The art of Credit Underwriting : NBFC (Asset Base Finance)

Underwriting, the term is related to financial markets for a long time now. Underwriting is predominantly done in investment banking, insurance, commercial banking, NBFCs etc... The term underwriting means, the willingness to cover a potential contingent risk.

Over here I shall be only dealing with the NBFC aspect of credit underwriting in asset based finance. In this context, underwriting is the assessment / judgement of the borrower's credibility and agreeing to fund loans. The risk over here is that the borrower would default in the loan & thus would fail to repay the loan. The underwriting fee is the interest charged at regular time intervals till the time balance is due on the loan contract.

There are different aspects in underwriting process :--
1. Measurement/analysis of any potential risk
2. Market feedback
3. Credit Bureau report

1. Measurement/analysis of any potential risk- There can be an array of risk in funding to customers based on asset. The cash flow generation can be from the deployment & utilization of the asset. Over here market risk plays a key role. The underwriter gauges the current market scenario and takes the decision accordingly. Any favorable market would result in aggressive funding while negative market would result in defensive funding. Other cash flow generation can be from other sources of business activity, whereby credit risk and interest risk plays a role. If party is having a a lot of debt already in the market then its a sign of high credit risk and similarly any rising interest rate environment would eat away a share of the profitability thus decline its Debt Service Coverage Ratio (DSCR).

2. Market feedback- Feedback about the customer from the market is very important. This gives us knowledge about the customer's business activities, relation with stakeholders, past business encounters & details. It is to know the customer and check that the finance is not for money laundering / illegal purposes. Often underwriters visit locations for PD & also for delinquency control to enhance their own knowledge about the customer and locality and potential business activity in future

3. Credit Bureau report-  There a few credit bureau which captures the database and details of loans taken by the customer in past. This helps to understand the customer repayment behavior, no. of loans taken, Overdue amount and other details.

For large customers and loans taken financial statements are checked and seen their credibility. Ratio analysis and balance sheet figures help in this analysis.

It is an art that is gained by years and hours of practice and experience. There are many other aspects in portfolio management which is not included in this extract. I shall discuss about the portfolio management in due course of time.

Brexit : The after effects

The referendum vote conducted on 23-June-2016 by the British signaled a divorce from the EU. This long standing union is now on a verge of new rules, uncertainty and financial hiccups.

European stock market has ended lower for the session of the week amidst the uncertainty in risk appetite for stocks given the talks of UK leaving the EU. Germany's DAX 30 index closed 1.7% lower while UK's FTSE 100 index was lower at 0.98% at Tuesday close.

German factory orders show no growth month on month basis after a slum of 1.9% before. Year on year de-growth is 0.2% compared to an expectation of 0.9% growth. Linkages between the individual sectors of the economy would be a tedious work to estimate the exact impact that Brexit would bring to the economies as a whole. Investors shy away from equities market and are following more safe heavens like gold.

Oil prices are stabilizing in the negative territory as the broad risk-off move is continuing in the financial markets keeping the focus on the supply side of the story. Fear of lower growth in global economy and less demand of the commodity is pushing the prices further low. Libya and Nigeria are increasing their production in oil. Increase in supply from Iran and gulf countries are also seen lately. Thus volatility in prices would continue till the end of 2016 at-least.

US benchmark borrowing cost, yield on US treasury fell 9 basis point to 1.37%. The move came after soft data was reported from China corner. The Chinees service sector grew to a 11 month high in June-2016 but the composite measure of activity including manufacturing fell to 4 month low. The Chinees central bank had fixed the Yuan/Dollar reference rate to a 5.5 yr low, keeping a worry that it is artificially trying to revamp growth in the economy.

The global financial markets have started to face the music of globalization. Italian banking sector had hit a slump of 60% this year. The Indian market is also in the uncertainty phase. For India is Brexit plus Rexit (Dr. Raghuram Rajan exit the RBI).

The British exit is going to have a hit on the GDP growth in India too but marginally. India's exports accounts for 0.4% to UK and about 1.7% to EU in GDP numbers.  Factors like subdued global and weak rural income would impact the growth strata. Credit supply dampening due to NPA issues in banking sectors are key hindrances as of now. Imposition of minimum import price for steel would be a positive side but again the expensive telecom auction 2016 would leverage up the sector which is still under recovery from the last auction outcome.

Continued high corporate leverage, low domestic growth, can hold back investments for a couple of quarters. Poor asset quality and weak capitalization would refrain the public sector bank's lending capacity. The FCNR maturity in Sept-2016 is another big event for India. RBI said that it is fully prepared to contain the market volatility and liquidity when the FCNR starts maturing from Sept-2016.

Banks had raised about $34 billion during Sept-2013 to Nov-2013 out of which $27 billion was through FCNR (B) deposits maturing in 3 years. The banks then swapped these dollars with RBI. The central bank thereafter readied itself by buying forward dollar.

"The investment climate is weak and uncertain. Only fundamentally strong could see the storm pass-by unharmed "

Crowdfunding : P2P lending in India

"Crowd Funding" in general means raising funds of small amounts from a large number of people for the purpose of financing / funding a project or venture or a social cause.

This can be divided into 4 categories:-
A. Social Crowd Funding- Gathering of funds for social or philanthropic purpose
B. Reward Crowd Funding- Gathering of funds where investors receive tangible reward as consideration.
C. Peer to Peer Lending- Online platform wherein lenders and borrowers are matched for unsecured loans. Rate of Interest is determined as per mutual negotiations or as per the platform rule.
D. Equity Crowd Funding- Gathering of funds to fund a business or company against which equity shares of the business / company is issued.

With the advancement in technology and start-up world, financial markets are not well behind the euphoria. P2P lending is a platform wherein borrowers and lenders are matched to fund the requirement. These loans are needed to be paid back along with interest. The interest rate is determined by mutual negotiations or as per the platform rules. There are fees which is needed to be paid by both the borrower and the lender to the platform. Additional fees may be imposed for the service rendered by the platform like legal advice, credit scoring, assessment of credit worthiness etc... The platform earns from the admin fees and the service fees that it charges, unlike in traditional financial institutions the earnings is the spread between deposit rates / cost of funds and lending rates.

In India P2P is in a very nascent stage unlike in other countries where the presence is much large. Countries like Israil & Japan don't allow P2P lending activities while US runs a two level regulatory for this sector (SEC and the State level). Countries like France, Germany Italy requires the platform to acquire banking licence and full disclosure as per the regulations. China is still having an unregulated market, and is the largest in the wold with hundreds of platforms offering diverse services.

P2P lending services depend on technological advancement and are registered under the Company Act. They act as gathering point for both borrowers and lenders and thereby creating a match. Both borrowers and lenders are needed to register themselves in the platform website, post which due-diligence is initiated by the platform. If found acceptable they can carry on the process of lending or borrowing. A method of reverse auction is followed wherein lenders bid for the borrower's proposal and the borrower has the right but not the obligation to accept or reject an offer. Several other enhanced services are also provided by the platform. Credit scoring, risk profiling, recovery etc... Documentation is facilitated by the platform and transfer of funds are done via bank only (to avoid money laundering). Post dated cheques are collected from the borrower in the name of lender by the platform. Since all transactions are via banking, its deemed that KYC compliance is already done by banks.

Why to regulate this ?
The dealings are on money and to regulate it would discount the potential disruption it can bring to the traditional financial sector (Banks or NBFC). Since the process is having low operational cost it would attract other players soon and create a competitive scenario. To help in sustainable and reasonable growth regulations must be put into place. Regulations would help to offset the risk to some extend whereby lenders with low awareness about the risk may engage in extending funds.

Disruptions in financial markets are due to the innovative instruments brought in by technological changes. A more proactive regulation and risk mitigation activity with regards to the pace of developments must be kept to ensure sound fundamental strength and sustainability.

  

Brexit : British exist from EU : A critical review

In the recent past a lot of talks & discussions are emerging regarding the British exist from EU. On 23rd of June'2016 British voters have voted in a favor for Brexit from the EU, which means that in the coming few months the EU leaders and British leaders would be going through a long debate / negotiations regarding the departure.

British Prime Minister, David Cameron didn't want to hold a vote for Brexit at all, but due to mounting pressure from the populist rights over immigration and Britain's EU membership, he  promised to hold a referendum if his Conservative Party won 2015 elections. Now this was partly to stop dissenters in his own party and also to stop the rise of UK Independence party.

Just after the voting result were out in favor of the Brexit , Mr. Cameron announced he would resign by October'2016. No one knows what is next but likely outcome is that former London Mayor who supported the campaign for Leave Vote, Mr. Boris Johnson may take over.

In the coming few years the British trade uncertainty with EU, its largest trading partner may push Britain to a mild recession. Volatility in the currency market and stock markets are seen everywhere. Brit pounds lost 9% & FTSE 100 stocks was down 3% the very next day. This volatility is a sign of worry and sights of a favorable deal with EU is weakened with the exist of Cameron.

In the business prospects there could be need for multi-approvals or regulations as boundaries are now separated with the exist. Immigration laws that allowed citizens of EU member countries to travel or work with minimal paperwork might get stricter. Currently there are about 1.2 million Brits living in EU member countries and about 3 million non-Brit EU member countries live in Britain.
As per some critics British economy would be smaller by about 4-7 % by 2030, but it depends on how well the negotiations are done in the coming months.

 Now the British exist can have repercussions to other parts of the globe too. The ambiguous negotiations could cripple investments and may led to more exists. Economic risk is a function of uncertainty, now the financiers and companies are concerned that they get cut-out of the free trade channels and are in search of safer heavens for their money. Multinational companies invests in UK operations partly to access the free trade corridors that UK enjoys. Now since the corridor is now closed it might result in multi-nationals booking drastic reduced profits. In 2014 about 1.84 trillion euros were invested by US and 1.99 trillion euros flowed out. Now even a small share of that pie can be catastrophic. UK has other big trade with China, India, Japan etc...

The uncertainty of the time has come and the world is a global financial village. A fire in one hut would soon catch up the second and then the third and it continues, Sound financial stability and fundamental strength of the economy backed by it banking system, technological reforms, innovative strengths would survive the future.