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Cost of Delivering Rural Credit in India
Deepti GeorgeIFMR Finance Foundation
3rd 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
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)
Pertinent Costs
• Marginal cost at which the banks are able to raise moneyCost of Debt
• How much equity to be kept aside for unexpected losses, and the cost of such equity
Cost of Equity
• How much to set aside for expected loan losses based on historical default dataLoan Loss
Provision
• Administrative costs directly attributable to the processing, delivering and administering of loans
Transaction Cost
Cost of Debt
Source Channel Cost of DebtPublic Sector Bank Bank Branch 4%
SHG Linkage 4%MFI 4%
Private Sector Bank Bank Branch 4%MFI 4%
• Lowest cost incurred by banks to raise money• Costs of acquiring depositors – is not factored in
Cost of Equity and Providing for Loan Loss
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 channelTotal COE = COE for bank + COE for channel
Mean default rates
Expected Losses (EL)
Loan Loss Provisions
Volatility of default rates
Unexpected Losses (UL)
Cost of Equity
Numbers needed
?Source Channel Default observed by Bank Default observed by Channel
Mean Default
Rate
Standard Deviation
Mean Default Rate
Standard Deviation
Public Sector Bank
Bank Branch
SHG Linkage
MFI (rated BBB)
MFI (rated A)
MFI (rated AA)
Private Sector Bank
Bank Branch
MFI (rated BBB)
MFI (rated A)
MFI (rated AA)
Calculating Cost of Equity
‘An approach to risk-pricing of loans’, by Chakrabarti, Ahmed, Mullick. 2002
I. Unexpected loss (UL) = n* Standard Deviation of default rate*(1-Recovery rate)
II. Hurdle Rate = Expected Return on Equity / (1- tax rate) – Risk free Rate
III. Cost of Equity = Hurdle rate * Unexpected Loss (UL)
Assumptions used:
Recovery Rate 0%Confidence Level 3σ Expected Return on Equity for Bank 20%Expected Return on Equity for MFI/SHG 25%Risk-free Rate 8%Tax Rate 33%
Assumes a normal distribution, therefore a 99% confidence level. This is consistent with an “A” credit rating aspiration for financial institutions.
Default on Bank lending through own branch
Channel / Observed Defaults 2008 2009 2010 2011 2012 Mean SDPublic Sector Bank Branch(Central Bank of India) 5.44% 4.04% 3.22% 2.73% 5.83% 4.25% 1.35%Private Sector Bank Branch(ICICI Bank) 3.58% 5.62% 7.61% 4.78% 5.40% 1.70%
*Annual Reports, calculations for NPAs on agri loans
Default on Bank lending to SHG
Channel / Observed Defaults 2008 2009 2010 2011 2012 Mean SD
PSB - SHG Linkage 2.90% 2.90% 2.94% 4.74% 6.38% 3.97% 1.56%
*Microfinance State of the Sector Reports, NABARD
Default on Internal lending within SHG
State Karnataka Orissa Rajasthan
# of SHGs surveyed
46
37
25
% PAR (> 360) 12.00% 9.00% 2.00%
Karnataka Orissa Rajasthan
Weighted Average PAR
5.11% 3.08% 0.46%
Average PAR 8.66%
SD across regions 5.13%
*Self Help Groups in India – A study of the lights and shades. EDA/APMAS, 2006
Default on Bank lending to MFI
Data from CRISIL one-year default matrix for 2004-2012
2012 2011 2010 2009 2008 2007 2006 2005 2004 MEAN SDAAA 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%AA 0.03% 0.04% 0.04% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.01% 0.02%A 0.74% 0.82% 0.93% 1.00% 0.94% 0.90% 0.98% 1.00% 1.01% 0.92% 0.09%BBB 1.68% 1.89% 2.82% 4.10% 3.40% 3.30% 3.36% 3.40% 3.47% 3.05% 0.79%BB 5.15% 5.80% 8.90% 15.90% 15.21% 15.20% 15.34% 15.48% 15.85% 12.54% 4.56%B 8.88% 8.25% 9.18% 16.30% 29.41% 29.40% 29.41% 29.41% 30.30% 21.17% 10.25%C 18.44% 21.36% 24.98% 31.20% 28.05% 28.40% 28.40% 28.40% 28.57% 26.42% 4.08%
Default on MFI lending to customer
PAR 90 data from IFMR Capital on 20 MFIs from 2008-2012
Mean 0.22%Standard Deviation (SD) 0.30%
To summarise the default numbers
Source Channel Default observed by Bank Default observed by Channel
Mean Default Rate
Standard Deviation
Mean Default Rate
Standard Deviation
Public Sector Bank
Bank Branch 4.25% 1.35% 0.00% 0.00%
SHG Linkage 3.97% 1.56% 8.66% 5.13%
MFI (rated BBB) 3.05% 0.79% 0.22% 0.30%
MFI (rated A) 0.92% 0.09% 0.22% 0.30%
MFI (rated AA) 0.01% 0.02% 0.22% 0.30%
Private Sector Bank
Bank Branch 5.40% 1.70% 0.00% 0.00%
MFI (rated BBB) 3.05% 0.79% 0.22% 0.30%
MFI (rated A) 0.92% 0.09% 0.22% 0.30%
MFI (rated AA) 0.01% 0.02% 0.22% 0.30%
Loan Loss Provisions
Total Expected Loss (EL) = EL for bank + EL for channel
Source Channel EL (Bank) EL (Channel) Total ELPublic Sector Bank (PSB)
Bank Branch 4.25% 0.00% 4.25%SHG Linkage 3.97% 8.66% 12.63%MFI (rated BBB) 3.05% 0.22% 3.27%MFI (rated A) 0.92% 0.22% 1.15%MFI (rated AA) 0.01% 0.22% 0.24%
Private Sector Bank
Bank Branch 5.40% 0.00% 5.40%MFI (rated BBB) 3.05% 0.22% 3.27%MFI (rated A) 0.92% 0.22% 1.15%MFI (rated AA) 0.01% 0.22% 0.24%
Calculating Cost of Equity
“An approach to risk-pricing of loans” by Chakrabarti, Ahmed, Mullick. 2002
I. Cost of Equity = Hurdle rate * Unexpected Loss (UL)II. Unexpected loss (UL) = n* Standard Deviation of default
rate*(1-Recovery rate)III. 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%
Recovery Rate 0%Confidence Level 3σ Expected RoE for Bank 20%Expected RoE for MFI/SHG 25%Risk-free Rate 8%Tax Rate 33%
Assumes a normal distribution, therefore a 99% confidence level. This is consistent with an “A” credit rating aspiration for financial institutions.
Cost of Equity
Source Channel UL (Bank)
Cost of UL
(Bank)
UL (Channel)
Cost of UL (Channel)
Total UL
Total Cost of
UL
Public Sector Bank (PSB)
Bank Branch 4.06% 0.89% 0.00% 0.00% 4.06% 0.89%SHG Linkage 4.68% 1.02% 15.39% 4.51% 20.08% 5.54%MFI (rated BBB) 2.36% 0.52% 0.91% 0.27% 3.27% 0.78%MFI (rated A) 0.28% 0.06% 0.91% 0.27% 1.19% 0.33%MFI (rated AA) 0.06% 0.01% 0.91% 0.27% 0.97% 0.28%
Private Sector Bank
Bank Branch 5.09% 1.11% 0.00% 0.00% 5.09% 1.11%MFI (rated BBB) 2.36% 0.52% 0.91% 0.27% 3.27% 0.78%MFI (rated A) 0.28% 0.06% 0.91% 0.27% 1.19% 0.33%MFI (rated AA) 0.06% 0.01% 0.91% 0.27% 0.97% 0.28%
Transaction Costs
Transaction Costs for Banks, MFIs
Transaction Costs Loan Size = Rs.25,000 Loan Size = Rs.10,000Private Sector Bank 8.62% 21.56%Public Sector Bank 12.95% 32.39%
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 loanFor MFI to customer lending, the Committee estimates 8.74% for a Rs.10000 loan
Transaction Costs
Transaction Cost (%) Loan Size (Rs.) Number of Loans
Total Transaction Cost (Rs.)
Bank – MFI 0.50%
100,000,000
1 500,000 MFI - Customer 8.74% 10,000 10,000 8,740,000 Total 9.24% 9,240,000
Transaction costs for SHG
We make some assumptionsNumber of members 15Incubation period (months) 6Loan duration (months) 24Loan amount (Rs.) 150,000 Average distance to and from bank (km) 24Cost of travel (Rs. per km) 3Period of apportionment of incubation cost (years) 4
SHG SHPI Bank
• Costs of opening savings bank account• Training costs
Group formation and incubation
• Ratings costs• Bank transaction costs• Panchayat Level Federation meeting costs• Stationery and register maintenance costs
Ratings and post-linkage
Costs borne by the SHG
Cost Head Cost (Rs.) Cost (%) Cost DetailGroup Formation and Incubation Costs
Savings A/C 111 0.07% Stationery at Rs.300 +Travel for 1 to bank
Bank Transactions
108 0.07% Travel for 1 to bank per month for incubation period
Ratings and Post-linkage Costs
Ratings Cost 150 0.10% Loan DocumentationBank Transactions
1728 1.15% Travel for 1 to bank per month for 24 months
Panchayat Level Federation Meetings
1728 1.15% Travel for 1 to PLF meetings per month for 24 months
Stationery & Registers
1920 1.28% Assumed at Rs.80 per month for 24 months
Total 5,745 3.83%
Costs borne by the SHPI
Cost Head Cost (Rs.) Cost (%) Cost DetailGroup Formation and Incubation Costs
Group Formation
73 0.05% 3 visits for 1 hr each + Travel for SHPI staff
Training 296 0.20% 6 days of training for 5 hrs each + Travel for SHPI staff
Savings A/C 13 0.01% 1 visit to bank for 2 hrs by SHPI staffMonitoring 146 0.10% 1 visit for 1 hr + Travel for SHPI staff
for each month of incubation periodRatings and Post-linkage Costs
Ratings Exercise
250 0.17% 2 visits to bank for 5 hrs each by SHPI staff
Monitoring 2,328 1.55% 1 visit for 1 hr each by SHPI staff for 24 months
Bank Visits 600 0.40% 1 visit to bank for 1 hr each for 24 months
Total 3,704 2.47%
*Salary of SHPI Staff at Rs.5000 / month
Costs borne by Bank
Cost Head Cost (Rs.) Cost (%) Cost DetailGroup Formation and Incubation Costs
Savings A/C 6 0.00% 15 mins. of bank staff timeBank Transactions
38 0.03% 15 mins. of bank staff time per month for incubation period
Ratings and Post-linkage Costs
Ratings Cost 50 0.03% 30 mins. of bank staff timeBank Transactions
600 0.40% 15 mins. of bank staff time per month for 24 months
Total 694 0.46%
*Salary of Bank Staff at Rs.20000 / month
Transaction cost for Bank-SHG
Transaction Cost (%) Transaction Cost (Rs.)
SHG level3.83% 5,745
SHPI level2.47% 3,704
Bank level0.46% 694
Total6.76% 10,143
Total Costs across Channels
Source Channel Total Cost Observed Price to Customer
Public Sector Bank (PSB)
Bank Branch 41.53% 11.25%SHG Linkage 28.93% 24.00%MFI (rated BBB) 17.29% 27.00%MFI (rated A) 14.71% 27.00%MFI (rated AA) 13.75% 27.00%
Private Sector Bank
Bank Branch 32.07% 14.00%MFI (rated BBB) 17.29% 27.00%MFI (rated A) 14.71% 27.00%MFI (rated AA) 13.75% 27.00%
Conclusions
• Rural credit through bank branches exhibits the highest Total Cost but lowest Observed Price to customer
• Total Channel Cost ranged 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
Losses in each Channel
Source Channel Total Cost Total Loss of the Channel
Public Sector Bank (PSB)
Bank Branch 41.53% 29.53%SHG Linkage 28.93% 16.93%MFI (rated BBB) 17.29% 5.29%MFI (rated A) 14.71% 2.71%MFI (rated AA) 13.75% 1.75%
Private Sector Bank
Bank Branch 32.07% 20.07%MFI (rated BBB) 17.29% 5.29%MFI (rated A) 14.71% 2.71%MFI (rated AA) 13.75% 1.75%
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
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
Thank you
