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Investing in financial inclusion

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An investment banker has to develop sector-specific guidelines and methodologies to help him deal with small and disaggregated clients, and scale up low-ticket transactions. The investment banker plays a key role in transferring risk and capital between high-quality companies and well-capitalised investors. This article explores the various facets of investment banking specific to financial inclusion and suggests innovations that would enable investment bankers play a greater role in facilitating capital market transactions.

The previous column in this series explored the importance of well-developed secondary markets in securities and the mechanisms that are required to develop such markets. Now, it is necessary to focus on the role and responsibilities of the investment banker, the critical market intermediary who sits between high quality borrowers/issuers and well-capitalised investors, and must act as a bridge to transfer risk and capital.

In the context of financial inclusion, the clients that an investment banker must deal with would be:

  • Small local businesses, micro-SMEs that have achieved a certain level of scale through their own resources and seek growth capital
  • Originators of financial services to low-income households

Adam Smith observed: “It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country.” The investment banker performs an important function in rendering financial capital mobile.

Investment Banker’s Role

Facilitating movement of capital: The investment banker’s primary role is in connecting high quality borrowers/issuers with well capitalised investors. The due diligence abilities of the investment banker are crucial in developing an understanding of his client’s business, and representing it fairly to the investor community. Given the absence of independent research, the investor will require to develop trust in the investment banker as a “sector expert”.

In the context of financial inclusion, an investment banker has to deal with small and disaggregated clients, and low ticket sizes of transactions. To facilitate a larger quantum and volume of transactions, the investment banker has to

  • Develop sector-specific due diligence guidelines and evaluation methodologies, which can be tested over time
  • Enable independent research and oversight of the client base, and develop an independent repository of data and analysis. This is possible through a partnership with rating agencies

To ensure the success of placement of a transaction, market making and developing deeper secondary markets in securities are critical. The investment banker is uniquely placed to fill this role, as she has been responsible for developing the primary market itself. Reducing the risk of financing through underwriting: One of the key aspects of reducing business risk is certainty of capital. The underwriting abilities of the investment banker will determine her success in assuring capital to her clients. Partial/full underwriting in a capital market issuance is a statement that the investment banker is willing to subscribe to whole/ part of an issuance, if investors are unwilling to subscribe.

When an investment banker underwrites an issuance, potential investors are comforted by the fact that the investment banker is willing to absorb the entire risk if necessary. The ability to underwrite securities comes from two factors: ability to price securities and availability of capital to absorb the risk. Given that in the realm of financial inclusion the investment banker’s clients will be smaller and lesser known, the ability to underwrite becomes more critical. Assisting the client in meeting corporate objectives: The investment banker is also an advisor to his clients. As an advisor, the investment banker helps her clients in translating their corporate objectives into a realistic business plan, developing capital raising objectives at different stages and establishing strategies to raise capital.

A key aspect of advisory services is monitoring the corporate governance of the client’s organisation. As a market intermediary, the investment banker is bound to ensure that her clients meet the highest level of corporate governance – independence of the board, transparency to investors etc.

Necessary Innovations

What are the innovations that an investment banker must incorporate to become a meaningful force in furthering financial inclusion?

First, conceptualising and developing sector-specific due diligence guidelines that can serve as a tool for the investment banker as well as capital market investors in gauging the quality of clients, as well as pricing risk. This requires reach and expertise. Second, structure transactions such that it ensures the alignment of incentives of all parties. The issuer achieves certainty of financing, however with a clear target (covenanted in some manner) to achieve the highest standards of corporate governance. The investor’s risk concerns are assuaged by the underwriting abilities of the investment banker. Third, develop partnerships with independent monitoring agencies such as rating agencies and other bodies that can create a repository of information and analysis.

Through efficient and innovative intermediation, the investment banker (in the issuance of both equity and debt securities, as the banker’s role in the two are not materially different) can become a key player in furthering financial inclusion by ensuring the sustainability of capital raising efforts for clients.

This article first appeared in The Hindu Business Line.

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