A number of chinks need to be ironed out during the process of microfinance securitisation. The RBI needs to look into these while finalising its draft guidelines on this subject

The RBI (Reserve Bank of India) has put up the draft guidelines on securitisation on 27th September and it includes guidelines for the "Lock-in Period and Minimum Retention for Securitisation Exposures: To ensure that the originators do not compromise on due diligence of assets generated for the purpose of securitisation, it was proposed in the Annual Policy Statement of April 2009 to stipulate a minimum lock-in period for bank loans before these were securitised. It was also proposed to lay down minimum retention criteria for the originators as another measure to achieve the same objective. Accordingly, it is proposed: that the minimum lock-in period for all types of loans would be one year before these can be securitised; and that the minimum retention by the originators will be 10% of the pool of assets being securitised".ⁱ

While the above aspects are important, a few other very important issues unique to microfinance appear to have an impact on securitising microfinance assets and those involved in this doing such deals may want to watch out for these. In other words, there are several peculiarities with regard to microfinance loan assets that need to be carefully considered while engaging in aspects such as securitisation:

a)    Microfinance loan assets tend to be predominantly small in amounts but large in number;
b)    While the transactions are also small, they are however numerous (repetitive) and most often, predominantly cash oriented-this makes it difficult to trace the source as well as end-use;
c)    The geographic diversity is huge in a country like India and these assets tend to be spread over remote rural areas and/or urban slums that make it rather difficult to physically locate them. Therefore, establishing the identity of the microfinance borrower and, hence, the loan asset becomes rather difficult. This is a very critical issue for securitisation; and
d)    While many of the lenders ask for KYC (Know Your Customer) documentation, it must be noted that what is provided is far from accurate. Therefore, it is very easy for an MFI (microfinance institution) to show the same assets for different lenders and redeploy the (surplus) funds in other activities like real estate and the like. Much of this was highlighted, as far back as May 2005, in the (now infamous) paperⁱⁱ  of Thorat and Arunachalam (2005).

Thus, as noted above, these peculiarities can cause serious problems for securitisation of microfinance assets and especially, those who buy these securitised assets must be very careful as there is a good chance that there may be no real persons at all with the associated assets or the assets themselves may have been hypothecated or pledged to other lenders. Also, there are other issues as well which impact securitisation and need to be considered by the RBI—while these are drawn from the present microfinance crisis in the Indian context, they can be adapted and used in other countries/contexts also by other central banks.

Client Acquisition Approaches Used By MFIs: First and foremost, this is a very crucial issue and there are several ways in which this can be done. The various methods and their implications for microfinance securitisation are given below:



So, I would ask the following key questions here (not exhaustive):

• How has the MFI, whose portfolio is being securitised, acquired its clients?
•  Do the client-acquisition strategies adopted by the MFI pose any problems for securitisation? If yes, what safeguards need to be built into the deal to mitigate the risks?

Frauds and Internal Control Failures in Portfolio: A second issue is the aspect of growth pattern of the MFI whose assets are being securitised and whether there could be frauds and internal control failures due to this. MFIs that have grown very, very fast could have a significant proportion of (Akerloff's) Lemons in their portfolio because of the rapid pace of their growth which may have undermined, stressed and/or sheared existing systems. Examples of the kind of frauds and control failures that could exist are given here in a previous Moneylife article^v . The implications of such kinds of frauds and control failures for securitisation are given below:

•  Loan Disbursement Related Frauds: The most common ones are: ghost or non-existent clients and staff giving loans to themselves (through non-existent clients)—the securitised portfolio in such cases could have a significant proportion of Akerloff Lemons. It goes without saying that such a portfolio would constitute a very serious credit risk. Further, sometimes, the staff indulge the clients and get them higher-than-required loans and take the remaining (excess) loan amount from clients—here too, there would be a serious credit risk as most often such staff either migrate or leave and the clients are thereafter unwilling to pay back the portion of loans not used by themselves (rather taken by the staff). Sometimes, staff have collected some extra fees upfront and again, there could be a credit risk as clients may not be able to or want to pay back, given that some "corruption" charge has been paid already by them. In a few MFIs in India, I have found that while incentive systems based on loan disbursement do not exist on paper, they actually operate on the ground. That needs to be ascertained during any securitisation deal.

•   Loan Repayment Related Frauds: A very common occurrence here is that staff retain regular and/or prepayments by clients and do not pay back to the institution. This has implications for securitisation. Further, in a few MFIs in India, I have found that while incentive systems based on loan repayment do not exist formally on paper, they actually operate on the ground through different means including zero-par policy of MFIs and related mechanisms whereby field staff cannot come back without collecting client repayment. In a few cases, I have seen staff even being given loans and/or having to pay large delinquent amounts from their personal resources. When this is the case, after some time, it is only natural that the staff tries and minimises personal losses and hence, they talk and act very tough on the ground with clients resulting in what is often called today as coercive repayment recovery. This problem gets even more exacerbated when loan disbursement is supply-led and this again, would have implications for securitisation.

Thus, the above aspects also need to be ascertained during any securitisation deal and here too, I would ask the following critical questions (not exhaustive):

1.    What can be said with regard to the growth pattern of the MFI, whose portfolio is being securitised?
2.    Are systems, practices and procedures at the MFI strong enough to withstand this rapid growth?
3.    Are there any differences between various (MIS, or Management Information Systems, internal audit etc) intended systems, procedures and practices (as they exist on paper) and the implementation on the ground (realised systems in operation)? Is it likely to have caused loan disbursement and/or loan repayment frauds and control failures? If yes, what are the implications for future repayments?
4.    Does the growth pattern of the MFI, whose portfolio is to be securitised, suggest that growth has come from offering supply-led (multiple) loans to shared JLGs and clients? Could this growth have caused high levels of indebtedness in the clients whose portfolio is being securitised?

Thus, the questions under all aspects given above certainly need to be asked during a securitisation deal as they have implications concerning the nature of the obligor(s) on whom cash flows are dependent and ability to estimate the cash flows from the assets being securitised as well as payment frequency and the propensity to prepay or make delayed payment. Three possible strategies could help in alleviating the above problems and ensure a higher degree of safety in securitisation of microfinance assets. First, stakeholders need to be aware of the critical issues such as those mentioned above and constantly keep asking questions as part of a securitisation deal. Second, it seems like an appropriate strategy and well worth the cost, for securitisers, to commission small sample studies by unrelated third parties (with no conflict of interest)—especially, for the first time as well as large quantum securitisation deals. Third, it also seems necessary to bring in a fair trade kind of certification (or equivalent) and permit securitisation only if the relevant MFI associations (and/or regulators) certify that the concerned MFI is indeed practicing ethical lending practices (defined appropriately). That will go a long way towards eliminating the above problems in securitisation and get the incentives right for microfinance securitisation and I hope that the RBI considers these issues as well when it finalises its draft guidelines.

 ⁱ http://rbidocs.rbi.org.in/rdocs/Content/PDFs/DGSD270911F.pdf
  ⁱⁱThorat, Y S P and Ramesh S Arunachalam, (May, 2005), "Regulation And Areas Of Potential Market Failure In Micro-Finance", Paper presented at the NABARD High level policy conference in New Delhi
 ⁱⁱⁱ http://www.microfinancefocus.com/news/2010/07/06/the-hidden-risks-behind-microfinance-securitization/
 ^iv (a) http://www.moneylife.in/article/implementation-safeguards-against-notorious-agents-are-an-imperative-for-the-proposed-microfinance-bill/19017.html); (b)  http://www.moneylife.in/article/how-and-why-did-microfinance-agents-become-a-part-of-the-indian-microfinance-business/19301.html; (c) http://www.moneylife.in/article/implementation-safeguards-against-notorious-agents-are-an-imperative-for-the-proposed-microfinance-bill/19017.html 
 ^v http://www.moneylife.in/article/indian-microfinance-credit-bureau-why-is-it-not-fully-operational-yet/20091.html

(The writer has over two decades of grassroots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural/urban development and urban poverty alleviation/governance. He has worked extensively in Asia, Africa, North America and Europe with a wide range of stakeholders, from the private sector and academia to governments).