Micro, Small, and Medium Enterprises (MSMEs) are the backbone of the Indian economy. However, they struggle to meet their working capital requirements since they do not meet the traditional banking system's lending criteria. Due to small ticket size, lack of credit history, and lower credit rating, they are compelled to resort to high-cost financing by private lenders. Factoring or Supply Chain Finance is an excellent means to overcome this issue.

Factoring is a financial transaction between three parties to facilitate liquidity requirements. In this process, a supplier sells its account receivables (invoices) to a third party (lender/factor) at a discount to avail immediate cash in hand. The buyer gets short-term credit by extending its payment terms, and the lender earns on the bargain given to the supplier. This agreement is a win-win situation for all three entities.

The Factoring Regulation Act and its evolution

The government introduced the Factoring Regulation Act 2011 to establish a cohesive legal framework that governs all factoring transactions. The aim was to facilitate access to cost-efficient working capital cash flows.

The Factoring Regulation Bill 2020, a revised amendment to the previous act, allowed banks and NBFCs to provide factoring services. The new law aimed to improve credit availability to MSMEs and improve transparency and financial inclusion in the country.

RBI further eased the lending criteria in the latest update in Jan 2022. The regulatory body has permitted all existing non-deposit-taking NBFC-Investment and Credit Companies (NBFC-ICCs) with asset size of Rs 1,000 Crore and above to undertake factoring business subject to the satisfaction of certain conditions.

What makes this apt timing for the move

The new announcement is a welcome move because businesses have incurred huge losses since the knee-jerk economic collapse due to the pandemic. In such times, MSMEs require additional liquidity support to revive and bring their operating cycles back on track.

The amendment widens the scope for companies that can undertake factoring business. The number of NBFCs eligible significantly increases from 7 to 182, and other NBFC-ICCs can also register as NBFC-Factor to enter the segment. This will help NBFCs diversify their revenue base and meet the increased demand for supply chain financing from various sectors.

The challenges faced by NBFCs

NBFCs have reacted positively to the new development. However, they are concerned about the challenges of receiving timely approvals from RBI since NBFCs have to apply for an additional certificate to enter this space. This process might prove to be cumbersome since RBI has laid down certain conditions and reserved the rights for approval. Also, NBFCs who do not have an asset size over Rs 1,000 crore have additional requirements; this limits their scope of expansion in SCF space.

Regarding the trade receivables financed through a Trade Receivables Discounting System (TReDS), RBI stated in its press release that the particulars of assignment of receivables should be filed with the Central Registry on behalf of the Factors by the TReDS concerned within ten days.

With the rise in SCF lending volumes, TReDS platforms need to have a robust infrastructure and seamless processes to meet this deadline.

The integration of supply chain finance ecosystem

Supply Chain Finance (SCF) is at a nascent stage in India and contributes only 2 percent of global factoring volumes, around $3.4 trillion. SCF platforms play a significant role in promoting and integrating the entire ecosystem. They provide cost and time-efficient digital solutions to overcome the hassle of onboarding, transaction processing, managing legal documentation, account treatment, registration charges, etc.

Since MSMEs usually have low credit scores or no credit history in many instances, SCF platforms provide technological intervention like blockchain and Artificial Intelligence (AI)-backed risk assessment to lenders. They can leverage alternate data such as GST data, details of the e-invoice, account aggregators, etc. This provides insights into borrowers’ creditworthiness and business growth.

Conclusion

NBFCs form a significant part of our shadow banking system and play a crucial role in penetrating financial services to various parts of the country. Their integration with SCF platforms will benefit millions of MSMEs and help create awareness about this short-term cost-efficient fundraising channel to lower their liquidity crunch.

The Central Bank has been supportive by introducing the amendments to the Factoring Regulation Act in a phased manner. This will boost financial inclusion and provide an equal level playing field to MSMEs.

Article is authored by Shantanu Bairagi, Co-Founder & COO, Artfine Advisory LLP. Views expressed are personal.