Inverting The Pyramid

Category: A lil’ adavanced

  • e₹- CBDC- How? Part-2

    Picking up from where we left off in the last post. The indirect model
    will pose certain challenges for the e₹-R such as the following:

    1. It will have almost no difference compared to the current rupee in
      digital form (read your account balance in a savings account with any
      commercial bank).
    2. Your e₹ balances will not be updated with RBI in real-time thereby taking away one of the biggest USPs, i.e finality of settlement (the user will run the Settlement Risk in this model).

    To overcome these challenges the model most likely to be implemented for the retail pilot is a Hybrid model. Before you ask what this hybrid model is, let’s see in some detail about all three models- direct, indirect & hybrid.

    AspectDirectIndirectHybrid
    IssuerRBIRBI issues to Intermediary for retail distributionRBI issues to Intermediary for retail distribution
    LiabilityRBIRBIRBI
    OperationsRBIIntermediary Banks/InstitutionsIntermediary Banks/Institutions
    Who maintains the Ledger?RBIIntermediary
    Banks/Institutions    		Intermediary
    Banks/Institutions & RBI
    Settlement Finality YesNoYes
    The Three Distribution Models

    The reason I think a Hybrid model suits better is that the indirect model does away with almost all the benefits that a Retail user might want from e₹. So what is
    even the point? The Hybrid model, simply put is an indirect model with a messaging layer with it. Using this messaging layer, RBI will be able to keep a real-time ledger for each retail user. You can think of this as an e₹ account with a Commercial Bank along with a UPI-like layer to it which will update any transaction with RBI.

    Now, dilemma no 2- this pertains to the token design. Should the e₹ have a token-based design like all major cryptocurrencies or should have an account-based design that enables book-keeping as well?

    Dilemma No 2 RBI’s Answer Rationale
    Should the e₹ have a token-based design or an account-based design Account-Based for the Wholesale segment for
    now and probably it will be Token-based for the Retail segment.     		e₹ should offer the level of anonymity Cash offers. In the retail segment, RBI is trying to achieve lower Cash circulation by introducing e₹. To that end, a token-based e₹ will offer the holder, the right to spend without having to maintain a trail of the transactions.

    This is easier said than done! Such an approach (token-based) will also have lots of decisions to be made- such as whether should there be an amount ceiling for e₹-R, given the anonymity. More in the next post.

  • e₹- CBDC- How? Part-1

    Now the big question-How?

    This is probably a multi-million-billion dollar question. There are so many dynamics at play here to keep in mind that it will require a very careful, deliberate, and intelligent approach to get this right. I will try to cover some of the dilemmas RBI will have and will also share some questions to which we don’t have the answers now. Would love to know your thoughts on this. I will try to make this a series of shorter, bite-sized nuggets.

    Let’s get started with the first of few. I guess you are aware by now that RBI kicked off the first pilot of e₹ with 9 Commercial Banks on the 1st of Nov 2022 (more about it here: https://economictimes.indiatimes.com/wealth/save/rbi-cbdc-digital-rupee-pilot-to-start-from-november-1-sbi-hdfc-7-other-banks-to-participate/articleshow/95205659.cms).

    We need answers to a lot of different questions before we can begin to visualize how the future looks to be. The larger questions are around the Distribution, Technology, Value proposition, Security, and Privacy of e₹.

    Let’s see what we know and what to expect on these fronts. In terms of the market for e₹, RBI will have 2 avatars of its CBDC- e₹-Retail (e₹-R) & e₹-Wholesale (e₹-W). The pilot is underway for the e₹-W. As mentioned in the last post, under how e₹ is different from the rupee balance you see in your savings bank account (or payment wallet)- it is issued by the RBI and is their liability. Let’s run with that idea for a minute, if RBI decides to allow me & you to have e₹ account, that account needs to be opened with RBI directly! Can you imagine the kind of infrastructure (digital & physical) such an undertaking would require? Also, it would be so redundant, given that for all these years the Govt & RBI have been trying to get Banks to expand their franchise and now by offering e₹ they will essentially be leaving out Banks from the transaction flow. So this is Dilemma No. 1- if to keep the distribution central or distributed

    Dilemma No 1RBI’s AnswerRationale
    Should Distribution be Direct or Indirect?Both; Direct for Wholesale Segment and Indirect for Retail.Wholesale will not require the kind of infra a Retail distribution will need, in terms of Account/Wallet creation, KYC, AML Checks, etc.

    Image Source: RBI’s Concept Note on CBDC

  • The Law of Evolution- Survival of the Largest ?

    As the central bank in its pursuit of achieving 100% financial inclusion keeps commissioning various committees, the landscape new age MFIs operate in is getting more and more dynamic. Well, what do we have today? –the recommendations made by V. K. Sharma Committee ( V K Sharma is the senior most executive director and the favorite to succeed Usha Thorat as the deputy governor at RBI).

    In November 2009, a Working Group was constituted by The Reserve Bank of India under the Chairmanship of Mr. V. K. Sharma to examine the pros and cons of the Priority Sector Lending Certificates (recommendations about which were made by the Committee on Financial Sector Reforms, chaired by Dr. Raghuram G. Rajan), and to make recommendations on introduction and trading of the PSLCs in the open market. Later, RBI in its 2010-11 monetary policy report expanded the scope of the working group and mandated them to review the pros and cons of inclusion of bank lending to micro-finance institutions (MFIs) under priority sector lending. This is where the problem started 🙂 . The group was supposed to submit its report by June 2010, which has not yet happened. The group however has submitted a draft report on its findings and recommendations (ET report)

    The recommendations as reported are-

     Bank’s exposure to Non-Banking Finance Company (NBFCs), having priority sector status should be withdrawn.

     The phase out period should be orderly and therefore should be allowed up to 31st March, 2012.

    Now, we will try to see what could be the implications if the recommendations made are endorsed by the apex bank in its entirety.

    The committee says since it could not be ascertained whether the loans extended to MFIs under PSL reach the poor, so banks should discontinue lending to MFIs under PSL. As of March’09 the loans extended by Pvt & public sector banks to all the MFIs aggregated to about 3/4th of the entire debt funding available to these institutions, so the impact of this recco is well understood. As of now banks lend to MFIs to meet their PSL targets (remember the 40% target?) as required, failing which RBI guides them to park an amount equal to the shortfall with institutions like NABARD, SIDBI etc, which yields a meager ~6% return. You might think this PSL thing might help MFIs to get a good bargain at the interest cost, well that logical too but it doesn’t happen at all! Going by the numbers the flag bearer SKS reports the cost is around 12% for them (that’s around 200-300bps costlier than what large corporate houses pay on a purely commercial borrowing), needless to say this number hits north as the size of the firm decreases. Now if this lending is excluded from PSL it will simply increase banks’ bargaining power, so the interest charged is bound to increase. This might be passed on to the customer by the MFIs which will push the dream of financial inclusion farther. Still worse, it might make it impossible for start-up and other growing MFIs to borrow at all, if that happens the microfinance market will never see competitive pricing as much it could have.

    If this happens the large MFIs might still be able to protect their margins owing to their scaled-up operations, better bargaining power with banks etc, but smaller MFIs might just get wiped off making the market more inefficient.

    The Rationale

    To my limited understanding its very challenging to find a good reason how-

    – On one side people (no names 🙂 ) complain about how the interest rates of MFIs have not come down as they should have, and on the other side we are talking of steps that will essentially translate to an increase in the borrowing cost further to ensure that the kind of competitive market place required for charges to come down is never achieved!

    – WE say MFIs charge astronomical interest rates, and that they are wrong citing high operating costs as the reason as lower delinquency (98%+ recovery rates) should offset the higher operating cost. At the same time it’s OK for banks to charge MFIs higher interest rates on the grounds of riskier business model, why is it that the same argument of lower delinquency is no longer valid?

  • Financial Reforms & MFIs

    Financial reforms that the government is trying to bring in are going to affect MFIs like all other financial institutions in some or the other way.  Among the major recommendations in the last report on financial reforms banking license to NBFCs & PSLCs are the ones which I think if implemented will affect MFIs most significantly. Banking license is still self explanatory, so I will try to find out what is this PSLC we are talking about.

    Priority Sector Lending Certificate..what is it??

    The idea was born in the abovementioned 2008 report of the Committee on financial sector reforms titled- ‘A Hundred Small Steps’ better known as the Raghuram G. Rajan committee report.  The committee came up with a very novel idea to help implement the priority sector lending mandate more efficiently. It suggests that all registered lenders be issued certificates for the amount they lend to the eligible priority sectors. Then a market would be opened up for such certificates, where the deficient banks can buy these certificates for the amount they are falling short by. However, the loan will remain on the books of the original lender and any default in the loan will affect the lender only and not the certificate holder. For those who know will find it much like the CERs or the carbon credits..Indeed it is, in many aspects.

    The million $ question..how will these certificates be priced?

    The price obviously will be less than the penalty faced by the banks in case they fail to achieve their target & sub targets. The actual price discovery will be done by the market.

    So why is it important for MFIs??

    At the heart of the proposal of PSLC lies the idea to make PSLC a market-driven interest subsidy to those who make priority sector loans. The income from selling these certificates is what will make lending more profitable for lenders. So now we can see how MFIs stand to benefit, especially the large MFIs will be the largest beneficiaries as these certificates will have some minimum size regulations, also only they can be of help to large banks who will be looking at some serious volumes of PSLC.

    The way I see it, if PSLC are introduced it will be the next big thing for major MFIs. We might see upsurge of many specialized institutions in priority sector lending which will try to thrive on this initiative. Whatever may be the consequence for the institutional participants, it will surely go a long way in benefitting the end customer, the borrower and will push us an inch closer to what we aspire to achieve- ‘financial inclusion’; cheers to that! 🙂

  • Banks & Priority Sector Lending

    As we know the commercial banks have to meet the RBI guidelines of 40% net advances of their Adjusted Net Bank Credit to the priority sectors. In case you are wondering what all sectors come under this ‘priority’ list they are- advances for agricultural sector, small & micro enterprises, retail trade, education, housing, Differential rate of interest scheme (there are various sub-targets apart from this overall 40% as well, but we won’t get into those details now). In case a bank fails to meet these targets they face penalty which is- Contribution by banks to Rural Infrastructure Development Fund (RIDF) or Funds with other Financial Institutions, as specified by the Reserve Bank. The term, interest and size of such deposits are dictated by the central bank from time to time. In logical conclusion the returns from such deposits are not favorable for the banks and so they try to avoid it, you will see banks going on PSL spree in the last quarter of the year trying to close down the gap.

     

    So the question is why do banks have to struggle to meet these targets & sub-targets, why don’t they lend enough to these sectors themselves??

    The Raghuram report on financial reforms identifies the reasons as-

    “Interest rate ceilings (either imposed by the centre or the state) make priority sector lending unprofitable, and ensure that the banker attempts to recover his money through hidden charges in the loans that are made, or that he does not lend so the poor are driven to the moneylender. The Committee believes a better way to proceed is to liberalize interest rates while increasing safeguards that prevent exploitation.”

    The committee goes further to recommend

    –          Liberalization of interest rates charged on these PSL to ensure that the credit reaches the poor.

    It also suggests having a system in place, to ensure-

    –          Lenders disclose the total cost being charged on such advances

    –          Periodic public disclosure of maximum and average interest rates charged by the lenders.

    –          Only loans that stay within a margin of local estimated costs of lending to the poor be eligible for PSLCs.

  • Funding the Microfinance Biz

    Moving on to the next level..we will now try to see how do these Microfinance companies manage to fund their business. This will involve both the fields which I am passionate about- micro & corporate finance :).

    Looking at the Indian scenario to find out the answer, one thing that stands out is that in the last two years, the five largest MFIs in India have been beneficiaries of approximately $180mn in private equity investments! and their combined client base during the period grew at an annually compounded rate of 45% .

    Now, why do they need private equity after all- Corporate Finance-101 will tell you that a company can’t fund itself solely by debt beyond a certain level. The increasing leverage will increase the cost of capital substantially. So beyond a certain stage the business needs infusion of fresh equity, since the promoters are not in a state to fund it by themselves, they also have not yet achieved the scale to be able to go public- so they turn to the only plausible option left, that is private equity.

    The private equity investing in microfinance is mostly in the form of early start-up or growth capital. This is different from the prevalent practices in the developed world in the way that otherwise private equity players are over-leveraged in the pursuit of short-term exit & return. However in the case of investment in MFIs they partner them for a longer duration as still its a long time before these investments will mature giving them an option to exit.

    An increase in inflow of such funds will not just help the sector to scale, but will allow greater transparency. The kind of corporate governance requirements of these investors will inevitably result in stronger organizations.

    On the contrary, despite the positives such investments, some people still criticize private equity backed MFIs for their rapid growth rates. Their concern is that in the pursuit to scale up fast these PE funded MFIs will compromise the quality of the loan portfolio. To my understanding that is not a problem, as a default ridden portfolio, no matter how large it is, is of limited use to the MFI as well as the PE firm, especially so amidst the current financial crisis. Also people often accuse PE backed MFIs to be driven only by profitability, now that comes from the school of thought that believes microfinance to be just a kind of social service. I will again repeat what I ve already said about microfinance- ‘it is about doing well, by doing good’. No business can sustain & scale up without having a financial business sense to it. We have to understand that grants can’t keep driving microfinance forever, they have to be profitable for them to scale-up & be able to provide the service to a larger base.