Banks Vs NBFCs: Why MSMEs Prefer The Latter For Loans

In the past few years, India’s public sector banks (PSBs) have witnessed an increase in lending to cash-strapped and crisis-hit micro, small, and medium enterprises (MSMEs). However, now a new player— non-banking financial companies (NBFCs) has entered the arena, posing formidable competition to these banks.

After all the delayed payments and heavy debt that the sector has been witnessing for a long time, the Indian MSME industry is still holding its ground and remains one of the pillars of the economy, significantly promoting employment generation, economic growth, and innovation. 

Currently, around 64 million MSME units are operating in the country. These account for about 30 per cent of gross domestic product (GDP), 45 per cent of manufacturing output and about 48 per cent of exports. MSMEs are also a source of income for around 120 million people, as per the Ministry of MSME.

However, despite all this, MSMEs have faced challenges in accessing finance as traditional banking institutions are reluctant to lend, primarily due to perceived risks and stringent collateral requirements. 

The data showed that about 14 per cent of MSMEs are estimated to have access to credit from banks, resulting in a considerable credit gap of USD 530 billion. This gap represents a substantial opportunity for lenders in the MSME segment.

Often referred to as shadow banks, non-banking financial companies (NBFCs) have recently emerged as disruptors in the lending landscape, radically transforming the way MSMEs access funding. 

The latest data from the Finance Industry Development Council and CRIF High Mark revealed that fresh unsecured business loans by NBFCs rose 24 per cent year-on-year (YoY) to Rs 339 billion as of March 2023. 

This is visible from the MSME portfolio of major NBFCs like Bajaj Finance, which posted a 33 per cent surge in its MSME loans from Rs 231 billion in 2021 to Rs 309 billion in 2022. Also, Aditya Birla Capital reported a 14 per cent growth from Rs 420 billion in 2021 to Rs 479 billion in 2022.

"NBFCs' interest in the MSME segment is largely driven by sustained demand from small enterprises for credit, a strong push from the government to grow MSMEs, and initiatives such as the Emergency Credit Line Guarantee Scheme (a credit guarantee scheme for MSMEs) and Pradhan Mantri Mudra Yojana. MSMEs prefer NBFCs over traditional banks due to the shorter turnaround time, minimal documentation, and customized offerings, among others," said Naveen Singh, Manager, Growth Advisory, Aranca. 

The lucrative offers: Banks Vs NBFCs

In India, MSME advances from 12 PSBs have increased from Rs 9.21 lakh crore in FY20 to Rs 11.48 lakh crore in FY23, with a loan book growth of 12 per cent, a media report stated. Interestingly, the State Bank of India (SBI) took the lead in this with an outstanding loan book of Rs 3.59 lakh crore, followed by Punjab National Bank (PNB) with Rs1.30 lakh crore and Union Bank of India with 1.25 lakh crore respectively.

In February 2023, the sectoral deployment credit growth data from the Reserve Bank of India (RBI) revealed that the outstanding bank credit to MSMEs stood at Rs 32.9 lakh crore, a YoY growth of 8.7 per cent. 

Talking about what attracts MSMEs to NBFCs, experts told BW Businessworld that it is their ability to give easy loan disbursals, flexible repayment options and non-collateralised loans.

"NBFCs have a faster loan approval process compared to traditional banks. Their tech-driven credit assessment allows for quicker evaluation, leading to reduced waiting times and quicker access to funds. NBFCs often offer more flexible repayment options tailored to the cash flow patterns of MSMEs. They may provide customized repayment schedules, seasonal adjustments, or cash flow-linked repayments," said Rohit Garg, CEO and Co-founder, SmartCoin. 

Aranca's Singh added that, unlike traditional banks, NBFCs adopt more flexible credit assessment and underwriting practices, enabling them to cater to the unique needs and challenges of MSMEs. By focusing on the viability and potential of the business rather than just collateral, NBFCs offer a lifeline to MSMEs that may lack traditional forms of security.

While shedding light on how are NBFCs reshaping the financial landscape by catering to the evolving needs of dynamic MSME enterprises, Manoj Nambiar, Managing Director, Arohan Financial Services added that it is by the speed of processing, better understanding and appreciation of their specific funding requirements, flexibility in tenor and repayment, and use of fintech to lend are all key differentiators.

A tough arena

For NBFCs, things are not as smooth as it looks, as with good things come drawbacks too. Handling compliance obligations effectively has always been an issue for India's NBFCs, as the RBI has specifically laid down its regulations for the sector. They also face challenges in terms of funding and risk management.

In 2022, India's central bank directed more than 27 regulatory updates specific to the NBFC industry. Notably, an NBFC operating in one state needs to comply with at least 621 regulations, which include more than 35 one-time registrations and approvals.

These compliances include maintenance of records, returns, and filings under the Prevention of Money Laundering Act, 2002, Prevention of Money Laundering (Maintenance of Records) Rules, 2005, and RBI Guidelines on Fair Practices Code for NBFCs, among others. 

In January 2023, TeamLease Regtech's report cited challenges for compliance management for NBFCs and stated that 92 per cent of the surveyed NBFCs agreed that they had missed at least one critical compliance in 12 months.

According to the report, an NBFC operating at a single location within the country faces more than 200 industry-specific compliance requirements.

While talking about the challenges NBFCs currently face to make a mark in India, Nambiar said, 'Backing of equity capital and then being able to leverage that with debt from banks is a key factor in their growth and scale-up plans.'

SmartCoin's Garg mentioned that NBFCs operate under stringent regulations, and compliance with evolving guidelines can be complex and resource-intensive.

'Access to low-cost funds is crucial for NBFCs to sustain their lending activities. Economic fluctuations and risk perceptions can impact their funding options. Ensuring a balanced portfolio with minimal non-performing assets (NPAs) requires robust risk management practices,' Garg added. 

A bright future ahead? 

Moody's Investors Service and International Credit Rating Agency (ICRA), in their recent report, stated that the credit profiles of Indian banks and non-banking financial companies (NBFCs) are expected to remain strong despite the challenging global environment. The report highlights various factors contributing to this resilience.

The credit quality of these lenders will be supported by robust domestic demand and improving credit conditions for bank borrowers. Additionally, the solvency and funding of rated Indian financial institutions have been strengthened, further enhancing their credit profiles.

Credit costs are expected to decline from one per cent in 2022-23 to 0.9 per cent in 2023-24, while return on assets is projected to remain stable. Moody's also noted that credit conditions in India have gradually improved, with a significant reduction in legacy problem loans and improved financial health among corporates and non-bank financial institutions.

However, the report highlights potential challenges such as rising deposit costs, which may put pressure on net interest margins for banks. Nevertheless, robust loan growth is expected to help maintain steady core operating profits. The transition to expected credit loss-based provisioning is also expected.

Meanwhile, as NBFCs continue to evolve and embrace technology in India, there are expectations that they will play a crucial role in reshaping the financial landscape for MSMEs, driving financial inclusion and supporting the growth of the MSME sector— the backbone of India's economy.