Has the cover fallen off Covered Bonds?

– Anita Baid, anita@vinodkothari.com

Recent activity in the Covered Bonds space

• The Covered Bond issuance have been surging in the Indian market since 2019
• FY 2019 witnessed the first instance of covered bonds, which was backed by vehicle loan
• Issuance of covered bonds witnessed a sharp growth in FY 2021, as the numbers increased to INR 22 Bn, as against INR 4 Bn in FY 2020^[1]
• However, certain media reports suggest that the recent RBI regulations on transfer of loan exposures have killed the market for Covered Bonds^[2]

What are Covered Bonds?

• Covered bonds are debt securities issued by financial institution and backed by separate group of assets, thereby providing dual recourse to the investors^[3]
• Dual recourse would mean that the investor shall have two recourses in case of default – first, on the issuer, and second, on the bankruptcy protected cover pool

Are Indian Covered Bonds same as global Covered Bond structures?

• Globally, it has been a 250 years old instrument which has no history of default
• Covered bond transactions in several countries follow what is known as ‘contractual transfer’ of ‘structured covered bond’ mechanism, as opposed to legislative structure^[4]
• However, there are more of legislative structures in existence
• The critical difference would be that the global covered bonds market is mostly prevalent for refinancing of long term assets like residential mortgages, ships, sovereign debt whereas, in India, covered bonds have been issued only against short term to medium term assets like gold loans, MFI loan, personal loans, etc.^[5]
• Also, global covered bonds are assisted by specific legislation or recognition, however, there is no legislation or regulatory framework on covered bonds in India ^[6]

Structure of Covered Bonds in India

• The market is following a structure involving a sale of loans to an SPV, which, in turn, guarantees the repayment of the bonds, in the event of bankruptcy of stated events of default of the issuer
• There are two major variants – (a) where there is an upfront sale of the cover pool to the SPV, and (b) where there is a conditional sale of the cover pool to the SPV
• In any event, the c overed bond transaction should not involve a ‘true sale’ of the cover pool from the first day, as the intent is not to do a true sale, but a legal sale
• Transfer of economic interest is neither required, nor desirable, in case of a covered bond transaction
• Since the repayment of the bonds is done by the issuer, and from out of the issuer’s own treasury rather than from the cover pool cashflows, there is no question of transfer of the pool cashflows to the SPV
• The transfer is more for the purpose of ring- fencing of the cashflows, rather than economic transfer

Covered Bonds in India- desirable or not?

• Surely, they are desirable
• Europe has also been thinking of a covered bond structure with dual recourse, to assist SME funding, for example European Secured Notes^[7]
• Most of these instruments are either at the backing of a specific legislation or at least regulatory recognition
• In absence of a regulatory framework, it is not possible to think of safe harbour when it comes to bankruptcy remoteness
• Evidently the sale of cover pool is not like a ‘true sale’ that happens in a securitisation transaction – therefore, the question is how will the investors have a bankruptcy protected right or dual recourse on the assets
• Though the rights of the investors can be enforced contractually and with the help of Section ** of IBC, however, the market thrives on any kind of legal or regulatory recognition of the subject. Hence, some recognition or legislation will do a world of good.

Any action taken for having a legislative framework in India

• Recommendations have been given in the past as well^[8]

Have the TLE Directions killed the market?

• TLE Directions state that no lender shall undertake any loan transfers or acquisitions other than those permitted and prescribed
• Accordingly, the loans cannot be transferred to anyone, other than the transferee mentioned therein, hence, this would now prohibit any loan transfers that happened outside the purview of the Directions
• The term ‘transfer’ has been defined to mean a transfer of economic interest in loan exposures by the transferor to the transferee(s), with or without the transfer of the underlying loan contract, in the manner permitted in the Directions^[9]
• Covered bonds involve sale of loan pools, and have not been specifically permitted by the RBI as well. Hence, On an apparent reading one might conclude that this would restrict covered bonds transactions.
• However, on a closer reading, one must understand that the provisions of TLE Directions shall apply if there is a transfer of economic interest in the loans. If the transfer does not result in transfer of economic interest, the same shall not be considered as a ‘transfer’ per se. In the context of covered bonds, only the legal title is transferred and the economic interest is retained by the originator, as the covered bonds are serviced from the issuers’ treasury.
• Hence, covered bonds transactions that are structured in a way that the legal title is transferred, however, the economic interest is retained by the originator, the same shall not be considered as ‘loan transfer’
• Idea is not to shift the collateral pool but to make it available when the issuer starts showing signs of stress.
• The transfer of economic interest on the loans happens at a later stage, when the trigger events happen; and is more in the nature of an enforcement of security action.
• Therefore, going forward, if the covered bonds are structured in a manner which allows retention of economic interest with the issuer, the same shall not violate the provisions of the TLE Directions.

[1] Refer to our article discussing the rise in CB issuances – https://vinodkothari.com/2021/07/covered-bonds-the-story-of-the-indianised-version-of-a-global-instrument/

[2] https://www.livemint.com/market/stock-market-news/new-rbi-rules-may-have-killed-india-s-nascent-covered-bonds-market-11633618253692.html

[3] Refer our article on Covered Bonds- https://www.vinodkothari.com/wp-content/uploads/covered-bonds-article-by-vinod-kothari.pdf

[4] A video session on the concept of Covered Bonds- https://www.youtube.com/watch?v=XyoPcuzbys4

[5] Refer to our article on Covered Bonds and Covid disruptions- https://vinodkothari.com/2020/06/covered-bonds-and-the-covid-disruption/

[6] An Introduction to Covered Bonds by Vinod Kothari can be read here- https://vinodkothari.com/wp-content/uploads/Introduction-to-Covered-Bonds-by-Vinod-Kothari.pdf

[7] Read our articles on the same here- https://vinodkothari.com/2021/08/use-of-dual-recourse-instruments-for-sme-finance-the-making-of-european-secured-notes/

[8] A working group was constituted by the National Housing Bank to promote RMBS and Covered Bonds, the report of the working group can be viewed here: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf

[9] Refer to our detailed FAQs on TLE Directions- https://vinodkothari.com/2021/10/37064/