As the economy continues on the path of recovery, small and medium businesses are jumping back after the harsh impact of the pandemic and intermittent restrictions on activities.
After the emergence of digital lending models for consumers, a space that’s gaining traction is small and medium enterprise (SME) borrowers. Over two years, fintechs have changed the way they assess SMEs for loan eligibility.
SME neobanking and lending startups, like others in the ecosystem, are also raking in funds as investors remain bullish on how these startups are digitising credit and banking for the large pool of small businesses in India.
What’s more, the definition of SMEs is rapidly changing. With content creators and well-funded startups joining the segment, the assessment of the risks in lending to these businesses and when any over-exposure will come to light are yet to be seen.
Even though these startups are lending on a much smaller scale than banks and non-banking financial companies (NBFCs), it is clear that SMEs are happy to access funds through fintechs despite the higher rates of interest.
Moneycontrol looks at how fintechs assess SMEs differently, whether they should be wary of any risks, and why SMEs are happy to bank and borrow from them.
The new SME client
The SME pool has always had various customer profiles – across sectors, some manufacturing, some retail. When it comes to fintechs, SMEs are no longer small local business owners, manufacturers or kirana owners.
Razorpay’s neobank RazorpayX caters mainly to startups and internet companies that fit the SME classification based on their turnover and investment. Neobank Open has freelancers including content creators as customers, besides other SMEs and startups. BharatPe focuses on retail merchants.
Rupifi, which recently bagged Series A funding of $25 million, facilitates buy now, pay later (BNPL) transactions between retailers and their suppliers. The model allows the retailer to pay later and Rupifi to pay the supplier when the inventory is supplied.
“For SME lending startups, it is important to choose their battles carefully,” said Anubhav Jain, cofounder of Rupifi. “Fintechs have been successful where they have very carefully chosen the segment which they understand well and reduced the risks.”
How fintechs lend differently
Most fintechs including Razorpay, Rupifi and KredX lend in partnership with banks and NBFCs. Lendingkart and NeoGrowth Credit, however, lend from their own books and through co-lending models.
There is a fundamental difference in the way lenders – old and new – assess the loan eligibility of SMEs. While banks and NBFCs look at balance sheets and profit and loss statements of prospective borrowers, fintechs take into account cashflows of businesses and their prospects.
“Fintech platforms have opened up channels to small businesses by understanding how their businesses work and doing more cashflow-based lending as opposed to what traditional banks have done,” said Shilpa Mankar Ahluwalia, partner & head-fintech at Shardul Amarchand Mangaldas & Co.
Balance sheet-based lending at this stage could be disadvantageous for SMEs because many of them took a hit during Covid-19. Looking at current cashflows and assessing future gains may be a better metric and will make more businesses eligible for loans.
“Fintech credit analytics is more forward-looking and traditional bank underwriting has been more historical. As a result, fintechs have opened themselves to markets where banks may not even have thought of lending,” Ahluwalia said.
Then there is collateral. Banks lend to SMEs in exchange for collateral such as land or assets. Fintechs offer unsecured lending, where loans are advanced only on the basis of a borrower’s creditworthiness and not backed by collateral.
However, collateral-free lending comes at a price. Fintech charge borrowers a higher rate of interest than what banks levy.
“Banks have a principle that if we are financing a building, for example, it will be taken as primary security,” a banker said on condition of anonymity. “In cases where security is there, lenders tend to give a reduced rate of interest because it is a pure risk-reward. In case anything goes wrong, I have the option of liquidating the collateral asset.”
For fintechs, the lack of collateral makes the cost of funds higher. Cost of funds refers to the loss the lender will bear in case of non-repayment.
Risks and rewards
Payments and other data-backed underwriting have opened the doors to a larger customer base for fintechs. Each SME spends 816 hours and Rs 32 lakh on banking on an average per year, according to a survey by IDC commissioned by Razorpay.
Covid-19 has spurred the adoption of digital financial services in India and SMEs are happy to spend less time on managing their money by using online tools given by fintechs. With small loans sanctioned in just about a day, more small business owners are turning to fintechs.
“Fintechs stand for innovation, better customer experience, speed and agility of services and in some cases, affordability as well,” said Sonali Kulkarni, managing director and lead of financial services at Accenture. “The banking industry does realise that it’s a good fit because banks have their own constraints around regulations and the speed at which they can move.”
Investors, too, are bullish on fintech lending because Covid-19 has opened up a host of possibilities in the form of data that can be used to underwrite these loans.
“In the last 18 months, companies have gotten access to more digital data to offer sharper solutions,” said Ganesh Rengaswamy, cofounder of Quona Capital, an investor in NeoGrowth Credit and Rupifi. “Many of these fintechs are new – they started during the pandemic, so they designed accordingly. SME lending has caught on momentum and these companies are growing at a very fast pace.”
Following the pandemic, the Reserve Bank of India pushed liquidity into the economy through interest rate cuts and other tools. Small businesses are recovering as the Indian economy makes a comeback and lending to this pool may only increase.
However, banks don’t want to burn their fingers in case things go south again. So some are forming partnerships with fintechs.
“Banks and large NBFCs are sitting on a lot of cash and now they want to deploy that through fintech tie-ups,” a senior executive from a fintech NBFC said on condition of anonymity. “They are giving exorbitant targets like Rs 1,000 crore in three months, for example.”
What is the safety net that fintechs offer to banks in such tie-ups? Fintechs provide banks with a First Loan Default Guarantee (FLDG), where the fintech promises to compensate the partner up to a pre-decided percentage in case customers fail to repay loans. This is in exchange for partners lending through the fintech from their own books.
However, FLDG has come under regulatory scrutiny. The RBI wants to look into whether costs are eventually passed on to customers in the form of high interest rates.
Additionally, new models come with their own set of risks.
“There is no way to find out if the SME has sought some other informal loan and is leveraged elsewhere. If a fintech lends to a sweet shop owner, when things go wrong the fintech cannot recover the money by selling sweets from his shop,” said an analyst who did not wish to be identified. “Fintech has helped the process better, it has found the answer for growth. But I don’t think they have figured out existing indebtedness. They’re yet to understand the entire credit-cycle problem. So, I think fintechs cannot be completely no-touch – an omnichannel approach will make sense.”
Most analysts said it will take time to figure out whether fintech assessment parameters and models will generate watertight results and low levels of non-performing assets. Additionally, with segments such as the creator economy joining the fray, the jury is out on the long-term credit behaviour of these borrowers.Razorpay cofounder Shashank Kumar summed it up: “Any new experiment in lending will always have concerns and some risk associated. But innovation still needs to happen and whenever new approaches are being tried, some of those will work right.”