Thursday, January 20, 2011

India's Central Bank finally give a loud unambigous policy signal: MFIs will not die, only need to be castrated.

Wednesday was a red letter for micro-finance industry. In the morning the Reserve Bank of India (RBI) announced the extension of the Special Regulatory Asset Classification (SRAC) benefit to Micro-lenders till March 31. 

Though a one-off exception, this step allowed a special relaxation in debt restructuring norms for MFIs. This provided the sector a much needed respite, who otherwise were on the verge of bankruptcy. 

The RBI step was in a bid to avoid a serious repayment crisis in the micro finance institutions (MFI) sector following the Andhra Pradesh Government’s restrictions on their activities due to suicides by their borrowers. Under these new norms, banks would be allowed to treat the advances to MFIs as good assets even if such loans are not fully secured. Banks will thus be able to restructure loans provided to the MFIs without much difficulty.

The SKS share that was languishing at Rs 650 levels spurted to an intra-day high of Rs 690.60 but lost most of the gains to close Rs 668.55. Bulls sobered their celebration when they learnt about the RBI caveat - MFIs has to agree to reduce their leverage and growth projections!

The same evening saw the release of the long-awaited Malegam report on microfinance companies. This is a Reserve Bank of India’s committee on microfinance institutions (MFIs) that was constituted in October last year to examine issues of high interest rates, coercive recovery process and multiple lending practices by some MFIs. The committee was headed by YH Malegam. 

Bull operators this morning engineered a huge spurt in SKS share price, triggering the 10% upward circuit breaker. The share hit an intra-day high of Rs 757, advancing 13% over the previous day's close, after touching an intra-day low of Rs 651.10, showing high volatility. SKS whose daily market width thinned to around 50,000 spurted to a whooping 4.1 million. 

The surge in the share was helped by SKS CFO, Dilli Raj giving live interviews on opening bell to financial news channels like CNBC welcoming the report. "The Malegam report brings structural clarity to the industry. Also, clarity on funding arrangement with the banking sector is a big positive. Interest rate capped at 24% doesn’t affect SKS in any significant way," he pointed out. He further added that the report clearly captures that the Reserve Bank is comfortable with lending to MFIs. And, he sees no regulatory gap in the microfinance industry now and said the new guidelines suggested on functional aspects are welcome. 

Vijay Mahajan, Founder, BASIX and Chairman, MFIN too said, "The Malegam committee report is a very good step forward to the whole controversy about microfinance institutions, particularly non-bank finance companies doing micro finance because that comes under RBI purview."
Despite this the rally turned out more in the nature of relief that enabled High Net worth (HNW) and private equity investors in SKS to exit at higher levels. The share lost more than 75% of the intra-day high to close Rs 689.35, advancing 2.93% over the previous day's close. The share has fallen over 60% from its all time high in a matter of months.

"The stock has been hammered badly so I believe this is a relief rally," said Arun Kejriwal, founder of advisory firm Kejriwal Research & Investment Services. "But the issues at hand have not been debated or resolved. It will be a matter of time before people realize we continue to remain where we are," he said.

Another trader in commented in the same vien "Can't understand the reason for this bounce. In effect, the recommendations would bring severe pressure on the margins of the MFIs, and affect the financials very adversely. And this time the damage would not only be limited to AP but would be felt across India. So no places for MFIs to hide. Sell the stock"
Radhika Gupta, Director of Forefront Capital Management is of the view that investors should stay away from SKS Microfinance. As reported by, Gupta told CNBC-TV18, 

"We have been bearish on the SKS Microfinance stocks since the IPO days. I think that sort of continues. There is still a couple of issues surrounding the stock. One is the regulatory environment for MFIs where there is some news that has come out but that is still not clear. Second is the corporate governance issues in the stocks has still not cleaned themselves up. Third, this is a business that does not have too much of a public track record as far as listed entities go. We would advice investors to stay away from it.”

"The 24 percent interest rate cap is too low,” said Sanjay Sinha, managing director of Gurgaon, India-based Micro- Credit Ratings International. “It’s going to limit the operations of some institutions -- especially the smaller ones.” 

Meanwhile, the first detailed analysis of the policy recommendations of the Malegam Committee began to trickle through. Ambit Capital opined that "If implemented, we believe these will significantly erode the growth and profitability of the sector and especially SKS Microfinance." Ambit feels that the move would erode SKS Microfinance's profitability and its RoEs could be reduced to levels below 10%. As  another trader in trader in that goes by the name "Anupiimi" observed:

"The caps for interest rates permitted under Malegam report are as follows: 1) 24% interest 2) 10% NIM levels. SKS has costs of over 6-7% as operational costs. That leaves margin of 3% for SKS. On that, maximum leverage would be around 3. That would give RoE of less (3%)*4 = 12% before NPAs. That is much lower than its cost of equity. This would cause value to deteriorate. We expect share price to decline. Even now, SKS trades at price-book value P/B levels of over 3. That is higher than most banks that have less riskier business models and higher returns."
[RoE = (earnings/assets)*(Assets/Equity)
=(the margin=3%)* ( 1+ Debt/Equity)
=(3%) * (1+leverage)
=(3%) * (1+3)
=(3%) * 4]
Ambit further feels "SKS's networth (total assets minus total outside liabilities) would shrink up to 50% due to delinquencies in AP." Though RBI permits banks not to treat MFI outstanding as bad debts as of now, this freedom does not extend to MFIs who need to reflect these on their own books. We will get an insight next Tuesday when SKS announces its unaudited 3rd quarter results. Whatever the percentage, it has to be significantly more the normal 1% SKS provides for. This factor takes a further hit on the 12% RoE, maximum leverage projections.

Some MFIs feel disappointed that the report only looks at rural poor and excludes urban poor. The reason is that the committee has recommended the creation of a separate category of MFIs called NBFC-MFIs. These NBFCs can give loans only to families whose total income is not more than Rs 50,000 per annum, and largely for income generation purposes. "Anupiimi" incisively points out, that in addition to non-performing assets (NPA), SKS's operational costs that is currently between 6-7% is poised to increase if the Malegam recommendations come into play that further hits the RoE.

“There are further problems for micro-finance companies highlighted in this report that I have not used but would cause further downside for SKS. They are: 1. Ticket size cannot be more than 25000. That would reduce transaction size and hence raise cost per rupee of lending. 2. More than 75% of lending to be used for investment that would increase paperwork for MFIs and raise operational costs."

This view is confirmed by SKS CFO, Dilli Raj in the CNBC interview. "Philosophically, one may oppose the cap on interest rate or regulatory interest regime. But we need to take things in balance and in holistic manner. Now what you need to do is to go back and reinvent your operational models and bring in lot of financial efficiency, reduce operating costs to maintain the ROI”. 

The fair value of the SKS share more and more look around Rs 200, its book value.


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