Loss Given Default Estimation using Transition Matrix (TM-LGD): A Case Study
By Kshama Fernandes, IFMR Capital
The goal of an investment professional is to maximise the risk-adjusted return on the overall portfolio through diversification within and across asset classes. High repayment rates, low volatility of returns and low correlation with other asset classes make microfinance an interesting asset class.What drives the high repayment rates and low volatility of returns? How can unsecured loans made to borrowers with no credit history be of higher credit quality than more established asset classes? To understand these questions, one has to look at the underlying model.
Social collateral
The joint liability group (JLG) system is an operationally intensive model with strong emphasis on adherence to simple, yet well-designed processes. The product is typically a one-year loan with equal weekly repayments. A group of borrowers get together and form the basic unit — the joint liability group. Coming from the same neighbourhood, they know each other well enough to understand the cash flows and requirements of households, and have insight into the ability and willingness of the members to repay.
The group members collectively guarantee the loan given to members in their group. If a member fails to pay an instalment, the others in the group pool together and pay.Very often, non-payment of an instalment is due to reasons of liquidity, not wilful default. Most low-income households have no collateral to provide. The model effectively replaces physical collateral with social collateral.
While this may appear simple, the implementation is complex. Borrowers, who have never availed loans in the past or experienced the discipline of repayments, need to be educated about the product, group formation process and the liability they take on being a member of the group.
Educating borrowers
MFIs spend a lot of time educating their borrowers through a well-defined CGT (Continuous Group Training) and GRT (Group Recognition Test) process before a loan is sanctioned and disbursed. While most MFIs insist on borrowers engaging in an income generation activity, often the loans are utilised to smoothen lumpy cash flows, typical of an agriculture-based economy.
Most rural households engage in multiple income-generating activities. They grow seasonal vegetables, rear livestock and work as daily wage labourers. Thus, repayments often come from within the existing household balance sheet, rather than from new business income.
The small weekly repayments match well with the high frequency cash inflows. The group guarantee, based on self-selection, repayment discipline with close group monitoring, and a financial product that matches the household’s cash flow patterns, results in high repayments.
The low correlation observed between returns on this asset class and mainstream asset classes, such as equities, bonds, commodities and bullion, is because in the short run, the small-scale activities and occupations engaged in by borrowers continue irrespective of the happenings in mainstream markets.
As markets for end products/services produced by clients are largely local, the micro economy continues to function irrespective of whether inflation skyrockets, stock index nosedives, interest rates strengthen or exchange rates collapse.
Distinctive features
The features distinguishing microfinance from other asset classes are:
Very high granularity resulting in portfolio diversification: Microfinance loans have small ticket sizes that average Rs 12,000. As explained earlier, these loans are used for income generation, to smoothen cash flows and repay high-cost debt. The granular nature of loans with diversified business activity underlying them makes for a well-diversified underlying loan portfolio;
Short-term assets: These are short tenor loans where the frequency of repayment is far higher than standard loans. The principal outstanding steadily reduces with every week of repayment. Hence the duration of a typical loan with a one-year maturity is around six months. From a risk-return perspective, this is an attractive feature; and
Superior credit quality due to underlying model: Except for instances triggered by political risk, losses in this sector have been in the range of 1.5-2.5 per cent. Pool performance has been consistently good for originators who have tapped capital markets through well-structured securitisation transactions; this enables investors to take an exposure to this asset.
Efficient geographical diversification can be achieved by pooling loans originated by multiple MFIs across States and districts. The collection efficiency of such transactions structured by IFMR Capital has been 99 per cent. These numbers are far superior to those exhibited by other retail asset classes.
Wider Investor Base
For an investor pursuing risk-adjusted returns, microfinance is certainly an asset class worth looking at. MFIs have been able to tap capital markets through securitisation transactions and non-convertible debentures (NCDs), attracting mainstream investors such as mutual funds, bank treasuries, and private wealth investors. As the investor base for microfinance diversifies, the sector is also likely to experience lower liquidity risk.
For instance, after the recent Andhra Pradesh crises, while banks reduced lending to the sector, NBFCs continued lending, preventing a liquidity crunch.
The professionalism and rigour of capital markets has resulted in increased transparency, operating efficiency and improved risk management practices in this sector. Market oversight and performance monitoring by investors and rating agencies will go a long way in establishing microfinance as a high-quality asset class.
This article first appeared in The Hindu Business Line.