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

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

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

To read the complete article, click here.

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

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

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

On November 22nd and 23rd, IFMR Capital held its first partners meet, a two day meet with all its partners to re-envision access to finance for institutions that impact low income households. Industry participants and researchers came together to discuss a broader vision for the industry. While the two day event saw active participation and debate on issues that currently concern the sector, the emphasis of the meet was largely on the way forward. Held at a critical juncture, participants brainstormed and discussed strategies for reshaping the sector towards a shared vision.

The meet followed the appreciative inquiry format and drew out the best from the participants. The first part was designed to shift the focus of participants from being short-term reactive to long-term proactive. The second part focused on the positives of the industry and on what was valuable about the way the sector has functioned in the past. The participants broke into groups of two and interviewed each other. Each person described their high points and success stories, sharing instances of how and why being in this sector made them feel glad they belonged here.

The third part of the approach sought to use the output from the interviews to get a clear sense of what were the most important factors that contributed to the success in the sector. Later, organised in groups of six, participants worked on a vision of what the sector would be like in five years if the root causes of success were leveraged in specific areas of focus such as governance, customer focus, risk management, product development, etc. The end result was a shared vision that institutions in the sector could look up to.

Some important questions that emerged during the meet are listed below:

1. How should we position MFIs so that they become an indispensable part of the financial system?
2. How do we engage with the political groups more effectively?
3. What are the unique and additional responsibilities of MFI boards, given that they deal with a segment that is financially and otherwise excluded?
4. As a sector, what data do we need to collect and disseminate, internally and externally, to enable holistic risk management?
5. What investments in training will organizations and the industry make in:
• Moving from mono-line to a multi product model
• Ensuring common minimum values are shared across the sector
• Taking on the new role of a financial advisor
6. How do we use technology or other disruptive methods to dramatically improve operating efficiencies?
7. What is the regulatory framework which will allow MFIs to flourish and serve a wider range of financial needs?
8. How do we resolve short-term funding & liquidity issues for the sector?

In the last part of the meet, the groups focused on developing tactical strategies on four areas : brand management, product development, political engagement and ensuring common minimum values, areas that needed immediate action to take the industry from where it is today to where the group would like to see it in the future.

Here is a brief summary of the themes that emerged from the meet.

a) Customer centric approach: The MFI industry’s main strength is its ability to reach out to and serve a vast number of clients. Client engagement is continuous and services provided are valuable. There was a clear consensus that going forward this customer centric approach must continue to be of key importance.

b) Innovation: Every growing sector continuously evolves. Institutions must be able to respond to the changes in the sector. The need is for an innovative and flexible approach which ensures sustainability and works in the interest of its end customers. The idea of MFIs offering multi-products was discussed at length. This was the way forward and MFIs must invest time, effort and capital towards this. MFIs already possess large amounts of granular financial data pertaining to their clients. This could help them understand the needs and capacities of their clients better and in turn aid the design of relevant financial products.

c) Operating efficiencies: The cost to serve low income households can potentially be dramatically reduced by disruptive innovations. Key pieces of infrastructure such as the UID have the potential of making KYC a public good. Enormous strides in technology such as the use of biometric identification, automated payment systems, mobile technology with improved authentication through the UID can also ensure that local branch staff leverages technology to perform their most repetitive day-to-day tasks, freeing up their time to perform their core duty of understanding the needs of clients and recommending appropriate solutions. There was a clear consensus that business models need to evolve and leverage such innovations.

d) Importance of the mission: While sustainability of business was crucial, it was agreed that the commitment to social and economic well-being of the client was crucial to the sector. Given the profile of the average client, MFIs perform the important role of giving access to finance to the most excluded segment of society. Going forward, organizations must not lose sight of this fact. Further, it is necessary that there is an alignment of objectives and vision across the entire company.

e) Positioning of the industry: Concerns were raised about the response of the industry to the recent crisis and the lack of a unified voice. The role of the board was stressed in this respect, many felt that the board should play a role in ensuring customer metrics are tracked continuously and senior management is held accountable to performance as measured against the metrics. This would also ensure that MFIs are collecting enough information during good times as well as bad, so an accurate picture can be presented to the media, investors and regulators.

f) Holistic risk management: The current business model of organisations in the inclusive finance sector is strong on operations and therefore manages operations related risks very well. However, in order to evolve into universal financial service providers, organisations need to focus on risk in a more holistic manner, ie look at all aspects of risk such as operational risk, credit risk, interest rate risk, liquidity risk, political and regulatory risk. Capacities need to be built internally, for instance, risk departments need to be set up, people need to be hired and adequate training needs to be provided, investment needs to be made in risk management systems. However, it was agreed that senior management buy-in was critical to the implementation of “holistic risk management”.

Participants comprise a select group of expert practitioners in the field of access to inclusive finance for low income households. The participants’ will engage and will help answer key questions of critical importance:

• How do we design a financial system in which there are multiple and diverse originators providing integrated financial services to low income households and small businesses, evaluating and pricing risks appropriately, and ultimately taking responsibility for good financial outcomes for their customers?
• How do we work towards understanding the needs of our customers for financial services better and fulfilling them?
• How do we design business models that are based on deep local knowledge and relationships, while ensuring systemic stability?
• How do we ensure that inclusive finance originators have adequate risk management capability and supporting infrastructure to ensure sustainability?
• How would the organization have to evolve to obtain efficient and reliable sources of funding?

The spirit of this meet is to take a step back from the existing products, institutional frameworks, and regulatory architectures, and take a more fundamental view of what can be done to improve the ability of our financial system to ensure access to finance for every individual and every enterprise.Together, we will work on a shared vision for the industry and identify specific pathways to achieve that vision.

Conference Website: http://capital.ifmr.co.in/partnersmeet/

As a part of its growth initiative the IGC recently convened “Growth Week” between 19th to 21st September at LSE, a 3-day conference which brought together a diverse set of policy-makers and researchers from Africa & South Asia. Viral Acharya organized the session on Finance, Colin Mayer chaired the part on Macrofinance and Greg Fischer chaired the part on Mobile Banking. The focus of the session was on identifying areas of academic research on policy issues that practitioners and policymakers are seeking to address in relation to finance in developing countries and emerging markets.

Kshama Fernandes represented IFMR Trust and participated on the panel on “Ideas for growth: Macro Finance” along with Dr. Subir Gokarn, Deputy Governor, Reserve Bank of India & Ms. Shyamala Gopinath, former Deputy Governor, Reserve Bank of India.

Talking about the past, present and future role of commercial banks in India, Dr. Gokarn spoke of the efficiencies and inefficiencies of the system and the challenges they pose in the present context. While suggesting that there was a need to build on the existing penetration of banks, banks would continue to remain the principal channel of intermediation as far as lending is concerned.  However other financial intermediaries could have a significant role to play in the financial inclusion space by developing business models that were designed to address the specific needs of their customers.

In her presentation, Ms. Gopinath pointed out that while financial innovation definitely does have an impact on growth, it needs a precise framework to function in the desired manner. The basic framework required was:

• Reasonable sophistication of participants (Financial literacy)
• Sound legal framework for dispute resolution
• Robust market infrastructure
• Reasonably liquid and deep cash market
• Financial Stability

Kshama Fernandes presented the Financial Systems Design framework based on a bottom-up approach with high quality origination, orderly risk transmission and robust risk aggregation as the three pillars of a well-functioning financial system.

The presentation below describes the key issues, the enabling infrastructure and some research questions that were discussed during the session.

The panel was attended by a large number of academics, researchers and some practitioners and generated a lot of discussion and interest on potential areas for future research. The broad areas that came up for research included: Finance and Growth (investment, bank lending, venture capital); Financial Systems and Stability (asset markets, securitization, financial regulation); and Financial Inclusion and Access by the Poor to Financial Services (savings, borrowing, payments).

As a follow-up to the Growth Week and an effort to advance these research areas, there will be a meeting of all academics associated with the Finance Programme of IGC on Tuesday November 15 at the LSE in London.

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

It recently structured and arranged a Rs. 401 million securitisation transaction backed by 45,954 microloans originated by Ujjivan Financial Services. This is the sixth capital market transaction for Ujjivan and second securitisation transaction. Ujjivan has raised debt capital through issuance of listed, secured, redeemable, non-convertible debentures in the last and current financial year.

KRIOS PIONEER IFMR CAPITAL 2011, the Special Purpose Vehicle created for the transaction, has issued two tranches of securities rated by CRISIL, India’s foremost rating agency:  an 89.5% senior tranche rated CRISIL A1(So) that was subscribed to by a NBFC and a 10.5% subordinated junior tranche that was invested into by IFMR Capital. Both tranches have an expected maturity of 9 months.

The structure created by IFMR Capital ensures that the incentives of the originator, servicer and structure are aligned. While the originator and servicer, Ujjivan, provides cash collateral as first loss. The structurer, IFMR Capital, has invested in the subordinated junior tranche. The cash collateral and the subordination of payments to junior tranche in the waterfall mechanism ensures that the senior investor is protected against losses and any first loss is borne by the originator and the second loss by the structurer.

Mosec 7

On September 7 2011, IFMR Capital concluded a Rs. 511 million multi-originator microloan securitisation backed by 49,881 microloans originated by seven Non-Banking Finance Company (NBFC)-Micro Finance Institutions (MFI), namely Asirvad Microfinance Private Limited, Disha Microfin Pvt. Ltd, Mimoza Enterprises Finance Pvt. Ltd., Satin Creditcare Network Limited , Suryoday Micro Finance Pvt. Limited, SV Creditline Private Limited and Utkarsh Micro Finance Private Limited. IFMR Capital Mosec VII, the SPV, issued two tranches of securities rated by ICRA: 85% senior tranche rated A1-LBBB+ (SO) and Series A2-Unrated.

The senior tranche has been subscribed by a Bank and HNI’s and Junior Tranche by IFMR Capital.

This is the biggest Multi Originator transaction arranged and structured by IFMR Capital involving 7 high quality Originators.

The structure created by IFMR Capital ensures that the incentives of the originator, servicer and the structurer are aligned. While the originators and servicers, provides cash collateral as first loss, the structurer, IFMR Capital, has invested in the subordinated junior tranche. The cash collateral and the subordination of payments to junior tranche in the waterfall mechanism ensure that the senior investor is protected against losses and any first loss is borne by the originators and the second loss by the structurer.

Aether IFMR Capital 2011

The Rs. 239 million single-originator securitisation transaction was completed with Grameen Financial Services Private Ltd also popularly known as Grameen Koota. Aether IFMR Capital 2011, the SPV, issued two tranches of securities backed by 23,108 microloans that were originated by Grameen Koota. Non-Banking Financial Institutions subscribed to the senior ICRA A- rated tranche and IFMR Capital invested in the subordinated ICRA BB+ rated piece.

This is the eighth capital market transaction for Grameen Koota with IFMR Capital.

The originator and servicer, Grameen Koota, provides cash collateral of 10% of the pool principal, while the structurer, IFMR Capital, has invested in the subordinated junior tranche. As in the above transaction, the waterfall mechanism ensures that here, the senior investor is protected against losses up to Rs. 240 million and any first loss is borne by the originator and the second loss by the structurer.

This transaction is significant not only because it is the first time that Sahayata has raised funds through listed bonds, but also because this transaction allows the company access to newer funding sources, which will be a robust support system for the low-income households that Sahayata serves across India. With this transaction, Sahayata has demonstrated its ability to attract diversified sources of financing. This transaction also reaffirms the commitment of DWM and IFMR Capital to the microfinance sector.

Commenting on the milestone deal, Ajay Verma, Managing Director & CEO, Sahayata, said “This is Sahayata’s first listed transaction and will boost confidence amongst investors and funders. The NCD transaction has opened up new avenues for funding to the company. Thanks to the DWM and IFMR Capital team for making this possible”.

Congratulating Sahayata and IFMR Capital, Jim Kaddaras, Partner for Debt, Structuring and Legal Affairs at DWM, said, “We are delighted to have brought financing to Sahayata, in order to support thousands of low-income entrepreneurs across India. At a time of uncertainty in the Indian microfinance sector, DWM is committed to financing socially committed MFIs with strong management teams like Sahayata. We hope to provide further financing to the sector in FY2012.”

Vineet Sukumar, Head Origination and Treasury at IFMR Capital said, “This transaction is yet another milestone in IFMR Capital’s efforts to provide high quality originators access to debt capital markets. We are delighted that Sahayata Microfinance, a long standing partner and a participant in all multi-originator securitisations structured by IFMR Capital, has availed of funding from rated, listed instruments that enhance transparency for the company and the sector, and pave the way for alternative and sustainable funding sources”.

Recently, I had the opportunity to attend a discussion on International Financial Reporting Standards (IFRS)  which was attended by chartered accountants and key financial stakeholders. In my years as an accountant, I have never come across such heated debate or such polarized views on an accounting topic.

Based on these discussions and my reading of IFRS, I am listing below a few important points which may occupy a pivotal role in Banking -IFRS conversion. These points are not exhaustive and comprehensive but cover most important aspects on the topic.

1.      Income recognition
2.      Definition of Debt vs Equity
3.      Identification of Impaired loan
4.      Impairment provision
5.      Presentation of financial statements and disclosures of financial instruments

Banks have to invest in government securities to comply with RBI’s prudential norms. As per current RBI rules, such investments are accounted for at ‘amortised cost’. Under IFRS 9, these securities may have to be accounted for on a ‘fair value’ basis, with the fair value changes taken to the income statement.

Under IFRS 9, when there is high turnover in the portfolio, the entire portfolio would have to be accounted for at fair value, since the bank’s business model is not to hold the securities to maturity. Currently, Indian banks account for loans and receivable at amortised cost. Under IFRS 9, loans and receivable portfolio are accounted on amortised cost basis, provided these loans do not contain any exotic embedded derivatives. Basic embedded derivatives, such as caps and floor or normal prepayment or extension terms, do not taint amortisation accounting.

However, amortisation accounting is not possible if a loan has a contractual interest rate that is based on a term that exceeds the instrument’s remaining life. Similarly, a loan with a convertible option is not eligible for amortisation accounting and will have to be accounted for on a fair value basis with changes taken to the income statement.

Loan portfolio is accounted for on a fair value basis in cases where banks transfer/securitise their loan portfolio. Amortisation accounting is also not allowed for certain non-recourse loans, for example, when a loan to a real estate developer states that the principal and interest on the loan are repayable solely from the sale proceeds of a specific real estate. In such cases, the ‘contractual cash flow characteristics’ is not met and hence, such loans are accounted on a fair value basis.

Cash Flow Characteristics :

IFRS 9 requires an entity to assess the contractual cash flow characteristics of a financial asset. The concept is that only instruments with contractual cash flows of principal and interest on principal could qualify for amortised cost measurement. IFRS 9 describes interest as consideration for the time value of money and credit risk associated with the principal outstanding during a specific period. Therefore, an investment in a convertible debt instrument would not qualify because of the inclusion of the conversion option, which is not deemed to represent payments of principal and interest.

The cash flow characteristics criterion is met when the cash flows on a loan are entirely fixed (e.g., a fixed interest rate loan or zero coupon bond), when interest is floating, or when interest is a combination of fixed and floating.

Financial assets that do not meet the above criteria are required to be measured at fair value, including all equity investments, all derivative assets, all trading assets, and those loans, receivables, and debt securities that do not meet the two criteria described above.

Under RBI norms, investment in equity instruments (other than subsidiaries, joint ventures), are marked to market. Net losses are recognised but net gains are ignored. Under IFRS 9, investments in equity instruments are fair valued. The gains or losses are either recognised in the income statement or in a reserve account. That choice is required to be made at the inception, on an instrument by instrument basis, and is irrevocable. With regards to impairment of loans (not covered by IFRS 9), the IASB in a proposed standard is looking at a model that is based on expected losses rather than incurred losses. In other words, the proposed standard requires estimated credit losses to be included in the determination of the effective interest rate, for purposes of amortisation accounting.

There has been a lot of criticism regarding the complexity of the IFRS on financial instruments.. Taking a cue, the International Accounting Standards Board (IASB) is in the process of simplifying them.  Needless to say, the impact of IFRS 9 on banks will be significant. As India is on the path of IFRS adoption/ convergence, Indian banks will have to closely examine the impact of IFRS 9 not only on their financial statements but also on their capital adequacy, IT systems, taxes and product design, among others.