Choppy landing for soft lending: Regulatory concerns on quality of lending

– Vinod Kothari, finserv@vinodkothari.com

Some of the RBI’s recent stringent actions, with stop-business directions, raise an alarm amongst financial sector entities. Are these concerns limited to a particular type of lending, or can they lead to any general observations on the quality of lending? One shouldn’t be tunnel-visioned and believe that these regulatory objections are limited to specific types of collateral – gold lending, IPO funding or loans against share trading. In fact, underlying these concerns is a general philosophy – lenders must do a close introspection of their lending practices.

Lenders may have their own appetite for credit risk and may choose their asset classes and borrowers accordingly. For example, a fintech or BNPL lender knowingly takes a higher borrower risk than a lender giving a loan against a house or a car. These lenders perceive, quantify and price their risk based on their admitted risk policy. Even the credit underwriting models are unique to the NBFCs, based on the loan product offered, borrower type, repayment capacity, collateral quality etc.

However, the matter becomes quite different when apparent collateral is sitting with group entities, or where the end-use of lending defines some essential prudential principles of lending. It is hard to generalise and set principles; as lending prudence cannot be bound in definitive principles. But we may at least cite some examples.

1. First case is lending against requisite equity infusion. Equity infusion is required either as a regulatory requirement, or as a prudential requirement. For example, NBFCs need a minimum NoF of Rs 10 crores, or CAR whichever is higher. AIFs need a sponsor contribution of at least 2.5%. General prudential requirement for a lender is to insist on equity based on a maximum debt equity ratio.

Each of these are based on the principle of minimum skin-in-the-game for the operator. For example, a lender agrees to provide a funding of Rs 500 crores, if the investor brings equity of Rs 200 crores.

Now the investor sets up a company, with an equity of, say Rs 50 crores, and raises a debt of Rs 150 crores in that upstream entity. That money is lent by helpful lenders as the so-called “general corporate purposes” loan. Having thus raised debt of Rs 150 crores, the investor puts in equity of Rs 200 crores into the downstream entity, and then raises a debt of Rs 500 crores. Now what is the debt equity ratio? As you may imagine, the equity of Rs 200 crores that went into the downstream entity has a debt component of Rs 150 crores. Therefore, a total asset base of Rs 700 crores has been created with a net equity of Rs 50 crores, implying a leverage of 14 times. Leverage, built upon equity, which itself is leveraged, resulting into multiple layers of leverage.^[1]

The most glaring examples of this phenomenon were to be seen during the GFC, but everyone in the banking world is well aware that it is quite common for lenders to give debt, where they know clearly that the debt will be bundled and invested as equity into a downstream entity.

2. The case of margin requirement for margin trading is quite similar. A trader, doing margin trade with a stock broker is required to put in a stipulated margin -which is based on VAR and ELM. Assuming that the margin requirement at 20% is Rs 1 crore, the trader can do a trade of Rs 5 crores, on the strength of the margin of Rs 1 crore. But how if the margin itself is funded by another entity? Whether that margin requirement is funded by a group NBFC or any other NBFC, the position remains the same  – because the margin was the skin-in-the-game looking at the volatility of the stock. If the margin itself is based on external borrowing, the whole prudential and regulatory purpose of the margin is lost.

3.Let us come to a third case – funding to effectively increase the LTV ratio. This may happen in case of gold loans as well as home loans. Gold lending has become extremely competitive, as gold prices have continued to shore up. Hence, the only scope for high cost lenders to compete is on the LTV ratio. There is a regulatory limit to the LTV – it cannot exceed 75% of the principal outstanding in case of NBFCs. However, a lender may effectively try to transgress that by giving an unsecured loan to the borrower who simultaneously takes a gold loan as well. While, on one hand, this is outright breach of the regulation in spirit, lenders need to understand – would they be able to hold the gold as collateral if the borrower has defaulted on the unsecured loan? The creation of a cross default in this case would clearly highlight the breach of LTV requirements.

4.Same thing quite often happens in case of home loans too. There may be cases of an entity giving a loan for funding down payment.

5.Let us now come to the case of shared collateral where the collateral or transactions sit with group entities. The case of share trading accounts with POA for operating the demat accounts of clients has already been flagged by the RBI. But I will talk of something else. Assume a captive NBFC gives funding to a vendor who has trade transactions with a group entity. The credit comfort for the NBFC is the trading relation that the borrower has with the group entity. But if the loan with the NBFC goes bad, will the trading entity have any right to stop payments for whatever transactions it has with the borrower? The answer will be yes, if the borrower has created a charge on any of the amounts receivable from the group entity, but not otherwise.

6.Lenders should also take care of the caption or product description put on a loan. The description is not just a name – it results into regulatory risk weights, and also gives indication of the end use of the money. For example, lenders use a product description such as “personal loan” or “working capital loan”.  Personal loan is mostly relevant for personal expenses. Generally, personal loans are small. A loan which is admittedly to be used for business purposes cannot be called personal loans. The size of the loan also may defy the description. Similarly, use of the caption “working capital loan” should be relevant for loans given to commercial entities for build up of working capital. It is not appropriate to give a working capital loan to a borrower who has no GSTIN or history of commercial transactions, because then, evidently, the end use of the loan couldn’t have been working capital.

7.Monitoring of end use is a basic part of lending prudence, except for small value loans given for expenditure.

8.Ever-greening with the help of group entities by letting the group company take a fresh exposure and repaying the defaulting loan. This concern has already triggered a ban on regulated entities taking exposure in AIFs, but surely AIFs are not the only device for funding

^[1] It may be noted that to prevent the multiple levels of leverage, there are regulatory restrictions on the number of CICs in a group, limited to two

Other Resources:

1. Lending without risk and risk without lending:
2. FAQs on Digital Lending Regulations