2. Dimensions of a well functioning financial system
High Quality
Origination
Robust Risk Orderly Risk
Aggregation Transmission
3. 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
4. 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
5. 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
6. 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
7. 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
8. 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
9. 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
10. 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
11. 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
12. 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.
13. 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 raised
1Source: McKinsey Report 2006- India’s Financial System : More market, less government
14. 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
2,000
INR 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 Limit
Source: Respective financial statements and pillar-3 disclosure of banks, 2011
15. 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.
16. 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
17. 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
18. 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?
19. 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?
