The authors Aman Bhargava and Akshay Sharma are Senior Vice President and Manager at Capital Float, respectively. Capital Float specialises in digital lending to MSMEs in India.
In this age of digital disruption where technology has made an impact across a number of service sectors — e.g. transportation (Uber), accommodation (Airbnb), retail (Amazon) etc.– finance is clearly no exception. Post the financial crisis, incumbent large financial institutions have been weathering a storm of increased capital requirements (i.e. reduced ability to lend) and increased regulatory costs whilst dealing with an erosion of public confidence.
Digital lending, a subset of digital finance, has been growing rapidly in several large economies in tandem with lending platforms (e.g. Lending Club in the US, Funding Circle in the UK, and Lufax in China). As terms such as peer to peer (P2P) and marketplace lending have come to dominate headlines, digital lending has begun to revolutionise the traditional lending business through the use of technology in order to reduce costs, underwritten with surrogate data points, and speeded up processes.
Lending — ripe for disruption
Lending itself consists of three key areas:
- (i) Origination (or customer acquisition)
- (ii) Underwriting (or credit assessment)
- (iii) Execution (including documentation, contract and flow of monies)
Conventional lending, especially in emerging economies, is an archaic process that is ripe for disruption in each of the above areas.
Traditionally, customer acquisition occurs via brokers or middlemen, underwriting is heavily collateral-based and execution is a tedious process requiring a lot of paperwork that usually stretches up to six weeks in duration. Furthermore, there is a fear of rejection, which in several cultures prevents a number of creditworthy borrowers from applying.
While the opportunity to disrupt traditional financial services is immense, it is important to understand the key drivers in this field. Like most sectors, it is imperative that governments put in place an ecosystem that can help and enable players to create these disruptions.
The three most important enablers for digital lending are:
1. Telecommunications and connectivity
The telecommunication sector has been pivotal in spurring the digital revolution globally. Creating networks that enable consumers to connect from computers, laptops and mobiles are the most basic requirements to kickstart a digital revolution.
From financial services to retailers, everybody depends on networks to provide a compelling online and mobile experience. Telecom operators must offer an integrated, multi-channel or omni-channel user experience: on the desktop, on mobile devices and in stores. The reach of such networks is essential for digital finance to succeed and penetrate new markets.
2. Technology and data
Technology, as one would expect, is at the heart of the digital revolution. Investments in technology by organisations have only been increasing over time.
Advances in digital technology have allowed services to reach a number of people, who had limited or no access earlier. If these advances have to continue, then increased capital investment in equipment and software is an absolute must. Encouraging companies to invest more in R&D, say, via tax incentives is crucial to penetrating the consumer base.
3. Regulations and policies
Post the financial crisis, increased regulations have forced large banks to reconsider their traditional methods, especially in light of additional balance sheet charges. This has opened up new markets globally.
Regulators in the West, particularly the UK followed by the US, have been proactive in allowing these markets to grow and challenge the traditional players. As the rest of the world cautiously opens up to this new space, digital finance players have thrived under flexible and friendly regulations.
It is imperative to encourage an atmosphere in which innovation in financial services and products offered to consumers is prevalent. While the need to be cautious post the 2008 crisis is justified, regulators should be careful not to stamp out truly innovative and disruptive ideas.
Digital finance — banking for the ‘unbanked’
A recent report by The Guardian, states that almost 500 million people across Southeast Asia still often turn to informal moneylenders to meet their everyday needs. Decisions requiring credit, such as expanding a business, buying a house or paying medical bills, are taken out of the hands of the so-called “unbanked”. Uninsured and with no savings, they are also less resilient to health problems, unemployment or a natural disaster.
Digital finance holds the key for financial inclusion, as nearly 50 per cent of the population in developing countries own mobile phones. The impact of digital lending in emerging economies goes beyond the traditional financial services offered. It also helps create additional jobs and acts as an economic stimulator.
A number of firms in Africa and Asia are using digital finance to tackle development challenges. Technological innovations, like mobile money, have acted as catalysts in providing a variety of financial services. Consumers at the bottom of the pyramid in several countries today are using mobile money to make payments for a wide range of services.
Apart from traditional services — such as credit, savings and financial education — consumers also enjoy access to money-transfer services, micro-loans and insurance.
How can we make this happen?
MSMEs (Micro Small and Medium Enterprises) also stand to gain substantially from digital lending. Apart from access to finances, electronic payment systems allow them to secure a diverse range of financial products and an opportunity to build a financial history. The importance of digital finance in building both credit history and transactional data of individuals and firms for lenders cannot be underestimated.
Close public-private cooperation is a key factor for this type of innovation to be taken to scale and enable people to live a more secured, empowered and included life. If approached wisely, it is possible for emerging economies to leapfrog developed nations in the adoption of these digital channels, and at the same time accelerate financial inclusion.
Article sourced from E27. Read the original article here.
A wave of change is sweeping across the nation, transforming accessibility of credit at an individual and institutional level. As stated by the World Bank in 2014, nearly 47% of Indian adults are disconnected from formalized financial systems, increasing their dependency on informal credit channels. The nature of these informal channels and the environment fostering their sustenance make these modes of funding exorbitantly expensive. These channels typically provide immediate funding but debilitate the borrower’s sustainability and competitiveness in the long-term. Usurious rates of interest, loans terms disconnected from business fundamentals and delayed-decision making shackle entrepreneurs armed with ambition.
The apprehensions involving credit-access notwithstanding, SMEs find themselves lucratively placed in the timeline of the Indian economy, wherein Governmental and capitalistic forces are aligning in order to further SME progression in the country. Centre-led initiatives and evolutionary processes set up by tactful corporates are becoming building blocks to facilitate economic development through SMEs.
SMEs central to India’s economic development
The Government of India has identified the significant role SMEs play in shaping and developing the economy. The ‘Make in India’ initiative was launched last year to attract foreign and local investment to the country’s manufacturing sector. SMEs are required to participate actively in making this initiative a success. The pro-manufacturing stance of the Government provides these businesses with the opportunity to scale and grow at an accelerated pace.
India destined to become an e-commerce superpower
Similarly, e-commerce companies in India are in the golden phase of technological advancement. According to Goldman Sachs, India’s e-commerce market will cross the $100 billion mark by FY20. A study by PWC indicated that the e-commerce industry is expected to grow from $16.4 billion in 2014 to $21.3 billion in 2015. Alibaba.com, the B2B division of the world’s largest e-retailer Alibaba Group recently announced that India is the second most important market for the company globally . A whopping majority of the e-commerce space presently comprises of e-tailing and e-travel companies. Alibaba is likely to provide B2B companies the much-needed platform to establish their presence.
Credit now just a click away
Several factors could hinder SMEs from expanding at a geometric rate. Possibly the most critical of these is credit. Companies are queuing to alter the perception and approach to credit, with many organisations attempting to transform finance from a function to a service.
A recent article on YourStory mentioned that over 500 financial technology start-ups in India have received $1.4 billion in funding since 2012. These are not merely in the credit services sector but also include companies in the mobile payment services sector. With 90% mobile phone penetration in the country and smartphone sales expected to reach 500 million units in the next five years, digital engagement with consumers will be higher than ever before.
Pioneer with purpose
Capital Float, the pioneer in digital lending for SMEs in India, is spearheading this digital revolution. We understand the crippling effects collateral-based loans have on business progression and the inherent anxiety they cause. Our expertise in big data, decision sciences proficiency and technological prowess gives us the edge to provide specially tailored financial services to small and medium businesses across the country. Competitive interest rates make us relevant and digital platforms increase our reach. Gone are the days when SMEs toiled to acquire credit. Digitized processes have bridged the gap between the borrower and capital, the two now being separated by a few clicks of the mouse.
Digital Lending will gradually replace conventional credit channels. In response to the altering financial landscape, traditional organisations are revisiting their work-flows and are attempting to revitalize processes to become felicitous options.
SMEs are evolving at a rapid rate and it’s not surprising that access to finance too is changing simultaneously.
Author - Rajath Kumar, Marketing Manager, Capital Float.
Since his appointment last year, Raghuram Rajan has been making the headlines for all the right reasons. But beyond his interventions in currency markets and the macroeconomy, a steady stream of pronouncements from the RBI Governor on potential priority sector reforms should give the SME sector in India much to cheer about.
In his inaugural address, Rajan specifically highlighted the importance of SME finance in spurring growth across the broader economy:
As the central bank of a developing country, we have additional tools to generate growth – we can accelerate financial development and inclusion. Rural areas, especially our villages, as well as small and medium industries across the country, have been important engines of growth even as large company growth has slowed…
He went on to endorse receivables financing as a key policy tool to unlock timely credit to SMEs and address the massive working capital gap in the sector today:
For small and medium firms, we intend to facilitate Electronic Bill Factoring Exchanges, whereby MSME bills against large companies can be accepted electronically and auctioned so that MSMEs are paid promptly. This was a proposal in the report of my Committee on Financial Sector reforms in 2008, and I intend to see it carried out.
On a cautionary note, it is worth noting that this is not the first formal RBI pronouncement in recent times advocating factoring or receivables-based financing as a financial inclusion tool for the SME sector. In fact, the RBI has signaled a steady commitment in recent times to SME credit growth, but its policy directives have frequently not translated into real priorities for public and private sector banks operating on the ground.
In 2013, IFMR reported that 16 out of 26 public sector banks had failed to meet their priority-sector lending (PSL) targets. Half the private sector banks also did not reach their targets, bringing the total shortfall in priority-sector lending in 2013 to USD 28 billion.
Despite these hiccups, Mr. Rajan’s strong words and visible proactivity since coming into office suggest that the RBI may embarking on a fresh chapter of promoting innovation to further financial inclusion for priority sectors. If recent sentiment across capital markets is any indication to go by, the consensus is that this Governor means business. This is good news for innovators trying to bring new and disruptive business models to sectors that have traditionally been starved for credit. But for entrepreneurs in these sectors, it could mean something more transformative – unprecedented access to an entirely new set of institutions, tools, and financial products more finely attuned to serving their business requirements and financing needs.
(Image credit: Business Today Aug 12, 2013)
Let us consider the following hypothetical scenario:
ABC & Co., a small services firm, began operations in mid-2011. It reported a 40% jump in annual turnover from Rs. 5 Cr in FY 2012 to Rs. 7 Cr in FY 2013. As a startup, the company has not yet broken even and reported losses for consecutive years. The promoter is well educated, previously worked in organizations of repute for over a decade before deciding to float this venture. The short-term finance requirement of ABC & Co is about Rs. 40 lac for 90 days, but does not have any physical collateral to offer as security. At this stage, the promoter of ABC & Co. decides to approach banks and NBFCs in the market to fund this debt gap.
What would this promoter’s experience be in today’s scenario? Would he be successful in securing the necessary funds?
According to a recent statistic, 33% of companies operating in the Micro, Small and Medium Enterprises sector have access to banks and financial institutions, while the rest remain excluded and are compelled to raise money through informal channels.
This debt gap is alarming especially in the backdrop of the fact that SME segment contributes nearly 10 percent of the country’s gross domestic product and 45% of all industrial output.
Till date, banks and NBFCs have not been able to finance this debt gap effectively. What has prevented or restricted them from profitably penetrating this sector? Is it due to inherent credit risk in the segment, lack of collateral, government regulation and laws, or simply because there are greener pastures elsewhere to lend money?
Lets us understand the debt requirement of the SME segment (both early-stage as well as mature entities) before we try to further dissect this issue. In our example, ABC & Co. could require financing for primarily two reasons:
1) Capex, i.e. medium to long-term finance for business expansion, product diversification, renovation of business premises, or purchase of machinery.
2) Working Capital i.e. to cover short-term immediate cash flow needs arising from day-to-day business operations.
To cater to this demand, banks and financial institutions already have specific products (both fund and non-fund based) that can be broadly categorized into two categories for the sake of simplicity:
1) Simple lending products, which would typically cater to the first requirement of SMEs for Capex. These are medium to long-term financing products in the form of equipment and machinery loans, high yield unsecured business loans, Loan against Property etc.
2) Specialised lending products, which typically include factoring, trade finance, cash management services, project finance, bank guarantee, or letters of credit, which typically cater to the second requirement of working capital finance.
As is evident from the above, it is not the lack of “products” that explains the under-penetration of finance flowing to the SME sector. Rather, it is in the design, applicability and administration of these products to the SME sector that banks have fallen short.
In an effort to go deeper, we can identify four key reasons among others, for this shortfall:
1) Sole Focus on Financials: The current approach to SME lending in most institutions is still heavily dependent on business financials- i.e. looking at historical data to predict future creditworthiness. Typically this involves a lot of paper work and many visits to the applicant.
This approach has not been very successful in the SME sector to-date due to the fact that the financials provided by the applicant are often opaque given the cash nature of business transactions and incentives to under report income to save on taxes. ABC & Co., on this parameter alone (aside from business vintage) would be filtered out as the current financial position reflecting business losses would not be very appealing to most financiers.
2) Bureau Reporting: There are two kinds of credit bureau reports that can be generated by member banks and NBFCs – Individual and Corporate. While individual records are provided by most bureaus, only CIBIL currently provides reports for corporate entities in India. Valid records for SME entities are still not very evolved in the country. And while the bureaus can provide data on credit worthiness of the individuals involved in any given company, they cannot give relevant insights about an applicant who is a first time borrower.
Since ABC & Co. is newly established, there would not be any bureau record on the company. The application would then have to be judged on the strength of the individual records for the promoter as well as the business viability of ABC & Co.
3) Selective Segmentation: The implication of the above two factors is that only the “upper layer” of the medium to large enterprise segment is able to pass through banks’ and NBFCs’ credit assessment parameters, leaving aside the major chunk of “small” entrepreneurs and entities whose need for adequate finance is more pronounced. These small entities could be major links in the supply chains of large players, and their inability to access finance could have the ripple effects across the value chain.
4) Lack of Collateral Security: Lending in India traditionally has relied on taking adequate collateral as a “risk mitigant” to cover the credit risks associated with SME lending and the ambiguity around appraising this segment. The Loan to Value ratio (LTV) becomes the yardstick to segregate and approve or reject cases based on risk. This ratio is inversely proportional to the risk perception of the applicant.
Since ABC & Co. does not have any physical collateral such as property or machinery to offer and the promoter has pitched in whatever money he had in the form of initial capital into the business, his application would be rejected by most banks and NBFCs in the market today.
This problem of access to finance for SMEs in India is even more accentuated for early-stage companies or startups such as ABC & Co. In their case, past financial performance would be not a correct indicator of the future potential of the enterprise. After initial round of equity funding from family and friends or seed investors, working capital requirements or ad-hoc needs for short term finance would inevitably kick in and must be dealt with in a timely manner to keep the firm operational.
To conclude, traditional lending to the SME sector in India can best be described as a “One Size Fits All Approach.” The risk management techniques used by banks and other financial institutions today are invariably more suitable for medium and large corporate entities. The same set of rules when inadvertently applied to small and early-stage enterprises result in a faulty output, i.e. the systemic rejection of most SME loan applications like ABC & Co. Given the intense nature of competition in the lending industry today, the consequence is that too many banks and financial institutions end up chasing the same set of “good” customers, leaving aside a much larger untapped segment of SMEs in the process.
Watch this space for more articles on the subject as well as suggested ways to underwrite “small” and “early-stage” entities in the SME sector.
(Image credit: http://blog.directcapital.com/misc/small-business-loan-video/)