By Deepti George, IFMR Finance Foundation

IFMR Finance Foundation worked with Pension Fund Regulatory and Development Authority of India (PFRDA) as Knowledge Partners to help organise their first NPS-Lite Aggregators’ Meet in New Delhi, on 21st November, 2011. The meet brought together aggregators and other stakeholders under one roof, to address issues and concerns faced while distributing NPS-Lite and Swavalamban benefits to their customers.

The Meet was attended by all senior members of PFRDA along with representatives from over 25 different organisations, including Nitin Chaudhary and Anil SG from IFMR Rural Finance who were also part of separate panels. PFRDA used this opportunity to announce a new incentive scheme for the Aggregators where they increased the fixed incentive from INR 50 to INR 100. PFRDA also released new communication material that was designed specific to each aggregator’s need and could be used for creating awareness about pensions, NPS-Lite and Swavalamban benefits.

The Meet kicked off with an opening statement by Mr.P Upadyay, Chief General Manager, PFRDA, and was followed by an overview of the two pension schemes, NPS Lite and Swavalamban, by Ms.Padma Iyer Kaul, Executive Director, PFRDA. She set the tone of the conference by highlighting the importance of pensions and guided the participants in practically addressing the issues they may have with the two schemes. Mr.Yogesh Agarwal, Chairperson, PFRDA, also graced the conference with his presence and thanked the aggregators for their efforts.

The Meet brought critical issues to the table resulting in lively discussions on product design, need for a standardised method of delivery through technology and the inherent necessity for a nation-wide awareness campaign to highlight pensions as an important financial planning tool.

In response to the concerns highlighted, some fascinating suggestions and innovations, few already being implemented by Aggregators, were brought to light. Some of these are:

1) The need to develop communication and marketing collateral that can be deployed to create awareness and educate people on pensions – in order to create the market for pensions
In this context, Nitin Chaudhary, explained the Wealth Management approach of KGFS entities that has enabled it to become the leading aggregator in terms of penetration of NPS Lite. He also shared training materials and flipcharts currently being used at KGFS. South Indian Bank also shared their ideas they had successfully implemented, where they used the NPS-Lite logo on all receipts and envelopes. A few aggregators like Bandhan Financial Services and Department of Women and Child Development (DWCD) had even developed their own passbooks to record transactions and help customers keep track of their contributions.

2) The importance of building technology platforms which help to reduce transaction and process costs along with reducing operational risk
Mr. Amit Sinha, from NSDL suggested that using mobile phones for transactions would encourage portability across aggregators and increase efficiency. It was also suggested that creating applications that could be shared with all Points of Purchase was cost-effective and easy to build, also paving way for inter-operability between aggregators, and across locations. Inter-operability was especially important given that the access to this long-term product must not be aggregator-dependent.

3) Concerns relating to delayed issuance of PRAN (Permanent Retirement Account Number) cards and data errors
IFMR Rural Finance shared its feat of being the first aggregator to generate PRAN directly in collaboration with the CRA (Central Recordkeeping Agency), thereby reducing TAT to less than 24 hours. Data errors could also be minimized by IFMR Rural Finance as the application forms get pre-populated with customer details directly from the Customer Management System rather than by a manual data-entry process.

4) KYC requirements contribute to exclusion of segments of the population, especially the migrant population
Ms. Gayathri of Labour Net suggested that given the essentially floating nature of migrant populations that could potentially enroll for NPS-Lite, a more diverse set of documents could be included for KYC norms to enhance outreach. It was also suggested that a “one-size-fits-all” strategy should not be adopted for the given target population, but rather there is a need to develop different strategies for different segments such as the stable urban poor, the daily wage migrants, seasonal migrants, and so on.

5) Increase benefits and attractiveness of NPS Lite and Swavalamban for the customer
It was suggested by Anil SG of IFMR Rural Finance that NPS-Lite may be clubbed with health insurance products like RSBY to take care of a gamut of eventualities that the individual or household may face, which may otherwise force them to dip into their pension corpus. This would provide customers with multiple benefits, mitigating not only longevity risk but also addressing to an extent, health shocks.

Going forward, IFMR Finance Foundation is drafting a report collating recommendations of participants from the Meet and suggesting ways forward for the NPS-Lite and Swavalamban schemes.

By Bindu Ananth

I had a fascinating meeting today with Gayathri, CEO of LabourNet Services that reminded me of some fundamental challenges in financial inclusion. So, here is a company deeply wedded to its mission of providing essential services and skills to urban informal sector workers. Over the years, they have realised that identity and basic financial services (savings and insurance) is an important need for the informal sector worker and started getting involved in facilitating access. However, 23000 accounts later, they find themselves in the familiar ‘bewilderment zone’ in dealing with multiple financial institutions and the lack of connect between existing products/processes and their sense of what their typical client requires.

This meeting reiterated for me the need for many-many more specialised distributors of financial services in India. These cannot be individuals or kirana shops, but formal institutions with the processes and understanding to effectively intermediate between the clients on the one hand and the product manufacturer (bank, insurance company, mutual fund) on the other. Like we are creating a set of new-generation distributors called KGFS to serve remote rural India, there is a similar need for high-quality distributors for the urban poor, for seasonal migrants and other demographic profiles with fundamentally different demand characteristics.

At IFMR, we think that pushing manufacturers to build last-mile distribution is a losing battle (one we have waged as a financial system for decades). Instead, we need to create several more institutional distributors in India with incentives aligned to the financial well-being of customers.

By Shweta Aggarwal, IFMR Rural Finance

As a welcome step, SEBI released a circular for AMCs requesting them to regulate distributors. This is the first time distributors of mutual funds in India will function in a regulated environment within a structured framework. In this circular, SEBI separates out two functions that can be played by the distributor, as an advisor and as an executor. By separating these functions, SEBI has empowered the customers to select distributors based on either their advisory expertise or their capacity to execute transactions or both. Both services have separate charges that need to be paid by the customer and advisory charges can be rejected by the customer.  Transaction charges paid for execution services to the distributor are indirect charges to the customer as they are paid by AMCs from subscription money.

SEBI further keeps customer interests in mind while levying INR 100 transaction charges for only transactions above INR 10,000. This is to attract small and medium investors and encourage them to invest in mutual funds. SEBI also pays attention to improving the quality of originators as they ask Asset Management Companies (AMCs) to conduct thorough Due Diligence for distributors.

These guidelines seem well aligned with customer interests but if viewed from a distributor’s lens may seem to distort incentives and leave grey areas for AMCs. Some of the guidelines addressed by SEBI in the circular are analysed below:

1. Guidelines regarding transaction charges:

The new pricing structure introduced seems inflexible and charges all customers investing more than INR 10,000 a fee of INR 100. Even though this is less than a 1% fee, it may incentivise distributors to ignore small investors since the distributors will earn only if small investors are investing for the first time in mutual funds. Hence a more dynamic price structure needs to be introduced which keeps both, distributor incentives and customer interests in mind.

We feel that a more flexible pricing structure, like ad valorem fees with a cap of INR 100, may be better suited for the Indian mutual fund industry.

2. Due Diligence process conducted by the AMC

The introduction of due diligence checks before appointing distributors is a positive step. It will help maintain reports on quality checks and maintain updated audit reports. It will also help AMC’s monitor the distributors and ensure that they are abiding by regulations and are keeping customer interests in mind. The only concern that arises here is whether all AMCs have the expertise to carry out such checks. AMCs may have to invest in establishing due-diligence and monitoring processes.

The next steps for SEBI should be to publish a comprehensive check list and a unified format for building reports. Themes covered in the check list should be debated and discussed and must eventually align distributors to cater to customer needs through customer awareness programs, product innovation and capable advisory services.

3. Customer Relationship and Transactions shall be categorized as “Advisory” and as “execution only”

This is a great distinction to put in place since the distributor now has an incentive to build expertise in advisory services and the customer has the right to choose and pay for advisory services best suited to his needs. Each time a customer declines advice from a distributor and accepts only its execution services, a distributor will be encouraged to fine tune its advisory expertise. This will create healthy competition amongst distributors and benefit customers over a period of time.

The SEBI circular is definitely a step forward in encouraging presence of high quality distributors that are well aligned with customer interests. However, over a period of time these guidelines will require refinement and more detail to help deepen retail investor base beyond Tier 1 and Tier 2 cities. Important steps forward would be to introduce nationwide awareness campaigns that are conducted by SEBI, more flexible price structures that enable product innovation and increasing presence of distributors even beyond Tier 2 and Tier 3 cities.

By Shweta Aggarwal, IFMR Rural Finance

The Committee to Review Implementation of Informal Sector Pension (CRIISP) recently released their report focusing on National Pension Scheme (NPS), its design architecture, its performance till date and recommendations for increasing outreach and awareness about the product. The committee recognises that the current design of NPS excludes a large part of the population engaged in the unorganised sector. It gives recommendations on different aspects of the product, its cost structure, delivery channels and strategies for marketing and promoting the product to make it more accessible for the end customer.

We go over some of the recommendations and analyse benefits if these do get accepted.

Given all these recommendations, it is important to implement a regulatory framework that addresses cases of mis-selling and aligns distributor incentives with customer incentives, especially when broad basing distributions agents. The report suggests that PFRDA develop this framework based on a code of conduct for NPS distributors. This should be implemented along with other changes to encourage responsible scale-up.

NPS has the potential to meet needs of millions of retirees in India through offering a competitive, fair and convenient savings option. The CRIISP report presents a thorough analysis of the products and the importance of aligning product design and delivery with these needs. We believe if these recommendations are accepted, NPS will be able to effectively address the problem of an ageing population in the Indian context.

- By Shilpa Sathe and Deepti George, IFMR Rural Finance

In the series ‘Finance Matters’, we have examined the various elements that enable the provision of high-quality financial services, particularly for the under-served segments of the population. In this column (the last in this series), we summarise this thinking and paint a vision for the future of financial service access for households.

The current financial system takes a product-menu driven approach, where different providers meet different household requirements such as savings, insurance, credit, pension and payments on a piecemeal basis. The customer takes responsibility for the ultimate outcome, which could be achieving a target annuity during retirement, building the required corpus for a child’s education, or being protected for the full value of human capital.

Today, the disaggregated delivery of financial services has put the onus of taking technically complex financial decisions on the consumer. Even for the highly educated individual, this task has become difficult, if not impossible, given the rapid innovation in the financial marketplace, coupled with limited ability to assess alternatives. Even with easy availability of information, the principal-agent problem remains, with the agent or advisor having limited liability for what she sells.

We have argued in this series that a household needs providers who can offer integrated solutions in a continuous and convenient manner. There is adequate research to show that the financial needs of households are multi-dimensional and one must look to solutions that can necessarily deliver on comprehensiveness. The starting point is a customised financial plan, based on a clear assessment of a household’s financial goals, current and expected cash-flows, appetite for risk, and so on. Specific products are a means to achieve household goals, and not ends in themselves.

Customised plan

This additional responsibility of computation and advice means that the provider will have to take on a more holistic approach, cutting across traditional barriers of institutions and products. Future financial services providers will be akin to general physicians, who bear great responsibility for the health of their patients.

Such a prescriptive approach would also minimise instances of unsuitable advice, such as selling illiquid assets to clients with immediate liquidity requirements, or selling loans that require repayments that do not match the household’s cash-flows.

In such a regime, incentives need to move away from standalone product sale to following a set of protocols that will subsequently enhance the financial well-being of the households served. Such well-being is the state in which a household can optimally choose patterns of consumption over time and in uncertain states of the world.

To choose these patterns of consumption, households should have the ability to grow, manage liquidity and overcome financial shocks, across different periods of time. The integrated approach will equip households with the means to achieve this.

Structural models will have to evolve to incorporate market imperfections such as irrational behaviour, which will necessitate a greater investment in the development of intelligent systems and training resources to deliver high-quality solutions.

Provider’s liability

While developing provider expertise will aid better choice, this approach also calls for extending a provider’s liability to following protocols that are consistent with financial well-being, and for this to be enforceable as a statutory obligation, rather than just a fiduciary one.

This is particularly important because, unlike physical products, financial products lack visibility and, unlike many services, they reveal their real outcomes at a point in time beyond the time of purchase. Clients thus have limited ability to assess upfront, the quality of a product.

This is clearly problematic and highlights the need for ex-post liability regimes in the context of financial service providers. One way this could be addressed is by setting ‘negligence standards’, similar to those in place for consumer products. Customer protection regulation that is currently at a very nascent stage in India will have to evolve to meet these challenges.

The evolution of this fundamentally different approach to product design and delivery stresses the need for functional regulation — that is not product- or institution-based but based on functions served by them. Regulators and policy-makers have a key role to play in aligning the incentives of agencies in the financial market place.

Business model innovation must be encouraged to discover new and integrated approaches to financial services delivery. As discussed earlier, the optimal role of Government is in creating infrastructure — connectivity, unique identity and payment backbone — that will enable all service providers to reduce their cost of operations. Moving ahead, we see no trade-off between ubiquity and quality of services in financial services delivery. Both are achievable.

In summary, a well-functioning financial system should aid transfer of resources across time and different states of the world, helping individuals and organisations manage risk, disseminate price information and align incentives. This is best achieved through the provision of integrated solutions by well-trained providers and requires reliable financial institutions that work towards maximising the financial well-being of clients. Institutional structures and product innovations will need to move together to ensure that the true transformative power of finance is realised.

This article first appeared in The Hindu Business Line

By Shweta Aggarwal & Shilpa Sathe, IFMR Rural Finance

A common refrain that one hears in the context of financial services for low-income households is the importance of “keeping it simple”. A simple product, combined with “financial literacy”, is the most common prescription for financial inclusion. But this is a dangerous approach and one that is not rooted in a good understanding of the nature of finance.

Let’s first see how simplicity can affect financial design in the case of a farmer. Before the sowing season, the farmer needs to finance his sowing operations. This can be done in two ways: first, a crop loan payable in equal monthly instalments and second, a crop loan where principal and interest payments are linked to the amount of rainfall obtained in the region.

The first option is clearly a simple product to design and communicate for a provider, since it shifts to the farmer the responsibility of insuring against rainfall risk. The damaging effect of this “simple” loan product is evident, as fixed payments are attached to volatile cash-flows.

The second option, however, requires the provider to develop an integrated solution by hedging the risk at his level. While the resulting product is complex, it addresses the farmer’s needs more efficiently.

Difficult choices

Re-examining this notion of simplicity in the context of retirement planning, we find a household with earning members today wants to invest in assets that will give them stable income post-retirement and protect them from longevity and health risk. An optimal choice here is a contract combining an annuity scheme with health insurance. But, in the market, these are two stand-alone products, priced with very different assumptions.

A health insurance contract assumes that the people who purchase it will be those who expect to fall ill more often; the logic that goes into pricing an annuity, on the other hand, is just the reverse. In this disaggregated method of delivery, purchasing these products individually would not only impose a high cost on the consumer, but will also assume that the average consumer has the capability to understand this contract.

Financial literacy

Policy-makers see financial literacy as a solution to empower consumers and enable them to take decisions that will benefit them. But in the case highlighted above, the expertise needed to choose the optimal bundle of products goes beyond financial training. The financial marketplace is dynamic and it is almost impossible, even for the sophisticated consumer, to keep pace with financial innovation. Even for a well-informed consumer, translation of such knowledge into a purchase decision calls for his getting past an array of cognitive biases, such as procrastination, regret and loss-aversion, mental accounting and information overload. Financial literacy makes the very troubling assumption that if customers had all the necessary information, they would make perfect, welfare-enhancing decisions. Unfortunately, there is very little evidence to back this assumption.

A study conducted by professors at the London School of Economics, and published by Financial Services Authority, shows that behavioural biases often result in sub-optimal decisions for consumers. For instance, lower rates of annuitisation among retirees are attributed to a greater weight being assigned to the risk of early death over a longer-than-expected retirement period.

The inherent difficulty in navigating the growing assortment of choices results in customers placing higher levels of trust in their financial service providers and advisors. However, how much liability does the provider have today for this ‘advice’ that he gives?

Benefits for agents

The model of delivery is largely commission-based, with mutual funds and insurance schemes being pushed on to clients in a way that maximises the agent’s commission and not always the clients’ welfare. Disclosure is usually in the form of a bulky document that the client has to sign on, often a poor substitute for informed consent. Outcomes from an investment are not always possible to predict ex-ante and, in many cases, will depend on the provider’s decisions.

Speculation by a fund manager can, for example, lead to losses for the investor, without the company taking responsibility for it. Risks and losses may not be appropriately conveyed, or conveyed late, leaving the investor to deal with them. Alternatively, the right combination may be technically too complex for the investor to choose by himself. Financial literacy has a very limited role to play here. Is it fair, then, to say that the preoccupation with simplification gives the provider an unfair advantage? Households and individuals are looking to fulfil certain basic functions over their lifetime, such as reducing risks and accumulating assets. These functions may vary at different stages of the life-cycle, as does their capability to achieve them.

An inclusive financial system should be able to equip a household with the right set of tools to enable informed decision-making. While this requires basic knowledge on the part of the consumer, the optimal choice can result only with changes in the current system of product design and delivery. The provider will have to cut across traditional institutional barriers to develop integrated products and services that lead to more efficient financial outcomes. In order to facilitate this process of financial re-engineering regulators and policy-makers will need to work in a coordinated manner. The way forward will be a shift in responsibility from the user to the provider, through a more prescriptive approach to financial service delivery.

This article first appeared in The Hindu Business Line.

- By Arun Kumar D, IFMR Rural Finance

India is home to about 26 million small enterprises (with investments less than 50 million) that account for about 20 per cent of the country’s GDP . While small enterprises drive economic growth with their ability to innovate and employ in large numbers, the biggest challenge faced by them is access to finance.

Small enterprises, such as brick-kilns, grocery stores and small restaurants, need finance to purchase raw materials, procure stock, pay wages, meet other working capital requirements and support expansion plans.

Despite the efforts of Ministry of Small and Medium Enterprises, SIDBI and support from the RBI by inclusion under priority sector, there continues to be a huge demand-supply mismatch in small enterprise financing.

One of the major reasons for banks/financial institutions (FIs) being unable to bridge this gap is the perceived credit risk involved in financing small enterprises. This is primarily on account of non-availability of valid bills, proper accounting systems and lack of known buyers.

To mitigate such credit risk, banks typically look for enhanced collateral or traditional equity, both of which cannot be brought in by most entrepreneurs. Further, due to their small size and local presence, the transaction costs involved in financing them are very high.

ASSESSING LENDING RISKS

In the face of banks’/FIs’ reluctance to lend, these enterprises are compelled to resort to high cost, non-continuous financing from money lenders and other informal sources, or continue to operate at sub-scale. Banks charge an interest rate of 10-20 per cent, compared with 36-70 per cent from informal sources like money lenders. Risks faced by any business can be broadly classified as idiosyncratic or systemic. Idiosyncratic risks are specific to an enterprise, like location of business or skill of the entrepreneur.

Systemic risks, on the other hand, are beyond the control of any enterprise. Such risks make up the environment in which a business operates. Risks due to change in preference of customers, a catastrophic event, and changes in economy are all examples of systemic risks.

The key to financing any enterprise lies in the ability of the financier to evaluate and manage such business risks. High quality origination can help evaluate idiosyncratic risks well. Traditional equity acts as a cushion for such risks. A high quality local originator with geography and business specific information about such enterprises in the operational area will be able to evaluate and manage this risk well and will demand lesser traditional equity to be brought in by entrepreneurs.

Systemic risks, however, are a different ball game. No amount of traditional equity is sufficient when the financier is uncertain about an enterprise selling anything at all in an environment where demand patterns and economic situations can change very quickly.

A financier searches for cues to establish that the business has a current and future ability to service loans, even in an uncertain business environment. For small enterprises that have large number of cash transactions, poor record of sales, produce undifferentiated goods and lack known clients, assessment of systemic risk becomes very difficult.

Such challenges can be addressed through structures that allow financiers to trap cash flows, or by resorting to a stronger and well established sales pattern in a supply chain.

FINANCING METHODS

Some ways of financing small enterprises are as follows: Supply-chain financing, where a supplier and a buyer with known balance sheets can be financed.

For example, small enterprises that manufacture and supply jam to large players can be financed if their cash flows are trapped through bills, or by obtaining a collateral/guarantee/comfort letter from the company to which it supplies.

This can be adopted by many financial intermediaries, even large banks. The method has its limits because it requires careful mapping of supply chains. Lending through a local financial intermediary who can verify cash flows and income of the enterprise and finance them through relationship-based approach is another option.

A local financial intermediary who understands the working capital cycle, seasonality, procurement place and mode, point of sales, and demand for the product or service, can finance small enterprises based on an understanding of the geography in general and various aspects of the business in particular.

A local intermediary can ascertain turnover, income and other key financial information required to arrive at a credit decision about the enterprise.

Business-specific templates can be developed for each small enterprise and a master limit can be fixed taking into consideration the scale of business, projected sales turnover and surplus they would generate.

Depending on business requirements, FIs can provide working capital loans, term loans or both. Also, long-term, relationship-based lending helps mitigate credit risk by creating dynamic incentives for the enterprise to maintain a relationship with FIs.

PRODUCT INNOVATIONS

Innovation in product structuring is as important in addressing gaps in small enterprise financing as the channel itself. Innovative products such as equipment lease finance can help address the need for term debt, and products such as receivable financing, bills discounting and factoring could substitute requirements of working capital finance, addressing the unique needs of small enterprises.

Local originators are best placed to do this given their monitoring capability and knowledge of small enterprises, allowing structuring of products like working capital finance, channel finance and cash credits that meet needs of the enterprise, enabling scale.

This article first appeared in The Hindu Business Line

IFMR Rural Finance has been appointed as one of the first Interested Non-Governmental Agencies (INGA) by the Ministry of Labour and Employment, Government of India, to participate in its Rashtriya Swastya Bima Yojana (RSBY).

The RSBY is a Government of India flagship initiative to provide insurance coverage for Below Poverty Line (BPL) families. Hospitalisation coverage up to Rs. 30,000 (arising out of health shocks) is provided under RSBY. The RSBY has already enrolled close to 23.5 million households in the BPL category.

As a result of this appointment, customers of Kshetriya Gramin Financial Services (KGFS) can now avail health insurance under the RSBY. More than 170,000 rural households in Tamil Nadu, Orissa, and Uttarakhand that are already being serviced by IFMR Rural Finance can now benefit from the scheme.

 “Health shocks are a major threat to the income earning capacity of households and lack of access to affordable and quality health care systems in rural areas make these households even more vulnerable. Health insurance, which provides a safety net by protecting the human capital, plays an important role in ensuring the financial well-being of these rural households. Partnering with RSBY will help us offer this much needed product to our customers, who will also be able to benefit from the scheme’s technology driven platform to access an extensive network of quality health care services”, said SG Anil Kumar, CEO, IFMR Rural Finance

Under this arrangement, it is envisaged that the KGFS will be responsible for customer identification, creating awareness about the benefits and premium collection, while the insurers and RSBY will be responsible for managing the hospital network and administering of the insurance programme. The product portfolio of KGFS includes investment, credit, remittance and insurance products.IFMR Rural Finance is already an aggregator for PFRDA’s NPS-Lite. At present, customers can avail Personal Accident, Life, Livestock and Shopkeepers insurance through KGFS. The latest development offers the much needed protection against health shocks for remote rural households.

By Uday Krishna & Rajendra Kumar, Agricultural Terminal Markets Network Enterprise, IFMR Trust

Agriculture incomes in India are volatile because of a number of unforeseen factors, such as weather, disease/pest infestations and/or market conditions. With 65 per cent of the population dependent on agriculture, it is essential to manage both production and price risks. The government has responded by encouraging the setting up of modern exchanges, with daily mark-to-market margins, a trade guarantee fund, back-end computerisation, on-line trading and demutualising of new exchanges.

However, to realise the benefits from such initiatives, the bulk of farmers, who are small and marginal, require access to finance immediately after harvest, though they possess limited collateral to obtain bank funding. Physical collateral such as land and agricultural implements are of little value in mitigating a financier’s risks as the collateral is difficult to enforce and has a low resale value.

Liquidity problems

Agriculture is a seasonal business with high price uncertainty. During harvest, prices drop due to excess supply. But, if the harvest is lower than expected, the prices rise. Hedging against price fluctuation is possible through derivative contracts such as commodity futures, fixed price forward sales or purchase of put options.

With commodity futures, the farmer agrees to sell the commodity at a pre-determined price and date. While a fixed price forward sale agreement is possibly the simplest price hedging strategy, it is difficult to find the right counter-party unless the size of the expected crop is reasonably well known, prices are satisfactory and buyers have enough confidence in the seller to commit on a forward basis.

Since there are several variables, such contracts are better implemented with a put option for the farmer or a call option for the buyer. In India, proposals to allow options in commodities and provide for registration of brokers by suitably amending the Forward Contracts (Regulation) Act have been pending in Parliament for over five years.

Warehouse receipt financing

Small farmers need liquidity urgently and the crop is inevitably sold to traders/village-level aggregators immediately after harvest. The buyers hold the stock through the harvest season till prices rise. If farmers are enabled to hold their crop beyond harvest, this price benefit could accrue to them. Farmers face two major problems — lumpy cash flows and non-availability of intermediate finance.

Warehouse receipt finance, which can be used to extend the sales period beyond harvest season and secure collateral for obtaining finance, can play an important role in smoothening farmers’ incomes by providing liquidity at times when cash-flows dry out.

The concept of warehouse receipt financing is not new in India. Banks have been extending these facilities to large aggregators, traders and bulk farmers, ignoring small and marginal farmers. Extending cheaper credit to small/marginal farmers is easily done through warehouse receipt financing if banks purchase suitable hedges on the price of commodities, assuming only a minimal credit risk.

In warehouse receipts financing, producers deposit goods of a certain quality, quantity and grade in accredited warehouses and receive a receipt for it. Since these receipts are now accepted as negotiable instruments (under the Warehouse Development and Regulation Act 2007), they can be traded, sold, swapped and used as collateral to support borrowing or accepted for delivery against a derivative instrument such as futures contract. This facilitates access to finance.

For the receipts to work effectively, it is essential to ensure infrastructure, and grading and collateral management systems which guarantee the quality and quantity of stored commodities. This will provide comfort to farmers — to store their produce, as well as to banks — to accept warehouse receipts as secure collateral to finance farmers.

Trading units on national-level commodity exchanges are large, preventing small and marginal farmers from participating individually; they depend on local mandis/middlemen. Also, the rather small number of delivery centres and the price difference across physical markets limit farmers from participating in trading.

There is a need to increase the reach, provide the services of an assayer and reduce transportation costs. Setting up local access to commodity exchanges and end-buyers, allowing them the kind of price discovery offered by national exchanges, and convenience of access, is a possible solution.

An example of a local exchange is the Agricultural Terminal Markets Network Enterprise, which works with castor farmers, allowing them to trade at local branches across Kadi Taluka, 65 km from Ahmedabad.

Price discovery

Small and marginal farmers are also inconvenienced by the inter-bank settlement time, preventing exchanges from making instantaneous payments to traders. Price discovery between international and domestic commodity markets can improve by allowing banks to offer commodity solutions as an intermediary between international counterparties and smaller Indian companies.

While domestic exchanges currently offer over 50 commodities across various segments, the number of contracts listed on the exchange for agricultural commodities continues to be low. As the number of listed contracts increases, price discovery will improve.

This article first appeared in The Hindu Business Line.

Bindu Ananth, President, IFMR Trust has written the latest post in a new CGAP Microfinance series on savings.

Excerpt

My colleague and I were once asked at a conference, “So, how exactly does a bank account reduce poverty?” Great question.

If you are a low-income household, among the myriad range of challenges competing for your time and attention; there are two that very likely claim the lion’s share: the everyday problem of managing income-consumption timing mismatches; and the problem of building, over a long term, lump sums that help finance the households’ lifecycle goals such as education, housing and marriage. Portfolios of the Poor provides insightful narratives on the nature of these challenges. In recent years, the imperative to find high-quality solutions to these problems has been well-recognised.

By and large, these problems boil down to one issue: lack of convenient access to ‘accounts’ where one can receive, store and withdraw flexible amounts of value in a safe and remunerative way. This account need not necessarily be a bank savings account. Based on the client needs, the nature of this ‘account’ may change as do priorities around key features—liquidity, returns, and inflation protection.

Read the full post at the CGAP Microfinance Blog.