MUDRA Bank – How will it help?

First things first, a regulator cum re-financier (market player)  is bad design. Period. It leads to moral hazard where the regulator will shape policy to grow only its business. Yes, refinance is business.

But I hear that MUDRA Bank is expected to be a regulator and financier of microfinance institutions and micro-enterprises. Why?

The only other entity with such an entitlement, the National Housing Bank (which is a regulator and refinancier for Housing finance companies and bank housing loans) is expected to lose that status once the long pending NHB Bill is passed in its current form. The bill aims to move the regulatory powers of the NHB to the RBI and let NHB continue to operate as a sector focussed bank like NABARD and SIDBI. Obviously, the law makers realised that regulation and business do not go hand in hand.

That brings me to the second question, NABARD refinances MFIs, so does SIDBI. SIDBI refinances/ guarantees small/micro enterprise finance. So, basically, between the two they pretty much already do what the MUDRA Bank is supposed to do on the refinance side. So, why do we need a MUDRA Bank?  Yes, they don’t regulate. So, to regulate?

When the microfinance crisis broke out, there were discussions of NABARD being made a regulator for the MFI industry but that did not happen, primarily due to the fact that NABARD was actually a refinancier (a service provider) for MFIs and the significant majority wanted NABARD to continue as a service provider and not become a regulator in parts due to the lack of infrastructure and in parts to avoid the moral hazard issue. The only reason why NABARD was brought into the picture was microfinance institutions not only included the RBI regulated NBFC-MFIs but also societies and trusts not regulated by he RBI.  However, NABARD felt that they did not have some of the “missing links to operate in the sector” as a regulator.

What then, will the MUDRA Bank do differently? If the several decade old and experienced NABARD thinks they can’t handle the job, how will the MUDRA Bank manage?

Another interesting proposed change is that the FMC and SEBI are going to be merged, the logic seems to be that financial and commodity markets are, at the end of the day,markets and hence they should have a common regulator because this will streamline decision making and potentially trigger new products. Great!

And there comes my third question, why then are we trying to create multiple entities for microfinance and enterprise finance? Where is the coherence in “strategy”?

Instead of seeding new ideas, would it not be better to energise the NABARD and SIDBI to take the word “Development” in their names seriously for their respective sectors? To adopt innovation and  shake away  some of the bureaucracy that binds them down? To adopt proactive measures to tackle the problem of access to finance for small businesses?

And please, for the sake of humanity, why should a bank promoting entrepreneurship favour only the scheduled castes and tribes? Favour all enterpreneurs, if you can. Nobody does that in our country.

(Edited on 9th March, 2015 to add an article on the same topic by noted journalist/author Mr. Tamal Bandyopadhyay. He seems to point out similar concerns.)

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Pricing: Loan against property v/s home loan

Simplified Definitions

Mortgage Loan/Loan Against Property (LAP):A mortgage loan is given for an open end use and is given against the lien of a property.

Home Loan: is given for a restricted purpose of buying/ constructing a house to stay.

Typically a mortgage loan is often the most common way of raising funds for growing the business. Banks typically get comfort from the availability of fixed collateral to be able to recover from in case of loan default.

The rate of interest charged on a Loan Against Property is higher (much higher) than a Home Loan.

Historically, default rates of LAP (for business purposes) have been high justifying a high rate of interest.

Why?

Question 1: Is the assessment of loan eligibility for LAP done assuming that cash flows from the business will grow due to utilisation of the funded amount for capex/WC use? If that is not the case, why would the default happen?

Question 1 a.) why can’t we give the loan based on existing cash flows?

People say that the loan size would be too small and not meet the requirement for the capex. My comment on that response would be “Oh common! let’s grow step by step. Give me some other reason”.

Question 2: Why doesn’t the “emotional attachment” story that works in case of home loan doesn’t work for LAP?

Question 2. a.) Does the person seeking a LAP have multiple properties and so property offered on mortgage has lesser “Emotional attachment”?

Guess so.

(Also, the question is how enforceable is the mortgage? In a lot of cases, especially developing countries, legal recourse may just be too cumbersome/ inefficient. So, isn’t the collateral acting more as a deterrent. I guess it is.)

Question 3: Would a LAP given based on existing cash flows AND after taking the owners current residential home as collateral completely change the loan performance?

That is what a number of financial institutions are now trying out with the lower income/informal sector entrepreneurs. Assess loan eligibility based on current cash flows and take the residential property of the entrepreneur as collateral. However, the interest rates continue to be higher going with the notion that LAP has generally resulted in high defaults. Interestingly, last 3 year’s history in these kind of loans show very low (between 0.5- 1 % delinquency in the 90 days past due bucket). Off course, three years is not enough time but these 3 years have been the roughest phase for business in India in general as well. The other key reason for good portfolio performance could be that this type of lending is new and the good quality selection could be due to the initial “start-up precautions” taken by the financial institutions starting this product.

Assuming loan performance does show improvement in this kind of loans, is there a reason to suggest lower interest rates and hence greater affordability?

At last but very important, one oft stated reason for low home loan interest rates is that the purchase of home does not generate additional revenue but LAP for small business does and hence the borrower can pay a premium. For all practical purposes, this reasoning silences all the discussion and the confusion around the pricing by simply stating that the lender wants his pound of flesh! That’s all!

What do you think?

Mezzanine Financing (Part 2)

Situations

Mezzanine capital is often utilized in the following situations by an enterprise:

  • The bank is at its comfort level and will not lend beyond a certain point.
  • Public equity financing is not available due to the present IPO market and/or company’s track record, industry, or growth prospects.
  • Equity financing is not available in the private marketplace because investors want a greater equity percentage than you are prepared to give up.
  • The venture capital market doesn’t view the company as a rapid growth situation.

Small businesses may use mezzanine financing to overcome working capital constraints caused by fast growth; higher-than-acceptable leverage under traditional underwriting criteria; as a means to preserve capital and gain a longer repayment term; and to address credit issues that do not meet bank thresholds.

However, the entrepreneur believes that the company will experience rapid appreciation in the next few years. Therefore, instead of selling undervalued equity today and receiving a low price,the entrepreneur h can use mezzanine financing to bridge the company until it proves itself in the marketplace. At that point, you can sell stock for a higher price.