View: Traditional financial institutions continue to be the biggest contributors of credit for nanoentrepreneurs

There is substantial evidence to show the importance of small businesses in the growth and dynamism of an economy, including creating jobs, stimulating innovation and absorbing the shocks of business cycles. With MSMEs contributing over 30% of its GDP, almost 98% of which are classified as micro- and nano-enterprises, India is no exception.

Nano companies include very small companies with an annual turnover of between ₹10 lakh and ₹1 crore. These include small retail stores, micro-wholesalers, repair shops and traders. They are usually run by nano-entrepreneurs who have received limited formal education, live in rented houses and earn less than ₹25,000 per month. However, unlike other countries, there has been a massive growth of nano-entrepreneurs in India.

Since nano-entrepreneurs typically have no collateral, they have no access to formal credit, creating a situation where these small business owners are only steps away from closing the business. In the financial year 2021, ₹9.5,000,000 was disbursed to the MSME segment, of which only ₹1.61,000,000 was disbursed to micro businesses – a very small amount for a large group of people. It is estimated that there are around 10 million nanoentrepreneurs in India, of which less than 10% have access to formal finance.

Traditional financial institutions were designed to offer large business loans backed by collateral. This has left too many companies that aspire to succeed but have limited means to grow. Closing this gap requires more than systemic change. This requires a paradigm shift.

Traditional financial institutions such as banks and non-banking financial companies (NBFCs) continue to be the main providers of credit for nanoentrepreneurs. However, due to the prevailing mindset among these institutions, most nano-enterprises do not have access to credit or do not receive the required amount. This risk-averse mindset is largely the result of two factors.

First, nano-companies operate in the informal sector. Over 90% of business owners do not have the necessary documents to qualify for formal credit. Moreover, two-thirds have no collateral to offer against these loans. As a result, traditional institutions view them as high risk, limiting their access to credit. It becomes a vicious circle – small business owners cannot access credit because they are high risk, which then prevents them from building a credit history.

Second, nano-entrepreneurs need to borrow a small amount of money for the types of businesses they operate. This makes them less attractive to large lenders. It also makes it more expensive to service these loans, placing additional constraints on lenders.

There is, however, good news. Digital innovation addresses the cost challenge and enables finance companies to more effectively assess and manage credit risk. The credit decision is based on automated algorithms, allowing rapid disbursement within 24 hours. This level of automation and digital access moves beyond face-to-face interactions.

The problem of credit risk is solved by technological innovation through alternative credit rating platforms and innovative credit models. Over 75% of nano-entrepreneurs have smartphones or feature phones, and nearly 50% have made some form of digital payment. This has already left digital traces that can be exploited for other credit scoring purposes.

Risk sharing is another approach that can be leveraged to mitigate risk for individual lending institutions. Several wholesale credit guarantee structures emerged after the pandemic (which were also used effectively after the 2010 microfinance crisis). These make it possible to transfer part of the risk to the guarantor, thus giving additional solidity, risk absorption capacity and a better credit rating to the lending institution. Similar loan guarantee structures for individuals are offered by the Small Industries Development Bank of India (Sidbi) through its Credit Guarantee Scheme for Micro and Small Enterprises (CGTSME). More such tools and structures can unlock a much higher level of credit flow for nanoentrepreneurs.

As in advanced markets, the process of developing a mature economy requires the growth of micro and small businesses. The space they free will be occupied by nano-entrepreneurs. This growth journey requires increased compliance, the ability to accept and make digital payments, and manage finances and inventory sustainably. Financial institutions are making strides to ensure that nanoentrepreneurs have access to the financing they need to succeed. Now is the time to double down on the innovations that are already working.

Marianne R. Winn