The Hindu Business Line : Case for structured financing

Finance is a critical input for any business, more so commodity production and trade. Timely and adequate availability of finance exerts a positive impact on current business volumes and future plans.

The traditional ways of financing (for example, through village lenders who, though flexible in terms of access, usually charged usurious rates of interest) have largely given way to bank finance with the spread of banking in the rural areas.

Also gone are the days of credit restriction on commodity trade. Until the mid-1990s, the Reserve Bank of India followed a policy of ‘Selective Credit Control.’ Many essential commodities of daily consumption, including edible oil, sugar and cotton, had restricted credit access. Borrowing against commodities was subject to margins that were varied (raised or lowered) depending on price and market conditions. Margins impacted the extent of credit flow for commodity business.

Credit access restrictions were removed as part of economic liberalisation. The RBI has encouraged easy flow of credit. Banks are free to finance physical commodity transactions. Rapid economic strides, expansion of trade volumes and the need to mitigate risks have necessitated exploration of newer ways of financing.

The traditional methods of finance, including through the banking system, have delivered and will continue to play a role. They did serve a purpose in a given economic context, but that context is now changing. These forms of finance are now perceived to be inefficient systemically. To address new and emerging needs of borrowers as also risks of lenders, both constantly explore newer, customised methods of finance that meet their specific needs.

Balance-sheet lending

The traditional method of bank finance is based on what is called ‘Balance-Sheet lending.’ In this, the bank looks at the financial status (as reflected in the Balance Sheet) of the prospective borrower and decides to lend or otherwise. There are risks associated with this type of lending. This way, the bank usually ends up financing an open position of goods without adequate control over the goods. Commodity markets, by their very nature, are volatile and prices fluctuate in the open market. Credit risk thus directly relates to market prices. This may force the lender to impose margins on what could be perceived to be arbitrary terms.

Moreover, assets could be tied up as security. And often, the security is illiquid (for instance, land). This kind of lending also involves individual credit risk evaluation and monitoring. This unstructured financing is less transaction-intensive. Importantly, the risk profile of agribusinesses is different. Take clients as varied as a plantation company, a commodity trading house, a processor (converting input into output) or special cases such as someone with old stocks. Their financing needs are not uniform, nor would a single system of financing be appropriate for all. For these reasons, unstructured financing has its own limitations.

Structured financing

Enter structured financing. This may be defined as “A technique whereby certain assets with more or less predictable cash flows can be isolated from the originator and used to mitigate various risks and thus to secure credit.”

Structured financing is essentially transaction-based lending (independent of the Balance Sheet). In this system, the lender finances the entire chain of pre-sold trade deals, or hedged, with effective control over goods/title documents. Such a system of financing is on better terms as commodity risk is standardised and other assets are let free. It also enables quick settlement of liquid security.

Advantages

The advantages of structured financing are many. First, there is the clearly identified risk of the assets. Because the structure is tight, the quality of asset is usually high. The lender has an active tie-up with brokers and logistics service providers such as shipping companies, transporters and warehouses. This makes for ease of executing trade deals.

How does structured financing benefit stakeholders? For traders, it is timely, high-quality credit. It enables planning and prompt execution of deals. Goods can be procured and/or sold in any part of the world. Turnover, as well as profits, stands improved. Importantly, documentation is simple.

For lenders, it is a better quality of asset (risk). There is traceability at every stage — from production to sales. Importantly, because structured financing is transaction-based, it helps avoid over-trading. For the community as a whole, it is beneficial.

The system ensures measured flow of credit and importantly, prevents duplication of credit. Wild or excessive speculation in the marketplace, often encouraged by easy access to (unmonitored) funds, will be curbed.

Overall, therefore, structured financing is superior to conventional Balance Sheet financing. It helps address imbalances in commodity production, processing and trade. It can, therefore, be said that developing the capacity to use structured finance tools in a sound manner is crucial for an orderly and rapid development of the commodity sector. Next week, we shall look at the forms of structured financing and its status in India.

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