IFPRI-ICAAP project to provide global agricultural advisory services to small and marginal farmers

- By Senthil Kumar Govindararaja, Project Coordinator, IFPRI

International Food Policy Research institute (IFPRI), Washington DC and ICAAP (IKP Centre for Advancement in Agricultural practice) joined together to establish global agricultural knowledge facility through information and communication technology (ICT) in India. The project aims to establish an interactive internet-based platform for facilitating knowledge and experience sharing between the various agri-stakeholders (including men and women farmers, extension agents, agricultural scientists, agro-industries, agri-financing institutions, policymakers and planners).

To kick-start the project, being piloted in Thanjavur and Thiruvarur districts, we visited the locations to understand existing agricultural extension systems in the region, needs and demands of stakeholders in accessing scientific information through various channels. To explore the probable entry points to pilot IFPRI – ICAAP knowledge portal in the locality, we interacted with knowledge intermediaries like extension professionals, KVK (Farm science centre), agricultural research station, civil society organizations, KGFS, farmers associations and small and marginal farming community.

Agriculture scenario at Thanjavur and Thiruvarur districts

Rice and Rice fallow pulses i.e. black gram and green gram and oilseeds i.e. Gingelly, groundnut (Rainfed crop) are the dominant crops in Thanjavur and Thiruvarur districts. Most of the farmers depend on Cauvery water to meet their farming activities. In some of the areas, progressive farmers grow sugarcane and banana by using bore-well water as annual crop.

Recently, the stagnation in growth of rice productivity was noticed in the two districts, caused by various factors like imbalance in fertilizer application, labour scarcity etc. Similarly, even pulses cultivation faces various impediments not least of which would be the lack of scientific methods of production.

Small and marginal farmers are looking at alternate solutions like diversified agriculture, vegetable cultivation and allied activities for livelihood to improve their standard of living.

Few developments at Thanjavur and Thiruvarur districts by various stakeholders

State and central ministries (Agriculture) have launched various schemes to empower farmers in order to realize the profitability in farming. Recently, they launched ATMA (Agricultural Technology Management Agency) in 591 districts in the country, including in Thanjavur and Thiruvarur districts. The agency, a decentralized model where farmers’ issues will be surfaced during meetings and ways to address them would be carved out, aims to integrate all the line departments, research community, farmers association, self-help group and farmers. Additionally, extension professionals organize tours for farmers to visit some of the successful models like organic farming, precision farming etc (Seeing is believing).

Also MSSRF has initiated village resource centre and village knowledge centre that helps rural communities to access information through ICT. They have also launched a mobile van, which travels across different villages to provide farming solutions by way of soil and water testing. In addition, Agricultural research stations i.e. Tamil Nadu Rice Research Station, Soil and Water Management Research Station and Coconut Research station and KVK (Farmers science centre) are trying to bridge gaps between research scientists and farmers.

Discussion at Villamangudi village with agricultural laborers who availed financial services at KGFS

A very unique model for delivery of financial services in rural areas is KGFS. Being at the grassroots level and in touch with the small and marginal farmers, its branches provide a platform for potentially disseminating agricultural scientific knowledge to the local farming community.

Stakeholders Need Assessment

Farmers

• The reality of the rural economy in the districts is one where farmers need not just technology, but information on prices, consumer preferences, markets and trade. They need access to credit and other agricultural market oriented scientific information.
• Their information needs change quickly and requires rapid responses and solutions. Information needs to be complemented by links to markets and other players in the local and global value chains.
• For the poorest households, they don’t necessarily need agricultural development support, but, rather, support for diversified livelihoods in the new rural economy.

Knowledge intermediaries

• Extension agents and subject matter specialist in an ideal world would resemble knowledge brokers. They need to articulate the demand of farmers for knowledge, facilitate linkages between stakeholders with ideas and resources and manage the knowledge process.
• Extension workers lack ability to handhold the stakeholders who are involved in the crop value chain and lack relationship skills with the farming community.

IFPRI-ICAAP will join with above local stakeholders to implement the project and bring the innovative and sustainable model to provide comprehensive advisory services to the small and marginal farmers and link them with the market for profit realization.

—
Senthil can be reached at: s.govindarajan [at] cgiar.org

Supply chain intervention and access to finance

- Bindu Ananth, President IFMR Trust

What is the link between supply chain interventions and access to finance?

The Rural Tourism Network Enterprise (RTNE) has received a lot of attention from the press recently for its work in connecting rural homestays to budget travellers. This is a good time to recap the original hypothesis of RTNE and the link to IFMR’s mission (to ensure that every individual and every enterprise has complete access to financial services).

Several small businesses in rural India, (a rural homestay being a classic example), face tremendous volatility in revenues due to an uncertain market. It is no wonder then that they have enormous constraints accessing debt – lenders dislike volatility and seek predictability of cash flows. There are two ways to go about addressing this:

1. Infuse more equity into each small business so that their ability to withstand revenue shocks and leverage debt increases, or,

2. Minimise the root cause of revenue volatility itself.

We believe that Option 1 is not scaleable given the size of many of these businesses. We have taken the broad direction of Option 2. A company like RTNE reduces the revenue uncertainty to tens of thousands of rural homestays by providing an information and accreditation facility to potential travellers. This provides a steady base of travellers to qualified properties. In this manner, the revenue certainty and ability to leverage debt goes up for every single rural homestay accredited by RTNE.

We believe that this is a promising approach to improve access to debt for small businesses that have market uncertainty.

What do you think?

(Read the RTNE story in Financial Times here and Business Standard here.)

The Fundamental Premise of Securitisation: The Microfinance Case Study

-By Vineet Sukumar, IFMR Capital

In a recent post, Daniel Rozas and Vinod Kothari have argued that microfinance securitisation does not, in reality, separate ‘pool risk’ from ‘originator risk’ and hence should not be rated very differently from the originator of the portfolio.

Some of the arguments are well reasoned out such as the lack of control over co-mingling of cashflows and lack of regulatory supervision on ‘bilateral assignments’. However, some of the other arguments presented beg greater scrutiny.

Microfinance securitisation has really taken off in the last one-and-a-half years. Prior to that, MFIs, like other financial institutions, sold assets on a bilateral basis to a banks, which were largely incentivized by regulatory benefits. Bilateral assignments still constitute a majority of off-balance sheet transactions. Such deals are opaque, largely unrated and mostly occur in the last quarter of the financial year.Such bilateral deals do not constitute ‘securitisation’. Securitisation is a market-driven transaction, priced against comparable rated benchmarks, tracked by independent agencies and transparent in nature. As such, to tar bilateral deals and market-linked securitisation transactions with the same brush is to do injustice to the tightly structured microfinance securitisation market that has recently developed.

Let us focus on the fundamental question that the authors have raised about microfinance securitisations in this context.

How can assets be rated better than the originator?

The premise of any securitisation is that the underlying assets can be ring-fenced from the originator – cash flows from such assets are pooled into a secure account controlled by a trustee. Further, it is possible to select high quality assets, originated in less risky geographies from borrowers who have historically had good credit history. Third, the assets are not exposed to servicing risk precipitated by a bankruptcy event.

The rationale for a securitisation of assets to have a better rating than that of the originator is that the assets being securitised are of higher credit quality than that of the originator’s own credit quality (which comprises its entire balance sheet).

Vinod Kothari describes securitisation aptly as “the process of de-construction of an entity. If one envisages an entity’s assets as being composed of claims to various cash flows, the process of securitisation would split apart these cash flows into different buckets, classify them, and sell these classified parts to different investors as per their needs. Thus, securitisation breaks the entity into various sub-sets.” Further, he describes receivables securitisation as a way to “originate an instrument which hinges on the quality of the underlying asset. As the issuer is essentially marketing claims on others, the quality of his own commitment becomes irrelevant if the claim on the debtors of the issuer is either market-acceptable or is duly secured. Hence, it allows the issuer to make his own credit-rating insignificant or less-significant, and the intrinsic quality of the asset more critical.”

The arguments in the afore-mentioned article against superior rating of the asset pool are twofold:

(a) Collections are manual, hence co-mingling risk is high and effectively removes ring-fencing (in fact the authors have gone so far as to say that MFIs may pay the investor the scheduled amount regardless of the actual collection) and

(b) if the servicer fails, there is no alternate mechanism to collect from the end-borrowers.

However, in the microfinance securitisation transactions, several structural mitigants have been built in to counter servicer risk.

First, it is mandatory for the MFI to pay the trustee of the SPV on a weekly basis. Hence, the co-mingling risk is reduced to a week’s cash flows. This risk is accounted for while taking into account the rating of the transaction (Please refer to the rating rationales available on IFMR Capital’s Deal Portal)

Second, the MFI maintains a first loss cash collateral from the onset of the transaction. It is difficult to understand why an MFI would make scheduled payments to the trustee despite receiving lower collections (and hence ‘mask’ the true pool performance), while at the same time maintaining a cash collateral – a double whammy! Would it not make better financial sense to let the cash collateral be debited at the end of the transaction?

Third, it is mandatory for MFIs to provide a detailed MIS on collections to the trustee with every payment. The Arranger and the trustee play a key role in in terms of diligence of the MIS. This reduces the risk of fraud.

Fourth, one of the key benefits of the structure is to mitigate the risk of systemic default. The structure provides diversification across branches, geographies, loan types such that the risk of an external shock is minimal. Such diversification can be achieved across multiple originators, where the underlying diversity in a single originator is not sufficient.

Fifth and most important, IFMR Capital’s monitoring and surveillance setup is a critical early warning signal system that has been set up to counter this risk. The monitoring team consists of microfinance professionals with deep experience on the field and strong networks across the sector. The team holds both close relationships with the top management and has indepth knowledge of field operations through these visits. It diagnoses weaknesses in the MFI’s operations and/or systems and provides inputs on corrective measures to the MFI. This continued involvement and diligence by the Arranger post transaction settlement differentiates microfinance securitisation as it is today from securitisation of other asset classes.

In rating microfinance asset backed securitisations, CRISIL has indeed been conservative in its assumptions, due to the limited track record of microfinance securitisations in capital markets. On a more careful analysis of the securitisation structure, the authors of the “Hidden Risks” article should note that the underlying pool of micro-loans securitised, despite their low default rates, have not been assigned a higher rating than that of the originator. After a detailed analysis of default rates of the underlying micro-loan pool, its volatility, the sustainability of the originator and commingling risk, the rating agency arrives at an assessment of base case default rates and the amount of additional credit protection required to achieve the ratings of the senior and junior tranches of securities. The authors’ contention that the rating agency in question “apparently does not understand” the underlying sector and the assets is spurious as CRISIL has assessed more than 140 MFIs over the past eight years and has in fact developed a separate methodology for this sector. CRISIL does not only rate microfinance securitisations, they also provide risk assessments, ratings on bank facilities and debentures. This is accompanied by the arranger, IFMR Capital’s due diligence, monitoring and supervision processes of each MFI that is a potential candidate for securitisation. This is the crux of what goes behind the “P1+ or AAA” rating!

The rating agencies’ approach has been consistent across other retail asset classes such as personal loans, commercial vehicle loans, car loans and small business loans. For instance, Tata Motors executed more than Rs. 2000 crores of rated securitisations in the year 2009. The senior tranches were assigned a AAA rating, while Tata Motors’ senior secured loan rating is at A+. While there is capital markets supervision of retail assets by investors and rating agencies, there is no back up servicer in place for any of these retail loans.  What is important in the securitisation of any retail asset is the risk assessment of sustainability of the originator over the life of the underlying asset, a detailed analysis of the underlying pool and a robust monitoring and surveillance system that can monitor triggers that may indicate increasing servicer risk.

So how have the  ‘AAA’s’ performed till date?

IFMR Capital has structured, arranged and co- invested in six rated microfinance securitisations comprising a total financing amount of Rs 195 crore

While this is a drop in the ocean in the context of the entire banking and finance sector, this is important as it signifies a way for high quality microfinance institutions to access debt capital markets, in a framework that builds in tight supervision, and rewards better access at better pricing to those microfinance institutions that are underwriting loans well.

Micro-loan securitisations have shown remarkably strong performance with 0.6% defaults in the underlying pool till date. Four of twelve tranches of securities have been upgraded. However, to maintain this performance, IFMR Capital recognizes that “event risk” and systemic risk such as the originator’s or the arranger’s incentives not being aligned must be carefully considered and incorporated in the design today itself.

The author quotes the example of a political risk event in Krishna district, in which MFIs suffer significant losses in their micro-loan portfolios. However, the largest lenders to MFIs operating in Krishna, have four years later, entirely recovered their dues from this district. This is a promising indicator that recoveries are possible, and that setting up an independent backup servicer that monitors & supervises performance and “steps in” in the worst case, is a probable future reality.

To mitigate systemic risk, the off balance sheet micro-loan securitisations are structured in a manner that the incentives of all the participants are aligned to those of the investors. Securitisation structures “pre- global financial crisis”, by and large did not have sufficient incentives for the originator or the arranger to underwrite and monitor well post sale, this is one of the important lessons we have learnt from this crisis.

Incentivizing the Originator: The MFI or the Originator has to ‘originate wisely’ and ‘collect well’. The investor carries the risk of being sold the riskier assets in the MFI’s portfolio as well as having to depend on the MFI to collect from assets that no longer belong to the MFI.

This risk is mitigated by the MFI retaining the first loss portion of the risk under the pool in the form of cash collateral or an irrevocable bank guarantee. The size of the cash collateral depends primarily on the following factors  – historical default rates and their volatility, the extent of co-mingling of cash, an assessment of the originator’s sustainability,and prepayment rates.

The first loss default guarantees in the securitisation transactions till date have been in the range of 10-14% of the transaction size, while the observed default rates on the pools have been less than 0.6%.

The Reserve Bank of India has mandated that the first loss default guarantee is deducted from the Tier I and Tier II capital of the originator. Thus, this provides a powerful incentive for the MFI to ensure that there is no slip-up in its efforts to collect from the underlying pool.

Incentivizing the Arranger: An important risk that is not mentioned in the quoted article is mis-selling. This is even more pertinent for microfinance where there are very few listed organizations, very little public information and very little understanding of how microfinance actually works.

The Arranger in a capital market transaction is best placed to understand the originator and has the responsibility of effectively communicating its strengths and weaknesses to target investors. However, arrangers in debt capital market transactions usually have little involvement with the transaction once the placement is concluded.

However, in each of the microfinance securitisation transactions highlighted above, the Arranger (IFMR Capital) is also an investor in the subordinated tranche of the issuance. The Arranger thus takes the risk of having a junior claim on the asset cash flows. This is a strong incentive for the Arranger to conduct due diligence, monitoring and supervision properly.

IFMR Capital also takes on the responsibility of detailed credit surveillance of the Originator. This is in the form of quarterly visits that cover not only field operations in multiple geographies, but detailed financial analysis and operations review as well. These monitoring and surveillance visits highlight early warning signals well ahead of any potential stress event. Documentation signed with the MFI gives substantial powers to the Arranger to step in and conduct such discretionary audits.

Microfinance securitisation is an important alternative for financing that has opened up to MFIs in India. This permits smaller MFIs to reduce their dependence on a single source of financing, access the capital markets and avail of transparent, market-linked financing, as opposed to opaque, bilateral transactions. These transactions compel the MFI to adhere to the rigor of financial markets, share data, increase external oversight and improve internal systems and processes to meet capital market standards.

Risks in microfinance securitisation are recognised, have been sufficiently highlighted by both the rating agency and the Arranger, are similar to any other asset class securitisation in India and investors are compensated for the risks in the returns on such investments. Perhaps we should devote our energies on strengthening the mitigants instead.

Professor T. N. Srinivasan on the importance of integrating finance, management and development

Considered alone, development, finance and management is each a vast field, albeit with substantial overlaps among them.  Let me illustrate the overlap by means of an example which has relevance from a historical and contemporary perspective, namely, the central role of finance and management in development.

At the early stages of economic development, agriculture and related activities employ almost all the resources and provide work and livelihood for the entire population.  Even today the dominance of agriculture in India and South Asia is evident. The dominant asset and non-labour factor of production, historically for millennia until the emergence of large scale manufacturing and industry, was land.  Agriculture, broadly defined to include animal husbandry, with land and labour as primary inputs was the production activity around which all other services, trade, arts and petty manufacturing were organized at early stages of development, if not always. Economy was the idealized self-sufficient village community or small areas reachable with the relatively primitive transport and communications technologies.

Two features of agriculture illustrate the significance of finance, credit and management in development. First, the inputs and their allocation—of land across various crops and of labour across land preparation, irrigation and application of fertilizers prior to sowing—must be committed at the beginning of the crop cycle.  Farmer has very limited flexibility to adjust the allocations during the crop cycle in response to weather and demand shocks. Other inputs such as fertilizer, labour for irrigation and weeding, etc., can be adjusted to realised shocks. Second, while most inputs are committed during the crop cycle, the output being subject to additional weather shocks is not known until the harvest is processed and securely stored. Further, the value of the output depends on post-harvest spot prices. Since at best only the joint probability distribution of shocks, prices, etc., and not their actual realisations can be known, the environment of agricultural production is highly uncertain.

The uncertainty and risk of committing land and other inputs in advance of realization of value generates demand for credit to finance the inputs and to sustain the farmer’s consumption during the crop cycle. The length of this cycle varies from a few months for seasonal crops to a year or more for annual and tree crops. Moreover in areas where there is ample rainfall or assured irrigation more than one crop can be raised on the same plot of land. This allows the possibility that the loss of crop in one season could be offset by a bountiful crop in the next. Indeed, in parts of India where Kharif crops could be lost because of floods, the retained moisture and silt from floods could enable more extensive cultivation and higher yields of crops in the following Rabi season. Thus the agricultural risk—ex ante and realized—could could change from year to year due to natural disasters of floods and droughts.

Historically, in addition to credit, risk taking, and risk sharing arrangements have evolved, first in agriculture and then elsewhere as development proceeded, eventually to a specialized and complex financial sector. On the supply side, only those who had enough accumulated resources, social and legal instruments for collecting the principal and interest, and a capacity and taste to bear the default risk, could extend credit.  It is no surprise that only landlords with large landholdings and traders in agricultural inputs and outputs had the capacity, desire and ability in adequate combinations to become large players in providing credit. And the demand for credit arose not only for financing the crop cycle but also for covering households in general for variations in cash flows subject to health shocks, demographic events (e.g. births and deaths), social and religious expenditures (marriages, funerals) whose timing and costs are uncertain. Credit is necessary for household consumption smoothing, i.e., to shield their consumption stream from large variations in their income stream.  The virtual absence of means of insurance against various risks across families or communities meant that credit was a joint mechanism for inter-temporal resource allocation through borrowing and lending as well as means of insurance against risks. Serving two related but different objectives through the single instrument of credit forced inevitable compromises in the service of each. In other words, a single instrument will almost never achieve two objectives as well as two instruments—one for each objective—could.

Various forms of tenancy developed early on such as share-cropping, fixed produce rent, fixed cash rent to provide a range of arrangements for risk-sharing, each with its own risk and expected return patterns for the landlord and tenant.  The attractiveness of each arrangement to individual landlords and potential tenants depended in large part on the sources of risk and covariations (in physical yields per hectare, in spot price per unit of output at harvest, cost and capacity to store harvested output to gain flexibility in the time of its sale, and so on) and the capacity to bear risk and risk preferences.  The fact that a landlord (or trader) is often a provider of credit to his/her tenant meant that the landlord and tenant have a bilateral relation with respect to land and credit (whose supplier is the landlord and the tenant is the demander), and labour (whose supplier is the tenant and demander is the landlord). Such simultaneity of bilateral relations across three markets (land, labour and credit) might confer more market power on one of the two parties (usually the landlord or trader) relative to independent pairing in the three markets.

In the case of a trader (who is the supplier of credit, agricultural inputs and marketing service for output) and his agriculturist (who is demander of credit and inputs and supplier of outputs) the situation is analogous. In addition to making a portfolio choice of allocating her land among crops, the cultivator also decides on inputs (e.g., when and how much fertilizer to use), allocates her and her family’s labour between self-employment on her land and supplying it to others, and chooses when and how much to sell her harvests of different crops net of her family consumption, etc. Responsibility for making these decisions makes her a manager of resources. Thus finance and management have been core functions in agriculture at all stages of development, increasing in complexity and specialization as development proceeded.

The post Second World War literature on development was devoted to the analysis of the efficiency and distributional implications of alternative credit, insurance, marketing and other arrangements. While these arrangements may have originated in the historical past in what were then called “underdeveloped” countries, they remain present, if not endemic, in contemporary developing countries.  The sophistication of the tools of analysis increased in step with their development in economic theory and econometrics.

It is no accident that historically the interest rate on finance or credit has been the target of attention of religious, literary and secular analysts. Apart from the Islamic prohibition of the charging of interest on loans, fulminations against “usurious” interest rates and characterization of money lenders as heartless “usurers” with no compassion for adverse shocks experienced by borrowers are ubiquitous in almost all religions.

A very early attempt to regulate interest rates is seen in Kautilya’s Arthasastra (commonly dated as a work of 4th century BCE). Kautilya’s sophisticated understanding of the link between interest rate and risk (regulated interest rate steeply rising from a ‘risk free’ 1.5% per month as the transactions financed become riskier and riskier and of legal aspects of liabilities for repayment) in loan transactions in Arthasastra is nothing short of remarkable, leaving aside the privileges to Brahmins and higher castes in rewards and punishments. Appendix I contains an extract from Arthasastra on interest rate regulations. In fact the sophisticated understanding of Kautilya of many aspects of economics and finance including the role of the state (i.e., the King) for provision of irrigation through construction of dams, standardization, weights and measures, preparation of budgets and audits with a clear understanding of income and expenditures, the possibility of corruption by public servants and incentive aspects of payment of adequate salaries for them, import and export taxes, etc., is truly amazing. Appendix II contains brief excerpts from R.P. Kangle’s (1972) translation that include, (i) Pages 90-98 on accounts, audit and definitions of revenues and expenditures, (ii) Pages 98-103 on administrative corruption, (iii) Pages 145-148 on Trade, (iv) pages 162-165 on Customs duties and tolls and (v) finally pages 350-351 on salaries of civil servants.

It is widely believed that the state described by Kautilya is a police state or at least a high centralized state. While there is some evidence in support of such a view, Kangle provides a much more nuanced view that it was a bureaucratic welfare state. Kautilya lists at least twenty departments! Indeed, one can claim that India has been a bureaucratic state for millennia, whether under Mauryas whom Kautilya helped to gain power, Mughals, the British or since independence, though the efficiency of the bureaucracy is another matter altogether. Appendix III contains Kangle’s analysis of Kautilya’s conception of the state.

More than a year ago, I was requested to chair a sub-committee of the Academic Affairs Committee for reviewing the MBA programme of the IFMR Business School and coming up with a vision for its future.  The Committee presented the Board with its future vision of the IFMR Business School and a proposal to offer a single integrated, rather than three, Post Graduate Diplomas in management which would be, if not unique, at least have few parallels in the world in its integration of development, finance and management.  The Committee’s vision had its academic rationale in the overlap among the disciplines of Finance, Management and Development. This note explains this rationale and illustrates this with the example of a major sector, Agriculture, in which risk taking, credit, finance and management are central.  The note also explains the comparative advantage of IFMR Business School in offering an integrated MBA with its proven record of excellent research on finance and development and location in a currently very dynamic developing and emerging market country, India.

–

Professor T.N. Srinivasan is Samuel C. Park Jr. Professor of Economics, Yale University and Member, IFMR Business School Board.

RBI Draft Guidelines on Securitisation: Balancing growth and stability

-By Sucharita Mukherjee

Securitisation of assets by NBFCs came under regulatory purview with draft guidelines being put on the RBI website on June 3rd. With more than 80% of the microfinance market being with NBFC MFIs, this has a strong effect on the microfinance securitisation market. Securitisation has recently come up as a way for small but high quality microfinance institutions (“MFIs”) to tap debt capital markets. Microfinance loans are unique in their nature due to characteristics such as a short one year term, group based credit risk exposure, periodic weekly repayments and very low default rates. The minimum holding period of nine months, as specified in the Draft Securitisation Guidelines, closes the nascent microfinance securitisation market, important not only for the growth of the microfinance sector in a way that reduces systemic risk, but in my view, also for the overall financial inclusion agenda of the country.

There are only three ways in which an MFI can fund itself:

(a) Accepting Deposits;
(b) Bank loans; and
(c) Capital markets.

Accepting deposits as a source of fund is quite rightly not available to MFIs and banks have a strong preference for larger MFIs who are able to absorb large amounts of funding quickly.  Banks either lend directly to them or purchase portfolios from them. MFIs (both large and small) represent an essential component of the financial inclusion strategy for us in India and today, they serve more than 20 million clients with over Rs. 17,000 crores of loans  However, as it stands, the microfinance sector is highly concentrated, with the top ten MFIs comprising about 75% of the market.    As the market expands if growth is restricted only to these ten MFIs, it could present significant servicer concentration risks.   In my view small but high quality MFIs are also needed to better serve our diverse populations as well as to address servicer concentration risk concerns.  For these smaller MFIs, securitisation represents a very important additional source of capital markets funding, which has been taken away with these new guidelines.

While promoting sound asset quality through capital markets oversight and the involvement of intermediaries such as CRISIL and IFMR Capital, securitisation has also enabled reduction in the cost of financing to  MFIs by over 200 basis points and more than one MFI has in turn reduced interest rates to their own clients. The Draft Securitisation Guidelines take an important step forward in ensuring orderly risk transfer from high quality local financial institutions and MFIs to large well-capitalised institutions such as banks and mutual funds, in the capital markets. The minimum retention requirement (MRR) of 5% in the first loss portion, as prescribed in the current draft, ensures that originators retain strong incentives for good due diligence as well as ongoing collection and monitoring. In fact, the microfinance securitisation transactions have seen MRR in the range of 10%. This is much higher than the historical default rate observed in the pools and is substantially higher than the 5% MRR prescribed under the new Draft Securitisation Guidelines.

However, I want to suggest that the minimum holding period (MHP) for one year microfinance loans with periodic weekly instalments (since a majority of microfinance loans are 50 weeks in maturity with weekly repayments) could be specified as the period pertaining to

(a) repayment of 9 instalments or
(b) repayment of 20% of the principal amount of the loan – whichever is larger.

The minimum holding period will then be linked to the tenor, as well as the frequency of repayments of the underlying micro-loans in the same way that the Guidelines make a distinction between bullet repayment loans and amortising loans.  Also, a further suggestion would be to bring direct bilateral portfolio assignments under the purview of the Draft Securitisation Guidelines, else, off-balance sheet direct assignment transactions may continue in an unregulated, perhaps under-capitalised fashion.

The size of the microfinance sector is currently small (circa Rs. 17,000 crores) when compared to the combined banking and mainstream NBFC industry. There is much scope for outreach as currently, vast regions and populations of the country are uncovered. To achieve the dual goals of financial inclusion and the design of a stable and efficient financial system for the microfinance sector, the growth and development of high quality small MFIs is a must and deserving of careful regulation.

–

[The author is the CEO of IFMR Capital Finance Private Limited]

Unearthing the real issues in microfinance: Quality

Sucharita Mukherjee and Kirthi Rao talk about the importance of quality of underwriting standards in microfinance institutions. This is the first in a series of articles by the authors on the topic “Unearthing the real issues in microfinance”.

Recently, the media coverage on the evolution of microfinance has taken on a worried tone about the future of the sector. Forthcoming IPOs from large Indian microfinance institutions (MFIs) after a period of ‘runaway’ growth fuelled by the ‘irrational exuberance’ of private equity and the declining asset quality in some countries such as Nicaragua and Pakistan seems to have raised grave concerns. Also pointed out are political risk, lack of regulation and the nascent level of self-regulation in the industry with the inference that a tightening of standards will bring about a meltdown. IFMR Capital, with its deep understanding and involvement in the sector, has reason to believe that these worries are misplaced.

Indeed, the microfinance sector has grown tremendously (portfolio outstanding of Indian MFIs grew at 102% between 2008 and 2009), this can be attributed to two reasons: the strength of the underlying “Grameen” model of uncollateralised lending, and the vast unmet demand for credit within low income households in India.

Vast unmet demand

A variety of public policy measures such as the promotion of cooperative banks, regional rural banks and local area banks, bank nationalisation, loan waivers, recapitalisation of failing cooperative banks and regulation directing lending to priority sectors by commercial banks, have been aimed at providing access to finance more broadly in India. However, financial inclusion still remains a distant dream. This is illustrated by the fact that only 2.9% of the lowest income quartile has a loan from a formal institution. As per the CRISIL Top 50 MFIs report, India still represents the largest microfinance market, with only about 10% of the demand being met by existing MFIs. CRISIL’s report estimates the figure for credit demand by low income households at least INR 1.2 trillion, a small fraction of which is the current size of the microfinance sector.

Multiple asset evaluation criteria

The “Grameen” model is a pioneering development, in that it enables “good” selection of borrowers by leveraging on rich information possessed by the members of the group that cross guarantees each other. Most microfinance institutions (MFIs) in India today follow the “Grameen” model. The strength of the “Grameen” model has been amply demonstrated by strong equity investor appetite, bank funding and very low defaults despite no subsidies. This model, with a standard structure of lending to joint liability groups has the twin features of being both strong and replicable. Rapid growth is possible, provided MFIs follow the operational framework of this model with rigour. This implies that these MFIs must not only have robust financials, but also invest in a strong second line of management, training of field staff and a system to track and monitor the performance of their loan portfolio. These are some of the factors that debt investors consider when evaluating MFI asset quality. These criteria have been synthesised into Underwriting Standards, by CRISIL and IFMR Capital. The performance of MFIs can be tracked not only by rating agencies but also is publicly available on the IFMR Capital Deal Portal. While political risk in this asset class can certainly not be ruled out, the performance of MFIs till date has been driven by how well each MFI follows the Underwriting Standards.

The CRISIL report states “MFI asset quality indicated by their portfolio at risk (PAR) greater than 30 days, is healthier than those of other financial service players in India. MFIs have maintained relatively healthy asset quality mainly because of strong group pressure and efficient collection mechanisms, which have ensured high repayment rates. The asset quality is expected to remain superior to asset classes such as vehicle loans, credit card receivables and small ticket personal loans.”

Strong underwriting standards is the key

Concerns about an impending collapse a la the US sub-prime crisis in the media seem to emanate largely from opinion rather than fact. The sub-prime crisis was characterised by poor underwriting standards, lack of incentives for mortgage finance companies to originate high quality portfolios as most loans originated were sold down immediately, and overly aggressive rating models assuming very low loss rates, correlations and an unstated assumption of “house prices cannot fall”! The microfinance sector has demonstrated default rates under 2% for more than five years, is financed largely by on-balance sheet loans, and MFIs retain a strong incentive for good due diligence and follow up as they hold first loss equity positions in rated off balance sheet securitisations that are several multiples of their historical default rates. What we must learn from the sub-prime crisis is the importance of monitoring the quality of underwriting standards of originators, and the need to invest in systems that have such monitoring and supervision capability such that credit flows most reliably and at the best price to the MFIs that are less risky, as measured by their quality of underwriting. The microfinance sector can then deliver on financial inclusion built on a solid, sustainable platform of high quality underwriting and supervision.

The media, we believe, would do well to focus on criteria that truly drive asset quality, such as quality of systems, group loan origination processes, cash management, second line of management and governance practices of MFIs.  These institutions are clearly critical for equitable growth in our country, and in order to strengthen them, we need a debate focusing on the real questions raised here.

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[Sucharita Mukherjee is the CEO and Kirthi Rao is a team member of IFMR Capital Finance Private Limited.]

Do Consumer Price Subsidies Really Improve Nutrition?

The National Bureau of Economic Research recently published a working paper by Robert T. Jensen and Nolan H. Miller on this topic. The paper analyses data from a randomised program of large price subsidies for poor households in two provinces of China and finds no evidence that the subsidies improved nutrition. In fact, it may have had a negative impact for some households.

The findings have sparked a discussion on subsidies and its long-term effects.

Cash transfer may work

Dr Nachiket Mor says “…I read this article through and perhaps did not fully understand all its implications. It seems to conclude that people as they get richer make somewhat adverse Taste-Nutrition tradeoffs but it is not clear from the article what can really be done about that.  This is similar to the male-preference issue – it seems to grow with income and since only the rich can afford to get (illegal) sex determination tests done you see the richer districts in the country with much more adverse sex ratios.  Perhaps there is a “J” curve after which people start to make better decisions.  But I worry that perhaps the “J” curve transmission is through a much higher quality of education than is currently on offer in our schools at the moment.”

“There is of course a more micro question as well buried here – do conditional cash transfers add any value relative to unconditional cash transfers?  I am not sure what the research evidence suggests but with the arrival of the UID it is possible that we may be able to finally do targeting (and disbursement) much more accurately and without leakage. Therefore we may be able to dismantle a lot of government programmes and simply hand over the money to poor people to do as they will with it.  Mega schemes such as the Mid-day meal scheme of the government seem to have questionable (if any) benefits and we may all be better off if they were simply dismantled and cash handed over to poor people.”

Invest in Infrastructure

Professor Nilanjan Banik of IFMR adds his views “In terms of agricultural produce there are three main issues: growth of agricultural output, food security and importantly, to make sure that the agricultural produce reach the target group i.e., a proper food management policy.”

“What data suggests is [that] agricultural output in India is very volatile with a coefficient of variation (mean over standard deviation) close to 190. Given this high volatility one also finds capital investment as a portion of GDP is least in the agriculture sector relative to the industry and services sector. In fact, growth of agricultural sector has struggled to keep with the long run target growth of 4 percent, assuming that the economy is growing at 9 percent.”

“Despite this, India has been successful in terms of providing food security by stashing food grains in the government storehouse. Government has been successful in procuring because of higher procurement price of cereals. By doing this, government is however discouraging farmer to go for higher value addition crops like fruits and nuts, and also to venture into milk, poultry and fishery types activities.”

“The other point, and this to me is the big failure of the government, is its inability to distribute these procured items to the target group. I remember seeing some news item carried by CNN-IBN showing how these procured items decay in government storehouses. Also, I think, Mint carried one news item commenting about the fallacy of the public distribution system with most people in Tamil Nadu qualifying as a BPL member.”

“In fact, thinking forward, government will do some justice by reducing subsidies relating to fertilizers, irrigation and power. Instead it will make sense to invest this saved amount in agriculture related infrastructure, like building more irrigation facilities, developing cold storage facilities, better road network etc. A proper irrigation facility will also be beneficial in terms of checking the fall in ground water level because of increase usage of hand pumps.”

“To me in the present context these issues are more important although the change in food type consumption because of government providing subsidy is an interesting read.”

Interventions affect individual choices and behaviour

Niranjan Rajadhyaksha, managing editor of Mint thought this paper was important because, according to him, the government seems to be moving towards a right to food law. He says “The Chinese example cited in the paper may offer a sobering lesson. More broadly, I think that the main debates about the NREGA and the right to food have focussed on broadly macro issues such as how to fund them without creating an unsustainable fiscal deficit.”

“My own view is that the more interesting challenges are of the micro sort, in the sense that these interventions affect individual choices and behaviour. We have, for example, seen that NREGS is creating labour shortages in areas such as Punjab and Haryana as migrant labour prefers to stay at home and subsequent reports that farmers in those states are leaning towards more mechanisation. These are second-order effects. In other words, the analysis may have to go beyond partial equilibrium in one market to a general equilibrium approach that encompasses potential distortions/effects in other markets.”

Dr. Nachiket Mor responded by saying “The Centre for Microfinance has done some good research on NREGA but I think the point you make about labour shortages bears further research – I have heard many people say this.  Are you aware of any debate regarding conditional versus unconditional cash transfers?  I wonder what the longer term implications of moving to unconditional cash transfers might be?  Unless you feel that transfers themselves are not advisable in any form.”

“My own instinct is that unconditional cash transfers combined with concerted efforts at creating high quality public institutions (law and order, land titling, etc.) and basic infrastructure such as health, education and financial access represents a much more sustainable direction for us.  The worry about cash transfers is regarding the labour-leisure tradeoff that it implies – I understand that there is a concern that perhaps one is seeing a much stronger movement towards leisure than was previously anticipated, given the absolute level of poverty.”

“One of the academics at IFMR, Professor Maheswaran believes (this is my interpretation of his arguments, he may not agree) that this maybe because the poor do not have “Markovian Renewal” and “suffer” from “long-memory” (this is also consistent with the more recent work of Professors Abhijit Banerjee and Sendhil Mullainathan).  Perhaps the work on financial inclusion (which includes risk management instruments such as open credit lines, savings and insurance) will help build “Markovian Renewal” and maybe change the labour-leisure tradeoff (Professors Ratul Lahkar and Vishwanath Pingali at IFMR I think are planning to research this question of why the poor don’t save as much further).  It seems too extreme to say that, in the face of extreme poverty, we should not have any transfers at all.”

What do you think?

Pens n’ Parrys

Legend would have it that ‘a pen is mightier that sword’ and for good reason. But if you were to go by a recent study by the Small Enterprise and Finance Centre (SEFC) at IFMR, the tiny pen can tell you a thing or two about the preferences of the guy who bought and sold that pen. Intrigued? Read on.

The spotlight on marquee multinationals and big brands aside, small and medium enterprises are at the heart of the nation’s economy. It can be a complex endeavor to understand the multitude factors that interplay when it comes to the way they approach their business – key amongst which would be ethnicity, thanks to the vast diversity that exists across the nation.

Dwelling deep, does ethnicity influence the choices that small business owners make when it comes approaching business decisions and strategies employed towards trade? There have been no systematic studies that have been able to document its holding good; precisely an outcome that SEFC set out to close on. The research set out to test whether indeed there are important differences in trading strategies and business practices across small business owners that come from different ethnic backgrounds.

For this purpose SEFC, after careful deliberation and keeping in mind a few factors, identified the wholesale pen industry for its research. Parrys, a locality in North Chennai, with a name sounding similar to an exotic foreign capital was chosen for research. For a visitor, Parrys can be anything but its similar sounding cousin: Chaotic, dusty, crowded and fast-paced, yet the locality has a rhythm of its own. Sandya Kumar, senior researcher on the study calls it “a wonderland for researchers and one of the best places to study small enterprises in Chennai”.

SEFC adopted an audit-study approach to the research, simulating a transaction in real-time, for which it identified a total of 47 entrepreneurs from 3 different communities – Marwaris, Tamilians and Andhrites. These entrepreneurs (called auditors) after extensive training and under strict supervision were asked to hit the wholesale market with a tailor-made script to follow. They visited 107 shops owned by mixed ethnicities and placed orders for pens – both customized and non-customized. The investigation lasted for a year and the research findings conclude that ethnicity of the parties involved did play an important role in determining the features of the business transaction.

In-depth findings of the study can be viewed in the presentation below:

What’s your opinion?

Role of Moneylenders in relaxing credit constraints

From Shylock to the neighborhood pawn-broker, money lenders have always been reviled for exploitative practices and prices in lending to the poor. However, for those of us in the business, we know that moneylenders are very often an important source of liquidity – price notwithstanding.

Let’s understand the “value proposition” of the moneylender in some more detail:

Flexibility in collateral and contract type: For a household with low-income and irregular cash flows, financial services should be flexible and convenient. Unfortunately, this is not the case with most formal financial institutions. In such a scenario, the money lenders provide loans that match these criteria, enabling access to credit for the urban and rural poor.

They function in close physical proximity to the borrower, enabling frequent contact and thus minimizing the need for traditional collateral. Collateral accepted includes agricultural land, jewelry, food grains and other moveable and immoveable assets providing the clients a wide range to choose from. Screening of clients by the moneylenders is highly subjective and based on personal relationships. The loans provided are usually short-term finance, ideal to meet consumption mismatches frequently experienced by the poor.

Timeliness: The instantaneous appraisal of the loan request and any-time availability of loan (since moneylenders keep cash at home) provides convenience to the clients in accessing the credit. Most importantly, money lenders are not fussy about the purpose of the loan (which can be even used for consumption purpose or to repay another loan) as long as they repay it.

Flexibility in repayment: Moneylenders not only offer doorstep repayment collection service but also accept various modes of repayment. In-kind repayment modes like providing goods (farm produce or other goods) and services (labor) are very common.

With all these advantages, what is the hue and cry about moneylenders? The major criticism against them is that they charge exorbitant interest rates from the poor, ranging from 70% per annum (Aleem, I 1990, Swaminathan, M.1991) and 10% per day for daily working capital. So with such a high interest rate and little operating expenses, you would think that money lending is an extremely profitable activity?

However the paper written by Antoinette Schoar of MIT and Rohit Mukkawar of IFMR compels us to understand this business from a money lender’s perspective. The paper sheds light on the internal dynamics and economic constraints of the money lending business. It is interesting to observe from the paper that the greatest constraint for the moneylender in expanding his business is – moneylender himself. The absence of delegation of decision-making to his employees in terms of selection of clients and the time involved in screening of clients (which is based on personal relationships and recommendation) prevents them from exploiting economies of scale in the business. Since lending decisions are based on personal relationship and knowledge about the borrowers, the area of operation for the moneylender gets restricted to a small geography – less borrowers to choose from and lend to! The cost of capital for the moneylenders is also high as they largely depend on their own funds. This, in addition to the prevalence of high default rates among the clients’ forces them to be choosy and limits their ability to expand.

In such a scenario, with clearly a gap in credit supply, newer money lenders see an opportunity and step in to plug the gap. However as the Schoar and Mukkawar paper suggests that difficulty in managing the portfolios by new moneylenders who are inexperienced as regards the intricacies of the business, forces many of them to leave the market. Hence in a world, where financial access relies on relationship and building track record with your lender, even good clients can be barred from credit after the moneylenders drop out.

The fact that the high interest rates are not just because of the monopolistic rent but due to many other factors like – high transaction cost, limited geographical scope for expansion of business, expensive screening of borrowers and cash collection from doorstep – should perhaps explain why most moneylenders are still small time business person and not the millionaires you might expect them to be!

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C.A Farzana Najeeb and Rohit Mukkawar contributed to this post.

Chit Fund Research – The way forward

By Preethi Rao

After the successful completion of the first phase of our Chit Fund Research, Small Enterprise Finance Centre (SEFC) is entering into the second phase that involves 3 year long, rigorous, on-the-ground experiments. Our findings from the study titled “Chit Funds as an innovative access to finance for low income households” point to the fact that though Chit Funds are an important source of finance for small businesses and low-income households in India, there has been a general exodus of low value chit schemes from the registered Chit Fund market. This is mainly because registered Chit Funds find it less lucrative to serve the poor due to the increased cost of operating such schemes imposed by the regulators.

We find that the Chit Fund industry addresses the savings needs of people, is considered very safe and also offers loans at lower interest rates than moneylenders. In order that these benefits reach the poor, we propose to test different schemes for the poor in collaboration with Chit Fund companies across India and understand how Chit Funds can be developed as an innovative access to finance for low-income households.  In particular we propose to test the following:-

1.    Impact of setting up registered Chit Funds in rural areas – Majority of the poor people in India live in the rural areas. Under this pilot project, we propose to collaborate with volunteering chit companies to start a registered chit scheme in one village in each of the four states – Tamil Nadu, Andhra Pradesh, Karnataka and Delhi. We will document the costs of registration and implementation of the schemes as well as the defaults and repayment behavior of the rural chit members. We will compare the costs and member behavior to that of an urban scheme with similar characteristics to understand what are the costs and benefits to chit companies to do business in rural areas and thus serve the poor in these areas.

2.    Impact of altering collateral/guarantee requirements – Most of the poor people in India are unable to provide collateral or guarantee for the loans they require as they do not have access to any property of significant value nor are they able to provide guarantees from trusted people (like government employees). Under this pilot project, we propose to work with volunteering chit companies to start low value chit schemes where the members are asked to provide nil or lower collateral or guarantee than in a usual scheme. We will study the defaults and repayment behavior in the schemes to understand the impact of lowering collateral and guarantee requirements.

3.    Developing a credit scoring model for Chit Funds – Given the long history of chit funds in India, the information that each chit company will have on its members will be humongous. Under this pilot project, we propose to look at the data available with the chit companies, put the data in an analyzable format and finally build prediction models using the data that would help Chit Funds to foresee the repayment behavior of the members.

In order to explain the nuances of the research projects and to gain cooperation from the participants we have conducted in-depth meetings and discussions with chit fund companies in Tamil Nadu and Karnataka and we propose to conduct similar meetings in the other two states i.e. Andhra Pradesh and Delhi. So far, the participating chit fund companies have expressed interest in the proposed projects and are very enthusiastic to take it forward.

To learn more about how chit fund is an innovative access to finance for low-income households, write to preethi.rao [at] ifmr.ac.in or sharon.buteau [at] ifmr.ac.in or leave a comment below. We would love to hear what you have to say.

Preethi Rao is a senior research associate with the Small Enterprise Finance Centre at IFMR Research.