Nirupama Parsineti 1811343

RBFI End Term Solution – Codensa: Easy credit for all

Part A: Codensa: Easy credit for all:
In order to turnaround its business, Codensa deployed a multi-pronged strategy. While improving its
community relations, it put in place technical measures to reduce theft and put in place soft financing to
lessen defaults and late payments. The lower strata of the population, which comprised 83.3% of all the
clients, primarily was riddled with debt and also electricity loss. The company had to provide the clients
higher value addition so that electricity which was perceived as a commodity could be used to build
customer loyalty and thereby its brand value. Codensa Hogar, the financial wing of the Codensa to finance
household appliances was created. The objective of creating the financial service was three fold, i) To
create a new business for Codensa, ii) Inspire customer loyalty and iii) To provide value addition and
improve living standard of the bottom of the pyramid, which otherwise had no access to credit. The
program was a huge success mainly because of the company’s’ utilization of its core competencies to gain
advantage in the financial services space. The company almost had zero information and regulatory costs.
Establishing identity is relatively easier as the client would be required to produce electricity bill.
Transaction trail is established by third party and could also be concluded by Codensa by utilizing clients’
credit history, if it exists. Collection costs are also greatly reduced because it leverages the existing
infrastructure of electricity bill collection. As given in Exhibit 2, the company experienced less defaults and
higher collection rates with the share of owned locales billing network increasing to 25.6%.

Although it can’t be said that providing electrical appliances has resulted in greater financial inclusion of
the client base, it is true that Codensa managed to remove an important obstacle stopping them from
becoming the part of the formal finance facilities. The client base of Codensa had an interesting feature.
Around 84% of them held high-school diplomas and were largely young group. A restriction that might be
hindering them from accessing financial credit might be lack of credit history or sound transaction trail. By
providing credit to them, Codensa has managed to alleviate this problem and thus facilitated them in
becoming a part of the financial system at large. This can be supported by the fact in the case that around
45% of the Codensa users gained access to formal financial credit. Although this is true, the entire onus of
providing credit history and verifying customer identity lies with Codensa and this is accompanied with
certain risks. The success rate that is inherent to Codensa might not be replicable by every other company
and relying on this could be risky for the banking sector at large. Also, the experience of Codensa might be
applicable and replicable only under certain economic conditions. In cases of economic downturn or
recession, the quality of asset loans does take a hit. This could result in scenarios such as Global financial
crisis of 2008 where the objective of serving(providing home loans) to the marginalized communities got
hit because of ripple effect in the economy. A similar series of events might occur here because the loan
portfolio consisting of lower economic strata clients is treated as inherently risky and their loan paying
ability highly depends on larger economic conditions. With more and more credit being directed towards
this client base, any downturn or deterioration of quality of loans can result in a credit crunch which could
further slow-down the economy.

Scalability of the business model depends on how easily it can generate revenues with only marginal
increase in resources or cost. This model is scalable across the consumer electronics, personal finance and
even the holiday segment. As the cost of establishing identity and transaction remain same, the collection
costs also change only marginally in each of the above financing with time period of collection being the
prominent variable. In terms of geographical markets, it can scale to markets in which it can leverage the
existing infrastructure to reduce the identity and collection costs. In this sense, it is different from the
traditional vegetable lender in a market whose model is inherently non-scalable due to high tacit
knowledge which can’t be replicated elsewhere. Because the screening process is outsourced and also
because it involved documents such as electricity bill and salary receipt, it becomes easier to establish this
model anywhere as long as collection costs are low. However, the company is financing the loan portfolio
through the surplus in the power business which may not be sustainable across a larger client base.
The low costs in establishing identity and collections are important attributes of this model. The ability of
the institution in providing value addition and reducing default rates is essential to maintaining profitability
while commanding customer loyalty. In the case of supermarkets and fuel distribution chain, the switching
costs for the customer are very low. Because of this, collection costs for the supermarket and fuel
distribution chain might run high as their competencies lie elsewhere. But what can be extended is the
ability to provide value to the customer. Super markets and fuel distribution chain can tie up with Codensa.
Instead of granting request for different purchases in the above markets, Codensa can issue special credit
card to customers with good to remarkable credit history. This would increase the ease of collection and
encourage customers who would otherwise go to local Kirana stores to avail services and products from
supermarkets.

According to Exhibit 8, the percentage of revenue earned as interest on loans is around 58.36%. Comparing
this with revenue and monthly expenses table of Codensa Hogar from Exhibit 7, we can see that it’s
interest income from loans as a percentage of total revenue is around 89%(In Aug, 2006). This suggests
that the requirement for establishing credit history and need to drive down default rates is very high for
Codensa. In case there’s a change in the default rates with them spiking up, then the company has to
protect them with its own profits or provisions which would reduce the liquidity crunch of the company.
Exhibit 8 suggests that the percentage of provisions as part of the total revenue is 17.51% in a typical
financial entity(which also has less dependence on interest income as compared to Codensa). Codensa, on
the other hand has provisions to be around 16.94% of the total revenue. What this might mean is that it
may not be adequately prepared for dealing with deterioration of loan quality or liquidity crunch, which
may be reasoned by macroeconomic conditions or fall in profits of the electric company.

Codensa can resort to possession of collateral to ensure that it does not assume all the risk in case of any
default and has an effective way to collect outstanding debts. In case the client has an own house, it could
be used as a collateral. If the client is an employee in the formal sector, a portion of his salary could be
used as a collateral. If the client is self-employed, Codensa can follow Islamic banking principle of Profit-
sharing as part of collateral. It could also practice the Islamic banking principles of credit card financing
without commanding high interest rates. It could make a purchase of securities with AAA/AA rating of the
amount equivalent to issuing credit. In case of default, it could sell the securities to cover up most of its
losses. It would also mean that the asset side and liability side of the balance sheet would be equally
balanced to a large extent. Any increase in security value could be shared with the client. In case, Codensa
goes for a non-financial, non-social based collateral such as power supply deterrence, it could lose out on
goodwill among the people which was one of the main goals and reasons for it starting the financial credit
business. It goes against the principle of providing high quality life to all the clients although it will be a
very effective collateral. An interesting example of non-financial, non-social collateral, especially in tropical
countries, might be providing solar panels to be set up on top of home in case of default and selling the
produced power units in the local community which includes profit sharing. Codensa could tie up with
solar-panel producing companies and rent the panels. Alternatively, they could set up different rates of
electricity after a certain cap depending on the default history. They could also take back the asset
financed and create a repository of assets, classify them based on usage and quality and rent them for less
rates. Exhibit 5 gives an exact idea of the purchases made by each strata, which can be combined with
default rates to generate estimation of assets available. Although these collaterals are not coercive, they
create a win-win situation for both lender and the borrower. More importantly, they make good losses for
Codensa without damaging it’s goodwill.

An inference from the above would be that Codensa has to look for sources of finance to sustain its
outpacing financial services business and maintain its provision so as to not get hit by liquidity crunch. In
order to sustain its growth, Codensa has to incur additional capital costs apart from financing through
surplus from electricity business. Codensa can issue short term bonds(New product in Colombia according
to Exhibit 11, table 2) , 2-5 years, to finance its credit situation. If the credit quality drops, this could affect
the Codensa’s finances and thereby credit rating which would make Codensa to increase its capital cost.
This could effect Codensa’s fund(capital) raising ability and thereby threaten its finance service program.
Part B: Regulatory perspective:

Codensa’s market share and the market it serves are very large. The market it serves does not have an
alternative means of credit making Codensa’s services crucial. If the outstanding loans suffers a
contraction, experiences high default rates and deterioration in quality, it could mean a credit crunch for
lower strata and the low-income groups and may mean financial instability. The client base and service it
offers are of pivotal nature and any disruption in them could pose a systemic risk for the entire system.
This could mean that the regulator puts a cap on lending as a percentage of revenue and mandates the
required percentage of provision in the form of government securities or cash. The impact of borrowing
from the financial market has to be studied and regulations should mandate the risk and cost the business
can incur.

Although the loans of Codensa are performing above the industry average, accurate and latest information
regarding the client base, their credit history and demand for its services has to be reported regularly. This
is essential in reducing the information asymmetry inherently present between the market and customer.
This would also inspire high degree of confidence for Codensa. The regulator should also make sure that
Codensa doesn’t resort to excessive coercion when the loan allocated is not productive or is of low quality.

The regulator should also be focus on the criterion on which the loans are approved. Codensa approves
loans up-to three times the clients salary. While this increases the credit capacity and freedom of the
client, it also places the company in profitable position. Increasing consumerism and the usage of
electricity at large might benefit the company in a long term as usage of electricity is pushed higher. It is
mentioned in the case that a client who went with a intention to purchase one television ended up
purchasing two television as her credit limit was high. The costs on the finances of the client due to placing
the entire process of due diligence and critical evaluation on him/her have to be evaluated.

The regulator, first and foremost should ensure non-coercive methods of collection as in majority cases,
there exists no collateral. It should also assign a judicial body the function of grievance redressal and
appellate authority in case of any conflict between the consumer and the company to ensure the right of
the consumer are protected. The regulator can also release a policy which examines the credit history and
requirement or need of particular appliance, which can reduce the consumeristic behaviour. Data and
privacy of the customers also has to be governed by national data policy or pointers specific to the industry
should be formulated.
Part C:

The regulator should use the deep penetration network of companies like Codensa to reach otherwise
unpenetrated customers. As the registration by Codensa has a positive effect on them joining the formal
financial system, this could further leveraged in delivering services and understanding consumer
characteristics. For example, Government could partner with Codensa in setting up solar unit and providing
client with solar panel. This would be similar to KUSUM scheme in India but with greater knowledge of
small, marginal and large farmers and with greater appreciation of regional differences. With increasing
rural electrification, including electricity companies in the process of facilitating schemes of high relevance
can be an interesting step.

While solving major problems of collection and identity costs while adding high value to the customer,
Codensa has managed to gather a high momentum. Though equipped with a scalable model, financial
constraints and erodible brand equity pose a delicate conundrum for the company. With the space of
financial credit, especially to marginalized undergoing a change, the job of regulator also undergoes a shift.
Without trampling the innovativeness of the business, how it leverages the existing structure while
ensuring financial stability at large is the conundrum for the regulator.