FAQs on refund of interest on interest

-Financial Services Division (finserv@vinodkothari.com)

The Supreme Court of India (‘SC’ or ‘Court’) had given its judgment in the matter of Small Scale Industrial Manufacturers Association vs UOI & Ors. and other connected matters on March 23, 2021. The said order of SC put an end to an almost ten months-long legal scuffle that started with the plea for a complete waiver of interest but edged towards waiver of interest on interest, that is, compound interest, charged by lenders during Covid moratorium.  While there is no clear sense of direction as to who shall bear the burden of interest on interest for the period commencing from 01 March 2020 till 31 August 2020. The Indian Bank’s Association (IBA) has made representation to the government to take on the burden of additional interest, as directed under the Supreme Court judgment. While there is currently no official response from the Government’s side in this regard, at least in the public domain in respect to who shall bear the interest on interest as directed by SC. Nevertheless, while the decision/official response from the Government is awaited, the RBI issued a circular dated April 07, 2021, directing lending institutions to abide by SC judgment.[1] Meanwhile, the IBA in consultation with banks, NBFCs, FICCI, ICAI, and other stakeholders have adopted a guideline with a uniform methodology for a refund of interest on interest/compound interest/penal interest.

We have earlier covered the ex-gratia scheme in detail in our FAQs titled ‘Compound interest burden taken over by the Central Government: Lenders required to pass on benefit to borrowers’ – Vinod Kothari Consultants>

In this write-up, we have aimed to briefly cover some of the salient aspects of the RBI circular in light of SC judgment and advisory issued by IBA.

FAQs

(updated based on the IBA Advisory dated April 19, 2021)

Applicability on Lenders:

1. Which all financial institutions are covered by the RBI Circular?

The RBI Circular is directed to the following lenders :

  • All commercial banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks)
  • Co-operative Banks- Urban Co-operative Banks,  State Co-operative Banks and District Co-operative Bank
  • All India Financial Institutions
  • All Non-Banking Financial Companies (including Micro Finance Companies, systemically important NBFCs, non-systemically important NBFCs and Housing Finance Companies)

2. What exactly is the relief to be given?

The Relief is relief against compound and/or penal interest for any failure to pay, or delay in payments, by the Borrower, during the Moratorium Period, that is, 1st March 2020 to 31st August, 2020.

Thus, the compound interest and/or penal interest charged, explicitly or implicitly, during the Moratorium Period, for payments which were either delayed or failed during such period, will be replaced by simple rate of interest, at the rate contractually fixed between the parties.

3. How exactly is the relief to be given?

The Relief may be given by either refunding the amount of relief to the Borrower, or adjusting the same against any dues payable by the Customer. In case there are any payments already due, the Lender generally has the right to appropriate the amount payable to the Borrower against amounts which have already fallen due under the facility.

4. I was not a party to the litigation in the Supreme Court, and therefore, can it be contended that the SC has passed an order against all financial institutions, even if they were not before the Court, and therefore, had no opportunity to make or plead their case?

Pursuant to the Supreme Court Order, the RBI had issued a circular on April 7, 2021 directing all lending institutions (specified above) to abide by the instructions of the SC. Hence, irrespective of a lending institution being a party to the SC order, the RBI Circular is intended to be implemented uniformly by all lending institutions.

Of course, it remains a contentious question as to who shall take the burden of the Relief – whether the lending institution itself shall bear it, or lay the claim on the government. Pending clarity on that, we are assuming that the lending institution will have to shoulder the burden of Relief.

5. I am an investment company; I don’t have loan transactions with the public. Am I covered by the RBI Circular?

Pure Investment Companies, though registered as an NBFC, may not be carrying out lending activities. Hence, there does not seem to be any actionable on their part under the RBI Circular

6. I am an NBFC; my borrower has given an explicit waiver that the borrower does not want to avail the benefit of Relief on compounding interest. Do I still have to give that relief to the borrower? Can my policy, for example, say that the benefit of compound interest relief will be given to all borrowers, except those who have explicitly waived off their right to the same?

The benefit under Supreme Court order is to be extended to all the Eligible Accounts (covered in FAQ 8) uniformly. The burden of refunding the interest on interest amount to the customer, is on the lender. It seems counter intuitive that a Borrower will waive off what is clearly for relief to the borrower. Such waiver by the borrower will give rise to apprehension of use of pressure tactics.

7. I am a retail lender and none of my borrower accounts had outstanding loan facilities of more than 2 crores as on 29 February 2020. I have already extended the interest on interest benefit to my customers under the ex-gratia scheme. Do I still have to comply with the actionables under the RBI Circular?

In cases where the outstanding amount for all the loan accounts of the lender were below  2 crore as on 29 February 2020, there may be 2 reasons why the 7th April circular may still have to be complied with:

  1. The benefit was not extended to a Borrower, though the Borrower was eligible for the same.
  2. The benefit was not extended to a Borrower, if the Borrower belonged to the classes which were not eligible for the relief under ex-gratia owing to aggregate exposure of such borrower to all the lenders being more than Rs. 2 crore.

Hence, a Lender may see whether there is any actionable, including any provision to be made in the financials of 20-21.

Facility Covered

8. Which all classes or categories of loans/facilities are eligible under the RBI Circular?

All “standard accounts” have to be given the benefit of relief. The determination date for this purpose is 29th Feb., 2020. That is, the days past due (DPD) status should be less than 90 DPD as on 29.02.2020 (“Eligible Accounts”). While NPA classification is mostly done on account of DPD, there should not have been any other reasons for which the account was classified as an NPA as on 29 February 2020.

Accounts not eligible for Relief under RBI Circular:

  • Accounts classified as NPA as on 29 February 2020.
  • Loan facilities which were charged with simple interest.
  • Accounts already refunded interest on interest under ex-gratia scheme
  • Non-Funded facilities (bank guarantee, Letter of Credit) not eligible for any refund.

9. Are non-performing assets as on 1st March 2020 ineligible for the Relief?

The IBA Circular creates a confusion by use of the following expression: “NPA Accounts as on 29.02.2021 (presumption being no interest or no compound interest is changed in case of NPA accounts).

The presumption that compound interest is not charged on NPA accounts is fallacious. While interest is not accrued for accounting purposes, contractual right of the lender to charge interest continues even while the loan is an NPA.

However, the question is, was an NPA borrower actually eligible to avail the moratorium at all? The intent of the moratorium was to grant relief against difficulties arising due to the pandemic.

10. In case the lender is collecting EMIs and not charging any penal interest, will such loans be eligible?

The language of the RBI Circular para 2 is that all lending institutions shall immediately put in place a Board-approved policy to refund/adjust the ‘interest on interest’ charged to the borrowers,irrespective of whether moratorium had been fully or partially availed, or not. The RBI Circular intends to provide a relief on ‘interest on interest’ charged to the borrowers during the moratorium period, i.e. March 1, 2020, to August 31, 2020. That is to say, the intent of the RBI, following the directive of the SC, seems to give relief to a borrower who has been charged compound interest during the Moratorium Period.

Now, assume the following situation: A borrower did not avail of the moratorium, and was regularly paying loan instalments, and interest on the outstanding principal during the Moratorium Period. As there were no instalments that were overdue during the period, the question of the lender charging any interest on interest did not arise. Interest was being charged, but that was on the outstanding principal. Hence, if no compound interest has either been charged or posted to the account of the borrower, no benefit/refund is applicable to such borrower.

11. In the answer to the question immediately above, will it make any difference if the loan agreement provided for payment by EMIs rather than by equal instalments of principal or interest?

In EMIs too, the interest is inherently computed on outstanding principal (POS), and as there was no deferral of payments by the borrower, there was no interest on interest charged during the Moratorium Period.

12. Para 1.1 of the IBA Circular dated April 19, 2021  says : “where compound interest/interest on interest/ penal interest for non-payment/delayed payment was applied during moratorium”. This seems to imply that the relief is applicable only where (a) there has been a non-payment or (b) there has been a delayed payment during the Moratorium Period. In line with the SC ruling, the non-payment or delayed payment may either be covered by the mutual moratorium, or there may not have been a moratorium and still there may be a delay in the payments.

In essence, it seems from the reading of the IBA Circular that there are 2 conditions to be satisfied to grant the relief:

There was:

  1. Either a delayed payment or non-payment during the Moratorium Period, or there was a moratorium period availed and granted, and therefore, the compound interest was imposed on the restructured payment schedule
  2. And, the Lender has charged either compound interest or penal interest or both on account of either the delay, or non-payment, or shifting of payments due to the Moratorium.

Is it a correct interpretation to say that the relief under the IBA Circular is not applicable where the first or the second condition is not satisfied?

Yes, this understanding is correct. In fact, it becomes even clearer by reading the “remarks” column against entry 1, where it says, “Account eligible for refund only if compound interest/interest on interest/penal interest has been applied during the moratorium.” A similar comment appears against entry 2: “Accounts where compounding interest/interest on interest/ penal interest for non-payment/ delayed payment has not been applied during the moratorium will not be eligible for refund of interest.”

13. The facility in question did not have any payments due during the Moratorium Period. As there was no payment due during the Moratorium Period, the question of any compound interest or penal interest charged during the Moratorium Period, for payments delayed or failed during such period, does not arise. The following are some examples:

a) A loan was extended on 1st Jan., 2020 and the instalments were to begin from 1st October as the loan was under original moratorium. 

b) A loan was given on 1st Jan., 2020 but a bullet repayment at the end of 1 year. 

In both the cases, the intrinsic computations involve compound interest but as there was no failure to pay or delay during the Moratorium Period, there was no implication on any of the payments to be made by the borrower. Further, since no payments were due, the question of any moratorium did not arise.

In these cases, is it correct to contend that the 7th April circular does not apply?

Yes. As there is no case of delay or failure to pay during the moratorium period, there is no case for applying the 7th April circular.

14. The loan was standard as on 1st March, but was already 60 DPD as on that date. Hence, the overdue instalments were already attracting a penal rate, say at the rate of 24%. From 1st March to 31st August, can such penal interest, on instalments due and payable before 1st March, 2020, continue?

While it is possible to have a different interpretation, the intent of the SC ruling and the RBI Circular is that the time clock had stopped during the moratorium. The borrower could not pay till 1st March 2020 – that was a case of failure to pay. However, during the moratorium period, it was a case of inability to pay due to a supervening difficulty. Hence, neither compound interest nor penal interest can be charged during the Moratorium Period.

15. In case a lender does not charge compound interest on loan, will such loans still be eligible for refund/adjustment?

In cases where the lender does not charge compound interest on its loan facilities, this essentially means that there is no compounding of the principal amount by such lender over the tenure of such loan. Hence there is no question of refund of interest on interest on such loan facilities. However, if any penal interest has been charged with respect to such loan facilities, during the moratorium period, the same is liable to be refunded.

16. In case a borrower did not avail the moratorium in respect to the loan facility and such borrower defaulted on its EMI during the moratorium period, will such borrower be covered under the RBI Circular?

The refund of interest on interest is available to the Borrower under RBI Circular, irrespective whether the moratorium has been availed or not by such Borrower.  A Borrower who did not avail the moratorium and subsequently defaulted on its EMI.

Then in such cases:

  • Either the account is subjected to penalty on its EMI after such default by the customer, OR
  • In case no penalty is charged, even in such a case EMI includes a compound interest component

Therefore, in cases where penalty is charged during the moratorium period all the amount towards penalty including interest on such penalty (if any) should be refunded/adjusted by the lender in addition to the differential amount payable in respect to interest on interest ( Six months compound interest on amount outstanding as on 29.02.2020 minus simple interest on amount outstanding as on 29.02.2020).

17. Will guarantee arrangements be covered under the RBI Circular?

Guarantee is an unfunded support. Hence, there is no question of any payments due, except for payments for by way of guarantee commission.

The IBA clarification dated 19 April 2021 clearly provides in its annure 1 column 2 that non-funded facilities are not eligible for refund.

Note that guarantee commission is not subject to a moratorium

18. Will it make a difference if the guarantee has been invoked and become a funded facility?

If the guarantee is a funded facility, on account of the guarantee having been invoked, it will certainly be covered by the Circular.

19. Will the accounts not eligible for benefit under the ex-gratia scheme, qualify for the refund of interest on interest under RBI Circular? 

The ex-gratia scheme excluded certain accounts out of its ambit, such as agricultural and allied activities loans including tractor loans. The RBI Circular makes no distinction on such basis, hence interest on interest benefit should be passed to all the Eligible Accounts even if they were ineligible earlier under the ex-gratia scheme.

20. Will the loan facilities by banks to NBFCs/HFCs, qualify for the refund of interest on interest under RBI Circular? 

The RBI Circular does not distinguish the loan accounts on the basis of end-use or the purpose of the loan account. Therefore, Eligible Accounts should also include loan facilities extended by banks to the NBFCs/HFCs, or loan facilities by one NBFC to another NBFC provided there was delay or failure to pay during the moratorium period and interest on interest or penal interest was charged.

Borrowers covered

21. Which all borrowers are eligible to be benefitted under the RBI Circular?

All borrower accounts that are eligible, have aggregate fund based activities with all the lenders of Rs. 2 crore and above and below. Subject to following conditions:

  • Such accounts were not NPA as on 29 February 2020
  • The interest/EMI on the borrower account is based on compound interest
  • Interest has been charged on such interest/EMI payment during the moratorium period, either penal interest for delayed payment or non-payment has been charged on such interest/EMI.
  • No refund of interest on interest was provided under ex-gratia scheme to such account.

22. In case an Eligible Borrower was not extended the benefit under the Ex-Gratia Scheme due to any reason, (such as non availability of bank account details for borrowers whose loan account have been closed), can the borrower avail the benefit under the RBI Circular?

All the Eligible Accounts of the Borrowers should be entitled to refund/adjustment of interest on interest under the RBI Circular, even if no benefit to such accounts was granted under the ex-gratia scheme.    

23. What will be the eligibility of a borrower who has not availed any moratorium?

The fact that the borrower has availed the moratorium, or not, is inconsequential for the purpose of RBI Circular. All Eligible Accounts, whether moratorium was availed, or not, are entitled to refund of interest on interest for the period commencing from 01-03-2020 till 31-08-2020, provided there was delay or failure to pay during the moratorium period and interest on interest or penal interest was charged.

Computation

24. How will the computation of the relief be done?

(a) Identify the sums which have been failed or delayed during the Moratorium Period (Unpaid Amounts).

(b) Compute, based on actual rate charged, the compound interest and/or penal interest (Actual Charge) on Unpaid Amounts.

(c) Compute, on Unpaid Amounts, simple interest at the contractual rate of interest. Note that the contractual rate of interest may itself be a compound rate. There is no need to transform the compound rate into an equivalent simple interest rate. The compound interest rate itself may be applied on simple interest basis.

(d) The difference between step (b) and (c) is the Relief.

25. On what date is the Borrower entitled to get the benefit of the Relief? If the credit of the amount of Relief is to be given at the end of the Moratorium Period, then the compound interest charged on an amount equal to the Relief may have extended beyond the Moratorium period too. 

In our view, the intent of the SC ruling followed by the RBI Circular is that the compound interest ought not have been charged at all during the Moratorium period. If the compound interest has been charged during the Moratorium Period, it will obviously have impact after the moratorium period too. In our view, the credit, therefore, has to be given at the end of the Moratorium Period.

26. On what rate of interest will the difference between compound interest and simple interest be calculated?

The difference between the compound interest and simple interest shall be calculated on the contractual rate (loan agreement rate) between the lender and borrower as on 29 February 2020.

27. Will there be any refund/ adjustment in case the contractual rate of interest is 0%?

In case the contractual rate is NIL or 0%, there is no question of granting any benefit to the borrower, given that the borrower has not paid any interest at all.

Accounting Provision

28. What is the exact manner of passing on the benefit to the borrower? Is it merely a credit to the account of the borrower, or does it lead to any cash benefit being transferred to the borrower?

The benefit has to be passed on to the borrower by either adjusting the differential amount with the future payables by the borrower or in case the loan account has been closed, the amount shall be refunded to the borrower. In either case, the lender is required to create a provision in its books of accounts for the financial year ending March 31, 2021.

29. When is the impact of such relief to be recognised in the books of accounts of the lender?

As per the RBI Circular, lending institutions shall disclose the aggregate amount to be refunded/adjusted in respect of their borrowers in their financial statements for the year ending March 31, 2021.

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12071&Mode=0

Payment and Settlement Systems: A Primer

– Siddarth Goel (finserv@vinodkothari.com)

Introduction

A payment denotes the performance or discharge of an obligation to pay, which may or may not involve money transfer. Payment is therefore a financial obligation in whatever parties have agreed constituting a payment. A payment and settlement system could be understood as a payments market infrastructure that facilitates the flow of funds in satisfaction of a financial obligation. The need for a payment system is an integral part of commerce. From the use of a payment system in an e-commerce purchase, a debit or credit card fund transfer, stock or share purchase. The payment obligation can also be settled without the presence of any financial intermediary (peer-to-peer). The payment transaction need not always be settled in money, it could be settled in security, commodity, or any other obligation as may be decided by payment system participants.

One of the earlier known payment mechanisms was the barter system. With the evolution of civilisation, the world moved to a system supported by tokens and coins that are still prevalent and are widely used as the mode of payment. The payment mechanism supported by physical currency notes or coins is simple, as it offers peer-to-peer, real-time settlement of obligation between the parties, by way of physical transfer of note or coin from one party to another.

In contemporary electronic payment systems, the manner of flow of funds from one payment system participant to another is central to the security, transparency, and stability of the payment system and financial system as a whole. The RBI’s main objective is to maintain public confidence in payment and settlement systems, while the other function being to upgrade and introduce safe and efficient modes of payment systems. The RBI is also the banker to all scheduled banks and maintains bank accounts on their behalf.  All the scheduled commercial banks have access to a central payment system operated by RBI. Thereby banks have access to liquidity funding line with RBI which have been discussed later in this chapter.

Electronic payments usually involve the transfer of funds via money in bank deposits. While securities settlement system involves trade in financial instruments namely; bonds, equities, and derivatives. The implementation of sound and efficient payment and securities settlement systems is essential for financial markets and the economy. The payment system provides money as a means of exchange, as central banks are in control of supplying money to the economy which cannot be achieved without public confidence in the systems used to transfer money. It is essential to maintain stability of the financial systems, as default under very large value transfers create the possibilities of failure that could cause broader systemic risk to other financial market participants. There is a presence of negative externality that can emanate from a failure of a key participant in the payment system.[1]

Read more

Understanding regulatory intricacies of Payment Aggregator business

-Siddarth Goel (finserv@vinodkothari.com)

Abstract

The penetration of electronic retail payments has witnessed a steep surge in the overall payment volumes during the latter half of the last decade. One of the reasons accorded to this sharp rise in electronic payments is the exponential growth in online merchant acquisition space. An online merchant is involved in marketing and selling its goods and/or services through a web-based platform. The front-end transaction might seem like a simple buying-selling transaction of goods or services between a buyer (customer) and a seller (merchant). However, the essence of this buying-selling transaction lies in the payment mode or methodology of making/accepting payments adopted between the customer and the merchant. One of the most common ways of payment acceptance is that the merchant establishes its own payment integration mechanism with a bank such that customers are enabled to make payments through different payment instruments. In such cases, the banks are providing payment aggregator services, but the market is limited usually to the large merchants only. Alternatively, merchants can rely upon third-party service providers (intermediary) that facilitate payment collection from customers on behalf of the merchant and thereafter remittance services to the merchant at the subsequent stage – this is regarded as a payment aggregation business.

The first guidelines issued by the RBI governing the merchant and payment intermediary relationship was in the year 2009[1]. Over the years, the retail payment ecosystem has transformed and these intermediaries, participating in collection and remittance of payments have acquired the market-used terminology ‘Payment Aggregators’. In order to regulate the operations of such payment intermediaries, the RBI had issued detailed Guidelines on Regulation of Payment Aggregators and Payment Gateways, on March 17, 2020. (‘PA Guidelines’)

The payment aggregator business has become a forthcoming model in the online retail payments ecosystem. During an online retail payment by a customer, at the time of checkout vis-à-vis a payment aggregator, there are multiple parties involved. The contractual parties in one single payment transaction are buyer, payment aggregator, payment gateway, merchant’s bank, customer’s bank, and such other parties, depending on the payment mechanism in place. The rights and obligations amongst these parties are determined ex-ante, owing to the sensitivity of the payment transaction. Further, the participants forming part of the payment system chain are regulated owing to their systemic interconnectedness along with an element of consumer protection.

This write-up aims to discuss the intricacies of the regulatory framework under PA Guidelines adopted by the RBI to govern payment aggregators and payment gateways operating in India. The first part herein attempts to depict growth in electronic payments in India along with the turnover data by volumes of the basis of payment instruments used. The second part establishes a contrast between payment aggregator and payment gateway and gives a broad overview of a payment transaction flow vis-à-vis payment aggregator. The third part highlights the provisions of the PA Guidelines and establishes the underlying internationally accepted best principles forming the basis of the regulation. The principles are imperative to understand the scope of regulation under PA Guidelines and the contractual relationship between parties forming part of the payment chain.

Market Dynamics

The RBI in its report stated that the leverage of technology through the use of mobile/internet electronic retail payment space constituted around 61% share in terms of volume and around 75% in share in terms of value during FY 19-20.[2] The innovative payment instruments in the retail payment space, have led to this surge in electronic payments. Out of all the payment instruments, the UPI is the most innovative payment instrument and is the spine for growth in electronic payments systems in India. Chart 1 below compares some of the prominent payment instruments in terms of their volumes and overall compounded annual growth rate (CAGR) over the period of three years.

The payment system data alone does not show the complete picture. In conformity with the rise in electronic payment volumes, as per the Government estimates the overall online retail market is set to cross the $ 200 bn figure by 2026 from $ 30 bn in 2019, at an expected CAGR of 30 %.[4] India ranks No. 2 in the Global Retail Development Index (GRDI) in 2019. It would not be wrong to say, the penetration of electronic payments could be due to the presence of more innovative products, or the growth of online retail has led to this surge in electronic payments.

What are Payment Aggregators and Payment Gateways?

The terms Payment Aggregator (‘PA’) and Payment Gateways (‘PG’) are at times used interchangeably, but there are differences on the basis of the function being performed. Payment Aggregator performs merchant on-boarding process and receives/collects funds from the customers on behalf of the merchant in an escrow account. While the payment gateways are the entities that provide technology infrastructure to route and/or facilitate the processing of online payment transactions. There is no actual handling of funds by the payment gateway, unlike payment aggregators. The payment aggregator is a front-end service, while the payment gateway is the back-end technology support. These front-end and back-end services are not mutually exclusive, as some payment aggregators offer both. But in cases where the payment aggregator engages a third-party service provider, the payment gateways are the ‘outsourcing partners’ of payment aggregators. Thereby such payments are subject to RBI’s outsourcing guidelines.

PA Transaction Flow

One of the most sought-after electronic payments in the online buying-selling marketplace is the payment systems supported by PAs. The PAs are payment intermediaries that facilitate e-commerce sites and merchants in accepting various payment instruments from their customers. A payment instrument is nothing but a means through which a payment order or an instruction is sent by a payer, instructing to pay the payee (payee’s bank). The familiar payment instruments through which a payment aggregator accepts payment orders could be credit cards, debit cards/PPIs, UPI, wallets, etc.

Payment aggregators are intermediaries that act as a bridge between the payer (customer) and the payee (merchant). The PAs enable a customer to pay directly to the merchant’s bank through various payment instruments. The process flow of each payment transaction between a customer and the merchant is dependent on the instrument used for making such payment order. Figure 1 below depicts the payment transaction flow of an end-to-end non-bank PA model, by way of Unified Payment Interface (UPI) as a payment instrument.

In an end-to-end model, the PA uses the clearing and settlement network of its partner bank. The clearing and settlement of the transaction are dependent on the payment instrument being used. The UPI is the product of the National Payments Corporation of India (NPCI), therefore the payment system established by NPCI is also quintessential in the transaction. The NPCI provides a clearing and settlement facility to the partner bank and payer’s bank through the deferred settlement process. Clearing of a payment order is transaction authorisation i.e., fund verification in the customer’s bank account with the payer’s bank. The customer/payer bank debits the customer’s account instantaneously, and PA’s bank transfers the funds to the PA’s account after receiving authorisation from NPCI. The PA intimates the merchant on receipt of payment and the merchant ships the goods to the customer. The inter-bank settlement (payer’s bank and PA’s partner bank) happens at a later stage via deferred net-settlement basis facility provided by the NPCI.

The first leg of the payment transaction is settled between the customer and PA once the PA receives the confirmation as to the availability of funds in the customer’s bank account. The partner bank of PA transfers the funds by debiting the account of PA maintained with it. The PA holds the exposure from its partner bank, and the merchant holds the exposure from the PA. This explains the logic of PA Guidelines, stressing on PAs to put in place an escrow mechanism and maintenance of ‘Core Portion’ with escrow bank. It is to safeguard the interest of the merchants onboarded by the PA. Nevertheless, in the second leg of the transaction, the merchant has its right to receive funds against the PA as per the pre-defined settlement cycle.

Regulatory approach towards PAs and PGs

The international standards and best practices on regulating Financial Market Infrastructure (FMI) are set out in CPSS-IOSCO principles of FMI (PFMI).[5] A Financial Market Infrastructure (FMI) is a multilateral system among participating institutions, including the operator of the system. The consumer protection aspects emerging from the payment aggregation business model, are regulated by these principles. Based on CPSS-IOSCO principles of (PFMI), the RBI has described designated FMIs, and released a policy document on regulation and supervision of FMIs in India under its regulation on FMIs in 2013.[6] The PFMI stipulates public policy objectives, scope, and key risks in financial market infrastructures such as systemic risk, legal risk, credit risk, general business risks, and operational risk. The Important Retail Payment Systems (IRPS) are identified on the basis of the respective share of the participants in the payment landscape.  The RBI has further sub-categorised retail payments FMIs into Other Retail Payment Systems (ORPS). The IRPS are subjected to 12 PFMI while the ORPS have to comply with 7 PFMIs. The PAs and PGs fall into the category of ORPS, regulatory principles governing them are classified as follows:

These principles of regulation are neither exclusive nor can said to be having a clear distinction amongst them, rather they are integrated and interconnected with one another. The next part discusses the broad intention of the principles above and the supporting regulatory clauses in PA Guidelines covering the same.

Legal Basis and Governance framework

The legal basis principle lays the foundation for relevant parties, to define the rights and obligations of the financial market institutions, their participants, and other relevant parties such as customers, custodians, settlement banks, and service providers. Clause 3 of PA Guidelines provides that authorisation criteria are based primarily on the role of the intermediary in the handling of funds. PA shall be a company incorporated in India under the Companies Act, 1956 / 2013, and the Memorandum of Association (MoA) of the applicant entity must cover the proposed activity of operating as a PA forms the legal basis. Henceforth, it is quintessential that agreements between PA, merchants, acquiring banks (PA’s Partners Bank), and all other stakeholders to the payment chain, clearly delineate the roles and responsibilities of the parties involved. The agreement should define the rights and obligations of the parties involved, (especially the nodal/escrow agreement between partner bank and payment aggregator). Additionally, the agreements between the merchant and payment aggregator as discussed later herein are fundamental to payment aggregator business. The PA’s business rests on clear articulation of the legal basis of the activities being performed by the payment aggregator with respect to other participants in the payment system, such as a merchant, escrow banks, in a clear and understandable way.

Comprehensive Management of Risk

The framework for the comprehensive management of risks provides for integrated and comprehensive view of risks. Therefore, this principle broadly entails comprehensive risk policies, procedures/controls, and participants to have robust information and control systems. Another connecting aspect of this principle is operational risk, arising from internal processes, information systems and disruption caused due to IT systems failure. Thus there is a need for payment aggregator to have robust systems, policies to identify, monitor and manage operational risks. Further to ensure efficiency and effectiveness, the principle entails to maintain appropriate standards of safety and security while meeting the requirements of participants involved in the payment chain. Efficiency is resources required by such payment system participants (PAs/PGs herein) to perform its functions. The efficiency includes designs to meet needs of participants with respect to choice of clearing and settlement transactions and establishing mechanisms to review efficiency and effectiveness. The operational risk are comprehensively covered under Annex 2 (Baseline Technology-related Recommendation) of the PA Guidelines. The Annex 2, inter alia includes, security standards, cyber security audit reports security controls during merchant on-boarding. These recommendations and compliances under the PA Guidelines stipulates standard norms and compliances for managing operational risk, that an entity is exposed to while performing functions linked to financial markets.

KYC and Merchant On-boarding Process

An important aspect of payment aggregator business covers merchant on-boarding policies and anti-money laundering (AML) and counter-terrorist financing (CFT) compliance. The BIS-CPSS principles do not govern within its ambits certain aspects like AML/CFT, customer data privacy. However, this has a direct impact on the businesses of the merchants, and customer protection. Additionally, other areas of regulation being data privacy, promotion of competition policy, and specific types of investor and consumer protections, can also play important roles while designing the payment aggregator business model. Nevertheless, the PA Guidelines provide for PAs to undertake KYC / AML / CFT compliance issued by RBI, as per the “Master Direction – Know Your Customer (KYC) Directions” and compliance with provisions of PML Act and Rules. The archetypal procedure of document verification while customer on-boarding process could include:

  • PA’s to have Board approved policy for merchant on-boarding process that shall, inter-alia, provide for collection of incorporation certificates, constitutional document (MoA/AoA), PAN and financial statements, tax returns and other KYC documents from the merchant.
  • PA’s should take background and antecedent checks of the merchants, to ensure that such merchants do not have any malafide intention of duping customers, do not sell fake/counterfeit/prohibited products, etc.

PAs shall ensure that the merchant’s site shall not save customer’s sensitive personal data, like card data and such related data. Agreement with merchant shall have provision for security/privacy of customer data.

Settlement and Escrow

The other critical facet of PA business is the settlement cycle of the PA with the merchants and the escrow mechanism of the PA with its partner bank. Para 8 of PA Guidelines provide for non-bank PAs to have an escrow mechanism with a scheduled bank and also to have settlement finality. Before understanding the settlement finality, it is important to understand the relevance of such escrow mechanisms in the payment aggregator business.

Escrow Account

Surely there is a bankruptcy risk faced by the merchants owing to the default by the PA service provider. This default risk arises post completion of the first leg of the payment transaction. That is, after the receipt of funds by the PA from the customer into its bank account. There is an ultimate risk of default by PA till the time there is final settlement of amount with the merchant. Hence, there is a requirement to maintain the amount collected by PA in an escrow account with any scheduled commercial bank. All the amounts received from customers in partner bank’s account, are to be remitted to escrow account on the same day or within one day, from the date amount is debited from the customer’s account (Tp+0/Tp+1). Here Tp is the date on which funds are debited from the customer’s bank account.  At end of the day, the amount in escrow of the PA shall not be less than the amount already collected from customer as per date of debit/charge to the customer’s account and/ or the amount due to the merchant. The same rules shall apply to the non-bank entities where wallets are used as a payment instrument.[7] This essentially means that PA entities should remit the funds from the PPIs and wallets service provider within same day or within one day in their respective escrow accounts. The escrow banks have obligation to ensure that payments are made only to eligible merchants / purposes and not to allow loans on such escrow amounts. This ensures ring fencing of funds collected by the PAs, and act as a deterrent for PAs from syphoning/diverting the funds collected on behalf of merchants. The escrow agreement function is essentially to provide bankruptcy remoteness to the funds collected by PA’s on behalf of merchants.

Settlement Finality

Settlement finality is the end-goal of every payment transaction. Settlement in general terms, is a discharge of an obligation with reference of the underlying obligation (whatever parties agrees to pay, in PA business it is usually INR). The first leg of the transaction involves collection of funds by the PA from the customer’s bank (originating bank) to the PA escrow account. Settlement of the payment transaction between the PA and merchant, is the second leg of the same payment transaction and commences once funds are received in escrow account set up by the PA (second leg of the transaction).

Settlement finality is the final settlement of payment instruction, i.e. from the customer via PA to the merchant. Final settlement is where a transfer is irrevocable and unconditional. It is a legally defined moment, hence there shall be clear rules and procedures defining the point of settlement between the merchant and PA.

For the second leg of the transaction, the PA Guidelines provide for different settlement cycles:

  1. Payment Aggregator is responsible for the delivery of goods/service– The settlement cycle with the merchant shall not be later than one day from the date of intimation to PA of shipment of goods by the merchant.
  2. Merchant is responsible for delivery– The settlement cycle shall not be later than 1 day from the date of confirmation by the merchant to PA about delivery of goods to the customer.
  3. Keeping the amount by the PA till the expiry of refund period– The settlement cycle shall not be later than 1 day from the date of expiry of the refund period.

These settlement cycles are mutually exclusive and the PA business models and settlement structure cycle with the merchants could be developed by PAs on the basis of market dynamics in online selling space. Since the end-transaction between merchant and PA is settled on a contractually determined date, there is a deferred settlement, between PA and the merchant.  Owing to the rules and nature of the relationship (deferred settlement) is the primary differentiator from the merchants proving the Delivery vs. Payment (DvP) settlement process for goods and services.

Market Concerns

Banks operating as PAs do not need any authorisation, as they are already part of the the payment eco-system, and are also heavily regulated by RBI. However, owing to the sensitivity of payment business and consumer protection aspect non-bank PA’s have to seek RBI’s authorisation. This explains the logic of minimum net-worth requirement, and separation of payment aggregator business from e-commerce business, i.e. ring-fencing of assets, in cases where e-commerce players are also performing PA function. Non-bank entities are the ones that are involved in retail payment services and whose main business is not related to taking deposits from the public and using these deposits to make loans (See. Fn. 7 above).

However, one could always question the prudence of the short timelines given by the regulator to existing as well as new payment intermediaries in achieving the required capital limits for PA business. There might be a trade-off between innovations that fintech could bring to the table in PA space over the stringent absolute capital requirements. While for the completely new non-bank entity the higher capital requirement (irrespective of the size of business operations of PA entity) might itself pose a challenge. Whereas, for the other non-bank entities with existing business activities such as NBFCs, e-commerce platforms, and others, achieving ring-fencing of assets in itself would be cumbersome and could be in confrontation with the regulatory intention. It is unclear whether financial institutions carrying financial activities as defined under section 45 of the RBI Act, would be permitted by the regulator to carry out payment aggregator activities. However, in doing so, certain additional measures could be applicable to such financial entities.

Conclusion

The payment aggregator business models in India are typically based on front-end services, i.e. the non-bank entitles are aggressively entering into retail payment businesses by way of providing direct services to merchants. The ability of non-bank entitles to penetrate into merchant onboarding processes, has far overreaching growth potential than merchant on-boarding processes of traditional banks. While the market is at the developmental stage, nevertheless there has to be a clear definitive ex-ante system in place that shall provide certainty to the payment transactions. The CPSS-IOSCO, governing principles for FMIs lays down a good principle-based governing framework for lawyers/regulators and system participants to understand the regulatory landscape and objective behind the regulation of payment systems. PA Guidelines establishes a clear, definitive framework of rights between the participants in the payment system, and relies strongly on board policies and contractual arrangements amongst payment aggregators and other participants. Therefore, adequate care is necessitated while drafting escrow agreements, merchant-on boarding policies, and customer grievance redressal policies to abide by the global best practices and meet the objective of underlying regulation. In hindsight, it will be discovered only in time to come whether the one-size-fits-all approach in terms of capital requirement would prove to be beneficial for the overall growth of PA business or will cause a detrimental effect to the business space itself.

 

[1] RBI, Directions for opening and operation of Accounts and settlement of payments for electronic payment transactions involving intermediaries, November 24, 2009. https://www.rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=5379

[2] Payment Systems in India – Booklet (rbi.org.in)

[3] https://m.rbi.org.in/Scripts/AnnualReportPublications.aspx?Id=1293

[4] https://www.investindia.gov.in/sector/retail-e-commerce

[5] The Bank for International Settlements (BIS), Committee on Payment and Settlement Systems (CPSS) and International Organisation of Securities Commissions (IOSCO) published 24 principles for financial market infrastructures and  and responsibilities of central banks, market regulators and other authorities. April 2012 <https://www.bis.org/cpmi/publ/d101a.pdf>

[6]Regulation and Supervision of Financial Market Infrastructures, June 26, 2013 https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=2705

[7] CPMI defines non-banks as “any entity involved in the provision of retail payment services whose main business is not related to taking deposits from the public and using these deposits to make loans”  See, CPMI, ‘Non-banks in retail Payments’, September 2014, available at <https://www.bis.org/cpmi/publ/d118.pdf>

 

Our other related articles:

Overview of Regulatory Framework of Payment and Settlement Systems in India by Anita Baid – Vinod Kothari Consultants

RBI to regulate operation of payment intermediaries – Vinod Kothari Consultants

Major recommendations of the Committee on Payment Systems on Payment and Settlement System Bill, 2018 – Vinod Kothari Consultants

No compound interest during moratorium: RBI directs lenders pursuant to SC order

Anita Baid | Vice President, Financial Services (anita@vinodkothari.com)

Overview

The Supreme Court of India (‘SC’ or ‘Court’) had given its judgement in the matter of Small Scale Industrial Manufacturers Association vs UOI & Ors. and other connected matters on March 23, 2021. The said order of SC put an end to an almost ten months-long legal scuffle that started with the plea for complete waiver of interest, but edged towards waiver of interest on interest, that is, compound interest, charged by lenders during Covid moratorium. From the miseries suffered by people due to the pandemic, to the economic strangulation of trade and activity – the unfinished battle with the pandemic continues. Nevertheless, the SC realised the economic limitation of any Government, even in a welfare state. The SC acknowledged that the economic and fiscal regulatory measures are fields where judges should encroach upon very warily as judges are not experts in these matters. What is best for the economy, and in what manner and to what extent the financial reliefs/ packages be formulated, offered and implemented is ultimately to be decided by the Government and RBI on the aid and advice of the experts.

Compound interest continues to elude judicial acceptance – there are several rulings against compound interest pertaining to arbitral awards, and a lot more for civil awards. In the present ruling as well, observations of the Apex court seem to be indicating that compound interest is penal in nature. This may be surprising to a person of finance, as in the financial world, compound interest is ubiquitous and unquestionable.

In the concluding part of the judgment while dismissing all the petitions, the Court lifted the interim relief granted earlier, pertaining to the NPA status of the borrowers. However, the last tranche of relief in the judgement came for the large borrowers that had loans outstanding/ sanctioned as on February 29, 2020 greater than Rs. 2 crores, and other borrowers who were not eligible to avail compound interest relief as per the Scheme for grant of ex-gratia payment of difference between compound interest and simple interest for six months to borrowers in specified loan accounts (1.3.2020 to 31.8.2020) dated October 23, 2020 (“Ex-Gratia Scheme”). The Court did not find any basis for the limit of Rs 2 crores while granting relief of interest-on-interest (under ex-gratia scheme) to the borrowers. Thus, the Court directed that there shall not be any charge of interest on interest/ penal interest for the period during moratorium for any borrower, irrespective of the quantum of loan, or the category of the borrowers.  The lenders should give credit/ adjustment in the next instalment of the loan account or in case the account has been closed, return any amount already recovered, to the concerned borrowers.

Given that the timelines for filing claims under the ex-gratia scheme have expired, it was expected that the Government would be releasing extended/ updated operational guidelines in this regard for adjustment/ refund of the interest on interest charged by the lenders from the borrowers. Further, it seemed that the said directions of the Court would be applicable only to the loan accounts that were eligible and have availed moratorium under the COVID 19 package.

However, as a consequence of the aforesaid ruling, the Reserve Bank of India (‘RBI’) has issued a circular on April 7, 2021 (‘RBI Circular’) instructing the financial institutions to take steps for refund/ adjustment of the interest on interest. While the SC order clearly pertains to the Ex-Gratia Scheme of MoF, the RBI does not talk anywhere about the burden being passed to the GoI.

The RBI Circular is applicable on all lending institutions, that is to say, (a) Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks), (b) Primary (Urban) Co-operative Banks/State Co-operative Banks/ District Central, Co-operative Banks, (c) All All-India Financial Institutions, (d) Non-Banking Financial Companies (including Housing Finance Companies).

Interest on Interest

More than 20 writ petitions were filed with the Supreme Court and the relief sought by them can broadly be classified in four parts – waiver of compound interest/ interest on interest during the moratorium period; waiver of total interest during the moratorium period; extension of moratorium period; and that the economic packages/ reliefs should sector specific. Our write on the issue can be read here.

The contention of the petitioners was that even charging interest on interest/compound interest can be said to be in the form of penal interest. Further, it was argued that the penal interest can be charged only in case of wilful default.  In view of the effect of pandemic due to Covid­19 and even otherwise, there was a deferment of payment of loan during the moratorium period as per RBI circulars, hence, it cannot be said that there is any wilful default which warrants interest on interest/penal interest/compound interest. The appeal was that there should not be any interest on interest/penal interest/compound interest charged for and during the moratorium period.

The Central Government and RBI had already provided the following reliefs to mitigate the burden of debt servicing brought about by disruptions on account of Covid­19 pandemic:

The nature of moratorium was to provide a temporary standstill on payment of both, principal and interest thereby providing relief to the borrowers in two ways, namely, the   account   does   not become NPA despite nonpayment of dues; and since there was no reporting to the Credit Information Companies, the moratorium did not adversely impact the credit history of the borrowers.

It is important to understand the concept of “moratorium”- the word “moratorium” is categorically defined by the RBI, while issuing various circulars. The relevant circulars of RBI show that “moratorium” was never intended to be “waiver of interest”, but “deferment of interest”. In other words, if a borrower takes the moratorium benefit, his liability to make payment of contractual interest (both normal interest and interest on interest) gets deferred for a period of three months and subsequently three months thereafter. After a very careful and major consideration of several fiscal and financial criteria, it’s inevitable effects and keeping the uncertainty of the existing situation in mind, the payment of interest and interest on interest was merely deferred and was never waived.

Further, it is to be noticed that while the standstill applicable to bank loans results in the bank not getting its funds back during the period of moratorium, the bank continues to incur cost on bank’s deposits and borrowings. Since a moratorium offers certain advantages to borrowers, there are costs associated with obtaining the benefit of a moratorium and placing the burden of the same on lenders might just shift the burden on the financial sector of the country. If the lenders were to bear this burden, it would necessarily wipe out a substantial and a major part of their net worth, rendering most of the banks unviable and raising a very serious question over their very survival. Even on the occurrence of other calamities like cyclone, earthquake, drought or flood,  lenders do not waive interest but provide necessary relief packages to the borrowers. A waiver   can only be granted by the Government out of the exchequer. It cannot come out of a system from banks, where credit is created out of the depositor’s funds alone. Any waiver will create a shortfall and a mismatch between the Bank’s assets and liabilities.

Considering the same, the Government had granted the relief of waiver of compound interest during the moratorium period, limited to the most vulnerable categories of borrowers, that is, MSME loans and personal loans up to Rs. 2 crores. Our write up on the same can be viewed here.

However, the SC felt that there is no justification to restrict the relief of not charging interest on interest with respect to the loans up to Rs. 2 crores only and that too restricted to certain categories. Accordingly, the SC had directed that directed that there shall not be any charge of interest on interest/compound interest/penal interest for the period during the moratorium and any amount already recovered under the same head, namely, interest on interest/penal interest/compound interest shall be refunded to the concerned borrowers and to be given credit/adjusted in the next instalment of the loan account.

The ruling however, did not clarify as to who shall bear the burden of the waiver of such interest on interest. Further, the RBI Circular seems to place the burden on the lenders and not wait for the Government to come up with a relief scheme or extend the existing ex-gratia scheme.

RBI Circular

Coverage of Lenders

All lending institutions are covered under the ambit of the RBI Circular. The coverage includes all HFCs and NBFCs, irrespective of the asset size. Clearly, non-banking non-financial entities, or unincorporated bodies are not covered by the Circular.

Coverage of Borrowers

The borrowers eligible as per March 27 Circular (COVID-19 – Regulatory Package) were those who have availed term loans (including agricultural term loans, retail and crop loans) and working capital financing in the form of cash credit/ overdraft. Certain categories of borrowers were ineligible under the March 27 Circular such as those which were not standard assets as on 1st March 2020. Hence, loans already classified as NPA  continued with further asset classification deterioration during the moratorium period in case of non-payment.

The question that arises is whether the benefit under the RBI Circular is limited to any particular type of facility? The benefit of the RBI Circular is to be provided to all borrowers, including those who had availed of working capital facilities during the moratorium period. Further, the benefit is irrespective of the amount sanctioned or outstanding and irrespective of whether moratorium had been fully or partially availed, or not availed. However, this should include only those loans that were originally eligible to claim the moratorium but did not claim it or claimed partially or fully.

Thus, all corporate borrowers, including NBFCs who may have borrowed from banks, are apparently eligible for the relief.

Another crucial aspect is whether the benefit is applicable to facilities which have been repaid, prepaid during the moratorium period? If so, upto what date? The benefit must be provided to all eligible loans existing at the time of moratorium but has been repaid as on date.

Coverage of facilities

Both term loans as well as working capital facilities are covered. Facilities which are not in the nature of loans do not seem to be covered.  Further, facilities for which the Covid moratorium was not applicable also do not seem to be covered. Examples are: unfunded facilities, loans against shares, invoice financing, factoring, financial leases, etc. In addition, borrowing by way of capital market instruments such as bonds, debentures, CP, etc are not covered by the RBI Circular.

Questions will also arise as to whether lenders will be liable to provide the relief in case of those loans which are securitised, assigned under DA transactions or transacted under co-lending arrangement? We have covered these questions in our detailed FAQs on the moratorium 1.0  and 2.0.

Since the moratorium benefit was to be extended only to such installments that were falling due during the said moratorium period. Hence, only those borrowers were eligible for availing moratorium who were standard as on February 29, 2020 and whose installments fell due during the moratorium period. Accordingly, there can be the following situations:

 

Burden of interest on interest

The SC order was with reference to the Central Govt decision vide Ex-Gratia Scheme. Among other things, the petitioners had challenged that there was no basis for limiting the amount of eligible facilities to Rs 2 crores, or limiting the facility only to categories of borrowers specified in the Ex-Gratia Scheme. As per the GoI decision, the benefit was to be granted by lending institutions to the borrowers, and correspondingly, there was a provision for making a claim against SBI, acting as the banker for the GoI.

The SC order is an order upon the UoI. Neither were individual banks/NBFCs parties to the writ petition, nor does it seem logical that the order of the Court may require parties to refund or adjust interest which they charged as per their lending contracts. The UoI may be required to extend a benefit by way of Covid relief, but it does not seem logical that the burden may be imposed on each of the lending institutions, who, incidentally, did not even have the chance to take part in the proceedings before the apex court.

Hence, it seems that the impact of the SC order is only to extend the benefit of the Ex-Gratia Scheme to all borrowers, but the mechanics of the original circular, viz., lending institutions to file a counterclaim against the UoI through SBI, should apply here too.

Accounting disclosure for FY 20-21

The RBI Circular talks about a disclosure for the adjustment or refund to be reflected in the financial statements for FY 20-21.

In terms of accounting standards, the question whether the liability for refund or adjustment of the compound interest is a liability or a provision will be answered with reference to Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets. Since the RBI Circular may be seen as creating a liability as on 31st March, 2021, the lending institution may simply adjust the differential amount [that is, compound interest – simple interest on the Base Amount] into the ongoing account of the customer. If such a liability has been booked, there is no question of any provision.

The computation of the differential amount will have to be done for each borrower. Hence, any form of macro computation does not seem feasible. Therefore, there will not be much of a difference between a provision and a liability.

Accounting for the refund in FY 20-21 by the borrowers

If the lending institution makes a provision, can the borrower book a receivable by crediting interest paid or provided? The answer seems affirmative.

Mechanism of extending the benefit

Methodology for calculation is to be provided by IBA. In this regard, representation has been made to the Government to bear the burden.

Base amount: If the mode of computation as provided in the RBI Circular is to be followed [IBA’s methodology will be awaited], then the computation will be based on the amount outstanding as on 1st March 2020.

Computation: On the Base amount, the differential amount will be CI- SI.

If the facility has been fully repaid during the moratorium period, the Differential Amount will run upto the date of the repayment.

Actionables

A board approved policy is to be put in place immediately. In this regard, the concern is whether the lenders can modify existing moratorium policy or adopt a new policy altogether? In our opinion, the existing policy itself may be amended to give effect to the RBI Circular or alternatively a new policy may be adopted.

Also, there is no timeline prescribed as to by when are these actionables required. However, since there are certain disclosure requirements in the financials for the FY 2020-21, the policy must be in place before the financials are approved by the Board of the respective lenders.

The lender may await the instructions to be issued by the Government and the methodology to be prescribed by IBA. Logically, the same method as was provided under the Ex-Gratia Scheme should be applicable. Accordingly, lenders may create provisions for the refund of the excess interest charged and whether corresponding receivable will be shown would depend on whether the same is granted by the Government.

Asset Classification

The RBI moratorium notifications freezed the delinquency status of the loan accounts, which availed moratorium benefit under the scheme. It essentially meant that asset classification standstill was imposed for accounts where the benefit of moratorium was extended. A counter obligation on Credit Information Companies (CIC) was also imposed to ensure credit history of the borrowers is not impacted negatively, which are availing benefits under the scheme.

Various writ petitions were filed with the SC seeking an extended relief in terms of relaxation in reporting the NPA status to the credit bureaus. Hence, while hearing the petition of Gajendra Sharma Vs Union of India & Anr. and other writ petitions, the SC granted stay on NPA classification in its order dated September 03, 2020. The said order stated that:

“In view of the above, the accounts which were not declared NPA till 31.08.2020 shall not be declared NPA till further orders.”

The intent of granting such a stay was to provide interim relief to the borrowers who have been adversely affected by the pandemic, by not classifying and reporting their accounts as NA and thereby impacting their credit score.

In its latest judgment, the SC has directed that the interim relief granted earlier not to declare the accounts of respective borrowers as NPA stands vacated. We have also covered the same in our write up.

As a consequence of the SC order, the RBI Circular has clarified the asset classification as follows:

This would mean that after September 1, 2020 though there was a freeze on NPA classification, the same cannot be construed as a freeze on DPD counting. The DPD counting has to be in continuation from the due date of the EMI. The accounts classified as standard, but in default of more than 90 DPD may now be classified NPA, since the freeze on NPA classification is lifted by the SC and directed by the RBI as well.

Risk-based Internal Prescription for Audit Function

Qasim Saif | Executive (finserv@vinodkothari.com)

Introduction

It is a well-known fact that an independent and effective internal audit function is of special importance to all corporates for mitigation of their risk. And it has increased importance for a financial sector entity as it provides for reasonable assurance to the board and its senior management regarding the quality and effectiveness of the entity’s internal control, risk management, and governance framework.

Given the current relatively uncertain economic environment which has put significant pressure on debt servicing capabilities of corporates and businesses, there is a need to critically examine the existing portfolio and take an account of the related risk management and accounting practices.

This on-going stressed situation coupled with the uncertain economic environment and the increased global regulatory watch requires financial institutions to critically evaluate the quality of their regulatory submissions, risk model, capital adequacy, and conduct in the financial markets.

In recent times, Non-Banking Financial Companies (NBFCs) / Urban Co-operative Banks (UCBs) have grown in size and have become systemically important in the economy given their increased participation in the financial credit market. Just like banks, NBFCs and UCBs face similar risks by virtue of being engaged in financial intermediation activities, hence, it makes sense that their internal audit systems should also broadly align while keeping in mind the principle of proportionality.

Applicability

Earlier this year, RBI had issued RBIA Framework for Strengthening Governance Arrangements for commercial banks, local area banks, small finance banks, and payment banks on 7th January 2021[1].

To increase focus on the risk management function of NBFCs/UCBs, the RBI on 3rd February 2021[2] issued a circular prescribing the requirement for Risk-Based Internal Audit (RBIA Framework). The requirements prescribed under the circular are to be implemented by 31st March 2022.The said circular is applicable on-

The framework for NBFCs and UCBs draws largely from the framework for banks.

The circulars clearly indicates that RBI is now accepting a more stringent attitude towards risk management and audit, specifically given the challenges faced due to Covid -19. It seems like Covid-19 acted as a wake-up alarm to increase focus on risk management and its mitigation by financial sector entities.

Applicability on Housing Finance Companies (HFCs)

The RBI circular does not specifically state the applicability of RBIA Framework on HFCs. Since the same is open for interpretation by the stakeholders and so there are 2 different school of thoughts on this. First is that as HFCs are also a class of NBFCs hence the circular should be applicable on HFCs as well. However, a counter interpretation is that the Master Direction for Housing Finance Company (which assembles all applicable regulations at one place) which was notified on February 17, 2021[3] (after the given 3rd February circular), does not include compliance with RBIA Framework. Accordingly, the coverage of the RBIA Framework does not seem to be applicable on HFCs. In absence of any clarification from RBI, the issue currently remains unresolved.

Risk Based Internal Audit: A Sub-set of Risk Management Framework

An essential characteristic of an effective RBIA Framework would be that it should be a connecting link between various components of risk management framework and should provide for reasonable assurance that organisation’s internal controls, risk management, and governance related systems and processes are adequate to deal with risk faced by it.

The internal audit function should ideally be targeted towards contributing to the overall improvement of the organization’s governance, risk management, and control processes using a systematic and disciplined approach.

The circular provides that internal audit function is an integral part of sound corporate governance and is considered as the third line of defence. The inference for different lines of defence for risk management may be drawn from the RBIA circular for Banks, which provides as follows-

Based on the recent developments and emerging trends, the focus areas for robust internal audit should ideally inter-alia the following components-

The internal audit function in NBFCs/UCBs has generally been concentrated on accounting requirements and regulatory compliance etc. However, considering the market developments, testing limited to these factors may not be sufficient. Therefore, the current framework includes, above aspects along with, an evaluation of the risk management systems and control procedures in various areas of operations. This will help in anticipating areas of potential risks and mitigating such risks.

The RBIA should be conducted based on a RBIA plan which is required to be formulated after considering the elements of risk management framework of the entity.

Actionable

As mentioned above, reasonable amount of time is provided to NBFCs/UCBs to prepare for effective implementation of the RBIA Framework, that is, by 31st March 2022. However, though the requirements are to be complied by the end of next financial year, the preparedness for the same must be initiated immediately. A list of actionable on the part of NBFCs/UCBs has been provided below for reference:

Role and responsibilities of functionaries

It is a well understood notion that to get a particular task done, a fixed responsibility centre should be set-up, this enables proper implementation and also increases the efficiency of the implementation. Considering the same RBI has prescribed for responsibilities of senior management, Board and Audit committee to ensure proper implementation of RBIA Framework.  The allotted role and responsibilities shall be as follows-

Board of Directors / Audit Committee of Board

The Board of Directors (the Board) / Audit Committee of Board (ACB) of NBFCs/UCBs shall have the primary responsibility of overseeing the internal audit function in the organization. The major responsibility of the Board and ACB would be to establish and further review the RBIA systems.

The RBIA policy is to be formulated with the approval of the Board and would be disseminated widely within the organization. The policy should be consistent with the size and nature of the business undertaken, the complexity of operations and should factor in the elements of internal audit. The ACB and Board would further review the performance of RBIA and shall also formulate and maintain a quality assurance and improvement program that covers all aspects of the internal audit function.

Senior Management

The senior management shall be responsible for implementation of the systems established by the board and ACB.

The senior management shall ensure adherence to the internal audit policy guidelines as approved by the Board and development of an effective internal control function that identifies, measures, monitors, and reports all risks faced. The senior management shall ensure audit reports is placed before the ACB/Board. Further, a consolidated position of major risks faced by the organization shall be presented at least annually to the ACB/Board, based on inputs from all forms of audit.

The senior management shall also be responsible for establishing a comprehensive and independent internal audit function that should promote accountability and transparency. It shall ensure that the RBIA Function is adequately staffed with skilled personnel of right aptitude and attitude who are periodically trained to update their knowledge, skill, and competencies.

Internal Audit Function: Major Elements

The RBIA Framework broadly provides for a comprehensive internal audit function the major elements and their requirements are summarised as follows-

Risk Matrix

A risk matrix is a matrix that is used during risk assessment to define the level of risk by considering the category of probability or likelihood as against the category of consequence severity. This is a simple mechanism to increase visibility of risks and assist in management decision making.

The circular requires that the RBIA function should consider risk matrix while setting up action plan. Further, certain risk mentioned shall be given enhanced attention during the RBIA, the matrix and areas of focus are marked red in graph below-

Outsourcing of the Internal Audit Function

The internal audit function cannot be outsourced. However, where required, experts including former employees can be hired on a contractual basis subject to the ACB/Board being assured that such expertise does not exist within the audit function of the NBFC/UCB. Any conflict of interest in such matters shall be recognised and effectively addressed.

Monitoring and follow up

Monitoring and follow-up actions form an integral part of entire internal control system to ensure effective functioning of the procedures. Accordingly, the process as well as findings under the RBIA Framework should be regularly monitored. The said responsibility lies with the Board and Senior Management, as discussed above.


[1] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=12011&Mode=0

[2] https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR10365F8B4F9BF8FE4A209F3BD7FD1D62B7D9.PDF

[3] Our write up on the topic “RBI consolidates directions for Housing Finance Companies http://vinodkothari.com/2021/02/rbi-consolidates-directions-for-housing-finance-companies/

Introduction to Covered Bonds

Covered Bonds have the potential to disrupt the traditional financing market. This presentation provides a basic understanding of covered bonds. It deals with the concept of covered bonds, the history of origination of the concept, features, and benefits of covered bonds and how they differ from corporate bonds and MBS.

Our video on the topic may be viewed here: https://www.youtube.com/watch?v=XyoPcuzbys4

Other write-ups:

http://www.vinodkothari.com/wp-content/uploads/covered-bonds-article-by-vinod-kothari.pdf

 

 

Factoring Law Amendments backed by Standing Committee

-Megha Mittal 

[finserv@vinodkothari.com]

In the backdrop of the expanding transaction volumes, and with a view to address the still prevalent delays in payments to sellers, especially MSMEs, the Factoring Regulation (Amendment) Bill, 2020 (‘Amendment Bill’) was introduced in September, 2020, so as to create a broader and deeper liquid market for trade receivables.

The proposed amendments have been reviewed and endorsed by the Standing Committee of Finance chaired by Shri. Jayant Sinha, along with some key recommendations and suggestions to meet the objectives as stated above.  In this article, we discuss the observations and recommendations of the Standing Committee Report  in light of the Amendment Bill.

Read more

RBI consolidates directions for Housing Finance Companies

– Qasim Saif (finserv@vinodkothari.com)

 

Finance Minister in her speech for the budget 2019-20[1] stated that “Efficient and conducive regulation of the housing sector is extremely important in our context. The National Housing Bank (NHB), besides being the refinancer and lender, is also regulator of the housing finance sector. This gives a somewhat conflicting and difficult mandate to NHB. I am proposing to return the regulation authority over the housing finance sector from NHB to RBI. Necessary proposals have been placed in the Finance Bill.” Subsequently, the provisions of National Housing Bank Act, 1987 were amended w.e.f August 09, 2019[2] pursuant to the Finance Act, 2019 thereby shifting the power to govern Housing finance Companies (HFCs) from National Housing Bank (NHB) to the Reserve Bank of India (RBI). Consequently, the RBI on June 17, 2020[3], issued a draft for review of extant regulatory framework for HFCs, and had invited comments from the industry on the same. After considering the inputs received from the industry, the RBI, on October 22, 2020[4] issued the Regulatory Framework for HFCs (‘Regulations’).

Our write-up covering the changes made by Regulations issued on October 22, 2020 and its analysis can be accessed here

After the Regulations were notified, the regulatory framework for HFCs became patchy as requirements came in from different sources and the need for a single point reference was felt.

To deal with the said issue, RBI has now issued the Master Directions – Non-Banking Financial Company – Housing Finance Company (Reserve Bank) Directions, 2021 on February 17, 2021[5] (“Directions”). The Directions broadly accumulate the regulatory requirements, from the Regulations notified on October 22, 2020, erstwhile Master Circular for Housing Finance Companies (NHB) Directions, 2010 and other applicable circulars[6]. The Directions neither impose any new requirements nor amend any existing regulation, but merely aggregate them.

Overview of the Direction

In order to get a comprehensive understanding of the Directions we have summarised the major requirements and also provided the original regulations from where the requirement arises.

Para Regulation in Master Direction Reference Circular
3 Following guidelines made applicable to HFC-

➔    Guidelines on Liquidity Risk Management Framework

➔    Guidelines on Maintenance of Liquidity Coverage Ratio

➔    Guidelines on Securitization Transactions and reset of Credit Enhancement

➔    Managing Risks and Code of Conduct in Outsourcing of Financial Services

➔    Implementation of Indian Accounting Standards

➔    Master Direction – Know Your Customer (KYC) Direction, 2016,

➔    Master Direction – Monitoring of Frauds in NBFCs (Reserve Bank) Directions, 2016,

➔    Master Direction – Information Technology Framework for the NBFC Sector dated June 08, 2017,

October 22, 2020 Regulations
3 LTV for Loan Against Shares and Gold Jewellry capped at 50% and 75% respectively
4 “Housing finance company” shall mean a company that fulfils the following conditions:

a. It is an NBFC whose financial assets, in the business of providing finance for housing, constitute at least 60% of its total assets (netted off by intangible assets)

b. Out of the total assets (netted off by intangible assets), not less than 50% should be by way of housing finance for individuals.

  Existing HFCs to comply the limits in phased manner till 2023
5 NOF Requirement to be increased to Rs. 20 Cr

Existing HFCs to achieve NOF of

➔    Rs. 15 Cr by 31.4.2022 and

➔    Rs. 20 Cr by 31.4.2023

HFC unable to fulfil the NOF requirement may convert to NBFC-ICC

6 HFCs shall, CRAR consisting of Tier-I and Tier-II capital which shall not be less than-

➔    13% on or before 31.4.2020;

➔    14% on or before 31.4.2020; and

➔    15% on or before 31.4.2020 and thereafter

The Tier-I capital, at any point of time, shall not be less than 10%

NHB Notification dated 17th June 2019[7]

 

7-17 Asset Classification, Provisioning and Accounting requirements As per the existing NHB Guidelines
19 LTV for grant of housing loans to individuals shall be capped at:

➔     < 30 lakhs                             90%,

➔     > 30 lakhs and < 75 lakhs    80%

➔     > 75 lakhs                             75%.

20 Norms for credit/investment concentration
21 Exposure of HFCs to group companies engaged in real estate business October 22, 2020 Regulations
22 Investment in real estate by HFC capped at 20% of capital funds
23 Limits on housing finance companies’ exposure to capital market
Chapter VII Acceptance of Public Deposits As per the existing NHB Guidelines
Chapter VIII Prior approval for change in control and directorship
Chapter IX Corporate Governance Norms
Section IV Miscellaneous Instructions
Chapter XIII Fair Practice Code

Pursuant to the consolidation as above, the corresponding extant NHB Guidelines as well as the October, 22 Regulations have been repealed.

 

[1] Speech Budget 2019-2020

[2] Transfer of Regulation of Housing Finance Companies (HFCs) to Reserve Bank of India

[3] Review of extant regulatory framework for Housing Finance companies (HFCs) – Proposed Changes

[4] Review of regulatory framework for Housing Finance Companies (HFCs)

[5] Master Direction – Non-Banking Financial Company – Housing Finance Company (Reserve Bank) Directions, 2021

[6] Master Circular – The Housing Finance Companies (NHB) Directions, 2010

[7] NHB Notification dated June 17, 2019

 

Our Other Related Write-ups can be viewed here-

 

Draft Credit Derivatives directions: Will they start a market stuck for 8 years?

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

Credit derivatives, an instrument that emerged around 1993–94 and then took the market by storm with volumes nearly doubling every half year, to fall off the cliff  during the Global Financial Crisis (GFC), have been a widely used instrument for pricing of credit risk of entities, instruments, and countries. Having earned ignoble epithet as “weapons of mass destruction” from Warren Buffet, they were perceived by many to be such. However, the notional outstanding volume of CDS contracts reached a volume of upwards of USD 9 trillion in June, 2020, the latest data currently available from BIS website.

In India, CDS has been talked about almost every committee or policy recommendation that went into promoting bond markets, and yet, CDSs have been a non-starter ever since the CDS guidelines were first issued in 2013. A credit derivative allows a synthetic trade in a credit asset, and is not merely a hedging device. One of the primary limitations with the 2013 guidelines was that the RBI had taken a very conservative stand and would permit CDS trades only for hedging purposes. The 2021 draft Directions seek to open the market up, on the realisation that much of the activity in the CDS market is not a hedge against what is on the balance sheet, but a synthetic trade on the movement in credit spreads, with no underlying position on the reference bonds or loans.

What is a CDS?

Credit derivatives are derivative contracts that seek to transfer defined credit risks in a credit product or bunch of credit products to the counterparty in the derivative contract. The counterparty to the derivative contract could either be a market participant, or could be the capital market through the process of securitization. The credit product might either be exposure inherent in a credit asset such as a loan, or might be generic credit risk such as bankruptcy risk of an entity. As the risks, and rewards commensurate with the risks, are transferred to the counterparty, the counterparty assumes the position of a virtual or synthetic holder of the credit asset.

The counterparty to a credit derivative product that acquires exposure (called the Protection Seller), from the one who passes on such exposure (called the Protection Buyer), is actually going long on the generalised credit risk of the reference entity, that is, the entity whose debt is being synthetically traded between the Protection Seller and Protection Buyer. The compensation (CDS premium) which the Protection Buyer pays and the Protection Seller receives, is based on the underlying probability of default, occurring during the tenure of the contract, and the expected compensation (settlement amount) that the Protection Seller may be called to pay if the underlying default (credit event) occurs. Thus, this derivative product allows the protection buyer to receive . Thus, the credit derivative trade allows the parties to express on view on (a) whether a credit event is likely to occur with reference to the reference entity during the tenure; and if yes, (b) what will be the depth of the insolvency, on which the compensation amount will depend. As a result, the contract allows people to trade in the credit risk of the entity, without having to trade in a credit asset such as a loan or a bond.

Credit default swaps (CDSs) are the major credit derivative product, which itself falls within the bunch of over-the-counter (OTC) derivatives, the others being interest rate derivatives, exchange rate derivatives, equity derivatives, commodity derivatives, etc.  There are, of course, other credit derivative products such as indices trades, basket trades, etc.

Structure of a plain vanilla CDS contract has been illustrated in the following figure:

Fame and shame

Credit derivatives’ claim to fame before the GFC, and shame thereafter, was not merely CDS trading. It was, in fact, synthetic CDOs and their more exotic variations. A synthetic CDO will bunch together several CDS contracts, create layers, and then trade those layers, mostly leaving the manager of the CDO with a fee income and an equity profit. While it could take years to ramp up a book of actual bonds or loans, a synthetic CDS book could be ramped in a matter of hours. In the benign market conditions before the GFC, there were not too many defaults, and therefore, synthetic CDOs and structured finance CDOs would be happily created and sold to investors, with happiness all over. However, since every synthetic CDO would, by definition, be a highly leveraged structure (the lowest tranche bearing the risk of the entire edifice), and multiple sequential layers of such leverage were built by structured finance CDOs, the entire edifice came crumbling during the GFC, as modeling assumptions based on good times of the past were no more true.

RBI hesitatingly allows CDS

The RBI developed cold feet looking at the mess in the global CDS market, and rightly so, and therefore, the RBI has never been bullish on unbridled CDS activity. Hence, the 2013 Guidelines were very guarded and limited permission – only for hedging purposes. Hedging was not something that the Indian bond market needed, as India mostly had highly rated bonds, and the bondholder earning fine spreads will not pay out of these spreads to shell out the risk of a highly rated, mostly held-to-maturity bond investment. Hence, the CDS market never took off.

Nearly every committee that talked about bond markets in India talked about the need to promote CDS. In August 2019[1], the FM announced several reforms that could boost economic growth. One of the proposals was that the MOF, in consultation with the RBI and SEBI will work on the regime for CDS so that it can play an important role in deepening the bond markets in India.

Latest move of the RBI

The Reserve Bank of India (“RBI”) in the Statement of Developmental and Regulatory Policies dated 4th December, 2020[2], expressed its desire to revise the regulatory framework for Credit Default Swaps as a measure to deepen the corporate bonds market, especially the ones issued by the lower rated issuers.

Subsequently, on 16th February, 2021[3], the RBI issued draft Reserve Bank of India (Credit Derivatives) Directions, 2021 (“Draft Directions” or “Proposed Directions”) to replace the Guidelines on Credit Default Swaps (CDS) for Corporate Bonds which was last revised on 7th January, 2013[4] (“2013 Guidelines”).

This write-up attempts to provide a detailed commentary on the Draft Directions, with references to the 2013 Guidelines as and where required, however, before that let us take a note of the key highlights of the proposed revised directions.

Highlights of the Draft Directions

  1. Participants in a CDS transaction:

The major participants in the proposed transactions:

    1. Market-makers: they are financial institutions
    2. Non-retail users: they can be protection buyers as well as protection sellers, and purpose of their engagement could be for hedging their risk or otherwise. An exhaustive list of the institutions has been laid down who can be classified as non-retail users
    3. Retail users: they can be protection buyers as well as protection sellers, however, the purpose of their engaged should be for hedging their risk only. A user who fails to qualify as non-retail user, by default becomes a retail user. Additionally, the Proposed Directions also allow non-retail users to reclassify themselves as retails users.

Persons resident in India are allowed to participate freely, however, persons resident outside India are allowed to participate as per the directions issued by the RBI, which are yet to be issued.

2. Only single-name CDS contracts are permitted:

The Proposed Directions allow single-name CDS contracts only, that is, the CDS contracts should have only one reference entity. Therefore, other forms of the CDS contracts like bucket or portfolio CDS contracts are not allowed.

3. Presence of a reference obligation:

Credit derivatives could either have a reference entity or a reference obligation. The Proposed Directions however envisages the presence of a reference obligation in a CDS contract. This is coming out clearly from the definition of the CDS states that the contract should provide that the protection seller should commit to compensate the other protection buyer for the loss in the value of an underlying debt instrument resulting from a credit event with respect to a reference entity, for a premium.

4. Eligible reference obligations:

The reference obligations include money market instruments like CPs, CDs, and NCDs with maturity upto 1-year, rated rupee denominated (listed and unlisted) corporate bonds, and unrated corporate bonds issued by infrastructure companies. In this regard, it is pertinent to note that the

5. Structured finance transactions:

Neither can credit derivatives be embedded in structured finance transactions like, synthetic securitisations, nor can structured finance instruments like, ABS, MBS, credit enhanced bonds, convertible bonds etc., be reference obligations for CDS contracts.

Commentary on some of the Key Provisions of the Draft Directions

Applicability

The Proposed Directions will apply on all forms of the credit derivatives transactions irrespective of whether they are undertaken in the OTC markets and or on recognised stock exchanges in India.

Definitions

5. Cash settlement:

Relevant extracts:

(i) Cash settlement of CDS means a settlement process in which the protection seller pays to the protection buyer, an amount equivalent to the loss in value of the reference obligation.

Our comments:

The Proposed Directions allow cash settlement of the CDS, where the protection seller pays only the actual loss in the reference obligation to the protection buyer. There are usually two ways of computing the settlement amount in case of cash settlement – first, based on the actual value of the loss arising from the reference obligation, and second, based on a fixed default rate which is agreed between the parties to the contract at its very inception.

To understand the second situation, let us take an example of a contract where the protection seller agrees to compensate the losses of the protection buyer arising from a reference obligation. Say, the seller agrees to compensate the buyer assuming a 10% default in the buyer’s exposure in a debt instrument on happening of a credit event. In this case, if the credit event happens, the seller will compensate the buyer assuming a 10% default rate, irrespective of the whether losses are more or less than 10%.

However, in the first case, settlement amount would work out based on the assessment of actual losses arising due to happening of the credit event.

Apparently, the definition of cash settlement seems to include only the first case, as it refers to an amount equivalent to the loss in value of the reference obligation.

6. Credit default swaps

Relevant extracts:

(iii) Credit Default Swap (CDS) means a credit derivative contract in which one counterparty (protection seller) commits to compensate the other counterparty (protection buyer) for the loss in the value of an underlying debt instrument resulting from a credit event with respect to a reference entity and in return, the protection buyer makes periodic payments (premium) to the protection seller until the maturity of the contract or the credit event, whichever is earlier.

Our comments:

CDS contracts can be drawn with reference to a particular entity or to a particular obligation of an entity. In the former case, the reference is on all the obligations of the reference entity, whereas in the latter case, the reference is on a particular debt obligation of the reference entity – which could be a loan or a bond.

However, the definition of CDS in the Proposed Directions states the contract should be structured in a manner where the protection seller commits to compensate the protection buyer for the loss in the value of an underlying debt instrument. Therefore, the exposure has to be taken on a particular debt obligation, and it cannot be generally on the reference entity.

 7. Credit event:

Relevant extracts:

(iv) Credit event means a pre-defined event related to a negative change/ deterioration in the credit worthiness of the reference entity underlying a credit derivative contract, which triggers a settlement under the contract.

Our comments:

In the simplest form of a credit derivative contract, credit event is a contingent event on happening of which the protection buyer could incur a credit loss, and for which it seeks protection from the protection seller. The definition used in the Proposed Directions is a very generalised one. As per ISDA, the three most credit events include –

  1. Filing for bankruptcy of the issuer of the debt instrument;
  2. Default in payment by the issuer;
  3. Restructuring of the terms of the debt instrument with an objective to extend a credit relief to the issuer, who is otherwise under a financial distress.

8.Deliverable obligation

Relevant extracts:

(v) Deliverable obligation means a debt instrument issued by the reference entity that the protection buyer can deliver to the protection seller in a physically settled CDS contract, in case of occurrence of a credit event. The deliverable obligation may or may not be the same as the reference obligation.

Our comments:

Refer discussion on physical settlement below.

In case of physical settlements, the question arises, what is the asset that protection buyers may deliver? As discussed under physical settlement, protection buyers may exactly hold the reference asset. A default on this asset would also imply a default on other parallel obligations of the obligor: therefore, market practices allow parallel assets to be delivered to protection sellers. Essentially, a protection buyer may select out of a range of obligations of the reference entity, and logically, will select the one that is the cheapest to deliver. To ensure that the asset delivered is not completely junk, certain filters are covered in the documents, and the deliverable asset must conform to those filters. In particular, these limitations are quite relevant when the reference entity has not really defaulted on its obligations, but only undergone a restructuring credit event.

9. Physical settlement

Relevant extracts:

(xv) Physical settlement of CDS means a settlement process in which the protection buyer transfers any of the eligible deliverable obligations to the protection seller against the receipt of notional/face value of the deliverable obligation.

Our comments:

We discussed earlier that one of the ways of settling a CDS contract is the cash settlement. The other way of settling a CDS contract is the physical settlement. In case of physical settlement, protection buyers physically deliver; that is, transfer an asset of the reference entity and get paid the par value of the delivered asset, limited, of course, to the notional value of the transaction. The concept of deliverable obligation in a credit derivative is critical, as the derivative is not necessarily connected with a particular loan or bond. Being a transaction linked with generic default risk, protection buyers may deliver any of the defaulted obligations of the reference entity.

In case of physical settlement, there is a transfer of the deliverable reference obligation to protection sellers upon events of default, and thereafter, the recovery of the defaulted asset is done by protection sellers, with the hope that they might be able to cover some of their losses if the recovered amount exceeds the market value as might have been estimated in the case of a cash settlement. This expectation is quite logical since the quotes in case of cash settlement are made by potential buyers of defaulted assets, who also hope to make a profit in buying the defaulted asset. Physical settlement is more common where the counterparty is a bank or financial intermediary who can hold and take the defaulted asset through the bankruptcy process, or resolve the defaulted asset.

10. Reference entity:

Relevant extracts:

(xvi) Reference entity means a legal entity, against whose credit risk, a credit derivative contract is entered into.

Our comments:

As may be noted later on in the writeup, reference entity in the context of the Proposed Directions refers to a legal entity resident in India.

11. Reference obligation

Relevant extracts:

(xvii) Reference obligation means a debt instrument issued by the reference entity and specified in a CDS contract for the purpose of valuation of the contract and for determining the cash settlement value or the deliverable obligation in case of occurrence of a credit event.

Our comments:

Reference obligation is the underlying debt instrument, based on which the contract is drawn. In practice, this obligation could be loan, or a bond of the obligor. However, the Proposed Directions refer to certain money market instruments and corporate bonds. Discussed later.

12. Single-name CDS

Relevant extracts:

(xix) Single-name CDS means a CDS contract in which the underlying is a single reference entity.

Our comments:

Usually, CDS could be created with reference to either a single obligation, or obligations from a single reference entity, or a portfolio of obligations arising from different reference entities. The Proposed Directions completely rules out portfolio derivatives, and allows CDS contracts with reference to a single entity only.

Eligible participants

Relevant extracts:

  1. Eligible participants

The following persons shall be eligible to participate in credit derivatives market:

(i) A person resident in India;

(ii) A non-resident, to the extent specified in these Directions.

Our comments:

Any person resident in India is eligible to participate in the credit derivatives market. Even retail investors have been allowed to be a part of this, however, restrictions have been imposed on specific classes of users concerning the purpose of their participation.

Non-resident users, like FPIs, have also been allowed to participate on a restricted basis, however, specifics of their limitations will come by way of specific directions which will be issued by the RBI in due course.

Permitted products

  1. Permitted products in OTC market

(i) Market-makers and users may undertake transactions in single-name CDS contracts.

(ii) Market-makers and users shall not deal in any structured financial product with a credit derivative as one of the components or as an underlying.

As already discussed earlier, only single-name CDS contracts are allowed, bucket or portfolio CDS contracts are not permitted. One of the reasons for this could be that RBI might like to test the market before allowing the users to write contracts on exposures on multiple obligors.

Clause (ii) prohibits the use of credit derivatives in the structure finance products. Synthetic securitisation is one of the products that use embeds a credit default swap in the securitisation transaction. Presently, the Securitisation Guidelines[5] has put a bar on synthetic securitisation, in fact, the draft Guidelines on Securitisation, issued by the RBI in 2019[6], also retained the bar on synthetic securitisation.

Vinod Kothari, in his article Securitisation – Should  India be moving to the next stage of development?[7], stated:

It is notable that a synthetic securitisation uses CDS to shift a tranched risk of a pool of assets into the capital markets by embedding the same into securities, without giving any funding to the originator. Synthetic structures are intended mainly at capital relief, both economic capital as well as regulatory capital.

Synthetic securitisation may come in handy for Indian banks to gain capital relief. Synthetic securitisation structures are seen by many to have made a comeback after the GFC. In fact, the European Banking Authority has launched a consultation process for laying down a STS framework for synthetic securitisations as well[8]. A Discussion Paper of EBA says: “The 2008 financial crisis marked a crash of the securitisation market, after which, also due to stigma attached to the synthetic segment, the securitisation market has gradually emerged in particular in the traditional (and retained) form. With respect to synthetic securitisation following a few years of subdued issuance, the synthetic market has been recovering in the recent years, with both the number and volume of transactions steadily increasing. Based on the data collection conducted by IACPM, altogether 244 balance sheet synthetic securitisations have been issued since 2008 up until end 2018. In 2018, 49 transactions have been initiated with a total volume of 105 billion EUR.”[9]

In the USA as well, credit risk transfer structure has been used by Freddie Mac and Fannie Mae vide instruments labelled as Structured Agency Credit Risk (STACR) and Connecticut Avenue Securities™ (CAS) bonds. Reportedly, the total volume of risk transferred using these instruments, for traditional single family dwelling units, has crossed USD 2.77 trillion by end of 2018[10].

There may be merit in introducing balance sheet synthetic securitisations by banks and NBFCs. To begin with, high quality portfolios of home loans, consumer loans or other diversified retail pools may be the reference pools for these transactions. Gradually, as the market matures, further asset classes such as corporate loans may be tried.

Synthetic securitisations were frowned upon by financial regulators across the globe after the GFC, however, as may have been noticed in the extracts quoted above, several developed jurisdictions now allow synthetic securitisation, with the required level of precautions added to the regulatory framework dealing with it.

Reference entities and obligations for CDS

Relevant extracts:

  1. Reference Entities and Obligations for CDS

(i) The reference entity in a CDS contract shall be a resident legal entity who is eligible to issue any of the debt instruments mentioned under paragraph 5(ii).

(ii) The following debt instruments shall be eligible to be a reference / deliverable obligation in a CDS contract:

  1. Commercial Papers, Certificates of Deposit and Non-Convertible Debentures of original maturity upto one year;
  2. Rated INR corporate bonds (listed and unlisted); and
  3. Unrated INR bonds issued by the Special Purpose Vehicles set up by infrastructure companies.

(iii) The reference/deliverable obligations shall be in dematerialised form only.

(iv) Asset-backed securities/mortgage-backed securities and structured obligations such as credit enhanced/guaranteed bonds, convertible bonds, bonds with call/put options etc. shall not be permitted as reference and deliverable obligations.

Our comments:

As per Clause 5(i), only resident legal entities can be reference entities for the purpose of CDS contracts, however, the Proposed Directions are silent on the meaning of the term resident legal entity. One could argue that entities which are registered in India should be treated as resident legal entities, however, a clarification in this regard shall remove the ambiguities.

Clause (ii) allows the use of the following instruments as a reference obligations:

  1. Money market instruments like CPs, CDs and short-term NCDs
  2. Rated Rupee-denominated corporate bonds, both listed and unlisted
  3. Unrated rupee-denominated corporated bonds issued by infrastructure companies.

The 2013 Guidelines also provided for similar set of instruments. However, it is pertinent to note that the Proposed Directions provide for an express bar on usage of the following structured products as reference obligations:

  1. Asset backed securities
  2. Mortgage backed securities
  3. Credit enhanced or guranateed bonds
  4. Convertible bonds
  5. Bonds with embedded call/ put options

Loans continue to be ineligible for use as reference obligation.

Market makers and users

Relevant extracts:

6.1 Market-makers

(i) The following entities shall be eligible to act as market-makers in credit derivatives:

  1. Scheduled Commercial Banks (SCBs), except Small Finance Banks, Payment Banks, Local Area Banks and Regional Rural Banks;
  2. Non-Bank Financial Companies (NBFCs), including Housing Finance Companies (HFCs), with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet and subject to specific approval of the Department of Regulation (DoR), Reserve Bank.
  3. Standalone Primary Dealers (SPDs) with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet and subject to specific approval of the Department of Regulation (DoR), Reserve Bank.
  4. Exim Bank, National Bank of Agriculture and Rural Development (NABARD), National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI).

(ii) In case the net owned funds of an NBFC, an HFC or an SPD as per the latest audited balance sheet fall below the aforesaid threshold subsequent to the receipt of approval for acting as a market-maker, it shall cease to act as a market-maker. The NBFC, HFC or SPD shall continue to meet all its obligations under existing contracts till the maturity of such contracts.

(iii) Market-makers shall be allowed to buy protection without having the underlying debt instrument.

(iv) At least one of the parties to a CDS transaction shall be a market-maker or a central counter party authorised by the Reserve Bank as an approved counterparty for CDS transactions.

Our comments:

When compared to the 2013 Guidelines, the only addition to list of entities that are eligible to act as market makers is housing finance companies. The net-worth requirements for NBFCs and SPDs remain the same as that under 2013 Guidelines. However, here it is pertinent to note that while the banks are not required to obtain any specific approval from the RBI, NBFCs and SPDs will have to obtain specific approval from the Department of Regulation. The RBI may reconsider this position and remove the requirement of obtaining special approval for the NBFCs and SPDs and put them in a level playing field with the banks.

Relevant extracts:

6.2 User Classification Framework

(i) For the purpose of offering credit derivative contracts to a user, market-maker shall classify the user either as a retail user or as a non-retail user.

(ii) The following users shall be eligible to be classified as non-retail users:

  1. Insurance Companies regulated by Insurance Regulatory and Development Authority of India (IRDAI);
  2. Pension Funds regulated by Pension Fund Regulatory and Development Authority (PFRDA);
  3. Mutual Funds regulated by Securities and Exchange Board of India (SEBI);
  4. Alternate Investment Funds regulated by Securities and Exchange Board of India (SEBI);
  5. SPDs with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet;
  6. NBFCs, including HFCs, with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet;
  7. Resident companies with a minimum net worth of ₹500 crore as per the latest audited balance sheet; and
  8. Foreign Portfolio Investors (FPIs) registered with SEBI.

(iii) Any user who is not eligible to be classified as a non-retail user shall be classified as a retail user.

(iv) Any user who is otherwise eligible to be classified as a non-retail user shall have the option to get classified as a retail user.

(v) Retail users shall be allowed to undertake transactions in permitted credit derivatives for hedging their underlying credit risk.

(vi) Non-retail users shall be allowed to undertake transactions in credit derivatives for both hedging and other purposes.

Our comments:

As brought out earlier under the highlights section, there can be two types of users – non retail and retail users. Financial institutions, resident corporates with networth of Rs. 500 crores or above, and FPIs can become non-retail users. The non-retail users can participate in these contracts either for hedging their credit risk or any other purposes.

On the other hand, anyone who is not eligible to become a non-retail user, by default becomes a retail user. Additionally, non-retail users have been given an option to reclassify themselves as retail issuers should they want. Retail users are allowed to undertake these transactions only for the hedging their credit risk.

The provisions under the Proposed Directions differ significantly from that under the 2013 Guidelines which allowed only financial institutions and FIIs to participate as users. Further, neither did the Guidelines differentiate between retail and non-retail users, nor did it allow the use of CDS for other than hedging purposes.

The classification between retail and non retail users is welcome move where they have not put any restriction on the more serious non-retail users, who can use these even for speculative purposes, apart from hedging. This could increase the liquidity of the instruments, therefore, deepening the market.

Operations and standardisations

Relevant extracts:

7.1 Buying, Unwinding and Settlement

(i) Market-makers and users shall not enter into CDS transactions if the counterparty is a related party or where the reference entity is a related party to either of the contracting parties.

(ii) Market-makers and users shall not buy/sell protection on reference entities if there are regulatory restrictions on assuming similar exposures in the cash market or in violation of any other regulatory restriction, as may be applicable.

(iii) Market-makers shall ensure that all CDS transactions by retail users are undertaken for the purpose of hedging i.e. the retail users buying protection:

  1. shall have exposure to any of the debt instruments mentioned under paragraph 5(ii) and issued by the reference entity;
  2. shall not buy CDS for amounts higher than the face value of the underlying debt instrument held by them; and
  3. shall not buy CDS with tenor later than the maturity of the underlying debt instrument held by them or the standard CDS maturity date immediately after the maturity of the underlying debt instrument.

To ensure this, market-makers may call for any relevant information/documents from the retail user, who, in turn, shall be obliged to provide such information.

(iv) Retail users shall exit their CDS position within one month from the date they cease to have underlying exposure.

(v) Market participants can exit their CDS contract by unwinding the contract with the original counterparty or assigning the contract to any other eligible market participant.

(vi) Market participants shall settle CDS contracts bilaterally or through any clearing arrangement approved by the Reserve Bank.

(vii) CDS contracts shall be denominated and settled in Indian Rupees.

(viii) CDS contracts can be cash settled or physically settled. However, CDS contracts involving retail users shall be mandatorily physically settled.

(ix) The reference price for cash settlement shall be determined in accordance with the procedure determined by the Credit Derivatives Determinations Committee or auction conducted by the Credit Derivatives Determinations Committee, as specified under paragraph 8 of these Directions.

Our comments:

The Proposed Directions imposes restrictions on the users to enter into contracts involving their related parties.

Further, as noted earlier, contracts entered into by the retail users must be for the purpose of the hedging credit risks only, in addition to it there are some other restrictions with respect to the tenor and amount of the protection. However, the onus to ensure that these conditions are met with have been imposed on the market makers. This leads to an additional compliance on the part of the market makers.

In terms of settlement, the Proposed Directions allow both cash and physical settlement, however, for retail users only physical settlement is allowed.

Further, the Proposed Directions also provide for the manner of exiting a CDS contract. In practice, there are three ways of settling a credit derivative contract – first, by settlement in cash or physically, second, by entering into a matching contract with a third party, therefore knocking off the contract in the hands of the protection buyer, and third, by assigning the contract to third parties. The Proposed Directions allow all of these.

Relevant extracts:

7.2 Standardisation

(i) Fixed Income Money Market and Derivatives Association of India (FIMMDA), in consultation with market participants and based on international best practices, shall devise standard master agreement/s for the Indian CDS market which shall, inter-alia, include credit event definitions and settlement procedures.

(ii) FIMMDA shall, at the minimum, publish the following trading conventions for CDS contracts:

  1. Standard maturity and premium payment dates;
  2. Standard premiums;
  3. Upfront fee calculation methodology;
  4. Accrual payment for full first premium;
  5. Quoting conventions; and
  6. Lookback period for credit events.

Our comments:

FIMMDA has been authorised to standardise the documents, and conventions for CDS contracts. World-over standard CDS products are prevalent with standard maturity dates, coupon payments, rates. Standardisation of key terms of a credit derivative contract transform the product from bespoke bilateral transactions to standard marketable products.

Some of the prevalent conventions used internationally are the Standard North Amercian Corporate Convention (SNAC) or the Standard European Corporate (SEC) Convention. The aim of both these conventions is to standardize the trading mechanics of credit default swaps (the SNAC for North American corporate names and the SEC for European corporate names) and facilitate trading through a central clearing counterparty, as well as to reduce uncertainty associated with credit events. This is because in order to make trades completely fungible (i.e., so they have the quality of being capable of exchange or interchange), all trading conventions have to be fully standardized.

Both the conventions have the following trading mechanics:

  1. They have a fixed coupon and an upfront fee.
  2. The first coupon of a CDS accumulates from the date of the last coupon, regardless of the trade date.
  3. The quoted spread for a given maturity is assumed to be a flat spread, rather than representing a point in the term structure.

References from the aforesaid conventions could be drawn while standardisation of the CDS conventions for the Indian market.

Prudential norms, accounting and capital requirements

Relevant extracts:

  1. Prudential norms, accounting and capital requirements

Market participants shall follow the applicable prudential norms and capital adequacy requirements for credit derivatives issued by their respective regulators. Credit derivative transactions shall be accounted for as per the applicable accounting standards prescribed by The Institute of Chartered Accountants of India (ICAI) or other standard setting organisations or as specified by the respective regulators of participants.

Our comments:

The market participants shall have to follow prudential norms and capital adequacy requirements for credit derivatives issued by the sectoral regulators. For NBFCs, for credit protection purchased, for corporate bonds held in current category – capital charge has to be maintained on 20% of the exposure, whereas for corporate bonds held in permanent category, and where there is no mismatch between the hedged bond and the CDS, full capital protection is allowed. The exposure shall stand replaced by exposure on the protection seller, and attract risk weights at 100%.

Similar provisions apply for banks, however, for bonds held in the permanent category, where there is no mismatch between the hedged bonds and CDS, the capital charge on the corporate bonds is nil, whereas, the capital charge on the exposure on protection sellers is maintained at 20% risk weight.

In terms of accounting, for NBFCs and HFCs, Ind AS 109 will have to be followed. Banks however will have to rely on ICAI’s Guidance Notes, if any, to do the accounting.

Our other resources on the topic:

  1. Our dedicated page on Credit Derivatives: http://vinodkothari.com/cdhome/
  2. Our articles on Credit Derivatives: http://vinodkothari.com/creart/
  3. Our book, Credit Derivatives & Structured Credit Trading, by Vinod Kothari – http://vinodkothari.com/crebook/

[1] https://static.pib.gov.in/WriteReadData/userfiles/ASss%2023%20August.pdf

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50748

[3] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=51138

[4] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=7793&Mode=0

[5] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/C170RG21082012.pdf

[6]https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/STANDARDASSETS1600647F054448CB8CCEC47F8888FC78.PDF

[7] http://vinodkothari.com/2020/01/securitisation-india-and-global/

[8] https://eba.europa.eu/eba-consults-on-its-proposals-to-create-a-sts-framework-for-synthetic-securitisation

[9] https://eba.europa.eu/file/113260/download?token=RpXCSVe2,

[10] Based on https://www.fhfa.gov/AboutUs/Reports/ReportDocuments/CRT-Progress-Report-4Q18.pdf