MSMEs are vital for the sustainable economic development of the country providing livelihood to millions, especially in rural and semi-urban areas. They are the engines of incessant growth, contributing nearly 30% to India's GDP, producing a wide range of products, from simple consumer goods to high-precision sophisticated finished products. SMEs are responsible for enhancing competitiveness, entrepreneurship and the establishment of an effective innovation system. They create employment prospects in all geographic regions and sectors, especially for low-skilled workforce and allow opportunities for skills growth.

MSMEs have a starring role to play in the government's plan to solve problems related to poverty, social exclusion and unemployment. Policymakers realise this importance and are prioritising the development of a resilient MSME sector with many fiscal measures being directed towards them.  An agile and dynamic MSME sector is imperative for India to realise its aspirations of becoming a global powerhouse.

Traditionally, MSMEs have been beset with many challenges, including inadequate credit, infrastructure bottlenecks, regulatory constraints, scarcity of raw materials, restricted access to new markets (including overseas) and competition from larger corporates. Cash-starved small businesses struggle to reach their full potential as they are unable to invest in technology, upskill workers or enhance infrastructure, as risk-averse banks often require MSMEs to furnish sufficient collateral, which first-time entrepreneurs normally don't have, hampering credit disbursal.

The Struggle

Enterprises who were already reeling from the economic slowdown in 2019 had the wind taken out of their sails by the impact of the COVID-19 pandemic. A severe liquidity crunch and poor demand due to multiple lockdowns has resulted in many small businesses struggling with business continuity while others have closed down temporarily or permanently.

The standard approach to funding MSMEs is based on rigid credit appraisal systems that revolve around financials, paper intensive manual and cumbersome processes, hierarchical decision making, inflexible systems and limited credit products. Credit risk challenges are driven by information asymmetry, resulting in high cost SME risk assessments, limiting lending to SMEs. These inefficiencies were further exacerbated by the lockdown and funding flowed to a trickle in mid-2020, notably due to the following factors;

· General sentiment that MSMEs are the first to be affected and last to recover from any crisis

· Declining collateral values, further reducing lendable amounts

· Uncertainty on which sectors would bounce back and which would face a prolonged impact

· Single channel led (Direct sales agents) paper-heavy acquisition model, which couldn't function

· Shortage of processing staff at the lenders end, due to connectivity and infrastructure issues as a result of Work from Home (WFH) situation

Government Measures

Not all was gloom and doom though. There were some silver linings too. Notable among them, were a slew of government measures aimed at providing a stimulus to kick-start the economy. The moratorium on loan repayments for a period of six months offered the much-needed breather to entrepreneurs. The Rs 3 lakh crore ECLGS scheme which provided a 100% guarantee to financial institutions for disbursing collateral-free emergency working capital loans was a shot in the arm and kick-started the revival process. Regulatory constraints faced by these businesses including high entry barriers (difficulty in procuring operating licenses, permits); unfriendly tax codes; unfavorable exit terms (resolving bankruptcy and insolvency issues, asset sales);  all began to ease.

A major positive outcome has been the accelerated pace of digitisation, forced upon lenders, to ensure business continuity and cope with staff shortages due to WFH situations. The pandemic has created the need for seamless, secure and remote services and lenders needed to redefine their business models by embracing digital transformation. Aided by fintechs who offer a vast array of services right from prospecting suitable customers to post disbursal servicing, banks have become more agile. There has been a transformation in the way that customers can apply for credit, the manner in which those applications are now processed and how overall life cycle is managed. Digitisation, improved connectivity, analytics and big data have all combined to ease the flow of credit.

· Omni channel distribution capabilities of lenders have cut out the middleman, reducing costs and time for credit.

· Online applications, e-KYC and ability of lenders to pull out financial and other public records have replaced lengthy manual  processes

· Digital processing provides faster and more accurate insights into the customer's business.

· Assessment is cash-flow based rather than relying on outdated financial papers

· Artificial-Intelligence-based scoring models and improved fraud detection capabilities are leading to quick and confident decision making

· Early warning systems help identify signs of stress to take quick remedial measure

Rebuild the Financial Architecture

The recently revised Co-Lending Model (CLM) between banks and NBFCs aims to improve the flow of credit to unserved and underserved sections of the economy and to make funds available to borrowers at an affordable cost. For the micro segment who were wholly dependent on NBFCs for funding, this is a lifeline since NBFC funding had dried up of late. With NBFCs being the point of interface with the customer, banks can capitalise on the greater reach, operational abilities, and technical capabilities of NBFCs who ensure better last-mile connectivity. This is a win-win situation for everyone as banks can serve larger markets without incurring high operational costs, NBFCs get access to liquidity and financial backing and the customer gets the much needed funding at reduced interest rates.

While MSMEs are disproportionately affected by pandemic-related shocks, it is also a fact that they are flexible and can quickly adapt to new environments such as the one created by COVID-19. How well the MSMEs can cope with changed realities is largely dependent on the support extended by lenders and governments. There is a need to rebuild the financial architecture of how small businesses access finance and the many green shoots that have emerged in this space bodes well for the future. The ultimate goal is to lower financing costs and increase the formalisation of the economy, such that the MSME sector becomes self-sustainable and resilient in the post-pandamic world.

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-Amit Bhatia is Managing Director & Head of International Private bank, Deutsche Bank India.