Ensuring Debt Finance for All Professionally-run MSMEs.

For several years, a number of policy initiatives have been taken to address the financing gaps for MSMEs. Of course, we have improved over the years. However, a lot still needs to be done. Here is a set of views, that I have, on how to go about doing it. Some of it is about approach and some of it is about actual implementation. Of course, this is a complex problem and I am not denying that genuine efforts have been made in the past. My argument is that those efforts have fallen short and it may be a time for policy makers to do a few things differently (to the extent that some of the suggestions may seem impractical but I am taking the liberty to list them out here.)

Note: Unsecured, small ticket lending to MSMEs based on credit of the individual promoter is largely (on the How to aspect) a solved problem (in India) and has got/getting a lot of attention. (We are miles to go for universal access to finance for MSMEs even in the small ticket, individual credit led lending.) The focus of this write-up is on corporate SMEs with high growth aspirations, where the funding requirements is in crores (individual promoters credit is not a good alternative for company credit) and is generally not done by traditional lenders without mortgage collateral. For new age, asset light but professionally run businesses, it is a key gap, that remains unsolved at scale. Hence, the focus on that segment in this write-up.This write-up is addressed to those shaping policy and regulation. This write-up is specific to the Indian context.

Do NOT broad brush: The MSME segment includes not just the local tea shop, or the puffed rice making factory but also includes the SME corporate with turnover upto INR 250 Cr (as per the recommended Budget 2018 classification) with some of them having raised institutional venture capital. Hence, the funding requirement, credit evaluation process and lending model will not be the same. If we don’t separate out the sub-segments and find specific solutions for each segment based on loan size, security and nature of entity, we will not have a comprehensive solution.

It may make sense to break down MSMEs into categories based on legal structure i.e. individual, proprietorship, partnership and OPC or private limited and have priority sector or lending target setting done separately for them. Have caps on loan amounts for each type of legal structure. The reason why I say this is, I am not sure why a firm with several crores of rupees in turnover, borrowing from banks, etc in crores should have the legal structure of a partnership/proprietorship. It should be a private limited company. The regulators have to make it easier for people to set up companies and be compliant. This will enable access to additional sources of data which can be leverage to take lending decisions.

(A note for SMEs seeking larger loans: If you don’t have mortgage or collateral security AND you haven’t put in much of your money as equity because you don’t have much AND you don’t have reasonable size of operations AND you don’t want to be compliant with additional regulations or provide verifiable data on various aspects of your business AND you still expect funding in crores – time to get some coffee. The purpose of adding compliance and improving access to different sources of data from the SME is to deal with the lack of security. Please note that unlike equity investors, lenders do not get a share on your upside but they do get a share of your downside for sure and hence they need to ensure that downside is limited. )

Accept that only Banks will NOT be able to help us in ensuring complete access to finance for MSMEs: Banks hold public/retail deposits and it is natural that they will have less risk appetite than NBFCs or specialised funds who are typically funded by entities that have the ability to manage risk unlike the retail depositor of a bank. By design, NBFCs or specialised funds will take more risk through sectoral specialisations. Historically, banks have been treated as the favoured child by regulators. If there is genuine interest in enabling access to finance for all segments of MSMEs, it has to be recognised that banks, NBFCs, specialised funds will together be able to address the funding needs of MSMEs.

How about allowing specialised MSME lenders partial access to the payments and settlements system? This will allow them to set up basic escrow accounts and current accounts with zero or close to zero EOD balance and ability to receive funds ONLY from corporates. NO cheques, NO savings or other deposits. This will enable specialised MSME lenders/NBFCs to offer payments, set up escrows to do a cash flow traping arrangements to deduct repayments without having to depend upon banks who create severe roadblocks in letting specialised lenders access to these simple operations. Sounds, kind of, like payment banks but I am talking about larger value transactions. Say, those who offer loans in INR crores to corporate SMEs and need to transact in several lakhs and crores and not in thousands.

Use Govt backed DFIs as market developers: India needs to find a way to use Govt backed DFIs in a market development role and not in competitor role. Their role should be to find ways to encourage other commercial lenders/investors (Banks, NBFCs, specialised funds) to do the job of lending to MSMEs instead of competing with them by trying to reach the MSMEs directly. I understand that there was a time when DFIs had to “show the way” because the commercial lenders/investors were not interested. However, over the past 8-10 years, it has been shown that private entities have been trying to find different ways of reaching out to the lucrative MSME finance gap. Frankly, if all the banks and NBFCs together are not able to directly reach all MSMEs, it is good reason to introspect and accept that one or two DFIs with limited geographic presence can reach out to all MSMEs.

Policy makers should encourage the use DFI funds to act as market developers through guarantees/credit enhancements for institutional investors to invest into NBFCs/specialised funds that are trying to fund MSMEs in India. This opens up a much larger tap of borrowings for the NBFCs and specialised funds (beyond banks) and also enables them to raise funding at a cheaper cost (assuming credit enhancement by DFI will lead to better rating of the transaction.). Oddly enough, I have seen multiple instances where Indian DFIs offer funding to NBFCs/specialised funds at a cost that is signifcantly higher than what the commercial banks or offshore commercial and DFI lenders are ready to offer at.

Consider Bank, NBFCs and specialised funds as partners and not adversaries: Banks in India (DFIs included) do not like sharing of pari-passu or second charge with NBFCs or specialised funds, as a practice, when lending to SMEs. Even though nothing in the regulation or law disallows it. This is a version of caste system propagated within our financial services industry under the excuse of lack of sufficient assets. Interestingly, I have seen multiple cases of companies that are profitable for more than 3 years with INR 50 Cr+ revenues (and fixed and current assets worth atleast INR 15-20 Cr) having INR 2 Cr worth short term facilities from banks backed by 75% cash deposits and security over entire current and future assets of the company (and possibly even the kidney’s of the promoters) NOT willing to share pari-passu charge over receivables (not on cash, not on fixed assets, just receivables) for NBFCs willing to lend higher amount than the bank and under more flexible terms. Since, forced regulation and orders will not solve this “social” problem, a better way is to encourage banks i.e. say that for the MSME loan accounts that the bank has, if the banks are able to demonstrate another non-bank lender on-board, they will be awarded 1.5x the value of their loans as priority sector.

Over-leverage of SMEs has to be addressed differently: Initiatives like the central credit registry is necessary to give a clear idea about over-leverage.(This is already being done.) It should be made compulsory to have all types of financial lenders (not just banks) add the details of the loans on the platform.

Data, data, data: Enable electronic access to data for all types of statutory, regulatory and transaction compliance done by companies. Eg: Specialised lenders or even banks should have access to data on taxes, electricity payments, EPFO, ESI, salary, bank transactions, etc. Security and privacy concerns are paramount but given that they are solvable issues, we need to find ways in which access to all that data is made extremely convenient, if we were to expand access to finance for MSMEs.

“World Domination”​ of the Agri Supply Chain

Historically misdirected/misutilised subsidies of the Govt made it very difficult for private players to operate in the agriculture supply chain. With the easing of regulations, we are seeing a large number of new private ventures (traditional and new age startups) entering agriculture. That is a good sign.

However, what worries me is that some of these companies (startups) and their VC investors are looking at the agri supply chain “domination” game with a similar approach like the Uber/Ola/Flipkart/Amazon model of “world domination” by burning huge volume of money to deliver market distorting “subsidies” to capture market share with the hope that the last startup standing will win it all. (Remember the days when drivers and riders were being paid to ferry you around? Or deep discounted sales prices for products?)

While Uber/Ola/Flipkart/Amazon is still to prove business viability, they are already shifting gears and causing significant distress to the affected. It may be argued that they have distorted local transportation markets for riders (costs have gone up significantly and availability is still a major problem) and have left several drivers with debt burdens they can’t service. We don’t know how this will end. (Anybody who knows, I am ready to buy you a coffee.)

If the startups and VCs replicate the same model of “world domination” in the agriculture supply chain (particularly when dealing directly with the farmer), they will most certainly leave the agri ecosystem with much more pain and damage than what the Govt did with misdirected subsidies.

VC Associates and Partners with no special expertise or knowledge of agri markets but with boatloads of cash will continue to wear Rolexes purchased with fund management fees whether or not their invested startup works. Startup entrepreneurs with “game changing” ideas but no capability to build a profitable business or achieve frugal growth, will buy mansions in Koramangala or Lutyens and select the next “Entrepreneur of the Year”, whether or not their startup works. But the farmer will be stuck between the devil (Govt) and the deep sea (startups) after enjoying a brief period of money induced trance and exuberance.

I know some will agree with all that I wrote. Good to know. Let’s get some coffee and discuss more. I also know that some will disagree with all that I have written and say that I can’t see the “big picture” and worse I am a “communist”. True, I can’t see the big picture but atleast, I am not blind or a communist. Let’s get some coffee and see if you can help me see the “big picture” and if I can get your eyesight back.

Access to Finance for Financiers

dKXGkaWhile enough literature is available pointing out to the lucrative business (and impact) that local financial institutions could target by reaching out to the micro and small businesses in any economy, there is very little written about how these “local financial institutions” can access funding to re-lend to this segment underserved segment. By nature, small businesses are risky and lack of formally verifiable income makes it difficult for banks to lend to small business. To some extent, it is right that banks avoid getting into financing risky business at a large scale given that they risk putting retail deposits at risk in case they build a very risky loan book. This means that there is clearly a need to address the credit needs of smaller enterprises through a network of more nimble financial institutions. In fact, in India some specialised lenders have come up over the years catering to different types of small businesses. Such financial institutions are recognised by the Reserve Bank of India as well.

They reach out to the “lucrative” MSME segment through customised appraisal mechanisms and lending processes and often due to their close ground presence manage to have a fairly good quality of loan book. Higher risk is adequately compensated by higher yield AND additional measures like closer monitoring prevents high default rates. This makes it look like an attractive proposition for people who want to invest (as debt or equity) in such businesses. In fact, a lot of these business have got significant equity interest. And that is where it starts to get interesting.

They have an interesting problem of being able to raise equity while not being able to raise enough domestic debt. A clearer inspection would reveal that the equity raises have largely been from foreign sources and often result in companies facing hurdles around the guidelines that guide loss of shareholding vs FDI amounts invested.

While the debt could have also come in from offshore sources, bringing debt into India from foreign jurisdictions faces lot of obstacles in terms of process (which has become significantly smoother over the years but it still continues to be a pain). These small financial institutions depend largely upon banks for debt funding and banks in India don’t fund anything unless the borrower is large enough or unless they the borrower is classified as priority sector. If a corporate entity doesn’t fall into any of those categories, their growth expectations are doomed because banks just wouldn’t fund.

Of course, banks have their own reasons. Most of these small financial institutions would be less than investment  grade (as per rating agencies) or just about investment grade. “Risking” money in something that the rating agencies don’t call investment grade is criminal in a bank setup.What banks miss though is that there is a way to assess such companies by moving out of the branches and observing the operations of those companies, their people and their practices. A small group of debt funding companies (companies that I have worked for most of my career) understand that and provide funding to such small financial institutions based on strong/relevant evaluation practices. In my experience of working with such companies and debt funding of more than INR 9000 Crores, there has not been a single case of non performing assets, be it in the form of on balance sheet loans or in the form of off balance sheet transactions.

Beyond banks, we also have other sophisticated financial institutional investors who can measure and establish appropriate risk mitigation strategies but even they don’t because the size of funding that each individual small financial institution seeks is not economically interesting. Honest and successful efforts have been made by the organisations that I have worked with to bring larger investors to fund these smaller financial institutions but it still takes a lot of push to make such transactions happen. It is not the norm.

As a result, the growth of new small financial institutions which have the ability to cater to smaller enterprises and customers, enabling financial access for all have been very slow, painfully slow. Entrepreneur interest in setting up new financial institutions to reach out to smaller enterprises and households have waned in spite of all data/reports and literature suggesting that there is a large market to be addressed. The number of new NBFCs coming up in the Indian market have slowed down in the last 2-3 years. The only ones who continue to move ahead are the ones with significantly large equity backing. Crossing the Chasm before success is dependent entirely on equity.

A portfolio size of INR 100 Crores in portfolio outstanding seemed to be like something that could garner interest of banks. Such a portfolio size could also give rating agencies enough track record to consider a rating upgrade. It seems that the number is of INR 100 Crore in portfolio size is becoming less important now. It is more important to know how much of that INR 100 Crore is funding with equity because more often than not, debt wouldn’t be easy to get for such companies anyways.

In other words, bootstrapping as a strategy to enable access to finance for SMEs in India is a very challenging job! So, banks won’t fund small enterprises because they are small and risky and no body would fund those who can fund small enterprises because they are not large and not priority sector. How do we then make it easier for small enterprise to access debt in India?

Photo Courtesy: rgbfreestock

Also published on LinkedIn.

MUDRA Bank – How will it help?

First things first, a regulator cum re-financier (market player)  is bad design. Period. It leads to moral hazard where the regulator will shape policy to grow only its business. Yes, refinance is business.

But I hear that MUDRA Bank is expected to be a regulator and financier of microfinance institutions and micro-enterprises. Why?

The only other entity with such an entitlement, the National Housing Bank (which is a regulator and refinancier for Housing finance companies and bank housing loans) is expected to lose that status once the long pending NHB Bill is passed in its current form. The bill aims to move the regulatory powers of the NHB to the RBI and let NHB continue to operate as a sector focussed bank like NABARD and SIDBI. Obviously, the law makers realised that regulation and business do not go hand in hand.

That brings me to the second question, NABARD refinances MFIs, so does SIDBI. SIDBI refinances/ guarantees small/micro enterprise finance. So, basically, between the two they pretty much already do what the MUDRA Bank is supposed to do on the refinance side. So, why do we need a MUDRA Bank?  Yes, they don’t regulate. So, to regulate?

When the microfinance crisis broke out, there were discussions of NABARD being made a regulator for the MFI industry but that did not happen, primarily due to the fact that NABARD was actually a refinancier (a service provider) for MFIs and the significant majority wanted NABARD to continue as a service provider and not become a regulator in parts due to the lack of infrastructure and in parts to avoid the moral hazard issue. The only reason why NABARD was brought into the picture was microfinance institutions not only included the RBI regulated NBFC-MFIs but also societies and trusts not regulated by he RBI.  However, NABARD felt that they did not have some of the “missing links to operate in the sector” as a regulator.

What then, will the MUDRA Bank do differently? If the several decade old and experienced NABARD thinks they can’t handle the job, how will the MUDRA Bank manage?

Another interesting proposed change is that the FMC and SEBI are going to be merged, the logic seems to be that financial and commodity markets are, at the end of the day,markets and hence they should have a common regulator because this will streamline decision making and potentially trigger new products. Great!

And there comes my third question, why then are we trying to create multiple entities for microfinance and enterprise finance? Where is the coherence in “strategy”?

Instead of seeding new ideas, would it not be better to energise the NABARD and SIDBI to take the word “Development” in their names seriously for their respective sectors? To adopt innovation and  shake away  some of the bureaucracy that binds them down? To adopt proactive measures to tackle the problem of access to finance for small businesses?

And please, for the sake of humanity, why should a bank promoting entrepreneurship favour only the scheduled castes and tribes? Favour all enterpreneurs, if you can. Nobody does that in our country.

(Edited on 9th March, 2015 to add an article on the same topic by noted journalist/author Mr. Tamal Bandyopadhyay. He seems to point out similar concerns.)

Money comes full circle (?)

(Ramblings below. Just thinking out aloud. Any guidance helpful.)

Currency evolved as a means of exchange of value, an improvement over the barter system. The barter system was in itself an exchange of value but it was not standardised and secondly, because the items exchanged varied from people to people, the barter system did not have the ability to duplicate/compare the value in two separate transactions. It could not “store” value  beyond one transaction. If you duplicated the same transaction in another situation with another set of people it may/may not have the same worth or value. It was each specific transactions that decided the worth of the exchange. The value of a transaction changed with the type of item exchanged and with the demand and supply situation of that item exchanged.

Commodity based currencies were the first to evolve, I guess, gold drops, silver coins, bronze coins. All created by nature and shaped into some form by men and introduced into transactions by a royal order. Standardisation arrived. Now, instead of the individuals deciding the worth of the exchange, the royal authority did.

Then came Central Banks and paper currency backed by gold, silver, etc. Now, instead of a small local kingdom, the value of a transaction was set decided by a Government. It created currency and assigned values based on gold stock available.Then the currency was de-linked from gold.

The Government or Central Bank now controlled the circulation and creation of more currency and hence had complete control over the value assigned to the currency.

With BitCoins, the creation of currency is decentralised to individuals instead of Central Banks or Governments. BitCoins interestingly do not represent a currency but a transaction . The worth of  a specific transaction is decided by individuals in that specific transaction. Its value goes up and down with the demand/supply. Is BitCoin a standardised Barter System with a central register where all transactions are authorised?

Payments, Banking and Cost implications of cash – India

Electronic Payments have always intrigued me. I have written about this in the past. I was reading through a few more documents on electronic payments and read through the Reserve Bank of India Vision Document on Payments. Quite an insightful document in terms of statistics. However, my feeling was it doesn’t quite clearly layout the strategic framework to be adopted for payments in India. SOme statistics from the vision document and some other sources.

 Penetration of banking services
  • Of the six lakh villages in India, the total number of villages with banking services stands at less than one lakh villages as at end March 2011 and nearly 145 million households are excluded from banking.
Penetration of Electronic payment
  • Only 0.6 million of the 10 million plus retailers in India have card payment acceptance infrastructure.
  • Mid-2011, the number of non-cash transactions per person stands at just 6 per year.
  • 32% of e-commerce takes place through the system of “cash on delivery” (COD) NOT online payment.
 Other numbers:
  • The Indian bill payment market is a US$ 160 billion market. Indian households pay on an average 50 -55 bills a year. Among the electronic payments infrastructure, ECS occupies a 50% share followed by cards and bank account funding.
  • It is estimated that Government subsidies alone constitute more than Rs. 2.93 trillion and if these payments are effected electronically, it may translate to 4.13 billion electronic transactions in a year.
  •  The penetration of ATMs is 63 per million population and that of PoS terminals is 497 per million population
 Banking Infrastructure
  • Today, the banking infrastructure in the country consists of 80,000 bank branches, 1,50,000 post offices, 88,000 ATMs, and 500,000 POS machines. Of these, the rural banking infrastructure only consists of about 30,000 bank branches and 1,20,000 post offices. In comparison, there are more than 10 lakh telecom retailers that operate throughout the country.
  • 18 million outstanding credit cards and 228 million debit cards.
 How much cost does the economy bear to support a cash economy?
Cost of cash to the economy is 5-7% of GDP.
-costs for rbi  include printing currency, currency chest management, and wear and tear
-cost for bank include cash logistics, cash management, security, storage, and the opportunity cost of idle cash in branches and ATMs