Why MSME Bank is a Bad Idea: Better Banking over More Banks

The idea of launching an MSME-focused bank in India has gained traction as policymakers and industry leaders search for solutions to address the persistent credit gap for nano, micro, small, and medium enterprises (MSMEs). However, I feel this proposal has many challenges that outweigh its potential benefits. Instead of creating a new entity, we must strengthen existing schemes, and financial institutions like NBFCs, Microfinance Institutions, Business Correspondents, Small Finance Banks (SFBs), and Universal Banks to empower MSMEs. Let me explain why a dedicated MSME bank is not the right path, supported by historical data, institutional examples, and industry dynamics.

Niche Banking: A History of Evolved Intentions

1. Big Bank’s Evolution A big private sector bank began as a Housing Development company focused on providing housing finance in a market-starved sector. Over the decades, it transformed into a universal bank, expanding into retail, corporate lending, and even personal finance. Its journey shows how niche banks eventually broaden their focus to grow and remain viable.
2. Mahila Bank Launched in 2013 to address women’s financial needs, the Bharatiya Mahila Bank struggled to mobilize funds and achieve scale. In 2017, it was merged with the State Bank of India (SBI). The Mahila Bank story shows how niche banks often face challenges in mobilizing deposits and establishing a sustainable customer base.
3. Payment Banks and Small Finance Banks While a few Payment Banks aimed to drive financial inclusion, they faced regulatory restrictions that limited profitability. Similarly, SFBs, although relatively successful, are constrained by high compliance costs and struggle with operational scalability, making them less competitive than universal banks. Payment banks started giving loans, insurance, travel bookings etc, through NBFC and other bank tie-ups, similarly SFBs target corporate funds, and high net worth for fund mobilisation and cross-subsidising to fulfil their license mandates.
4. Specialized Institutions Exist India already has robust institutions like SIDBI and other similar institutions, which are designed to address niche financing needs. These institutions are better positioned to collaborate with existing banks to improve credit access for MSMEs rather than creating a new bank with overlapping objectives. The Reserve Bank of India (RBI) has designated MSMEs as a priority sector and directed banks to allocate 40 per cent of the Adjusted Net Bank Credit (ANBC) to priority sectors, including MSMEs.

The above points indicate that even if MSME bank/s get created, they will evolve sooner into something else, leaving us in the same position, with new ideas and interventions.

Challenges that I see

1. Limited Fund Mobilization Niche banks often struggle to attract deposits. MSME-focused banks would face the same hurdle, as MSME customers are primarily borrowers, not depositors. Without a broad deposit base, the cost of funds remains high, affecting lending rates and viability. If it’s the same case why not incentivise or integrate more NBFCs or existing structures, what additional a new institution will be able to achieve that the existing ones are not able to with available resources, technology, digital public infrastructures and years of on-ground and policy understanding.
2. Cannibalisation of Existing Bank and Other Financial Institutions’ Business Establishing an MSME-focused bank could cannibalise the MSME portfolios of existing banks and NBFCs. As a result, these institutions may deprioritize MSMEs, potentially reducing competition and credit flow in the sector.
3. Low Financial Viability Historically, MSMEs have high credit risks and low margins. A standalone bank targeting such a risky segment may struggle to maintain profitability. This is evident in the operational difficulties faced by smaller banks like Regional Rural Banks (RRBs). Punjab State Industrial Development Corporation (PSIDC) and Punjab Finance Corporation (PFC), are experiencing funds crunch and have stopped credit flow. PSIDC gathered liabilities worth Rs 4700 crore, therefore, has not given any fresh loans to any company for the last 16 years. (1).
4. Regulatory Complexity A new bank would require significant regulatory oversight and compliance mechanisms. Given the challenges already faced by India’s financial regulators, adding another specialized bank would only increase administrative burdens.

A better approach: Empower Existing Institutions

Instead of creating an MSME-focused bank, I suggest we should empower existing financial institutions:

1. Enhancing NBFC and SFB Capabilities NBFCs and SFBs already have the local reach and expertise to serve MSMEs. They can be supported with lower capital costs, refinancing options, and technology upgrades to improve credit flow. Leverage SHG, JLG, and NGO’s network more effectively.
2. Leveraging SIDBI and NABARD Institutions like SIDBI and NABARD are already specialized in promoting MSMEs and rural enterprises. By strengthening their partnerships with universal banks and creating better MSME-targeted credit schemes, they can improve outcomes without duplicating efforts.
3. Digital Public Infrastructure (DPI) Initiatives like the Open Credit Enablement Network (OCEN) and Account Aggregator Framework are already revolutionizing MSME financing. These digital innovations can scale credit delivery faster and more effectively than setting up a new bank. Use, ULI, UPI, ONDC and many others.
4. Encouraging Collaboration Universal banks already have significant MSME portfolios. Incentivizing them to expand lending to this sector through tax benefits, partial credit guarantees, or blended finance can ensure a more robust MSME credit ecosystem.
5. Better-suited products as per their needs, cash flow and industry will help MSMEs. However, that will require an alternate method of product design and not workarounds like industry benchmarking and copying of the features from each other. This approach will always have an average of what already exists and has largely not worked in the MSME’s favour. Read here my detailed Digital MSME Yatra 2024 Article.
6. Differentiated products based on industry, cash flow and seasonalities will make them more comfortable as the MSME industry is too wide and diverse, a one-size-fits-all all/most will not help.
7. The government has introduced various initiatives and schemes to enhance financing for Micro, Small, and Medium Enterprises (MSMEs), such as the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE), Pradhan Mantri Mudra Yojana (PMMY), and Stand-Up India. While these measures are praiseworthy, it is crucial to ensure widespread awareness and efficient implementation of these schemes to maximize their reach and impact. Moreover, the private sector also has a significant role to play in advancing MSME financing.
8. We need more Venture Capitalists and Angel Investors for micro-investment in Micro businesses till such companies become structured and can raise funds. How about institutions like National Small Industries Corporation Ltd. and others playing a bigger role?

Globally too, niche banks often fail to remain focused. For instance, community banks in the U.S. expanded their portfolios over time due to sustainability concerns. Specialized MSME-focused banks in countries like Bangladesh and Pakistan faced liquidity and operational challenges, limiting their long-term impact.

MSMEs need Better Banking and not More Banks.

We already have enough, Collaborate and Integrate.

India doesn’t need another specialized bank to solve the MSME credit problem. What we need are systemic reforms to improve credit delivery and strengthen existing financial institutions. By empowering NBFCs, SFBs, and other touch points and universal banks and leveraging digital public infrastructure, we can address the credit needs of MSMEs more sustainably. Let us focus on better banking for MSMEs, not more banks.

As we’ve seen with HDFC, Mahila Bank, and payment banks, specialized institutions often evolve into something broader or fade into irrelevance. Instead, let’s build on what we already have to ensure a more inclusive, viable, and scalable financial ecosystem for MSMEs in India.

References:
https://www.dailypioneer.com/2024/columnists/dedicated-bank-for-msmes-to-boost-credit-access.html
Digital MSME Yatra – 2024 , supported by the CeDISI NGO. (Centre for Digital Inclusion and Social Impact)

Disclaimer: The opinions expressed here are those of the author and do not reflect the views of FrankBanker.com