is Fellow, Indian Council for Research on International Economic Relations. Views are personal