Facing Difficulties in Financing MCCs Turn to Trust Companies

There are two methods for Microcredit Companies (MCCs) to raise capital: raising equity or taking on debt. In theory these are both viable options; in practice MCCs face significant obstacles with both channels of funding. MCCs are regulated at a provincial level and therefore regulations vary from province to province. Some provinces place a cap on the registered capital a MCC can raise. On the other hand, despite the People’s Bank of China and China Banking Regulatory Commission’s push to ease limitations, debt in the form of bank lending remains difficult for MCCs. Currently MCCs cannot have a debt/equity ratio greater than 0.5x. In reality, because of various constraints such as stringent bank loan requirements, MCCs only reach a fraction of this restriction (see Blog posting). Unlike other microfinance institutions (MFIs) such as Rural Credit Cooperatives (RCCs) or Village Township Banks (VTBs), MCCs are commercial companies, not financial institutions. Therefore they are not allowed to collect deposits or access cheaper sources of funding such as wholesale loans.

In order to address these issues, some MCCs have turned to repurchase agreements with trust companies as a form of financing. The basic model resembles a transfer of credit between a trust company and MCC. MCCs will sell outstanding assets from their loan portfolio to trust companies, the capital raised is then used to finance further lending, as original borrowers repay their loans, the MCC will buy-back the assets at a premium. In the process, trust companies may either hold the asset for the duration of the agreement or resell the credit asset to other parties or investors.

Some recent examples of this up-and-coming model include:

• May 18, 2010, Dongxin Microcredit Company, Inner Mongolia Branch of China Construction Bank, and Xinhua Trust established cooperation in designing and offering “Xinhua Trust Inner Mongolia Donxin Huize Collective Equity Investment Trust Program”. Currently, Dongxin MCC has successfully issued RMB 200 million of trust capital.
• June 28, 2010, Shanxi Trust offered “Shanxi Trust-Lvliang City Xinyuan Microcredit Company Collective Floating Capital Loan Trust Program”. It collects capitals from several clients to form portfolios of certain scale, and grant floating capital loans to Luliang City Xinyuan MCC by lending while achieving ideal trust profits for the clients (beneficiaries).
• July 19, 2010, Xi’an Trust issued “Boyuan Microcredit Company Collective Floating Capital Loan Trust Program”, granting floating capital loans to Boyuan MCC. Within the trust term, Boyuan MCC pays interests for trust loans on a quarterly basis; before and after the maturity of trust term, Boyuan MCC pays back the principal of trust loan at twice.

The main concern in these repurchase agreements and reselling assets is the ability to repurchase and the internal operational risk. If there is no limit of times for transfer, MCC loans may be re-sold countless times, which in turn multiplies the asset risk. If any of the borrowers default on their loans, the repurchase ability of the MCC will be discounted, this in turn will affect the profit of the trust companies. Moreover, unlike commercial bank loans which are sometimes also sold, microcredit loans have shorter loan terms and smaller amounts, which may require re-packaging and bundling of asset classes. For example, a re-sale package with a term of 6-months may be backed by 1-month assets. Doing this can significantly increase internal operation costs.

While this new model serves as a short-term remedy for urgent financing needs, if we’ve learned anything from the current financial crisis, there exists tremendous risk to the entire banking system in promoting and adopting this model. If there is no effective supervision, the damage of this system can be devastating. Currently, CBRC has banned buy-back trade services of assets between trust companies and banks. CBRC allows “trust companies [to] invest in bank assets but the banks cannot repurchase in any form”. Because this model has only recently been introduced in the Chinese microfinance sector, supervisory bodies have yet to restrict and impose similar restrictions to microfinance institutions.

Another issue to consider is the MCCs ability to absorb loss, the capital adequacy ratio. Currently, commercial banks have a capital adequacy ratio of 8%, should MCCs face the same capital adequacy restrictions as their commercial counterparts? MCCs are relatively young (the pilot model was introduced in 2005), and therefore their internal risk control remain rudimentary. In the event of loan defaults, not only will the MCC be affected, but also the trust companies and related investors can incur huge financial losses. More importantly, the order of financial market will be disturbed and as the effects may snowball and result in a situation similar to the subprime crisis. Therefore, PlaNet Finance China strongly urges the involvement of supervisory bodies to introduce regulations which will control and curb these risks.

Sources:  

http://www.chinamfi.net/news_show.asp?/2506.shtml
http://www.gov.cn/gzdt/2008-05/08/content_965058.htm
http://www.21cbh.com/HTML/2010-6-9/xMMDAwMDE4MTQxMQ.html
http://www.northnews.cn/2010/0628/247281.shtml
http://trust.jrj.com.cn/product/107028383.shtml
http://www.gov.cn/ztzl/2008-12/22/content_1184934.htm
http://www.yanglee.com