Risk Transmission
Risk Transmission

What We Think?

To ensure that originators are sustainable, the financial system must provide mechanisms for orderly risk transmission from local originators to well-capitalised risk aggregators with proper prudential regulation. Given their small size and orientation, a local originator is 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 efficiently, or distributed through financial markets to various entities capable of holding the risks.

What is Happening Now?

The importance of risk transmission is increasingly being realised in the Indian financial system. There has been an increased emphasis on building market infrastructure that eases this process for interested participants. Still, much of the usage of risk transmission mechanisms is not focused on using it to transmit risk from localised originators, but in the recent past, risk transfer through securitisation has been a trend in the Indian markets for microfinance. Some institutions have managed to successfully complete a number of transactions, injecting  much needed liquidity while transferring some risk to well placed aggregators. However, there remain many regulatory challenges within this space that inhibit depth and breadth of such markets.

Our Work

Our efforts for facilitating orderly risk transfer are streamlined through two broad areas of work:

Strengthening the OTD Model

The Originate-to-Distribute (OTD) model of lending is one in which financial institutions originate financial products with the intent of transferring part of their associated risk and revenue to another financial institutions for a fee. Under the OTD model, origination, a specialised “front end” activity, is effectively separated from risk aggregation. OTD covers a wide range of financial services, from securitisation to parametric insurance.  IFMR Trust held a seminar on The OTD Model of Credit Provision and its Future in the Financial System Design, where along with key members of the trust, practitioners and academics discussed the benefits of this model for risk transfer.  This seminar highlighted some broad issues that need to be studied, such as the amount of “skin in the game” that originators should have to align incentives across market participants.

In the recent past, IFF has also worked with Centre for Advanced Financial Studies (CAFS), IFMR Capital and other partners to deepen our understanding of these issues. IFF has, on a continued basis, implemented research that helps fill knowledge gaps in this area. For instance, we are currently striving to make the rating process of microfinance institutions by various agencies more transparent and clear. Several other areas like securitisation guidelines, regulatory environment etc, are being explored for further research.

Enabling Infrastructure for Risk Transfer

A big lacuna related to the risk transfer pillar is the absence of critical entities that would provide key services and information for various market players. These entities include arrangers/advisers who can act as a bridge between buyers and sellers of assets, rating agencies that rate microfinance securities, back up servicers who may be required to service loans that are sold, credit bureaus, exchanges etc. IFF is working with its partners to fill some of these gaps.

To demonstrate a new institutional structure and develop innovative risk transfer mechanisms for emerging asset classes, IFF is working with IFMR Capital, an NBFC with the explicit mandate to serve as a bridge to mainstream capital markets for entities and asset classes of relevance to low-income households. IFMR Capital has been successful in developing a stronghold in identifying good-quality underlying portfolios and achieving diversification via pooling of risks across various sectors and geographical locations. They have completed a set of securitisation of micro-loans and are in the process of developing innovative models of financing for SMEs, agriculture commodities and urban local bodies.

Along with institutions such as IFMR Capital, rating agencies represent a key piece of market infrastructure for ensuring orderly risk transmission. IFF has partnered with CRISIL, the Indian subsidiary of S&P, to develop products for rating microfinance institutions, urban local bodies, and vocational training institutes, enabling better analysis and a deeper understanding of these entities.

IFF partnered with  CAFS at IFMR to develop a risk management portal that will be useful for smaller financial institutions. The portal allows the users to enter information about their complete portfolio using the web interface, computes the risk numbers, and also allows back-testing on the portfolio for any time window.