Why MSMEs Struggle for Formal Finance and What Banks Look For

By Eram Shaikh --
Wednesday, 01 Oct, 2025

India has over 64 million MSMEs but estimates show that only 14–20% of these enterprises access formal credit. The estimated credit gap stands at ₹20–25 lakh crore, highlighting a massive unmet demand for institutional finance across the sector. Key barriers include the lack of formalisation, inadequate collateral, limited credit histories, and poor financial literacy.

Most MSMEs operate informally without Udyam registration or comprehensive financial records, making it difficult for lenders to appraise their creditworthiness. Collateral remains a major bottleneck, as many MSMEs cannot pledge adequate unencumbered assets, particularly for loans beyond ₹10 lakh where collateral-free schemes do not apply. Additionally, many MSMEs are located in rural or semi-urban areas with limited banking penetration and awareness about government credit schemes.

The documentation and procedural requirements of banks are often complex and time-consuming. Many entrepreneurs lack the support systems and skill sets to prepare viable business plans and financial statements, further reducing their chances of loan approval.

What Banks Look For When Lending to MSMEs

Banks have become more cautious and structured in their lending practices, focusing on risk mitigation and compliance with regulatory priorities. Their lending criteria for MSMEs typically include:

Business registration with valid Udyam certificates and adherence to KYC norms.
A satisfactory credit history and good CIBIL scores; MSMEs new to credit face greater hurdles.
Collateral security for loans exceeding ₹10 lakh, although collateral-free loans under credit guarantee schemes have expanded recently.
Credible business viability supported by financial statements, cash flow projections, and operational metrics.
Compliance with relevant government policies and environmental regulations.

Data and Trends in MSME Credit

Despite challenges, MSME lending has shown encouraging growth. By March 2025, commercial credit exposure to MSMEs crossed ₹35–40 lakh crore, growing annually by 13–20%. MSME loans comprise about 17.7% of total bank lending, reaching ₹14.3 lakh crore outstanding.

Micro enterprises constitute 81% of active MSME loans but only 40% of total outstanding credit, highlighting the prevalence of small-ticket loans. Notably, about 47% of new loans in early 2025 were to ‘new-to-credit’ MSMEs, reflecting gradual financial inclusion.

Asset quality is improving, with the delinquency rate at a low 1.8% overall, though smaller loans below ₹10 lakh record higher rates around 5.8%. Public sector banks dominate micro lending, while private banks and NBFCs cater more to larger MSMEs. NBFCs’ assets under management for MSME loans are projected to exceed ₹5.3 lakh crore by FY26.

Bridging the Credit Gap

Bridging the gap calls for enhancing MSME formalisation, improving financial literacy, and simplifying access to credit products. Digital tools can aid MSMEs in maintaining transparent records and applying for loans efficiently. Expansion and better utilisation of credit guarantee schemes like CGTMSE, which covered loans worth ₹5.2 lakh crore by May 2025, are critical to reducing collateral constraints.

Continued reforms and proactive outreach by financial institutions, combined with government support, are essential to extend formal finance to more MSMEs. Doing so would unlock the sector’s potential, driving job creation, innovation, and export growth for India’s economy.

Why MSMEs Struggle for Formal Finance and What Banks Look For. <p>India has over 64 million MSMEs but estimates show that only 14–20% of these enterprises access formal credit. The estimated credit gap stands at ₹20–25 lakh crore, highlighting a massive unmet demand for institutional finance across the sector. Key barriers include the lack of formalisation, inadequate collateral, limited credit histories, and poor financial literacy.</p>

<p>Most MSMEs operate informally without Udyam registration or comprehensive financial records, making it difficult for lenders to appraise their creditworthiness. Collateral remains a major bottleneck, as many MSMEs cannot pledge adequate unencumbered assets, particularly for loans beyond ₹10 lakh where collateral-free schemes do not apply. Additionally, many MSMEs are located in rural or semi-urban areas with limited banking penetration and awareness about government credit schemes.</p>

<p>The documentation and procedural requirements of banks are often complex and time-consuming. Many entrepreneurs lack the support systems and skill sets to prepare viable business plans and financial statements, further reducing their chances of loan approval.</p>

<h2><strong>What Banks Look For When Lending to MSMEs</strong></h2>

<p>Banks have become more cautious and structured in their lending practices, focusing on risk mitigation and compliance with regulatory priorities. Their lending criteria for MSMEs typically include:</p>

<ul>
 <li>Business registration with valid Udyam certificates and adherence to KYC norms.</li>
 <li>A satisfactory credit history and good CIBIL scores; MSMEs new to credit face greater hurdles.</li>
 <li>Collateral security for loans exceeding ₹10 lakh, although collateral-free loans under credit guarantee schemes have expanded recently.</li>
 <li>Credible business viability supported by financial statements, cash flow projections, and operational metrics.</li>
 <li>Compliance with relevant government policies and environmental regulations.</li>
</ul>

<h2><strong>Data and Trends in MSME Credit</strong></h2>

<p>Despite challenges, MSME lending has shown encouraging growth. By March 2025, commercial credit exposure to MSMEs crossed ₹35–40 lakh crore, growing annually by 13–20%. MSME loans comprise about 17.7% of total bank lending, reaching ₹14.3 lakh crore outstanding.</p>

<p>Micro enterprises constitute 81% of active MSME loans but only 40% of total outstanding credit, highlighting the prevalence of small-ticket loans. Notably, about 47% of new loans in early 2025 were to ‘new-to-credit’ MSMEs, reflecting gradual financial inclusion.</p>

<p>Asset quality is improving, with the delinquency rate at a low 1.8% overall, though smaller loans below ₹10 lakh record higher rates around 5.8%. Public sector banks dominate micro lending, while private banks and NBFCs cater more to larger MSMEs. NBFCs’ assets under management for MSME loans are projected to exceed ₹5.3 lakh crore by FY26.</p>

<h2><strong>Bridging the Credit Gap</strong></h2>

<p>Bridging the gap calls for enhancing MSME formalisation, improving financial literacy, and simplifying access to credit products. Digital tools can aid MSMEs in maintaining transparent records and applying for loans efficiently. Expansion and better utilisation of credit guarantee schemes like CGTMSE, which covered loans worth ₹5.2 lakh crore by May 2025, are critical to reducing collateral constraints.</p>

<p>Continued reforms and proactive outreach by financial institutions, combined with government support, are essential to extend formal finance to more MSMEs. Doing so would unlock the sector’s potential, driving job creation, innovation, and export growth for India’s economy.</p>