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.

Timelines

The resolution timelines have 2 components – a Review Period and Resolution Period.

The first period, of 30 days, starts immediately in case of borrowers having aggregate exposure of Rs 2000 crores or more from the banking system, and in case of borrowers with aggregate exposure of Rs 1500 crores to Rs 2000 crores, it starts from 1st Jan 2020. For borrowers with aggregate borrowings of less than Rs 1500 crores, there is no defined timeline as of now – thereby leaving all small moderate loan sizes out of the scope of the FRESA.

During the review period, the lenders will have presumably agreed on the resolution plan. The plan itself has 6 months of implementation.

The 6 months’ implementation timeline is not a hard timeline. If the timeline is breached, the impact is additional provisioning. If the implementation fails the 6 month deadline, there is an additional provision of 20% for period upto 1 year from the end of the review period, and 35% for period beyond 1 year.

Directions are centered around banks

Though the FRESA has made applicable to scheduled commercial banks, AIFIs, small finance banks and NBFCs, however, the same revolves around banks and financial institutions. For the framework to get triggered, the borrower must be reported as default by either an SCB, AIFI or small finance bank. The provisions under the paragraph shall not get triggered with an NBFC declaring an account as default.

Similarly, for reckoning the amount outstanding credit for determining the reference date for implementation, only the credit exposures of the SCBs, AIFIs and small finance banks have to be considered.

It seems these Directions have been made applicable to NBFCs, only to bind them by the proceedings under FRESA, in case of borrowers having multiple lenders.

Mechanics of the FRESA

On an account being declared as default, the lenders will, within a period of 30 days, have to review the account and decide the course of action on the account. That is, during this period, an RP will have to be prepared. The lenders can either resolve the stress under this framework or take legal actions for resolution and recovery.

If the lenders decide to resolve the stress under this framework, ICA must be signed among them. The ICA must provide for the approving authority of the RP, the rights and duties of the majority lenders, safety and security of the dissenting lenders.

Upon approval of the RP, the same must be implemented within a period of 180 days in the manner prescribed in the Directions. After the implementation, the same must be monitored during the monitoring period and the extended specified period, discussed below.

Implementation conditions for RPs

The implementation of RPs also comes with several conditions. The pre-requisites of implementing an RP are:

  1. Where there are multiple lenders involved, approval of 75% of the lenders by value and 60% of the lender by number must have been obtained.
  2. The RPs must be independently rated – where the aggregate exposure is ₹ 1 billion or above, at least from 1 credit rating agency; and where the aggregate exposure is ₹ 5 billion or above, at least from 2 credit rating agencies. The rating obtained from the CRAs must be RP4 or better[2].
  3. The borrower should not be in default as on 180th day from the end of Review Period.
  4. An RP involving restructuring/ change in ownership, shall be deemed to be implemented only if,
    1. All the legal document have been executed by the lenders in consonance with the RP;
    2. The new capital structure and/ or changes in the terms and conditions of the loans get duly reflected in the books of the borrower;
    3. The borrower is not in default with any of the lenders

Restructuring with several covenants

Restructuring was no brainer earlier and was the device to keep bad loans on the books without any action.

The FRESA provides that upon restructuring, the account [having an aggregate exposure of more than Rs 100 crores] will be upgraded to standard status only on investment grade by at least one rating agency (two in case of aggregate exposure of Rs 500 crores and above). Also, after restructuring, the account should at least pay off 10% of the aggregate exposure.

Prudential norms in case of restructuring/ change in ownership

  1. In case of restructuring –
    1. Upon restructuring, the account will be immediately be downgraded to sub-standard and the NPAs shall continue to follow the asset classification norms as may be applicable to them.
    2. The substandard restructured accounts can be upgraded only after satisfactory performance during the following period:
      1. Period commencing from the date of implementation of the RP up to the date by which 10% of the outstanding credit facilities have been repaid (monitoring period); or
      2. 1 year from the date of commencement of the first payment of interest or principal, whichever is later.
    3. However, for upgradation, fresh credit ratings, as specified above,  will have to be obtained.
    4. If the borrower fails to perform satisfactorily during this period, an additional provision of 15% will have to be created by all the lenders at the end of this period.
    5. In addition to above, the account will have to be monitored for an extended period upto the date by which 20% of the outstanding credit facilities have been repaid. If the borrower defaults during this period, then a fresh RP will have to be required. However, an additional 15% provision will have to be created at the end of the Review Period.
    6. Any additional finance approved under the RP, shall be booked as “standard asset” in the books of the lender during the monitoring period, provided the account performs satisfactorily. In case, the account fails to perform satisfactorily, the same shall be downgraded to the same category as the restructured debt.
    7. Income in case of restructured standard assets should be booked on accrual basis, in case of sub-standard assets should be booked on cash basis.
    8. Apart from the additional provisioning mentioned above, the lenders shall follow their normal provisioning norms.
  2. In case of change of ownership, the accounts can be retained as standard asset after the change in ownership under FRESA or under IBC. For change in ownerships under this framework, following are the pre-requisites:
    1. The lenders must carry out due diligence of the acquirer and ensure compliance with section 29A of the IBC.
    2. The new promoter must acquire at least 26% of the paid up equity capital of the borrower and must be its single largest shareholder.
    3. The implementation must be carried out within the specified timelines.
    4. The new promoter must be in control of the borrower.
    5. The account must continue to perform satisfactorily during the monitoring period, failing which fresh review period shall get triggered. Also, it is only upon satisfactory performance during this period that excess provisions can be reversed.
  3. Reversal of additional provisions:
    1. In case, the RP involves only payment of overdues, the additional provisions may be reversed only of the borrower remains not in default for a period of 6 months from the date of clearing the overdues with all its lenders.
    2. In case, the RP involves restructuring/ change in ownership outside IBC, the additional provisions created against the exposure will be reversed upon implementation of the RP.
    3. In case, the lenders initiate insolvency provisions against the borrower, then half of the provisions created against the exposure will be reversed upon submission of application and the remaining amount may be reversed upon admission of the application.
    4. In case, the RP involves assignment/ debt recovery, the additional provision may be reversed upon completion of the assignment/ debt recovery.

Exceptions

Project loans where date of commencement of commercial operations (DCCO) has been deferred, will be excluded from the scope of the circular.

Hierarchy of periods

  • Review period – 30 days for preparing the resolution plan
  • Implementation period – 6 months from the end of the review period – for implementing the resolution plan
  • Monitoring period for upgradation – 1 year from date of commencement of first payment of interest or principal or reduction of aggregate exposure by 10%, whichever is later
  • Specified period – until the aggregate exposure is repaid by at least 20% – if there is a default, a fresh resolution plan will be required.

Other provisions of the FRESA

Some common instructions from the earlier directions have been retained in this framework as well, namely:

  1. Identification of an account under various special mention accounts. Where the default in account is between 1-30 days, the same must be treated as SMA-0. Where the default is between 31-60 days, it must be reported as SMA-1. Where the default is between 61-90 days, it must be reported as SMA-2.
  2. Reporting requirements to CRILC for accounts with aggregate exposure of ₹ 50 million will continue.
  3. The framework requires the lenders to adopt a board approved policy in this regard.
  4. For actions by the lenders with an intention to conceal the actual status of accounts or evergreen the stressed accounts, will be subjected to stringent supervisory / enforcement actions as deemed appropriate by the Reserve Bank, including, but not limited to, higher provisioning on such accounts and monetary penalties. Further, references under IBC can also be made.
  5. Disclosures under notes to accounts have to be made by the lenders with respect to accounts dealt with under these Directions.
  6. The scope of the term “restructuring” has been expanded under the Directions.
  7. Sale and leaseback transaction involving the assets of the borrower shall be treated as restructuring if the following conditions are met:
    1. The seller of the assets is in financial difficulty;
    2. Significant portion, i.e. more than 50 per cent, of the revenues of the buyer from the specific asset is dependent upon the cash flows from the seller; and
    3. 25 per cent or more of the loans availed by the buyer for the purchase of the specific asset is funded by the lenders who already have a credit exposure to the seller.
  8. If borrowings/export advances (denominated in any currency, wherever permitted) for the purpose of repayment/refinancing of loans denominated in same/another currency are obtained:
    1. From lenders who are part of Indian banking system (where permitted); or
    2. with the support (where permitted) from the Indian banking system in the form of Guarantees/Standby Letters of Credit/Letters of Comfort, etc., such events shall be treated as ‘restructuring’ if the borrower concerned is under financial difficulty.
  9. Exemptions from restrictions on acquisition of non-SLR securities with respect to acquisition of non-SLR securities by way of conversion of debt.
  10. Exemptions from SEBI (ICDR) Regulations with respect to pricing of equity shares.

Withdrawal of earlier instructions

The following instructions, earlier issued by the RBI have been withdrawn with immediate effect:

Framework for Revitalising Distressed Assets, Corporate Debt Restructuring Scheme, Flexible Structuring of Existing Long Term Project Loans, Strategic Debt Restructuring Scheme (SDR), Change in Ownership outside SDR, and Scheme for Sustainable Structuring of Stressed Assets (S4A) stand withdrawn with immediate effect. Accordingly, the Joint Lenders’ Forum (JLF) as mandatory institutional mechanism for resolution of stressed accounts.

[1] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=11580&Mode=0

[2] The Directors lay down various categories ratings. RP4 resembles debt facilities carrying moderate risk with respect to timely servicing of financial obligations.

Large Exposures Framework: New RBI rules to deter banks’ concentric lending

-Kanakprabha Jethani |Executive
Vinod Kothari Consultants

Background

The RBI has made some crucial amendments to the Large Exposures Framework (LEF) by notification dated June 03, 2019. These changes are intended to align with global practices, such as look through approach for identifying exposures, determination of the group of “connected” counterparties, to name a few.

The LEF, announced by the RBI vide its notification dated December 01, 2016[1] and amended through notification dated June 03, 2019[2], is applicable with effect from April 1, 2019. However, the provisions relating to Introduction of economic interdependence criteria in definition of connected counterparties and non-centrally cleared derivatives exposures shall become applicable from April 1, 2020. This framework is likely to widen the scope of the definition of group of connected counterparties on one hand, and narrowing down the same by expanding the scope of exempted counterparties. Further, look-through approach demarcates between direct or indirect exposure of banks in various counterparties.

More about the LEF

A bank may have exposure to various large borrowers, and of group of entities that are related to each other. This exposure in large borrowers, whether singularly or by way of different related entities, results in concentration of bank’s exposure in the same group, thus increasing the credit risk of the bank. There have been examples of large banking failures throughout the world. In the words of the Basel Committee on Banking Supervision-

“Throughout history there have been instances of banks failing due to concentrated exposures to individual counterparties (eg Johnson Matthey Bankers in the United Kingdom in 1984, the Korean banking crisis in the late 1990s). Large exposures regulation has been developed as a tool for limiting the maximum loss a bank could face in the event of a sudden counterparty failure to a level that does not endanger the bank’s solvency.”

To deal with the risk arising out of such concentration, there has to be in place limits on concentration in a single borrower or a borrower group. Accordingly, after considering various frameworks being included in local laws and banking regulations and recommendations of committees such as Basel Committee on Banking Supervision, ‘Supervisory framework for measuring and controlling large exposures’[3] was issued by the said committee. The same was adopted by the RBI in respect of banks in India.

The Large Exposure Framework (LEF) shall be applied by banks at group level (considering assets and liabilities of borrower and its subsidiaries, joint ventures and associates) as well as at solo level (considering the capital strength and risk profile of borrower only).

Reporting of large exposure: As per the LEF, large exposure shall mean exposure of 10% or more of the eligible capital base of the bank in a single counterparty or a group of counterparties. The same shall be reported to Department of Banking Supervision, Central Office, Reserve Bank of India.

Limit on large exposure: the maximum exposure of a bank in a single counterparty shall not be more than 20% of its eligible capital base at any time. This limit shall be raised to 25% of bank’s eligible capital base in case of a group of counterparties.

Eligible capital base, in this reference shall mean the aggregate of Tier 1 capital as defined in Basel III – Capital Regulation[4] as per the latest balance sheet of the company, infusion of capital under Tier I after the published balance sheet date and profits accrued during the year which are not in deviation of more than 25% from the average profit of four quarters.

Applicability

The LEF shall be applicable on all scheduled commercial banks in India, with respect to their counterparties only.

The LEF has become applicable with effect from April 1, 2019. The revised guidelines on LEF shall also become applicable from the same date with retrospective effect except for the provisions of economic interdependence and non-centrally cleared derivative exposures.

What sort of borrowers are affected?

The revised guidelines have an impact on the borrowers who used to take advantage of different entities and hide behind the corporate veil to avail funding. The introduction of economic interdependence as a criteria for determining connected counterparties ensures that no same persons, whether promoters or management avail facilities through other entity.

Further, borrowers who operate as special purposes vehicles, securitisation structures or other structures having investments in underlying assets would also be affected as the banks will now look-through the structure to identify the counterparty corresponding the underlying asset.

However, the LEF does not address issues relating to lending to any specific sector or such other exposures.

What happens to affected borrowers?

The borrowers taking advantage of corporate veil will no more be able to avail funds in the covers of veil. The entities having same or related parties in their management shall not be able to avail funds exceeding the exposure limit. This would result in shrinkage of the availability of borrowed funds that would have otherwise been available to the entities. Also, entities operating as aforementioned structures, are likely to face contraction of borrowed fund availability.

Global framework

The global framework on large exposures called the Supervisory framework for measuring and controlling large exposures became applicable from 1st Jan 2019. The key features of the global framework are as follows:

  • Norms for determining scope of counterparties and exemptions thereto.
  • Specification of limits of large exposures and reporting requirements.
  • The sum of exposure to a single borrower or a group of connected borrowers shall not exceed 25% of bank’s available capital base.
  • If a G-SIB (Global systemically Important Banks) shall not exceed exposure limit of 15% of its available capital base in another G-SIB.
  • Principles for measurement of value of exposures.
  • Techniques for mitigation of credit risk.
  • Treatment of sovereign exposures, interbank exposures, exposures on covered bonds collective investment schemes, securitisation vehicles or other structures having underlying assets and in central counterparties been specified.

“Connected” borrowers

A bank shall lend within concentration limits prescribed in the LEF. For this purpose, the aggregate of concentration in all the connected counterparties shall be considered. Basically, connected counterparties are those parties which have such a relationship among themselves, either by way of control or interdependence, that failure of one of them would result in failure of the other too. The LEF provides the following criteria for determining the “connected” relationship between counterparties.

  • Control- where one of the counterparties has direct or indirect control over the other, ‘Control maybe determined considering the following:
    • holding 50% or more of total voting rights
    • having significant influence in appointment of managers, supervisors etc.
    • significant influence on senior management
    • where both the counterparties are controlled by a third party
    • Qualitative guidance on determining control as provided in accounting standards.
    • Common owners, shareholders, management etc.
  • Economic interdependence- where if one of the counterparties is facing problems in funding or repayment, the other party would also be likely to face similar difficulties. Following criteria has to be considered for determining economic interdependence between entities:
    • Where 50% or more of gross receipts or expenditures is derived from the counterparty
    • Where one counterparty has guaranteed exposure of the other either fully or partly
    • Significant part of one counterparty’s output is purchased by the other
    • When the counterparties share the source of funds to repay their loans
    • When the counterparties rely on same source of funding

Look through approach

In case of investing vehicles such as collective investment vehicles, securitisation SPVs and other cases such as mutual funds, venture capital funds, alternative investment funds, investment in security receipts, real estate investment trusts, infrastructure investment trusts etc., the recognition of exposures will be done on a see-through or look-through approach. The meaning of look-through approach is the underlying exposures will be recognised in constituents of the pool or the fund, rather than the fund.

When banks invest in structures which themselves have exposures to underlying assets, the bank shall determine if it is able to look-through the structure. If the bank is able to look-through and the exposure of bank in each of the underlying asset of the structure is equal to or above 0.25% of its eligible capital base, the bank must identify specific counterparties corresponding to the underlying asset. The exposure of bank in each of such underlying assets shall be added to the bank’s overall exposure in the corresponding counterparty.

Further, if the exposure in each of the underlying assets is less than 0.25% of bank’s eligible capital base, the exposure maybe assigned to the structure itself.

However, if a bank is unable to identify underlying counterparties in a structure:

  • bank’s exposure in that structure is 0.25% or more of its eligible capital base, the bank shall assign such exposure in the name of “unknown client”.
  • bank’s exposure in that structure is less than 0.25% of its eligible capital base, the exposure shall be assigned to the structure itself.

However, if the exposure of bank in the structure is less than 0.25% of the eligible capital base of the bank, the total exposure maybe assigned to the structure itself, as a distinct counterparty, rather than looking through the structure and assigning it to corresponding counterparties.

Overall impact of the LEF

The primary objective of LEF is to limit the concentration of bank in a single group of borrowers. By specifying criteria for large exposures, determination of “connected” relationship, reporting to RBI, ways to mitigate risk etc. the LEF intends to reduce credit risk of banks caused due to concentration in a single borrower or a group of borrowers.

The application of provisions of LEF will reduce the concentration risk of banks which in turn would result in reduction of credit risk of the bank. It would also result in increased monitoring by the RBI on the lending practices of banks. It is likely to reduce the instances of default in repayments, which have become a routine practice nowadays.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10757&Mode=0

[2] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=11573&Mode=0

[3] https://www.bis.org/publ/bcbs283.pdf

[4] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=9859&Mode=0

RBI’s 12th February circular: The Last Word Becomes the Lost World

RBI’s 12th February circular:

The Last Word Becomes the Lost World

Abhirup Ghosh (abhirup@vinodkothari.com)

The 12th February 2018 circular of the Reserve Bank of India (RBI)[1] (Circular), arguably one of the sternest of measures requiring banks to stop ever-greening bad loans, and resolve them once for all, with a hard timeline of 6 months, or mandatorily push the matter into insolvency resolution, was aimed at being the last word, overriding several of the previous measures such as CDR, JLF, SSSS-A, etc. However, with the Supreme Court striking it down, in the case of Dharani Sugars and Chemicals Limited vs Union of India and Ors.[2], the mandate of the RBI in directing banks with how to deal with stressed loans has fallen apart. While the SCI has used very technical grounds to quash the 12th Feb circular, the major question for the RBI is whether it should continue to micro-manage banks’ handling of bad loans, and the major question for the banks is when will they grow up into big boys and stop expecting RBI to tell them how to clean up the mess on their balance sheet.

The judgment has received mixed reactions from various parts of the economy. This write-up will take you through how it started, and how it ended and what the way forward is.

How it started?

The inception of the entire trail dates back to 5th May, 2017 when the Banking Regulation (Amendment) Ordinance, 2017 was notified. The Ordinance was passed with the intention to empower the Central Government (CG) to authorise the RBI to issue directions to banking companies to initiate insolvency resolution process (IRP) under the provisions of Insolvency and Bankruptcy Code, 2017 (IBC). Two new sections were introduced in the Banking Regulation Act, 1949, namely, sections 35AA and 35AB. While section 35AA empowered the CG to authorise RBI to direct banks to initiate IRP proceedings, section 35AB empowered the RBI to issue directions to the banking companies for resolution of stressed assets.

Soon after the Ordinance was notified, the Ministry of Finance empowered the RBI to issue directions under section 35AA on 5th May, 2017[3].

The Ordinance was replaced by the Banking Regulation (Amendment) Act, 2017 on 25th August, 2017[4]. However, before the Ordinance could turn into an Act, the RBI issued a press release[5] conveying the following:

  1. That it has constituted an Internal Advisory Committee that will help identifying accounts for which IRP must be launched;
  2. That it is laying down criterion for referring accounts for resolution under IBC among top 500 exposures in the banking system which are either wholly or partially NPA; and that 12 accounts satisfy the conditions;
  3. That for the accounts which do not satisfy the criterion laid down by IAC, the banks must prepare a resolution plan within six months and where a valid resolution plan is not agreed upon IRP must be launched after the expiry of six months;
  4. That the RBI will issue directions, based on the recommendations of the IAC, to banks to initiate insolvency proceedings under IBC;
  5. That the RBI will subsequently issue framework for dealing with other NPAs.

Subsequently, the RBI came out with a framework for dealing with other NPAs on 12th February, 2018. The framework was notified by RBI, purportedly, deriving powers from four sections – sections 35A, 35AA and 35AB of the BR Act and section 45L of the RBI Act.

The central theme of this framework revolved around identification of stress in large ticket sized accounts, implementing a resolution plan within 180 days from the date of default and in case of failure to implement, IRP action must be initiated against the borrower under IBC, within 15 days from the date of expiry of the timeline. Large accounts for this purpose means accounts where the aggregate exposure of the lenders exceed ₹ 2,000 crores.

The salient features of the framework are as follows:

  • Identification of early signs of stress in accounts with outstanding of Rs. 5 crores or above, through SMA account classifications and filing of relevant information with the Central Repository of Information on Large Credits (CRILC).
  • Resolution plans must be worked upon for all cases of default and must be implemented within a period of 180 days from the date of default or from the reference date, that is 1st March, 2019, in case the default was subsisting as on the date of reference date. This timeline is however applicable for accounts with outstanding debt of Rs. 2000 crores. However, the reference date was accounts with outstanding of debt of less than the specified amount but more than Rs. 100 crores, for the purpose of debt resolution, has not been notified yet.
  • Independent credit rating to be obtained before implementing the RP.
  • In case of failure to implement the RP within the specified timeline, the account must be dragged into IRP under the IBC within a period of 15 days from the expiry of the time period. The reference under IBC can be made by the banks either singly or jointly.
  • In case of timely implementation of RP, if the account faces any default during the specified period, then the same must be referred for IRP under IBC by the lenders singly or jointly, within 15 days from the date of default. Specified period, in this regard means period within which at least 20 percent of the outstanding principal debt as per the RP and interest capitalisation sanctioned as part of the restructuring, if any, is supposed to be repaid.
  • Sale and leaseback transactions of any asset of the borrower will be treated as a case of restructuring for the purpose of the framework and be subject to asset classification norms applicable to restructured accounts.
  • The framework repealed all the other frameworks for dealing with stressed assets, issued earlier by the RBI, namely, Framework for Revitalising Distressed Assets, Corporate Debt Restructuring Scheme, Flexible Structuring of Existing Long Term Project Loans, Strategic Debt Restructuring Scheme (SDR), Change in Ownership outside SDR, Scheme for Sustainable Structuring of Stressed Assets (S4A), and Joint Lenders’ Forum (JLF) as an institutional mechanism for resolution of stressed accounts.

How it ended?

The framework raised several eyebrows as some felt that the RBI had categorised all defaulted accounts into one single bucket, irrespective of the kind of stress they are facing. Other felt that the framework becoming applicable even on a single day default is an unreasonable measure. However, the most important issue of contention that dragged the matter to the court was questioning the authority of RBI to issue the framework on the first place.

The ruling passed by the SCI is result of this contention and the SCI has ruled it against the RBI. The SCI declared that the issuance of the framework ultra vires the powers granted to the RBI under various statutes and that the framework shall be of no effect in law.

While building up this ruling the SCI considered the following:

  • Sections 35A, 35AA and 35AB of the BR Act – The SCI stated that the stressed assets can be resolved through the provisions of IBC or otherwise. When the measure intended is IBC, section 35AA is the only resort. However, if the RBI wishes to resolved stressed accounts other than through IBC, then it can use general powers under section 35A and 35AB. While section 35A grants wide powers to RBI to give directions when it comes to the matters specified therein, section 35AA calls for an additional requirement of “authorisation” from CG to give directions to banks to proceed under IBC.

Therefore, for exercising powers under the 35AA, the RBI requires specific authorisation from the Central Government, however, for enforcing powers granted under sections 35A and 35AB, no specific authorisation is required. Had there been no section 35AA, RBI would have needed no authorisation to give such directions, as such power could be derived from the existing section 35A, which is wide and expansive enough.

To quote SCI –

“30. The corollary of this is that prior to the enactment of Section 35AA, it may have been possible to say that when it comes to the RBI issuing directions to a banking company to initiate insolvency resolution process under the Insolvency Code, it could have issued such directions under Sections 21 and 35A. But after Section 35AA, it may do so only within the four corners of Section 35AA.

  1. The matter can be looked at from a slightly different angle. If a statute confers power to do a particular act and has laid down the method in which that power has to be exercised, it necessarily prohibits the doing of the act in any manner other than that which has been prescribed. . .”

The court pointed out that if the RBI had the power under sections 35A or 35AB of the BR Act to direct the banks to initiate proceedings under the IBC, it would obviate the necessity of the Central Government authorisation under section 35AA to do so. It noted the following:

“40. Stressed assets can be resolved either through the Insolvency Code or otherwise. When resolution through the Code is to be effected, the specific power granted by Section 35AA can alone be availed by the RBI. When resolution de hors the Code is to be effected, the general powers under Sections 35A and 35AB are to be used. Any other interpretation would make Section 35AA otiose. In fact, Shri Dwivedi’s argument that the RBI can issue directions to a banking company in respect of initiating insolvency resolution process under the Insolvency Code under Sections 21, 35A, and 35AB of the Banking Regulation Act, would obviate the necessity of a Central Government authorisation to do so. Absent the Central Government authorisation under Section 35AA, it is clear that the RBI would have no such power.”

Therefore, it becomes important to understand if the RBI acted well within its powers under section 35AA while issuing the circular. Section 35AA states the following:

‘35AA. The Central Government may, by order, authorise the Reserve Bank to issue directions to any banking company or banking companies to initiate insolvency resolution process in respect of a default, under the provisions of the Insolvency and Bankruptcy Code, 2016.

Explanation.—For the purposes of this section, “default” has the same meaning assigned to it in clause (12) of section 3 of the Insolvency and Bankruptcy Code, 2016.

As noted above, section 35AA allows the RBI to issue directions to banks to initiate IRP in respect of “a default”. The meaning of term default has been drawn from the IBC, as per which a default is non-payment of a debt when it has become due and payable by the corporate debtor. All this indicates that the default in the present context refers to a specific default and not defaults in general.

Further, the SCI also took note of the press note of the Ordinance of 5th May, 2017 which indicated that the intention of deal with resolution of “specific” stressed assets which will empower the RBI to intervene in “specific” cases of resolution of NPAs. The same was also the understanding of the Central Government when it issued the notification on 5th May, 2017 to authorise the RBI to issue directions to the banks to act against “a default” under IBC. Therefore, this made it conclusive that directions issued in relation to debtors in general, is ultra vires the powers under section 35AA.

  • Section 45L of the RBI Act – The RBI stated in the framework that it drew one of its powers from section 45L of the RBI Act. The section grants power to direct non-banking financial institutions. However, section 45(3) of the RBI Act states the following:

XX

(3) In issuing directions to any financial institution under clause (b) of sub-section (1), the Bank shall have due regard to the conditions in which, and the objects for which, the institution has been established, its statutory responsibilities, if any, and the effect the business of such financial institution is likely to have on trends in the money and capital markets.

XX

It was emphasised that in order to issue any direction under this section, the RBI must have due regard to the conditions in which, and the objects for which, the institutions have been established, their statutory responsibilities, and the effect the business of such financial institutions is likely to have on trends in the money and capital markets. However, the framework did not discuss anything as such. Further, since, the very intention of bringing in NBIs under this framework was to deal with cases which had joint lending arrangements between banks and NBIs, the SCI found it difficult to separate banks and NBIs and make the circular applicable on NBIs even though ultra vires for the banks.

Therefore, the entire circular was declared ultra vires as a whole.

What is the way forward?

The ruling has created an awkward situation, as the banks have already acted upon the directions issued by the RBI. They have either implemented an RP or dragged the borrower to NCLT to proceed under IBC. Now that the circular is gone, following are the probable outcomes:

  1. For cases where RPs have been implemented – the lenders may decide to go ahead as per the RP and treat the same as restructured account.
  2. For cases where the corporate debtor has been taken to the NCLT – now that the very basis for taking the account to NCLT is gone, the lenders will have to take a call whether they want to pursue the proceedings under the Code without making references to RBI Circular.

Another apparent question that arises here is what will happen to the various frameworks which were withdrawn vide the 12th February circular. As stated by the SCI, the Circular will have no effect in law, therefore, the “withdrawal” clause too has been nullified. Therefore, the old restructuring frameworks can be said to be existing as on date.

Nevertheless, the Circular played the role of a game-changer by inducing a certain degree of credit discipline or at least the fear of being dragged into IBC. Now, as the Circular goes away, RBI may have to think of new restructuring frameworks – if that is through IBC, it would surely need CG’s authorisation.

[1] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=11218&Mode=0

[2] https://www.sci.gov.in/supremecourt/2018/42591/42591_2018_Judgement_02-Apr-2019.pdf

[3] http://egazette.nic.in/WriteReadData/2017/175797.pdf

[4]https://www.prsindia.org/sites/default/files/Banking%20Regulation%20%28Amendment%29%20Act%2C%202017.pdf

[5] https://rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=40743

Indefinite deferral of IFRS for banks: needed reprieve or deferring the pain?

Vinod Kothari (vinod@vinodkothari.com); Abhirup Ghosh (abhirup@vinodkothari.com)

On 22 March, 2019, just days before the onset of the new financial year, when banks were supposed to be moving into IFRS, the RBI issued a notification[1], giving Indian banks indefinite time for moving into IFRS. Most global banks have moved into IFRS; a survey of implementation for financial institutions shows that there are few countries, especially which are less developed, where banks are still adopting traditional GAAPs. However, whether the Notification of the RBI is giving the banks a break that they badly needed, or is just giving them today’s gain for tomorrow’s pain, remains to be analysed.

The RBI notifications lays it on the legislative changes which, as it says, are required to implement IFRS. It refers to the First Bi-monthly Monetary Policy 2018-19[2], wherein there was reference to legislative changes, and preparedness. There is no mention in the present  notification for preparedness – it merely points to the required legislative changes. The legislative change in the BR Act would have mostly been to the format of financial statements – which is something that may be brought by way of notification. That is how it has been done in case of the Companies Act.

This article analyses the major ways in which IFRS would have affected Indian banks, and what does the notification mean to the banking sector.

Major changes that IFRS would have affected bank accounting:

  • Expected Credit Loss – Currently, financial institutions in India follow an incurred credit loss model for providing for financial assets originated by them. Under the ECL model, financial assets will have to be classified into three different stages depending on credit risk in the asset and they are:
    • Stage 1: Where the credit risk in the asset has not changed significantly as compared to the credit risk at the time of origination of the asset.
    • Stage 2: Where the credit risk in the asset has increased significantly as compared to the credit risk at the time of origination of the asset.
    • Stage 3: Where the asset is credit impaired.

While for stage 1 financial assets, ECL has to be provided for based on 12 months’ expected losses, for the remaining stages, ECL has to be provided for based on lifetime expected losses.

The ECL methodology prescribed is very subjective in nature, this implies that the model will vary based on the management estimates of each entity; this is in sharp contrast to the existing provisioning methodology where regulators prescribed for uniform provisioning requirements.

Also, since the provisioning requirements are pegged with the credit risk in the asset, this could give rise to a situation where the one single borrower can be classified into different stages in books of two different financial institutions. In fact, this could also lead to a situation where two different accounts of one single borrower can be classified into two different stages in the books of one financial entity.

  • De-recognition rules – Like ECL provisioning requirements, another change that will hurt banks dearly is the criteria for derecognition of financial assets.

Currently, a significant amount of NPAs are currently been sold to ARCs. Normally, transactions are executed in a 15:85 structure, where 15% of sale consideration is discharged in cash and the remaining 85% is discharged by issuing SRs. Since, the originators continue to hold 85% of the SRs issued against the receivables even after the sell-off, there is a chance that the trusts floated by the ARCs can be deemed to be under the control of the originator. This will lead to the NPAs coming back on the balance sheet of banks by way of consolidation.

  • Fair value accounting – Fair value accounting of financial assets is yet another change in the accounting treatment of financial assets in the books of the banks. Earlier, the unquoted investments were valued at carrying value, however, as per the new standards, all financial assets will have to be fair valued at the time of transitioning and an on-going basis.

It is expected that the new requirements will lead to capital erosion for most of the banks and for some the hit can be one-half or more, considering the current quality of assets the banks are holding. This deferment allows the banks to clean up their balance sheet before transitioning which will lead to less of an impact on the capital, as it is expected that the majority of the impact will be caused due to ECL provisioning.

World over most of the jurisdictions have already implemented IFRS in the banking sector. In fact, a study[3] shows that major banks in Europe have been able to escape the transitory effects with small impact on their capital. The table below shows the impact of first time adoption of IFRS on some of the leading banking corporations in Europe:

Impact of this deferment on NBFCs

While RBI has been deferring its plan to implement IFRS in the banking sector for quite some time, this deferral was not considered for NBFCs at all, despite the same being admittedly less regulated than banks. The first phase of implementation among NBFCs was already done with effect from 1st April, 2018.

This early implementation of IFRS among NBFCs and deferral for banks leads to another issue especially for the NBFCs which are associates/ subsidiaries of banking companies and are having to follow Ind AS. While these NBFCs will have to prepare their own financials as per Ind AS, however, they will have to maintain separate financials as per IGAAP for the purpose of consolidation by banks.

What does this deferment mean for banks which have global listing?

As already stated, IFRS have been implemented in most of the jurisdictions worldwide, this would create issues for banks which are listed on global stock exchanges. This could lead to these banks maintaining two separate accounts – first, as per IGAAP for regulatory reporting requirements in India and second, as per IFRS for regulatory reporting requirements in the foreign jurisdictions.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11506&Mode=0

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=43574

[3] https://www.spglobal.com/marketintelligence/en/news-insights/research/european-banks-capital-survives-new-ifrs-9-accounting-impact-but-concerns-remain