Mudra Bank: Can it finance small businesses in India?

In this file photograph taken on May 14, 2012, Indian labourers work on machines inside a jute mill at Jagatdal some 75kms north of Kolkata Image copyright AFP
Image caption The new bank is aimed at providing loans to small business entities with little access to funding

Financial inclusion for a majority of its population is key to economic growth of any country.

Unfortunately in India's case, the lack of it - not just for individuals but also for small enterprises - has been a big hurdle to unlocking its economic potential.

But there are signs that things are changing on that front.

After announcing a plan to provide bank accounts to some 480 million Indians who have little or no access to financial services, last year, India's government has now unveiled a new bank aimed at providing loans to small business entities with little access to funding.

Micro-financing growth

The latest initiative looks to tap into micro-finance, a financial service that has previously been successful in India.

The new bank, with the acronym MUDRA (Micro Units Development and Refinance Agency), will be responsible for refinancing micro-finance institutions that lend to small entities.

It will have an initial corpus of 200bn rupees ($3.2bn; £2.1bn) and is expected to benefit 58 million small businesses across the country.

It is a great initiative, as small businesses in the country have generally found it difficult to get funding. Helping these businesses get access to finance is key not just to their growth, but also of the overall economy.

Small businesses in India are major source of employment, providing jobs to nearly 120 million people. If given proper access to funding and a chance to expand, they can create more job opportunities.

That will translate into more people having a regular income and contributing to India's domestic consumption and growth. Not to mention, increased revenues for the government in the form of taxes from businesses as well as employees.

To put it in Prime Minister Narendra Modi's words: The strength that small business "give the economy is one of its most overlooked secrets".

Sustainable funding

While the initial noise around the initiative is encouraging, its overall success will depend on whether this can be sustained in the long term.

The key thing to note is that Mudra bank is not going to lend to business directly. Instead it has been given a huge corpus of funds to refinance the various micro-finance institutions that lend to such entities.

The last-mile lenders will have to ensure they run a profitable model. They will have to be diligent while checking the credibility of the businesses they are lending to and their ability to pay back.

Image copyright AFP
Image caption Small businesses have lacked access to funds in India

While the value of each loan is likely to be relatively small, a large number of bad loans can add up and become a significant issue.

With Indian government's expenses already under strain due to various subsidies, it will be very difficult for the policymakers to keep pumping in endless cash into the bank.

Technology dependent

One of the big reasons that small businesses have lacked access to funding is the economics of big banking.

The big legacy players have been unable to cater to such entities, especially in smaller towns and rural areas as they have not been too keen to open physical branches in such centres. The low volume of business, a lack of trained staff and infrastructure costs are among the many reasons behind that.

However, the advancements in technology can help address that issue. Institutions that specialise in micro-finance can tap into technology to provide increased access to funding for small businesses.

A prime example of that is CreditEase in China. It launched a peer-to-peer microcredit platform in 2006 helping bring together urban lenders with extra cash and people with micro-credit needs, such as urban micro-entrepreneurs, salary workers, vocation school students and the rural poor. In just eight years it has become the world's biggest peer-to-peer lending platform.

There are various other examples across the world including, Kabbage, CAN Capital, OnDeck, Bond Street, Fundera, Lendio, LendingClub, and Prosper to name a few.

All these platforms use the Internet to power their business. They all have almost no physical branches. They mainly fund person-to-person, have extremely simple processes and advanced credit underwriting models. All of that allows them to work with low cost platforms and agile solutions.

Image copyright AFP
Image caption There are more than 900 million mobile phone users in India

If Indian micro-finance institutions can set up similar models, it can help address the issues that big banks have faced in India. Of course, access to Internet is key here. Internet penetration in India is still relatively low, but it is improving, not least because of broadband access offered via smartphones.

There are more than 900 million mobile phone users in India. Increasingly many of them are switching to smartphones. As more and more people and businesses get online, technology driven micro-finance can help bridge the gap between the demand and supply of micro-credit.

Not only will that help the growth of such businesses, but also contribute towards the expansion of the Indian economy.

Jungkiu Choi, a former banker, is Partner, Financial Institutions Practice, with global management consulting firm AT Kearney

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