Privilege Banking Redefined

Our idea of classic privilege banking is that the bank comes to the door-steps of the rich to deliver services. How would you react to the latest developments in financial inclusion where an agent comes to your door-step to deliver various financial services like credit, savings, RD, insurance, and other services like mobile, DTH recharge, rail/bus ticket bookings, payment of insurance premiums etc? And hold.. we are talking about these services in a rural backdrop, where ferrying to and from the branch would sometimes cost about the average ticket size of the transaction itself. (You should be surprised only if you don’t know about RBI’s BC initiatives). If you are not amused please proceed no further, because you will be just wasting your time
In recent times RBI has made more concrete moves towards achieving financial inclusion, one of which is introducing the BC (business correspondent) model, for places where having brick-mortar branch is unviable for banks. RBI’s aim? – is to make banks reach places having a population above 2000. Banks appoint BC agencies/service providers in these areas, who on behalf of the bank provide these services in the hinterland. This development is in economic favour of banks too- estimates show that cost of a transaction at a typical bank branch costs the bank somewhere around Rs 60, and given the small average size of transaction in rural areas it becomes unfeasible for the bank to set-up a branch at these places. Going via the BC route the bank incurs a much lower cost per transaction. For the customer, he/she gets the service at his/her doorsteps without any branch visiting costs. So naturally, it looks to be a win-win situation for the bank as well as the customer (Having said that, we have to remember that banks are being told to do so. If they had their way it would’ve still been a long time before they reached these places, but that’s what regulators are for, isn’t it?).
It sure looks like privilege banking being delivered to the bottom of the pyramid (long live Dr. Prahlad). Now, the people who make it possible- the BC service providers. It’s a market that is growing at a phenomenal rate, it already has quite a few players like FINO, Eko, ALW (Please don’t get me wrong- I’m not getting paid for this ). These players try to leverage technology to reduce the transaction costs, and the kind of technology they employ to make this happen is really impressive. Well, you might not find it as impressive if you haven’t been to any of the place where these services are being delivered; I mean it’s really a tough task to imagine its extent if you don’t have the first hand experience of being in an regular rural set-up at least once. The bouquet of services/products being offered through this model are already pretty much all the essentials, and its set to expand furthermore as these players try to leverage their existing infrastructure of agents & technology in place for maximum benefit. Seems finally something is happening somewhere..will it help invert the pyramid? Only time can answer that

The Law of Evolution- Survival of the Largest ?

As the central bank in its pursuit of achieving 100% financial inclusion keeps commissioning various committees, the landscape new age MFIs operate in is getting more and more dynamic. Well, what do we have today? –the recommendations made by V. K. Sharma Committee ( V K Sharma is the senior most executive director and the favorite to succeed Usha Thorat as the deputy governor at RBI).

In November 2009, a Working Group was constituted by The Reserve Bank of India under the Chairmanship of Mr. V. K. Sharma to examine the pros and cons of the Priority Sector Lending Certificates (recommendations about which were made by the Committee on Financial Sector Reforms, chaired by Dr. Raghuram G. Rajan), and to make recommendations on introduction and trading of the PSLCs in the open market. Later, RBI in its 2010-11 monetary policy report expanded the scope of the working group and mandated them to review the pros and cons of inclusion of bank lending to micro-finance institutions (MFIs) under priority sector lending. This is where the problem started . The group was supposed to submit its report by June 2010, which has not yet happened. The group however has submitted a draft report on its findings and recommendations (ET report)

The recommendations as reported are-

 Bank’s exposure to Non-Banking Finance Company (NBFCs), having priority sector status should be withdrawn.

 The phase out period should be orderly and therefore should be allowed up to 31st March, 2012.

Now, we will try to see what could be the implications if the recommendations made are endorsed by the apex bank in its entirety.

The committee says since it could not be ascertained whether the loans extended to MFIs under PSL reach the poor, so banks should discontinue lending to MFIs under PSL. As of March’09 the loans extended by Pvt & public sector banks to all the MFIs aggregated to about 3/4th of the entire debt funding available to these institutions, so the impact of this recco is well understood. As of now banks lend to MFIs to meet their PSL targets (remember the 40% target?) as required, failing which RBI guides them to park an amount equal to the shortfall with institutions like NABARD, SIDBI etc, which yields a meager ~6% return. You might think this PSL thing might help MFIs to get a good bargain at the interest cost, well that logical too but it doesn’t happen at all! Going by the numbers the flag bearer SKS reports the cost is around 12% for them (that’s around 200-300bps costlier than what large corporate houses pay on a purely commercial borrowing), needless to say this number hits north as the size of the firm decreases. Now if this lending is excluded from PSL it will simply increase banks’ bargaining power, so the interest charged is bound to increase. This might be passed on to the customer by the MFIs which will push the dream of financial inclusion farther. Still worse, it might make it impossible for start-up and other growing MFIs to borrow at all, if that happens the microfinance market will never see competitive pricing as much it could have.

If this happens the large MFIs might still be able to protect their margins owing to their scaled-up operations, better bargaining power with banks etc, but smaller MFIs might just get wiped off making the market more inefficient.

The Rationale

To my limited understanding its very challenging to find a good reason how-

- On one side people (no names ) complain about how the interest rates of MFIs have not come down as they should have, and on the other side we are talking of steps that will essentially translate to an increase in the borrowing cost further to ensure that the kind of competitive market place required for charges to come down is never achieved!

- WE say MFIs charge astronomical interest rates, and that they are wrong citing high operating costs as the reason as lower delinquency (98%+ recovery rates) should offset the higher operating cost. At the same time it’s OK for banks to charge MFIs higher interest rates on the grounds of riskier business model, why is it that the same argument of lower delinquency is no longer valid?

Financial Reforms & MFIs

Financial reforms that the government is trying to bring in are going to affect MFIs like all other financial institutions in some or the other way.  Among the major recommendations in the last report on financial reforms banking license to NBFCs & PSLCs are the ones which I think if implemented will affect MFIs most significantly. Banking license is still self explanatory, so I will try to find out what is this PSLC we are talking about.

Priority Sector Lending Certificate..what is it??

The idea was born in the abovementioned 2008 report of the Committee on financial sector reforms titled- ‘A Hundred Small Steps’ better known as the Raghuram G. Rajan committee report.  The committee came up with a very novel idea to help implement the priority sector lending mandate more efficiently. It suggests that all registered lenders be issued certificates for the amount they lend to the eligible priority sectors. Then a market would be opened up for such certificates, where the deficient banks can buy these certificates for the amount they are falling short by. However, the loan will remain on the books of the original lender and any default in the loan will affect the lender only and not the certificate holder. For those who know will find it much like the CERs or the carbon credits..Indeed it is, in many aspects.

The million $ question..how will these certificates be priced?

The price obviously will be less than the penalty faced by the banks in case they fail to achieve their target & sub targets. The actual price discovery will be done by the market.

So why is it important for MFIs??

At the heart of the proposal of PSLC lies the idea to make PSLC a market-driven interest subsidy to those who make priority sector loans. The income from selling these certificates is what will make lending more profitable for lenders. So now we can see how MFIs stand to benefit, especially the large MFIs will be the largest beneficiaries as these certificates will have some minimum size regulations, also only they can be of help to large banks who will be looking at some serious volumes of PSLC.

The way I see it, if PSLC are introduced it will be the next big thing for major MFIs. We might see upsurge of many specialized institutions in priority sector lending which will try to thrive on this initiative. Whatever may be the consequence for the institutional participants, it will surely go a long way in benefitting the end customer, the borrower and will push us an inch closer to what we aspire to achieve- ‘financial inclusion’; cheers to that!

Banks & Priority Sector Lending

As we know the commercial banks have to meet the RBI guidelines of 40% net advances of their Adjusted Net Bank Credit to the priority sectors. In case you are wondering what all sectors come under this ‘priority’ list they are- advances for agricultural sector, small & micro enterprises, retail trade, education, housing, Differential rate of interest scheme (there are various sub-targets apart from this overall 40% as well, but we won’t get into those details now). In case a bank fails to meet these targets they face penalty which is- Contribution by banks to Rural Infrastructure Development Fund (RIDF) or Funds with other Financial Institutions, as specified by the Reserve Bank. The term, interest and size of such deposits are dictated by the central bank from time to time. In logical conclusion the returns from such deposits are not favorable for the banks and so they try to avoid it, you will see banks going on PSL spree in the last quarter of the year trying to close down the gap.

 

So the question is why do banks have to struggle to meet these targets & sub-targets, why don’t they lend enough to these sectors themselves??

The Raghuram report on financial reforms identifies the reasons as-

“Interest rate ceilings (either imposed by the centre or the state) make priority sector lending unprofitable, and ensure that the banker attempts to recover his money through hidden charges in the loans that are made, or that he does not lend so the poor are driven to the moneylender. The Committee believes a better way to proceed is to liberalize interest rates while increasing safeguards that prevent exploitation.”

The committee goes further to recommend

-          Liberalization of interest rates charged on these PSL to ensure that the credit reaches the poor.

It also suggests having a system in place, to ensure-

-          Lenders disclose the total cost being charged on such advances

-          Periodic public disclosure of maximum and average interest rates charged by the lenders.

-          Only loans that stay within a margin of local estimated costs of lending to the poor be eligible for PSLCs.

The Land of Darkness

This story is from the land governed by narcissists, it may be true for few other states of the country as well, but I speak for the one I have firsthand experience with. Country’s most populous state and in what state! ; The account here is from the eastern most part of the state, where overwhelmingly large part of the population is dependent upon agriculture for their livelihood.
In the present when we as a country boast a stupendous record of an impressive GDP growth rate year after year for close to one decade now, the situation here is quite disturbing. To my understanding, power is the ‘most’ important resource or growth enabler for growth, and mind you this power is not the power that the people of this land are more bothered about, this is the power that runs industries but as unfortunate as it is, people here are much more active about the power that a democracy like ours bestows upon the elected representatives. I think power is most important because other infrastructure will come in as and when the demand comes, but without power you would never see the demand come in.
We often talk about growth for now forget growth, this district has seen degradation of basic infrastructure in the past. Till some 10 years back the average electricity supply was about 16hrs a day which has dropped to a near 12hrs a day, that is the kind of ‘growth’ we are talking here. The district even saw its MP rise to become the PM for a short stint, but all that to this consequence! Governments came and went while the district slowly and quite steadily slumped into worse states, while the representatives the people selected were busy building their own empires. Of course the people themselves are at fault, they themselves don’t know their priorities, otherwise how can one explain a political party that blows thousands of crores of state government funds on building parks with statues of animals (elephants & few others ..I wonder if you get the joke) still continue to run the government without any problem. That kind of money was big enough to lessen the power deficit the state has, not by a large quantity but intent wise would have been big enough. It’s amusing how such thoughtless, shameful projects are implemented so fast when the ones those are needed never see the light of the day.
I know people who think its unimaginable to have long power cuts in summers, infact for that matter most of my Google generation doesn’t actually know what its like to live without power..an odd day’s power cut doesn’t even come close to what it’s like to live in a place which has electrification just for the sake of records. Have you ever wondered how would it be to live in such a place? Well right now I am in one such place, thankfully I am one of the very few fortunate ones around as we have all possible means of power generation, gensets, solar panels, invertors etc. but not all have access to such facilities, infact this district has a population of more than 30 lakhs which survives on an upto* 8 hrs of electricity supply a day! The kind of electricity that is wasted every day in lighting up these stone parks built across the state could very well be used to power many such villages in the same state.
Some people in the towns are willing to pay any price to ensure uninterrupted supply, but not all can afford that. All this breeds resentment, people don’t pay electricity bills…in fact the number of legitimate electricity connections is very very low as compared to actual nos. The state power boards are sick, but this vicious cycle has to break somewhere. It’s no brainer to guess that the government can only initiate any such major shift of state, but unfortunately the political parties in power don’t have the political will to take steps like privatizing the distribution & billing of power at least. You can very well argue that privatization is not the end of all problems but I know one thing for sure, right now I have access to the internet(GPRS based), but no electricity!, thanks to the private telecom companies. Also, it is working great in most of the places and so I have no reason to think otherwise. Even in the power generation space Pvt. players are awarded projects but they face far too many hurdles unlike that in construction of parks across the state, strange isn’t it? What is more amusing is how these very electricity boards manage to provide almost 24hrs electricity supply in the same areas when elections are around the corner..Power of democracy! Isn’t it??
P.S: For record the place I am talking about is Ballia, Uttar Pradesh.

Funding the Microfinance Biz

Moving on to the next level..we will now try to see how do these Microfinance companies manage to fund their business. This will involve both the fields which I am passionate about- micro & corporate finance .

Looking at the Indian scenario to find out the answer, one thing that stands out is that in the last two years, the five largest MFIs in India have been beneficiaries of approximately $180mn in private equity investments! and their combined client base during the period grew at an annually compounded rate of 45% .

Now, why do they need private equity after all- Corporate Finance-101 will tell you that a company can’t fund itself solely by debt beyond a certain level. The increasing leverage will increase the cost of capital substantially. So beyond a certain stage the business needs infusion of fresh equity, since the promoters are not in a state to fund it by themselves, they also have not yet achieved the scale to be able to go public- so they turn to the only plausible option left, that is private equity.

The private equity investing in microfinance is mostly in the form of early start-up or growth capital. This is different from the prevalent practices in the developed world in the way that otherwise private equity players are over-leveraged in the pursuit of short-term exit & return. However in the case of investment in MFIs they partner them for a longer duration as still its a long time before these investments will mature giving them an option to exit.

An increase in inflow of such funds will not just help the sector to scale, but will allow greater transparency. The kind of corporate governance requirements of these investors will inevitably result in stronger organizations.

On the contrary, despite the positives such investments, some people still criticize private equity backed MFIs for their rapid growth rates. Their concern is that in the pursuit to scale up fast these PE funded MFIs will compromise the quality of the loan portfolio. To my understanding that is not a problem, as a default ridden portfolio, no matter how large it is, is of limited use to the MFI as well as the PE firm, especially so amidst the current financial crisis. Also people often accuse PE backed MFIs to be driven only by profitability, now that comes from the school of thought that believes microfinance to be just a kind of social service. I will again repeat what I ve already said about microfinance- ‘it is about doing well, by doing good’. No business can sustain & scale up without having a financial business sense to it. We have to understand that grants can’t keep driving microfinance forever, they have to be profitable for them to scale-up & be able to provide the service to a larger base.

Microfinance & the way forward…

The term Microfinance refers to small-scale financial services- both credit & savings, provided to the poor in rural, semi-urban & urban areas. The service providers in this space are banks, insurance companies, agricultural & dairy co-operatives & MFI s (Micro Finance Institutions) etc.

Since MFI s don’t have a banking license, they can’t take deposits which prevents them from offering the savings facility. So largely the savings facility in micro-finance is provided by banks only as of now. In fact in India microfinance is synonymous to micro-credit, the reason behind is that savings, micro-insurance etc comprise a very miniscule segment of the microfinance space here.

Now what is the definition of a micro-loan?

The Development & Regulation bill 2007 defines Microfinance loans as loans with amount not exceeding Rs 50,000 in aggregate per individual/enterprise. However, in practice most micro-loans are in the range of Rs 5000- Rs 20,000.

How big is this market we are talking about?

The microfinance sector and MFIs in India are estimated to have outstanding total  loans of Rs.16,000 crore to Rs.17,500 crore, and Rs.11,000 crore to Rs.12,000  crore,  respectively,  as  on  March  31,  2009.  The microfinance sector in India is fragmented - there are more than 3,000 MFIs,  NGOs,  and  NGO-MFIs,  of which  about  400  have active lending programmes. However the good thing is that the top 10 MFIs account for about 74% of the total outstanding.

In the past the microfinance industry in India has witnessed astounding growth. One of the measures- the total loan amount outstanding has grown from Rs 1600 crore in March’06 to an impressive Rs 11,400 crore by March’09! (We hope it grows even faster going forward so as to fetch us all PGDM-DSF students at IFMR a worthy job )

Understanding MFI s Better-

MFIs according to their lending model can broadly be classified under two heads- The ones lending as per the SHG(Self Help Groups) model & the ones lending as per the JLG( Joint Liability group) model. Now we will try to chalk out how these two models are different-   Under the SHG model the MFI lends to a group of 10-20 people( women essentially in the present Indian context). Under the SHG-bank linkage model, an NGO promotes a group and gets banks to extend loans to the group. Under the JLG model,  loans are extended to, and recovered  from, each member of the group  (unlike under  the SHG model, where the loan is extended to the group as a whole). The most  popular  JLG  models  are  the  Grameen  Bank  model (developed by Grameen Bank, Bangladesh) and the ASA model (developed by ASA, a leading Bangladesh-based NGO-MFI). Most of  the  large MFIs  in  India  follow a hybrid of  the group models. 

The model of  lending  to  individuals  is similar  to  the  retail  loan financing model  of  banks.  In  India, MFIs  adopting  the  group-lending  models  extend  individual  loans  to  more  successful borrowers who have  completed a  few  loan  cycles as part of a group  (who have  relatively  large credit  requirements and good repayment track record). Corporates and cooperatives, typically dairy  farms  and  sugar  mills,  are  also  known  to  undertake
microfinance  by  extending  credit  to  farmers;  this  helps  the companies  strengthen  their  procurement  and  distribution channels. 

Now coming to the what I call the not-so-pleasant part of MFI operations – the interest rates charged by these MFIs.

MFIs  following  the JLG model charge  flat  interest rates of 12  to 18%  on  their  loans,  while MFIs  following  the  SHG model charge  18  to  24%   per  annum!!  based  on  the reducing  balance method.  In  addition  to  interest  rates,  some MFIs  also  charge  a  processing  fee  comprising  a  certain proportion  of  the  loan  amount  sanctioned,  at  the  time  of disbursement. I know we all couldn’t agree more on that these interest rates are bit too high for the poor people we are serving. But if I may take the liberty to leave the complete humanitarian point of view and draw your attention to the MFI as a business..like any other business ( remember this business about doing well by doing good ) we should see that the cost of loan disbursements in the case of MFIs is higher than a bank, also the risk involved( as no collaterals) is also on the higher side. So we can’t just blame the MFIs for leaching on to the poor..afterall they are still doing some good work, and so no reason they should be deprived  of their credit, that they rightfully deserve.

We know that this sector has grown multitudes in the past..so what does the future hold for MFIs?

Well, the way I see it- taking SKS as the flag bearer of the industry ( I guess it’s not a vague assumption, after all it account for about 25% of loans outstanding alone!) – it’s cost-of-capital stands at 9.58%(sep’08), charges 23.6% in Andhra & 28% in other states!..it has a very healthy margin to operate in. Most if not all the MFIs are highly leveraged, now once SKS goes public for funds (which it plans to do in the current year) it will be able to de-leverage it’s financials considerably, bringing down the cost-of-capital. A reduction in cost of capital keeping other factors constant will surely provide the company a cushion in operations and profitability.

Also, I expect that going forward the MFIs will get a banking license ( well not all, but I hope a few big ones do). That will be the turning point in terms of reducing CoC, and probably then only we can expect the MFIs to charge a lower interest rate from the people. Looking at the way banking system in India is regulated it’s very unlikely to happen any time soon, but that is what I think can bring about the next big revolution in the MF industry, and so I sincerely hope it does.

What is Financial Inclusion?

Ok..so before I run out of my josh to blog let’s get something useful here

So what is this ‘Financial Inclusion’ that the newspapers keep talking about?

Financial Inclusion in simple words is the idea of providing banking services at very low costs to the poor. So now the next question comes that why has it become so important all of sudden that every bank is talking about it? Well largely the reason why every bank is talking about it is because their banker i.e RBI wants them to do so!  The reason behind  this move is again pretty simple- the ratio of number of current & savings a/c to adult population in our country is still low (it is .59 as per the last census data of 2000 & no of a/c as of 2004). The urban population has a fair access to banking services, and since providing them these services is more profitable even the banks prefer serving the urban population. Now some stats to substantiate what we are trying to say- only 39% of rural adult population has access to a/c as compared to 60% in urban areas. Still worse, only 14% of Indian adult population has a loan account with a bank which again for rural population is as low as 9.5%!

Most of the commercial banks except for regional rural banks have stayed away from serving the rural population, the reason is quite apparent too- 44% of total deposits come from the top six metros! So, the grand daddy of all banks RBI steps in to tell them what they need to do in order to provide the poor in semi-urban & rural areas access to banking. Banks were told to offer ‘no-frills’ savings a/c to the poor and given targets to increase their number of accounts. There are many ways in which the RBI is trying to push the banks towards the goal of inclusion. It has relaxed the norms of KYC for a/c with deposits less than Rs. 50,000. Other important steps have been, allowing RRBs’( Regional Rural Banks) / Co-operative banks to sell Insurance and Financial Products, Relaxing norms for ATM, Kisan Credit cards etc. But the most significant thing that RBI is ‘banking’ on is technology! They are hoping things like mobile technology will help the banks to reduce their cost of providing the service, thereby making it a profitable proposition for them.

Now what has prevented the banks from doing that in the past? I guess it’s not difficult to understand the high transaction cost incurred by the banks in providing these services to the poor. Also there is a limitation in providing cash access points. But it’s not that this sector can’t be serviced profitably. We have had organisations like Sewa Bank of Gujarat which have shown that providing services to this segment can also be profitable. Then the world third world also witnessed great microfinance revolution, which again reinforced the idea. The main motive is to relieve the under privileged from the clutches of moneylenders, pawn brokers etc (how successful we are in that attempt we ll see that later). Now the aim is to provide services like credit, insurance, health care/life insurance to this segment at an affordable cost so that they can also join the growth run that we are having. Probably only then we can boast of our GDP growth rates in real sense.

Going forward I will try to touch upon what is microfinance and other related topics. My apologies for my myopic view on the topic, as it only talks about India. It is so because I intended to keep it that way .

Mathematical Dilemma

*It’s a hopeless situation when your happiness quotient is given by = ƒ(Someone else’s action or shud I say inaction). Only if it could be restored to = ƒ(my own actions)..(Can’t use an ! as it could be misunderstood for another mathematical expression!)

Just a Thought

All our actions..every single one can be traced back to be driven by our own happiness, and the extent to which our happiness is intertwined to the happiness of people around is what makes us human!