By Deepti George, IFMR Finance Foundation

Continuing on our series on ‘Consumer Protection’, we will take a look at how consumer protection has found its place within the regulatory architecture of select countries, namely Australia and South Africa. A previous post had dealt on the emergence of the twin-peaks model in Australia. In this post, we briefly describe the regulatory principles that form the basis for the Australian regulatory reform process that began with the Government’s implementation of the Wallis Inquiry recommendations.

In June 1996, the Financial System Inquiry¹ (known as the Wallis Inquiry) was established to:

i. Examine the results of the deregulation of the Australian financial system
ii. Examine the forces driving further change, particularly technological; and
iii. Recommend changes to the regulatory system to ensure an ‘efficient, responsive, competitive and flexible financial system to underpin stronger economic performance, consistent with financial stability, prudence, integrity and fairness.

Chapter 5 of the Wallis Inquiry report outlines the regulatory principles that the new structure was based on. The Inquiry identifies five regulatory principles, as given below:

Competitive Neutrality

Competitive neutrality requires that the regulatory burden applying to a particular financial commitment or promise apply equally to all who make such commitments. It requires further that there be minimal barriers to entry and exit from markets and products; No undue restrictions on institutions or the products they offer; and that markets are open to the widest possible range of participants.

Cost effectiveness

A cost-effective regulatory system requires a presumption in favor of minimal regulation unless a higher level of intervention is justified; an allocation of functions among regulatory bodies which minimizes overlaps, duplication and conflicts; an explicit mandate for regulatory bodies to balance efficiency and effectiveness; a clear distinction between the objectives of financial regulation and broader social objectives; and, the allocation of regulatory costs to those enjoying the benefits.

Transparency

Transparency of regulation requires that all support/guarantees from the regulator or the government to financial institutions be made explicit and that all purchasers and providers of financial products be fully aware of their rights and responsibilities, and that financial promises (both public and private) be understood by all parties concerned.

Flexibility

The constant evolution of the financial system makes flexibility critical. The regulatory framework must have the flexibility to cope with changing institutional and product structures without losing its effectiveness.

Accountability

Regulatory agencies should operate independently of sectional interests and with appropriately skilled staff. In addition, the regulatory structure must be accountable to its stakeholders and subject to regular reviews of its efficiency and effectiveness.

The Twin-peaks model of Australia encompasses two agencies, besides the Reserve Bank of Australia: The Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC). ASIC is Australia’s corporate, market and financial services regulator, which includes being the regulator for consumer credit. The Australian Securities and Investments Commission Act 2001 made ASIC responsible for the following:

1. Maintain, facilitate and improve the performance of the financial system and entities in it
2. Promote confident and informed participation by investors and consumers in the financial system
3. Administer the law effectively and with minimal procedural requirements
4. Enforce and give effect to the law
5. Receive, process and store, efficiently and quickly, information that is given to it
6. Make information about companies and other bodies available to the public as soon as practicable

ASIC’s priorities therefore include ensuring that investors and financial consumers are confident and informed, promoting fair and efficient financial markets and ensuring efficient registration and licensing.

ASIC administers the following functional areas through specific legislations:

Australian Financial Services License (AFS)

ASIC administers the Financial Services Reform Act 2001 that introduced a single licensing regime for all financial services and products. This piece of legislation was later incorporated into chapter 7 of the Corporations Act 2001.This legislation requires those who carry on a business of providing financial services to hold an Australian Financial Services (AFS) licence. An AFS licence is required for entities that:
• Provide financial product² advice³
• Deal in a financial product
• Make a market for a financial product
• Operate a registered managed investment scheme
• Provide a custodial or depository service
• Provide traditional trustee company services

The obligations of an AFS licensee, as mandated by law, include:

• Obligation to ensure that financial services offered are provided efficiently, honestly and fairly
• Obligation to meet adequate financial requirements (e.g. solvency and cash obligations) to provide financial services and to carry out supervisory arrangements
• Obligations to meet compliance and risk management requirements if the licensee is not a APRA-regulated body
• Obligation to maintain competence to provide financial services (both technological and human resources)
• Obligations of monitoring, supervising and training of authorised representatives in order that they comply with the financial services laws
• Conduct and disclosure obligations
• Obligation to manage conflicts of interest
• Obligation to establish and maintain dispute resolution (internal and external) mechanisms
• Obligation to have prescribed compensation and insurance arrangements
• Obligation to comply with requirements set out by ASIC from time to time

In the next post in this series, we will focus on the conduct and disclosure obligations that need to be met by all AFS license holders and its implications for providers and consumers of financial services.

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1 – http://fsi.treasury.gov.au/content/FinalReport.asp
2 – As pre Corporations Act 2001, Chapter 7.1, Div 3,“For the purposes of this Chapter, a particular facility that is of a kind through which people commonly make financial investments, manage financial risks or make non cash payments is a financial product even if that facility is acquired by a particular person for some other purpose”.
3- Financial product advice is a recommendation or a statement of opinion, or a report of either of those things, that is intended to influence a person or persons in making a decision in relation to a particular financial product or class of financial products, or an interest in a particular financial product or class of financial products.

In the current edition of Economic & Political Weekly, Anand Sahasranaman of IFMR Finance Foundation has published a paper on Panchayat Finances based on an analysis of three villages – Pallavapuram, Pandiyapuram and Cholapuram in rural Tamil Nadu. The paper outlines the different aspects concerning their finances and infrastructure and argues that with judicious increases in their tax and fee regimes, all three will be in a position to self-finance a substantial portion of their infrastructure and service needs, resulting in improved local governance and quality of life of local citizens.

Abstract from the paper below:

One of the key tests to real empowerment of panchayats lies in the ability of local self-governing institutions to finance their own expenditures through internal generation of resources. Based on an analysis of three villages in Tamil Nadu, this paper argues that many gram panchayats are today in a position to substantially finance themselves and build a culture of self-sufficiency, independence and accountability to their citizens, reducing their dependence on devolutions from state governments. It concludes that by incentivising competition among panchayats and instituting a rural development fund to enable them to access debt capital, the perverse incentives they now face can be mitigated to a large extent, leading to several significant positive outcomes.

To read the full paper click here.

By Anand Sahasranaman and Vishnu Prasad, IFMR Finance Foundation

In the second blog in the Consumer Financial Protection series, we explore insights from behavioral economics that could fundamentally impact the design of legislation and regulation for consumer protection in finance.

Neo-classical economic theories like expected utility hypothesis and efficient market hypothesis are based on the assumption that the consumer is a rational agent. However, recent insights from behavioral economics point out that the consumers do not always behave as time-consistent, rational utility maximizers. Consumers are, in fact, beset with a number of cognitive limitations and biases which influence their decision making and make them acts in ways contrary to the traditional model of hyper-rationality. We will explore some of the insights from cognitive psychology and experimental economics that could impact the design of consumer protection legislation and regulation in the future.

Prospect Theory:

The work of behavioral economists Daniel Kahneman and Amos Tversky provided early insights into consumer behavior. Their seminal work found evidence to suggest that consumers do not make decisions that expected utility theory predicts. The central insights of this theory help explain observed consumer behaviors such as:

a. Loss Aversion: People are extremely sensitive about losses and exhibit deep seated loss aversion to even small amounts of money. In fact, there is evidence that individuals are more sensitive to losses than profits – in fact, people value moderate losses more than twice as much equal sized gains (Tversky and Kahneman: 1991). This translates into financial decisions that would be at significant variance from the theory of expected utility.

b. Incorrect Probability Calculations: People have a tendency to overweigh small probabilities and under-estimate risks with larger probabilities. This explains why people more readily buy insurance on refrigerators and TV sets, but are less likely to buy life or accident coverage. Individuals also tend to be more sensitive to differences in probabilities at higher probability levels.

c. Response to Framing: People make different choices in identical situations because of the way the choices have been framed for them. The way in which a problem is described can be responsible for upto a 30-40% shift in preferences (Barberis and Thaler: 2003). The fact that framing can fundamentally impact consumer choice means that investor welfare could be seriously compromised in the absence of countervailing regulation.

d. Mental Accounting: The process people use to formulate financial problems for themselves is called mental accounting (Avgouleas: 2006). One classic case of mental accounting is “narrow framing”, where individuals evaluate a particular gamble (or financial transaction) as if it were independent of everything else in the world and not assess its utility in terms of the gamble’s effect on the individual’s overall wealth.

Biases and cognitive limitations:

Human beings also exhibit biases and other cognitive limitations that can contribute to poor decision making. In the context of financial products, consumers are prone to take decisions that can have negative future consequences for themselves (also called internalities).

a. Self-restraint: Consumers often behave in ways that compromise long-term well-being for short-term gains. This bias of present consumption out-weighing future welfare manifests itself in various forms such as the failure to save for retirement. It is also observed that consumers discount future benefits/costs in a time-inconsistent manner. For example, if offered $100 now and $200 a year from now, a consumer is likely to choose the immediate $100. However, when offered $100 five years from now and $200 six years from now, a consumer is likely to wait the additional year even though the it is the same choice she makes five years from now. This time inconsistent, present biased model of discounting is referred to as hyperbolic discounting.

b. Herding: Consumers often mimic behavioral patterns of peer leaders or peer groups, leading them to ignore signs and indicators that would lead a rational consumer to take different decisions. Such irrational behavior is fueled by overconfidence (in peer leaders or rating agencies and in assessments of new financial products) and can often threaten systemic stability. History is replete with examples of irrational behavior leading to economic bubbles, from the Tulip mania in the 1600s to the present financial crisis caused partly by the real estate bubble in the USA.

c. Information Overload: In the previous blog post, we mentioned Akerlof’s seminal study of the used-car industry, where information asymmetry leads to market inefficiency. Contrary to expectations, a regulatory response to provide the consumer with additional information (beyond a point) can be counterproductive. This happens due to the phenomenon of information overload, where the consumer is unable to assess the quality and amount of information given to them. Examples of this phenomenon include consumers casually flicking through tens of pages of terms and conditions when insurance is bought online, without understanding the risks and clauses involved.

Systemic irrationality and regulatory responses:

There are several limitations to the use of insights from behavioral economics in consumer financial protection.

Work in experimental economics argues for the emergence of rational behavior in the context of a repetitive market activity. Consumers display rational behavior in the long run, through a trial and error adaptation process and repeated market activity and spurts of irrationality are characteristic only of the short run. So, consumer irrationality, it is argued, can only be a factor in the policy of consumer protection, not the starting point. Second, behavioral economics is yet to come up with an all-encompassing theory of the market or consumer choice that can challenge the existing neo-classical theories; it has only pointed out deficiencies of the latter. Third, behavioral economics does not formulate any normative principles, which can be used either for empirical testing as economic models or for normative use as a guideline to an efficient market mechanism.

Even if consumer irrationality is an exception to the norm of rational behavior, the insights of behavioral economics alert us to the possible risks of systemic irrational behavior and the consequence this can have on the financial system. Any regulatory mechanism should therefore be designed to be able to respond to systemic irrationality. However, regulators should be required to tread carefully before intervening in a situation of perceived systemic irrationality. At the very least they must have to demonstrate indications of irrationality in the system, provide plausible explanations of how such irrationality can have a financial system-wide impact and finally make clear the case for how their proposed regulation will be effective in countering the irrational behavior.

To ‘nudge’ or not to ‘nudge’?

If consumers cannot maximize their own welfare (due to lack of cognitive capability or financial literacy), it is argued that regulation needs to ‘nudge’ the consumers into making those decisions which reflect the presumed judgment of what consumers would want, were they fully informed or well advised. This approach is referred to as libertarian or asymmetric paternalism.

The idea behind libertarian or asymmetric paternalism is not to restrict the consumer’s autonomy; rather it seeks to counter the harmful effects of cognitive biases without affecting the choices of the less behaviorally challenged consumers. Some of the suggested regulations include increased pluralism in information disclosure formats and in the prescribed volume of information reaching different investor classes, mandated use of structured and edited investment contracts that consumers can easily comprehend and mandatory use of long term performance reports. These suggestions imply that regulators must drop the ‘one size fits all’ approach as consumers’ decisions vary depending on factors such as income, education, age, attitude and the type of financial product they consume.

There are, however, strong arguments against the ‘nudge’ principle on the grounds of its interventionist approach, implied restrictions of choice and possible impact on rational consumers. These arguments speak to the heart of debates around behavioral economics and consumer protection today.

References
1. Backstrom, Hans. Financial consumer protection- goals, opportunities and problems. Economic Review. 2010
2. Campbell, John Y., Jackson E Howell et al. Consumer Financial Protection. Volume 25, Number 1. Pp 91-114. Journal of Economic Perspectives. 2011
3. Spindler, Gerald. Behavioral Finance and Investor Protection Regulations. Journal of Consumer Policy. 2011
4. Emilios, Avgouleas. Cognitive Biases and Investor Protection Regulation: An Evolutionary Approach. 2006. Available at SSRN: http://ssrn.com/abstract=1133214
5. Kahneman, Daniel and Tversky, Amos. Prospect Theory: An Analysis of Decision under Risk. No. 2, Volume 47. Econometrica. 1979
6. Kahneman, Daniel and Tversky, Amos. Loss Aversion in Riskless Choice: A Reference-Dependent Model. 106, Quarterly Journal of Economics. 1991

By Anand Sahasranaman, IFMR Finance Foundation

IFMR Finance Foundation is working on the agenda of consumer protection in finance as part of its mandate on financial systems design. We will be regularly showcasing our learnings on this front as a part of this new blog series called “Consumer Financial Protection”. We start off by delving into the theoretical underpinnings of consumer protection and its relevance to the provision of financial products and services.

Consumer protection is widely viewed as one of the two critically important functions of financial regulation, the other being maintenance of the financial system’s stability. While the need for consumer protection regulation seems to make intuitive sense, it is useful to dig a little deeper so as to better understand the need for consumer protection in competitive financial markets.

The basic questions that we seek answers for are these: In the case of a well-functioning market with multiple financial product and service providers, should not competition lead to optimal consumer outcomes? Why then do we need the intervention of public regulators to protect consumers of financial products?

A survey of the literature on consumer financial protection throws up a number of insights into the market failures that necessitate the need for regulation.

1. Informational Asymmetry and the problem of “lemons”:

A fundamental problem characterising the market for financial products and services is that of information asymmetry. Because of the expertise that is required for the development of most financial products and strategies, the seller of a financial product is always at an “informational” advantage over the buyer (who generally lacks expertise). This information asymmetry has the potential to adversely incentivise the seller to mis-sell the product, which could lead to poor financial outcomes for the buyer.

Akerlof’s seminal study on the information asymmetry between sellers and buyers in the market for used-cars in the US concludes that the uncertainty over product quality will progressively drive away owners of better quality cars from the market. Over time, this leads to a consistent decline in the average quality of used cars in the market and a corresponding downward adjustment of the price that buyers are willing to pay – until a “no-trade” equilibrium is reached. Such a situation minimises the welfare of buyers and sellers in the market.

In the case of financial markets, such sub-optimal outcomes on account of information failures can be prevented through suitably designed regulations (such as on information disclosure) that enable the creation of a more equitable market for buyers and sellers.

2. Nature of financial decisions and outcomes:

Many important financial decisions such as investing in a mortgage or saving for retirement are undertaken very infrequently in the course of a lifetime. The outcome of many financial investments and strategies becomes obvious only in the long term, and not immediately upon product purchase. Financial product outcomes are also complicated by the fact that market movements can have a substantial impact on product performance, and it can be difficult to pin-point the reasons behind poor outcomes: was it primarily on account of product mis-sale or the consequence of random shocks?

The unfolding of consequences over prolonged time-periods thus distinguishes consumer protection in finance from consumer protection for other products. In case of physical products (such as biscuits or soap) the outcome of the purchase becomes obvious upon immediate usage and high-quality producers can distinguish themselves through signalling devices such as warranties on their products. Financial products are, in a sense, more akin to medical services, where the treatment is administered upfront and the consequences become obvious only with the passage of long periods of time.

Financial consumer protection regulation therefore requires specialised responses (and could perhaps learn from medical consumer protection) considering the nature of manifestation of outcomes. This also opens up the debate for whether consumer financial protection regulation should sit within an umbrella consumer protection regulator that is responsible for consumer welfare across sectors or be situated in an entity specifically created for the purpose of the financial sector.

3. High Search Costs and Price Dispersion:

Despite the fact that financial service providers provide almost identical products, there can be substantial price differences between them. These price variations across sellers of similar financial products can be attributable to high search costs that consumers have to incur to meaningfully compare products and as a result, lead them to pay higher prices than they should. On the one hand, this is because of the lack of a repository of reliable information to enable price comparison and, on the other, the tendency of product sellers to market their products as being different from others in the market, even in the absence of any substantive differentiating features between them. In such a scenario, the consumer is likely to forgo her own welfare by sticking with her existing financial service provider and paying the price determined by them, thus giving them a modicum of market power, which, in a transparent market they would not be able to enjoy.

While transparent, comparable information on prices is obviously desirable from a consumer welfare point of view, there also needs to be clarity on detailed terms and conditions that can have a material impact on the usage of the financial product. This is especially so in the case of decisions which are infrequent and have long-term implications. Consumers are not in a position to generate information on their own or to get together and jointly generate information with other consumers – a classic case of co-ordination failure because of the public-good nature of the endeavour.

Well-designed financial regulation that requires financial services providers to provide access to material, meaningful and reliable information is therefore critical in maximising consumer welfare.

4. Behavioural Characteristics of Consumers:

In the past few years, there have been many new insights from the field of behavioural economics that could significantly impact the design of consumer protection regulation in the future. We will discuss these in the next blog post in this series.

This blog post draws heavily from the following sources:
Campbell, John, Howell Jackson, Brigitte Madrian, Peter Tufano, “Consumer Financial Protection”, Journal of Economic Perspectives, Vol 25, #1
Backstrom, Hans, “Financial Consumer Protection – Goals, Opportunities and Problems”, Economic Review 03/2010
Goodhart, Charles, “How should we regulate the financial sector?”, The Future of Finance, Centre for Economic Performance, London School of Economics
Lumpkin, Stephen, “ Consumer Protection and Financial Innovation: A few basic propositions”, OECD Journal: Financial Market Trends, Vol 2010, #1

By Anand Sahasranaman, IFMR Finance Foundation

High-quality access to financial services is important not only for households and enterprises, but also for cities and Panchayats so that they have the ability to undertake projects that provide essential goods and utilities to citizens. This is especially crucial for several emerging/small cities in India that will experience very high rates of growth in the coming years due to the overall urbanisation trend and will need to supplement their resource base. IFMR Finance Foundation has launched an initiative (Financial Access for Small Cities) that is focused on the town of Srirangapatna in Mandya district of Karnataka, India. The objective of this partnership is to develop a long-term vision for infrastructure development in Srirangapatna and design sustainable financing mechanisms for the same. We hope this will provide a template for other small cities as well.

We are in the process of drawing out a long-term vision for the city in partnership with citizens and the local government – specifically focusing on issues of land, water and housing. Our engagement with the city is a deeply participatory process, with involvement of local citizens, community groups, businesses, slum residents, students and others. At the conclusion of this phase of local engagement, we expect to be able to derive a unified vision for the future of Srirangapatna – as articulated by local stakeholders.

The objective of the second phase is to design and sustainably finance public infrastructure projects in the areas of land, water and housing that are derived from this unified long-term vision. These projects are envisioned to be in the nature of ‘minimal’ investments that the city will need to make today, in order to be reasonably prepared for the coming urbanisation. This will enable a planned approach to urbanisation without having to constantly play catch-up – as is the case in our larger cities today. We will also work with the city in raising finance for projects that emerge out of this initiative.

We will be showcasing this initiative at our “Financing Small Cities” blog, which will chart our work over time. Our intention is for this blog to become a forum for rich discussions between citizens, policy makers, researchers and practitioners involved in urban infrastructure and financing issues.

The blog is at: http://financingcities.ifmr.co.in/.

We look forward to your ideas, thoughts and comments as we proceed with this work.

By Darshana Rajendran, IFMR Finance Foundation

An asset becomes non-performing when it ceases to generate income for the bank. In India, a Non-Performing Asset (NPA) is broadly defined as one with interest or principal repayment instalment unpaid for more than 90 days.

There exist defined mechanisms to deal with NPAs of banks and financial institutions today. However prior to 1993, banks had to take recourse to the long legal route against defaulting borrowers, beginning with the filing of claims in the courts. A lot of time was therefore spent in the judicial process before banks could have any chance of recovery on their loans. On average, a civil suit decision took anywhere between 5 to 7 years.

Under the Recovery of Debts to Banks and Financial Institutions Act 1993, Debt Recovery Tribunals (DRTs) were set up for recovery of loans of banks and financial institutions. This led to speedy recovery of loans in about 1 year’s time as against the average time of 5 to 7 years required in civil suits. While initially the DRTs performed well, their progress suffered as they got overburdened with the huge volume of cases referred to them.

To speed up the process of recovery from NPAs, The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI) Act was enacted in 2002 for regulation of securitization and reconstruction of financial assets and enforcement of security interest by secured creditors. The SARFAESI Act empowers Banks / Financial Institutions to recover their non-performing assets without the intervention of the Court. The Act provides three alternative methods for recovery of non-performing assets, namely: -

• Securitisation
• Asset Reconstruction
• Enforcement of Security without intervention of the court

Secured creditors are given the power to take possession of the securities in the event of default and sell such securities for the purpose of recovery of the loan. The Act provides for enforcement of Security interest by a secured creditor without intervention of the court, in cases of default in repayment of instalments and non-compliance with the notice period of 60 days after the declaration of the loan as a non-performing asset.

The Act also provides for setting up of Securitisation Companies/ Reconstruction Companies (SC/RC), which acquire the NPAs from banks and financial institutions by raising funds from Qualified Institutional Buyers (as defined by the Act) by issue of Security Receipts (As defined by the Act) representing undivided interest in such financial assets. The Act enables SC/RCs to take possession of secured assets of the borrowers including right to transfer and realize the secured assets. SC/RCs act as debt aggregators or agents of the banks or financial institutions focused in the resolution of NPAs. The SC/RCs buy the impaired assets from banks and financial institutions, thereby cleaning the balance sheets of the banks and permitting them to focus on their normal banking business.

The promulgation of the SARFAESI Act has been a benchmark reform in the Indian banking sector. The progress under this Act had been significant, as evidenced by the fact that during 2002-03 when the Act came into effect, there was an overall reduction of non-performing loans to 9.4 per cent of gross advances from 14.0 per cent in 1999-2000¹.

Currently, three legal options are available to banks for resolution of NPAs- the SARFAESI Act, Debt Recovery Tribunals and Lok Adalats. The SARFAESI Act has been the most important means for recovery of NPAs. The amount of NPAs recovered under the SARFAESI Act formed over half of the total amount of NPAs recovered in 2009-10. Banks have referred as many as 78,366 loan default cases by end march 2010 under the SARFAESI Act involving a loan amount of Rs. 14, 249 crores. Against this, banks managed to recover Rs. 4,269 crores representing 30% of the loans².

Recently the ‘Report of the Working Group on the Issues and Concerns in the NBFC Sector’ laid out recommendations to extend the coverage of SARFAESI to NBFCs as well. This move will benefit NBFCs, ensuring quicker recovery of their non-performing assets. This, in turn, could encourage NBFCs to provide access to a wider range of financial products and serve better the cause of financial inclusion.

–
1 – Reserve Bank of India on Trend and Progress of Banking India 2002-2003
2 – Reserve Bank of India on Trend and Progress of Banking India 2009-2010

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.

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 Anand Sahasranaman, IFMR Finance Foundation

The High Powered Expert Committee (HPEC) for estimating the investment requirements for urban infrastructure services released its final report recently. The committee was set up by the Ministry of Urban Development in 2008 under the chairmanship of Dr. Isher Judge Ahluwalia.

The objective of the group was to assess the challenges of urbanisation and project the quantum of investment required for the provision of public infrastructure and services in urban India. The report also outlines the reforms in governance and financing that will be essential for cities to discharge their responsibilities in provision of these public services.

The group comprised of eight experts – Nasser Munjee, Chairman, DCB; Nachiket Mor, Chairman, IFMR Trust; M. Vijayanunni, Former Chief Secretary, Kerala; Sudhir Mankad, Former Chief Secretary, Gujarat; Rajiv Lall, Managing Director, IDFC; Hari Sankaran, Vice Chairman and Managing Director, IL&FS; Ramesh Ramanathan, Co-Founder, Janaagraha; and Om Prakash Mathur, NIPFP.

The committee estimates the investment for urban infrastructure over the next 20 years at Rs 39.2 lakh crore (at 2009-10 prices), which is an indication of both the large current backlogs in public service provision as well as the scale of expected urbanisation till 2031.

In order to achieve this scale of investment, the committee states that fundamental reforms in governance will be essential. These reforms include increased focus on metropolitan and regional planning; service delivery reforms such as corporatisation of service delivery institutions; regulatory reforms such as the setting up of urban utility regulator; enhanced community participation through empowered area sabhas and preparation of citizen report cards and a strong focus on institutional capacity building.

The committee also recognises the critical need for financing reforms such as the adoption of an area based system of property tax appraisal by cities; the revision of user fees periodically to ensure recovery of overall O&M charges; the need for state level financial intermediaries to work with smaller cities; and the creation of regulatory guidelines for municipal borrowings.

IFMR Trust has been advocating some of the reforms that the HPEC has recommended in its report and this paper outlines these ideas in greater detail.

By Shweta Aggarwal, IFMR Finance Foundation

The KGFS model is structured around the concept of financial well-being and aims to maximize the financial well-being of every individual and every enterprise. Among the questions that immediately arise are: What is financial well-being? How do we know that it is being maximized?

These questions are not always easy to answer as there is no one universally accepted definition and method of measuring financial well-being. IFMR Rural Finance and IFMR Finance Foundation is working together to develop the notion of financial well-being in order to assess the impact and viability of the KGFS model. The team is also developing an index to measure changes in financial well-being of households on an ongoing basis. This is a complex task as financial decisions are intricately linked and extremely dependent on each other and hence, not easy to discern.

We define financial well-being as:

The state in which a household can optimally choose patterns of consumption over time and in uncertain states of the world

In other words, a household’s ability to grow, manage liquidity and weather downturns across different periods of time and states of the world can be used to determine its financial well-being. Using this working definition, we structure the index around four domains: Protection, Liquidity Management, Diversification and Growth. The core wealth management methodology adopted by KGFS is designed around these four domains, allowing and encouraging households to achieve their goals and dreams over time.

Developing the Index

Each of the four domains is specified by indicators that capture a household’s ability to maximize its financial well-being. All the indicators have identical underlying characteristics:

1.    Efficiency: Relying largely on institutional data (i.e. CMS, CBS), rather than survey data. This will make data collection process continuous and cost effective
2.    Reliability and Validity: Ensuring consistency and exactness of measurement of the intended variable
3.    Timeliness: Easy to obtain and amenable for periodic updation
4.    Comparability: Fair measure of comparison across regions, taking into consideration region specific factors that may affect outcomes

Effort has been made to ensure that all indicators have these characteristics. However, efforts at refining and fine-tuning them, specifically for comparability, are underway.

The Domains

The table below gives an overview of the four domains and potential indicators. Column 3 offers the underlying rationale for using these indicators in assessing financial well-being of a household, while column 4 highlights how a movement in these indicators will effect the overall index. We discuss some of these indicators later.

*Assumptions for measuring the Sharpe Ratio will take into consideration diversification across financial and non-financial assets along with geographical diversification of physical assets, such as accounting for land within the district as opposed to land owned in another district.
**We account for value of human capital in NAV and include investments in education and other vocational courses made as contributing to human capital.

Protection: The ability of households to safeguard their assets and spread and manage their liabilities effectively.

To capture a household’s level of protection, independent of growth, and taking into account optimality and, individual needs and preferences, proved much harder than expected.

We decided to use the Life Wealth Envelope (LIWE) simulator developed by IFMR Trust, for advising households on the optimal levels of financial services they need, depending on their current and future financial needs. The graph below highlights how we can use the simulator to measure protection levels of a household.

The optimal level of protection is reflected through minimizing the area between the line reflecting cash flows in the best and worst states of the world, given their acquired level of insurance – life, health, accident and livestock. This is generated specific to each household, taking into account current income states and future financial needs, requirements and obligations. This measure also takes into account volatility in a household’s cash flow and can be updated regularly to reflect any change in a household’s financial state.

Liquidity: The ability of households to manage cash flows and maintain a balance between current and future requirements, to maximize the utility derived from lifecycle consumption.

To successfully manage liquidity, a household must be able to smoothen consumption and income over a period of time (Morduch, 1995). Given below is a method to comprehensively capture liquidity of a household: Standard Deviation of Monthly Consumption (adjusted for seasonality)

Consumption includes “all expenditures on nondurables plus imputed service flows from consumer durables, income, savings (net worth), and borrowed funds. It refers to that part of disposable income (income after taxes paid and transfer payments received) that is not included in savings”. Given this definition of consumption, we can even account for expenditure on education and other vocational courses while estimating cash flow of a household.

We recognize that accessing and gathering such data on consumption using institutional resources may be difficult.  However, given the need and effort made to smoothen consumption, this information is essential and the indicator above will help in aligning all future services and products for the estimation of household cash flows.

Diversification: Diversification is defined as the ability of households to reduce the volatility of return on the asset portfolio by investing in a variety of assets, including financial and non-financial.

Diversification is imperative to maintain an ideal risk-return portfolio that increases the probability of a smooth cash flow in all states of the world.

We use a variation of the Sharpe Ratio to measure diversification. Our assumptions take into account issues of extra-local versus local investments, along with diversification over physical and financial assets. The correlation and covariance matrices designed for this purpose will reflect all such assumptions. To measure improvements in a household’s level of diversification, we can measure the movement towards an ideal Sharpe Ratio overtime.

Growth: Growth may be defined as the ability of households to access capital and identify avenues to help increase their cash flow.

Measuring growth of a household over time is important to capture the effect of financial services on their overall financial wealth and worth. We identify two indicators to capture growth – Net Assets Value (NAV) and  using LIWE  by maximizing the area between wealth in the best states across time.

The NAV measure is an indicator of how much the household’s wealth has changed since last year. We include investments in education and other vocational courses as contributing to an increase in the total value of human capital, thereby increasing the net value of assets.

Our second option for measuring growth is to use the LIWE framework again and capture movement of the upper bound of the envelope. This will capture the impact on cash flows of a household over time, taking into account all assets, earnings and liabilities. An increase in the area between the current upper bound and previous upper bound will positively affect the index, as it will reflect growth in a household’s wealth.

Moving Forward

Moving forward, we must address a number of complex issues. We have managed to tackle some of them effectively by providing solutions to contentious issues such as measurement and collection, as well as conceptual and alignment issues. Questions that remain are those related to aggregation and normalization that are currently being discussed and debated. Some of the key questions we addressed are:

1. Do these indicators capture each domain effectively, taking into consideration a household’s short and long-term needs, while keeping in mind current status?

2. How can we make sure that the data collected is accurate and includes all attributes defined in the index? For instance, a dynamic indicator, such as consumption, is not only difficult to define but even harder to measure comprehensively and accurately.

3. Given the list of indicators, what method of aggregation can be used to construct an index without losing information and compromising on accuracy? The existing indices, such as the HDI and the Grameen PPI, are options worth considering, but cannot be taken as the final choice. We could give each indicator a score – a higher score if they are close to optimality and a lower score if they are further away. However, given that we have four domains, aggregating four scores to a single score may result in loss of information. Given this over-simplification process, a choice of a 4-number index, one for each domain may be a more comprehensive indicator of financial well-being.

In conclusion, the Index should represent and measure our mission of providing complete access to financial services to each household and enterprise, while maximizing their financial well-being. Building such an index is a complex task and is being done keeping in mind precision, fairness and comprehensibility.