-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.
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[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.
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[Sucharita Mukherjee is the CEO and Kirthi Rao is a team member of IFMR Capital Finance Private Limited.]
Let’s talk Quality in Microfinance
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.
Marking a new phase in the evolution of the microfinance market in India, Bandhan (an MFI headquartered in West Bengal) reduced its interest rate to an unprecedented 19%. This is one of the rare, if not only, instance of an MFI reducing interest rates voluntarily and without the spectre of political duress. We think this is a fantastic and highly overdue move – because it will focus competition finally on the dimension that really matters – price. We showed here that even with effective interest rates between 16 – 18% , ROEs of 20% plus are possible for investors.
(Note: Chandra Shekhar Ghosh is the Managing director of Bandhan.)
