Time for lenders to rethink MSME credit beyond collateral-based models

Financial institutions must pivot towards cashflow tracking and unified digital networks to unlock funding for small businesses

Finance Minister Nirmala Sitharaman has asked lenders to go beyond standard offerings for micro, small and medium enterprises (MSMEs), urging them to think in terms of specific business verticals’ needs and adopt a cashflow-based approach.  MSMEs contribute nearly 35 per cent to India’s manufacturing output, 48 per cent to exports and around 31 per cent to gross domestic product. They comprise over 74.7 million entrepreneurs and provide livelihood to more than 320 million people.

The encouraging aspect is that the building blocks are in place now, and it is up to lenders to use them imaginatively. 

Beena Vaheed, executive director of Bank of Baroda (BoB), points to the rapid formalisation of this sector. It has more than 75 million enterprises on the Udyam and Udyam Assist platforms, providing an unprecedented volume of verifiable data to tap into. “We are leveraging digital data, GST information, banking transaction patterns, account conduct, supply-chain linkages and alternative data sources to better understand MSME business models.” BoB has designed credit structures for unique sectoral needs, such as Digi-Udyam for loans up to ₹2 crore. The scheme is backed by the Credit Guarantee Fund Trust for Micro and Small Enterprises and was jointly set up by the Ministry of MSME and the Small Industries Development Bank of India. 

Beyond collaterals 

Going beyond a one-size-fits-all approach will push lenders beyond their comfort zones. They are fine with the traditional collateral-backed route rather than cashflow-based credit. It is another matter that the value of such credit may not be much — a risk that can come back to bite if the loan were to turn sour. (This holds true even for large credit under the Insolvency and Bankruptcy Code, 2016). In any case, expecting small businesses to have much by way of collateral can be problematic: Their business is cyclical and in many cases, linked to harvest time. It will require going granular to distinguish among MSME sub-categories. This realisation is creeping in. 

“A template approach has to be replaced with one that combines collateral and cashflow-based approaches,” says Ganesh Sankaran, executive director (designate) and head of wholesale banking group, IndusInd Bank. Take mango cultivators for example. A lot depends on the harvest, when the produce is sold, and therefore, the whole cash conversion cycle. “The GST architecture being robust can also be a great tool for evaluating customers. We will increasingly see GST-linked credit products in smaller businesses that are less formal. Also, with UPI replacing cash to a certain extent, this data can support credit evaluation.” 

A policy intervention beyond credit may be needed though. Maharashtra, Tamil Nadu and Uttar Pradesh account for a disproportionately large share of MSMEs, notes Debopam Chaudhuri, chief economist of Piramal Group, in a report titled “The Geography of MSMEs: Why India’s Growth Is Concentrated, Not Broad-Based”. Uttar Pradesh and Bihar remain underserved in MSME credit relative to their enterprise base. Nearly 80 per cent of MSME activity in Maharashtra is concentrated in a handful of districts. Manufacturing states such as Gujarat, Karnataka and Tamil Nadu continue to generate higher productivity and value addition compared to trading-led MSME ecosystems. The report calls for differentiated credit frameworks and the

development of new MSME clusters across Tier-II and Tier-III markets. 

Show us the money 

One way out is to “relook at priority-sector lending and see within the portfolio if areas can be promoted to address geographical concentration,” says Chaudhuri. His point: The skew towards urbanised centres is high. “And even intervention schemes have seen a concentration towards these areas. If the Smart Cities Programme is finetuned, some of these issues can be taken care of.” 

“For many MSMEs today, the bigger challenge is increasing access to their own money rather than access to capital,” says Arun Poojari, chief executive officer (CEO) and cofounder, Cashinvoice. An estimated ₹8.1 trillion remains locked in dues. A business may have a healthy order book, strong customer relationship and demand, “but if payments are delayed by 60, 90, or even 120 days, the cashflow comes under pressure. In effect, MSMEs end up funding their buyers while continuing to bear the costs of running their own businesses. After all, “growth becomes much easier when entrepreneurs can focus on running their businesses rather than waiting to get paid”. 

The Trade Receivables Discounting System (TReDS) tackles this aspect by helping small businesses discount bills held up by large firms. The Reserve Bank of India (RBI) enabled the participation of trade credit insurance companies as the fourth participant category on TReDS in 2023. This facilitates an additional layer of credit protection for financiers. It has the potential to strengthen lender confidence and expand financing capacity without necessarily relying on guarantee structures. 

But beyond providing liquidity, lenders can play an important role in strengthening awareness and adoption of receivables financing among MSMEs. Capacity-building initiatives for knowledge sharing and ecosystem development can significantly enhance the effectiveness of TReDS platforms. This includes “collaborative outreach programmes involving lenders, industry associations and MSMEs,” says Ketan Gaikwad, managing director and CEO, Receivables Exchange of India. 

Mint Road’s “Payments Vision 2028” — it seeks to build upon the remarkable trajectory of digital payments with the core theme of “Shaping India’s Payment Frontier” — is for interoperability among the TReDS platforms. This is to be watched for, as it will lead to a unified ecosystem where platforms can seamlessly exchange transaction data, enabling wider access to financing. The supplier is onboarded onto platform “A” and the buyer on “B”. “A” will share buyer details with all other exchanges; “B” will invite financiers to bid and share details with the supplier through “A”. The supplier accepts the bid on “A” and financing is done on “B”; “A” and “B” will then share revenue in a pre-agreed ratio. FY26 saw invoice financing of nearly ₹3.5 trillion

on TReDS. 

The credit bureau in the plot is relatively unexplored. “The lender-bureau relationship is an all-weather partnership — and a closer one clearly will help” is how Sachin Seth, chairman of CRIF High Mark and regional managing director (CRIF India & South Asia), sees it. As credit insights partners, “we work alongside lenders through every phase of the cycle, bringing bureauwide signals no single institution can see on its own: Early, directional indicators of where risk is concentrating”. 

Change of models 

When it comes to the regulatory front, the RBI’s expected credit loss (ECL) framework takes effect on April 1, 2027. It will replace the older “incurred loss” model which required provisioning only after an asset defaulted. (Non-banking financial companies are already compliant with ECL). Sankaran is categorical: “How you onboard credit will have a link to the ECL framework and provisioning. This has to be thought through.” This has the potential to increase lenders’ concerns regarding MSMEs, though it is not restricted to them. The sector is already under stress. If lenders also adopt a cashflow approach to MSMEs, it will also mean their stress will quickly become apparent. This will lead to faster provisioning under ECL. 

That said, this is not something to fret over, according to experts. “The increasing adoption of cashflow-based lending models can strengthen lenders’ preparedness for the ECL framework,” notes Vaheed of BoB. 

Such structures, typically characterised by shorter tenures, smaller ticket sizes and closer monitoring, can also contribute to lower “loss given default” through improved recoverability and reduced exposure. 

Small businesses can still be beautiful. Lenders need to give them a helping hand.