Deepali Pant Joshi: Credit scoring
Speech by Dr Deepali Pant Joshi, Executive Director of the Reserve Bank of India, at the
launch of credit scoring model by Canara Bank, Mumbai, 8 May 2014.
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Assistance rendered by Smt. Lily Vadera, General Manager is gratefully acknowledged.
Shri R.K. Dubey, Chairman and Managing Director, Canara Bank of India, other
distinguished guests, ladies and gentlemen. I am happy to be here for the launch of Canara
Bank's credit scoring model for MSMEs. We had recently on November 29, 2014 held a
workshop on credit scoring models with experts from IFC, which was fundamentally aimed at
capacity building in the banking sector by imparting practical knowhow to Bankers who are
expected to use it in their day-to-day operations. I am happy to note that Canara Bank has
taken the initiative to launch the credit scoring model for loan evaluation of MSME loan
proposals. I compliment Shri R.K. Dubey, Chairman and Managing Director, Canara Bank,
for his enlightened leadership and taking this initiative to further the growth of the MSME
sector.
A. Importance of the MSME sector
1. Micro, Small and Medium Enterprises (MSME) sector has emerged as a highly vibrant and
dynamic sector of the Indian economy. The sector contributes about 8 per cent of India's
GDP, 45 per cent of the manufacturing output and 40 per cent of the exports. The growth in
the manufacturing sector had dropped by 8.6 points from 7.4% in April-June 2011 to minus
1.2% in April-June 2013.
After agriculture, MSME sector employs the largest number of persons. The employment
picture is disturbing. According to the Planning Commission, between fiscal years 2004-05
and 2009-10, employment growth slowed, increasing by merely 2.7 million people. The
largest absolute decline was in agriculture, followed by manufacturing, down by 7.2 million
people or 13% of those employed in 2004-05. The decline is worrisome; more disconcerting
is the sharp fall in the percentage change in employment for each percentage change in
value added a metric known as employment elasticity. Simply stated, increase in value
added led to increase in employment in the first period and to virtually none in the second.
Manufacturing elasticity of demand has fallen from 0.76 in the first period to 0.31 in the
second. So a sector with high employment elasticity has reduced its growth and potential for
creating more jobs. MSMEs are widely dispersed throughout the country and produce a
diverse range of products catering to various segments of the market. The geographic
spread, diverse product range and potential for innovation and employment generation make
them extremely important in the context of economic growth. They also help in
industrialisation of rural and backward areas, thereby, reducing regional imbalances,
assuring more equitable distribution of national income and wealth. MSMEs are
complementary to large industries as ancillary units and this sector contributes enormously to
the socioeconomic development of the country. The MSME sector in general and more
particularly the Micro and Small Enterprises (MSE) sector, assumes even greater importance
now as the country needs to move towards faster and a more inclusive growth agenda. The
deceleration in the sector has been marked and is a cause of great concern. The entire SME
sector needs to be nurtured.
B. Features of MSME sector
2. Office of the Development Commissioner, Ministry of Micro, Small & Medium Enterprises,
has conducted 4th Census on MSMEs with reference period 2006-07. Some of the
socioeconomic features of MSME sector in India are given in Table 1.

C. MSMEs and the manufacturing sector
3. The National Manufacturing Policy (NMP) envisages increasing the sectoral share of
manufacturing in GDP to 25 % over the next decade from 16% at present and generating
additional 100 million jobs in manufacturing sector through an annual average growth rate of
12-14 % in manufacturing sector. MSME sector being the major base of manufacturing
sector in India, with its contribution of over 45% in the overall industrial output, the
achievement of the NMP targeted growth of the manufacturing sector would necessitate
substantial enhancement of the growth rate of MSME sector.
4. In the coming years, India is expected to witness significant demographic growth and a
disproportionate expansion in the working age population. To absorb much of this labour
force, the manufacturing sector would need to play an important role. Currently, the sector
accounts for 12% of the total employment in the country and also provides a transitional
opportunity to the labour force in agriculture. In addition, the sector has a multiplier effect for
job creation in the services sector. According to the National Manufacturing Policy, every job
created in the manufacturing sector creates two-three additional jobs in related activities.
5. Although the present fragile economic recovery in US and European countries and
subdued business sentiments restrict the growth of the manufacturing sector, the country
needs to be prepared for the times when an upswing in world demand would require an
impetus to domestic manufacturing. Meanwhile, the huge domestic market, encompassing
the rising aspirations not only of the urban middle class, but also of the rural economy, need
to be addressed through innovative domestic products and business models.
D. Financing of MSMEs
6. The MSME sector in general and more specifically the small and micro enterprises rely
heavily on the banks for finance and as such banks have to recognise the vast potential that
exists in responsible lending to the MSE segment. The Scheduled Commercial Banks need
to understand the problem of the sector and devise strategies to gear their credit mechanism
structure so as to achieve the prescribed target of lending to the sector as recommended by
the PM's Task Force. Sensitivity on the issue needs to be developed at various hierarchical
levels.
7. Over the years, there has been a significant increase in credit extended to this sector by
the banks as may be seen from Table-1 below. As at the end of March 2013, the total
outstanding credit provided by all Scheduled Commercial Banks (SCBs) to the MSE sector
stood at Rs.6,84,796 crore as against Rs.5,27,684 crore in March 2012, registering an
increase of 29.77%.
8. Nonetheless, despite the increase in financing to the sector there is still a considerable
credit gap which needs to be bridged. The extent of financial exclusion and the vicious cycle
of credit issues as graphically shown in the Report of the Inter-Ministerial Committee for
Accelerating Manufacturing in the MSME Sector (Chairman: Shri Madhav Lal, Secretary
Ministry of MSME) shows that the cycle starts from lack of access to formal sources of
finance which leads to tapping alternate sources of funds that are costly - higher cost of
credit results into poor net cash inflow - which increases the risk profile of the small unit and
reduces their credit worthiness - which in turn further aggravates lack of access to formal
sources of finance.
9. Thus access to timely and adequate credit from banks is critical for the sector. The ability
of MSMEs (especially those involving innovations and new technologies) to access alternate
sources of capital like equity finance, angel funds/risk capital is extremely limited. At present,
there is almost negligible flow of equity capital into this sector, which poses serious challenge
to development of knowledge-based industries, particularly those that are promoted by
firstgeneration entrepreneurs with the requisite expertise and knowledge. In the absence of
alternate sources of finance, the SMEs' reliance on debt finance is very high. The high
reliance on debt, combined with high cost of credit adversely impacts the financial viability of
start-ups, particularly in the initial years, thereby threatening their long-term survival and
sustainability.
10. Credit is a crucial input for promoting growth of MSME sector, particularly the MSE
sector, in view of its limited access to alternative sources of finance. Various estimates on
the credit availability to the MSME sector, however, indicate a serious credit gap. Though the
heterogeneous and unorganised nature of the sector poses inherent challenges for a
credible estimate, the fact remains that there is considerable credit gap, which is a matter of
serious concern and needs to be bridged if the sector has to foray into the next level of
growth trajectory.
11. Information opacity arising from MSEs' lack of accounting records, inadequate financial
statements or business plans also makes it difficult for potential creditors to assess the
creditworthiness of MSE applicants. Besides, high administrative/ transaction cost of lending
small amounts also queers the pitch for banks insofar as MSE financing is concerned.
Further, the existing system of banks' credit appraisal and related processes also need to be
geared to appraise the financial requirements of MSE sector.
12. Alongside extending the reach of their banking services, banks need to improve and
customize the products offered, fine tune the pricing aspects and enhance the quality and
efficiency of services. For this, banks need to have a proper business plan and delivery
model that would harness the benefits of technology. This would help in planning product
delivery and building lasting customer relationships which will translate into higher revenues.
The costs of banking transactions need to be dramatically reduced just as in so many other
fields such as telecom, after the advent of technology. It needs to be appreciated that the
credit process in case of micro and small entrepreneurs cannot be identical to that of large
corporations, where the borrower is able to provide detailed information about business plans
and the firm's financial statements and the lender carefully reviews the data using analytics
that are time-consuming and expensive. In view of the relatively small size of the loan, banks
do not find it worthwhile to conduct an elaborate appraisal of SME credit proposals both in
terms of value and profit. Therefore, in order that the banks can quickly conduct appraisal of
SME loan proposals without expending too much resources, it would be imperative to ensure
the efficiency of the appraisal process.
13. Credit scoring offers an alternative method of evaluating loans for small businesses. The
credit scoring approach, which is based on use of computer technology and mass production
methods, was originally designed to handle consumer loans, but are now being used
effectively for lending to small businesses by predicting their potential loan delinquency. I am
happy to note that Canara Bank has taken the initiative to launch the credit scoring model for
loan evaluation of MSME loan proposals.
14. Credit scoring, is a model applied by banks in their assessment and approval or decline
of the loan requests by SMEs. As there is a strong link between the payment behaviour of
the business owner and that of the business, SME credit scores usually include financial
characteristics from both the business and the business owner. Credit scoring is based upon
information like how the repayment of the previous loans has gone, what is the current
income level of the enterprise, what are the outstanding debts, if any? It focuses on the credit
history of the enterprise. As part of the process, the lenders see whether the
enterprise/business owner has the reliability and honesty to repay the loan. It also examines
how the enterprise has used credit before, its record for repayment of bills, including utility
bills, how long the enterprise has been in existence, assets possessed by the enterprise and
sustainability and viability of the activities that the unit is engaged in. Credit scoring model
draws inputs from historical information on the performance of loans with similar
characteristics.
E. Benefits of credit scoring
15. When used appropriately, credit scoring can benefit multiple stakeholders, including
lenders, borrowers, and the overall economy. For the lender, scoring leads to process
automation which facilitates process improvements leading to many by-products such as
improved management information, control and consistency. It also increases the profitability
of SME lending by reducing the time and cost required to approve loans and increasing
revenues by expanding lending opportunities as lenders can safely approve marginal
applicants that an individual underwriter might reject. International evidence has shown that
credit scoring can assist in overcoming the inherent benefit/cost trade-off that banks face
when deciding whether or not to invest in obtaining information regarding a potential
borrower. A study that was meant to test the credit scoring situation in US estimated that the
cost of evaluating micro loan applications in the US using credit scoring was reduced to
around $100 compared to a range of $500-$1800 prior to the introduction of credit scoring.
The time saving involved meant that banks could focus more time on marginal applications,
existing loans that are showing signs of distress and processing more loan applications. Use
of credit scoring has also meant that the marginal benefits of taking and maintaining
collateral are not justified for small loans.
16. The Bank of England has also acknowledged that there is some evidence of banks being
more willing to lend on an unsecured basis when using credit scoring, which potentially
improves the access to bank finance for very small and start-up Small and Medium
Enterprises. For the borrower, the benefits from credit scoring include increased access to
credit and, in some cases, lower borrowing costs. In its study of SME credit scoring's impact
on access to credit, the Federal Reserve Bank (FRB) of Atlanta found that, in general, the
use of credit scoring increased the amount of credit banks extended to the Small and
Medium Enterprises. It found that banks using scoring were more likely to lend to the Small
and Medium Enterprises that lacked sufficient financial information for approval through
traditional underwriting methods. Presumably, this is due to the inclusion of the business
owner's personal information in the scoring process. The study also found that banks using
scoring were more likely to lend in low-income areas, a fact it attributed to greater objectivity
in the underwriting process.
17. While credit scoring would definitely improve the speed and efficiency in SME lending,
banks need to ensure effective follow up and monitoring of the MSME accounts. We should
be careful to ensure that credit standards do not become lax so that lenders are willing to
provide credit to more distant borrowers without conducting the appropriate due diligence or
monitoring. Ultimately while models do help there is no substitute for the commercial
judgement of the seasoned hardnosed banker which also must be applied!
F. Way forward in bridging the gap in MSME financing
18. Access to finance needs to be enlarged through alternative sources of capital such as
private equity, venture capital and angel funds. This is crucial for facilitating the growth of
knowledge based enterprises which have high potential in Indian context. They would require
such alternative sources of finance since traditional channels may not meet their needs.
Apart from fiscal incentives for promoting such alternative sources of capital (such as tax
concessions), there has to be aggressive market intervention, such as promoting companies
for market making and ensuring scaling up of operation of SME exchange by providing
appropriate incentives.
19. Delayed payments or delayed realisation of receivables has all along been a growth
constraint of MSME sector by impinging on their liquidity. Timely payments from customers
will help SMEs in reducing their working capital requirements leading to lower interest costs,
improved profitability and a positive impact on the long-term health and sustainability of
India's SME sector. Delays in settlement of dues adversely affect the recycling of funds and
business operations of the SME units. A study of 5,000 SMEs by CRISIL shows that high
quantum of receivables is an endemic problem across industry sectors and geographies in
the SME space. Smaller SMEs, perhaps due to their lower bargaining power, are in a more
disadvantageous position with weaker receivable positions. The CRISIL study estimates that
SMEs can enhance profits by at least 15% if they receive payments on time from their large
corporate customers.
20. It is, therefore, critical to ensure that the small entities are able to raise liquidity against
their receivables. This problem can be institutionally tackled by factoring, which provides
liquidity to SMEs against their receivables and can be an alternative source of working
capital. World over, factoring is a preferred route of accessing working capital for SMEs and
even larger organisations. Some banks and financial institutions in India have already
launched factoring services and I would urge more banks to offer such services, particularly
for the MSMEs. To provide a legislative framework for factoring services, the Parliament has
passed the Factoring Regulation Act that would address delays in payment and liquidity
problems of micro and small enterprises. The Reserve Bank has also recently put up a
Concept Paper on Financing of MSMEs -Trade Receivables and Credit Exchange on its
website. The purpose is to create an institutional infrastructure for creating necessary
liquidity for trade receivables through the mechanism of efficient and cost effective
factoring/reverse factoring process. The Governor in his statement on September 4, 2013
had clearly stated the intention to facilitate Electronic Bill Exchanges, whereby MSME bills
against large companies can be accepted electronically and auctioned so that MSMEs are
paid promptly.
G. Conclusion
21. Before, I conclude let me re-emphasise that given the extent of exclusion in the SME
sector and the criticality of the sector for the economy, banks urgently need to step up
lending to the sector. For evaluating loan proposals and for facilitating SME financing, banks
would need to employ low cost and quick decision making alternatives. The use of credit
scoring models can go a long way in facilitating lending decisions by reducing costs and
increasing service levels, which can deliver great benefits for both the lenders and MSE
borrowers. By launching the credit scoring model, Canara Bank has shown willingness and
determination to expand credit coverage to this sector. I once again compliment the bank for
this initiative and wish them all success in their endeavour.
Thank You!
References
1. Report of the Working Group on Micro, Small and Medium(MSMEs) Enterprises
Growth for the 12th Five Year Plan (102-2017), Ministry of MSME, New Delhi, January13,
2012
2. Recommendation of the Inter-Ministerial Committee for Accelerating Manufacturing
in MSME sector (Chairman: Shri Madhav Lal, Secretary Ministry of MSME, New Delhi),
September 2013.
3. Does Distance Still Matter? The Information Revolution in Small Business Lending -
Mitchell A Peterson and Raghuram G. Rajan, March 2001.
4. Annual Reports of the Ministry of MSME.