The Reserve Bank of India (RBI) through various policy measures has sought to promote small-ticket lending (primarily through priority sector lending stipulations). Some of these measures overlap with what is now known as microfinance.
The RBI’s objective was to promote and strive to achieve financial inclusion. With the recent growth in microfinance in India, and an increase in microfinance institutions (MFIs), it is now time to rethink the traditional model of MFIs borrowing from banks for the purpose of on-lending, and evaluate innovative financing mechanisms such as the securitization of microfinance portfolios and guarantee as credit enhancement.
Besides driving down transaction costs, such financial innovations allow certain investors to fulfil their philanthropic or social welfare objectives while at the same time enabling such investors to earn returns on their investments.
Microfinance loans disbursed by MFIs, can be securitized in two ways. Firstly, by way of a direct sale of the microfinance loans to one or more banks, or any refinance institution, and secondly, through a sale to a trust, which then issues pass through certificates (PTCs) to its beneficiaries.
Such beneficiaries may be various investor classes such as mutual funds, insurance companies and refinance agencies. Usually banks have an appetite for direct assignments, since it helps them in meeting their priority sector obligations as per the RBI requirements.
Securitization allows MFIs to diversify their investor base. This is particularly true in the case of PTC structures, since microfinance loans can be restructured into different tranches with different risk exposures (and varying seniority) in order to cater to the risk appetites of different investor classes. However, in order to make the market for such papers liquid, it is essential that the PTCs are credit enhanced either by the MFI itself, or through a third party to secure better ratings and finer rates from investors.
Credit enhancements can be in the form of a guarantee, including those by offshore investors seeking synthetic exposures to microfinance loans, through first loss and second loss credit enhancement. In fact, offshore investors and institutions seeking to promote microfinance can provide institutional setups for such purposes, without necessarily charging market rates to provide such guarantees.
In the context of guarantees on a cross-border basis, certain issues need to be noted. Upon invocation of a guarantee, the amounts to be remitted by the guarantor will be the US dollar equivalent of the rupee amounts payable by the guarantor under the guarantee (assuming the guarantee amount is in US dollars). Remittances of US dollars will be done through the originator’s bank account.
The recipient bank (in India) will convert the US Dollars into rupees and issue a foreign inward remittance certificate (FIRC). The originator is required to file the FIRC with the RBI. When providing remittance instructions, it would be advisable for the guarantor to set out the purpose for which such amounts are being remitted.
Under the extant foreign exchange regulations, amounts remitted outside India on account of reimbursement to the guarantor cannot exceed the rupee equivalent of the amount paid by the guarantor under the guarantee. In other words, the currency risk with respect to the reimbursement of the amounts paid by the guarantor must be borne by it.
As usual, tax issues will arise with regards to the payment of the guarantee commission, payable to the guarantor.
It may be noted that the RBI has recently allowed systemically important non-deposit taking non-banking financial companies (SI-ND-NBFCs) with an asset size of Rs1 billion (US$21 million), to raise Tier I and Tier II capital through the issue of perpetual debt instruments (PDIs), which may be in the form of either bonds or debentures. If the MFI is a SI-ND-NBFC, then it is possible to issue PDIs and raise funds, thereby diversifying funding sources and investor bases. It appears that such instruments can be held by offshore investors registered with Indian authorities as foreign institutional investors.
In order to attract such types of funding, MFIs need to become more transparent about their work, maintain better details of their loan portfolios, institutionalize their processes, including the use of standard documentation.
Investors financing microfinance ventures have diverse objectives, such as assisting in poverty alleviation, improving financial inclusion, accelerating outreach so that microfinance can be offered to a greater number of borrowers, and achieving profitable growth with an appropriate return on investments. MFIs with access to such funding have the potential to offer various products on a sustainable basis.
MFIs can use these structures to raise loans at a cheaper rate of interest than the traditional model of borrowing from banks. Such structures also allow MFIs to remove loans from their balance sheets. Furthermore, investors (especially offshore investors) acting as credit enhancement providers help achieve better ratings, which is a prerequisite if the papers are to be made available to a wider class of investors.
Sonali Sharma is a partner and Suprio Bose is an associate at Juris Corp. The firm is a full-service law firm based in Mumbai and specializes in financial transactions including capital markets and securities, banking, corporate restructuring and derivatives.
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