Structured finance between micro finance institutions and banks

Abstract

Management of financial resources has garnered utmost importance in this world of uncertainty. Almost every finance manager in the real or financial economy has been grappling with right capital structure and better liquidity management systems for his/her company to run it in most efficient form, making it almost flexible enough to adapt to the external world. In that direction, many innovative financial products were designed and adopted by various industries depending on their need and suitability to their organizations’ objectives. As the complexity of financial products increased, most of the banks who have gained expertise in these innovative products have moved away from traditional interest-bearing products such as loans/savings products to non-interest bearing ‘other income’ services such as trading, design of customized financial products such as CDO, CDS and the like. Further, the banks have innovated securitized products to convert almost illiquid assets on banking books in to the securities (created out of such assets) on trading books, which are transferable. So, the creation of such securities has become a specialization on its own and many investment banks/other financial intermediaries have become expert service providers of these services, leaving the traditional banking business. While many banks in most economies have been providing both fee-income based financial services as well as traditional interest-income services, most of the banks in India remained as traditional interest-bearing financial service providers even after financial reforms post- 1990s and their services are limited to premium customers, leaving the bottom of the pyramid (BoP) people in the economy. However, after Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act – 2002, securitization of erstwhile nontradable loan products on banking books such as Non-Performing Assets (NPA), and other project finance related advances, can be sold to asset reconstruction companies which in turn securitize them and sell to investors. This has allowed banks to restructure their books based on their risk-appetite and expertise. These specialized financial products have attracted many NBFCs which are providing financial services in specific sectors such as housing loans, auto and used/new commercial vehicle finance, construction equipment finance and most recently microfinance industry. Almost all NBFCs depend on funds from banks in the form of term loans, capital markets in the form of bonds/debentures and there are very few deposit taking NBFCs in India. As their funds come under unsecured borrowings and of long-term in nature, these companies face high interest rates, which are crippling their scale of operations. Except microfinance loans, all other loans originated by NBFCs are backed by corresponding assets. In that case, microfinance industry faces double risk of customer as well as facility, as the MFI originated-loans are not backed by any tangible asset, nonetheless intangible security such as group liability. However, most MFIs have come a long way from the stereotypical NGO image to NBFCs to formal investment vehicles. Fulfilling the regulators need to bridge the gap between the formal banking systems and the informal credit mechanism, MFIs have become the next generation institutions to do inclusive banking. However, as lending to bottom of the pyramid involves high risk and also the costs associated with such system are high, they are always starved of funds for their operations. Even bank finance is limited due to their ‘unsecured’ nature, let alone the social nature of the investment and priority sector status accorded by RBI to these loans, made banks to scramble for financing such institutions only to fulfill their priority sector limits. But banks have to allocate higher capital against advances to MFIs as per the latest Basel norms, which make banks risk-averse to provide finance to these MFIs beyond their priority limits. In such a scenario, financial innovations have come to rescue both banks as well as MFIs, to satisfy both the parties and also run the institutions efficiently. These innovations include Pass-Through Securities (PTCs) or Collateralized Debt Obligations (CDOs), Credit Default Swaps (CDS), and Bilateral Assignment of loans etc. As MFIs need bank finance utmost to scale up their operations and accomplish their objective of serving the unbanked people, and the banks need to obey the inclusive finance agenda of the government and also to reap the benefits of reaching to bottom of the pyramid people, synergy between traditional banks and micro finance institutions has become need of the hour and for the benefit of all the stakeholders. The following sections are organized as follows: A brief overview on grossroots of microfinance in India at its nascent stage is given in the second section. Third section discusses about new age microfinance institutions and their management philosophy including financial, operational and human resource management. Fourth section gives details on sources of funds and pros and cons of each source of fund for MFIs. Fifth section deals with Collateralized Debt Obligations (CDO) products for MFIs, their structure, cash flows, credit enhancement techniques and risks for investors in these securities. Sixth section illustrates actual design and pricing of CDO securities using a typical microloan portfolio. As microloans are considered to be highly risky investments, how microfinance institutions can protect themselves using Credit Default Swaps (CDS) is discussed in seventh section. As a final word, our insights and recommendations are presented in the conclusion section.