After 15 years: New Securitisation regulatory framework takes effect

-Financial Services Division (finserv@vinodkothari.com)

[This version dated 24^th September, 2021. We are continuing to develop the write-up further – please do come back]

On September 24, 2021, the RBI released Master Direction – Reserve Bank of India Securitisation of Standard Assets) Directions, 2021 (‘Directions’)^[1]. The same has been released after almost 15 months of the comment period on the draft framework issued on June 08, 2020^[2]. This culminates the process that started with Dr. Harsh Vardhan committee report in 2019[3].

It is said that capital markets are fast changing, and regulations aim to capture a dynamic market which quite often leads the regulation than follow it. However, the just-repealed Guidelines continued to shape and support the securitisation market in the country for a good 15 years, with the 2012 supplements mainly incorporating the response to the Global Financial Crisis (GFC).

Considering the fact that securitisation, along with its regulatory alternative (direct assignment) has become a very important channel of inter-connectivity and bridging between the non-banking finance companies and the banking sector, and since the ILFS crisis, has been almost existential for NBFCs, it is very important to examine how the new regulatory framework will support securitisation market in India.

By way of highlights:

• The bar on securitisation of purchased loans has been removed; there is a holding period requirement for acquired loans, after which the same may be securitised.
• The risk retention requirement for residential mortgage backed transactions has been reduced to 5%.
• Minimum holding period reduced to 6 months maximum, whereas it will be 3 months in case of loans with a tenure of upto 2 years.
• In line with EU and other markets, there is a new framework for simple, transparent and comparable (STC) securitisations, which will qualify for lower capital requirements for investors.
• Ratings-based risk weights introduced for securitisation transactions, adopting the ERB approach of global regulators.
• Direct assignments continue to be subjected to the familiar criteria – no credit enhancement or liquidity facility, adherence to MHP, etc. However, risk retention criteria in case of direct assignments, called Transfer of Loan Exposures, have been removed, except where the buyer does not do a due diligence for all the loans he buys.
• By defining who all could be permitted transferees of loans, the fledgling market for sale of loans through electronic platforms, to permit retail investors to participate in the loan market, completely nipped in its bud.

Scope of Applicability

Effective date:

The Directions are applicable with immediate effect. This should mean, any transaction done or after the date of the notification of the Directions must be in compliance therewith. Para 4 of the Directions clearly provides that any transaction of securitisation “undertaken” subsequent to the notification of the Directions will have to comply with the same. This implies that 24th September is the last date for any securitisation transaction under the erstwhile Guidelines.

The immediate implementation of the new Directions may create difficulties for transactions which are mid-way. Para 4 refers to transactions undertaken after the notification date. What is the date of “undertaking” a transaction for determining the cut-off date? Quite often, securitization transactions involve a process which may be spread over a period of time. The signing of the deed of assignment is mostly the culmination of the process. In our view, if the transaction is already mid-way, and effective term sheets have been signed with investors within the 24th September, it will be improper to disrupt that which has already been structured.

Lending entities covered:

As proposed in the Draft Directions, the Directions are applicable to banks and small finance banks (excluding RRBs), all India Term financing institutions (NABARD, NHB, EXIM Bank, and SIDBI), NBFCs and HFCs. These institutions are referred to as Lenders (or Originators) herein.

Eligible Assets

What is not eligible:

The Directions provide a negative list i.e. list of the assets that cannot be securitised. These are:

1. Re-securitisation exposures;
2. Structures in which short term instruments such as commercial paper, which are periodically rolled over, are issued against long term assets held by a SPE. Thus, what is globally prevalent as “asset backed commercial paper” (ABCP) has been ruled out. ABCP transactions were seen as responsible for a substantial liquidity crisis during the GFC regime, and Indian regulators seem to have shunned the same.
3. Synthetic securitisation; and
4. Securitisation with the following assets as underlying:
   1. revolving credit facilities
   2. Restructured loans and advances which are in the specified period; [Notably, the Directions do not seem to define what is the “specified period” during which restructured facilities will have to stay off from the transaction. It appears that the bar will stay till the facility comes out of the “substandard” tag. This becomes clear from para 8 of the Directions.
   3. Exposures to other lending institutions;
   4. Refinance exposures of AIFIs; and
   5. Loans with bullet payments of both principal and interest as underlying;

The draft guidelines did not exclude 2, 3, 4(b), (c) and (d) above. It is noteworthy that the exposure to other lending institutions has also been put in the negative list. Further, synthetic securitisation, on which several transactions are based, also seems to be disallowed.

Apart from the above, all other on-balance sheet exposures in the nature of loans and advances and classified as ‘standard’ will be eligible to be securitised under the new guidelines.

With respect to agricultural loans, there are additional requirements, as prescribed in the draft directions. Further, MHP restrictions shall not be applicable on such loans.

What is not not eligible, that is, what is eligible:

It is also important to note that the bar on securitisation of loans that have been purchased by the originator goes away. On the contrary, Explanation below para 5 (l) [definition of Originator] clearly states that that the originator need not be the original lender; loans which were acquired from other lenders may also be the part of a securitisation transaction. Further, Para 9 provides that the respective originators of the said assets transferred to the instant originator should have complied with the MHP requirements, as per the TLE Directions.

At the same time, a re-securitisation is still negative listed. That is, a pool may consist of loans which have been acquired from others (obviously, in compliance with TLE Directions), but may not consist of a securitisation exposure.

Another notable structure which is possible is securitisation of a single loan. This comes from proviso to para 5 (s). This proposal was there in the draft Directions too. While, going by the very economics of structured finance, a single loan securitisation does not make sense, and reminds one of the “loan sell off” transactions prior to the 2006 Guidelines, yet, it is interesting to find this clear provision in the Directions.

Rights of underlying obligors

Obligors are borrowers that owe payments to the originator/ lender. Securitisation transactions must ensure that rights of these obligors are not affected. Contracts must have suitable clauses safeguarding the same and all necessary consent from such obligors must be obtained.

MRR Requirements

Underlying Loans	MRR	Manner of maintaining MRR
Original maturity of 24 months or less	5%	Upto 5%- ●      First loss facility, if available; ●      If first loss facility not available/ retention of the entire first loss facility is less than 5%- balance through equity tranche; ●      Retention of entire first loss facility + equity tranche  < 5%- balance pari passu in remaining tranches sold to investors Above 5% ●      First loss facility, or ●      equity tranche or ●      any other tranche sold to investors ●      combination thereof In essence, the MRR may be a horizontal tranche, vertical tranche and a combination of the two (L tranche]. If the first loss tranche is within 5%, the first loss tranche has to be originator-retained, and cannot be sold to external investors. However, if the first loss tranche is more than 5%, it is only 5% that needs to be regulatorily retained by the originator.
Original maturity of more than 24 months	10%
Loans with bullet repayments
RMBS (irrespective of maturity)	5%

Para 14, laying down the MRR requirements, uses two terms – equity tranche and “first loss facility”. While the word “first loss facility” is defined, equity tranche is not. Para 5(h) defines “first loss facility” to include first level of financial support provided by the originator or a third party to improve the creditworthiness of the securitisation notes issued by the SPE such that the provider of the facility bears the part or all of the risks associated with the assets held by the SPE .

However, Explanation below para 14 may be the source of a substantial confusion as it says OC shall not be counted as a part of the first loss facility for this purpose.

What might be the possible interpretation of this (euphemistically termed as) Explanation? OC is  certainly a form of originator support to the transaction, and economically, is a part of the first loss support. However, first loss support may come in different ways, such as originator guarantee, guarantee from a third party, cash collateral, etc. Equity tranche, deriving from the meaning of the word “tranche” which includes both the notes as also other forms of enhancement. Therefore, what the Explanation is possibly trying to convey is that in capturing the equity or first loss tranche, which, upto 5%, has to be  originator-retained, the OC shall not be included.

This, however, does not mean that the OC will not qualify for MRR purposes. OC is very much a part of the originator’s risk retention; however, in constructuring the horizontal, vertical and L tranche of transactions, the OC shall not be considered.

To give examples:

• A transaction has 15% OC, and then a AAA rated tranche: In this case, the original has the 15% OC which meets the MRR requirement. He does not need to have any share of the senior tranches. This point, looking at the language of the Explanation, may be unclear and may, therefore, reduce the popularity of OC as a form of credit enhancement.
• A transaction as 5% OC, 5% junior tranche, and remaining 95% as senior tranche. The originator needs to hold the entire 5% junior tranche (assuming original maturity > 24 months).
• A transaction has 5% OC, 2% junior tranche, and 98% senior tranche. The originator needs to hold the entire 2% junior tranche, and 3% of the 98% senior tranche.

Para 16 first clarifies what is though clear from the 2006 Guidelines as well – that the requirement of retention of MRR through the life of the transaction does not bar amoritisation of the MRR. However, if MRR comes in forms such as cash collateral, it cannot be reduced over the tenure, except by way of absorption of losses or by way of reset of credit enhancements as per the Directions.

Listing Requirements

The Directions specify a minimum ticket size of Rs. 1 crore for issuance of securitisation notes. This would mean an investor has to put in a minimum of Rs 1 crore in the transaction. Further, the Directions also state that in case securitisation notes are offered to 50 or more persons, the issuance shall mandatorily be listed on stock exchange.

Interestingly, the limit of 50 persons seems to be coming from the pre-2013 rules on private placements; the number, now, is 200. It is typically unlikely that securitisation transactions have 50 or more investors to begin with. However, recently, there are several portals which try to rope in non-traditional investors for investing in securitisation transactions. These portals may still do a resale to more than 50; it is just that the number of investors at the inception of the transaction cannot be more than 49. Also, if there are multiple issuances, the number applies to each issuance. The number, of course, has to be added for multiple tranches.

The Draft Directions stated a issuance size based listing requirement in case of RMBS, as against the investor group size based requirement prescribed in the Directions.

SPE requirements

SPE requirements are largely routine. There is one point in para 30 (d) which may cause some confusion – about the minimum number of directors on the board of the SPE. This is applicable only where the originator has the right of nominating a board member. If the originator has no such right, there is no minimum requirement as to the board of directors of the SPE. In any case, it is hard to think of SPEs incorporated in corporate form in India.

Accounting provisions

The Directions give primacy to accounting standards, as far as NBFCs adopting IndAs are concerned. In such cases, upfront recognition of profit, as per “gain on sale” method, is explicitly permitted now. As for other lenders too, if the gain on sale is realised, it may be booked upfront.

Unrealised gains, if any, should be accounted for in the following manner:

1. The unrealised gains should not be recognised in Profit and Loss account; instead the lenders shall hold the unrealised profit under an accounting head styled as “Unrealised Gain on Loan Transfer Transactions”.
2. The profit may be recognised in Profit and Loss Account only when such unrealised gains associated with expected future margin income is redeemed in cash. However, if the unrealised gains associated with expected future margin income is credit enhancing (for example, in the form of credit enhancing interest-only strip), the balance in this account may be treated as a provision against potential losses incurred.
3. In the case of amortising credit-enhancing interest-only strip, a lender would periodically receive in cash, only the amount which is left after absorbing losses, if any, supported by the credit-enhancing interest-only strip. On receipt, this amount may be credited to Profit and Loss account and the amount equivalent to the amortisation due may be written-off against the “Unrealised Gain on Loan Transfer Transactions” account bringing down the book value of the credit-enhancing interest-only strip in the lender’s books.
4. In the case of a non-amortising credit-enhancing interest-only strip, as and when the lender receives intimation of charging-off of losses by the SPE against the credit-enhancing interest-only strip, it may write-off equivalent amount against “Unrealised Gain on Loan Transfer Transactions” account and bring down the book value of the credit-enhancing interest-only strip in the lender’s books. The amount received in the final redemption value of the credit-enhancing interest-only strip received in cash may be taken to the Profit and Loss account.

STC securitisations

Having a simple, transparent and comparable (STC) label for a securitisation transaction is a very important factor, particularly for investors’ acceptability of the transaction. Securitisation transactions are structured finance transactions –the structure may be fairly complicated. The transaction may be bespoke – created with a particular investor in mind; hence, the transaction may not be standard. Also, the transaction terms may not have requisite transparency.^[4]

Simple transparent and comparable securitisations qualify for relaxed capital requirements. STC structures are currently prevalent and recognised for lower capital requirements in several European countries. The transactions are required to comply with specific guidelines in order to obtain a STC label. The Basel III guidelines set the STC criteria for the purpose of alternative capital treatment.

The STC criteria inter-alia provides for conditions based on asset homogeneity, past performance of the asset, consistency of underwriting etc.The Para 37 of the Directions provides that securitisations that additionally satisfy all the criteria laid out in Annex 1 of the Directions can be subject to the alternative capital treatment. The criteria mentioned in the Directions are at par with requirements of Basel III regulations.

Investors to the STC compliant securitisation are allowed relaxed risk-weights on the investment made by them.

The Directions further require, originator to disclose to investors all necessary information at the transaction level to allow investors to determine whether the securitisation is STC compliant.

STC criteria need to be met at all times. Checking the compliance with some of the criteria might only be necessary at origination. .In cases where the criteria refer to underlying, and the pool is dynamic, the compliance with the criteria will be subject to dynamic checks every time that assets are added to the pool.

Facilities supporting securitisation structures

A securitisation transaction may have multiple elements – like credit enhancement, liquidity support, underwriting support, servicing support. These are either provided by the originator itself or by third parties. The Directions aim to regulate all such support providers (“Facility Providers”).  The Directions require the Facility Providers to be regulated by at least one financial sector regulator. For this purpose, in our view, RBI, IRDAI, NHB, SEBI etc. may be considered as financial sector regulators.

Common conditions for all Facilities

For provision of any of the aforesaid facilities, the facility provider must fulfill the following conditions:

• Proper documentation of the nature, purpose, extent of the facility, duration, amount and standards of performance
• Facilities to be clearly demarcated from each other
• On arm’s length basis
• The fee of the Facility Provider should not be subject to subordination/waiver
• No recourse to Facility Provider beyond the obligations fixed in the contract
• Facility Provider to obtain legal opinion that the contract does not expose it to any liability to the investors

Credit Enhancement Facilities

In addition to the above mentioned conditions, following conditions must be fulfilled by the Facility Provider:

• To be provided only at initiation of transaction
• Must be available to SPV at all times
• Draw downs to eb immediately written-off

Liquidity facilities

The provisions about liquidity facilities are substantially similar to what they have been in the 2006 Guidelines. However, the provisions of 2006 Guidelines and the Draft Directions requiring co-provision of liquidity facility to the extent of 25% by an independent party have been omitted. This would mean, the originator itself may now be able to provide for the liquidity facility if an independent party could not be identified or in any other case.

Underwriting facilities

Underwriting is hardly common in case of securitisations, as most issuances are done on bespoke, OTC basis. Again, most of the provisions in the Directions relating to underwriting are similar to the 2006 Guidelines with one difference. The 2006 Guidelines required Originators (providing underwriting facilities) to reduce Tier 1 and Tier 2 capital by the amount of holdings (if it is in excess of 10% of the issue size) in 50-50 proportion.

The Directions are silent on the same.

Servicing facilities

Third party service providers have started emerging in India, particularly by way of  necessity (forced by events of default  of certain originators) rather than commercial expediency.

The provisions of the Directions in para 59-60 are applicable even to proprietary servicing, that is, the originator acting as a servicer, as well as a third party servicer.

It is important to note that arms’ length precondition [Para 45 (b) ] is applicable to originator servicing too. Hence, if the servicing fees are on non-arms’ length terms, this may certainly amount to a breach of the Directions. The other requirement of para 45 (e) seems also critical – the payment of servicing fee should not be subordinated. There should not be any bar on structuring a servicing fee in two components – a fixed and senior component, and an additional subordinated component. This is common in case of third party servicers as well.

Lenders who are investors

The meaning of “lenders” who are investors, in Chapter V, should relate to the entities covered by the Directions, that is, banks, NBFCs, HFCs and term lending institutions, who are investing money into securitisation notes. Obviously, the RBI is not meant to regulate other investors who are outside RBI’s regulatory ambit. The part relating to stress testing was there in the earlier Guidelines too – this finds place in the Directions.

It is also made clear that the investors’ exposure is not on the SPE, but on the underlying pools. Hence, the see-through treatment as given in Large Exposures Framework applies in this case.

Capital requirements

Capital has to be maintained in all securitisation exposures, irrespective of the nature of the exposure an entity is exposed to. If the securitisation transaction leads to any realised or unrealised gain, the same must be excluded from the Common Equity Tier 1 or Net owned Funds, and the same must be deferred till the maturity of the assets.

Further, if an entity has overlapping exposures, and if one exposure precludes the other one by fulfilment of obligations of the former, then the entity need not maintain capital on the latter. For example, if an entity holds a junior tranche which provides full credit support to a senior tranche, and also holds a part of the senior tranche, then its exposure in the junior tranche precludes any loss from the senior tranche. In such a situation, the entity does not have to assign risk-weights to the senior tranche.

Liquidity facilities

For the liquidity facilities extended in accordance with Chapter IV of the Directions, capital can be maintained as per the External Rating Based Approach (which has been discussed later on). For liquidity facilities not extended in accordance with Chapter IV of the Directions, capital charge on the actual amount after applying a 100% CCF will have to be considered.

Derecognition of transferred assets for the purpose of Capital Adequacy

 The Directions has laid down clear guidelines on derecognition of transferred assets for capital adequacy, and has no correlation with accounting derecognition under Ind AS 109. Therefore, irrespective of whether a transaction achieves accounting derecognition or not, the originator will still be able to enjoy regulatory capital relief so long as the Directions are complied with.

There is a long list of conditions which have to be satisfied in order achieve derecognition, which includes:

1. There should complete surrender of control over the transferred exposures. The originator shall be deemed to have retained effective control over the exposures if:
   • It is able to repurchase the exposures from the SPE in order to realise the benefits, or
   • It is obligated to retain the risk of the transferred exposures.
2. The originator should not be able to repurchase the exposure, except for clean-up calls.
3. The transferred exposures are legally taken isolated such that they are put beyond the reach of the creditors in case of bankruptcy or otherwise.
4. The securitisation notes issued by SPE are not obligations of the originator.
5. The holders of the securitisation notes issued by the SPE against the transferred exposures have the right to pledge or trade them without any restriction, unless the restriction is imposed by a statutory or regulatory risk retention requirement
6. Clean-up call
   • The threshold at which clean-up calls become exercisable shall not be more than 10% of the original value of the underlying exposures or securitisation notes.
   • Exercise of clean-up calls should not be mandatory.
   • The clean-up call options, if any, should not be structured to avoid allocating losses to credit enhancements or positions held by investors or otherwise structured to provide credit enhancements
7. The originators must not be obligated to replace loans in the pool in case of deterioration of the underlying exposures to improve the credit quality
8. The originator should not be allowed to increase the credit enhancement provided at the inception of the transaction, after its commencement.
9. The securitisation does not contain clauses that increase the yield payable to parties other than the originator such as investors and third-party providers of credit enhancements, in response to a deterioration in the credit quality of the underlying pool
10. There must be no termination options or triggers to the securitisation exposures except eligible clean-up call options or termination provisions for specific changes in tax and regulation

Further, a legal opinion has to be obtained confirming the fulfilment of the aforesaid conditions.

The draft directions issued some quantitative conditions as well, which have been dropped from the final Directions.

Securitisation External Ratings Based Approach

 The Directions require the lenders to maintain capital as per the ERBA methodology. Where the exposures are unrated, capital charge has to be maintained in the actual exposure.

Para 85 signifies that the maximum capital computed as per the ERBA methodology will still be subject to a cap of the capital against the loan pool, had the pool not been securitised.

The maximum risk weight prescribed in the ERBA approach is 1250%, which holds good for banks, as they are required to maintain a capital of 8%. For NBFCs, the capital required is 15%, so the maximum risk weight should not have been more that 667%. However, para 85 should take care of this anomaly which limits the capital charge to the capital against the loan pool, had the pool not been securitised.

Investor disclosures

Disclosures, both at the time of the issuance, and subsequent thereto, form an important part of the Directions. A complete Chapter (Chapter VII) is dedicated to the same. The disclosures as laid in Annexure 2 are to be made at least on half yearly basis throughout the tenure of the transaction.

This includes substantial pool- level data- such as a matrix of % of the pool composition and corresponding maturities, weighted average, minimum and maximum MHP, MRR and its composition broken down into types of retention, credit quality of the pool (covering overdue, security related details, rating, distribution matrix of LTVs, Debt-to-Income ratios, prepayments etc.), distribution of underlying loan assets based on industry, geography etc.

^[1] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/85MDSTANDARDASSETSBE149B86CD3A4B368A5D24471DAD2300.PDF

^[2] https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/STANDARDASSETS1600647F054448CB8CCEC47F8888FC78.PDF

[3] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=48106

^[4] Our write-up on STC criteria can be viewed here; https://vinodkothari.com/2020/01/basel-iii-requirements-for-simple-transparent-and-comparable-stc-securitisation/

Refer our write-up on guidelines for transfer of loan exposures here- https://vinodkothari.com/2021/09/rbi-norms-on-transfer-of-loan-exposures/