Equity & Leverage in Indian MFIs
The purpose of this technical note is to provide a practical understanding of the need for equity to improve the resource position of MFIs and its impact on prudential operations. It is also an extremely useful short document which explains capital adequacy ratios, leverage and risk weighting quite clearly.
Leverage is the use of fixed rate financial instruments (usually debt) to raise additional capital to magnify the potential return on equity. Leverage is used when the ability of a business to generate return on investments is higher than the cost of debt used to finance those investments. While financial leverage can magnify return on investments, it can also harm an enterprise if the return is lower than the cost of borrowings. The extent of this effect depends on the proportion of the investment in the enterprise that is financed with debt; a higher level of debt implies higher leverage and, consequently, higher magnification of return (or loss) on equity.
Central banks of countries specify what is to be included in the total capital of financial enterprises and what is to be included in capital assets as well as their level of risk (risk weight). Typically in the case of MFIs, capital includes share capital (paid in equity) where applicable, donor grants (donor equity), accumulated profits (or losses) and a proportion (25-50%) of long term sub-ordinated debt. Risk weights for assets typically include 100% risk on loan portfolio, around 50% on bank deposits and net fixed assets, and zero risk on cash holdings.
In India, commercial, cooperative and local area banks are required by the Reserve Bank of India to maintain a minimum capital adequacy ratio of 9%, while the minimum capital adequacy for non-bank finance companies (NBFCs) is 12% if they do not accept public deposits and 15% if they accept public deposits. Looking at the distribution of CARs for Indian MFIs, it is only in the smallest institutions that average capital adequacy is reasonable – usually on account of the predominance of donor grants in the balance sheet. Only 4 of the 8 largest MFIs have CAR in excess of 12%. Thus a substantial proportion of Indian MFIs have become over-leveraged.
Data presented in this technical note show that paid-in equity (or share capital from investors) is still a relatively small proportion of the total capital of MFIs, amounting to less than 25% for medium and small MFIs. Only 23 of the 110 MFIs studied have generated sufficient profits to contribute to their capital from internal accruals. Furthermore, as the level of net grants (total donor equity less accumulated losses) declines with MFI size, the extent of financial liabilities (deposits + debt) rises. Thus, the largest Indian MFIs have nearly 90% of funds as financial liabilities implying debt-equity ratios of the order of 9:1 and a very high level of risk for lenders.
The note goes on to discuss the effect of various factors on the financial leverage of MFIs in India, such as the profile of promoters, the size and growth rate of the MFI, the robustness of the business plan and the legal form of the MFI. It also observes that the lack of a market for MFI equity has led to the development of innovative instruments for investment in microfinance including securitisation, subordinated debt and the partnership model where a commercial bank contracts the MFI to offer microcredit services on its behalf.