Law relating to collective investment schemes on shared ownership of real assets

-Vinod Kothari (finserv@vinodkothari.com)

The law relating to collective investment schemes has always been, and perhaps will remain, enigmatic, because these provisions were designed to ensure that enthusiastic operators do not source investors’ money with tall promises of profits or returns, and start running what is loosely referred to as Ponzi schemes of various shades. De facto collective investment schemes or schemes for raising money from investors may be run in elusive forms as well – as multi-level marketing schemes, schemes for shared ownership of property or resources, or in form of cancellable contracts for purchase of goods or services on a future date.

While regulations will always need to chase clever financial fraudsters, who are always a day ahead of the regulator, this article is focused on schemes of shared ownership of properties. Shared economy is the cult of the day; from houses to cars to other indivisible resources, the internet economy is making it possible for users to focus on experience and use rather than ownership and pride of possession. Our colleagues have written on the schemes for shared property ownership[1]. Our colleagues have also written about the law of collective investment schemes in relation to real estate financing[2]. Also, this author, along with a colleague, has written how the confusion among regulators continues to put investors in such schemes to prejudice and allows operators to make a fast buck[3].

This article focuses on the shared property devices and the sweep of the law relating to collective investment schemes in relation thereto.

Basis of the law relating to collective investment schemes

The legislative basis for collective investment scheme regulations is sec. 11AA (2) of the SEBI Act. The said section provides:

Any scheme or arrangement made or offered by any company under which,

  • the contributions, or payments made by the investors, by whatever name called, are pooled and utilized solely for the purposes of the scheme or arrangement;
  • the contributions or payments are made to such scheme or arrangement by the investors with a view to receive profits, income, produce or property, whether movable or immovable from such scheme or arrangement;
  • the property, contribution or investment forming part of scheme or arrangement, whether identifiable or not, is managed on behalf of the investors;
  • the investors do not have day to day control over the management and operation of the scheme or arrangement.

The major features of a CIS may be visible from the definition. These are:

  1. A schematic for the operator to collect investors’ money: There must be a scheme or an arrangement. A scheme implies a well-structured arrangement whereby money is collected under the scheme. Usually, every such scheme provides for the entry as well as exit, and the scheme typically offers some rate of return or profit. Whether the profit is guaranteed or not, does not matter, at least looking at the definition. Since there is a scheme, there must be some operator of the scheme, and there must be some persons who put in their money into the scheme. These are called “investors”.
  2. Pooling of contributions: The next important part of a CIS is the pooling of contributions. Pooling implies the contributions losing their individuality and becoming part of a single fungible hotchpot. If each investor’s money, and the investments therefrom, are identifiable and severable, there is no pooling. The whole stance of CIS is collective investment. If the investment is severable, then the scheme is no more a collective scheme.
  3. Intent of receiving profits, produce, income or property: The intent of the investors contributing money is to receive results of the collective investment. The results may be in form of profits, produce, income or property. The usual feature of CIS is the operator tempting investors with guaranteed rate of return; however, that is not an essential feature of CISs.
  4. Separation of management and investment: The management of the money is in the hands of a person, say, investment manager. If the investors manage their own investments, there is no question of a CIS. Typically, investor is someone who becomes a passive investor and does not have first level control (see next bullet). It does not matter whether the so-called manager is an investor himself, or may be the operator of the scheme as well. However, the essential feature is there being multiple “investors”, and one or some “manager”.
  5. Investors not having regular control over the investments: As discussed above, the hiving off of the ownership and management of funds is the very genesis of the regulatory concern in a CIS, and therefore, that is a key feature.

The definition may be compared with section 235 of the UK Financial Services and Markets Act, which provides as follows:

  • In this Part “collective investment scheme” means any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.
  • The arrangements must be such that the persons who are to participate (“participants”) do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions.
  • The arrangements must also have either or both of the following characteristics—
  • the contributions of the participants and the profits or income out of which payments are to be made to them are pooled;
  • the property is managed as a whole by or on behalf of the operator of the scheme.
    • If arrangements provide for such pooling as is mentioned in subsection (3)(a) in relation to separate parts of the property, the arrangements are not to be regarded as constituting a single collective investment scheme unless the participants are entitled to exchange rights in one part for rights in another.

It is conspicuous that all the features of the definition in the Indian law are present in the UK law as well.

Hong Kong Securities and Futures Ordinance [Schedule 1] defines a collective investment scheme as follows:

collective investment scheme means—

  • arrangements in respect of any property—
  • under which the participating persons do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions in respect of such management;
  • under which—
  • the property is managed as a whole by or on behalf of the person operating the arrangements;
  • the contributions of the participating persons and the profits or income from which payments are made to them are pooled; or
  • the property is managed as a whole by or on behalf of the person operating the arrangements, and the contributions of the participating persons and the profits or income from which payments are made to them are pooled; and
  • the purpose or effect, or pretended purpose or effect, of which is to enable the participating persons, whether by acquiring any right, interest, title or benefit in the property or any part of the property or otherwise, to participate in or receive—
  • profits, income or other returns represented to arise or to be likely to arise from the acquisition, holding, management or disposal of the property or any part of the property, or sums represented to be paid or to be likely to be paid out of any such profits, income or other returns; or
  • a payment or other returns arising from the acquisition, holding or disposal of, the exercise of any right in, the redemption of, or the expiry of, any right, interest, title or benefit in the property or any part of the property; or
  • arrangements which are arrangements, or are of a class or description of arrangements, prescribed by notice under section 393 of this Ordinance as being regarded as collective investment schemes in accordance with the terms of the notice.

One may notice that this definition as well has substantially the same features as the definition in the UK law.

Judicial analysis of the definition

Part (iii) of the definition in Indian law refers to management of the contribution, property or investment on behalf of the investors, and part (iv) lays down that the investors do not have day to day control over the operation or management. The same features, in UK law, are stated in sec. 235 (2) and (3), emphasizing on the management of the contributions as a whole, on behalf of the investors, and investors not doing individual management of their own money or property. The question has been discussed in multiple UK rulings. In Financial Conduct Authority vs Capital Alternatives and others,  [2015] EWCA Civ 284, [2015] 2 BCLC 502[4], UK Court of Appeal, on the issue whether any extent of individual management by investors will take the scheme of the definition of CIS, held as follows:  “The phrase “the property is managed as a whole” uses words of ordinary language. I do not regard it as appropriate to attach to the words some form of exclusionary test based on whether the elements of individual management were “substantial” – an adjective of some elasticity. The critical question is whether a characteristic feature of the arrangements under the scheme is that the property to which those arrangements relate is managed as a whole. Whether that condition is satisfied requires an overall assessment and evaluation of the relevant facts. For that purpose it is necessary to identify (i) what is “the property”, and (ii) what is the management thereof which is directed towards achieving the contemplated income or profit. It is not necessary that there should be no individual management activity – only that the nature of the scheme is that, in essence, the property is managed as a whole, to which question the amount of individual management of the property will plainly be relevant”.

UK Supreme Court considered a common collective land-related venture, viz., land bank structure, in Asset Land Investment Plc vs Financial Conduct Authority, [2016] UKSC 17[5]. Once again, on the issue of whether the property is collective managed, or managed by respective investors, the following paras from UK Financial Conduct Authority were cited with approval:

The purpose of the ‘day-to-day control’ test is to try to draw an important distinction about the nature of the investment that each investor is making. If the substance is that each investor is investing in a property whose management will be under his control, the arrangements should not be regarded as a collective investment scheme. On the other hand, if the substance is that each investor is getting rights under a scheme that provides for someone else to manage the property, the arrangements would be regarded as a collective investment scheme.

Day-to-day control is not defined and so must be given its ordinary meaning. In our view, this means you have the power, from day-to-day, to decide how the property is managed. You can delegate actual management so long as you still have day-to-day control over it.[6]

The distancing of control over a real asset, even though owned by the investor, may put him in the position of a financial investor. This is a classic test used by US courts, in a test called Howey Test, coming from a 1946 ruling in SEC vs. Howey[7]. If an investment opportunity is open to many people, and if investors have little to no control or management of investment money or assets, then that investment is probably a security. If, on the other hand, an investment is made available only to a few close friends or associates, and if these investors have significant influence over how the investment is managed, then it is probably not a security.

The financial world and the real world

As is apparent, the definition in sec. 235 of the UK legislation has inspired the draft of the Indian law. It is intriguing to seek as to how the collective ownership or management of real properties has come within the sweep of the law. Evidently, CIS regulation is a part of regulation of financial services, whereas collective ownership or management of real assets is a part of the real world. There are myriad situations in real life where collective business pursuits,  or collective ownership or management of properties is done. A condominium is one of the commonest examples of shared residential space and services. People join together to own land, or build houses. In the good old traditional world, one would have expected people to come together based on some sort of “relationship” – families, friends, communities, joint venturers, or so on. In the interweb world, these relationships may be between people who are invisibly connected by technology. So the issue, why would a collective ownership or management of real assets be regarded as a financial instrument, to attract what is admittedly a  piece of financial law.

The origins of this lie in a 1984 Report[8] and a 1985 White Paper[9], by Prof LCB Gower, which eventually led to the enactment of the 1986 UK Financial Markets law. Gower has discussed the background as to why contracts for real assets may, in certain circumstances, be regarded as financial contracts. According to Gower, all forms of investment should be regulated “other than those in physical objects over which the investor will have exclusive control. That is to say, if there was investment in physical objects over which the investor had no exclusive control, it would be in the nature of an investment, and hence, ought to be regulated. However, the basis of regulating investment in real assets is the resemblance the same has with a financial instrument, as noted by UK Supreme Court in the Asset Land ruling: “..the draftsman resolved to deal with the regulation of collective investment schemes comprising physical assets as part of the broader system of statutory regulation governing unit trusts and open-ended investment companies, which they largely resembled.”

The wide sweep of the regulatory definition is obviously intended so as not to leave gaps open for hucksters to make the most. However, as the UK Supreme Court in Asset Land remarked: “The consequences of operating a collective investment scheme without authority are sufficiently grave to warrant a cautious approach to the construction of the extraordinarily vague concepts deployed in section 235.”

The intent of CIS regulation is to capture such real property ownership devices which are the functional equivalents of alternative investment funds or mutual funds. In essence, the scheme should be operating as a pooling of money, rather than pooling of physical assets. The following remarks in UK Asset Land ruling aptly capture the intent of CIS regulation: “The fundamental distinction which underlies the whole of section 235 is between (i) cases where the investor retains entire control of the property and simply employs the services of an investment professional (who may or may not be the person from whom he acquired it) to enhance value; and (ii) cases where he and other investors surrender control over their property to the operator of a scheme so that it can be either pooled or managed in common, in return for a share of the profits generated by the collective fund.”

Conclusion

While the intent and purport of CIS regulation world over is quite clear, but the provisions  have been described as “extraordinarily vague”. In the shared economy, there are numerous examples of ownership of property being given up for the right of enjoyment. As long as the intent is to enjoy the usufructs of a real property, there is evidently a pooling of resources, but the pooling is not to generate financial returns, but real returns. If the intent is not to create a functional equivalent of an investment fund, normally lure of a financial rate of return, the transaction should not be construed as a collective investment scheme.

 

[1] Vishes Kothari: Property Share Business Models in India, http://vinodkothari.com/blog/property-share-business-models-in-india/

[2] Nidhi Jain, Collective Investment Schemes for Real Estate Investments in India, at http://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/

[3] Vinod Kothari and Nidhi Jain article at: https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html

[4] http://www.bailii.org/ew/cases/EWCA/Civ/2015/284.html

[5] https://www.supremecourt.uk/cases/docs/uksc-2014-0150-judgment.pdf

[6] https://www.handbook.fca.org.uk/handbook/PERG/11/2.html

[7] 328 U.S. 293 (1946), at https://supreme.justia.com/cases/federal/us/328/293/

[8] Review of Investor Protection, Part I, Cmnd 9215 (1984)

[9] Financial Services in the United Kingdom: A New Framework for Investor Protection (Cmnd 9432) 1985

 

Our Other Related Articles

Property Share Business Models in India,< http://vinodkothari.com/blog/property-share-business-models-in-india/>

Collective Investments Schemes: How gullible investors continue to lose money < https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html>

Collective Investment Schemes for Real Estate Investments in India, < http://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/>

 

Digital Consumer Lending: Need for prudential measures and addressing consumer protection

-Siddarth Goel (finserv@vinodkothari.com)

Introduction

“If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck”

The above phrase is the popular duck test which implies abductive reasoning to identify an unknown subject by observing its habitual characteristics. The idea of using this duck test phraseology is to determine the role and function performed by the digital lending platforms in consumer credit.

Recently the Reserve Bank of India (RBI) has constituted a working group to study how to make access to financial products and services more fair, efficient, and inclusive.[1]  With many news instances lately surrounding the series of unfortunate events on charging of usurious interest rate by certain online lenders and misery surrounding the threats and public shaming of some of the borrowers by these lenders. The RBI issued a caution statement through its press release dated December 23, 2020, against unauthorised digital lending platforms/mobile applications. The RBI reiterated that the legitimate public lending activities can be undertaken by Banks, Non-Banking Financial Companies (NBFCs) registered with RBI, and other entities who are regulated by the State Governments under statutory provisions, such as the money lending acts of the concerned states. The circular further mandates disclosure of banks/NBFCs upfront by the digital lender to customers upfront.

There is no denying the fact that these digital lending platforms have benefits over traditional banks in form of lower transaction costs and credit integration of the unbanked or people not having any recourse to traditional bank lending. Further, there are some self-regulatory initiatives from the digital lending industry itself.[2] However, there is a regulatory tradeoff in the lender’s interest and over-regulation to protect consumers when dealing with large digital lending service providers. A recent judgment by the Bombay High Court ruled that:

“The demand of outstanding loan amount from the person who was in default in payment of loan amount, during the course of employment as a duty, at any stretch of imagination cannot be said to be any intention to aid or to instigate or to abet the deceased to commit the suicide,”[3]

This pronouncement of the court is not under criticism here and is right in its all sense given the facts of the case being dealt with. The fact there needs to be a recovery process in place and fair terms to be followed by banks/NBFCs and especially by the digital lending platforms while dealing with customers. There is a need to achieve a middle ground on prudential regulation of these digital lending platforms and addressing consumer protection issues emanating from such online lending. The regulator’s job is not only to oversee the prudential regulation of the financial products and services being offered to the consumers but has to protect the interest of customers attached to such products and services. It is argued through this paper that there is a need to put in place a better governing system for digital lending platforms to address the systemic as well as consumer protection concerns. Therefore, the onus of consumer protection is on the regulator (RBI) since the current legislative framework or guidelines do not provide adequate consumer protection, especially in digital consumer credit lending.

Global Regulatory Approaches

US

The Office of the Comptroller of the Currency (OCC) has laid a Special Purpose National Bank (SPNV) charters for fintech companies.[4] The OCC charter begins reviewing applications, whereby SPNV are held to the same rigorous standards of safety and soundness, fair access, and fair treatment of customers that apply to all national banks and federal savings associations.

The SPNV that engages in federal consumer financial law, i.e. in provides ‘financial products and services to the consumer’ is regulated by the ‘Consumer Financial Protection Bureau (CFPB)’. The other factors involved in application assessment are business plans that should articulate a clear path and timeline to profitability. While the applicant should have adequate capital and liquidity to support the projected volume. Other relevant considerations considered by OCC are organizers and management with appropriate skills and experience.

The key element of a business plan is the proposed applicant’s risk management framework i.e. the ability of the applicant to identify, measure, monitor, and control risks. The business plan should also describe the bank’s proposed internal system of controls to monitor and mitigate risk, including management information systems. There is a need to provide a risk assessment with the business plan. A realistic understanding of risk and there should be management’s assessment of all risks inherent in the proposed business model needs to be shown.

The charter guides that the ongoing capital levels of the applicant should commensurate with risk and complexity as proposed in the activity. There is minimum leverage that an SPNV can undertake and regulatory capital is required for measuring capital levels relative to the applicant’s assets and off-balance sheet exposures.

The scope and purpose of CFPB are very broad and covers:

“scope of coverage” set forth in subsection (a) includes specified activities (e.g., offering or providing: origination, brokerage, or servicing of consumer mortgage loans; payday loans; or private education loans) as well as a means for the CFPB to expand the coverage through specified actions (e.g., a rulemaking to designate “larger market participants”).[5]

CFPB is established through the enactment of Dood-Frank Wall Street Reform and Consumer Protection Act. The primary function of CFPB is to enforce consumer protection laws and supervise regulated entities that provide consumer financial products and services.

“(5)CONSUMER FINANCIAL PRODUCT OR SERVICES  The term “consumer financial product or service” means any financial product or service that is described in one or more categories under—paragraph (15) and is offered or provided for use by consumers primarily for personal, family, or household purposes; or **

“(15)Financial product or service-

(A)In general The term “financial product or service” means—(i)extending credit and servicing loans, including acquiring, purchasing, selling, brokering, or other extensions of credit (other than solely extending commercial credit to a person who originates consumer credit transactions);”

Thus CFPB is well placed as a separate institution to protect consumer interest and covers a wide range of financial products and services including extending credit, servicing, selling, brokering, and others. The regulatory environment has been put in place by the OCC to check the viability of fintech business models and there are adequate consumer protection laws.

EU

EU’s technologically neutral regulatory and supervisory systems intend to capture not only traditional financial services but also innovative business models. The current dealing with the credit agreements is EU directive 2008/48/EC of on credit agreements for consumers (Consumer Credit Directive – ‘Directive’). While the process of harmonising the legislative framework is under process as the report of the commission to the EU parliament raised some serious concerns.[6] The commission report identified that the directive has been partially effective in ensuring high standards of consumer protection. Despite the directive focussing on disclosure of annual percentage rate of charge to the customers, early payment, and credit databases. The report cited that the primary reason for the directive being impractical is because of the exclusion of the consumer credit market from the scope of the directive.

The report recognised the increase and future of consumer credit through digitisation. Further the rigid prescriptions of formats for information disclosure which is viable in pre-contractual stages, i.e. where a contract is to be subsequently entered in a paper format. There is no consumer benefit in an increasingly digital environment, especially in situations where consumers prefer a fast and smooth credit-granting process. The report highlighted the need to review certain provisions of the directive, particularly on the scope and the credit-granting process (including the pre-contractual information and creditworthiness assessment).

China

China has one of the biggest markets for online mico-lending business. The unique partnership of banks and online lending platforms using innovative technologies has been the prime reason for the surge in the market. However, recently the People’s Bank of China (PBOC) and China Banking and Insurance Regulatory Commission (CBIRC) issued draft rules to regulate online mico-lending business. Under the draft rules, there is a requirement for online underwriting consumer loans fintech platform to have a minimum fund contribution of at least 30 % in a loan originated for banks. Further mico-lenders sourcing customer data from e-commerce have to share information with the central bank.

Australia

The main legislation that governs the consumer credit industry is the National Consumer Credit Protection Act (“National Credit Act”) and the National Credit Code. Australian Securities & Investments Commission (ASIC) is Australia’s integrated authority for corporate, markets, financial services, and consumer credit regulator. ASIC is a consumer credit regulator that administers the National Credit Act and regulates businesses engaging in consumer credit activities including banks, credit unions, finance companies, along with others. The ASIC has issued guidelines to obtain licensing for credit activities such as money lenders and financial intermediaries.[7] Credit licensing is needed for three sorts of entities.

  • engage in credit activities as a credit provider or lessor
  • engage in credit activities other than as a credit provider or lessor (e.g. as a credit representative or broker)
  • engage in all credit activities

The applicants of credit licensing are obligated to have adequate financial resources and have to ensure compliance with other supervisory arrangements to engage in credit activates.

UK

Financial Conduct Authority (FCA) is the regulator for consumer credit firms in the UK. The primary objective of FCA ensues; a secure and appropriate degree of protection for consumers, protect and enhance the integrity of the UK financial system, promote effective competition in the interest of consumers.[8] The consumer credit firms have to obtain authorisation from FCA before carrying on consumer credit activities. The consumer credit activities include a plethora of credit functions including entering into a credit agreement as a lender, credit broking, debt adjusting, debt collection, debt counselling, credit information companies, debt administration, providing credit references, and others. FCA has been successful in laying down detailed rules for the price cap on high-cost short-term credit.[9] The price total cost cap on high-cost short-term credit (HCSTC loans) including payday loans, the borrowers must never have to pay more in fees and interest than 100% of what they borrowed. Further, there are rules on credit broking that provides brokers from charging fees to customers or requesting payment details unless authorised by FCA.[10] The fee charged from customers is to be reported quarterly and all brokers (including online credit broking) need to make clear that they are advertising as a credit broker and not a lender. There are no fixed capital requirements for the credit firms, however, adequate financial resources need to be maintained and there is a need to have a business plan all the time for authorisation purposes.

Digital lending models and concerns in India

Countries across the globe have taken different approaches to regulate consumer lending and digital lending platforms. They have addressed prudential regulation concerns of these credit institutions along with consumer protection being the top priority under their respective framework and legislations. However, these lending platforms need to be looked at through the current governing regulatory framework from an Indian perspective.

The typical credit intermediation could be performed by way of; peer to peer (P2P) lending model, notary model (bank-based) guaranteed return model, balance sheet model, and others. P2P lending platforms are heavily regulated and hence are not of primary concern herein. Online digital lending platforms engaged in consumer lending are of significance as they affect investor’s and borrowers’ interests and series of legal complexions arise owing to their agency lending models.[11] Therefore careful anatomy of these models is important for investors and consumer protection in India.

Should digital lending be regulated?

Under the current system, only banks, NBFCs, and money lenders can undertake lending activities. The regulated banks and NBFCs also undertake online consumer lending either through their website/platforms or through third-party lending platforms. These unregulated third-party digital lending platforms count on their sophisticated credit underwriting analytics software and engage in consumer lending services. Under the simplest version of the bank-based lending model, the fintech lending platform offers loan matching services but the loan is originated in books of a partnering bank or NBFC. Thus the platform serves as an agent that brings lenders (Financial institutions) and borrowers (customers) together. Therefore RBI has mandated fintech platforms has to abide by certain roles and responsibilities of Direct Selling Agent (DSA) as under Fair Practice Code ‘FPC’ and partner banks/NBFCs have to ensure Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Service (‘outsourcing code’).[12] In the simplest of bank-based models, the banks bear the credit risk of the borrowers and the platform earns their revenues by way of fees and service charges on the transaction. Since banks and NBFCs are prudentially regulated and have to comply with Basel capital norms, there are not real systemic concerns.

However, the situation alters materially when such a third-party lending platform adopts balance sheet lending or guaranteed return models. In the former, the servicer platform retains part of the credit risk on its book and could also give some sort of loss support in form of a guarantee to its originating partner NBFC or bank.[13] While in the latter case it a pure guarantee where the third-party lending platform contractually promises returns on funds lent through their platforms. There is a devil in detailed scrutiny of these business models. We have earlier highlighted the regulatory issues in detail around fintech practices and app-based lending in our write up titled ‘Lender’s piggybacking: NBFCs lending on Fintech platforms’ gurantees’.

From the prudential regulation perspective in hindsight, banks, and NBFCs originating through these third-party lending platforms are not aware of the overall exposure of the platforms to the banking system. Hence there is a presence of counterparty default risk of the platform itself from the perspective of originating banks and NBFCs. In a real sense, there is a kind of tri-party arrangement where funds flow from ‘originator’ (regulated bank/NBFC) to the ‘platform’ (digital service provider) and ultimately to the ‘borrower'(Customer). The unregulated platform assumes the credit risk of the borrower, and the originating bank (or NBFC) assumes the risk of the unregulated lending platform.

Curbing unregulated lending

In the balance sheet and guaranteed return models, an undercapitalized entity takes credit risk. In the balance sheet model, the lending platform is directly taking the credit risk and may or may not have to get itself registered as NBFC with RBI. The registration requirement as an NBFC emanates if the financial assets and financial income of the platform is more than 50 % of its total asset and income of such business (‘principal business criteria’ see footnote 12). While in the guaranteed return model there is a form of synthetic lending and there is absolutely no legal requirement for the lending platform to get themselves registered as NBFC. The online lending platform in the guaranteed return model serves as a loan facilitator from origination to credit absorption. There is a regulatory arbitrage in this activity. Since technically this activity is not covered under the “financial activity” and the spread earned in not “financial income” therefore there is no requirement for these entities to get registered as NBFCs.[14]

Any sort of guarantee or loss support provided by the third-party lending platform to its partner bank/NBFC is a synthetic exposure. In synthetic lending, the digital lending platform is taking a risk on the underlying borrower without actually taking direct credit risk. Additionally, there are financial reporting issues and conflict of interest or misalignment of incentives, i.e. the entities do not have to abide by IND AS and can show these guarantees as contingent liabilities. On the contrary, they charge heavy interest rates from customers to earn a higher spread. Hence synthetic lending provides all the incentives for these third-party lending platforms to enter into risky lending which leads to the generation of sub-prime assets. The originating banks and NBFCs have to abide by minimum capital requirements and other regulatory norms. Hence the sub-prime generation of consumer credit loans is supplemented by heavy returns offered to the banks. It is argued that the guaranteed returns function as a Credit Default Swap ‘CDS’ which is not regulated as CDS. Thus the online lending platform escapes the regulatory purview and it is shown in the latter part this leads to poor credit discipline in consumer lending and consumer protection is often put on the back burner.

From the prudential regulation perspective restricting banks/NBFCs from undertaking any sort of guaranteed return or loss support protection, can curb the underlying emergence of systemic risk from counterparty default. While a legal stipulation to the effect that NBFCs/Banks lending through the third-party unregulated platform, to strictly lend independently i.e. on a non-risk sharing basis of the credit risk. Counterintuitively, the unregulated online lending platforms have to seek registration as an NBFC if they want to have direct exposure to the underlying borrower, subject to fulfillment of ‘principal business criteria’.[15] Such a governing framework will reduce the incentives for banks and NBFCs to exploit excessive risk-taking through this regulatory arbitrage opportunity.

Ensuring Fairness and Consumer Protection

There are serious concerns of fair dealing and consumer protection aspects that have arisen lately from digital online lending platforms. The loans outsourced by Banks and NBFCs over digital lending platforms have to adhere to the FPC and Outsourcing code.

The fairness in a loan transaction calls for transparent disclosure to the borrower all information about fees/charges payable for processing the loan application, disbursed, pre-payment options and charges, the penalty for delayed repayments, and such other information at the time of disbursal of the loan. Such information should also be displayed on the website of the banks for all categories of loan products. It may be mentioned that levying such charges subsequently without disclosing the same to the borrower is an unfair practice.[16]

Such a legal requirement gives rise to the age-old question of consumer law, yet the most debatable aspect. That mere disclosure to the borrower of the loan terms in an agreement even though the customer did not understand the underlying obligations is a fair contract (?) It is argued that let alone the disclosures of obligations in digital lending transactions, customers are not even aware of their remedies. Under the current RBI regulatory framework, they have the remedy to approach grievance redressal authorities of the originating bank/NBFC or may approach the banking ombudsman. However, things become even more peculiar in cases where loans are being sourced or processed through third-party digital platforms. The customers in the majority of the cases are unaware of the fact that the ultimate originator of the loan is a bank/NBFC. The only remedy for such a customer is to seek refuge under the Consumer Protection Act 2019 by way of proving the loan agreement is the one as ‘unfair contract’.

“2(46) “unfair contract” means a contract between a manufacturer or trader or service provider on one hand, and a consumer on the other, having such terms which cause significant change in the rights of such consumer, including the following, namely:— (i) requiring manifestly excessive security deposits to be given by a consumer for the performance of contractual obligations; or (ii) imposing any penalty on the consumer, for the breach of contract thereof which is wholly disproportionate to the loss occurred due to such breach to the other party to the contract; or (iii) refusing to accept early repayment of debts on payment of applicable penalty; or (iv) entitling a party to the contract to terminate such contract unilaterally, without reasonable cause; or (v) permitting or has the effect of permitting one party to assign the contract to the detriment of the other party who is a consumer, without his consent; or (vi) imposing on the consumer any unreasonable charge, obligation or condition which puts such consumer to disadvantage;

It is pertinent to note that neither the scope of consumer financial agreements is regulated in India, nor are the third-party digital lending platforms required to obtain authorisation from RBI. There are instances of high-interest rates and exorbitant fees charged by the online consumer lending platforms which are unfair and detrimental to customers’ interests. The current legislative framework provides that the NBFCs shall furnish a copy of the loan agreement as understood by the borrower along with a copy of each of all enclosures quoted in the loan agreement to all the borrowers at the time of sanction/disbursement of loans.[17] However, like the persisting problem in the EU 2008/48/EC directive, even FPC is not well placed to govern digital lending agreements and disclosures. Taking a queue from the problems recognised by the EU parliamentary committee report. There is no consumer benefit in an increasingly digital environment, especially in situations where there are fast and smooth credit-granting processes. The pre-contractual information on the disclosure of annualised interest rate and capping of the total cost to a customer in consumer credit loans is central to consumer protection.

The UK legislation has been pro-active in addressing the underlying unfair contractual concerns, by fixation of maximum daily interest rates and maximum default fees with an overall cost cap of 100% that could be charged in short-term high-interest rates loan agreements. It is argued that in this Laissez-faire world the financial services business models which are based on imposing an unreasonable charge, obligations that could put consumers to disadvantage should anyways be curbed. Therefore a legal certainty in this regard would save vulnerable customers to seek the consumer court’s remedy in case of usurious and unfair lending.

The master circular on loan and advances provide for disclosure of the details of recovery agency firms/companies to the borrower by the originating bank/NBFC.[18] Further, there is a requirement for such recovery agent to disclose to the borrower about the antecedents of the bank/NBFC they are recovering for.  However, this condition is barely even followed or adhered to and the vulnerable consumers are exposed to all sorts of threats and forceful tactics. As one could appreciate in jurisdictions of the US, UK, Australia discussed above, consumer lending and ancillary services are under the purview of concerned regulators. From the customer protection perspective, at least some sort of authorization or registration requirement with the RBI to keep the check and balances system in place is important for consumer protection. The loan recovery business is sensitive hence there is a need for a proper guiding framework and/or registration requirement of the agents acting as recovery agents on behalf of banks/NBFCs. The mere registration requirement and revocation of same in case of unprofessional activities will serve as a stick to check their consumer dealing practices.

The financial services intermediaries (other than Banks/NBFCs) providing services like credit broking, debt adjusting, debt collection, debt counselling, credit information, debt administration, credit referencing to be licensed by the regulator. The banks/NBFCs dealing with the licensed market intermediaries would go much farther in the successful implementation of FPC and addressing consumer protection concerns from the current system.

Conclusion

From the perspective of sound financial markets and fair consumer practices, it is always prudent to allow only those entities in credit lending businesses that are best placed to bear the credit risk and losses emanating from them. Thus, there is a dearth of a comprehensive legislative framework in consumer lending from origination to debt collection and its administration including the business of providing credit references through digital lending platforms. There may not be a material foreseeable requirement for regulating digital lending platforms completely. However, there is a need to curb synthetic lending by third-party digital lending platforms. Since a risk-taking entity without adequate capitalization will tend to get into generating risky assets with high returns. The off-balance sheet guarantee commitments of these entities force them to be aggressive towards their customers to sustain their businesses. This write-up has explored various regulatory approaches, where jurisdictions like the US and UK, and Australia being the good comparable in addressing consumer protection concerns emanating from online digital lending platforms. Henceforth, a well-framed consumer protection system especially in financial products and services would go much farther in the development and integration of credit through digital lending platforms in the economy.

 

[1] Reserve Bank of India – Press Releases (rbi.org.in), dated January 13, 2020

[2] Digital lending Association of India, Code of Conduct available at https://www.dlai.in/dlai-code-of-conduct/

[3] Rohit Nalawade Vs. State of Maharashtra High Court of Bombay Criminal Application (APL) NO. 1052 OF 2018 < https://images.assettype.com/barandbench/2021-01/cf03e52e-fedd-4a34-baf6-25dbb55dbf29/Rohit_Nalawade_v__State_of_Maharashtra___Anr.pdf>

[4] https://www.occ.gov/topics/supervision-and-examination/responsible-innovation/comments/pub-special-purpose-nat-bank-charters-fintech.pdf

[5]  12 USC 5514(a); Pay day loans are the short term, high interest bearing loans that are generally due on the consumer’s next payday after the loan is taken.

[6] EU, ‘Report from the Commission to the European Parliament and the Council: on the implementation of Directive 2008/48/EC on credit agreement for consumers’, dated November, 05, 2020, available at < https://ec.europa.eu/transparency/regdoc/rep/1/2020/EN/COM-2020-963-F1-EN-MAIN-PART-1.PDF>

[7] https://asic.gov.au/for-finance-professionals/credit-licensees/applying-for-and-managing-your-credit-licence/faqs-getting-a-credit-licence/

[8] FCA guide to consumer credit firms, available at < https://www.fca.org.uk/publication/finalised-guidance/consumer-credit-being-regulated-guide.pdf>

[9] FCA, ‘Detailed rules for price cap on high-cost short-term credit’, available at < https://www.fca.org.uk/publication/policy/ps14-16.pdf>

[10] FCA, Credit Broking and fees, available at < https://www.fca.org.uk/publication/policy/ps14-18.pdf>

[11] Bank of International Settlements ‘FinTech Credit : Market structure, business models and financial stability implications’, 22 May 2017, FSB Report

[12] See our write up on ‘ Extension of FPC on lending through digital platforms’ , available at < http://vinodkothari.com/2020/06/extension-of-fpc-on-lending-through-digital-platforms/>

[13] Where the unregulated platform assumes the complete credit risk of the borrower there is no interlinkage with the partner bank and NBFC. The only issue that arises is from the registration requirement as NBFC which we have discussed in the next section. Also see our write up titled ‘Question of Definition: What Exactly is an NBFC’ available at http://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

[14] The qualifying criteria to register as an NBFC has been discussed in our write up titled ‘Question of Definition: What Exactly is an NBFC’ available at http://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

[15] see our write up titled ‘Question of Definition: What Exactly is an NBFC’ available at http://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

[16] Para 2.5.2, RBI Guidelines on Fair Practices Code for Lender

[17] Para 29 of the guidelines on Fair Practices Code, Master Direction on systemically/non-systemically important NBFCs.

[18] Para 2.6, Master Circular on ‘Loans and Advances – Statutory and Other Restrictions’ dated July 01, 2015;

 

Our Other Related Write-Ups

Lenders’ piggybacking: NBFCs lending on Fintech platforms’ guarantees – Vinod Kothari Consultants

Extension of FPC on lending through digital platforms – Vinod Kothari Consultants

Fintech Framework: Regulatory responses to financial innovation – Vinod Kothari Consultants

One-stop guide for all Regulatory Sandbox Frameworks – Vinod Kothari Consultants

 

Banking exposure to open the current account by the banks

-Siddarth Goel (finserv@vinodkothari.com)

Background

Declaration from current account customers

The RBI issued a circular dated August 06, 2020, whereby the regulator instructed all scheduled commercial banks and payments banks shall not open a current account for customers who have availed credit facilities in form of cash credit (CC)/overdraft (OD) from the banking system. The motive behind the circular being that all the transactions of borrowers should be routed through the CC/OD account.

The genesis of this circular was in RBI circular dated May 15, 2004, where banks were advised that at the time of opening of current accounts for their customers, they have to insist on a declaration form by the account-holder to the effect that he is not enjoying any credit facility with any other bank or obtain a declaration giving particulars of credit facilities enjoyed by such customer. The move was in essence to secure the overall credit discipline in banking so that there is no diversion of funds by the borrowers to the detriment of the banking system. Post-May 15, 2004, a clarification notification was issued by the regulator dated August 04, 2004, stipulating that in case there is no response obtained concerning NOC after waiting a minimum period of a fortnight, the banks may open current accounts of the customers.

Thus there was an obligation on banks to scrupulously ensure that their branches do not open current accounts of entities that enjoy credit facilities (fund based or non-fund based) from the banking system without specifically obtaining a No-Objection Certificate (NOC) from the lending bank(s). Further, the non-adherence by banks as per the circular is to be perceived as abetting the siphoning of funds and such violations which are either reported to RBI or noticed during the regulator inspection would make the concerned banks liable for penalty under Banking Regulation Act.

Establishment of CRILC

The RBI established a Central Repository of Information on Large Credits (CRILC). The CRILC was established in connection to the RBI framework “Early Recognition of Financial Distress, Prompt Steps for Resolution and Fair Recovery for Lenders: Framework for Revitalising Distressed Assets in the Economy“. As under the framework banks were required to furnish credit information to CRILC on all their borrowers having aggregate fund-based and non-fund based exposure of Rs. 5 Crores and above with them. Besides banks were required to furnish current accounts of their customers with outstanding balance (debit or credit) of Rs 1 Crore and above to the CRILC. The reporting under the extant framework was to determine SMA-0 classification, where the principal or interest payment is not overdue for more than 30 days but account showing signs of stress. An increase in the frequency of overdrafts in current accounts is one of the illustrative methods for determining stress.

Reposting of large credits

Post establishment of CRILC, a subsequent guideline on the opening of current accounts by banks was issued by the RBI via circular dated July 02, 2015, dealing with the same subject. To enhance credit discipline, especially for the reduction in NPA level in banks, banks were asked to use the information available in CRILC and not limit their due diligence to seeking NOC. Banks were to verify from the data available in the CRILC database whether the customer is availing of credit facility from another bank.

The chart below highlights the series and events and relevant circulars.

Credit Discipline- August 06, 2020 Circular

As per the circular dated August 06, 2020, issued by the regulator on Opening of Current Accounts by Banks – Need for Discipline (‘Revised Guidelines’), there are two aspects that need to be considered before opening a CC/OD facility or opening the current account of the customer. The Revised Guidelines provides a clear guiding flowchart for banks to follow when the customer approaches a bank for opening of the current account, the same has been categorised into two scenarios which could be considered by the banks to comply with the revised guideline.

Case 1: Customer wants to avail or is already having a credit facility in form of CC/OD

Case 2: Customer wants to open a current account or have an existing current account with the bank

 

Further, there is a requirement on banks to monitor all CC/OD accounts regularly at least quarterly, especially concerning the exposure of the banking system to the borrower. There has been an ambiguity surrounding what would amount to ‘exposure’ under the Revised Guidelines.

‘Exposure to the banking system’ under Revised Guidelines

The Revised Guidelines provides that exposure shall mean the sum of sanctioned ‘fund based and non-fund based credit facilities’. However, there is a regulatory ambiguity, since neither the term used by the RBI has been specifically defined in the Revised Guideline nor elsewhere under any other regulations. There is no straight jacket exclusive definition for determining as to what exposure banks should include determining funded and non-funded credit facilities. Therefore, based on back-tracing of regulatory regime an inclusive list can be of guidance for banks and borrowers especially large borrowers (like NBFCs and HFCs) and other financial institutions and corporates who rely on banking facilities (current account and CC/OD) extensively for their business.

The CRILC may not be the only source for banks while the collection of borrower’s credit information. Other modes could be information by Credit Information Companies (CICs), National E-Governance Services Ltd. (NeSL), etc., and even by obtaining customers’ declaration, if required. However, since the revised guideline stresses on borrowers having exposure more than 5 crores, therefore, information disseminated by the banks to CRILC is a good point to start with and to comply with under the revised guidelines. The circular dated July 02, 2015, draws reference to the Central Repository of Information on Large Credits (CRILC) to collect, store, and disseminate data on all borrowers’ credit exposures. The guideline further provided banks to verify the data available in the CRILC database whether the customer is availing credit facility from another bank. Further even under the Guidelines on “Early Recognition of Financial Distress, Prompt Steps for Resolution and Fair Recovery for Lenders” dated January 30, 2014, provided that credit information shall include all types of exposures as defined under RBI Circular on Exposure Norms.

The RBI Exposure Norms dated July 01, 2015, defines exposure as;

“Exposure shall include credit exposure (funded and non-funded credit limits) and investment exposure (including underwriting and similar commitments). The sanctioned limits or outstandings, whichever are higher, shall be reckoned for arriving at the exposure limit. However, in the case of fully drawn term loans, where there is no scope for re-drawal of any portion of the sanctioned limit, banks may reckon the outstanding as the exposure.”

The banking exposure norms provide for two exposures; namely credit and investment exposures. Further RBI Exposure Norms defines ‘credit exposure’ and ‘Investment Exposure’ as follows;

“2.1.3.3. Credit Exposure

Credit exposure comprises the following elements:

(a) all types of funded and non-funded credit limits.

(b) facilities extended by way of equipment leasing, hire purchase finance and factoring services.

2.1.3.4 Investment Exposure

  1. a) Investment exposure comprises the following elements:

(i) investments in shares and debentures of companies.

(ii) investment in PSU bonds

(iii) investments in Commercial Papers (CPs).

  1. b) Banks’ / FIs’ investments in debentures/ bonds / security receipts / pass-through certificates (PTCs) issued by an SC / RC as compensation consequent upon sale of financial assets will constitute exposure on the SC / RC. In view of the extraordinary nature of the event, banks / FIs will be allowed, in the initial years, to exceed the prudential exposure ceiling on a case-to-case basis.
  2. c) The investment made by the banks in bonds and debentures of corporates which are guaranteed by a PFI1(as per list given in Annex 1) will be treated as an exposure by the bank on the PFI and not on the corporate.
  3. d) Guarantees issued by the PFI to the bonds of corporates will be treated as an exposure by the PFI to the corporates to the extent of 50 per cent, being a non-fund facility, whereas the exposure of the bank on the PFI guaranteeing the corporate bond will be 100 per cent. The PFI before guaranteeing the bonds/debentures should, however, take into account the overall exposure of the guaranteed unit to the financial system.”

The Revised Guidelines, specifically define exposure in a footnote to the revised guideline stipulating that to arrive at aggregate exposures in the footnote as follows;

“‘Exposure’ for the purpose of these instructions shall mean sum of sanctioned fund based and non-fund based credit facilities”.

Further the RBI in its subsequent FAQs on revised guidelines dated December 14, 2020, guided on what could be included in aggregate exposure.

4. Whether aggregate exposure shall include Day Light Over Draft (DLOD)/ intra-day facilities and irrevocable payment commitments, limits set up for transacting in FX and interest rate derivatives, CPs, etc.

All fund based and non-fund based credit facilities sanctioned by the banks and carried in their Indian books shall be included for the purpose of aggregate exposure.”

Further in FAQ No. 3 in the circular dated December 14, 2020, the RBI clarified that

3. For the purpose of this circular, whether exposure of non-banking financial companies (NBFCs) and other financial institutions like National Housing Bank (NHB) shall be included in computing aggregate exposure of the banking system.

The instructions are applicable to Scheduled Commercial Banks and Payments Banks. Accordingly, the aggregate exposure for the purpose shall include exposures of these banks only”

While the regulator evaded assigning express meaning as to what could be included while determining banking exposure and took an inclusive view. However, from the foregoing, it is amply clear that the credit facilities should include credit exposures (funded and not funded) that have been sanctioned by banks. Therefore, only exposures to banks and payments banks are to be included while calculating exposures, any or all the exposure of a borrower to the other financial institutions like NHB, LIC Housing, SIDBI, NABARD, Mutual funds & other development Banks are neither commercial banks nor payments banks hence are to be excluded. [The list of licensed payments banks by the RBI can be viewed here. ]

CIRLC captures credit information of borrowers having aggregate fund-based and non-fund based exposures of Rs. 5 Crores and above including investment exposures. The banks are required to submit a quarterly return to CIRLC. It is pertinent to note that total investment exposure is to be indicated separately under the head total investment exposure. While there is a need for a detailed breakup on fund-based and non-fund based credit facilities in the CIRLC return. The table below is an indicative list of (funded and non-funded) loans to be submitted from the CIRLC return.

 

Non-Funded credit exposure  Funded credit exposure
Letter of Credit Cash Credit/ Overdraft
Guarantees Working Capital Demand Loan (including CPs)*
Acceptances Inland Bills
Foreign Exchange Contracts Packing Credit
Interest Rate Derivatives (incl FX Interest Rate Derivatives) Export Bills
Term Loan
Credit equivalent of OBS/derivative exposure

*CP to be included in WCDL only if part of working capital sanctioned limit. All other CPs are to be considered as investment exposure.

Therefore, all the investment exposures of banks to the borrower such as investments in corporate bonds, shares, PTCs issued by asset reconstruction companies and securitisation companies, and others are to be excluded while arriving at aggregate fund-based and non-fund based credit facilities as under the Revised Guidelines. Nevertheless, the PTCs issued by NBFCs or HFCs are investment exposure of banks on the underlying loan pools and not on the originator entity. Similarly, exposure of a bank in a co-lending transaction is exposure on the ultimate obligor and not the co-originating partner NBFC.

 

 

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RBI refines the role of the Compliance-Man of a Bank

Notifies new provisions relating to Compliance Functions in Banks and lays down Role of CCO.

By:

Shaivi Bhamaria | Associate

Aanchal Kaur Nagpal | Executive

Introduction

The recent debacles in banking/shadow banking sector have led to regulatory concerns, which are reflected in recent moves of the RBI. While development of a robust “compliance culture” has always been a point of emphasis, RBI in its Discussion Paper on “Governance in Commercial Banks in India’[1] [‘Governance Paper’] dated 11th June 2020 has dealt extensively with the essentials of compliance function in banks.  The Governance Paper, while referring to extant norms pertaining to the compliance function in banks, viz. RBI circulars on compliance function issued in 2007[2] [‘2007 circular’] and 2015[3] [‘2015 circular’], placed certain improvement points.

In furtherance of the above, RBI has come up with a circular on ‘Compliance functions in banks and Role of Chief Compliance Officer’ [‘2020 Circular’] dated 11th September, 2020[4], these new guidelines are supplementary to the 2007 and 2015 circulars and have to be read in conformity with the same. However, in case of or any common areas of guidance, the new circular must be followed.  Along with defining the role of the Chief Compliance Officer [‘CCO’], they also introduce additional provisions to be included in the compliance policy of the Bank in an effort to broaden and streamline the processes used in the compliance function.

Generally, in compliance function is seen as being limited to laying down statutory norms, however, the importance of an effective compliance function is not unknown. The same becomes all-the-more paramount in case of banks considering the critical role they play in public interest and in the economy at large. For a robust compliance system in Banks, an independent and efficient compliance function becomes almost indispensable. The effectiveness of such a compliance function is directly attributable to the CCO of the Bank.

Need for the circular

The compliance function in banks is monitored by guidelines specified by the 2007 and 2015 circular. These guidelines are consistent with the report issued by the Basel Committee on Banking Supervision (BCBS Report)[5] in April, 2005.

While these guidelines specify a number of functions to be performed by the CCO, no specific instructions for his appointment have been specified. This led to banks following varied practices according to their own tailor-made standards thus defeating the entire purpose of a CCO. Owing to this, RBI has vide the 2020 circular issued guidelines on the role of a CCO, in order to bring uniformity and to do justice to the appointment of a CCO in a bank.

Background of CCOs

The designation of a CCO was first introduced by RBI in August, 1992 in accordance with the recommendations of the Ghosh Committee on Frauds and Malpractices in Banks. After almost 15 years, RBI introduced elaborate guidelines on compliance function and compliance officer in the form of the 2007 circular which was in line with the BCBS report.

According to the BCBS report:

‘Each bank should have an executive or senior staff member with overall responsibility for co-ordinating the identification and management of the bank’s compliance risk and for supervising the activities of other compliance function staff. This paper uses the title “head of compliance” to describe this position’.

Who is a CCO and how is he different from other compliance officials?

The requirement of an individual overseeing regulatory compliance is not unique to the banking sector. There are various other laws that the provide for the appointment of a compliance officer. However, there is a significant difference in the role which a CCO is expected to play. The domain of CCO is not limited to any particular law or its ancillaries, rather, it is all pervasive. He is not only responsible for heading the compliance function, but also overseeing the entire compliance risk[6] in banks.

Role of a CCO in a Bank:

The predominant role of a CCO is to head the compliance function in a Bank. The 2007 circular lays down the following mandate of a CCO:

  1. overall responsibility for coordinating the identification and management of the bank’s compliance risk and supervising the activities of other compliance function staff.
  2. assisting the top management in managing effectively the compliance risks faced by the bank.
  3. nodal point of contact between the bank and the RBI
  4. approving compliance manuals for various functions in a bank
  5. report findings of investigation of various departments of the bank such as at frequent intervals,
  6. participate in the quarterly informal discussions held with RBI.
  7. putting up a monthly report on the position of compliance risk to the senior management/CEO.
  8. the audit function should keep the Head of compliance informed of audit findings related to compliance.

The 2020 circular adds additional the following responsibilities on the CCO:

  1. Design and maintenance of compliance framework,
  2. Training on regulatory and conduct risks,
  3. Effective communication of compliance expectations

Selection and Appointment of CCO:

The 2007 circular is ambiguous on the qualifications, roles and responsibilities of the CCO. In certain places the CCO was referred to as the Chief Compliance officer and some places where the words compliance officer is used. This led to difficulty in the interpretation of aspects revolving around a CCO. However, the new circular gives a clear picture of the expectation of RBI from banks in respect of a CCO. The same has been listed below:

Basis 2020 circular 2007 circular
Tenure Minimum fixed tenure of not less than 3 years The Compliance Officer should be appointed for a fixed tenure
Eligibility Criteria for appointment as CCO The CCO should be the senior executive of the bank, preferably in the rank of a General Manager or an equivalent position (not below two levels from the CEO). The compliance department should have an executive or senior staff member of the cadre not less than in the rank of DGM or equivalent designated as Group Compliance Officer or Head of Compliance.
Age 55 years No provision
Experience Overall experience of at least 15 years in the banking or financial services, out of which minimum 5 years shall be in the Audit / Finance / Compliance / Legal / Risk Management functions. No provision

 

Skills Good understanding of industry and risk management, knowledge of regulations, legal framework and sensitivity to supervisors’ expectations No provision
Stature The CCO shall have the ability to independently exercise judgement. He should have the freedom and sufficient authority to interact with regulators/supervisors directly and ensure compliance No provision
Additional condition No vigilance case or adverse observation from RBI, shall be pending against the candidate identified for appointment as the CCO. No provision
Selection* 1.      A well-defined selection process to be established

2.      The Board must be required to constitute a selection committee consisting of senior executives

3.      The CCO shall be appointed based on the recommendations of the selection committee.

4.      The selection committee must recommend the names of candidates suitable for the post as per the rank in order of merit.

5.      Board to take final decision in the appointment of the CCO.

No provision
Review of performance appraisal The performance appraisal of the CCO should be reviewed by the Board/ACB No provision
Reporting lines The CCO will have direct reporting lines to the following:

1.      MD & CEO and/or

2.      Board or Audit Committee

No provision
Additional reporting In case the CCO reports to the MD & CEO, the Audit Committee of the Board is required to meet the CCO quarterly on one-to-one basis, without the presence of the senior management including MD & CEO. No provision
Reporting to RBI 1.      Prior intimation is to be given to the RBI in case of appointment, premature transfer/removal of the CCO.

2.      A detailed profile of the candidate along with the fit and proper certification by the MD & CEO of the bank to be submitted along with the intimation, confirming that the person meets the supervisory requirements, and detailed rationale for changes.

No provision
Prohibitions on the CCO 1.      Prohibition on having reporting relationship with business verticals

2.      Prohibition on giving business targets to CCO

3.      Prohibition to become a member of any committee which brings the role of a CCO in conflict with responsibility as member of the committee. Further, the CCO cannot be a member of any committee dealing with purchases / sanctions. In case the CCO is member of such committees, he may play only an advisory role.

No provision

*The Governance paper had proposed that the Risk Management Committee of the Board will be responsible for selection, oversight of performance including performance appraisals and dismissal of a CCO. Further, any premature removal of the CCO will require with prior board approval. [Para 9(6)] However, the 2020 circular goes one step further by requiring a selection committee for selection of a CCO.

Dual Hatting

Prohibition of dual hatting is already applicable on the Chief Risk Officer (‘CRO’) of a bank. The same has also been implemented in case the of a CCO.

Hence, the CCO cannot be given any responsibility which gives rise to any conflict of interest, especially the role relating to business. However, roles where there is no direct conflict of interest for instance, anti-money laundering officer, etc. can be performed by the CCO. In such cases, the principle of proportionality in terms of bank’s size, complexity, risk management strategy and structures should justify such dual role. [para 2.11 of the 2020 circular] 

Role of the Board in the Compliance function

Role of the Board

The bank’s Board of Directors are overall responsible for overseeing the effective management of the bank’s compliance function and compliance risk.

Role of MD & CEO

The MD & CEO is required to ensure the presence of independent compliance function and adherence to the compliance policy of the bank.

Authority:

The CCO and compliance function shall have the authority to communicate with any staff member and have access to all records or files that are necessary to enable him/her to carry out entrusted responsibilities in respect of compliance issues.

Compliance policy and its contents

The 2007 circular required banks to formulate a Compliance Policy, outlining the role and set up of the Compliance Department.

The 2020 circular has laid down additional points that must be covered by the Compliance Policy. In some aspects, the 2020 circular provides further measures to be taken by banks whereas in some aspects, fresh points have been introduced to be covered in the compliance policy, these have been highlighted below:

1. Compliance philosophy: The policy must highlight the compliance philosophy and expectations on compliance culture covering:

  • tone from the top,
  • accountability,
  • incentive structure
  • Effective communication and Challenges thereof

2. Structure of the compliance function: The structure and role of the compliance function and the role of CCO must be laid down in the policy

3. Management of compliance risk: The policy should lay down the processes for identifying, assessing, monitoring, managing and reporting on compliance risk throughout the bank.

The same should adequately reflect the size, complexity and compliance risk profile of the bank, expectations on ensuring compliance to all applicable statutory provisions, rules and regulations, various codes of conducts and the bank’s own internal rules, policies and procedures and must create a disincentive structure for compliance breaches.

4. Focus Areas: The policy should lay special thrust on:

  • building up compliance culture;
  • vetting of the quality of supervisory / regulatory compliance reports to RBI by the top executives, non-executive Chairman / Chairman and ACB of the bank, as the case may be.

5. Review of the policy: The policy should be reviewed at least once a year

Quality assurance of compliance function

Vide the 2020 circular, RBI has introduced the concept of quality assurance of the compliance function Banks are required to develop and maintain a quality assurance and improvement program covering all aspects of the compliance function.

The quality assurance and improvement program should be subject to independent external review at least once in 3 years. Banks must include in their Compliance Policy provisions relating to quality assurance.

Thus, this would ensure that the compliance function of a bank is not just a bunch of mundane and outdated systems but is improved and updated according to the dynamic nature of the regulatory environment of a bank.

Responsibilities of the compliance function

In addition to the role of the compliance function under the compliance process and procedure as laid down in the 2007 the 2020 circular has laid down the below mentioned duties and responsibilities of the compliance function:

  1. To apprise the Board and senior management on regulations, rules and standards and any further developments.
  2. To provide clarification on any compliance related issues.
  3. To conduct assessment of the compliance risk (at least once a year) and to develop a risk-oriented activity plan for compliance assessment. The activity plan should be submitted to the ACB for approval and be made available to the internal audit.
  4. To report promptly to the Board/ Audit Committee/ MD & CEO about any major changes / observations relating to the compliance risk.
  5. To periodically report on compliance failures/breaches to the Board/ACB and circulating to the concerned functional heads.
  6. To monitor and periodically test compliance by performing sufficient and representative compliance testing. The results of the compliance testing should be placed before the Board/Audit Committee/MD & CEO.
  7. To examine sustenance of compliance as an integral part of compliance testing and annual compliance assessment exercise.
  8. To ensure compliance of Supervisory observations made by RBI and/or any other directions in both letter and spirit in a time bound and sustainable manner.

 Actionables by Banks:

Links to related write ups –

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49937

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=3433&Mode=0

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=9598&Mode=0

[4] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11962&Mode=0

[5] https://www.bis.org/publ/bcbs113.pdf

[6]  According to BCBS report, compliance risk is the risk of legal or regulatory sanctions, material financial loss, or loss to reputation a bank may suffer as a result of its failure to comply with laws, regulations, rules, related self-regulatory organization standards, and codes of conduct applicable to its banking activities”

PSL guidelines reviewed for wider credit penetration

By Siddarth Goel (finserv@vinodkothari.com)

Introduction

The Reserve Bank of India (RBI) issued Master Directions-Priority Sector Lending (PSL) Targets and Classification on September 4, 2020 (‘Master Directions’)[1]. The Master Directions are in the nature of a consolidating piece, of various circulars and guidelines issued by RBI in regard to PSL. The objective of Master Directions is to harmonise instructions guidelines for Commercial Banks[2], Small Finance Banks (“SFB”)[3], Regional Rural Banks (“RRBs”)[4], Urban Co-Operative Banks (“UCBs”)[5] and Local Area Banks (“LABs”) for PSL targets and classification under single universe.

The objective of Master Directions is to consolidate all the concerning circulars to PSL under one master direction. However, certain changes have been introduced under the Master Directions in line with the recommendations of Expert Committee on Micro, Small and Medium Enterprises (Chairman: Shri U.K. Sinha) and the ‘Internal Working Group to Review Agriculture Credit’ (Chairman: Shri M. K. Jain).

This write up endeavors to highlight major changes which has been implemented through the said Master Direction that were not forming part of the erstwhile notifications or guidelines in this regard.

Changes in Targets / Sub-targets Classification for Priority Sector

The targets and sub-targets set under priority sector lending is computed on the percentage basis of Adjusted Net Bank Credit (ANBC)/ Credit Equivalent of Off-Balance Sheet Exposures (CEOBE). The Master Directions, has increased the total priority sector lending target for Urban Co-Operative Banks, which is to be achieved through milestones-based targets in a phased manner. Further there has been increase in targets for advances to weaker sections and Small Farmer Margins (SMF) in the agriculture sector. The table below summarises the changes along with timelines for complying with Targets/Sub-targets for PSL.

Categories Domestic Commercial Banks Small Finance Banks RRB Urban Co-Operative Bank#
Total Priority Sector No change No Change No Change Increased in total priority sector target from 40 % to 75% of ANBC or CEOBE whichever is higher.
Advances to Weaker Sections Target * Increased to 12% of ANBC or CEOBE, whichever is higher.

[earlier target was 10%]

Increased to 12% of ANBC or CEOBE, whichever is higher.

[earlier target was 10%]

No Change Increased to 12% of ANBC or CEOBE, whichever is higher.

[earlier target was 10%] 

Agriculture Target * -No Change Small Marginal Farmers (SMF) target increased to 10% of the 18% of ANBC or CEOBE, whichever is higher.

[earlier it was 8 % of 18%] 

Small Marginal Farmers (SMF) target Increased to 10% of 18% of ANBC or CEOBE, whichever is higher.

[earlier it was 8% of 18%]

No Target
Micro Enterprises No Change No Change No Change No Change

# Target of total priority sector to be achieved in phased manner by Co-operative Banks as below.

Existing Target March 31, 2021 March 31, 2022 March 31, 2023 March 31, 2024
40% 45% 50% 60% 75%

 

* Phased manner for achieving Small Marginal Farmers and Weaker Section Targets as below.

Financial Year SMF Weaker Section Target
2020-2021 8% 10%
2021-2022 9% 11%
2022-2023 9.5% 11.5%
2023-2024 10% 12%

Inclusion of Weights in PSL Achievement

From the UK Sinha committee recommendations,[6] in order to address regional disparities in flow of credit to district levels. Adjusted Priority Sector Lending mechanism has been implemented under the new regime, to incentivise flow of credit to underserved districts. There will be no change in the underlying sectors eligible for PSL, however an additional weightage has been given to lending to the more underserved districts. From financial year 2021-2022 onwards weights would be assigned to incremental priority sector credit as follows:

  • Higher weight (125%) would be assigned to the districts where credit flow is comparatively lower, that is per capita PSL less than ₹ 6,000.
  • Lower weight (90%) would be assigned to the districts where credit flow is comparatively higher, that is per capita PSL is greater than ₹ 25,000.

RRBS, Urban Co-operative Banks and Local Area Banks and Foreign Banks have been kept out for the purpose of calculation of PSL weights, due to their limited presence.

Inclusions in Eligible Categories

Along with the inclusion of fresh categories eligible for finance under priority sector there has been some enhancement in the credit limit of the existing categories as well. Some of the changes are as follows-

Agriculture Lending Including Farm Credit (Allied Activities), lending for Agriculture Infrastructure and Ancillary Activities.
  • Inclusion of loans to farmers for installation of stand-alone Solar Agriculture Pumps and for solarisation of grid connected Agriculture Pumps.
  • Inclusion of loans to farmers for installation of solar power plants on barren/fallow land or in stilt fashion on agriculture land owned by farmer
  • Inclusion of loans up to ₹50 crore to Start-ups, as per definition of Ministry of Commerce and Industry, Govt. of India that are engaged in agriculture and allied services.
  • Inclusion of loans up to ₹2 lakh to individuals solely engaged in Allied activities without any accompanying land holding criteria. This change is in line with recommendation by M.K. Jain Committee[7].
  • Inclusion of loans for construction of oil extraction/ processing units for production of bio-fuels, their storage and distribution infrastructure along with loans to entrepreneurs for setting up Compressed Bio Gas (CBG) plants.
  • Laying of Indicative list conveying permissible activities under Food Processing Sector as recommended by Ministry of Food Processing Industries.
  • A credit limit of ₹5 crore per borrowing entity has been specified for Farmers Producers Organisations (FPOs)/Farmers Producers Companies (FPCs) undertaking farming with assured marketing of their produce at a pre-determined price. This inclusion is as per the M.K Jain Committee Recommendations[8].
Other Finance to MSMEs In line with the series of benefits being extended to MSMEs, loans up to ₹50 crore to Start-ups, as per definition of Ministry of Commerce and Industry, Govt. of India that confirm to the definition of MSME has been included under the PSL catergory. (On the basis of recommendations by UK Sinha Committee, to financially incentivise the startups in India)
Housing Loans

 

  • Increase in Loans up to ₹ 10 lakh (earlier ₹ 5 lakh) in metropolitan centres and up to ₹6 lakh (earlier 2 ₹ Lakh) in other centres for repairs to damaged dwelling units.
  • Bank loans to governmental agency for construction of dwelling units or for slum clearance and rehabilitation of slum dwellers subject to dwelling units with carpet area of not more than 60 square meters. Under the earlier regime, it was based on cost of dwelling unit which was ₹ 10 lakh per unit.
  • Inclusion of bank loans for affordable housing projects using at least 50% of FAR/FSI (Floor Area Ratio/ Floor Space Index) for dwelling units with carpet area of not more than 60 sq.m.
Social Infrastructure

 

Inclusion of loans up to a limit of ₹ 10 crore per borrower for building health care facilities including under ‘Ayushman Bharat’ in Tier II to Tier VI centres. This is in addition to the existing limit of ₹5 crore per borrower for setting up schools, drinking water facilities and sanitation facilities including construction/ refurbishment of household toilets and water improvements at household level, etc.
Renewable Energy Increase in loan limit to ₹ 30 Crore for purposes like solar based power generators, biomass-based power generators, wind mills, micro-hydel plants and for non-conventional energy based public utilities etc. This is to boost renewable energy sector, the earlier limit was up to ₹ 15 Crore.
Others

 

Inclusion of loans for meeting local needs such as construction or repair of house, construction of toilets not exceeding ₹2 lakh provided directly by banks to SHG/JLG for activities other than agriculture or MSME.

Investments by Banks in Securitised Assets & Direct Assignment

Earlier the interest rate charged to the ultimate borrower was capped at Base Rate of the investing bank plus 8 percent per annum. Post UK Sinha Committee recommendation,[9] the all-inclusive interest charged to the ultimate borrower by the originating entity should not exceed the External Benchmark Lending Rate (EBLR)/ MCLR of the investing bank plus appropriate spread which will be communicated separately.

The intent of the recommendation stood on the grounds that price caps are not applicable to banks when they originate directly through branches. Therefore, to encourage MSME lending in smaller areas where cost of intermediation is high by the smaller NBFCs, the committee proposed the cap at Base Rate of the investing bank plus 12% per annum initially and periodical review thereafter.

Conclusion

The Master Direction aids in compilation and provides easy understandability of all the guidelines at one place. The two committee reports recommendations have aided in recognising important sub-sectors of economy which were not covered under earlier regimes. Loans to starts-ups in agriculture and allied activities, loans to healthcare, sanitation along with impetus on renewable energy will not only bolster flow of credit in these sectors but also aimed at improving socio-economic conditions in the country. The introduction of incentive on incremental PSL by ranking of districts on basis of per capita credit flow could be an enabler for the deeper penetration of credit in rural economy. Therefore, the new Master Direction is a welcome move and will help in achieving better channeling of credit in the desired sectors of the economy.

[1] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MDPSL803EE903174E4C85AFA14C335A5B0909.PDF

[2] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/33MD08B3F0CC0F8C4CE6B844B87F7F990FB6.PDF

[3] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=11644&Mode=0

[4] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=11604&Mode=0

[5] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11274&Mode=0

[6] Para 9.24, Report of the Expert Committee on Micro, Small and Medium Enterprises, (UK Sinha Committee) https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=924

[7] Para 1.7.6, Report of the Internal Working Group to Review Agricultural Credit, ( M. K Jain Committee) https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=942#CP28

[8] Para 2.7.5, Report of the Internal Working Group to Review Agricultural Credit, ( M. K Jain Committee) https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=942#CP28

[9] Para 9.24, Report of the Expert Committee on Micro, Small and Medium Enterprises, (UK Sinha Committee) https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=924

RBI guidelines on governance in commercial banks

Vinita Nair | Senior Partner

Vinod Kothari & Company

vinita@vinodkothari.com

Prudential Framework for Resolution of Stressed Assets: New Dispensation for dealing with NPAs

By Vinod Kothari [vinod@vinodkothari.com]; Abhirup Ghosh [abhirup@vinodkothari.com]

With the 12th Feb., 2018 having been struck down by the Supreme Court, the RBI has come with a new framework, in form of Directions[1], with enhanced applicability covering banks, financial institutions, small finance banks, and systematically important NBFCs. The Directions apply with immediate effect, that is, 7th June, 2019.

The revised framework [FRESA – Framework for Resolution of Stressed Accounts] has much larger room for discretion to lenders, and unlike the 12th Feb., 2018 circular, does not mandate referral of the borrowers en masse to insolvency resolution. While the RBI has reserved the rights, under sec.  35AA of the BR Act, to refer specific borrowers to the IBC, the FRESA gives liberty to the members of the joint lenders forum consisting of banks, financial institutions, small finance banks and systemically important NBFCs, to decide the resolution plan. The resolution plan may involve restructuring, sale of the exposures to other entities, change of management or ownership of the borrower, as also reference to the IBC. Read more

Anticipated boost in liquidity position of NBFCs and HFCs

By Vineet Ojha (vineet@vinodkothari.com)

Read more

RBI’s First Monetary Policy for FY 2018-19

Anita Baid

finserv@vinodkothari.com

 

The Reserve Bank of India (RBI) released its first monetary policy statement for FY 2018-19 on April 05, 2018[1] (‘Policy Statement’). The aforesaid statement sets out various developmental and regulatory policy measures for the financial sector. It aims at strengthening regulation and supervision; broadening and deepening financial markets; improving currency management; promoting financial inclusion and literacy; and, facilitating data management. Some of the major issues from the Policy Statement have been discussed herein below: Read more