Formal Credit Is Elusive, Informal Credit Is Costly: The MSME Struggle in India

When we talk about Indian business, the usual suspects show up. Tata. Reliance. Birla. Boardroom titans that dominate our headlines and embody the country's corporate muscle.

But far away from glass towers and quarterly earnings calls, there’s another India Inc. One that doesn't wear pinstripes or feature on business dailies, but silently fuels the beating heart of the nation’s economy. This is the India of small businesses — or technically, “Micro, Small and Medium Enterprises” (MSMEs).

And their numbers tell a compelling story: contributing nearly 30 per cent of India’s GDP, accounting for 40 per cent of exports, and supporting the livelihoods of over 220 million Indians. That’s one in three working citizens who depend on MSMEs for their daily bread.

But there’s a twist: while MSMEs create value at scale, they’re starved of capital. A business can have a loyal customer base, strong orders, and skilled workers — but if it can’t access credit, it can’t survive. It’s like asking a car to run without fuel.

A recent NITI Aayog report about MSMEs delves into this issue, among others, in some detail. This is, after all, a foundational problem for Indian MSMEs, and by extension, for the Indian economy.

The Money Maze

When a small business finds itself in need of capital, it usually has two places to turn.

On one side: the familiar but perilous route of informal loans—from moneylenders, friends, and family. These sources may open their wallets easily, but the generosity comes at a price. The interest rates can be so high that they end up crippling the business.

On the other side, there is formal financial sector. Banks, non-banking financial companies (NBFCs), angel investors, venture capitalists.

In theory, these are safe, regulated avenues, backed by bodies like the Reserve Bank of India (RBI) or the Securities and Exchange Board of India (SEBI), which means the terms are generally fairer and the interest rates lower. But in practice? It’s a cold, complex labyrinth, and MSMEs often don’t have the map.

Now here’s the kicker. The latest time-series data reveals a quiet change: while banks still lead, NBFCs are steadily claiming a larger slice of the lending pie in the SME segment.

Why So Credit-Starved?

According to a 2023 report by Ernst & Young, credit penetration among Indian MSMEs languishes at a paltry 14 per cent. For perspective, that’s a far cry from the robust 50 per cent in the US and 37 per cent in China. The question is, why are Indian small businesses being left out in the cold?

The answer is a failure on two sides, supply and demand.

From the banks' perspective, MSMEs are seen as too risky, too informal, too small to bother with. Indian banks shy away from lending to these enterprises for a laundry list of reasons—lack of collateral, a history of non-performing assets (NPAs), high transaction costs, and the headache of verifying creditworthiness in a fragmented, under-documented economy.

Add to that the reality that financial services that banks offer are often insufficient to meet the needs of early-stage SMEs in India .

On the demand side of the equation, many MSMEs have simply stopped knocking on the door of banks. They know it won’t open. With no formal business registration, no GST filings, and little to no credit history, these enterprises know they don’t qualify. So they don’t even try.

The Vicious Loop

It’s the ultimate Catch-22. MSMEs need credit to grow, but they can’t access credit because they haven’t grown—at least, not in a way the system recognizes.

This cycle has produced a gaping mismatch between what MSMEs need and what the formal system can supply. A yawning void known as the MSME credit gap.

In FY17, India’s MSME sector demanded Rs 69.3 lakh crores in credit. Only 16 per cent of that came from formal sources. The remaining Rs 58.4 lakh crores? Covered by informal lenders, with brutal interest rates of 30 per cent to 60 per cent.

Then came the economic jolt of 2020 and the COVID-19 pandemic, which pushed the sector into deeper distress.

Government schemes like ECLGS offered some oxygen, but it wasn’t enough. By FY21, the credit demand had ballooned to Rs 99 lakh crore, and only 19 per cent of that was met through formal lending.

Five years ago, the U.K. Sinha Committee, appointed by the RBI issued a clarion call to dismantle the structural barriers choking the sector.

Yet here we are, with the gap wider than ever.

The Collateral Curse

The diagnosis is clear, as iSPIRT Foundation puts it: India doesn’t have a money problem — it has a money-moving problem. Our financial system lacks an effective mechanism to disburse loans to MSMEs at low-cost, low-ticket sizes, and low risk.

Right now, the vast majority of loans from banks and NBFCs are against collateral. But most MSMEs don’t own enough fixed assets or property to pledge. And so, they remain outside the formal lending net — unable to grow, scale, or even survive.

This "collateral curse" is especially devastating for very small businesses seeking small loans and first-generation entrepreneurs. They don’t need millions — just enough to buy a second sewing machine, a new delivery van, or raw material for the next batch. But without collateral, even that is out of reach.

Recognising this systemic chokehold, the government took action early on. As far back as 2000, the Ministry of MSME and SIDBI launched the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) — an attempt to break the collateral barrier and enable lending without the traditional strings attached.

In theory, CGTMSE allows eligible MSMEs to receive loans without pledging assets. In the last five years, from 2018-19 to 2022-23, the number of approved guarantees has increased significantly, with 2022-23 seeing 11,65,786 approvals, a substantial rise from 4,35,520 in 2018-19.

Even so, according to the 46th Report of the Standing Committee on Finance (17th Lok Sabha), only a few MSME enterprises are managing to get collateral-free loans under the government schemes.

The majority are still being asked to furnish collateral, even when they qualify for government-backed schemes. Why? Because banks, reluctant to fully trust the guarantee mechanism, continue to cling to old habits. That’s a problem, especially when 99 per cent of MSMEs fall under the micro category, and most have no real collateral to offer.

The U.K. Sinha Committee on MSMEs offered a powerful reimagining of creditworthiness: what if small businesses, like salaried individuals, could borrow against future income? Just like one gets a personal loan based on a salary slip, MSMEs should be allowed to use cash flow projections, digital transaction history, or customer orders as proof of viability. It’s not about what they have, it’s about what they can earn.

Across Asia’s emerging economies, Credit Guarantee Schemes (CGSs) have become the secret sauce behind countless SME success stories. By shouldering a slice of default risk with financial institutions, they coax banks to look past rigid collateral rules and archaic credit checks, opening doors for small businesses that would otherwise remain shut out.

When comparing India’s CGTMSE with similar schemes in other countries like Korea Credit Guarantee Fund (KODIT), Japan Federation of Credit Guarantee Corporations (JFG), Credit Guarantee Corporation Malaysia (CGCM) and Perusahaan Umum Jaminan Kredit Indonesia (PUJKI), the differences leap off the page.

To start with, CGTMSE’s corpus fund (US$ 1.5 billion) is much smaller than the fund size of other countries such as Japan and South Korea, a point noted in a CAG report.

Additionally, while these peers have evolved into credit information bureaus— providing SMEs with reliable risk assessments, along with consultancy and management services—CGTMSE does not offer support services to the MSEs. There is no direct contact between CGTMSE and the SME unit requiring funds. The SMEs are directly dependent upon the lenders for financial assistance.

These restrictions hinder the competitiveness of Indian MSMEs despite their proportion in the economy. The competitiveness of MSMEs extends beyond credit access; it encompasses the entire credit utilisation process.

Policies, Pilots, and Possibilities

The government and RBI aren’t blind to this crisis. From Priority Sector Lending (PSL) mandates to schemes offering collateral-free loans up to Rs 10 lakh, a patchwork of policies now exists. Budget allocations have doubled.

Technology, too, has begun to play a catalytic role. Platforms like the Trade Receivables Discounting System (TReDS) offer MSMEs a liquidity lifeline by enabling early payment on outstanding invoices. Essentially unlocking capital otherwise trapped in delayed receivables.

Complementing this is the Account Aggregator (AA) framework, a breakthrough in data integration. By aggregating digital records such as GST filings, the AA system allows lenders to evaluate an MSME’s creditworthiness with far greater precision, making it easier for businesses without traditional records to secure loans.

Yet, for all this progress, many of these interventions remain front-loaded. They are geared towards early-stage enterprises while overlooking the evolving capital requirements that surface as MSMEs grow and diversify.

States like Uttar Pradesh, Jharkhand, and Manipur, for instance, have introduced interest subsidies on term loans and working capital. However, these subsidy schemes often come with minimum turnover requirements that inadvertently exclude micro-enterprises, the very segment most in need of concessional credit.

To be truly effective, policy design must shift toward lifecycle financing: support that accompanies MSMEs from inception to maturity.

Another area ripe for reform lies in expanding the financing toolkit beyond traditional bank credit. States like Haryana, Gujarat, Odisha, and Himachal Pradesh have incentivised SME listings on stock exchanges such as the BSE SME platform and NSE EMERGE.

To bridge this divide, state-level policymakers could explore alternative instruments. Cash-flow-based lending, equity infusion, factoring, leasing arrangements, and venture capital mechanisms tailored to the MSME context.

The Big Gap

Walk into any small business in a Tier-2 town—be it a kirana store, a tailoring unit, or a local agri-tools workshop—and chances are you’ll find an owner juggling numbers in a worn notebook. They know the cost of every screw or sack of rice. But ask about their credit score, or the interest rate on their last loan, and the answers get vaguer.

This isn’t about a lack of ambition. It’s about a lack of access—to financial know-how as much as capital. For all the talk of inclusive finance, we’ve skipped a step: we’ve built the highways of credit without giving many people a driving lesson.

That missing piece? Financial literacy.

It’s easy to underestimate how fundamental this is. Without a basic understanding of credit, risk, and repayment, MSMEs often struggle to make use of even the schemes and digital tools available to them. A loan, after all, is only empowering if you know how to use it.

We need to stop treating financial education like a luxury and start embedding it into the system. This could mean smartphone-friendly learning apps in regional languages. Or even partnerships where banks and fintech firms step out of their glass offices and into the streets.

Credit discipline is another overlooked skill. Picking the right loan product, borrowing within limits, and building a repayment history—these are habits that can open doors to better rates, larger capital, and real growth.

Ultimately, if India is to truly democratize credit access for its 60+ million MSMEs, it must look beyond numerical targets and technological fixes. Fortunately, a few promising green shoots are already showing what this future could look like.