Originated to transfer- new RBI regime on loan sales permits risk transfers

Team, Vinod Kothari Consultants P. Ltd.

finserv@vinodkothari.com

Major changes have been proposed by the RBI in the regime on what has become a major part of the business model of NBFCs and MFIs in the country – direct assignments (DAs). We have separately dealt with the Draft Directions on Securitisation of Standard Assets in a write up titled “New regime for securitisation and sale of financial assets”

The term DA is so very typical of the Indian scene – globally, the practice of loan trading, loan sales or so-called whole-loan transfers has largely been out of the regulatory domain. However, in India, the motivation to shift from securitisation to DAs were partly the RBI Guidelines of 2006 which regulated securitisation but did not regulate DAs, and partly, the tax issues on securitisation that began prominent around 2011-12 or so. However, the DA model has, over the years, been a sizeable part of securitisation volumes in India, and is the mainstay of transfer of priority-sector loans from NBFCs to banks. Now that NBFCs have been permitted a major push for MSE lending by several GoI schemes, NBFCs are eagerly looking for another round of DA drive, and therefore, it is important to see whether the proposed regulatory regime for loan sales will facilitate NBFC-originated loans to end up on the books of banks and other investors.

Legal loan sale or sale of economic interest?

As one starts reading the draft Directions, the first impression one gets is that the Directions permit both legal assignment, as well as risk transfers (such as by way of a credit default swap or other modes of risk participation). This comes from the meaning of “transfer”, which is defined to mean a transfer of economic interest in loan exposures, and to include “loan participations” and transactions in which the loan exposure remains on the books of the transferor even after the said transaction.

However, it appears that the regulators have still not come out of the template of the existing regulations, which permit legal sales of the loan as the only mode of loan transfer. Thus, there is  a direct conflict between para 9 talking about “legal separation” of the transferor from the loan, where the definition of “transfer” itself refers to economic transfer, not necessarily legal.

Likewise, in para 13 of the draft Directions, there is a specific provision for even the modification of security interest to specifically include the interest of the transferee. This part is mostly not practical. For example, the modification of security interest in case of mortgages may require the amendment of mortgage records. Similarly in case of car or vehicle loans, modification of the hypothecation may involve a humongous exercise of modifying vehicle registration certificates. Mostly, the common practice is that the transferor continues to act as a trustee for the transferee, to the extent of the transferee’s interest.

Change of Lender of record vs assignment of loan receivables

Para 6 of the draft Directions refers to a transaction involving change of “lender of record under a loan agreement”. It provides for a borrower consent, unless the agreement has such explicit consent.

This seems to be scripting a law that has been recognised for nearly 200 years under Anglo-Saxon legal systems. The assignment of receivables or benefits of a contract is not the same as assignment of a contract. Therefore, the sale of a loan and the sale of loan receivables are two different things – what is intended in common practice is only the latter. There is very little reason for parties to want to have a change of “lender on record” as that is not intended. On the contrary, it is completely intuitive to expect that if a novation or variation of the loan contract requiring the borrower to be answerable to someone with whom he never contracted, the borrower’s concurrence, either as a part of the loan agreement or obtained subsequently, is required.

Note that if there is a change in so-called “lender of record”, the same is not, legally, a case of assignment; it becomes a case of variation or novation of contract. The may imply differential powers under the SARFAESI Act, as also different treatment for deduction of tax at source, etc.

Most loan contracts in practice have a clause for assignment; it is not common for loans to have a  clause for change of the so-called “lender of record”.

Bar on credit enhancements and liquidity continues

One of the significant features of the existing regime on DAs was the fact that credit enhancement of any form was not permitted for DAs. The RBI”s stance seems to be that a loan sale is a bilateral transaction between two entities in the financial system. If the buying entity wishes to acquire an exposure originated by another entity, it should do so without leaning on the transferor.

Hence, the draft Directions provide that neither can the transferor provide any credit support nor liquidity support.

It is notable that the marketplace, over roughly 14 years of practising DAs, has evolved several interesting work-arounds. There are practices which transfer the interest and principal differentially as between the transferor and transferee. There are practices for servicing fees or incentives based on efficiency. There are also practices of retained excess spread which is made over to the transferor only after seeing pool performance over time. In essence, every buyer of a DA pool invariably looks at a continuing support from the originator, which is so clearly proscribed by the regulatory regime. In view of the contrasting aims of the regulator and of the practitioners, the practitioners are constantly engaged in finding ways of perfunctory compliance with the regulations. The smarter ones, of course, try to outwit the rest.

The requirement that there ought not be any credit enhancement by the seller is sought to be made stronger, by provisions that that the transferor shall not re-acquire the transferred component, nor shall finance the acquisition thereof. Transferor shall not meet transferee’s expenses as well.

Removal of MRR

One of the major changes in the draft Directions is the removal of minimum retention requirements. Under the existing framework, DA transactions have MRR requirements similar to securitisation transactions. 

The genesis of this removal is the report of RBI’s Task Force on Development of Secondary Market for Corporate Loans. The Task Force in its report has mentioned that lender’s retention of a share in the loans have an adverse effect on the liquidity of loans. It refers to a study by Santos and Shao (2015) showing that there is a trade-off between lender share and liquidity in the secondary market. Specifically, they show that loans where the arranger did not retain any share (i.e. had 0% holding) had significantly better liquidity relative to loans where the arranger retained a share in the secondary market.

If this is retained as is in the final Directions, this could create an adverse effect on the securitisation transactions, which has MRR requirements.

Loan sale contracts to specify buyer share and seller’s share

A provision in clause 9 of the Directions reads as follows: “In case of any retained interest in the exposure by the transferor, the loan sale contract should clearly specify the distribution of the interest income from the transferred asset among the transferor and the transferee.”. This is bound to incite confusion and, potentially, opposition. However, once one understands the meaning of this clause, it fits into reason. First of all, in almost all loan sales, there is a case of transferor’s retained interest. Presently, this is due to combined result of the MRR requirements, as also the retention of excess spread by the transferor. Quite often, the distribution of transferor share and transferee share is quite complicated.

Thus, the clause requires the “loan sale agreement”, mostly called the assignment agreement, to specify clearly the buyer’s share and the seller’s share. The buyer is not a privy or party to a transaction that happens between the seller and the buyer, unless it is a case of change of “lender of record” as discussed earlier. Therefore, while this prescription does not pose difficulty to existing practices on DA sales, what it does mean is that there has to be greater certainty in mutual sharing of loan cashflows, and that certainty and clarity has to be upfront, rather than futuristic or in hindsight.

Servicing to be on arms’ length basis

Normally, the transferor acts as the servicer to the transaction in exchange for a servicing fee. The requirements spelled out under para 19 of the Draft directions relate to those of the transferor acting as a servicing facility provider. The requirements are similar to those earlier prescribed under the 2006 guidelines.

One of the conditions of providing the servicing facility is that the facility is provided on an ‘arm’s length basis’ on market terms and conditions, and subjected to the facility provider’s normal credit approval and review process.

In order to avoid any indirect credit enhancement the Draft directions also provide that if the transferor of loans acts as the servicing agent for the loans under a separate servicing agreement for fee, such service obligations should not entail any residual credit risk on the sold assets or any additional liability for them beyond the contractual performance obligations in respect of such services. The transferor, in the role of the servicing agent, should be under no obligation to remit funds to the transferee unless and until such funds are received from the borrowers.

Due diligence by acquiring lenders

Due Diligence requirements laid out in the Draft framework are broadly on the same lines of what was earlier specified in the 2012 guidelines for purchasing lenders. These aspects must be ensured as a standard of due diligence by the transferee, which include the following –

• Ensure that MHP has been strictly adhered to by the transferor;
• The lender must have the necessary expertise and resources in terms of skilled manpower and systems to carry out the due diligence of the loans/portfolios of loans before purchasing them;
• Formulate a Board approved policy regarding the process of due diligence which needs to be exercised by their own officers to satisfy about the KYC requirements and credit quality of the underlying assets.

Such policies should inter alia lay down the methodology to evaluate credit quality of underlying loans, the information requirements etc.;

• Due diligence functions cannot be outsourced and must be carried out by its own officers with the same rigour as would have been applied while sanctioning new loans, if any, by the lender;
• If a lender wishes to outsource certain activities like collection of information and documents etc., then this should be subject to the extant guidelines on outsourcing of non-core activities by banks. However, ultimate and full responsibility in regard to selection of loans for purchase and compliance with Know Your Customer requirements is with the bank itself.

Further, lenders are required to demonstrate that they understand thoroughly the loans purchased through analysing and recording –

• the risk characteristics of the exposures constituting the portfolio purchased;
• the reputation of the original lenders/transferors in terms of observance of credit appraisal and credit monitoring standards, MHP adherence and fairness in selection;
• Loss experience in earlier transfers of loans/ portfolios;
• Disclosures made by the transferor about their due diligence carried out;
• The methodologies and concepts on which the valuation of loans transferred is based.

Stress Testing & Credit Monitoring

Much like the earlier guidelines, the requirement of carrying out regular stress tests and credit monitoring remains the same.

Sale of standard assets

Standard Assets ineligible for DA

Chapter III of the draft Directions is specifically applicable to “standard assets”, that is, those which are not “stressed”. “Stressed asset” has been defined to mean both those which are NPAs and which are “special mention” accounts. Special mention accounts or SMAs are SMA 0, SMA 1, and SMA 2. This would mean that the so-called “standard” asset, within the meaning of the Directions, is actually much narrower than the meaning of “standard” for provisioning or income recognition norms. Under the provisioning and income recognition norms, whatever is not sub-standard, that is, non-performing, is standard. Thus, SMA 0, SMA 1 and SMA 2 are all standard. However, under the Directions, the so-called standard account must have no SMA status.

Does that mean there must be 0 DPD as on the date of the assignment? If that was to be the meaning, a DA would become practically impossible. It is impossible to do a daily monitoring of the loan receivables. In fact, SMA 0 does not mean 0 DPD – what it means is that there are no signals of credit weakness. As per the Prudential Framework for Resolution of Stressed Assets, SMA-0 means an asset where principal or interest payment or any other amount wholly or partly overdue between 1-30 days.

The existing bar on resale of loans which have been acquired by the transferor goes away. Therefore, it is possible for entities to effectively trade in loans. In fact, as is the common practice in a lot of other jurisdictions, larger intermediaries purchase loans from a lot of smaller or community players, assimilate a larger pool, and then sell the same to the bank. This actually serves the purpose of financial inclusion, and promotes smaller financial players – therefore, this easing of restriction is actually most welcome.

Loan novation and loan participation contracts to escape restrictions

There are basically only two types of facilities which are not permitted to be subject matter of a DA  – revolving credit facilities, and loans with bullet payment of interest as well as principal.

Both these restricted categories can also be transferred through a novation or a participation agreement.

Novation – means alteration in the terms of the original contract with the obligor.

Participation – means creation of a right in favour of the transferee, in the proceeds of the assets.

MHP requirements remain the same

Minimum Holding Period (MHP) is the minimum time for which a loan exposure is required to be mandatorily held by the originator, before transferring or selling the same to another party. Largely, the MHP requirements are the same as provided in the current guidelines, providing the MHP requirements based on the minimum number of installments paid on the loan exposure.

However, the MHP requirement is not applicable in case of loans with tenor up to 24 months extended to individuals for agricultural activities (under PSL category) where both interest and principal are due only on maturity and trade receivables with tenor up to 12 months discounted/purchased by lenders from their borrowers.The eligibility condition in such a case is that the borrower must have repaid last two loans/receivables (one loan, in case of agricultural loans with maturity extending beyond one year) within 90 days of the due date.

Further, since the draft Directions allow sale/transfer of loans purchased from other parties to be again sold under these guidelines, the MHP requirements for such loans is specified to be 12 months.

A prescription for accounting treatment

The Directions have laid down the rules for accounting, particularly pertaining to recognition of profits. However, after the implementation of IndAS 109, the accounting treatment of DA transactions was done in accordance with the Accounting Standards. However, these rules shall not be relevant, since they are not in line with the existing accounting rules.

Capital adequacy, income recognition and provisioning

The capital adequacy requirements for purchase of loans shall be in line with the requirements applicable to the originator in respect of such loans. The income recognition, asset classification and provisioning shall be based on individual loans rather than the entire portfolio. These guidelines are the same under the current guidelines.

Further, the requirement of carrying the loans at acquisition cost or face value whichever is lower and amortising the premium paid on purchase (when acquisition cost is higher than face value) on a straight line basis, which was earlier applicable to all assignees in a DA transaction, shall now be applicable only on banks and AIFIs.

One noticeable change is that in case of failure to comply with the requirements including MHP, MRR, asset classification, income recognition, provisioning etc. the exposure was earlier required to be weighted at 667% for the purpose of determining capital adequacy. This risk weight shall increase to 1250% with applicability of the draft Directions.

Sale of stressed assets

As a welcome move, the Directions club together the regulatory regime for sale of stressed assets. Presently, sale of NPAs was covered by the Master Circular – Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances. These guidelines were applicable to banks and NBFCs both. There was nothing specific about sale of stressed assets, which were effectively standard assets only.

However, as discussed earlier, the definition of “stressed assets” includes those assets in the special mention category.

Interestingly, even the sale of loans coming under the Prudential Framework for Resolution of Stressed Assets (PFRSA) will also be covered by the draft Directions. A sale of stressed assets undertaken as a resolution plan under the PFRSA will be covered under these directions.

Policies

These days, the first thing that a regulator starts with a board-approved policy, even though the activity in hand is purely operational. Over time, boards of banks and financial intermediaries have come to approve so many policies that their attention span may be easily deflected.

The Directions requires the Originator to have a board approved policy on sale of their stressed assets, which, inter alia, shall cover the following aspects:

1. 1. Financial assets to be sold;
   2. Norms and procedure for sale of such financial assets;
   3. Valuation procedure to be followed to ensure that the realisable value of financial assets is reasonably estimated;
   4. Delegation of powers of various functionaries for taking decision on the sale of the financial assets; etc.

The board approved policy was a requirement under the extant prudential norms as well.

Who can the buyer be?

As per para 50, the buyer can be any regulated entity that is permitted to take on loan exposures by its statutory or regulatory framework.

Thus, one may think of a large number of potential buyers:

-Banks

-NBFCs

-ARCs

Can it be companies? On the question whether a non-banking non financial entity, or, indeed, an HNI or other non-financial entity, also be a buyer of stressed financial asset, one may be beset with the terminology “any regulated entity that is permitted to take on loan exposures by its statutory or regulatory framework.”. That is to say, the buyer has to be a regulated entity though it can be a non financial entity as well. This will effectively eliminate any existing practice of selling NPAs to entities outside the financial system^[1].

However, there is lack of clarity as to who will be the buyers who are a regulated entity permitted to take on loan exposures by its statutory or regulatory framework but is not a financial entity.

Another interesting extension of the IBC-originated theme is the ouster of sec 29A (of IBC)-eligible buyers from buying stressed assets as well. That is, whoever is ineligible to buy assets under the IBC framework is also ineligible to buy financial assets under the Direction. While the undertone is understandable, given the fact that the buyer is a “financial entity”, such entities are mostly exempted from sec. 29A of IBC anyways.

Section 29A (c) provides that nothing in the said clause would apply to a resolution applicant where such applicant is a financial entity and is not a related party to the corporate debtor. Financial entity (for the purpose of Sec. 29A) means a SCB, foreign regulated banks in FATF compliant jurisdictions, investment vehicles, registered FIIs/ FPIs/ FVCIs, ARCs and AIFs.

Public solicitation, valuation, in case of stressed asset sales

The ideology of democratic purchase of loans or loan pools, seen in para 52 of the draft Directions, may require reshaping of existing practices. While NPA sales by public sector banks may take the e-auction route, the same when done by NBFCs may be completely on bespoke or OTC basis. However, para 52 says: “the bids should preferably be publicly solicited so as to enable participation of as many prospective buyers as possible”. While the word is “preferably”, lenders are likely to face regulatory questions as to why public dissemination of a sale bid was not done.

Also, there is a  prescription in para 54  that in case of a sale of exposures above Rs 50 crores, the pool must be valued by at least 2 valuers. This may prove to be counterproductive and perfunctory exercise. While, on one hand, the transaction is effected between entities which are a part of the financial system and therefore, are much better placed to understand the risks and valuations of assets, at the same time, valuers are being brought to prescribe minimum values. The provision seems like giving the stressed loan market a flavour of asset auctions under SARFAESI or IBC regime. Not only has the regulator gone into valuations, the regulator was not content without even specifying the discounting rate, and method of valuation.

Further, para 80 goes into much finer details of how the price discovery in case of sale of NPLs would be.

Single asset treatment to retail loan pools

The Draft directions lay down the single asset treatment for a portfolio of stressed retail assets. Para 58 states that lenders are permitted to sell/buy homogeneous pool within stressed retail assets, on a portfolio basis. This is at par with the existing regulations for purchase/ sale of NPAs.

Further, the criteria for determining homogeneity of a pool is also laid down which is at par with the Basel III securitisation norms dealing with how to assess homogeneity. (we have earlier covered the topic of determining a homogeneous pool based on the Basel III norms in a separate write up)

Stressed assets become Standard once sold

Para 60 calls for classification of the purchased stressed asset as standard upon acquisition if the transferee has no existing exposure to the borrower whose stressed loan account is acquired. This is similar to the extant norms on sale of NPAs.

Transfer of paper, in lieu of paper – in case of sale to ARCs

While in case of sale of stressed loans to others, the prescription is – “cash for junk”, in case of sale to ARCs, one is permitted to escape this rule. In essence, a bank may clean up its NPA book, and instead acquire “bonds, debentures, SRs or PTCs” issued by ARCs.

Also the existing requirement of a maximum 10% stake, in SRs, by the selling lender in case of sale of NPAs, has been mellowed down greatly, making it applicable only in case of “asset securitisation”. Presumably, therefore, this norm shall not be applicable in case of issue of SRs by ARCs, and will be applicable only in case of PTCs.

Currently, there is no practice of issue of PTCs backed by NPA loan pools – the concept of “SRs”, which emanated from the SARFAESI Act and is decisively an Indian innovation^[2], effectively serves the same purpose as PTCs. However, under the proposed regulatory regime, it will be intriguing to assess as to how SRs will be different from PTCs.

Read our related write ups here –

1. New regime for securitisation and sale of financial assets;
2. Comparison of the Draft Securitisation Framework with existing guidelines and committee recommendations;
3. Comparison of the Draft Framework for sale of loans with existing guidelines and task force recommendations;
4. Inherent inconsistencies in quantitative conditions for capital relief;
5. Presentation on Draft Directions on Securitisation of Standard Assets;
6. Presentation on Draft Directions Sale of Loans;
7. YouTube video of the webinar held on June 12, 2020.

^[1] One will actually wonder whether the Directions apply to ARCs as well? As there is a completely different regime applicable to ARCs, there is no reason to extend the Directions to ARCs.

^[2] The idea of a “receipt” instead of a bond or debenture was originally envisaged to minimise the stamp duty burden. The stamp duty in case of a “receipt” is much lower, and is a Union subject.