Risk Profiling of Manufacturing Micro and Small Enterprises

 

India’s Micro, Small and Medium Enterprises (MSME) viewed as the lifeblood of the Indian economy, contribute 30 percent to GDP and of them micro enterprises alone are estimated to employ 23 percent of India’s total workforce, according to the data of the Union Ministry of MSME. Access to credit has been the most contentious issue discussed on public platforms and IMF estimated that only 23 percent of the total number of enterprises in this segment got formal access to credit.

 

Post-pandemic, government of India has been laying lot of emphasis on the growth of micro, small and medium enterprises and extending incentives and products for easing the conduct of their business. The Union Finance Minister, in her usual meetings with the bankers, draws her untiring attention to the need for increase in credit to these enterprises. Banks, on their part, do not lose the opportunity to exhibit their fancy to lend to such enterprises.

 

Trust deficit was the major contributory factor from the lenders’ perspective. It is therefore considered expedient to look at the risk profile of such enterprises and see the possible mitigating factors.

 

Latest Profile of the Sector

Interestingly, TransUnion CIBIL-SIDBI MSME Pulse Report for July-September presents a very hopeful perspective presenting a growth of 24 percent year-on-year (Y-o-Y). Credit to ‘micro’, viewed as unmoving window of Banks for five continuous years since 2017 and even on the negative window, reported a 13 percent growth in credit outstanding y-o-y as of September 2022 versus 10.6 percent y-o-y for all the MSMEs y-o-y. Growth in disbursements for micro, small, and medium enterprises had been at 54 percent, 23 percent, and 9 percent respectively during the period.

 

According to RBI’s Financial Access Survey, 72.83 percent of MSME Credit is concentrated in ten states: Maharashtra, Gujarat, Tamil Nadu & Pondicherry, Uttar Pradesh, Delhi, Karnataka, Rajasthan, West Bengal, Telangana, and Haryana. Maharashtra takes the major slice of 26.19 percent. This obviously means that government assistance to the sector also reached these states in a significant measure, at least proportionately viewed.

 

Very small (with aggregate credit exposure not exceeding ₹ 10 lakh), micro1 (with aggregate credit exposure between ₹ 10-50 lakh) and micro2 (with aggregate credit exposure between ₹ 50 lakh-1 crore) experienced growth of 20 per cent, 15 per cent and 11 per cent y-o-y respectively showing sudden spurt in micro lending, which is not just a post-pandemic bounce back, it added.

 

Delinquency rates dropped y-o-y across all the three lender categories (public sector banks/PSBs, private sector banks(PVBs) and NBFCs); the highest drop was in PVBs segment (from 2.8 per cent in FY22-Q2 to 1.5 per cent in FY23-Q2).[i] Street Vendors’ financing programme, MUDRA loans (Rs.3.4cr sanctioned during FY21-22), 59-Minute loan programme for the MSMEs contributed to the steady uptick that was presented apart from the Union Finance Minister dinning into the ears of bankers that credit to MSMEs has been sluggish. There was a pressure on the banks to perform.

 

This positive vibration whittles down suddenly when we hear the Union Minister of State for MSME submits to the Parliament, duly reported in the Financial Express dated 23.02.23: “The number of Udyam-registered MSMEs closed in the current financial year has nearly doubled from the last financial year’s count, showed official data. From 6,222 MSMEs shut during FY22, the count has jumped to 12,307 as of March 9 in FY23 while only 175 units were closed between July 1 (when the Udyam portal was launched) and March 31 in FY21, taking the total number of MSMEs closed to an all-time high of 18,704. Maharashtra had the highest number of casualties with 4,871 Udyam-registered MSMEs shut since July 2020 followed by Tamil Nadu (2,326), Uttar Pradesh (1,568), Gujarat (1,558), Rajasthan (1,297), Bihar (1,075), and more.”

 

Gross Non-performing Assets ratio  (the ratio of total gross NPAs to the total advances made during a particular period by the lender) in MSME loans in FY22 stood at 7.6 per cent, 7.3 per cent in FY21 and 8.9 per cent in FY20. 

 

Resilience and sustainability of industrial growth is inextricably linked to the healthy growth of the manufacturing micro and small enterprises (MMSEs), that happen to front-end the supply chains of the industry at large. The data and analysis of the Transunion report does not provide information on how much is the share of growth of manufacturing MSEs. September 2022 PMI data shows that industrial growth has not kept pace with the overall growth of the economy. The growth obviously occurred in the services sector, due to the digitization of the highest scale, entry of FINTECHs, formalization of the MSMEs, widely dispersed 200-odd incentive schemes from the Union Ministry of MSME, and the unique success of unified payment interface system (UPI). Despite the U.K. Sinha Committee Report calling for cash-flow based lending of working capital to the MSMEs, RBI creating public credit registry, and pushing the banks to move to data-based lending instead of security-based lending, MMSEs did not catch the eye of the banks. Hence, risk profiling of the MMSEs would be necessary to understand the reasons for the trust deficit in the manufacturing sector.

 

Definitional Risk:

Manufacturing and Services have been combined in the way the MSMEs are defined. The changes to the definition adopting the twin criteria of investment and turnover to redefine them have given an escape window for the banks to keep at bay the MMSEs with investment below Rs.1crore (Rs. Ten million). The turnover threshold for such enterprises is five times the investment level – Rs.5cr per annum. While this definition coupled with the insistence of any new enterprise shall register on Udyog-Aadhar portal of Government of India, has enabled only the organized to have access  credit and incentives, it is yet to bring many unorganized MMSEs into the organized fold. Lenders still have their own definition – micro enterprises are those that have outstanding credit of less than Rs.1cr. The law of proportionality demands that the micro enterprises be brought under a separate statute so that the benefits meant for them reach without infringement.

 

By nature, micro manufacturing enterprises are owner-led proprietary or family partnerships. They do not distinguish their firm expenditure from family expenditure. Their books of accounts are also not well organised. Their maintenance of record of stocks of raw materials and finished products is less systematic than their counterparts in the small and medium enterprises even. They are mostly sub-contractors as their scale of production does not permit them to participate in private or public tenders directly. But their working capital cycle accommodates this unorganised way of running their enterprises. They lack counselling and guidance from their lenders as the later have little time for these large numbers in their books of accounts that tend to slip to non-performance at the turn of the hat. Thus, these enterprises have origination risk. Information asymmetry and adverse selection, the two factors that adversely affect the credit risk need mitigation.

 

Covenant Risks: These MMSEs in their eagerness to borrow money sign on the dotted line before their lender. They do not understand the implications of the covenants they are agreeing for. Earlier they were not knowing even the rates of interest. At least now, thanks to the widely publicised monetary policy interventions periodically, they know the interest rates. But they are ignorant of the insurance clauses and their implications. They do not, in many a case, know that their machinery and stocks are jointly insured with the lender and the premium is directly deducted annually from their working capital account. The extent of insurability is least known to them. Such insurance is invariably made with the insurance arm of the Bank that lends the enterprise. But the covenants of the policy are little known to them as the Banks do not share any copy of the insurance policy. This is a grey area.

 

Compliance Risk: MMSEs fail to comply with the regulations relating to products, processes, and finance more out of ignorance than out of own volition. Neither the regulatory institutions nor the financial institutions spare time to explain the implications of non-compliance of the rules and regulations. Environmental regulations and financial regulations are the most breached. Labour Code that has four components are least explained to the MMSEs. It is not uncommon to find that these enterprises fail to maintain even a muster roll and even where maintained does not agree with the reality. The number of persons actually engaged and the number in the roll rarely tally. There is a cost involved in compliance and such cost is felt onerous by the micro manufacturers. When the cost of compliance is more than the cost of avoidance, they prefer the latter. Transparency in the cost of compliance is also found wanting. These are areas of immediate correction to take these enterprises to the globally competitive levels.

 

Human Resource Risks: MMSEs employ on average 8-10 workers including the owners. They invariably depend on migratory labour instead of labour because of the low wages they demand and reliability. Many studies have indicated that they spend little resources on skilling, re-skilling, and up-skilling as the cost of such human resources development is beyond their capacity to absorb. In fact, these MMSEs act as providers of skilled persons to the Small and Medium Enterprises as the labour learn their art of working on the machine duly trained by the proprietors. Some States have insisted on engaging locally available skills and their experience with such persons on the production front has become counter productive and costly. They cannot afford to train their labour in reputed institutions. They require peripatetic trainers who are rarely available.

 

Product Risk: According to a number of studies, 60-70 percent of the MMSEs may conform to the quality of the product requirements but fail in packing and forwarding requirements. This puts the buyers at risk and therefore, the related payments.

 

Pricing Risks: Several manufacturing MSEs adopt neighbourhood pricing of their products as they would not like to lose out in competition with the peers. They lack abilities to cost their products. They also do not much understand the leakages that occur in their supply chains. The product is not priced cost plus. Since debt is their major source of capital they always look to loan swaps and interest subsidy as a major source to beat the pricing competition.

 

Technology Risks: While several enterprises are aware that new technologies have the potential to increase their efficiency, their ability to finance those new technologies is very limited. Quite many are scared to approach their lenders as they would have been in arrears already either of the interest or principal payment. They must have already availed one or two name-sake restructuring of their loans. Their ability to calculate return on investment in technology is also extremely limited. Banks hardly find time to spend time with the entrepreneur and guide him.

 

Payment Risk

Global Alliance for Mass Entrepreneurship (GAME) estimated that the problem of delayed payments to MSMEs is in the magnitude of Rs. 10.7 lakh crore, with 80 percent of this being attributable to delays to micro and small enterprises (MSEs). The problem of delayed payments is exacerbated by the lack of credit, specifically working capital facilities, that are available to these businesses. Reports such as the IFC’s 2018 Financing India’s MSMEs estimate that the total addressable debt requirement of micro and small enterprises was Rs. 24 lakh crores in 2018, with an estimated 70 percent attributable to the elevated working capital needs of these businesses.

 

Sovereign Risk: Industrial policies, Budgetary announcements, Export-Import policies, Trade Policies and not-so-enriching interface between various government departments that deal with the MSMEs and the Union Ministry of Finance, inter-state coordination issues are the various factors that impinge on sovereign risk. Enterprises have to adjust themselves and accommodate for the changes in the way they function rather than seeking instantaneous remedies to their business dealings.

 

Policy formulation for the MSMEs is at risk because of lack of reliable data. There has been no census of the units since 2004, the year of last Census. The data on the Union Ministry of MSME portal is that of 2012. While the data on Udyam registration is captured in isolation, its integration with the existing data did not take place. There is no data of mortality in the figure of 6crore-odd enterprises mentioned on the website.

 

While several state governments and union governments announce a host of incentives, the reach is suspect due to a variety of constraints: 1. Expediency decides the allocated budget for release to the sector and the first hit is the MMSEs, the most vulnerable. 2. There is invariably lack of information relating to the cost of securing these incentives – in terms of number of visits the entrepreneur has to make to the concerned department; the cumbersome approach to the person who actually decides on the sanction and release of the incentives. 3. Weak negotiating ability of the Industrial Associations over the incentive releases, etc.

 

Digitalization of enterprises, Account Aggregators (yet to mature in its access and use), Open Credit Enablement Network (OCEN), Co-lending with NBFCs, Factoring, Trade Related Exchange System (TReDs), have lately entered the Risk Mitigation instrumentality. Yet, the ability of the MMSEs to take advantage of these mitigants is way behind both in terms of awareness and the skills.

 

Therefore, there is a need for developing a separate framework for the MMSEs and a broad-based ecosystem involving policy makers, institutions that act as policy instruments, RBI, Indian Banks Association, NBFCs, Ministry of Agriculture and Cooperation, Ministry of Electronics and Information Technology, Ministry of Environment, Ministry of Energy of the Union Government and the ten state governments that have the major share in MMSEs. This framework should be discussed with the stakeholders in the leading ten states before firming up. Separate line of budget should be provided to meet the announced incentives and institutions like the NIMSME, NIRD, Central Universities and those that are licensed to run technology hubs should monitor the working of the framework.

*The author is an economist, risk management and SME Turnaround Specialist.

 

https://www.moneylife.in/article/risk-profiling-of-manufacturing-micro-and-small-enterprises/70258.html

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[i] https://www.thehindubusinessline.com/money-and-banking/loan-disbursements-to-msme-sector-grew-24-in-q2fy23-transunion-cibil-sidbi-report/article66652635.ece

 

Is risk management cost or revenue function?

 

Is Risk management a cost function or revenue function?

B. Yerram Raju*

Ever since enterprises and firms as well as banks and financial institutions got a hang on risk management function, two things happened. One, most viewed it as a regulatory imperative and felt that compliance is firm’s major responsibility. Two, when the enterprises started practicing risk management, it became more its risk culture than a regulatory function. Broadly, all the enterprises, banks and financial institutions realized that we continue to live in a complex and uncertain world despite improvements in technology and data collection. However, not many institutions realize that costs incurred on setting up good risk management practices would enhance their revenues even in the short term. How? Certainly not through mere data collection, and modelling.

The current year and the years ahead seem to pose as many challenges as opportunities and there will be many more border level institutions like the non-government organizations (NGOs) coming to interplay with the rest of the enterprise sector. It is difficult to predict or control with a degree of certainty the future, climate change, environment and social governance would bring together private players and NGOs.

For example, during the pandemic, health of individuals in organizations, migration of individuals from the enterprises to their homesteads out of fear of the outbreak of Covid-19, resettlement of people, work from home and its tracking exposed new risks and there are no models built for tackling such risks. But the enterprises developed common sense based approaches initially to combat them. Governments stepped in with fiscal, financial, and non-fiscal support measures and the whole world evolved coping mechanisms.

Many nations came to conclusion that it is better to learn to live with those risks and cope with them than running away from them. Supposing that it is a cost function, can these risks be managed without incurring them? If they are not incurred, sustainability of firms would be in grave danger. The profit curve dented but loss is minimized. and many firms could bounce back to normalcy in a few nations like India. China, continuing its lockdown as a higher risk mitigation suffered the risks of sustenance and growth.

Pandemic, more than the recession, taught risk managers the lesson that risk management is a revenue function. Further, it also taught us that such risks in the short term will also turn out as opportunities. India became the vaccine producer for the world. Pharmaceuticals, packaging and packing industry and goods transportation have seized the opportunity for growth on a sustainable basis.

E-commerce firms of various hues, that started as small ventures, became big. Food delivery firms like Zomato and Swiggy showed that it is yet another business opportunity in the waiting for many. Several cafes closed only to give space for several households to become food producers to deliver through e-commerce firms. A sea-change occurred in the firms’ growth path.

Cristian deRitis in an optimistic discourse on GARP, says: ‘How much effort we exert to avoid a negative outcome depends on how highly we discount the future. The higher the discount rate, the lower the value to us of avoiding a loss in the future.’

A unified theory of risk management would enable cohesive and integrated risk management function. Persons good at credit and operational risk would realize that they should enhance their knowledge into all other forms of risk to enhance the value of the firm. Such unified theory of risk management provides for better risk identification and assessment capabilities across the geographical spaces and the spaces between the credit, operational, market, reputational, and sovereign risks.

Enterprise Risk Management (ERM) of firms have to develop, train, and cultivate risk management techniques easily understandable to each of the staff and other stakeholders to enable risk culture to thrive and flourish in the organisation not just confining to the cabins of risk managers and chief risk managers. A realisation has to come that risk management enables growth of profit. It is an investment and not cost. The net result would be effective risk culture and governance.

*The author is an economist and risk management specialist and the views are personal.

https://timesofindia.indiatimes.com/blogs/fincop/is-risk-management-a-cost-function-or-revenue-function/

 

 

My 2021 - Satisfying and Engaging

 

The Year 2021 – Successes, Pitfalls, and work in progress

Personally, this was my Eightieth year that made me look at life as a journey. Prompted by good friends like Jaganmohan and Chowdary Prasad, I released my autobiography – Roots to Fruits: The Journey of a Development Banker as part 1 and Ripening Fruits as part 2. K. T. Rama Rao, Minister for Industries, IT, and Municipal Administration and Urban Development gave his precious time to release it on the net as a Kindle Book. Printed version was published by BS Publications, Hyderabad and is available on Amazon store.

On the Family Front:

My eldest grand-daughter, Akshita, working all along in Into IT, Canada, could move to the US and could see her chosen spouse in person, thanks to the abatement of the second Covid-19 wave. My second daughter, Swati, got appointment as Executive to a Member of Parliament, Canada. Her daughter Shriya got campus selection to METI in California requiring her to join in June 2022. Shanti, my third daughter, settled in a new house in Ottawa district of Canada. My three grandsons, Rohit Saiish, doing graduation in Economics in University of Waterloo, Canada, Milind, doing second year Computer Engineering and Gunit, joining computer engineering in University of Waterloo are all doing rapid strides in their fields of study. This is the pride of news for the year.

My last brother, Ramalinga Swamy, CPA, post-retirement joined Executive MBA with Rice University, US.

It has been  a shocking news that my brother Subbarao got cancer attack suddenly and has been helped by his daughter Aruna and son-in-law Kumar to face the challenge boldly. Since he is Yoga teacher, post operation, the cure is fast, and we hope he would see normal health ere long. My fifth brother, Srinivas Jagannath’s wife, Mahalaxmi had a bad osteoporosis and spondylitis in October 21. She is fortunately on good treatment and on road to recovery.

On the Office front

I took off from routine effective 1^st April 2021 while continuing as founding Director on the Board of Telangana Industrial Health Clinic Ltd. After five years of existence of the Company, it should re-envision for a future consistent with growth expectation. In the process, a new premises of its own has been identified along with Suresh Kumar, MD. Discussed with Zero code, for creating a mobile ap so that TIHCL could get easy access to Account Aggregator of the RBI. Prospect of co-lending with a resolute MSME focused Urban Cooperative Bank – Aditya Cooperative Bank, Jeedimetla that has nine branches with state-of-the-art technology and regulatory compliance. This would enhance the scope of functioning of TIHCL and look for a niche place in lending to micro and small manufacturing enterprises. The year 2022 is likely to see Aditya UCB to convert into a small finance bank. HR needed strengthening, for which purpose, management trainees from reputed B-Schools, and picking up internees in April-June, are in the process of selection.

At the request of Federation of Telangana Chamber of Commerce and Industry, I joined them as Adviser, pro bono. 

Both I and my dearest spouse, Satyavati got both the doses of vaccine by mid-April 2021. We are preparing for the booster dose sooner than later. I got a heel pain on my left leg that took me to Kerala Ayurvedic Clinic at Secunderabad. The tough treatment is continuing. This has restricted my physical movement. The field visits I am used to have been hampered.

We started investing in our thirty-year old house for essential repairs, whitewashing and painting. This is work in progress.

Two YouTube interviews featured me: 1. Interview by M. Somasekhar on my autobiography and 2. Managing the risks of an Enterprise by Naveen Madisetty, Bisynet, Indian Council for Commerce and Industry.

Donation

I gave away my library of more than 500 volumes to two academic institutions – Avinash College of Commerce for women, Kukatpally and Siva Sivani Institute of Management. I was invited for a meeting with NAC accreditation Committee at Siva Sivani in December 2021. They got B+ grade. I visited a very impressive B-school, Institute of Management and Technology, Shamirpet on December 23, 2021, and interacted with its Director, Dr. Sri Harsha Reddy. Their interests in MSME sector were an attraction for me. They have set up an Incubation and innovation Centre.

Publications:

Twelve articles on MSMEs and Cooperatives have been published on LinkedIn, Academia.edu, and in leading dailies of Telangana – Telangana Today and Eenadu.

Research

Center for Economic and Social Studies in collaboration with TIHCL has bid for a study of sickness in MSMEs in India and happy to share that we were qualified in the technical bid. The result of financial bid is yet to be announced. If this project comes to us, it will be a feather in our cap. Except for brief personal illness, the year has been happy, satisfying and energetic.

 

 

Risk Management in Indian Banks and FIs need Improvement

The scale of frauds across the Banks in India, from cooperative banks to commercial banks crossing half a trillion rupees, ballooning NPAs, slow and untimely resolve of bankruptcy cases have exacerbated the credit and operational risks. Finance specialists add to them the impending climate risks.

The PMC Urban Bank is just the tip of the iceberg viewing from regulatory perspective. Lack of oversight is clearly visible. Appointment of Directors failed to honor the ‘fit and proper criteria’. IL&FS and DHL in NBFC space shook up the shadow banking as well. This situation raises more questions than answers and require a firm resolve to warding off financial risks sooner than later, much before they translate into macro-economic risks.

Post-recession (2008), when the regulators hurried to drive risk management and governance of risks relied on Basel Committee. The industry’s new-found focus on risk management was ‘driven largely by a survival mentality and regulatory requirements’, as pointed out by Clifford Rossi and not by internalizing the risk assessment processes and governance improvements.

Rating institutions gave exemplary ratings and yet there was collapse of corporate credit. Risk management committees were set up and Chief Risk Officers were appointed and yet the risk mitigation did not take place. Both the government – the owner of the largest banking space and the Banks do not speak of risk management as a factor that led to the recent surge in frauds. Every product and process in these institutions is put for risk assessment.

New schemes and new programs do not get assessed for all the risks. Institutional failure to unlearn from the past and complacence on the part of Banks and FIs would appear to be the main reason for the current imbroglio. Time is not unripe for a 360⁰ thinking on the subject to put in place a mechanism for risk management and governance.  Noticeably, it is the absence of risk culture that is to blame for the absence of risk governance, process, analytics and expertise.

Banks sit on a mountain of data and claim AI and MML are receiving their immediate attention. The questions that come to my mind are: why then the Banks and FIs are unable to put in place a risk-based pricing system for all their loan products? How is it they fund start ups in manufacturing and services at the same level of interest rates? Again, why an owner-driven or proprietary or partnership micro and small enterprise and a medium enterprise driven by a Board with competent directors are also charged the same price? Why the Banks that claim latest technologies in place failed to transmit the rate cuts of the regulator to the clients requiring a mandatory compliance to pare the rates of interest with the Repo rate?

First and foremost for correction, is the tacit acceptance of failure of governance unabashedly and move to a thorough clean up. The four regulatory institutions – RBI, SEBI, IRDA, PFRDA should sit together and review the rating processes of all the Rating institutions they approved. Rating should not lead to a regulatory arbitrage. A simple uncompiled directive like the corporate institutions should reflect the dues beyond Rs.2lakh per vendor MSMEs did not reduce the rating of many a corporate. Had this been done, many MSMEs would not have become NPAs. There would not have been any need for the FM to give specific mandates to clear the dues to MSMEs before October 15, 2019.

Institutions that are adept at rating corporates have a myopic view of MSMEs and such thinking is largely driven by false risk perception driven by the lenders! Watch out the data – micro and small enterprises constitute around 8% of the credit to them as NPAs and every NPA is not unrecoverable. Rating is also influenced by the collateral rather than the enterprise, entrepreneur and environment over which the Banks have data but with no required behavioral analytics.

I agree with Clifford Ross, the leading risk professional when he says: “Risk professionals need to use disruptive technologies and perhaps find other tools to more effectively assess non-financial risks (e.g., cyber and operational), which have grown substantially over the past five years.

For both financial and non-financial risks, the continued development of risk expertise is vital. A great risk professional possesses the following qualities: (1) a balanced and logical temperament; (2) experience, over-the-cycle; (3) critical thinking; (4) analytical leanings; and (5) an action-driven mindset. What's more, on-the-job training is essential, because we are all at least accidental risk managers.”

*The author of ‘Risk Management – The New Accelerator’, economist and risk management specialist. Can be reached through www.yerramraju1.com

Can Cooperative banks be better alternatives?

Cooperative Banking – Hopes on the rise

Banking environment in India structurally has become more dispersed than before with the Small Finance Banks, Payment Banks, Postal Bank emerging on the scene. Mergers and amalgamations in the private and public sector banks and ever increasing NPAs in the commercial banks are threatening the stability of the system. Seemingly strong macro-economic fundamentals notwithstanding, disruptive technologies are also adding fuel to fire. FRDI Bill poses a threat to the security of depositors and leaders’ promises cannot be insurance to what the bill itself holds for the banking clientele. Senior citizens, differently abled citizens, women and several customers of small means feel distanced from the services they were expecting at the hands of the banks.

The Demon of Demonetisation

http://www.moneylife.in/article/the-demon-of-demonetisation/49255.html

In recent RBI history, some highlights: smooth transition to Basel regulations and efficient monetary policy under Bimal Jalan and Rangarajan, global aplomb post-recession under YV Reddy, preventing hyperinflation by Subbarao and taming of the NPAs by Raghuram Rajan. These achievements have put the RBI in prime position among central banks of the world. But the utter lack of planning and monumental mismanagement post-demonetisation by the same institution have tarnished its image.  

Banking operations other than currency operations in the country have almost come to a halt, barring exceptions. Credit is on a downturn. All the rating agencies, including Nomura, have down-rated the economic growth. The road to recovery sans GST is going to be difficult.

Basel Committee Core Principles for Effective Financial Inclusion

http://feedproxy.google.com/~r/indiamicrofinance/~3/14sC1YJOl0o/bis-core-principles-supervision-effective-financial-inclusion.html?utm_source=feedburner&utm_medium=email

Bank for International Settlements released a consultative document in December 2015, entitled: “Guidance on the application of the Core principles for effective banking supervision to the regulation and supervision of institutions relevant to financial inclusion” inviting comments before 31^st March 3016. This document meant for effective supervision of the non-banking financial intermediaries is the outcome of a survey Basel Committee on Banking Supervision (BCBS) conducted a range of practice survey in 2013 (ROP) on the regulation and supervision of institutions of relevance to financial inclusion and on financial consumer protection across 59 jurisdictions with 52 respondents.

I have kept the following ground rules in view while reviewing the Draft Document:

Ø  Cost of compliance must be less than the cost of avoidance.

Ø  Regulations and rules must be simple and straight forward inviting easy compliance.

Ø  Multiple regulators impacting on financial inclusion agenda should be able to strengthen and accelerate the implementation.

Ø  Financial Institutions engaged in financial inclusion should be able to deal with it as a portfolio for generating data and information required for proper regulation.

Ø  Instruments, tools and techniques of supervision should be uniform across the nations.

Ø  Financial Inclusion achievements should be subject to social audit as well.

Health insurance

Whose health are we insuring? thehindubusinessline.com · The new health savings plan appears more advantageous to insurers and agents than consumers My comments as posted in the article:

Insurance industry in this country is just evolving. Neither the operators nor regulators nor the insured know the intricacies in full. Not that I also know something great. All I know is the risks attached to insurance are far different and have varying dimensions across ages and sex. Premium as the insurance companies say is measured by the risk associated. So as one ages, the risks become larger and therefore, the premium is charged higher equivalent to an ageing automobile. Women become more vulnerable to certain health problems far different from after a particular age - say 40-45years. Both men and women while they are earning more could be charged higher premium for insuring risks to cover those that become larger when they age or when they retire and for women after 45 years. The moment one says he is insured in a corporate hospital, the list of tests become longer; charges become hefty to take the maximum in the insurance pie. This exploitation should be stopped by IRDA.

Cyber Risks

http://www.moneylife.in/article/the-threat-of-increasing-cyber-risks/40639.html?utm_source=PoweRelayEDM&utm_medium=Email&utm_content=Subscriber%2320149&utm_campaign=Daily%20newsletter%2027%20Feb%202015

Hyderabad City Police commissioner in a press conference recently revealed that the city police registered 21,035 cyber crime cases in 2014 as against 19,011 in 2013 and 18,744 in 2012. A near ten per cent rise in just two years is a cause for alarm. The rise is attributed to the large scale use of technology and mobile phones.

Social media contributed significantly with the uploading of fake woman profiles, online payment frauds, blackmailing, hacking, skimming, identity theft and data theft etc. The police are trying to use technology again to track and trace the criminals. Global trends are no different although it cannot be a solace.

Crude Shocks keep India in Smiles

B. Yerram Raju  & Nitin Gupta*

“The economics of oil have changed. Some businesses will go bust, but the market will be healthier,” says the Economist (December 6, ’14). Is this the beginning of cheap oil regime or just an interlude between two big bumps?

2013, in retrospect,  had turned out to be the strongest year of recovery, with growing US Economy and stabilizing Chinese economy. Commodity prices were projected to remain flat with an up-side risk due to unexpected supply-side shocks.

Enter December 2014 and all the projections seem little more than wishful thinking. IMF went on record recently: “the global economic growth may never return to pre-crisis levels” ! All the Quantitative Easing (QE) from the US (3 till now – totaling over $ 4 trillion or, twice that of the entire Indian economy) which was supposed to push cash to banks ended up just in increased valuations and stock indices accompanied by higher prices of gold and other commodities. Emerging economies like India had to contend with high inflation. Some even said: it is ‘US Fed exported inflation’!

Does capital cap it all?

Does Capital, cap it all?
Basel II new Operational Risk Guidelines a threat or opportunity?
Yerram Raju and Rao N. Venuturupalle*
‘Wholesale banking in India is set for a period of sharp growth. Revenues from wholesale banking activities are likely to more than double over the next five years as infrastructure investment, expansion by Indian companies overseas, and further “Indianization” of multinational businesses, among other trends, drive new business. Foreign players and the country’s domestic banks, however, will find themselves in a tough com¬mercial environment and must overcome a range of challenges if they are to maintain, or assume, a leading position in the market. (Akash Lal and Naveen Tahilyani, McKinseys 2011) In the context of globalization and shadow banking, there is a genuine concern on the part of regulators that the operational risks would be on the rise and that they need to be provided for in the banks’ balance sheets adequately. It is this ‘adequacy’ that is likely to upset the applecart of commercial banks’ expectations, more so, when multiple channels and universal banking are embraced. The global risk scenario remains icing on the cake although between 2008 and 2011, there is considerable improvement. This article would like to deal with the emerging financial system in India in the first part and the concerns arising out of the recently put out Basel document on the Management and Supervision of Operational Risk: governance, risk management environment and the role of disclosure. Part II examines the principles and various aspects of OR management vis-à-vis the prevailing operational processes and practices in some of the major Indian banks. The paper also presents the challenges, potential costs and benefits in implementing the proposed best practices.

Part I
Indian Financial System (IFS) has its generic novelties and complexities. It embraces cooperative banks under two streams – urban and rural with a three-tier structure; commercial banks comprising of public sector banks; private sector banks (old and new generation); regional rural banks including local area banks; and foreign banks. It proved resilient under the recent global recession era thanks to the robust regulatory system that took care of capital adequacy concerns with the twin instrumentality of Statutory Liquidity Ratio and Cash Reserve Ratio among others and a low leveraging. These five streams of banking in India have wide-ranging variances in adoption of technologies – primitive in the cooperatives to the most advanced in globally placed banks like the State Bank of India, ICICI Bank and foreign banks. The most virtuous aspect of regulation has been the compliance discipline of these institutions. In line with the ongoing supervisory and multiple regulator concerns, a Financial Super Regulatory Board had been set up and the central bank was entrusted with the coordination role. The central bank started releasing the financial stability reports (FSR) at frequent intervals commencing from March 2010 to reflect the health of the Indian Financial System. The latest FSR states that the ‘Indian financial system remains stable in the face of some fragilities being observed in the global macro-financial environment. Growth is slackening in most parts of the world, even as the risks from global imbalances and sovereign debt crises in Europe continue to hover. The uncertainties in global environment with persistently high energy and commodity prices have contributed to a slight moderation in India’s growth momentum as well. The macroeconomic fundamentals for India, however, continue to stay strong, notwithstanding the prevailing inflationary pressures and concerns on fiscal fronts.’ India is among the sizzling top seven emerging market overheating index of the Economist (London – June 2011), measured in terms of six indicators - inflation, spare capacity, labour markets, excessive credit expansion, real rate of interest, and widening current account deficit. In the short-term, Fitch has lowered the growth rate at 7.7 percent (June 2011) in this background whereas Standard & Poor predicted a robust inflow of FII and FDI resources into the economy. The growth projections of Indian Banking even in the wake of overall uncertain economic growth, is intriguing.
Last two years witnessed an increasing trend of frauds, misappropriations, embezzlements, ATM robberies, technology security failures in quite a few centres in the entire banking spectrum and all of them fall under the band of Operational Risk. RBI directs Banks to report every fraud above Rs.1lakh to their Boards promptly; frauds by employees for amounts exceeding Rs.10000 to the local police; cases involving more than Rs.7.5cr to the Banking Security and Fraud Cell of the Economic Offences wing of the CBI; and cases of cheating involving Rs.1crore and above to the CBI. Latest RBI guidelines (April 29, 2011) on banks’ technology governance, information security, audit, outsourcing and cyber fraud as a possible reaction to the surfacing of operational risks in increasing measure lately, are a pointer to further investments in those areas to mitigate Operational Risk.
Even in the backdrop of rising systemic risks in the banking ecosystem in Euromarkets leaving little hope, the RBI Governor succinctly summarized the concerns of Basel III and exuded confidence that the Indian banks would be able to meet up with the capital expectations. But does capital cap it all? - Is the question.
Part II
The earliest Basel Committee publication on Operational risk was a compilation of information on management of operational risk at thirty major banks from different member-countries. We are of the opinion that awareness of operational risk as a separate risk category and processes for measurement of the same was then at a nascent stage. However, a series of high profile incidents at Barings Bank, Daiwa Bank and Allied Irish Bank (to name a few) in the late 1990s heightened the need for regulation of operational risk. In India, the State Bank of India and Punjab National Bank – both in the public sector, take such credit in the second half of the first decade of the current millennium.

Operational risk was first recognized as sensitive to capital adequacy and given explicit treatment under Basel II Accord. Together with The Sound Practices for the Management and Supervision of Operational Risk(2003), the Accord laid down principles for effective management of operational risk, best practices for governance, identification and assessment, monitoring and reporting, control & mitigation etc. Besides these, the Accord also covered approaches for calculation of regulatory capital for operational risk. In response to these regulatory developments and prevention of operational failures, banks and supervisors have expanded their knowledge and experience in implementing ORM framework – loss data collection, modeling capital requirements, implementation of governance structure and other steps. For instance, formation of ORX (Operational Risk data eXchange), a repository of external operational risk loss events, is an initiative that would aid in exploring adequacy or weaknesses of internal controls, operational risk modeling and capital calculations etc.

Despite these developments, the fundamental reason for recent credit crisis was operational inefficiencies – lax underwriting standards, unbridled risk taking etc. – that eventually brought the interconnected world economy into a recession the likes of which was last seen only during the Great Depression.

Closer home, the systemic impact of credit crisis was much less because of timely interventions by the central bank, the RBI, by way of reining-in the economy using macro-economic variables CRR and SLR. However, this does not mean there are no operational inefficiencies in the Indian banking system. Most banks’ approach has primarily been compliance to regulation with minimal or no importance to imbibing a risk culture seeping through the entire organization. Risk evaluation is integral to everything that individuals do. Yet organizations often treat risk as an adjunct added on at the end of the process – ‘Let us do a risk assessment and see where we are.’ Such an approach is wholesomely inadequate. Instead, risk must be factored in at the beginning of an initiative and should remain a focus throughout the entire process. Given the expected growth in the Indian economy during the Twelfth Plan at an average of ten percent, and the concomitant growth in the banking industry, cultivating risk culture becomes imperative for the industry.

Based on the developments with respect to regulation and upheavals in the banking industry the world over in little over a decade, it can be concluded that the operational risk discipline is still evolving.

Collection of loss incidents data
Loss data collection (either internal or external) provides meaningful insight into effectiveness of internal controls, modeling of operational risk and capital calculations, and could provide information about previously unidentified risk exposures. For this to be effective, banks must have comprehensive documented procedures for capturing loss incidents data –
i) mapping of activities along various business lines
ii) define loss thresholds for each business line for the purpose of identifying those events that could have material impact on the bank’s balance sheet
iii) mapping loss data to appropriate business line (and sub-categories) and event types
iv) tracking of Internal loss data collection

It is generally observed that majority of the public sector banks in India have material business in around five of the eight business lines recognized by BCBS. Availability and reliability of loss event data in these business lines deserves lot of attention and much needed action, for, a branch that has not reported any loss data cannot be construed as functioning excellently. In order to improve internal data collection, clarity on collection of loss events data and their assignment to appropriate business lines is essential. Additionally, clarity on potential losses, near misses, attempted frauds, etc. where no loss has actually been incurred by the bank will go a long way in strengthening internal systems and controls. Active involvement of the Risk Management Committee of the bank could very well help in providing direction to this very important aspect of operational risk management.


OR governance and risk management function

Sound internal governance is fundamental to effective operational risk management framework that is fully integrated into the bank’s overall governance structure in risk management. The board of directors together with the senior management should lead the Governance processes to establish a strong risk culture. An industry best practice for internal governance is to have in place a 3-tiered structure:
i) business line management – responsibility of identification and management of risks inherent in a bank’s products, services and activities rests with the business units
ii) a functionally independent corporate operational risk function complementing the business line’s operational risk management activities and responsible for the design, maintenance and ongoing development of operational risk management framework within the bank.
iii) an independent unit performing review and challenging the bank’s operational risk management controls, processes and systems, typically, an audit function

A general observation in the Indian Banking industry is that the business lines and risk management departments are compartmentalized with no clear objective and direction from the senior leadership to bring these to work supportively towards a common objective of improving operational processes and shareholder value. The Risk Management department should be directly reporting to the Risk Management Committee of the Board instead of reporting to the CEO so as to ensure that revenue targets are pursued within the boundary of risk processes controls.

The role of the Board of Directors as mentioned under Principle (3) seems to be far-fetched and impractical especially in Indian Public Sector Banks. It is not possible for the non-executive directors to go into the detail required to ensure the firm is managing “operational risks associated with new strategies, products, activities, or systems, including changes in risk profiles and priorities”. This responsibility is more appropriate to senior management of the bank with the Board as an overseer.

Reporting and monitoring of operational loss data

Operational data – both qualitative and quantitative – could provide valuable insights into effectiveness of ORM framework, weaknesses in policies and procedures and measures needed to plug these, risk profiles, deviations from risk appetite, capital requirements and lot other information. Given the breadth and complexity of data, business intelligence tools can be used to present this data in the form of reports and pictorial dashboards to provide meaningful information to senior management and board.
For the Indian banks, there are a number of reasons that clearly justify the need to adopt business intelligence and data analytics tools:-
a) The 8.0% plus economic growth observed in the past decade and projected in the future
b) The recent economic crisis has shown that markets the world over are interconnected.
c) RBI’s mandate for an inclusive growth
d) Huge customer base in India
These tools will certainly help in proactive risk management and timely availability of reports to the senior management and the board.
Importance of audits
One of the sound industry practices for operational risk governance is setup of an independent audit unit that reviews and challenges the bank’s controls, processes and systems. The internal audit should not only be testing compliance to approved policies and procedures but should also be evaluating whether the ORM Framework meets organizational needs and supervisory expectations.
In general, the Indian banks have an audit department but lack importance and management oversight. These departments mostly perform transactional audits but gaps in underlying processes are never identified. Moreover, closure of audit findings continues to happen mechanically and there is no trail of audit compliance. Consequently, such a practice exposes the bank to loss of revenue, customer confidence and reputation.
Risk education, training and staff with required skills
An ORM framework is effective only when all departments implementing and evaluating the framework are staffed with required training and skills along with a continuous focus on education in risk. To this end, the board of directors and senior management must provide the required support and oversight.
There is a general feeling both among the regulators and the individual banks that the professional directors like the Chartered Accountants would take care of the risk management oversight better than the rest. Yes; only to a degree. Several Chartered Accountants also require intense knowledge and skills in the discipline of risk management. The ICAI has to put in place such arrangement, if necessary, by coordinating with knowledge providers of global repute like the Professional Risk Managers’ International Association (PRMIA) or GARP. When APRM, PRM, and FRM get premium attention in the placements and promotions to staff to handle the risk management function, there would be scope for professional directors to perform the risk management function more skillfully.

The budgets for risk training and education were inadequate. All employees in general and audit department, in particular, must be appropriately staffed with required training and skills along with a continuous focus on education in risk. To this end, the board of directors and senior management must provide the required support and oversight.
Implementation of proposed framework – costs and capital considerations
i) Operational risk cannot be treated as residual risk after accounting for credit and market risk. A leading public sector bank, capital at a maximum of 5 percent of the total risk weight assets is set aside for operational risk. This is certainly short of required adequacy for a bank of its size. Appropriate OR processes must be in place to enable calculation of required OR capital.

ii) The cost of implementation of the OR framework – particularly in regard to data collection and data analytics – is considered onerous and such costs cannot be passed on to the customers as is done in the areas of credit risk and market risk. The Central Bank could consider treating such costs differently and provide enough cushions for competitiveness. The Central Banks should incentivize banks which adopt data collection and data analytics tools for mitigating operational risks or capturing near misses by way of tax benefits or other subventions.

Timelines for implementation of AMA approach

Banks in India would be requiring time until 31st March 2014 to be in preparedness for adopting the AMA when alone it would be possible to secure high integrity data for the past 20 quarters under all data requirements. A step in the right direction is the formation of CORDEX (Compilation of Operational Risk Loss Data Exchange) initiated by Indian Banks’ Association. Such industry level data could very well be used for scenario and stress testing. However, this is in its formative stages and the Central Bank may itself take two years to validate the system.

Conclusion
Operational risk management is receiving immense importance and focus from all stakeholders – regulators, senior management & board and investors. Whereas credit and market risk management have matured considerably in the last couple of decades, operational risk management is still an evolving discipline.

Many banks world over have made considerable progress with respect to implementing an ORM Framework. Indian banks, however, have made some progress but this has been seen more as mandate for compliance than as a need for driving a risk management culture throughout the organization that will eventually reduce operational losses and improve shareholder value. In this respect, board and senior management oversight is the need of the hour.

Also, the ORM Framework must be periodically reviewed to ensure controls in response to material & non-material losses are implemented. Investments have to be made in training and education, and data analytics and business intelligence solutions as these will help in spreading a risk culture of highest quality throughout the bank and enable proactive risk management. Banks also have to make considerable investments for collection of loss data and for putting in place policies, procedures and controls before they can adopt AMA approach for calculation of operational risk capital.

The foregoing analysis clearly reveals that mere provisioning of capital of a high order does not insulate the banks from all the risks and the 2007 recession has proved beyond doubt that neither the size of the bank nor the size of the provisioning has insulated the bank from the catastrophic downfall. Robust processes are more important than mere provisioning of capital to take care of the commonly arising risks. These apart, the ORM is yet to capture the reputation risk as its measurability has some issues to debate. In essence, all the eleven principles highlighted in the Basel II document of December 2010 provide an opportunity to sprucing up the banks’ risk management platforms marginalizing the threat to adequacies of capital provisioning.


References

1. ‘Sound Practices for the Management and Supervision of Operational Risk’, Basel Committee on Banking Supervision, December 2010.
2. ‘Round Table on Sound Practices for Management and Supervision of Operational Risk’, PRMIA Hyderabad Chapter, January, 2011.

* Dr B. Yerram Raju is an economist and Regional Director, PRMIA, Hyderabad Chapter and Mr Rao N. Venuturupalle is Dy. Regional Director, PRMIA, Hyderabad Chapter and Lead Consultant, HSBC, Hyderabad. The views expressed are personal.