Financial Systems Design Framework

A Financial Systems Design Framework

Dimensions of a well functioning financial system High Quality Origination Robust Risk Orderly Risk Aggregation Transmission

1. Origination► Origination involves providing households and firms with financial products and services that enable them to manage liquidity (moving resources across time) and risk (moving resources across states of the world)► High quality origination enables this in a smooth, convenient and affordable manner

Key issues in origination in India ► Vast and diverse array of institutions, including banks, non-banking finance companies, post offices, insurance and asset management companies (and their agents), cooperative societies, self-help groups and business correspondents  Origination dominated by a few product manufacturers with proprietary distribution networks with some attempt at cross-selling  Outreach of originators is very limited. 50% of India’s population has bank account  Disqualification of a sizeable chunk of rural households on account of inability to measure household income and inherent income volatility  Informal originators dominate with respect to low income and rural households, and small firms  Customer protection mechanism is largely non-existent with reliance placed on internal mechanisms

High quality origination ► Increasing the outreach & ‘goodness of fit’ of originators  Local originators who can adapt to the local reality and culture providing access in an integrated and comprehensive manner  Nature of financial products and services delivered to customer are based on a combination both “hard” as well as “soft” information  Credit provider approach to wealth management approach ► Operational capability and financial strength of originators  Superior customer and local understanding, technological capability allowing for cheap real-time customer analysis  Ability to offer multiple services across different manufacturers  Reasonable amount of financial capital, always having capital at risk and accountability even for distribution of non-asset products

Enabling infrastructure for origination ► Unique ID/biometrics capability, high quality KYC with physical verification, credit bureaus ► Financial stability and capital at risk for all assets originated with ability to manage idiosyncratic risk ► Ability to efficiently transfer systemic risk ► Mechanisms to replace originators in a frictionless manner ► Legal redressal mechanisms

2. Risk transmission► Risk transmission involves the orderly reassignment of risks from originators to well-capitalised risk aggregators with sound financial management at the back-end► Risk transmission can take place in three ways:  Financial firms can construct financial products through which risk is laid off onto the household balance sheet. Through this, households bear risk, and (in return) earn a risk premium  Financial firms can intermediate risk transfers on a global scale, particularly through GDP-scale derivatives transactions, through which risks get transferred abroad  The risks which cannot be transferred are ultimately on the balance sheets of financial firms. That is, they get transferred to the households who own these financial firms

Key issues in risk transmission in India► Limited use of risk management instruments by individuals and firms► Missing markets - unavailability of full suite of risk transmission products  Price risk - treasury bill futures  Credit risk - credit default swaps► Limited availability of certain risk transmission products on account of “public good” deficiencies:  High quality rainfall measuring centres to support enforcement of rainfall insurance contracts  Professionally managed warehouses that enable warehouse receipt financing

Enabling infrastructure for risk transmission ► Enhancing risk pricing ability by reducing opaqueness in the system and thereby increasing transparency in measurement of risks of products and entities, especially large institutions with heavy governmental involvement ► Redefining roles of various agents like rating agencies and audit firms in assessing risk ► Strengthening public goods necessary for risk transmission markets– UID, credit bureaus ► Deepening risk transmission markets and mechanisms  Securitisation: use of adequate incentive structures to ensure risk-alignment  Credit derivatives and liquid bond markets

Illustration: Risk-transmission from originators to aggregators Rating Agency Assigns and Sonata maintains rating INR 40 mn for the portfolio P1+ Senior Notes Subscribed to by Sahayata Funds Funds Mutual Funds, Banks INR 187 mn SPV Satin Portfolio: INR 308 mn Portfolio of Securities INR 50 mn microfinance loans Junior Notes Asirvad Subscribed to by IFMR INR 32 mn Capital Cash Collateral First-loss by originators, proportionate to their portfolio sold  Originator incentivised to originate high quality assets  Structurer and arranger incentivised to design optimum structures (identifying high quality originators, putting together well diversified pools and risk-return structures, post investment monitoring)  Investors can come in at risk levels suitable to their risk appetites 10

3. Risk aggregation ► Risk aggregation allows local originators to transfer systematic risk such as a natural disaster or a political event, either to the capital markets or to well capitalised, diversified risk aggregators that have the capacity to bear and manage such risk. ► A well-functioning financial system should have robust risk aggregation capacity through a range of institutions, such as commercial banks, insurance companies and mutual funds, with the appetite and ability to hold and manage the risk. ► Government can play key role in risk aggregation, especially in areas that are not suitable for commercial institutions? E.g. SME guarantee (CGTSME), NREGA program

Key issues in risk aggregation in India ► Firms’ reliance on retained earnings instead of formal financing channels from markets and banks for most of their financing requirements. ► The financial system does not penetrate deeply enough to meet the needs of small and medium-sized enterprises in much of the country. ► Lack of level playing field across aggregators due to government guarantees, explicit or implicit (private versus government owned). ► Absence of transmission mechanisms to enable risk management for aggregators:  Weather/rainfall insurance to hedge agricultural portfolio.

Reliance on retained earning ► Private Indian companies mainly rely on internal funds to meet their financing requirements. During 2000 to 2005, internal funds accounted for nearly 80% of total funds raised1Source: McKinsey Report 2006- India’s Financial System : More market, less government

Are the aggregators big enough? ► A comparison of the asset size of the top ten corporates and exposure limits of the top ten banks below reveals the disparity in credit demand and supply 2,500 2,000INR Billion 1,500 1,000 500 - ONGC IOC RIL PFC BHARTI NTPC REL COMM HDFC (HD) TATA STEEL TATA MOTORS IDBI BOI UBI SBI BOB PNB CBI CANARA ICICI HDFC Capital Funds Single Borrower Limit Group Borrower LimitSource: Respective financial statements and pillar-3 disclosure of banks, 2011

Enabling infrastructure for risk aggregation ► Availability of efficient mechanisms (ratings, structured finance), liquid markets and regulations to allocate risk to entities best equipped to take them on ► Appropriate pricing methods reflecting the risk evaluation of the counterparty, the underlying asset pool, the instruments used and the level of liquidity ► Availability of reliable, high quality data on risk aggregators to monitor and manage counterparty risk and potential systemic risk to the financial system ► Close regulation and management to ensure that risk aggregators (especially ones that are identified as systemically important) are able to deal with plausible stress events such as a significant liquidity shock in the financial sector - no aggregator must be “too big to fail” ► Mechanisms to resolve the failure of aggregators and originators swiftly.

Some questions: Origination► A wealth management approach versus a product approach: impact on outcomes?  Portfolios of the poor: Poor people have surprisingly sophisticated financial lives, saving and borrowing with an eye to the future and create complex "financial portfolios" of formal and informal tools.► Decision making heuristics of clients: how do they evaluate convenience, flexibility and reliability when it comes to financial products?  Loans: Flexibility of repayments synchronised with household cashflows  Insurance: Quick and reliable claims settlement► Information asymmetry between provider and buyer of financial services and its impact on sale of financial products and outcomes:  A loan is often a substitute for medical/accident insurance that was not available/sold to the household

Some more questions: Origination► Lack of ex-post responsibility of originator and impact it has on design of financial products and outcomes:  Selling a money-back insurance policy in place of pure life insurance  Selling a monthly repayment scheme to a farmer who needs a bullet repayment loan.► Measurement of financial outcomes to impose ex-post liabilities

Some questions: Transmission► Incentive alignment of originators with aggregators and its impact on outcomes : study of financing structures that worked versus those that failed► Design of risk transfer mechanisms that mitigate moral hazard► Building the right incentive structures for risk managers.  How should risk managers be rewarded?  Should risk managers rise from a business function?

Some questions: Aggregation► To what extent does market/publicly available information reflect the risk of aggregators?► Going beyond financial statements and share prices, what mechanisms can be used to reduce opaqueness and better understand aggregator risk. : marking portfolio to market?► Can the asset-liability match and liquidity management withstand a sudden shock in interest rates or liquidity (typically banks finance their long term assets with short term liabilities)► Incentive structures for self regulation of aggregators ( as an aid to regulator)► Role of state as a large risk aggregator: relationship between corporate holding structures and governance of publicly owned enterprises. How should the state involvement be structured? Direct versus indirect ownership?

Thank you

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Financial Systems Design Framework

by IFMR on Nov 01, 2011

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Financial Systems Design Framework — Presentation Transcript