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Cost of Delivering Rural Credit in India

Cost of Delivering Rural Credit in India. Deepti George IFMR Finance Foundation. 3 rd June 2013. Overview. Five channels covered in the Note Costs covered in the Note Cost of Debt Cost of Equity Loan Loss Provisions Transaction Cost Total Channel costs Implications for Policy.

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Cost of Delivering Rural Credit in India

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  1. Cost of Delivering Rural Credit in India Deepti George IFMR Finance Foundation 3rd June 2013

  2. Overview • Five channels covered in the Note • Costs covered in the Note • Cost of Debt • Cost of Equity • Loan Loss Provisions • Transaction Cost • Total Channel costs • Implications for Policy

  3. Five Channels Through a Public Sector Bank (PSB) • Lending through its rural branch • Lending through SHG • Lending through MFI Central Bank of India Through a Private Sector Bank • Lending through its rural branch • Lending through MFI ICICI Bank 10,000 loans of Rs.10,000 each = Rs.100 million (Rs.10 cr)

  4. Pertinent Costs

  5. Cost of Debt • Lowest cost incurred by banks to raise money • Costs of acquiring depositors – is not factored in

  6. Cost of Equity and Providing for Loan Loss

  7. Cost of Equity and Loan Loss • Economic capital and not regulatory capital • Mean and volatility of default rates for bank and for channel Loan Loss = EL for the bank + EL for the channel Total COE = COE for bank + COE for channel

  8. Numbers needed ?

  9. Calculating Cost of Equity ‘An approach to risk-pricing of loans’,by Chakrabarti, Ahmed, Mullick. 2002 • Unexpected loss (UL) = n* Standard Deviation of default rate*(1-Recovery rate) • Hurdle Rate = Expected Return on Equity / (1- tax rate) – Risk free Rate • Cost of Equity = Hurdle rate * Unexpected Loss (UL) Assumptions used: Assumes a normal distribution, therefore a 99% confidence level. This is consistent with an “A” credit rating aspiration for financial institutions.

  10. Default on Bank lending through own branch *Annual Reports, calculations for NPAs on agri loans

  11. Default on Bank lending to SHG *Microfinance State of the Sector Reports, NABARD

  12. Default on Internal lending within SHG *Self Help Groups in India – A study of the lights and shades. EDA/APMAS, 2006

  13. Default on Bank lending to MFI Data from CRISIL one-year default matrix for 2004-2012

  14. Default on MFI lending to customer PAR 90 data from IFMR Capital on 20 MFIs from 2008-2012

  15. To summarise the default numbers

  16. Loan Loss Provisions Total Expected Loss (EL) = EL for bank + EL for channel

  17. Calculating Cost of Equity “An approach to risk-pricing of loans” by Chakrabarti, Ahmed, Mullick. 2002 • Cost of Equity = Hurdle rate * Unexpected Loss (UL) • Unexpected loss (UL) = n* Standard Deviation of default rate*(1-Recovery rate) • Hurdle Rate = Expected Return on Equity / (1- tax rate) – Risk free Rate Assumptions we made: Hurdle rates for banks and MFI/SHGs are 21.9% and 29.3% Assumes a normal distribution, therefore a 99% confidence level. This is consistent with an “A” credit rating aspiration for financial institutions.

  18. Cost of Equity

  19. Transaction Costs

  20. Transaction Costs for Banks, MFIs Report of the Committee on Financial Inclusion (Rangarajan Committee), 2008: For banks, For Bank to MFI lending, transaction cost is assumed at 0.5% of the loan For MFI to customer lending, the Committee estimates 8.74% for a Rs.10000 loan

  21. Transaction costs for SHG We make some assumptions

  22. Costs borne by the SHG

  23. Costs borne by the SHPI *Salary of SHPI Staff at Rs.5000 / month

  24. Costs borne by Bank *Salary of Bank Staff at Rs.20000 / month

  25. Transaction cost for Bank-SHG

  26. Total Costs across Channels

  27. Conclusions • Rural credit through bank branches exhibits the highest Total Cost but lowest Observed Price to customer • Total Channel Costranged from 13.75% (lending through AA rated MFI) to 41.53% (Public Sector Bank lending directly through its branches) • For every Rs.100 million being lent out as small rural loans by Banks through their branches, over Rs.27 million (Rs.2.7 crore or 27%) is being “wasted” in the form of higher channel costs • Total Capital Consumption (only unexpected losses) ranged from 20.08% (bank lending through the SHG) to 0.97% if the lending is done through very high quality MFIs

  28. Losses in each Channel If price to customer is at 12%, • If the bank chooses to lend through a BBB-rated MFI, it will need to provide for a subsidy of 5.29% or Rs.529 over the loan of Rs.10,000, as compared to absorbing loss of 29.53% or Rs.2953 in direct lending

  29. Implications for Policy • The channel of delivery matters • Inefficiencies in prescribing credit targets for a particular channel • 12% can be achieved by permitting banks to work with low-cost channel partners • Current cross-subsidisation (between bank branches) can be passed onto such partners to bring down the price to customer • Bank branch and SHG channels consume a lot more capital • SIFIs end up exposing themselves to much higher risk levels in the process • Strong case for well-capitalised high quality intermediaries to achieve the 3 policy goals of • Achieving complete financial inclusion • Building low-cost financial intermediation infrastructure • Keeping systemic risks low

  30. Thank you

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