In the current edition of Economic & Political Weekly, Anand Sahasranaman of IFMR Finance Foundation has published a paper on Panchayat Finances based on an analysis of three villages – Pallavapuram, Pandiyapuram and Cholapuram in rural Tamil Nadu. The paper outlines the different aspects concerning their finances and infrastructure and argues that with judicious increases in their tax and fee regimes, all three will be in a position to self-finance a substantial portion of their infrastructure and service needs, resulting in improved local governance and quality of life of local citizens.

Abstract from the paper below:

One of the key tests to real empowerment of panchayats lies in the ability of local self-governing institutions to finance their own expenditures through internal generation of resources. Based on an analysis of three villages in Tamil Nadu, this paper argues that many gram panchayats are today in a position to substantially finance themselves and build a culture of self-sufficiency, independence and accountability to their citizens, reducing their dependence on devolutions from state governments. It concludes that by incentivising competition among panchayats and instituting a rural development fund to enable them to access debt capital, the perverse incentives they now face can be mitigated to a large extent, leading to several significant positive outcomes.

To read the full paper click here.

A recent article in the Harvard Business Review on new approaches to funding social enterprises cites IFMR Capital’s work in securitisation and structured finance of microfinance loan portfolios. The article explores how unbundling societal benefits and financial returns can dramatically increase investment.

The authors argue that financial engineering can be a powerful force for change. It can permit the mobilization of more capital for investment than would otherwise be available. It can generate rich opportunities to fund projects that fuel economic growth and improve people’s lives.  The article also mentions that the ability of social enterprises to provide their products and services rises or falls with the availability of capital and that the lack of funding opportunities is one of the major disadvantages social enterprises face. The article offers the insight that the funding of a social enterprise can be treated as a problem of financial structuring: the enterprise can offer different risks and returns to different kinds of investors instead of delivering a blended return that holds for all investors but is acceptable to very few.

This new approach to structuring can close the financial-social return gap.  The article goes on to discuss the various types of financing-innovation in practice such as loan-guarantees, quasi-equity debt, pooling and social-impact bonds. In the context of techniques that involve pooling and creating tranches, the article mentions IFMR Capital’s work in securitising microfinance loan portfolios in which an investment share is retained by IFMR Capital. The article also reviews the lessons the financial crisis has taught us, most importantly, the importance of standards and ratings and the need for transparency.

The authors conclude by stating that the challenges involved in creating fully functioning capital markets and legal frameworks to serve social enterprises cannot be underestimated and that some innovations may not be suitable for all organisations. However, with the right market infrastructure and legal framework in place, enormous amounts of private capital could be mobilised for social enterprises.

To read the complete article, click here.

The Centre for Micro Finance, IFMR Research, published its latest report “Five Years of Researching Financial Services for the Poor” at its recently concluded annual conference held in association with RBI’s College of Agricultural Banking.

Founded in 2005, the report presents the different research studies, which CMF has undertaken over the years in the area of financial services for the poor. The report, organised thematically, under its broad focus areas of “Financial Inclusion”, “Livelihoods” & “Social Objectives”, describes the organisation’s current work and summarises key findings from completed studies. The report also identifies potential areas for future research and recommends ways that financial services practice could evolve to meet the needs of low-income households.

Some of the studies that are profiled in the report include:

• Miracle of Microfinance? Evidence from a Randomized Evaluation
• The Impact of Access to Finance in Rural Tamil Nadu: Evidence from a Randomized Control Trial
• The Economic Returns to Social Interaction: Experimental Evidence from Microfinance
• Targeting the Hard-Core Poor: An Impact Assessment
• Measuring the Impact of Providing Futures and Spot Prices of Crops to Farmers

To read the full report click here.

Subsequent to our earlier posts detailing the three broad themes from the IFMR Financial Systems Design Conference 2011, Day 2 of the conference witnessed participants identify pathways to achieve the specific visions that were formulated across the sessions in Origination, Risk Transmission and Aggregation. These pathways have been segmented into the categories of Research, Regulation, Innovation and Public Infrastructure.

I. Research

1. Conceptually, what are the trade-offs, if any, between financial inclusion and systemic risk? Are there particular models of financial inclusion that fare better than others as viewed from this perspective?

2. Are there market based instruments (ex: listed subordinate debt) that provide additional information regarding the health of systemically important financial institutions? Can these effectively supplement supervision-based information?

3. How critical is priority sector regulation to the flow of credit to sectors such as agriculture and SME? Does priority sector regulation cause allocative inefficiencies in the economy? Are there less distortionary measures to direct resources to some sectors that have a high perceived social return?

4. Does structuring Government ownership in financial institutions differently reduce distortionary effects? For ex: holding company structure to channel all Government investments into financial institutions versus direct Government investments into specific financial institutions.

5. How must the performance of Chief Risk Officers in financial institutions be measured? How should their compensation be structured?

6. Financial advice as a function of originators. How is this best structured? What liability must the originator have for advice provided to clients? How must financial advisors be compensated? What is the corresponding regulatory and legal framework for customer protection in India?

7. How different are customer outcomes in an environment characterised by: (a) Financial product access alone and (b) Financial product access combined with financial advice?

8. Why is the take-up for risk transmission products (principally insurance) low at a household level? Is the selling process and agent incentives creating barriers to take-up?

9. In markets like India, what is the inter-play of hard information and soft information for credit origination? Do regionally focussed originators have better soft information? Why are non-bank institutions much more successful in some segments (ex: used commercial vehicles finance, microfinance) than banks?

II. Regulation

10. How should regulation of the financial system be structured given that the product level distinctions are blurring? Is there a need for distinct regulators for systemic risk and customer protection?

11. The conference highlighted that the roles of the regulator and the policy-maker are quite distinct? Is increasing financial access in an under-served market like India a policy objective or a regulatory objective? How should these be coordinated?

12. What are the inherent conflicts of interest in the way regulation is currently structured? How can they be addressed?

13. How should financial sector regulators be governed?

14. With increasing sophistication of markets and products, risk measurement capabilities of regulators will become important. What are the best ways to build regulator capacity?

15. What data and reporting standards aid transparency, particularly in the regulation of systemically important financial institutions?

16. Are there market based instruments (ex: listed subordinate debt) that provide additional information regarding the health of systemically important financial institutions? Can these effectively supplement supervision-based information?

17. Managing moral hazard is important while regulating credit risk transmission mechanisms. Conference emphasised the importance of adequate capital at risk for originators that participate in securitisation as an example of this.

III. Public Infrastructure

18. Payment system innovations crucial to better origination. There are several important developments in India in this regard, including the Interbank Mobile Payment Service (IMPS) and UID-linked electronic transfer of benefits. These need to be further strengthened. Cash dematerialisation infrastructure is also an important element of this.

19. Well-defined frameworks for bankruptcy/resolution are important to orderly development of markets.

20. Need to develop electronic records for collateral and collateral transfers. This includes land, house titles and vehicles.

21. Development of cyber security and privacy laws an important complement to financial sector development.

22. Expansion of broadband connectivity will have important implications for how originators are structured. Real-time data transfer has some off-set on originator-related risk.

IV. Innovation

23. Can transactional information/behaviour available with utilities and telcos provide originators information about credit risk and substitute for soft information/collateral? This might enable newer kinds of originators and under-writing processes in the near future.

24. Technological development is gradually eliminating economies of scale in origination. It may be possible to have smaller sized but efficient originators going forward. As a related point, the justification for mega-sized financial institutions that pose serious systemic risk may get diminished.

25. The Conference noted the need for much more product innovation, both for origination as well as risk transmission. Examples include commodity options, inflation indexed bonds and corporate bonds.

A summary of the overall Conference’s proceedings is available here for further reading.

IFMR Capital raised INR 360 Million through its first issuance of senior non-convertible debentures (NCDs) listed on the Bombay Stock Exchange. This happened in a matter of weeks after having issued its first Commercial Paper (CP) of INR 74.5 Million. The CP issuance followed a short term rating of CARE A1, by CARE in October. The CP has a 6-month tenor and was privately placed.

Privately placed NCDs serve as a means of long-term funding and provide IFMR Capital with the ability to tap diversified sources of funding. The issuance of Commercial Paper serves as an alternative to bank credit for funding short-term capital requirements. Commercial Paper issuance lowers the cost of capital as only corporate borrowers rated above A-2 are eligible to raise short-term funds through capital markets.

These transactions are significant not only because it is the first time that IFMR Capital has raised funds through the capital markets route, but also because these allow the company access to newer funding sources that will enable it to support the growth of high quality originators that serve low-income households across India. With this transaction, IFMR Capital has demonstrated its capability to attract diversified sources of financing during a period when the sector has faced significant challenges.

Commenting on these landmark deals, Sucharita Mukherjee, CEO, IFMR Capital, said “These transactions represent significant milestones in IFMR Capital’s efforts in accessing the capital markets for itself and therefore, its clients. This will pave the way for the rapid growth of alternative and sustainable funding sources. These transactions will boost confidence amongst investors and funders as well.”

RBI’s College of Agricultural Banking together with the Centre for Micro Finance, IFMR Research will host their fifth annual conference, “Microfinance: Translating Research into Practice” on January 9th and 10th 2012 in Pune. The objective of the conference is to actively engage stakeholders and researchers in discussions relevant to current and future microfinance practice. This year renowned development economists Professor Rohini Pande (Harvard Kennedy School), Professor Erica Field (Duke University), Annie Duflo, Executive Director, IPA, Prof. Susan Thomas, IGIDR will be present to discuss results from a number of recent studies conducted in the area of financial services for the poor.

The 5 thematic sessions of the conference are:

• Government’s New Rural Employment Generating Initiatives and Programmes
• The psychology behind mass default in joint liability loans
• Way Forward: Future of Financial Services for the Poor
• Financial Literacy: Can financial literacy accelerate financial inclusion and help customers make rational decisions?
• Financing Microfinance: Scope and opportunities

Here are our picks:

1. De-regulation of savings account interest rates
2. Listing of securitised debt instruments
3. Launch of Credit Default Swap (CDS) contracts
4. Expansion of Inter-Bank Mobile Payment System (IMPS)
5. Growing momentum on unified KYC

Happy new year to all our readers and let’s look forward to more far-reaching reforms in 2012.

–
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India is rapidly urbanizing and the rate of urbanization is expected to climb steeply over the next few decades. The urban population of India will be close to 600 million by 2030, as compared to 340 million in 2008. The next three decades will, therefore, see the unfolding of a variety of urban issues, the responses to which will ultimately determine the long-term course of India’s development. Therefore, the design and implementation of appropriate urban policies based on data and evidence will be crucial in addressing these emerging urban issues and providing the ballast for sustained, long-term development of the nation.

In this backdrop, the India Urban Conference 2011 was envisaged as a series of events designed to raise the salience of urban challenges and opportunities in the ongoing debate on India’s development. The conference intended to bring together central, state and local policy makers, policy implementers, academics, students, civil society, and industry stakeholders to identify challenges and chart strategies for India’s urban development. The Conference saw the successful completion of its first year with three events that took place at Yale (April 2011), Mysore and Delhi (November 2011). It was jointly organised by Janaagraha Centre for Citizenship and Democracy, and the Indian Institute of Human Settlements, in partnership with Yale University.

IFMR Finance Foundation anchored one of the eight themes covered in the India Urban Conference, namely “Financial Inclusion and the Urban Economy” . In recent times, with the growing realisation that financial services are in the nature of a public good, this was an opportunity to accelerate the national economic and financial policy towards ensuring complete access to financial services for all Indians. Therefore, the theme delved in detail, into issues underlying access to finance to the three critical segments: low-income households, small and medium enterprises and local governments.

The sessions were organized into three main plenary sessions and four smaller workshop or deep-dive sessions. All these sessions delved deep into a number of issues such as: (i) quality of financial access to households and enterprises in the informal sector; (ii) challenges faced by practitioners in operationalising financial inclusion; (iii) city government finances and the issues in public infrastructure and service delivery; and (iv) efficacy of data generation through participatory planning processes.

The rich discussions yielded a number of insights into the types of data gaps that prevent: (a) the development of high-quality financial products to serve the needs of the informal economy and (b) the design of optimal policy responses for financial inclusion.

These data gaps include: household level financial information, government banking data and official statistics that are not public, real costs of service delivery to the bottom of the pyramid, housing arrangements of the urban poor, city level finances, public infrastructure quality and performance levels among others. While this lack of data emerged as a major constraint in promoting the cause of financial inclusion, it also became apparent that institutions with available data sets were not translating this data, through analysis, into meaningful and usable insights. In the context of data generation for public infrastructure, the discussions revealed that the processes of planning needed to be re-looked at so as to ensure meaningful citizen participation in generating data about cities.

The detailed outcomes of the day’s discussions will be presented in the form of conference proceeds in the coming months.

By Anand Sahasranaman and Vishnu Prasad, IFMR Finance Foundation

In the second blog in the Consumer Financial Protection series, we explore insights from behavioral economics that could fundamentally impact the design of legislation and regulation for consumer protection in finance.

Neo-classical economic theories like expected utility hypothesis and efficient market hypothesis are based on the assumption that the consumer is a rational agent. However, recent insights from behavioral economics point out that the consumers do not always behave as time-consistent, rational utility maximizers. Consumers are, in fact, beset with a number of cognitive limitations and biases which influence their decision making and make them acts in ways contrary to the traditional model of hyper-rationality. We will explore some of the insights from cognitive psychology and experimental economics that could impact the design of consumer protection legislation and regulation in the future.

Prospect Theory:

The work of behavioral economists Daniel Kahneman and Amos Tversky provided early insights into consumer behavior. Their seminal work found evidence to suggest that consumers do not make decisions that expected utility theory predicts. The central insights of this theory help explain observed consumer behaviors such as:

a. Loss Aversion: People are extremely sensitive about losses and exhibit deep seated loss aversion to even small amounts of money. In fact, there is evidence that individuals are more sensitive to losses than profits – in fact, people value moderate losses more than twice as much equal sized gains (Tversky and Kahneman: 1991). This translates into financial decisions that would be at significant variance from the theory of expected utility.

b. Incorrect Probability Calculations: People have a tendency to overweigh small probabilities and under-estimate risks with larger probabilities. This explains why people more readily buy insurance on refrigerators and TV sets, but are less likely to buy life or accident coverage. Individuals also tend to be more sensitive to differences in probabilities at higher probability levels.

c. Response to Framing: People make different choices in identical situations because of the way the choices have been framed for them. The way in which a problem is described can be responsible for upto a 30-40% shift in preferences (Barberis and Thaler: 2003). The fact that framing can fundamentally impact consumer choice means that investor welfare could be seriously compromised in the absence of countervailing regulation.

d. Mental Accounting: The process people use to formulate financial problems for themselves is called mental accounting (Avgouleas: 2006). One classic case of mental accounting is “narrow framing”, where individuals evaluate a particular gamble (or financial transaction) as if it were independent of everything else in the world and not assess its utility in terms of the gamble’s effect on the individual’s overall wealth.

Biases and cognitive limitations:

Human beings also exhibit biases and other cognitive limitations that can contribute to poor decision making. In the context of financial products, consumers are prone to take decisions that can have negative future consequences for themselves (also called internalities).

a. Self-restraint: Consumers often behave in ways that compromise long-term well-being for short-term gains. This bias of present consumption out-weighing future welfare manifests itself in various forms such as the failure to save for retirement. It is also observed that consumers discount future benefits/costs in a time-inconsistent manner. For example, if offered $100 now and $200 a year from now, a consumer is likely to choose the immediate $100. However, when offered $100 five years from now and $200 six years from now, a consumer is likely to wait the additional year even though the it is the same choice she makes five years from now. This time inconsistent, present biased model of discounting is referred to as hyperbolic discounting.

b. Herding: Consumers often mimic behavioral patterns of peer leaders or peer groups, leading them to ignore signs and indicators that would lead a rational consumer to take different decisions. Such irrational behavior is fueled by overconfidence (in peer leaders or rating agencies and in assessments of new financial products) and can often threaten systemic stability. History is replete with examples of irrational behavior leading to economic bubbles, from the Tulip mania in the 1600s to the present financial crisis caused partly by the real estate bubble in the USA.

c. Information Overload: In the previous blog post, we mentioned Akerlof’s seminal study of the used-car industry, where information asymmetry leads to market inefficiency. Contrary to expectations, a regulatory response to provide the consumer with additional information (beyond a point) can be counterproductive. This happens due to the phenomenon of information overload, where the consumer is unable to assess the quality and amount of information given to them. Examples of this phenomenon include consumers casually flicking through tens of pages of terms and conditions when insurance is bought online, without understanding the risks and clauses involved.

Systemic irrationality and regulatory responses:

There are several limitations to the use of insights from behavioral economics in consumer financial protection.

Work in experimental economics argues for the emergence of rational behavior in the context of a repetitive market activity. Consumers display rational behavior in the long run, through a trial and error adaptation process and repeated market activity and spurts of irrationality are characteristic only of the short run. So, consumer irrationality, it is argued, can only be a factor in the policy of consumer protection, not the starting point. Second, behavioral economics is yet to come up with an all-encompassing theory of the market or consumer choice that can challenge the existing neo-classical theories; it has only pointed out deficiencies of the latter. Third, behavioral economics does not formulate any normative principles, which can be used either for empirical testing as economic models or for normative use as a guideline to an efficient market mechanism.

Even if consumer irrationality is an exception to the norm of rational behavior, the insights of behavioral economics alert us to the possible risks of systemic irrational behavior and the consequence this can have on the financial system. Any regulatory mechanism should therefore be designed to be able to respond to systemic irrationality. However, regulators should be required to tread carefully before intervening in a situation of perceived systemic irrationality. At the very least they must have to demonstrate indications of irrationality in the system, provide plausible explanations of how such irrationality can have a financial system-wide impact and finally make clear the case for how their proposed regulation will be effective in countering the irrational behavior.

To ‘nudge’ or not to ‘nudge’?

If consumers cannot maximize their own welfare (due to lack of cognitive capability or financial literacy), it is argued that regulation needs to ‘nudge’ the consumers into making those decisions which reflect the presumed judgment of what consumers would want, were they fully informed or well advised. This approach is referred to as libertarian or asymmetric paternalism.

The idea behind libertarian or asymmetric paternalism is not to restrict the consumer’s autonomy; rather it seeks to counter the harmful effects of cognitive biases without affecting the choices of the less behaviorally challenged consumers. Some of the suggested regulations include increased pluralism in information disclosure formats and in the prescribed volume of information reaching different investor classes, mandated use of structured and edited investment contracts that consumers can easily comprehend and mandatory use of long term performance reports. These suggestions imply that regulators must drop the ‘one size fits all’ approach as consumers’ decisions vary depending on factors such as income, education, age, attitude and the type of financial product they consume.

There are, however, strong arguments against the ‘nudge’ principle on the grounds of its interventionist approach, implied restrictions of choice and possible impact on rational consumers. These arguments speak to the heart of debates around behavioral economics and consumer protection today.

References
1. Backstrom, Hans. Financial consumer protection- goals, opportunities and problems. Economic Review. 2010
2. Campbell, John Y., Jackson E Howell et al. Consumer Financial Protection. Volume 25, Number 1. Pp 91-114. Journal of Economic Perspectives. 2011
3. Spindler, Gerald. Behavioral Finance and Investor Protection Regulations. Journal of Consumer Policy. 2011
4. Emilios, Avgouleas. Cognitive Biases and Investor Protection Regulation: An Evolutionary Approach. 2006. Available at SSRN: http://ssrn.com/abstract=1133214
5. Kahneman, Daniel and Tversky, Amos. Prospect Theory: An Analysis of Decision under Risk. No. 2, Volume 47. Econometrica. 1979
6. Kahneman, Daniel and Tversky, Amos. Loss Aversion in Riskless Choice: A Reference-Dependent Model. 106, Quarterly Journal of Economics. 1991

By Bindu Ananth

A recent article in the Economist notes approvingly about the growing phenomenon of Village Savings and Loans Association (VSLA) as a means for low-income clients to save securely and earn high returns. In brief, the mechanism entails a group, typically at a village level, pooling their savings together and lending out of this corpus to each other. The underlying principle is similar to that of chit funds and ROSCAs.

This whole design of VSLAs is missing a very fundamental point about the way in which savings operates and the value of financial intermediation. When an individual saves with an institution, she takes risk on the solvency of the institution (unlike in credit where the institution takes risk on the individual/borrower). She should be able to withdraw her savings at any time which in turn entails that the savings has been channelled and managed in a way that enables the institution to honour this. A VSLA tries to replicate this at the level of a village/community. Now imagine there is a drought in the village and there is a widespread need for liquidity. The savers will want to withdraw their money, but equally the borrowers will find it a hard time to make their repayments. Both groups are impacted by the same event (a covariate shock). Effectively, there will be a “run” on the VSLA. The VSLA, unlike a bank faced with a similar situation, does not have the diversification or the deep pools of capital to simultaneously bear the default and honour the savings withdrawals.

There is no question that access to traditional savings accounts is hard for low-income clients in all countries and innovations like the VSLAs are well-intentioned attempts to address that. However, we need to ensure that the financial inclusion designs we choose to scale do not end up creating newer types of systemic risk. The Business Correspondent approach, despite several tactical challenges, scores very highly on this count – it leverages the access of village level institutions/agents but the savings is channelled into the formal financial system through a bank.