SEBI proposed amendments in PIT Regulation to incentivize Informants…

By Dibisha Mishra (dibisha@vinodkothari.com)

corplaw@vinodkothari.com

Introduction

SEBI’s recent Discussion Paper[i] on amendment to the SEBI (PIT) Regulations, 2015 presses the fact that mere Regulator’s watch on the illegal transactions are not enough to practically eliminate trading on the basis of UPSI. Wherein insiders are finding new ways to get into such illegal transactions including transactions through proxy, difficulty in tracking and proving the same even if they are tracked remains a challenge for SEBI. Hence, to ensure better tracking and maintain the integrity of the securities market, the regulator is intending to bring in informants to the stage. The informants shall basically be the employees or any other person who observes actual or suspected cases on insider trading. Such mechanism shall have a dedicated reporting window and also provide for near absolute confidentiality to so that the informants are not deterred by the fear of retaliation or discrimination or disclosure of personal data.

Is this altogether a new concept?

Such Informant Mechanism, is not a new concept brought in to tackle the issue of insider trading altogether. Several other regulation though out the globe have been following the same practice. One such example being UK’s Market Abuse Regulation (596/2014) which provides similar kind of reporting mechanism. This concept is similar to ‘Whistle Blower Policy’ for frauds as provided under the Companies Act, 2013. However, SEBI’s Informant Mechanism enables reporting to the regulator directly rather than routing the same to the Company’s management itself. It also takes a step further to incentivize the informants to encourage pro-active reporting.

Features

The salient features of the proposed Informant Mechanism shall be as follows:

  1. Voluntary Information Disclosure Form where information can be reported.
  2. Disclosure on source of information: The information should be original and not sourced from any other person
  3. Office of Informant Protection(OIP): A dedicated department separate from investigation and inspection wings.
  4. Submission of Information: either by himself or through a practicing advocate where the informant decides to report unanimously.
  5. Confidentiality of Informant shall be maintained throughout the proceedings, if any, initiated by SEBI unless evidence of such informant is required such proceedings.
  6. Information reported shall be taken up further if the same is material. Such information may further be forwarded to the operational department for suitable actions only after slashing down the identity details of the informant.
  7. Reporting of the functioning of OIP on an annual basis to SEBI.
  8. A dedicated hotline to guide persons on how to file information.
  9. Grant of reward where information provided as as per informant policy and amount of disgorgement exceeds Rs. 5 crores. The reward shall be paid from IEPF account.
  10. Provision for amnesty.

Few downsides

  1. Smaller cases nor covered: While the proposed Informant Reward Policy is headed to incentivize the informant to promote pro-active reporting of insider trading transactions which were earlier left undetected, the department also proposes to put the minimum threshold for the amount of disgorgement. Only those information revealing insider trading transaction amounting to Rupees Five Crores or more shall be taken up for the purpose of rewarding. This clause itself slashes down majority of comparatively smaller but rather more frequent transactions from coming under its purview.
  2. Material cases: Proposed policy states that only those cases that are material shall be processed further. The official who shall be responsible to determine whether the information is material is nowhere mentioned.
  3. Tracking System: The policy mentions no such system of tracking by the informants regarding the status of information by them.

Conclusion

The discussion paper indicates SEBI’s intention to buckle up its systems for tracking down insider trading transactions and take appropriate action. However, the extent to which the proposed policy gets implemented along with modifications, if any, is yet to be seen.

[i] https://www.sebi.gov.in/reports/reports/jun-2019/discussion-paper-on-amendment-to-the-sebi-prohibition-of-insider-trading-regulations-2015-to-provision-for-an-informant-mechanism_43237.html

SEBI’s proposed buyback rules for leverage limits: to what extent practical? Rules impose low leverage limits for NBFCs and HFCs

 

Pammy Jaiswal

Vinod Kothari and Company

corplaw@vinodkothari.com

Background

As the regulators eye the performance of business houses at the group level for getting a helicopter view of their economic position, many changes have been brought in this direction. Some of which include the requirement of preparing the consolidated results on a quarterly basis, consideration of profitability and other financial statements on a consolidated basis for the purpose of coming up with an IPO under SEBI ICDR Regulations, 2018 and recommendations of the Kotak Committee for making like changes under the Listing Regulations.

SEBI, going forward in the same direction has issued its discussion paper on the proposed changes in the buy-back conditions on 22nd May, 2019[1].  While one of the proposed changes in terms of computing the buy-back size is on the logical side, the other change on taking the debt to equity ratio on a consolidated basis for certain categories of listed companies is seemingly impractical. This note shall cover the brief of the proposed changes and certain extent of critical analysis on the same.

Buy-Back Conditions

Both section 68 of the Companies Act, 2013 (‘Act, 2013’) as well as SEBI Buy-Back Regulations spell out the conditions for buy-back, some of which are as follows:

  • Authorisation in the Articles of Association and the shares subject to buy-back are fully paid-up.
  • Source of funds for buy-back – Three sources are laid i.e. free reserves, securities premium account and proceeds of the issue of any shares or other specified securities.
  • Buy-back offer size – 25% of the paid-up share capital of the company.
  • Buy-back size – Upto 10% of the paid-up share capital and free reserves with the approval of the Board and upto 25% of the paid-up share capital and free reserves with the approval of the members of the company.
  • Debt to equity ratio post buy-back is not more than 2:1 (except for government companies which are NBFCs and HFCs and can have the ratio not exceeding 6:1).
  • Other conditions as mentioned under the SEBI Buy-Back Regulations, 2018 for listed companies going for buy-back.

Both the legislations till now require that these conditions are met on a standalone basis. However, the discussion paper suggests that considering the threshold on standalone basis may not be giving the correct and complete picture of the parent entity which is going got buy-back of its securities.

 

Accordingly, the said paper recommends certain changes which are briefly analysed below.

 

SEBI’s move for conservative computation of thresholds under buy-back

 

Sr. No. Existing Requirement Proposed change Rationale Our comments
1. Board can approve buy-back to the extent of utilising 10% of the paid-up equity capital and free reserves The threshold of 10%  to be considered on conservative basis (both standalone as well as consolidated basis, whichever is lower) ·      Complete overview of group as a whole;

·      Consolidated financials present the economic position of the entity as a whole along with its potential to serve its obligations.

 

Considering the lower of the consolidated and the standalone figures should be absolutely fine as no one will be able to take any advantage out of it, however, the change may adversely affect the buy-back size of the listed company.

 

Especially where the subsidiaries of the listed company have negative net worth, there the limits may substantially go down.

2. Members can approve buy-back to the extent of utilising 25% of the paid-up equity capital and free reserves The threshold of 25%  to be considered on conservative basis (both standalone as well as consolidated basis, whichever is lower) Same as above. Same as above.
3. Post buy-back debt to equity capital to be 2:1 (the debt to capital and free reserves ratio shall be 6:1 for government companies within the meaning of clause (45) of section 2 of the Act, 2013 which carry on Non-Banking Finance Institution activities and Housing Finance activities.) Post buy-back debt to equity capital of 2:1 (the debt to capital and free reserves ratio shall be 6:1 for government companies within the meaning of clause (45) of section 2 of the Act, 2013 which carry on Non-Banking Finance Institution activities and Housing Finance activities) shall be considered on consolidated basis, excluding subsidiaries only if the subsidiaries are regulated and have issuances with AAA ratings

 

Such subsidiaries should have debt to equity ratio of not more than 5:1 on standalone basis

Considering the situation where the subsidiary of the parent entity has large amount of debt in its books, it is not judicious to exclude such debt while computing the debt to equity ratio for the purpose of calculating the buy-back size. This change is not achievable at all considering the following:

·   NBFCs and HFCs are capital intensive;

·   NHB allows 16 times leverage to HFCs;

·   No NBFCs are running at the leverage of 2:1;

·   Even if the parent entity has surplus capital and the same is put in the subsidiary which is capital intensive, the proposition will be flawed; and

·   Considering the inverse relation between weighted average cost of capital (WACC) and leverage, if the funds are given to the subsidiary, the WACC goes up and the leverage comes down.

 

While the above changes have been discussed in the paper, it actually calls for change in the legislation itself which when made effective, will give way to these changes. Till such time, the existing framework shall continue to rule the buy-back exercise.

Whether the aforesaid suggestion is for all listed companies?

Para 4.4 of the discussion paper states that the Primary Markets Advisory Committee (PMAC) of SEBI proposed the changes for those companies which have NBFCs and HFCs as their subsidiaries. This implies that the proposed changes are with the intent of restraining the buy-back exercise for those parent companies which have subsidiaries engaged in the business of financing and therefore, have large exposure on their assets.

Further, this implies that the listed companies whose subsidiaries do not comprise of finance companies may still continue with their practice of considering the threshold at standalone basis unless otherwise mentioned.

Conclusion

While the intent of these changes are aimed to make the buy-back conditions more conservative with an overview on the economic status of the entity on a group level, however, it fails to understand the need for a higher leverage for capital intensive entities.

 

[1] https://www.sebi.gov.in/reports/reports/may-2019/discussion-paper-on-review-of-buy-back-of-securities_43054.html

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

Securitisation and covered bonds for housing finance