Leveraging Digital Banking to Improve MSME Financing

Problem

The ongoing pandemic has dealt an additional blow and placed MSMEs under conditions of significant financial distress. MSMEs are critical drivers of the Indian economy, both in terms of gross domestic product and employment generation. However, the formal banking sector has traditionally failed to cater to their credit needs. 

This may be partly attributed to the informal nature of MSMEs, which creates challenges for banks conducting their credit risk assessments. This risk aversion to MSME financing is exacerbated by traditional banks’ outdated credit appraisal systems that rely predominantly on balance sheets and collaterals that may not truly reflect the ability of a borrower to repay. This outdated underwriting process also leads to high turnaround time for credit disbursal. This calls for leveraging technological disruptions to meet the financing needs of the MSME sector.  While the Government has recently announced several reforms along with financial stimulus for the crisis-hit MSMEs, as a long-term measure, there is a need for a renewed approach to encourage a technology-driven banking framework to meet the credit needs of the underserved MSME sector. 

Solution

Incentives for technology adoption, increased competition, and heterogeneity in the formal banking sector can be strengthened by permitting the entry of ‘digital banks’ that provide banking services through digital means (as opposed to physical branches). Unlike financial technology (fintech) companies that currently partner with traditional banks to provide technological support to banking services, proposed digital banks will be specifically licensed by the RBI to provide banking services. Further, to encourage MSME focused digital banking, the RBI may consider issuing a separate category of licenses for digital banks that cater exclusively to MSMEs. This may enable serious technology players in the market that have structured their business models in serving the MSME sector to apply for such a license. 

Licensing of digital banks with innovative business models will add dynamism to the banking landscape and facilitate the creation of suitable and affordable financial solutions for MSMEs. Such digital banks can provide banking services at a lower cost compared to incumbents due to their internet-only infrastructure. They are unencumbered by legacy infrastructure and may leverage technology rapidly. Such technology-driven banks are better equipped to address issues related to lack of collateral and formal bookkeeping systems, by employing innovative methods of risk assessment based on alternative data that provide an accurate borrower risk profile. They can promptly meet MSME financing needs, by boosting the convenience of opening and operating accounts, facilitating seamless payments, offering transfer and remittance solutions, and packaging other personalized value-added services (including accounting, reconciliation). By providing a larger suite of digital banking services, such banks may enhance MSMEs’ ability to digitise and consequently formalise their own operations, thereby addressing what has often been the biggest impediment that MSMEs face in accessing formal credit. 

Implementation

• In line with its approach of providing a ‘differentiated banking license’, the RBI should release guidelines for the licensing of digital-only banks in India, including digital banks that will be permitted to accept deposits, provide loans, and banking services only to MSMEs. 
• In assessing the eligibility for such banks, RBI should require applicants to demonstrate the application of innovative technology to serve customer needs. 
• With a view to encourage technology or fintech companies, the eligibility criteria should also specify that at least one entity in the applicant group should have a track record of operating a business in the technology or e-commerce field. 
• Regulations for digital banks must account for such prudential and conduct regulation, taking into account a technology-neutral and risk-based approach, addressing systemic, operational, and consumer risks that arise from the digital-only nature of such entities.

About the Authors

Krittika Chavaly