By Deepti George, IFMR Finance Foundation

Following the sessions by Dr. Isher Ahluwalia and Mr. Vikram Kapur, (covered in this post) the workshop participants discussed critical topics such as decentralisation and governance, political economy and institutional fragmentation, revenue generation and infrastructure financing, water and sanitation, capacity building, and land and city growth. The discussions, group exercises and presentations coalesced around a few themes, highlighting their importance for the urban agenda.

These themes provide rich scope for further analysis and research, and highlight the need for deeper exploration of specific issues critical to understanding and managing the urbanisation process.

For instance, the discussion on financing strategies for cities to raise the huge quantum of investment required to build and maintain infrastructure and services, brought the following issues into sharp relief:

1. The importance of own revenue generation and the ability to leverage funds:

Cities in India have traditionally been used to financing themselves purely through grant funds provided by higher levels of government. This has led to a culture of dependency and lack of accountability to citizens. It was pointed out that in order to raise the magnitude of investments required for urban infrastructure over the next 20 years, cities would have no choice but to leverage their grant funds by reaching out to the debt markets. Currently, on account of poor capacities and insufficient own-revenue generation, most Indian cities are unable to access debt markets.

This brings into sharp relief the critical importance of cities being able to generate own-revenues (from sources such as property tax and user charges), because without sufficient internal revenue generation, external debt will not be serviceable. Strategies for cities to improve their internal revenue generation will be key to developing sustainable financing models for urban infrastructure.

The TNUDF model (a PPP focused on raising debt for small and medium cities) was also seen as a scalable mechanism for other states to enable their cities to raise debt funds from the market.

2. Market-worthiness of ULBs as a tool to enable flow of funds from capital markets:

ULBs will be constrained in raising funds from the markets also because the rating models used to rate ULB debt do not take into account the operating models of cities in performing their duties. Because rating agencies focus their analysis purely on the financial aspect of ULBs and the associated credit risk that this implies, they tend to miss out on the many other aspects critical to the way a ULB functions. This results in low credit ratings (below investment grade) overall for ULBs, and further it does not distinguish between cities that are financially similar but vastly different in terms of their management and operating capacities. These capacities have tremendous impact on the performance of local governments.

In this context, the role of a set of “market-worthiness” standards that provide deeper insights into the operating, technical and management capacities of ULBs was seen as being an important complement to the credit rating process. Taken together, the credit rating and “market-worthiness” rating could provide a more comprehensive sense of the risks associated with the ULB. Discussants saw this type of market-making activity as being especially important in the context of small and medium cities.

Similarly, there were deep discussions on a number of themes such as the importance of standards for public service delivery, the need for capacity building, the nature of decentralisation and the mechanisms for improved governance.

This note describes these themes in greater detail.

Following the release of a discussion paper on deregulation of savings bank deposit interest rates, the Reserve Bank of India (RBI) has in its second quarterly review of Monetary Policy 2011-12, deregulated savings bank deposit rates with immediate effect. Given the low penetration of savings bank accounts in India (only 36 bank accounts for every 100 persons as on March 2009^[1]), we are very excited by this significant step. In the short run, this is expected to increase returns to consumers on their savings accounts by triggering competition between banks, in a manner that may be similar to what was observed for deregulation of domestic term deposit interest rates. In the long run, bringing down the ‘negative real returns’ characteristic will make bank accounts a more attractive savings instrument.

We look forward to the operational guidelines for this deregulation move. We hope that these guidelines will take into consideration consumer protection measures to safeguard the interests of about half of all Indian households that save, invest and diversify into various physical assets in the absence of access to suitable financial assets. Our responses to RBI’s discussion paper on the same can be found here.

[1] Basic Statistical Returns of Scheduled Commercial Banks in India and Handbook of Statistics on the Indian Economy, RBI, Various Issues

By Shweta Aggarwal, IFMR Rural Finance & Deepti George, IFMR Finance Foundation

The High Powered Expert Committee, chaired by Dr. Isher Ahluwalia submitted its Report on Indian Urban Infrastructure and Service Delivery. The report lays out the infrastructure investment needs for urban India in the next twenty years and makes recommendations for mechanisms to finance such a magnitude of investments.

Having contributed to the drafting of the report, IFMR Finance Foundation and the Centre for Development Finance (CDF) invited Dr. Ahluwalia to speak about the report in a workshop on Urban Infrastructure and Service Delivery. Held on 8th September 2011, this workshop had participation from a small but diverse mix of people actively engaged in shaping the urban agenda, from practitioners, representatives from Government bodies, to academicians. The workshop commenced with a session by Dr. Ahluwalia, followed by a session by Mr. Vikram Kapur, IAS (who previously held the position of CEO of TN Urban Development Fund) and concluded with panel discussions by the participants.

The Sessions:

Dr. Isher Ahluwalia presented the report’s findings and shared experiences from the process of writing the report. While she spoke about the need for planning, financing, creating and maintaining urban infrastructure, she also specified that standards of service delivery must be available to all including the poor.  All efforts must be made towards consciously building rural-urban synergies in policy and planning. To this end, reforming governance at all levels of government, from the Urban Local Bodies (ULBs) to the Centre, as well as investing in capacity building of the ULBs should be the need of the hour. She stated that municipal entities need to be strengthened with ‘own’ sources of revenue and predictable transfers from state governments, to help them discharge the larger responsibilities assigned to them by the 74th Constitutional Amendment.

Dr. Ahluwalia also noted that having a ‘local bodies’ list in the Constitution and making devolution mandatory would empower ULBs by giving them opportunities to collect specific local body taxes and charges (such as motor vehicle tax, entertainment tax, advertisement fee). Policies will need to be altered to incentivise states that devolve more powers to the ULBs. Dr. Ahluwalia conveyed best practices that she had opportunity to see during the course of her work, which she regularly writes about in her monthly columns in the Indian Express.

Mr. Vikram Kapur shared experiences from Tamil Nadu while addressing Long Term Infrastructure Financing needs of Urban Local Bodies (ULBs), especially small and medium cities in India. He stressed that investment needs for small and medium cities over the next 20 years was 65 times the current level of investments. Mr. Kapur stressed that given India’s phenomenal growth rate of 8% and a record of healthy savings rates, the government should tap domestic capital markets to finance these needs. He stated that the key today is to shift the way government funds are used, to leverage government funds rather than looking at them purely as grants.

The below video contains some excerpts of the two sessions. The full video of the two sessions can be accessed here: Dr Isher Ahluwalia – Mr Vikram Kapur.

Excerpts from the two sessions:

Workshop:

The group discussions that ensued were based on critical themes such as decentralisation and governance, political economy and institutional fragmentation, revenue generation and infrastructure financing, water and sanitation, capacity building, and land and city growth. Many interesting ideas and themes were generated in this workshop. We will be carrying these in a subsequent post.

By Vineet Sukumar, IFMR Capital

The Reserve Bank of India yesterday released a fresh set of draft guidelines governing securitisation and assignment transactions. While the draft was released by the Department of Banking Operations and addressed to banks, it is expected that a similar draft will be issued for NBFCs as well.

The draft guidelines are comprehensive and cover various aspects of a securitisation including minimum holding period (MHP), minimum retention or risk (MRR), accounting treatment, true sale, credit enhancement requirements and due diligence by the purchaser. Further, the RBI seeks to cover assignment transactions under the ambit of its regulations.

Securitisation and assignment transactions have emerged as preferred financing routes for NBFCs in the last few years. On the whole, banks have been net buyers, acquiring largely priority sector portfolios from NBFCs. Given the stringent first loss requirements imposed by the RBI in the 2006 guidelines (marked off against Tier I and Tier II Capital, fixed till maturity of the transaction), banks issuers have been rare.

At the same time, securitisation has emerged as a viable route for non-traditional originators to access the capital markets. Microfinance institutions (MFIs) have raised substantial funds through this route, with the first rated assignment in 2004 and the first rated securitisation in 2009. In October 2010, the microfinance sector faced headwinds after the Andhra Pradesh government issued an ordinance curtailing microfinance activities. Post the ordinance, securitisation has emerged as the largest source of financing for MFIs, with an estimated INR 15 billion raised via this route¹.

We will attempt to highlight the key changes / inclusions in the draft guidelines and potential implications on issuances

• Minimum Holding Period (MHP)

MHP for loans is distinguished on two parameters:  a) frequency of repayment schedule (quarterly or more frequent) and b) tenor of loan (less or greater than 24 months). While the logic behind including the former is understandable and a good move, it is unclear why the RBI has split the market on a 24 month tenor basis. It would be significantly better from a regulatory perspective  to assess MHP requirements based on the average life of the underlying loans. This would prevent the possibility of having a 6 month MHP on a loan with weekly repayments and tenor of 12 months.

Imposing a high MHP will, in effect, prevent securitisation of lower tenor loans completely. Potentially, this could disincentivise originators from providing lower tenor loans due to lack of financing, thus increasing balance sheet risk.

• Minimum Retention of Risk (MRR)

The guidelines also advise a MRR of 5%. This is a welcome inclusion and in line with global practices. The concept of a dynamic cash collateral and reduction of the MRR through the transaction tenor is a good step that should bring bank originators back into the market. Further, this will force rating agencies to model and monitor asset behavior more closely.  It would be better, in our view, if the RBI allowed market forces to determine the frequency / amount of release of credit enhancement, rather than stipulate time / amount of release – given the variation in performance of different asset classes.

The draft guidelines also permit originators to invest into the equity tranche of a securitisation, unlike the existing regulation that allows originators to invest only into senior securities issued by an SPV.

• Accounting of Profits

The guidelines allow originators to recognise the cash profit on a limited basis on premium structure deals. Such profits is to be termed as “Cash Profit on Loan Transfer Transactions Pending Recognition” and maintained on a transaction basis. This divergence from regular accounting standards will encourage corporates to move away from amortisation to straight line basis. In a financial year, any loss on account of Mark to Market and write off will be adjusted in this account and net effect will be transferred to profit and loss account

• Assignments

The  RBI has finally stepped in to fill the regulatory vaccum that existed with respect to bilateral assignment of assets. Bilateral assignment is now governed by guidelines similar to that of securitisation. One major difference however, is that “external” credit enhancement by the originator is banned under the assignment route. The offered justification is that subscribers to this route are sophisticated, institutional investors who should be able to assess the risk involved and take a decision on the exposure. Disallowing credit enhancement will only increase investor discomfort in this route and prevent such transactions from taking place. The sophisticated market forces that exist under the assignment route should be able to determine the need for cash collateral.

• Purchaser due diligence

The guidelines place a greater onus on the buyer with respect to due diligence. Purchasers must carry out verification on at least 5% of the obligors. Such verification cannot be delegated to a specialized firm. The guidelines also require rigorous credit monitoring and identification of non-performing borrowers 90 days after the loans are due. Banks are required to collect information regarding default rates, prepayment rates, loans in foreclosure, collateral type and occupancy, and frequency distribution of credit scores or other measures of credit worthiness across underlying exposures, industry and geographical diversification.

It is essential that buyers are aware of the assets that they are investing in and the above requirements will ensure that quality of due diligence improves.

Last year, securitisation volumes fell by 29%. This was largely believed to be a fall-out of the draft guidelines released in April 2010.  The revised draft guidelines are significantly more comprehensive and include features that could completely transform the market. However, the draft guidelines are also too prescriptve. This could stifle a sector that has just begun to find its feet in the Indian market. A nuanced regulatory policy that recognizes the varied and dynamic nature of the market and encourages financial innovation is necessary.

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1 – IFMR Capital estimates

The first IFMR Conference on Financial Systems Design was held at our office in Chennai on Aug 5-6, 2011. The objective of the conference was to engage in an in-depth conversation on the future of the Indian financial system and some of the underlying design challenges being faced in various markets.

In order to retain a functional perspective, the conference was organised into three main sessions for discussion — Origination, Transmission and Aggregation — as three broad buckets of questions and concerns – one involving customers and customer protection issues, the other involving markets and derivatives and the third involving large, nationally important financial institutions and systemic risk concerns.

In the introductory session, Nachiket shared some of his thoughts on the Indian financial system.

The format of the conference allowed for collaborative work and visioning by the participants. Following a lead presentation for each of the main sessions that identified key themes, each table came up with vision statements for that theme which were then shared across the room and discussed. Following the visioning, there was an exercise to identify the pathways for us to get to the desired end-state. These pathways were categorised into Research, Regulation, Innovation and Public Infrastructure.

The conference yielded very rich discussions and the participants identified several interesting issues and priorities for the Indian financial system. In the following weeks, we will share the summary of discussions and identified pathways for each of the three sessions.