Collateral, delays and risk: The credit woes of MSMEs

With only 14% of credit needs met through formal channels, MSMEs are battling inconsistent lending standards and lengthy loan processes

Coimbatore: Three years into running a product-based firm, 42-year-old Ashwin knocked on the doors of two nationalised banks, where he has loan accounts, for a credit enhancement from Rs 6 lakh to Rs 25 lakh to service an important order. Ashwin pursued the order doggedly, as he believed it would yield him good profits and steady business in the future. 

Despite a good credit history, Ashwin was denied the loan, citing a decade-old credit card settlement (an agreement arrived between the company and the cardholder to pay a reduced amount) and lack of collateral as reasons. Left with no option, Ashwin turned to a private money lender in 2021, charging an exorbitant interest rate, to eventually complete the order. 

“It was a peak festive season. If I do not accept orders that come my way, there is no way I can sustain the business. Only because I serviced the order years ago I am doing well in my trade today, even though I lost heavily due to a high-interest burden,” Ashwin, a native of Chennai, told DH. 

“If only the nationalised bank had obliged then, I would not have struggled for years to pay both principal and steep interest charged by the private lender. My bank statement was clean, my CIBIL score was good, all my loan accounts were normal, and my track record was excellent. Yet, two banks shooed me off,” Ashwin added. 

Two years later, in 2023, another nationalised bank sanctioned a fresh loan for Ashwin, trusting his repayment capability and not considering his history with settlements. Ashwin flagged this as a major problem for entrepreneurs like him — different banks adopt different standards. 

“I am making decent profits now as I pay an interest of 12%. If there is no cash worry for an entrepreneur, he will turn his business into a profit-making entity in no time,” the first-generation entrepreneur said.

In November 2024, Arumugam, a grill manufacturer in Coimbatore, approached a public sector undertaking (PSU) bank for a loan of Rs 4 lakh to buy a new machine. The bank agreed to sanction the amount, but Arumugam had to settle for external credit from a Non-Banking Finance Company (NBFC) at an interest of 23% against 12.5% offered by the bank. Employees at the bank had informed him that the loan would take at least a month of processing time. 

“A month is too long a time. The seller will not wait for me to mobilise funds. He will sell it to whoever comes first. Within three days, I bought the machine and employed two people to operate it. Bank procedures do not help micro units like mine,” Arumugam said. 

The experiences are symptomatic of a larger gamut of issues that Micro, Small and Medium Enterprises (MSMEs), dubbed as the backbone of the country’s robust economy, are facing today. MSMEs contribute a whopping 30% to India’s GDP and account for over 60% of the workforce in the business sector. 

The credit penetration rate in this section of the industry stands at an abysmal 14%. This is much lower than that of developed economies like the US (50%), and China (37%), according to a 2023 report by Ernst & Young. 

Various studies peg the credit gap in India at about Rs 30 lakh crore. Though the bank credit to micro and small enterprises for April 2024 grew by 15.6% when compared to the same month last year, there remains a huge gap, yet to be bridged. 

Though the interest charged by banks – between 9.5% to 14% – is considered high due to ‘high-risk factors’, MSMEs prefer government-owned banks rather than NBFCs. Interest rates charged by the NBFCs and money lenders are above 18%. 

Lack of adequate formal credit avenues, losses incurred during the Covid-19 pandemic, teething problems due to digitisation, general lack of demand and labour shortages are bringing many businesses to their knees. There are about 5.6 crore MSMEs in India, according to registration data available on the Udyam portal as of December 2024. About 61,500 units have closed down in the last four years. 

Protracted processing time, extensive documentation and dependence on CIBIL score to disburse loans, are some reasons why there is a low formal credit penetration rate among MSMEs. 

K E Raghunathan, chairman of the Association of Indian Entrepreneurs, identified eligibility criteria, evaluation timeframe, terms of extending a loan, and resolution of an issue at the initial stage when it arises as factors that come in the way of MSMEs accessing formal credit. 

“The eligibility criteria kills MSMEs. Rules and regulations are vague and open to the interpretation of credit managers. There is no scientific or transparent methodology to know whether one is eligible for a loan or not. Banks look at CIBIL scores, whose methodology itself is not transparent,” Raghunathan said. 

After the reclassification of MSMEs in 2020, defining micro (with a turnover of up to Rs 5 crore), small (up to Rs 50 crore) and medium (up to Rs 250 crore) – bank managers have developed a fear of granting loans to small players, he said. 

“The banking system has made the fundamental mistake of not specifying the eligibility criteria. No time frame is ever given for the evaluation of a loan application. Time-bound replies from banks are absent and there is no resolution of a problem. There is a huge gap between the rules and their execution,” Raghunathan added. 

Another major issue flagged by entrepreneurs is the classification of accounts as a special mention account if payments are delayed beyond 30 days and categorising them as non-performing assets (NPA) in three months. 

M Karthikeyan, president of the Coimbatore District Small Industries Association (CODISSIA), explained that the interest rates for MSMEs are much higher than the rates offered for corporates. “The percentage of NPAs of MSMEs is at a mere 2.87%,” he added. 

“The banks should be magnanimous and trust us. Once an account becomes bad, straight is the recovery process even if it means killing the enterprise. Our credit history and bank statements are generally clean when compared to big corporates,” Karthikeyan said. 

Assessment systems

Since a majority of the micro units operate in the informal sector, banks are wary of lending credit to them due to high-risk perception as these enterprises lack professional bookkeeping practices, explained Maharashtra-based Vijay Kalantri, president of the All India Association of Industries. 

“Also, the average ticket size of MSME loans is less, making it unjustifiable for banks to incur administrative costs to cater to this segment. Another reason loans are turned away is due to the lack of collateral to access bank funding,” Kalantri said. 

Presently, MSMEs await new credit assessment models in the Union Budget 2024-25 to assess MSMEs, without relying on the existing scoring methods like CIBIL. “A new rating system should factor in all the problems that are currently being faced by MSMEs. It should solve all their problems in accessing formal credit,” Raghunathan said.

Karthikeyan lays the blame squarely on banks for sending entrepreneurs to NBFCs and private money lenders by dwelling too much on procedures and stressing a good CIBIL score. He stressed that only banks can ensure the success and progress of small industries. 

Collateral

Sandeep Bidasaria, vice-president of the Karnataka Chamber of Commerce and Industries, Hubballi chapter, said that banks’ insistence on collateral has discouraged entrepreneurs from approaching them to a large extent, especially after Covid-19. “The Union Government did come out with a policy for MSMEs to do away with collateral but that is only for loans up to Rs 8 lakh, and it is of not much help,” he added. 

Professor Suresh Babu, director of the Madras Institute of Development Studies, said: “When banks themselves have less liquidity, they get into a risk-averse mindset. They want to put their money in safe lending portfolios. This affects MSMEs badly. When their funds are less, the banks want to keep their balance sheets clean.”

Nationalised banks do not have enough bandwidth to handle the credit requirements of MSMEs due to a steep decline in bank deposits, he said. People are finding newer avenues to save like the stock market and mutual funds. 

MSMEs need quick access to credit and documentation processes often delay this. “Their credit demand is not only for expansion or diversification but also for working capital,” he said, adding that the only option is to go back to conventional old bank credit by infusing more funds into banks. “The most recent RBI Monetary Policy gives room for providing more liquidity, but we have to wait and watch how the situation evolves,” he said. 

The Prime Minister Micro Units Development and Refinance Agency Yojana was launched to support non-farming businesses, disbursing loans up to Rs 20 lakh. However, the funding gap is huge. A comprehensive analysis and impact of the scheme is imminent to evaluate the success of the scheme to get further insights on loaning behaviour to micro units, said Babu. 

Another major problem is that crores of micro units continue to operate informally without registering on government platforms. This leaves the industries out of the ambit of formal credit. In Telangana, about 65.7% MSMEs are yet to be formalised, as they find the process costly and challenging. Smaller firms experience a 35% increase in unit labour costs once they register on portals. 

Registration

A majority of the 1,800 members of the Coimbatore District Grill Manufacturers Association do not have access to formal credit. 

Associations are organising melas to push micro units to register on the Udyam portal to ensure that they get access to bank credit. However, some question the insistence of registration on such platforms. “Why is registration on the Udyam platform the base rule for applying for formal credit?” an entrepreneur asked. 

An internal survey by the government conducted in Telangana revealed that MSMEs find it difficult to meet collateral requirements set by banks for loans. “In some cases, banks ask MSMEs for collateral valued about 200% of the loan value. It is becoming difficult to access credit for our working capital needs,” an entrepreneur said. 

Telangana government is now implementing a reverse factoring arrangement, wherein a financial institution would make upfront payments to suppliers on behalf of MSMEs, who will return the money at a later date. In this way, reverse factoring allows MSMEs to participate in public contracts, without depleting their working capital. 

In Karnataka, nearly 5% to 7% of MSMEs have shut operations owing to financial crunch and poor implementation of government policies, after the Covid-19 pandemic. 

The Karnataka Chamber of Commerce and Industries recently sent a proposal to the state government, seeking to converge the Mahatma Gandhi National Rural Employment Guarantee Scheme with other industries to improve accessibility to labour. "The companies are ready to pay daily wages amounting to Rs 500 to job card holders. It will reduce the financial burden on the government and help industries get labourers," Bidasaria added. 

Apart from credit, MSMEs also face huge volatility in demand, which primarily comes from large enterprises and general consumers. When the aggregate demand does not grow, MSMEs will not get paid on time from large corporations, which further pushes them towards banks or money lenders. 

Kalantri said that large companies must clear vendor dues on time to reduce liquidity stress and the working capital cycles. 

Though there is a grievance redressal system called SAMADHAN, Babu doubts its accessibility. “We need to have a comprehensive policy for MSMEs. Tinkering here and there with existing policies to ensure more credit and short interventions might not solve the problems,” Babu said.  

“Banks and Fintech companies should harness the full potential of digital credit risk assessment tools and Account Aggregator framework to increase the flow of credit to MSMEs with minimal paperwork,” Kalantari added.

Raghunathan said after the reclassification of MSME in 2020, micro-enterprises asked for a separation of lanes of approach to formal credit. “Now, I do not have any separation of lanes, and I am getting crashed,” he added. With the reclassification, micro-industries are often banded together with larger enterprises, slowing down processing times. 

The entrepreneur also suggested that the government float a separate bank for micro and small enterprises to disburse loans up to Rs 50 crore, by drafting specific rules.  

Another idea is to build on the mechanism instituted by the Small Industries Development Bank of India to look at the credit rating of MSMEs to ensure that standard algorithms are not used to cater to their financial needs. There is a need for a fresh mechanism, said Babu. 

(With inputs from Gyanendra Keshri in New Delhi, Mrityunjay Bose in Mumbai, S N V Sudhir in Hyderabad, and Shrinidhi R in Dharwad)