Your neighbourhood corner store, the stationery business across the street from your office, and your favourite local cafe.
These tiny companies are an important aspect of every Indian’s life, as well as the smooth operation of the Indian economy. They are part of the country’s Micro, Small, and Medium Enterprise (MSME) sector, which accounts for 30% of the country’s GDP (GDP). The sector employs over 110 million Indians and accounts for more than 45% of the country’s total exports.
Despite their critical significance, they have long been underserved by the conventional banking system. The sector is suffering from a credit gap of INR 25 trillion, with banks only meeting their credit demands roughly 40% of the time.
The seamless integration of financial services into traditionally non-financial businesses or products is known as embedded finance (also known as embedded banking).
Many impediments, such as tight financial sector rules, industry preparedness, and a lack of supporting technology, have provided exclusivity to banks and prevented non-financial businesses from offering financial services.
However, recent industry pushes and regulatory changes (such as the open banking movement and PSD2) have helped to break down barriers, allowing non-financial firms to interface with banks and regulated institutions via APIs. As a result, businesses all around the world can “embed” banking and financial services within their platforms.
Embedded Finance allows these companies to monetise their client base, boost customer lifetime value, and, most crucially, vertically scale their product offering. It decreases the difficulties (costs, time, and so on) of developing a comprehensive FinTech solution.
Embedded finance is altering the financial services distribution model, which is disrupting the financial industry. Businesses that use embedded finance provide outstanding services to their clients while also increasing their bottom line. Forbes has corroborated this, citing Shopify, which has a gross payment volume of USD 14 billion through its Shopify Payments Service (partnered with Stripe) in Q3 2020, and Uber, which handles more than 70% of its driver pay-outs via Instant Pay.
Why Are Banks Not Lending To SMEs?
There are two major reasons why banks do not lend to this market.
A (Perceived) Data Shortage
Traditional lenders use credit agency scores and a borrower’s credit history to establish a borrower’s creditworthiness. However, MSMEs are frequently first-time or thin-file borrowers with little or no borrowing history. Any information they have is highly unorganised and informal.
Furthermore, they typically ask for small-ticket loans, which do not warrant the time and effort required for a bank to underwrite. It’s a vicious circle: lack of traditional data leads to limited access to credit, which further limits the options for developing a credit score. These enterprises may find it difficult to enter the traditional lending ecosystem.
Inadequate Security Collateral
Smaller businesses simply do not have the wherewithal to pledge security collateral as a loan guarantee. However, for many traditional, risk-averse lenders, this is a non-negotiable requirement.
As a result, small business owners are frequently driven by desperation to borrow from informal lenders at excessive interest rates. In fact, 67 per cent of small business credit in India is obtained unofficially, forcing them deeper into debt.
Is This An Unsolvable Issue?
It appeared to be so until a few years ago. However, as FinTechs evolved, they introduced new solutions to expand financial access to the poor.
One such invention, Embedded Finance, is intended to revolutionise the way small businesses get formal finance. Platform aggregators, such as digital accounting systems and B2B E-commerce platforms, can ’embed’ credit into their customer journeys, providing financing choices at the moment of demand generation.
Here’s what makes this model so effective:
A Captive Audience
There are currently a number of SMEs on these platforms, but the majority of them are unable to transact all of the time due to liquidity difficulties. Because the platform contains an ever-expanding library of alternative data for each SME on its platform, such as purchasing trends, cash flows, GST data, and so on.
This is an opportunity for these platforms to collaborate with a fintech firm to underwrite its consumers and provide credit in context. The platform can increase order value by making finance available to small firms, allowing them to prosper and grow in a sustainable manner. As a capital provider, the lender gains access to a new customer base.
Models of Advanced Underwriting
Embedded Finance providers of the future bring advanced underwriting methods based on Artificial Intelligence (AI) and machine learning (ML). Instead of static characteristics like salary or income, these models use real-time cash flow data to detect hazardous borrowers and enable very precise, automated decision-making.
This allows the platform to offer distinct solutions to MSMEs in various risk categories, while the lender can price risk appropriately with changing interest rates. MSMEs have the possibility to acquire a loan from a formal lender, but at a higher interest rate than other applicants. If they pay it back on time, they may be able to transfer from a higher risk bucket to a reduced risk one, increasing their chances of obtaining future loans.
Embedded Finance enables B2B (as well as B2C) platforms to include credit at the point of sale. The borrower receives funds exactly at the point of transaction, which increases conversion rates and Customer Lifetime Value (CLTV). The company may place higher-value and higher-volume orders, the platform secures the consumer, and the bank cashes in on a future borrower to nurture.
Short Turnaround Times
The complete lending lifecycle is brought into the partner platform by embedded finance providers. Users are prequalified and only presented appropriate loan offers because of rich platform data. After customers apply, the underwriting process takes only a few seconds, and the money is disbursed within 24 hours.
Credit Items Chosen With Care
With access to reams of alternative data, lenders may tailor loans to each customer in terms of size, tenure, and interest rate. This makes the loan book available to new-to-bank or new-to-credit consumers. The platform may confidently state that the vast majority of its captive users will be able to obtain a loan. A risk-focused method tailors loan amounts to the borrower’s ability to pay, allowing borrowers to repay on time and improve their credit score even further.
According to estimates, embedded finance could increase the whole SME banking market by up to USD 92 billion, demonstrating that it could be the catalyst that finally draws these small but vital enterprises into mainstream lending.
We at Ignosis have developed a new-age tech stack for the digital lending ecosystem. Our mission is to democratise digital lending and make it efficient and accessible across the entire digital ecosystem.