Let’s stop kicking the can down the road: Highlighting important and unaddressed gaps in microcredit regulations
By Deepti George, IFMR Finance Foundation
The Committee on Comprehensive Financial Services for Small Businesses and Low Income Households (CCFS) seeks the creation of an ecosystem of different types of institutions, each with their choice of specialisation such that there would be multiple partnerships between these specialists. It states that increasingly, each bank will need to become inherently stronger, focus more sharply on their core capabilities, and have the flexibility and the regulatory mandate to collaborate actively with other market participants who have complementary capabilities instead of being forced to follow identical strategies as every other participant. The CCFS report covers a set of recommendations that pertain to the role for Development Finance Institutions (DFIs) such as NABARD, SIDBI, NHB and CGTMSE in making this a reality.
1. Market Making and provision of risk-based credit enhancements
CCFS sees the role of DFIs to be one that moves away from being institution-specific providers of automatic finance/refinance, to one of market making – that facilitates the orderly development of the sector, strengthening the better institutions while allowing weaker institutions to gradually fade away. DFIs could become providers of second loss deficiency guarantees and credit enhancements as well as facilitate listing of debt securities for institutions. Such a market making function would enable institutions serving rural and agriculture sectors to bring down their cost of capital and access easier and cheaper funds from the market, thereby attracting stronger players and investors into the sector. Such facilities must be priced based on underlying risks and must be neutral in its choice of eligible institutions. In other words, such facilities are to be extended based on the nature of the activity of the end borrower and not to be based on the type of institution that can avail the benefit.
The idea of a market maker is not a novel one and DFIs such as NHB and SIDBI play this role. Another example of such an institution from the USA is the Federal Agricultural Mortgage Corporation or Farmer Mac1. It was created in 1971 as a statutory body to establish a secondary market by providing securitisation and guarantee services for agricultural real estate and rural housing mortgage loans, rural utility loans and loans guaranteed by the US Department of Agriculture2. As on December 31, 2012, total outstanding amount of eligible loans across all its lines of business amounted to $ 13 billion.
To fulfil the role of a market maker, there is a need for DFIs to shift to Risk- based mechanisms in both market making and supervisory functions. These mechanisms would entail graduating to risk-based pricing of all facilities that the DFI chooses to provide, such as refinance and guarantees, as well as of deposit insurance for supervised banks by the DICGC. To make this possible, there needs to be an environment where a picture that is closest to accurate is available on each of these entities in a high frequency manner. CCFS recommends that, given the absence of public information regarding the quality of these participants, these institutions be required to undergo rating exercises by commercial ratings agencies and make available to the public the results, especially in the case of Regional Banks. This will help signal to the market who the well-performing institutions are, and help put an end to any discrimination they may have been facing so far, as well as push bad-performers to either improve or to cease operations.
2. Management of Systematic Risks
CCFS acknowledges that Regional Banks such as cooperative banks are much better placed than large national level banks in agriculture credit delivery. Their local presence and deposit-taking capabilities permanently anchor them to the community giving them both the desire and the requirement to stay connected to the local community during both good times and bad ones. However, this also gives such institutions an inability to successfully manage regional level systematic risks such as rainfall shocks and local-economy related events such as commodity price fluctuations which have adverse effects on asset quality. The fear that local deposits used to fund the loan portfolio would get eroded due to these risks is a legitimate one. This fear is further exacerbated by the requirement for the loan portfolio to be necessarily held to maturity and the non-availability of risk transfer markets where those risks that cannot be managed locally can be transmitted to large national level institutions that are well-placed to hold them.
The CCFS report cites the example of Germany as a possible approach towards active risk management for Cooperative Banks. It covers the German Sparkassen Banks3 which are small banks each serving their respective region and function to provide bank accounts and loans and other financial services for the local community. These are not profit oriented and are part of a national system that spreads risk across a system of Regional Banks and national institutions which include the “Joint Liability Scheme” of national and regional guarantee schemes coordinated by the Deutscher Sparkassen und Giroverband (DSGV: the German Savings Bank Association). Germany also has credit guarantee banks that lend within each federal region or Land organised through the Verband Deutscher Bürgschaftsbanken (VDB: the Association of German Guarantee Banks). They are non-profit associations of lenders that historically provided sureties worth 80% of the loan value. Each guarantee bank would take on up to 35% of the risk, while the federal government took 40% and the Land 25%. The borrower pays a fee of 1-1.5% of the loan plus an annual commission of 1-1.5% on the amount outstanding each year. Historically borrowers were at risk for 20% of the loan value, but as a result of the recent financial crash the German Government has encouraged guarantee banks to cover 90% of the risk and to take up to 50% themselves. The absence of such a superstructure that cooperative institutions become part of and which guarantees some form of portfolio protection in the wake of an adverse event may be one important reason for the decline in market share of community banks in the USA4.
A body similar to the German VDB could be created by NABARD for all Regional Banks, to provide guarantees for a significant portion of the portfolio of cooperative banks and thus to help tide over losses due to systematic risk events that Cooperative banks are more prone to facing given their local nature.
Another alternative that DFIs have is to facilitate creation of active securitisation markets for the transfer of systematic risks (that these regional institutions are poorly equipped to hold) to large national-level aggregators. This is especially with regard to priority sector lending where Regional Banks (with respect to Direct Agriculture), as well as other entities such as NBFCs are very significant net originators of priority sector assets for which there is a proven demand from commercial banks.
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- www.farmermac.com
- Its main secondary market activities pertain to :
- Purchasing eligible loans directly from lenders,
- Providing advances against eligible loans by purchasing obligations secured by these loans,
- Securitising assets and guaranteeing the payment of principal and interest on the resulting securities that represent interests in or obligations secured by pools of eligible loans, and
- Issuing long-term stand-by purchase commitments for eligible loans
- “German Savings Banks and Swiss Cantonal Banks, Lessons for the UK”, written by Stephen L. Clarke, December 2010. Source: http://civitas.org.uk/pdf/SavingsBanks2010.pdf
- In the period from 1984 to 2011 the share of US banking assets held by community banks declined from 38% to 14%. Quoted in the CCFS Report from the FDIC Community Banking Study, December 2012
