Rebuilding Micro-Enterprises Are Small Finance Banks up to the Challenge?

Micro and Small Enterprises (MSE) are extremely vulnerable to the disruptions created by the pandemic. While the COVID 19 pandemic is affecting societies and econ­omies across the globe at their core, the damage to MSEs is severe owning to their inherent higher fragility and vulnerability. India’s adoption of stringent lockdown measures to curb the health impact of pandemic, wreaked havoc for the micro enterprises which forms 99.5% of MSME sector.

Annual Report of Department of MSME -2018-19 mentions, there are 6.34 crore MSME in the country employing a little over 11 crore individuals indicating less than 2 people employed per MSME on an average. Majority of the MSEs are household firms and usually deploy low level of capital, lack technical and managerial skills, follow family organizational pattern for employment. Most of them are unregistered and fall outside the formal network for accessing any meaningful social or economic entitlements and benefits from government. They have poor access to market –  limited market availability and inability to go beyond localized markets and depend heavily on middlemen.

Before the pandemic as well, MSEs as a segment was braving the challenge of lack of access to formal financial services in general and lack of credit in particular. They rely heavily on informal networks to borrow for business needs. MSEs also exhibited weak technological adoption in business operation leading to high inefficiencies and under-utilization of capacity. With the pandemic and lockdown striking them hard, MSEs were struggling to stay afloat with dwindling cash reserves, zero revenues, recurrent expenses, depleting stock levels and almost non-existent credit support. The fragility of their financial and operational health was more pronounced and exposed, post COVID.

As a stroke of relief, the government has opened up markets and businesses (with caution) and announced a slew of fiscal measures targeted for the MSME sector. The stimulus package of INR 20 Lakh Crores to tackle the economic fallout of COVID-19 and to revive the Indian MSMEs was much timely.

Key component of stimulus package wrt MSMEs included INR 3 Lakh Crores Collateral-free Loans with 4-year tenure and a moratorium period of 12 months for Businesses (including MSMEs). The package was targeted for MSMEs with INR 100 Crore sales or INR 25 Crore outstanding loans to help them pay their operational liabilities, disburse salaries for employees, and buy raw materials to get their businesses back on course. The eligibility criteria for accessing benefits from the above scheme resulted in benefits percolating to only 4.5 million enterprises contributing to less than 7% of the total Indian MSMEs under the older definition. More recently, the Government’s decision of increasing the threshold for qualifying for MSME may deprive the small players of benefits due to crowding out. The disbursement of INR 20,000 Crores in form of Subordinate Debt to functional but non-performing or stressed MSMEs and provision of equity support of INR 2 Lakhs to MSMEs through Promoter Loan by banks clearly targeted the Medium-sized enterprises.

As part of the Government relief measures, support for “business purpose” to MSEs was manifested in two critical schemes  (a) INR 1500 crores for 2% interest subvention on MUDRA Shishu Loans (up to INR 50,000)  to benefit 3 crore individuals (b) INR 5000 crores – Loans for street vendors up to INR 10,000.

While banks and larger financial institutions will be distinctly inclined towards directing credit flow to better rated, safer and perceived low risk entities and enterprises, MSEs will gasp for affordable and timely formal credit.

The differentiated Small Finance Bank category has been created with the objective of promoting financial inclusion by supplying credit to small business units; small and marginal farmers; micro and small industries; and other unorganised sector entities, through high technology-low cost operations. SFBs therefore will have an important role to play in the supporting the revival of micro and small enterprises. SFB’s presence across hinterlands and ability to underwrite the micro-enterprise segment are two inimitable core-capabilities and competencies which can help them provide the much sought after “credit support” to small enterprises, which typically get left out from the coverage of Microfinance Institutions as well as large banking and financial institutions.

In the meanwhile, the various challenges faced by SFBs like liquidity crunch, weakening capital market and deteriorating asset quality cannot be fully ignored. As they transformed themselves from largely mono-line asset-backed revenue businesses to a diversified asset and liability backed profitable businesses, the SFBs have managed the crisis ensuing demonetization and are now faced with a looming NPA crisis as an impact of the lockdown.  It has probably made them test their resilience by undergoing multiple stress points.

It is important to review some learnings in hindsight on what insular systems SFBs should have built-in for better crisis proofing. Going forward, the SFBs have to protect themselves along with responding to the needs of the last mile ‘inclusion’ clients.  In this context it would be critical to know the “essentials” for the SFBs to bounce back to business and devise innovative ways to rebuild the micro-enterprise sector by unlocking the access to credit. The scope for innovation could possibly vary from deployment of efficient financial instruments and structures to raise funds, smart use of blended finance mechanism to attract impact-focused capital, lean and relevant product structuring for MSEs and investing in partnerships and collaborations for credit underwriting across the value chain.

Join the Inclusive Finance India’s webinar on “Rebuilding Micro-Enterprises: Are SFBs up to the challenge?” to hear perspectives and experiences on these questions and more.  

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It is now over four years since the RBI issued licenses to 10 financial institutions to set up Small Finance Banks (SFBs) with the objective to provide financial services to sections of the economy not being served by other banks, such as small business units, small and marginal farmers, micro and small industries and unorganised sector entities. Of the 10, 8 were Microfinance Institutions, most of which have either completed or are close to completing three years of operations as SFBs. For most SFBs however, the portfolio continues to be dominated by microfinance loans and the share of retail liabilities is low. By September this year, all SFBs had been granted scheduled status by the RBI. Meanwhile, the RBI also released the draft guidelines for on tap licensing of SFBs, raising the expectations of MFIs and NBFCs for the next level of transformation into banking institutions.

The session provided an opportunity to review the extent to which this new set of differentiated banks have succeeded in achieving the objective of financial inclusion so far, and discussed operational, structural and regulatory challenges faced by them as they transformed themselves from largely mono- line asset backed revenue businesses to a diversified asset and liability backed profitable businesses. The session discussed various aspects of providing an enabling and supportive framework to SFBs for them to realize the potential of transforming into the bankers to the last mile, and also highlighted lessons learnt for financial institutions aspiring to be SFBs in future.

TEJI0553Key Takeaways

  • The transition journey to SFBs from MFIs was marked with challenges with the highest priority being to build trust among customers, market players and investors that MFIs can indeed be “banks” who have the intent to be in the financial system for long run as true “Banks”.
  • Of the various challenges faced, compliance challenge was the most critical as senior management time was primarily devoted to dealing with compliance adherence. Others include developing a truly granular liability franchise and diversifying asset line by venturing into new but related business verticals. On the regulatory front, meeting the requirements of dilution of shareholding and public listing remain an on-going concern.
  • SFBs have tackled the challenges of building liability by mobilizing wholesale deposits to begin with, while the intent and long term vision continues to be have retail liability base. Similarly, diversifying to new asset classes required setting up a strong team, integrating the team into the culture and investing in the right technology.
  • At a steady state, the liability business built up will be largely retail driven and deposit sizes will be small, however, the volume of transaction will be very high. To manage high volumes on liability side on a base that is built up on smaller deposit size, keeping costs under control while delivering the services is critical. Cost efficiency can be achieved through investment in innovative technology. Strengthening SFB’s readiness to manage volumes and diversity of services will need prudent investment in technology.
  • SFBs have emerged as an investible asset class for mainstream capital market investors.
  • Investor community has set higher benchmarks for SFBs on metrics to track return on investment compared to the private sector banks. Key strengths that have made SFB a lucrative proposition to invest in is largely driven by high standards of governance, strong grasp and understanding of customer and continued focus on vision of creating impact at scale.
  • Quality of service and ability to provide door step service is critical for SFBs to claim and retain market share.
  • Compliance adherence is at times, significantly more for SFBs than regular mainstream banks. Increased compliance and regulatory requirements for SFBs helps build trust. Since regulator’s prime responsibility is to protect the interest of depositors, SFBs attracted greater vigil and supervision given that they are new to the system.
  • Moreover, it is considered prudent to undergo the rigor of adhering to increased scrutiny and compliance. It builds a culture of trust with the regulator, investors and customers.
  • To build a resilient SFB ecosystem, it is important to build trust and building trust will need the effort to build a culture around transparency and highest standards of governance. Compliance helps in achieving those standards till they become part of organizational culture.