How Embedded Finance Startups Can Help Unlock Fast & Tailored MSME Credit

MSMEs have had an important role to play in India’s growth and development story. The sector has consistently contributed around 30% of the country’s GDP, representing a 45% share in exports and generating 111 Mn job opportunities for skilled and semi-skilled labour. Despite being the bastion of the economy, the MSME sector is credit-starved, with the current addressable credit gap estimated to be at $397 Bn. 

Practical Challenges To MSME Financial Inclusion

The conversation about financial inclusion for small and medium-sized businesses has been ongoing and has gained traction since the pandemic.  A major roadblock in this endeavour is that traditional lenders assess the borrower’s creditworthiness based on their assets. This disqualifies those small businesses that do not have assets to collateralise their loans or have their assets already earmarked against term loans and cash-credit lines. 

Lenders also require a certain level of formal documentation including credit history; this excludes 80% of MSMEs from formal credit since they don’t have a bureau history. MSMEs are therefore stuck in a vicious cycle — their applications are rejected due to a lack of credit history and they are unable to build a credit history as they are unable to avail formal credit.

Secondly, MSMEs have diverse use-cases and hence require customised credit solutions. For instance, a hotel’s financing needs and terms will not be the same as that of a car rental service. MSMEs frequently struggle to find the right credit products at the right time due to their aversion to technology and formal lending institutions. Given that MSMEs include a diverse group of businesses serving different customer segments with varying requirements and working capital needs, a one-size-fits-all approach to lending to MSMEs does not work. 

Differentiated MSME Credit Structures

Throughout the business cycle, most MSMEs require credit to fill working capital gaps.  This requires small amounts (ranging from INR 25,000 to INR. 50,000) for relatively short durations (1-4 weeks), known as sachetised loans. 

Given the cost economics, sachetised loans must be quick and in high volume in order to be profitable for lenders. Lenders need a tech-focused approach that can attract a large number of customers with zero or negative transaction value and effectively drive repeat behaviour across multiple touchpoints. 

Only machine learning models that enable banks to understand and cross-sell to borrowers will be able to accomplish this efficiently.  The current bank-driven lending model is unable to cope with the size and speed of these needs. 

How Embedded Finance Can Solve For This

Embedded finance companies leverage the trust built by a digital platform to offer loans, facilitate applications, and collect repayments. It uses data from a specific digital platform for cash flow-based underwriting, on which creditworthiness is then assessed.  Furthermore, embedded finance tailors loan application experiences in collaboration with digital platforms. This enhanced understanding of the customer allows the experience to become flexible, simplified, and guided. 

Embedded finance also increases the product’s relevance to the customer while lowering risk.  This is achieved by designing a product tailored to specific workflows and use cases. For example, purchase financing for MSMEs can be embedded in a marketplace platform to enable MSMEs to buy raw materials on credit. Similarly, invoice financing can be embedded on a payables platform, accelerating MSME cash flows while mitigating risk.

According to Anthemis, a UK venture investment firm, the global embedded finance market will be worth $7 Tn by 2030.  Even traditional lenders’ older systems can be upgraded by plug-and-play connections from embedded finance startups, allowing them to market their products in new-age ecosystems. 

To ride the embedded finance wave, lenders must digitise their processes and use alternate data underwriting to reduce acquisition costs and recover them through repeat transactions. They must also leverage partnerships with embedded finance infrastructure providers to quickly bring MSME credit products to market and iterate rapidly to tailor and innovate for the diverse MSME sector.

It is now clear that credit scarcity is caused by a lack of access.  Embedded finance addresses this issue by combining sophisticated technology infrastructure, expertise in distributing financial services at scale, and capital from financial institutions to increase credit access for MSMEs. 

Moving forward, the extent to which the products are personalised while keeping in mind how carefully data is handled is yet to be seen. Striking this balance will be critical for how embedded finance scales up and moves beyond ‘Buy Now Pay Later’ to drive financial inclusion for credit-deprived MSMEs.

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