At IFMR Finance Foundation, we believe that a well-functioning financial system is built upon three fundamental pillars: Origination, Transmission and Aggregation.
Origination may be defined as the design and delivery of financial services that provide households and firms the ability to manage liquidity (moving resources across time) and risk (moving resources across “states of the world”) in a smooth, convenient and affordable manner.
Risk Transmission in the financial system involves the movement/assignment of risk from one entity to another, in return for a compensatory payment at a market-determined rate. In a well-functioning financial system, risk moves in an orderly manner between those who are originating it and those who are best placed to manage it, thus improving the system’s overall capability to manage 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. In a financial system, risk can be mitigated either through diversification or transfer. The former involves a portfolio-based strategy designed to reduce overall risk by combining a variety of assets which are highly unlikely to behave in an identical manner. The latter involves the movement of risk to external counterparties (for instance, from the household to a firm, or from a domestic investor to an international investor). Entities ultimately bearing such risks may be termed “aggregators”.
High Quality Origination
We believe that the approach to origination should be guided by an intention to use financial services to steadily improve the financial well-being of households and enterprises over a period of time. To ensure this, we believe that continuity, flexibility, reliability and convenience of services provided, as well as the presence of wealth management support, is central to the notion of quality in the context of origination.
A combination of these characteristics ensures that institutions are designed to cater to specific needs of clients belonging to geographies where the originator is operational. For instance, a combination of the above mentioned characteristics should ensure that a household is able to transact any amount – at a location near their place of dwelling, at a suitable time, under transparent and rule-bound services – with an institution that is likely to service them in the long run. The wealth management process should help the household make optimal financial decisions after a thorough understanding of its current state and future needs along with the benefits and drawbacks of using available financial products.
In order for originators to serve each household comprehensively, we are arguing for localised originators focusing on specific geographies, growing vertically by serving each household. Wealth management is done through localised entities that are embedded in the community and are well-positioned to understand client needs and risks. Irrespective of the legal form, any entity can be a high quality originator given their adherence to certain guidelines.-
Orderly Risk Transmission
To ensure that originators are sustainable, the financial system must provide mechanisms for orderly risk transmission from local originators to well-capitalised and well-regulated risk aggregators. Given their small size and orientation, local originators are not in a good position to hold certain kind of risks – especially systematic risks, like risks of natural calamities. Such risks need to be transferred to well capitalised, diversified institutions like large national banks, mutual funds and insurance companies, which are able to manage these risks more effectively, or distributed through financial markets to various entities that have the appetite for and are capable of holding these risks.-
Robust Risk Aggregation
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 risk. This complements financial institutions whose footprint is narrow and local. In insurance, for example, it is critical that the risk pool is large enough so that any one systemic shock does not wipe out the entire insurance corpus of a community – herein lies the need for better risk pooling/aggregation across a variety of local originators. The important issues here are around appropriate regulation and management of aggregators.-