Olympia A. De Castro from IFMR Capital gave us an insight on the correspondent banking model in Brazil that led to some interesting comparison debates with the Indian model. We bring you some highlights of the discussion:
The Growth
According to the Central Bank of Brazil, Correspondent Banking (CB) is “a measure aimed at extending services to bank clients in areas where that bank did not have a branch”. Introduced in the 1970s, the correspondent banking channel has risen in relevance, especially after 1999 when regulatory changes broadened the range of services that could be offered by correspondent banking agents.
As the fifth largest country in the world with a population of 201 million, Brazil has correspondents covering 62 percent of the total number of points of service of the financial system. All of the 5,564 municipalities in Brazil are now reached by the channel, with 25% of the municipalities being served only by correspondents. Between 2000 and 2008, the correspondent banking system grew 85.5 percent while bank branches grew only 16.7 percent, clearly indicating the increasing presence of the channel.
Market Dynamics and Regulation – Aligned Incentives
The significant growth seen in correspondent banking industry in Brazil can be attributed to a unique market dynamic that created aligned incentives between the major stakeholders of the finance industry. In essence, the government, the central bank and the commercial banks were in different ways motivated to allow the correspondent banking model to flourish.
In 2003, Brazil’s newly elected Worker’s Party government needed an effective distribution channel to disburse its social welfare program, Bolsa Familia. The program at that point already reached 68 million benefits, equivalent to R$2.4billion. Transparent and efficient disbursement of this significant government cash transfer program was essential to its success. As of 2009, 1 in 4 households in Brazil receive a monthly G2P i.e. government to person payment. At the same time, the EIU Microscope Report released in 2008 to assess the environment for microfinance in Latin America ranked Brazil at a meagre 14 out of 20. In response to this, the Brazilian Central Bank (BCB) launched a financial inclusion program to improve financial access in the country. As a result, Brazil has seen an improvement of two points due to better regulatory capacity in the most recent 2009 Microscope report where it ranks 24 out of 55 (India was ranked 4).
Similarly commercial banks were in a position to benefit from exploring correspondent banking as a noteworthy business model. Given the years of hyperinflation in the early 90s, banks undertook technology improvements to allow for fast transaction processing. At the same time, banks became the predominant recipients for bill payments, as the public sought quick deposit and use of their rapidly depreciating currency. The resulting considerable increase in foot traffic to branches related to payment business became a strong driver for the need to find a cost effective alternative.
In turn, since the 1990s, regulation around correspondent banking has become more agreeable stimulating significant growth in the industry. From broadening the range of institutions allowed to hire agents, to widening the gamut of services and softening the restrictions over the location of agents, regulation around correspondent banking has been flexible enough to attract strong interest in it as a viable business alternative. Commercial banks are particularly keen on exploring this alternative as it allows for regional expansion and client reach with significantly lower costs. Unlike the rigid legislation of bank-branching, correspondent agents allows for lower security expenses, relatively lax liquidity management and lower labour costs given it does not fall under the domain of the strong branch unions.
Exploring the viability
Brazilian correspondent banks are authorized to offer a wide range of products and services. However, as noted below, bill payment continues to dominate the volume of transactions.
Types of transactions conducted by correspondents
The distribution of product range varies from entity to entity as there are several types of participants in the industry. The main players are the larger banks in the country, Banco do Brasil and Caixa Economica, both wholly-owned by the government, and Bradesco, a private sector bank that entered correspondent banking by partnering with the postal service, each benefiting from the model in different ways.
Bradesco’s Banco Postal seems to be the most profitable with profit per day of US$79 versus an average of 5.2 for the others. Profit margins are also relatively higher at 63% compared to an average of 10.6% for the other agents. Contracts between agent and bank tend to vary with revenue split, capital expenditure and operational expenses being negotiated on a case by case basis.
Banco Postal’s higher margins are arguably explained by its high negotiating power. In July 2009 it effectively increased prices by 60 percent. In addition, the relatively high volume of transactions also adds to its advantages.
Product offering and transaction volume tend to vary by geographic region. In urban areas, bill payments are even a larger share of the number of transactions representing as much as 88 percent of total transactions. Profitability attributed to this product relies on fast rotation of clients and high foot traffic. The below chart shows type of transaction by region:
Evidently, customers in different geographic regions have different needs. However, the dynamics have led to a general urban bias in the expansion of correspondent banking. A snapshot of Brazil’s demographics shows clear differences between the regions, with the South and Southeast region being wealthier and more populous, while the North and Northeast are poorer. Despite some slight improvement, agents tend to favour the wealthier regions of Brazil. Banco Postal especially favours the South and Southeast with roughly 43% of its client located in these regions as of 2004. On the other hand, Caixa, responsible for all Bolsa Familia withdrawal transactions, unsurprisingly shows greater presence in the North and Northeast with roughly 40% of its clients attributed to these regions.
The below chart shows the evolution of the geographic concentration of correspondent banks by region:
Risk Factors
The main risk factors for the industry lie in the fact that the Central Bank of Brazil has an unclear mandate under law to regulate outsourcing. Although the framework for the use of agents is based on the Central Bank’s regulations, its authority ends short of the correspondent agents. As a result Labour Law holds precedence over the Central Bank’s regulation when it comes to correspondent banking. The same applies to other regulatory entities such as the National Health Surveillance Agency which looks over pharmacies and drugstores. As a result, several issues currently threaten the industry, as they pose risks of unviably higher costs and significant disruption in the current agent channels. Specifically, these threats include legal actions from agent employees and branch-bank labour unions demanding higher pay for agents as well as challenges raised on whether pharmacies and drugstores should engage in correspondent banking; currently pharmacies and drugstores account for ~10% of total agents.
Challenges and lessons
When considering if complete financial access is being addressed via the correspondent banking model, it is evident that several challenges remain. First, although Brazil is proud to claim presence of an agent in every municipality, this is still not sufficient as the distance between an agent and a customer in the same municipality many times is too great. Secondly, service offering continues to be dominated by bill payments. Other services such as account opening remains relatively unsuccessful; although incentives have been created for an increase in new accounts a large number of these remain inactive. In addition, credit, a core factor for financial inclusion, remains at a standstill as the right model is yet to be determined. Finally, geographic coverage based on population needs remains limited with a significant urban bias perhaps driven by relatively more attractive profitability.
Conclusions
The corresponding banking system in Brazil has a lot that can be compared to the Indian model. Despite the differences in demographics, there are several points for discussion such as what makes for a conducive regulatory environment, the benefits of a proper credit agency, considerations for credit origination models, potential products and agents to be explored and the technological and training support necessary for an effective and viable correspondent model.
As India refines its agent model and explores the best alternatives to address its financial needs it is worth drawing from the experiences and lessons of its Brazilian counterpart, which although the explosive growth in coverage, remains tasked with a number of challenges.
Sources of data:
1) Gallagher, Terence, “Branchless Banking – Brazil Correspondent Banking Networks”,CGAP, June 2006
2) Kumar, Anjali; Ajai Nair, Adam Parsons, Eduardo Urdapilleta. “Expanding Bank Outreach through Retail Partnerships”, World Bank Working paper N. 85, (June 2006)
3) Branchless Banking and Consumer Protection in Brazil, CGAP, 2009
4) Branchless banking agents in Brazil – Building viable networks, CGAP, 2010
-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
| MFIs |
Type of Deal |
Size (Rs crore) |
Date |
| Equitas Microfinance |
Single-originator |
18 |
March 2009 |
| Equitas Microfinance |
Single-originator |
48 |
November 2009 |
| Sahayata, Satin, Asirvad, Sonata |
Multi-originator |
31 |
January 2010 |
| Grameen Financial Services |
Single-originator |
33 |
March 2010 |
| Sahayata, Satin, Asirvad |
Multi-originator |
34 |
May 2010 |
| Grameen Financial Services |
Single-originator |
31 |
June 2010 |
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.
-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]
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.
–
[Sucharita Mukherjee is the CEO and Kirthi Rao is a team member of IFMR Capital Finance Private Limited.]
Let’s talk Quality in Microfinance
There was an article published an Financial Chronicle about IFMR Capital and its future plans. The article quoted Sucharita Mukherjee, CEO of IFMR Capital saying “We have a strong pipeline from existing clients, with whom we have built deep relationships. Increasing product suites to cater to both on-balancesheet and off-balancesheet financing needs of clients, as well as meet specific requirement of key investor classes such as private wealth investors.”
Click here to read the article.
IFMR Capital completed its second securitisation transaction with Bengaluru based microfinance institution (MFI), Grameen Financial Services Private Limited (previously called Grameen Koota) on June 23rd. This is IFMR Capital’s sixth securitisation transaction as a structurer, arranger and primary investor. The 311.5 million rupee securitisation transaction involved over 27,000 microloan contracts of Grameen Koota being pooled and issued as debt securities by Alpha Pioneer IFMR Capital 2010, the special purpose vehicle or SPV created for this purpose. The securities were issued in two tranches with the P1+(so) rated senior tranche being subscribed by a large Indian mutual fund. With this deal, funding facilitated by the Chennai based inclusive-finance company for the microfinance sector has reached about INR 3 billion.
The market conditions were a trial for IFMR Capital’s securitisation product, handed with the task of bringing market investors in such a liquidity strained scenario and ensuring a cost reduction for the MFI. The company is satisfied that this transaction achieved both. Grameen Koota achieved a cost of funding much lower than what was possible through bank funding. IFMR Capital played the role of the structurer and arranger, apart from that of a primary investor by investing in the P4+(so) rated subordinated tranche.
IFMR Capital looks forward to meeting many more such challenges in future and to continue providing access to capital markets for high quality microfinance institutions.
In its endeavor to enhance investor awareness of micro finance, IFMR capital organized the second in its series of seminars titled “Microfinance: An emerging asset class” at the Grand Hyatt, Mumbai on June 3rd.
Aimed at providing an in-depth analysis of the micro finance sector, the seminar in addition to covering the various challenges, risks and evolution of the industry, also provided a platform for industry practitioners and investors to connect.
Several leading capital market investors including mutual funds, pension funds, bank treasuries and private wealth management companies converged at the seminar making it lively and a thought provoking exercise.
P.N Vasudevan from Equitas Micro Finance gave a brief description of the sector so that those new to micro finance could understand the model. His talk was followed by Kunal Agrawal from Crisil’s structured finance rating team who detailed on the intricacies of rating microloan-backed securities. Later Sucharita Mukherjee, CEO, IFMR Capital, spoke about the value add provided by IFMR Capital in structuring the transactions and building market infrastructure. Also, Chaitanya Pande, Head – Fixed Income from ICICI Prudential AMC, one of the first Indian mutual funds to invest in microloan backed securitization, spoke about their investing experience and expectations from the sector.
With a greater number of investors showing interest in the asset class and armed with their continuous feedback, IFMR Capital will be working to expand its product suite and meet investor expectations better. Ensuring cheaper and reliable sources of funding for our MFI partners will, of course, still be the cornerstone of everything we do.
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Kirthi Rao, IFMR Capital, contributed to this post.
What does it take to make a mutual fund invest in small MFIs? The one team that would be able to answer this question would be the IFMR Capital MOSEC team that has just concluded the second multi-originator microloan securitization. We talk to the IFMR Capital team to find out all about MOSEC, microloan securitization and what it means to the MFIs, and how the poor can benefit from it.
Consistent source of finance
Gaurav from the Origination team tells us “MFIs have difficulty in accessing the capital markets and traditionally bank lending has been seasonal. During the first quarter, many banks seldom lend to the priority sector, whereas in the third quarter, there is a spurt in lending. This lumpiness in availability of finance meant that MFIs had difficulty in planning their operations. We have just ensured MFIs can hope for a more consistent source of finance all through the year. MOSEC has given small MFIs access to reliable capital market finance even at the beginning of the year, and from a greater variety of investors.”
Gaurav has just got us interested and we ask him to explain more about MOSEC. “MOSEC is a Multi-Originator Securitization transaction where we combine portfolios of multiple small MFIs. We then design a unique structure and issue securities backed by the receivables from these portfolios” he explains. MOSEC I was executed in January for 4 MFIs and MOSEC II, recently concluded, had 3 MFIs. “We received the portfolios from the MFIs, analyzed them and put together a very unique structure through which an investor has invested in 76 percent of this portfolio. All this is done through a Special Purpose Vehicle called IFMR Capital MOSEC”. That definitely sounds quite complicated and difficult. Was it? “Yes and no”, says Gaurav, “It was not easy but it definitely was exciting for me.”
But the structuring must have been a lot of work? “It is”, says Hari Nathan, who worked on the structuring for both MOSEC I and II. “I learnt a lot during MOSEC I and that helped me for the second deal. It definitely was a steep learning curve for me – analyzing the portfolios and coming up with the right structure. I entered the financial inclusion space because I wanted to make a substantial contribution, but I come with a specific skill-set which I wanted to take advantage of. This deal made the best use of my technical skills and I am really happy to be a part of this team” he admits.
CRISIL rating adds credibility
“Our MFI partners are quite satisfied” smiles Bhagirath, also from Origination team. “This MOSEC has given them access to Rs. 339 million from the capital market and much more. Market transactions impart credibility to MFIs and the CRISIL rating adds value to their portfolio. Deals like this mean a lot to the small MFIs and I can say that with confidence because I have worked in both MFI and in credit rating. I know how difficult it is for a small MFI to get an MFI portfolio rated and raise funds. Initially they were a bit apprehensive about combining their portfolio with another MFI’s. We had to convince them a lot to make them understand that the risk would be limited to their portfolio, but the reduction in cost of funding they get makes it all worth it.”
This deal also means a lot to an aspiring finance professional like Dhiraj, who co-ordinated with the Chartered Accountants for the deal. He says “This Deal came just a month after our previous deal and thus, gave us insight about the operational constraints under which we are operating and considering the business plan of 10-12 such deals, it prepares us for automating the operational process so that it will be scalable and economical.”
Lower interest rates
We ask Kshama Fernandes, Head, Risk Management, if MOSEC II was a repeat of MOSEC I. “Yes and no”, she explains. “All three Mosec II MFIs were also a part of Mosec I. However, the Mosec II structure is very different in terms of weight of each MFI in the total pool as well as its geographic diversification. There has been a significant reduction in the amount of cash collateral that the MFIs had to put upfront. This translates into a lower cost of funds for the MFIs, which when passed down, results in the lowering of interest rates to the end borrower, the MFI’s clients. This is what we aim to achieve over the long run. ”
Didn’t we hear that MOSEC II was creating a history of sorts? “Yes” she replies. “This is the first time a mutual fund investor has subscribed directly to a primary microfinance multi originator issuance. The investor has purchased the entire amount of Series A1 PTC which is rated P1+. This is encouraging because it means that investors have started looking at microfinance-backed paper with underlying loans originated by small to medium sized MFIs, as a new asset class. Being uncorrelated to mainstream debt and equity markets, this could prove to be an interesting investment for mutual funds, not just from the return perspective, but also from the risk diversification perspective”.
Challenging task
Meenal Madhukar, Head, Investor Relations, shares her most challenging aspect of the deal. “Price discovery is a continuous challenge in every transaction. While the originators are eagerly looking for us to lower the cost of funding for them, the capital market investors demand a significant premium for investing not just in a new asset class, but in this case, in a brand new structure that happens to be a global first, a multi-originator securitization structure that has been tried just once before by IFMR Capital. Yet, for us at IFMR Capital, the battle is not just about bringing an alternate source of funds to the MFIs, it is also about ensuring that we get the best price for them. As a result, each transaction is a tightrope walk in trying to lower the premium demanded while at the same time convincing new investors of the inherent value of our transactions. Getting them to spend quality time in evaluating our small size transactions, and conforming to their last minute requirements add spice to the adventurous journey, which though not for the faint hearted, has been truly exciting and very rewarding as we have been able to create new benchmarks in almost every transaction, in terms of a lower pricing.”
Sucharita Mukherjee, CEO, IFMR Capital, attributed the successful completion of the deal to her team. She summed it up nicely when asked about her thoughts on the deal. “It is a total team effort and it is only right that the team answered all your questions”.
We just had one last question. “Are you guys going to celebrate now?” “Yes!” is the team’s reply. But we only know too well they will back soon to work on the next deal that is already lined up for execution.
How are the three MFIs reacting to this deal? What is the mood in their camp? Watch this space for more.
IFMR Capital recently concluded a Rs. 339 million multi-originator microloan securitisation with three Indian microfinance institutions (MFIs). IFMR Capital Mosec II, the SPV, issued two tranches of securities backed by 36,972 microloans that were originated by Sahayata Fintrade, Satin Creditcare, and Asirvad Microfinance. One of India’s largest mutual funds subscribed to the senior P1+(so) rated tranche and IFMR Capital invested in the subordinated piece.
Click here for the official Press Release.
In the current financial year, IFMR Capital aims to structure many more such transactions that build on its track record of bringing efficient and reliable access to debt capital markets for high quality institutions impacting low-income households.
Watch this space for an inside scoop about the people behind the transaction and their experiences from it!
On May 7th 2010, the University of Chicago and Northwestern University hosted the sixth annual Chicago Microfinance Conference. I represented IFMR Capital at the event to discuss the evolution of microfinance as an asset class in the Indian context. Below are some of the highlights from the many panels and speakers, but here is the 30 second summary of what I found most interesting:
- A greater amount of intellectual honesty around the discussion of microfinance’s impact on poverty. Nearly everyone now agrees control groups are necessary to study the impacts of micro-credit properly. Consumption smoothing is recognized as important.
- Interest rates are coming down and will continue to fall at a faster pace.
- There’s a danger of short-term money in some microfinance equity markets. Longer term investors are needed, but the pension fund/large institutional funding channel needs better vehicles to invest in.
- Microfinance bubbles in Morocco, Pakistan, and Bosnia could have been prevented with more discerning investment (on the part of multilaterals mainly) and credit bureaus.
- Reaching more remote populations is the next frontier. BRI is one of the few success stories.
- M-Pesa (the mobile payment platform) now has over 9 million clients in Kenya. Wow.
Impact Debate
The “impact of microfinance debate” has been a popular one over the past year, especially after the publication of the first few randomized evaluations in microfinance (e.g. CMF and MIT’s Spandana study) have shed light on how limited our knowledge of microcredit’s impact really is. During a panel entitled, “Impact Monitoring and Reporting,” the panelists (each from high-profile microfinance funders and networks) admitted that we do not know whether microfinance alleviates poverty. Even though some of the panelists’ websites and marketing materials do not yet reflect this admission, it is refreshing to hear in public a greater agreement upon the limitations of most previous impact evaluations, primarily due to the lack of control groups in past evaluations. Speakers also noted that even if it does not lift people out of poverty, microfinance’s ability to help smooth consumption is a praiseworthy accomplishment – an insight that many credit to Morduch, et al’s Portfolios of the Poor.
David Roodman from the Center for Global Development hosted a session discussing his Open Book Blog, in which he “shares the writing of a book about the history and impact of microfinance.” Some of the main points Roodman made in his presentation can be seen in this post he made last month. (I think the “OK Go” video really drives home his point on selection bias!)
Investment and Interest rates
Panel discussion; Peter, second from right at the panel.
On the “Microfinance and Wall St” panel, we discussed the evolution of MFI funding in recent years (e.g. more commercially driven, a bifurcation between top-tier and smaller MFIs) and how IFMR Capital is having early success working with small and medium sized MFIs to access domestic debt markets. Some panelists characterized the current global funding environment as, “too much money going after too few opportunities,” but I only see this as true if one limits the focus to the world’s 50 largest MFIs. In reality there are many underfunded but strong MFIs.
What is needed are: 1) More technical assistance providers to work with high-potential small MFIs, and 2) More conduits such as IFMR Capital to create structures linking smaller high-quality MFIs with the investment appetite of larger investors, who cannot individually go after relatively small-ticket deals.
Carlos Castello from ACCION International, and a Board Member of Banco Compartamos, was on the panel so there was a question from the audience on whether interest rates charged to customers are too high and MFIs too profitable. Mr. Castello pointed out that Compartamos has lowered their rates by about 10% the past year and reiterated their belief that high-returns will invite more competition, and that competition will be the driver for lower rates. I am still seeking to better understand why the flood of new MFI competition that markets such as India have seen is not occurring in Mexico, where Compartamos and others have proven microfinance can be a very profitable business (Compartamos’ ROE is approximately 40%).
I was pleased to highlight Bandhan’s recent interest rate slashing and drew a comparison to the Indian telecom sector as a more mature market that microfinance can continue to look to for a number of comparisons. As the Indian mobile market has shown, it is certainly exciting to see the pro-customer innovations that come once businesses realize their market will be require a low-margin, high-volume business model. This of course requires a different kind of equity investor – one with a long-term horizon vs. short-term – and will likely rattle some of the current private equity money investing in the Indian market.
Interview with IFC’s Microfinance Chief Investment Officer
The last session of the day was an interview with Martin Holtmann, who helps oversee IFC’s $1.4 billion portfolio of microfinance investments. Given how unique each country’s microfinance market is around the world, it was fascinating to hear the perspective of someone with investments in dozens of countries. When asked point blank whether multilateral organizations were responsible for the recent microfinance bubbles seen in countries like Pakistan, Bosnia, and Morocco (Nicaragua is a crisis but of a different kind), Mr. Holtmann provided an interesting response.
Given their mandate to work directly with private companies, he said the IFC had been as careful as possible to make investments where institutions had the capacity to absorb liquidity and grow, but funding from organizations like the World Bank (IFC’s parent) made subsidized loans directly to governments, such as a $100 million soft loan to Bosnia’s government, which then disbursed the funds as the government saw fit. In some cases this led to overheating the sector and damaging the market for all participants.
Turning to India, Mr. Holtmann expressed concern about the amount and kind of money chasing MFI equity ownership, and drew comparisons to the U.S. residential real estate market a few years ago, where investors looked for opportunities to “flip” investments within only a 12-24 months of investing.
I am not aware of many exits made in the Indian private equity market within two or three years of investing, with the exception of a few transactions such as Sequoia’s purchase of Kalpathi Suresh’s stake in Equitas in mid-2009. My sense is most of the PE money looking at MFIs today realize exits are at least 4+ years post-investment, but if quick exits are in fact expected by investors, then the aforementioned interest rate cut by Bandhan will hopefully spook some of this money out of the sector and allow long-term oriented investors better valuations at which to enter.
Here are my takeaways from the rest of Mr. Holtmann’s interview:
On Credit Bureaus: They make little sense in a pure group-lending environment, but in urban or individual/SME lending markets, they are crucial. In fact he thinks credit bureaus could have prevented much of the problems in Bosnia, Pakistan, and Morocco.
On Repayment Crises: In a stress situation, repayments only fall off a cliff if the growth of an MFI has been undisciplined. Contrary to prevalent opinions, if group lending is done properly then it is reasonable to believe delinquencies at an MFI could hit 10-15% and still recover. An MFI like FINCA Uganda would be almost impossible to destroy even if delinquencies were over 10% because of the overall strong culture.
What WON’T we be talking about in five years? Interest rates. They have come down globally by 150-200 bps the past two years (according to CGAP) and will continue to fall.
What WILL we be talking about in five years? We will still be talking about the difficult to reach populations/sectors (e.g. in Bosnia only 4% of MFI portfolio is in agriculture). Bank Rakyat Indonesia (BRI) is able to setup branches to serve areas with a population as small as 4,000 but for most MFIs the average population has to be much higher number in order to be profitable. Going to more remote, dispersed populations will be the next frontier.
If Mr. Holtmann is right, then kudos to KGFS and IFMR Rural Finance for taking on the next frontier (on many fronts) today.
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Peter Bremberg of IFMR Capital contributed to this post.
