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.