Cashflow-based lending will rule credit mkt in future as lenders rely on MSME trade profiles

Traditionally, the asset-based lending focuses on the past and present value of an asset, while cashflow-based (CF) lending includes a component of future predictions. "CF lending will dominate the market in the next few years as the Micro, Small and Medium Enterprises (MSME) and retail sectors look for newer and less-leveraged customers,' says Amit Das, CEO and founder, Algo 360, in an exclusive interview with Bizz Buzz

MSMEs don't own many assets or collaterals, but what they do have are good cashflows, which provide a better visibility of their trade profile and expected revenue. This helps lenders take more informed decisions around potential risks, rather than focusing on NPAs and disposing off the defaulters' assets

The common hindrances to getting a business loan include the (weight of) documentation and the long (unnecessary) timelines. Hence, MSMEs often turn to financing through the informal sector despite the heavy interest rates - due to lack of accurate information

What is the contribution of MSMEs in the Indian economy?

MSMEs drive a major part of the Indian economy - employing around 100 million people and contributing around 35 per cent to the GDP. This share is about to increase with one last obstacle left - high interest rates. According to the International Finance Corporation, 78 per cent of the Rs 32.5 trillion required (2012 figures) were from informal sources, while the remaining was fulfilled banks and NBFCs. The common hindrances to getting a business loan include the (weight of) documentation and the long (unnecessary) timelines. Hence, MSMEs often turn to financing through the informal sector despite the heavy interest rates - due to lack of accurate information.

Why the focus on CF lending has intensified?

In December 2020, at the National Council of Applied Economic Research (NCAER) webinar, RBI Governor Shashikant Das said, "to improve the credit to gross domestic product (GDP) ratio, access to credit and cost of credit need to be addressed by lesser reliance on collateral security and greater cash-flow based lending." In December 2019, SBI chairman Rajnish Kumar had shared the same thought. A much-needed change, which would have come after five-to-seven years, now has to be available at scale in the next 12-18 months.

How CF lending gained traction in last 18 month?

Let us look at 2020, a difficult year for industries globally. MSMEs in India were no exception - the industry was adversely affected by the coronavirus pandemic (and the lockdown). In September 2020, due to the severe cash crunch and less-than-ideal demand, MSMEs (led by SME Chamber of India) requested the RBI for an extension in the loan moratorium to March 2021 and allow banks to undertake CF-based lending for the sector. While the loan moratorium period was not extended - the RBI said a further extension (beyond six months) since it would negatively impact the credit behaviour of consumers and also increase the risks of delinquencies - the CF lending option definitely gained traction.

Does cashflow-based lending promote financial inclusion?

In CF lending, banks extend credit to companies considering their future sales projection. A collateral is not required for the loan amount since the company or borrower's account capability is treated as a measuring parameter for creditworthiness. This means that any individual, company can borrow money based on expected revenues or anticipated income, expenditure. Credit ratings feature as an important criterion in CF lending. The creditworthiness and credit limit of the consumer is also decided along the same parameters.

This lending scenario provides an opportunity to financial institutions (including fintech firms) to finance MSMEs with reasonable interest rates, helping in economic growth.

However, this option was mostly overlooked in the broader scenario - usually salaried individuals were considered for CF loans because of their fixed income status. Only about 12-16 per cent of the country can boast of regular monthly salary inflows. Other 'uncertain' segments like the self-employed group and MSMEs were not considered because their estimate is typically difficult to ascertain. For them asset-based lending was the traditional approach.

MSMEs don't own many assets or collaterals, but what they do have are good cashflows, which provide a better visibility of their trade profile and expected revenue. This helps lenders take more informed decisions around potential risks, rather than focusing on NPAs and disposing off the defaulters' assets.

It is fair to say that Indian lending institutions are ready to shift their mindset, and that alternate data will play a pivotal role in the new journey. For example, already digital payments start-ups, for smaller SMEs loans of less than Rs 20 lakh, have started evaluating a lot more than just asset base and rely heavily on alternate data sources to predict future incomes. While these players have already disbursed loans to the merchant and SMEs, the RBI needs to help them scale up in a bid to revive the struggling sector.

What is the role of alternate data in this situation?

Alternate data usually includes multiple sources of information, like telecom usage and history, mobile transactions, bill payments history, e-Commerce, spending patterns and more. It gives banks access to a far wider range of variables, information about assets, compared to standard creditworthiness tests, thus allowing banks and lenders to make better lending decisions. Alternate data enabled platforms help identify fluctuations (and their causes) in income as well as spending and saving patterns and recognizing financial difficulties and loan history. Lenders need to be mindful of accurate data set, accurate calculation methodologies and accurate technology before taking any decision. Even for customers with mature credit histories, this helps drive better confidence, optimal interest rates and terms all around.

Account Aggregator (AA), Public Credit Registry (PCR) and other aggressive innovations by fintech companies would use different formulae for measuring the non-salaried borrower segment. Hence, banks would have to consider the cashflow of the borrower. That will be step towards a new beginning because banks will get new customers. And, customers will get the credit.

The next big change expected is opening their database to the data governing organization through secured channel. Government database schemes, such as beneficiary and defaulters' data, vendor registration data, DBT data and schemes defaulters list among others, will be a big advantage in combination with existing traditional and alternate data. It will help predict the actual capabilities of a consumer, resulting in reduction of risk to the lenders and expansion of the service to the commons simultaneously. Now, is the time to act in earnest. To become financially stable as a nation we need to look at the larger picture and consider the ideal state of financial inclusion where CF lending is equally balanced like asset-based lending.