MSME loan underwriting: common errors in unsecured cases

Who the direction covers

The direction applies to Scheduled Commercial Banks, excluding Regional Rural Banks (RRBs). Every regulatory statement in this piece is limited to those banks. If you work at an RRB or an NBFC, check the rules that apply to your institution instead.

Checklist: financial appraisal errors

• Treating bank credits as sales. Remove transfers between the applicant’s own accounts, loan proceeds, owner infusions and reversals. Good looks like adjusted credits that reconcile to the GST returns and financials, with any gap explained in writing.
• Reading only the account submitted. Ask for statements on every operating account. Good looks like each account named in the financials or visible in transfers having been seen.
• Taking reported profit as repayable cash. Remove one-off gains and account for proprietor drawings and partner payouts. Good looks like a visible bridge from reported profit to cash available for debt service.
• Mixing business and household flows. Proprietors often run both through one account. Good looks like a note saying which flows you treated as business and why.
• Missing debt outside the entity. Pull bureau reports on the entity and its promoters, then scan statements for EMI debits and credits from lenders. Good looks like every obligation listed with where you found it.
• Overlooking loan stacking. Stacking means taking several loans from different lenders in a short period. Good looks like recent loans and enquiries being explained, and their repayments included in debt service.
• Averaging away seasonality. An annual average can hide months when inflows do not cover the EMI. Good looks like repayment tested against lean-month inflows.
• Ignoring the working capital cycle. Profit stuck in receivables or stock cannot pay an EMI. Good looks like debtor, creditor and inventory days calculated, with overdue debtors called out.
• Accepting concentration without comment. Good looks like the share of the largest buyers and any related-party sales stated in the note.
• Underwriting to projections. Good looks like repayment capacity built on actuals, plus a stated downside on lower sales and margin.
• Matching the wrong product to the need. A term loan that plugs a working capital gap can strain cash flow. Good looks like a tenor that follows the use of funds.
• Treating guarantee cover as repayment capacity. The direction says banks may use Credit Guarantee Scheme cover where applicable. Good looks like a case that stands on cash flow before any cover is considered.

Checklist: regulatory errors

These are the size criteria under Gazette Notification S.O. 1364 (E) dated March 21, 2025, as set out in the direction.

These amounts are easy to confuse, so keep them apart.

• Testing only one size criterion. The criteria use investment and turnover together. Good looks like both figures checked against the table.
• Tagging priority sector from your own calculation. For priority sector lending (PSL), banks are guided by the classification in the Udyam Registration Certificate. Good looks like a tag that matches the certificate, with any mismatch against the financials flagged.
• Missing the Udyam Assist route. A certificate from the Udyam Assist Portal issued to an Informal Micro Enterprise is treated at par with the Udyam certificate for PSL benefits, and the unit is treated as micro for PSL classification. Good looks like the certificate being accepted for that purpose.
• Treating traders as MSMEs for every purpose. Retail and wholesale trade are included for the limited purpose of PSL. Good looks like the note not stretching that treatment further.
• Asking for collateral below the limit. The mandate also comes with advice to extend collateral-free loans up to ₹20 lakh to all units financed under the Prime Minister Employment Generation Programme (PMEGP). Good looks like size and scheme being checked before any security is discussed.
• Reading the gold exception too widely. Gold and silver pledged voluntarily by the borrower, up to the collateral-free limit, is not treated as a violation. Good looks like the pledge being voluntary and limited to those metals.
• Letting a small case drift. Good looks like the file being tracked against the 14 working day limit, in the bank’s credit proposal tracking system or equivalent.
• Sending a vague rejection. Banks must give the main reason or reasons in writing, within Board-approved sanction time norms. Good looks like a reason specific to the case.
• Asking for documents piecemeal. Banks must give an indicative document checklist at the time of application. Good looks like queries tied to that checklist, plus anything the specific case needs.
• Assuming the limit is fixed for life. Bank lending policies must provide for standby credit on term loans, additional working capital for emergent needs, and mid-term review of regular working capital limits for viable MSE borrowers. Good looks like the structure leaving room for these.
• Leaving monitoring out of the note. The Framework asks banks or creditors to identify incipient stress through three Special Mention Account (SMA) sub-categories before an account turns into a Non-Performing Asset (NPA). Good looks like the note naming the early signals specific to this borrower.

Worked example, made-up numbers

A fictional proprietorship asks for an unsecured term loan of ₹18 lakh, at 18% over 36 months, so an EMI of about ₹65,000. Its investment in equipment is ₹40 lakh.

Turnover first. Bank credits are ₹3.60 crore. Remove own-account transfers of ₹0.45 crore, owner infusion of ₹0.10 crore and loan proceeds of ₹0.15 crore, and ₹2.90 crore remains. GST returns show ₹2.85 crore, so a small gap is left to explain.

Then debt service coverage (DSCR), which is cash available for debt service divided by annual principal and interest due. The bureau shows a personal loan in the proprietor’s name that is not in the books, with an EMI of ₹30,000.

The adjustments move the case from covered to not covered. No single line did that alone.

The regulatory checks then narrow the options. Investment of ₹40 lakh and turnover of ₹2.90 crore both sit inside the micro limits, and the PSL tag should follow the Udyam certificate. At ₹18 lakh, the bank cannot accept collateral security to close the gap, apart from voluntarily pledged gold or silver.

That leaves a smaller amount, a different structure, or a decline. The credit decision is due within 14 working days, and a decline goes out in writing with the main reasons.