The IFMR Financial Systems Design Conference 2011 was organised into three main sessions for discussions – Origination, Risk Transmission and Risk Aggregation. Our earlier post summarised the deliberations that took place on Origination. This post summarises the deliberations on the theme of Risk Aggregation.

In a financial system, risk can be mitigated either through diversification or transfer. The former involves a portfolio-based strategy designed to reduce overall risk by combining a variety of assets which are highly unlikely to behave in an identical manner. The latter involves the movement of risk to external counterparties that are better positioned to hold those risks, on account of being well capitalised and well diversified entities.

Entities ultimately bearing such risks may be termed “aggregators”. Any well-functioning financial system should have robust risk aggregation capacity with a range of institutions, such as commercial banks, insurance companies and mutual funds, having the appetite and the ability to play the role of aggregators.

Characterising the present state of risk aggregation in India

In discussing the current risk aggregation landscape in India, following features stand out:

• The size of the Indian financial system is not adequate to meet the needs of the real economy.
• The landscape is dominated by government owned institutions or directly by the government.
• There exist multiple regulators governing the field with absence of effective mechanisms for inter-regulatory exchange of information. Different substantive rules lead to a skewed playing field for different types of risk aggregators.
• Senior management compensation structures dominated by stocks and options are potentially faulty as they do not incentivise risk management.
• Mechanisms for dispute resolution are not sufficiently well developed.
• Positive regulatory developments are underway, including the setting up of the Financial Stability and Development Council to prevent inter-regulatory conflict, RBI guidelines permitting credit derivatives for corporate bonds, SEBI guidelines allowing exchanges to list securitised paper, and the setting up of a Financial Sector Legislative Reforms Commission to comprehensively rewrite the existing set of laws pertaining to the financial sector.

Watch video of Dr. Ajah Shah‘s keynote address on Risk Aggregation.

Key Themes

Ideas that emerged on aggregation from participant discussions at the Financial Systems Design Conference may be organised along the following themes:

Role of the government as a large risk aggregator

The first line of thinking advocated a neutral role for the government in this space, with it playing the role of an arbiter who sets the ground rules and not being involved in the capacities of owner, provider or interested party. The contrarian view took the stance that activities that have a “public character” can be achieved only if the government has ownership.

Regulation and management of systemically important risk aggregators

Participants stressed the need for effective regulation and management to ensure that risk aggregators are able to deal with plausible stress events, especially for “systemically important” entities. The need for norms stressing levels of capital adequacy was particularly emphasised.

Risk management capability within the financial system

In this context participants discussed effective risk management mechanisms. The participants debated outsourcing risk management to third party experts like rating agencies versus building internal risk management capabilities.

Vision statement

Following the discussions along these key themes, participants formulated the following vision statement for Aggregation:

“Our vision for risk aggregation in the Indian financial system is one where aggregators are numerous enough, large enough, and have the risk management capabilities to evaluate, price, hold and manage the diversity of risk originated from the real economy.”

A more detailed summary of the deliberations on Aggregation is available here.

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.

In a conversation with Nachiket Mor and Bindu Ananth, Dr. Viral Acharya, Professor of Finance at the New York University Stern School of Business, speaks on issues centring around aggregation of risks in a financial system, with an emphasis on those particularly relevant to the Indian financial system.

Dr Viral Acharya in conversation with Bindu Ananth

In particular, Dr. Acharya fleshes out three salient, and against-the-grain-of-current-thinking, points.

One, while scale does play an important role in allowing aggregators (Banks, Insurance companies, Monolines, other Government Sponsored Enterprises) to efficiently discharge their primary function as warehouses of risk, financial system designers must guard against the possibility that that systemic nature per se does not become a source of value creation (ie. through them consequently knowing that they have become “too big to fail” and therefore beginning to take on higher risk). To guard against this, financial system designers must thus encourage a diverse set of institutions to come up to play the role of aggregators. Thinking through resolution mechanisms for aggregators upfront and setting those rules of the game are extremely crucial. While corporate bankruptcy has become clearer post-SARFESI, individual and aggregator resolution mechanisms remain unspecified in India.

Two, while ensuring capital adequacy for aggregators is vital, Basel-type static capital requirements may not be adequate. He speaks at length about the formula proposed by him and others at the Stern school regarding setting capital adequacy in a manner that ensures aggregators remain well-capitalised in “plausible but sufficiently severe stress scenarios”. But where worst-case outcomes do materialise, two options are open: (a) allowing some aggregators to fail; and (b) using taxpayer’s money (ex-post, not ex-ante) to inject public capital into the system as the last resort.

Three, a fine balance needs to be struck between rigidity and flexibility in credit enforcement proceedings (be they at the ultimate firm / individual level or at any other level in the chain of transmission of risk). Too rigid an approach would defeat the purpose of the entire enterprise (namely, the orderly transfer of risk at market-determined prices to those who are most willing to hold it); too flexible an approach may lead to laxity in honouring of commitments. At the same time, he strongly emphasises that in an end-game situation where there is a “big blow-out”, the ultimate bearer of the risk has to be the aggregator – in other words, the present blame game in the American context on the “originate and distribute” model being flawed is invalid as the better option is to ensure that the design encourages aggregators to price in the cost of their being the ultimate risk-holder and thus impose arms-length discipline on originators (who are themselves of course ensured to be adequately capitalised, and who do provide credit enhancement in their risk-transfer transactions with aggregators to ensure their local information is appropriately factored in).

Dr. Acharya signs off making a few further points of importance to the regulatory structure of India: (a) that there might be a need for a separate regulator of systemic risks/systemically important institutions (in the way Dodd-Frank legislation has done for the US) – over and above prudential regulators and consumer protection regulators; and (b) states in India’s federal set-up should be subject to a minimum, non-negotiable standard in matters such as consumer protection to prevent a race-to-the-bottom situation where they end up competing to dilute regulation (c) the lack of a level playing field between private and public sector financial institutions will need to be addressed.

The entire chat transcript is available here. Prof. Acharya has recently co-authored a book “Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance” that looks at the US experience with GSEs in detail.

- G E Balajee, IFMR Blog Team

The recent securitisation transaction completed by IFMR Capital was a landmark deal in the microfinance sector. It was a Rs. 108 Mn rated securitisation transaction backed by microloans originated by Grama Vidiyal Micro Finance Limited. This is not the first time that a transaction such as this has been executed by IFMR Capital. What makes this transaction special is that, this is the first time private wealth investors have invested in microfinance. In other words, this is one of the best examples of the wealth of the richest being directed towards the poorest in the country.

IFMR Capital already has some innovations in the area of securitisation to its credit. Its Multi-Originator (MOSEC) structures have focused on smaller but high quality microfinance institutions (MFIs) that deserved capital market exposure. It has also arranged the first mutual fund investment in microfinance. “We have always been on the lookout for new investor classes for our clients”, says Vineet Sukumar, who heads Origination and Treasury at IFMR Capital.

Though a lot of private investors would have liked to invest in the sector, lack of publicly available information about the MFIs has been an important reason that has kept them away. “Efforts by IFMR Capital in collecting granular data, success in transaction placement, and engagement with a strong private wealth advisor like Avendus has ensured that a good start has been made”, explains Meenal Madhukar who heads Investor Relations at IFMR Capital.

While a commercial institutional investor has the resources to verify information about a company before investing, a private wealth investor relies on, and is very sensitive to, public opinion and information released in the press. Ever since SKS IPO filed its draft red herring prospectus, the sector has been beset with negative press coverage. It is well known that bank funding to MFIs had dried up after the Andhra Pradesh (AP) ordinance. If traditional sources were apprehensive of the future of the sector, private investors were even more wary of investing in the sector.

“This investment, coming in the backdrop of the AP Ordinance and liquidity shortfall in the sector, conveys a strong message that the sector is able to diversify fund sources even at such tough times. Further, funds from such non-traditional sources are being availed at commercial rates that are well comparable with other fund sources. Separately, IFMR Capital’s success in inculcating a new investor class into the sector at this time underscores the success of our business model and strategy”, says Vineet.

So what does this do to the microfinance sector? The earlier securitisation transactions arranged by IFMR Capital have consistently helped smoothen out the seasonality of the funding pattern that is prevalent in the MFI sector, or for that matter, even in the priority sector as a whole.

“This opens up a vast opportunity for microfinance. In general, private wealth investors have higher risk-taking ability and able to invest in times when mainstream investors take a back seat. So this deal not only opens a large investor base, but also a diversification opportunity to raise funding in tougher times”, explains Meenal.

This investment by private wealth investor is expected to form the base for more High Networth Individuals (HNI) and family offices to evaluate this sector. Family offices are substantial sources of funds in today’s market. While microfinance presents a good opportunity for social investing with commercial returns, the disclosures, monitoring and transparency associated with a structure of this nature makes the transaction attractive.

Here’s hoping that this transaction helps scale up private wealth investment into microfinance.

For any non-bank originator it is absolutely critical to raise large sums of risk capital on a continuing basis. While this need is primarily to meet capital adequacy requirements, there is usually a need of equity for growth, expansion, investments in infrastructure, or sometimes just to boost the balance sheet to help raise more debt.

Entities engaged in providing financial services in rural areas and to other excluded population have shown significantly high growth rates. Five year CAGR of some of the larger originators is as high as 80%.  This means that the equity base of such originators needs to almost double every year!

Our first blog post in this series, on debt examined ways in which loan funds can be raised by such originators and our second post on Mezzanine instruments started to address the issue of raising risk capital.

While Mezzanine Instruments can allow originators to most effectively leverage equity, there is a limit to how much mezzanine funds can be raised, both from a regulatory perspective and also from an efficient risk transfer perspective. This brings us to examine the various sources of equity capital (or Tier I capital). Broadly, the different sources of tier 1 capital are – (i) Accruals (ii) Additional investment by promoters (iii) Private Equity (PE)and (iv) A public equity offering.

For entities that are young, accruals may be extremely small and there may be a need to tap external sources of equity.

The two main sources are Private Equity and a Public Offer. Private Equity is not traded publicly on stock exchanges and is usually relevant when issuance size is smaller and there is limited public interest in dealing in the shares of the company. Private Equity can be raised from both retail and institutional investors.

A couple of considerations in taking equity public are the huge cost and time associated with an IPO. It is necessary for an originator to probe the viability of this expense. Another impediment to raising public equity is that there is every chance that the company may not be in the most appropriate stage for such financing.

According to Crisil’s India’s top 50 MFIs report, the 50^th largest MFI in India, has a loan outstanding of only INR 124 million, clearly demonstrating the very small scale of players in the industry today, making Private Equity the dominant source of risk capital for such originators.

Role of Private Equity

Private Equity investments are generally made by Private Equity firms, Venture Capitalists, Angel Investors (Angel Investors serve as the bridge between seed capital and Venture Capital) and other financial institutions established for this specific purpose and even by HNIs. While most of the Private Equity invested till date in India in originators has been to finance growth of existing businesses, in future there are possibilities of it being employed to finance Leveraged Buy-Outs (LBOs). Leveraged Buy-Outs involve raising a large volume of debt to fund a takeover, and are considered controversial because of the large amount of leverage involved in such transactions and the huge payoffs for partners in PE firms. Other well known uses are growth capital investments which are made in mid-size companies that seek capital infusion for funding growth, expansion or technology upgrades and Venture Capital investments which are made in early stage companies seeking seed funds. Venture Capitalists often play a significant role in shaping the company up and building strong balance sheets before they execute their exit strategy. Mezzanine investments are made to fund small or medium size, growth companies by providing funds subordinated to senior debt, either as subordinated debt capital or as preferred equity. Private Equity also plays a significant role in a mature environment where consolidation is imminent.

Types of Private Equity investors

There are two-types of Private Equity investors – (i) passive investors, who only provide capital support and depend on the management of the company to spearhead its growth and returns and (ii) active investors, who play a crucial role in bringing the company’s revenue model and growth up to shape. These investors provide more than just capital in that, they act as mentors to the investee company.

The environment for Private Equity and Private Equity investments in microfinance

China, Brazil and India still top the list of most attractive emerging markets for Private Equity investments. India’s FDI policy of 2005 allows up to 100% stake in ventures; however there are a set of sensitive sectors where caps on FDIs exist. FDIs in India surged for the first time in 2007, touching $11.19 billion. According to news reports, India received $18.35 billion in FDIs in the first 11 months of the financial year 2010-11 according to DIPP data.

In early 2010, before the Andhra Pradesh crisis, Private Equity companies and Venture Capitalists were upbeat about the microfinance sector. According to news reports, PE companies have invested INR 2,500 Crore in MFIs since 2006. PE investors found the sector’s immunity from the global economic crisis, low delinquency rates leading to assured returns and astounding growth, strong and highly positive investment parameters. The years 2009 and 2010 witnessed investments from big names like Oikocredit International that bought a 10% stake in Kerala based ESAF Microfinance and BlueOrchard PE which pumped INR 50 Crore in Asmitha Microfin Limited in addition to others like Avishkaar Goodwell and Unitus.  Very recently, Mumbai-based Svasti Microfinance raised its second round of funding from BlueOrchard PE Fund. 

Exit strategies

Returns to Private Equity is in the form of cash accumulation through cash flows from operation, repayment, increased earnings and other forms that constitute exit strategies. Exit strategies vary amongst investors, depending on their investment horizons and investment strategies. Exit strategies are generally in the form of -

1. Secondary sale - where the investors of the company sell their stake to a new investor
2. Company/Promoter Buyback – this is a theoretical exit option for most entities operating in origination. Given the continuous need for capital, it will usually be difficult for such entities to be able to buy back its own shares
3. Recapitalisation – where returns are distributed to the financial sponsor either from the cash flow generated by the company or by issuing debt and other securities for this purpose.
4. IPOs – the shares of the company are taken public, providing the investor with an immediate realisation. The PE investor can also choose to sell shares in the public market made available by this route at a later point in time
5. A merger or acquisition – through which the company is taken-over by another for cash, shares or both. This is a strategy employed by investors when their investments lie in companies belonging to industries where consolidation was imminent.

The first PE exit in Indian microfinance has already been executed successfully in SKS microfinance’s IPO. In late 2008, SKS raised INR 3.66 billion. The transaction led by Sandstone Capital represented the largest Private Equity investment in microfinance, globally, as of that date. Sandstone Capital was joined by existing SKS investors such as Sequoia Capital and Unitus.

Private Equity investments in an emerging market economy such as India’s help create more jobs by providing a fillip to growth, and also combine capital with expertise, making management more professional, thereby creating even more opportunities for investment and growth. Private Equity is a financing option that can work wonders for non-bank originators, in terms of fulfilling capital requirements, stabilising their balance sheets and in fuelling their growth and expansion plans. However, such capital comes along with an exit strategy – and non-bank originators will have to innovate in terms of business models, products and processes, and employ methods to reduce costs continuously to attract Private Equity investments and to sustain the interest of Private Equity players in their business.

- With inputs from Puneet Gupta and Jayshree Venkatesan, IFMR Mezzanine