If today, a Small and Medium Business (SMB) owner in India were to approach a bank for credit, they would invariably encounter the customary setbacks for loan approval: lack of credit history, unavailability of collateral, and insufficient documentation, to name a few. Unable to meet the criteria to secure credit from formal lenders, SMBs would be left with little choice but to approach informal lenders. The existence of a large, fragmented market of moneylenders and loan sharks – estimated to be over $500 billion – is a strong indication of this. 

Despite accounting for roughly a third of the national GDP, SMBs in India remain impacted by a substantial financing gap. A persistent issue for formal lenders continues to be economic feasibility, given the high operational expenditures (OPEX) and non-performing assets (NPAs) in the SMB segment. Past attempts by traditional lenders and Non-Banking Financial Companies (NBFCs) to bridge this funding gap have achieved limited success. 

However, SMB financing in India presents a large opportunity for fintech founders, who can leverage technology to shape the future of SMB lending. Challenges aside, there is significant scope for fintech builders to innovate around four key solution themes.

The first solution theme that can address this economic muddle is anchor lending. This approach involves inserting a credible anchor between the lender and the end borrower. Anchors serve a dual purpose: reducing OPEX by facilitating loan distribution or collection or both, and minimising NPAs by either sharing risk by parking First Loss Default Guarantee (FLDG) or providing proprietary borrower data for underwriting. 

Anchor-led lending taps into the credibility of established institutions, leveraging their expertise and data to enable more efficient and inclusive access to finance for SMBs. This solution theme finds fertile ground in various sectors, notably supply chain financing, where a large corporate buyer assumes the role of an anchor for its network of suppliers or distributors. Likewise, in the realm of  education financing, educational institutions can serve as anchors, empowering students to access loans. An example of this can be found in our portfolio company, Propelld, which is in the business of education financing, and leverages education institutes as anchors. Propelld has had low NPAs across cycles, including COVID-19, in a sector which is notorious for high NPAs.

A second solution theme is embedded lending, where non-financial offerings incorporate financial options within them. At the outset, the business initially offers non-lending products, such as software, commerce, or payments, and seamlessly embeds lending services into the offering as the customer relationship matures. This contextual embedding enhances loan conversion rates, lowers OPEX for distribution, and mitigates adverse borrower selection.

Embedded lending is not new, with banks having leveraged this to much success in the past. Providing payments and transaction banking to acquire SMBs, and cross-selling lending later on is an example. Much of embedding or cross-selling is enabled by an army of relationship managers and branch employees. However, fintechs can seize the opportunity to digitally engage vertical SMB segments by crafting vertical- specific offerings, and contextually embedding financial products including lending at times of need. 

Successful examples of embedded lending within our portfolio companies can be seen in CredFlow, which targets SMB manufacturers and distributors as customers with software as the day 1 product, and then embeds lending down the road as the vintage develops with the customer. I’ve also witnessed the success embedded lending at scale firsthand during my previous stints at CRED and Ola, with CRED Cash and Ola Money Postpaid respectively.

The third solution theme, sunrise sector lending, focuses on emerging sectors with significant growth potential. This approach anticipates future needs that may not be adequately addressed by traditional underwriting processes. For instance, in the electric vehicle (EV) financing industry, where nearly half of the vehicle cost is attributed to batteries, innovative EV financing companies are leveraging technology to underwrite the battery. By addressing this gap overlooked by incumbent lenders, these companies gain a unique competitive edge. An example of this is our portfolio company Turno, which is in the business of commercial EV financing. Nearly half the cost of the vehicle is the battery, and incumbent lenders did not have the processes at the time of our investment for underwriting the battery.

Finally, sachet lending targets small SMB loans i.e. those less than INR 2 lakhs. These bite-sized loans are typically offered for a short duration, and are often approved immediately, followed by prompt disbursement of the loan amount. Historically deemed economically unfeasible, sachet loans are made viable by digitization, which reduces OPEX across the loan lifecycle. Recent successes in profitable unsecured lending to rural micro SMBs, underscore the potential of sachet lending.

These innovative approaches are just the beginning. The future holds immense promise for numerous fintechs and technology-led NBFCs that will emerge under each of these solution themes, driven by the vast scope and depth of the SMB financing gap in India.

This article was originally published in Financial Express