Understanding Cluster-Based Lending Approaches for MSME Finance

The Government has designed policies and taken steps to encourage financial institutions to provide adequate and timely credit to MSME finance to facilitate their development.

Reports suggest 27.4 million MSME loans were sanctioned during the financial year 2024, amounting to Rs 54.2 trillion, a growth of 19.3 per cent in volume and 5.4 per cent in value.

Despite all the growth in MSME financing, some gaps remain—including a massive $240 billion credit shortfall, limited formal financial reach to only 16% of MSMEs, and a heavy reliance on informal funding sources.

Government support is driving FIs to implement different approaches to satisfy the growing demand for MSME lending. One such strategy is cluster-based financing.

An Overview of Cluster-based Approach to MSME Finance

Under cluster-based lending, financial institutions take a full-service approach to satisfy the various demands of the assigned MSME cluster. It includes lending money to groups of MSMEs that are in the same area or connected by a common value chain and making goods or providing services that are similar or complementary.

By meeting the needs of all of these businesses, this approach aims to make them more productive and competitive. Here are the key aspects:

1. Geographical Concentration

Financial institutions offer finance to MSMEs in nearby clusters; they can assess risks more efficiently and provide targeted support.

Examples include MSME finance to weavers for raw material procurement, skill development, and more Varanasi and financial support for engineering component manufacturers in Coimbatore.

2. Sectoral Specialisation

In general, MSMEs in a cluster fit or serve the same industry, which simplifies evaluating their needs for MSME funding.

Lenders in India sometimes create cluster finance plans for sectors such as textiles, leather goods, engineering components, or agro-processing.

3. Government Support

Government projects such as the Micro and Small Enterprises Cluster Development Program (MSE-CDP) help cluster development by infrastructure development funds inside clusters.

4. Support from SIDBI

By means of financial aid and supporting cluster development projects, the Small Industries Development Bank of India (SIDBI) has been quite helpful in promoting cluster financing.

What are the Benefits of MSME Finance?

Lenders providing MSME finance in clusters strengthen the entire ecosystem. The benefits extend beyond lenders and borrowers; the economy as a whole improves, and so do employment opportunities.

Let’s look at a few benefits MSME finance offers:

1. Access to Credit Improves

Lenders are more inclined to sanction loans to MSMEs operating in clusters as they pose lower credit risk and have improved business viability.

FIs can also customise products to meet specific requirements of MSME within the cluster and offer subsidised loans. All these aspects improve and simplify credit access for businesses.

2. Transaction Costs are Lower

Serving various businesses with a geographic location helps the lender minimise expenses incurred on credit assessment and loan processing and monitoring. FIs can minimise their transaction costs when they offer MSME finance in the following ways:

Lenders can evaluate the entire industry and the businesses within the cluster collectively using similar parameters.
Standardised loan assessment criteria help reduce the time and cost required to evaluate each loan request.
Monitoring loans after disbursement and tracking the borrower’s financial health becomes more efficient in a cluster compared to when they are diverse and scattered.
FIs can also streamline collections and repayment through a centralised system for the cluster.

3. Better Risk Management

A structured, data-driven approach customised to the specific industry helps improve risk management for lenders. Here are a few ways MSME finance in a cluster aids FIs in reducing their risks:

Clusters usually form around a particular industry; lenders can develop expertise in assessing the specific domain.
Evaluating the industry based on performance data, market conditions, and trends yields a more accurate result than evaluating individual enterprises.
Assessing the credit health of small businesses poses challenges that cluster financing can help overcome.
Strong business associations or cooperatives, often part of a cluster, help ensure that MSMEs make timely and consistent loan repayments, further minimising risks for lenders.
Governments and various organisations often support cluster financing through varied schemes, such as subvention lending, subsidies, loan guarantees, and more, thereby reducing default risk.

4. Credit at Favourable Terms for MSMEs

MSMEs within a cluster can get loans from FIs at better terms. Their collective bargaining power helps them to get loans at preferential rates from lenders owing to lower costs and risk.

MSME finance helps create a positive cycle where the collective power helps businesses get loans at better terms. This community setup helps FIs improve their operations and reach, making them more willing to pass the benefits to borrowers.

MSMEs also gain from the customised products that lender may offer them in their cluster due to assured credit demand.

5. Facilitates Financial Inclusion

Traditionally, lenders require collateral and evaluate credit history to sanction a loan, making it difficult for small businesses to get loans.

Cluster lending encourages financial inclusion by ensuring the often excluded entrepreneurs are also able to access credit, without compromising profitability or business viability for lenders.

MSME finance in clusters also promotes gender-inclusive financing as FIs design and offer loan schemes for women entrepreneurs in clusters.

To Sum It Up

Cluster-based MSME finance creates synergy and benefits all stakeholders. Additionally, it contributes to economic development and aids job creation.

Lenders can use modern technology and AI-driven automated solutions to streamline their loan processing and ensure MSMEs access credit with ease.

As a fintech tool to simplify the lending lifecycle, Finezza offers end-to-end solutions for lenders:

Loan Management System allows for efficient loan management and supports multiple loan types and flexible repayment frequencies, perfect for meeting MSME finance requirements.
The industry-leading Credit Bureau Data Analytics tool simplifies risk assessment through custom data analytics based on reliable credit data sources and verifying GSTIN and ITR data.