RBI granted moratorium on term loans: Impact on securitisation and direct assignment transactions

Abhirup Ghosh

abhirup@vinodkothari.com

In response to the stress caused due to the pandemic COVID-19, the regulatory authorities around the world have been coming out relaxations and bailout packages. Reserve Bank of India, being the apex financial institution of the country, came out a flurry of measures as a part of its Seventh Bi-Monthly Policy[1][2], to tackle the crisis in hand.

One of the measure, which aims to pass on immediate relief to the borrowers, is extension of moratorium on term loans extended by banks and financial institutions.  We have in a separate write-up[3] discussed the impact of this measure, however, in this write-up we have tried to examine its impact on the securitisation and direct assignment transactions.

Securitisation and direct assignment transactions have been happening extensively since the liquidity crisis after the failure of ILFS and DHFL, as it allowed the investors to take exposure on the underlying assets, without having to take any direct exposure on the financial intermediaries (NBFCs and HFCs). However, this measure has opened up various ambiguities in the structured finance industry regarding the fate of the securitisation or direct assignment transactions in light of this measure.

Originators’ right to extend moratorium

The originators, will be expected to extend this moratorium to the borrowers, even for the cases which have been sold the under securitisation. The question is, do they have sufficient right to extend moratorium in the first place? The answer is no. The moment an originator sells off the assets, all its rights over the assets stands relinquished. However, after the sale, it assumes the role of a servicer. Legally, a servicer does not have any right to confer any relaxation of the terms to the borrowers or restructure the facility.

Therefore, if at all the originator/ servicer wishes to extend moratorium to the borrowers, it will have to first seek the consent of the investors or the trustees to the transaction, depending upon the terms of the assignment agreement.

On the other hand, in case of the direct assignment transactions, the originators retain only 10% of the cash flows. The question here is, will the originator, with 10% share, be able to grant moratorium? The answer again is no. With just 10% share in the cash flows, the originator cannot alone grant moratorium, approval of the assignee has to be obtained.

Investors’ rights

As discussed above, extension of moratorium in case of account sold under direct assignment or securitisation transactions, will be possible only with the consent of the investors. Once the approval is placed, what will happen to the transactions, as very clearly there will be a deferral of cash flows for a period of 3 months? Will this lead to a deterioration in the quality of the securitised paper, ultimately leading to a rating downgrade? Will this lead to the accounts being classified as NPAs in the books of the assignee, in case of direct assignment transactions?

Before discussing this question, it is important to understand that the intention behind this measure is to extend relief to the end borrowers from the financial stress due to this on-going pandemic. The relief is not being granted in light of any credit weakness in the accounts. In a securitisation or a direct assignment, the transaction mirrors the quality of the underlying pool. If the credit quality of the loans remain intact, then there is no question of the securitisation or the direct assignment transaction going bad. Similarly, we do not see any reason for rating downgrade as well.

The next question that arises here is: what about the loss of interest due to the deferment of cash flows? The RBI’s notification states that the financial institutions may provide a moratorium of 3 months, which basically means a payment holiday. This, however, does not mean that the interest accrual will also be suspended during this period. As per our understanding, despite the payment suspension, the lenders will still be accruing the interest on the loans during these 3 months – which will be either collected from the borrower towards the end of the transaction or by re-computing the EMIs. If the lenders adopt such practices, then it should also pass on the benefits to the investors, and the expected cash flows of the PTCs or under the direct assignment transactions should also be recomputed and rescheduled so as to compensate the investors for the losses due to deferment of cash flows.

Another question that arises is – can the investors or the trustee in a securitisation transaction, instead of agreeing to a rescheduling of cash flows, use the credit enhancement to recover the dues during this period? Here it is important to note that credit enhancements are utilised usually when there is a shortfall due to credit weakness of the underlying borrower(s). Using credit enhancements in this case, will reduce the extent of support, weaken the structure of the transaction and may lead to rating downgrade. Therefore, this is not advisable.

We were to imagine an extreme situation – can the investors force the originators to buy back the PTCs or the pool from the assignee, in case of a direct assignment transaction? In case of securitisation transactions, there are special guidelines for exercise of clean up calls on PTCs by the originators, therefore, such a situation will have to be examined in light of the applicable provisions of Securitisation Guidelines. For any other cases, including direct assignment transactions, such a situation could lead up to a larger question on whether the original transaction was itself a true sale or not, because, a buy-back of the pool, defies the basic principles of true sale. Hence, this is not advisable.

[1]https://rbidocs.rbi.org.in/rdocs/Content/PDFs/GOVERNORSTATEMENT5DDD70F6A35D4D70B49174897BE39D9F.PDF

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0

[3] http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

Moratorium on loans due to Covid-19 disruption

Team Financial Services, Vinod Kothari Consultants P Ltd.

finserv@vinodkothari.com

[This version dated 28th March 2020. We shall continue to develop this further based on the text of notification and the clarifications, if any, issued by the RBI ]

To address the stress in the financial sector caused by COVID-19, several measures have been taken by the RBI as a part of its Seventh Bi-monthly Policy[1]. Further, the RBI has come up with a Notification titled COVID 19 package[2]. These measures are intended to mitigate the burden on debt-servicing caused due to disruptions on account of COVID-19 pandemic. These measures include moratorium on term loans, deferring interest payments on working capital and easing of working capital financing. We have tried to provide our analysis of the measures taken by RBI in form of the following FAQs.

1.    Has the RBI granted a compulsory moratorium?

No, the lending institutions have been permitted to allow a moratorium of three months. This is a relaxation offered by RBI to the lending institutions. Neither is it a guidance by the RBI to the lenders, nor is it a leeway granted by the RBI to the borrowers to delay or defer the repayment of the loans. Hence, the moratorium will actually have to be granted by the lending institution to the borrowers. The RBI has simply permitted the lenders to grant such moratorium.

2.    Who are the lending institutions covered by the moratorium requirement?

All commercial banks (including regional rural banks, small finance banks and local area banks), co-operative banks, all-India Financial Institutions, and NBFCs (including housing finance companies and micro-finance institutions) have been permitted to allow the moratorium relaxation to its borrowers.

3.    Is this the first time such a moratorium or relaxation has been granted by the RBI?

During the demonetisation phase in November 2016, a 60 day relaxation was offered to small borrowers accounts for recognition of an asset as sub-standard. Our detailed analysis on the same can be viewed here- http://vinodkothari.com/wp-content/uploads/2017/03/Interpreting_the_2_months_relaxation_for_asset_classification.pdf

4.    What is meant by moratorium on term loan?

Moratorium is a sort of granting of a ’holiday’- it is a repayment holiday where the borrower is granted an option to not pay during the moratorium period.

For example, in case the instalment falls due on April 01, 2020, and the lender has granted a moratorium of 3 months from a specific date, say April 1, 2020,  then the revised due date for repayment shall be July 1, 2020.

5.    From what date can the moratorium be granted?

The lenders are permitted to grant a moratorium of three months on payment of all instalments falling due between March 1, 2020 and May 31, 2020. The intention is to shift the repayment dates by three months. Therefore, the moratorium should start from the due date, falling immediately after 1st March, 2020, against which the payment has not been made by the borrower.

For example, if an instalment was due on 15th March, 2020, but has remained unpaid so far, the lender can impose the moratorium from 15th March, 2020 and in that case, revised due date shall be 15th June, 2020

6.    Is the moratorium on principal or interest or both?

The repayment schedule and all subsequent due dates, as also the tenor for loans may be shifted by three months (or the period of moratorium granted by the lending institution). Instalments will include payments falling due from March 1, 2020 to May 31, 2020 in the form of-

  1. i) principal and/or interest components;

(ii) bullet repayments;

(iii) Equated Monthly instalments;

(iv) credit card dues.

7.    What shall be the moratorium period?

Lending Institutions may use their discretion to allow a moratorium of upto three months. It is not necessary to provide a compulsory moratorium of three months- it can be less than three months as well.

However, a moratorium beyond three months shall be considered as restructuring of loan.

8.    Will the interest accrue during the moratorium period?

Yes, the moratorium is a ‘payment holiday’ however, the interest will definitely accrue. The accrual will not stop.

9.    Will there be delayed payment charges for the missing instalments during the moratorium period?

Overdue interest is charged in case of default in payment. However, during the moratorium, the payment itself is contractually stopped. If there is no payment due, there is no question of a default. Therefore, there will be no overdue interest or delayed payment charges to be levied.

10. Which all loans shall be considered eligible for the relaxation?

All term loans outstanding as on March 1, 2020 are eligible to claim the relaxation. Also, there may be a deferment of interest in case of working capital facilities sanctioned in the form of cash credit/overdraft and outstanding as on March 1, 2020.

11. Is the moratorium applicable to personal loans also?

The moratorium is applicable to all term loans and working capital facilities (refer para 5 and 6 of the Statement on Developmental and Regulatory Policies). Therefore the moratorium or deferment of interest is applicable to lending facilities in the nature of term loan as well as revolving line of credit aka working capital facility, as the case may be.

12. How will the moratorium be effective in case of working capital facilities?

The working capital facilities have been allowed a deferment of three months on payment of interest in respect of all such facilities outstanding as on March 1, 2020. The accumulated interest for the period will be paid after the expiry of the deferment period.

13. What are the actionables required to be taken by the lending institution to grant the moratorium?

The RBI Notification dated 27th March, 2020, para 8 mentions about a board-approved policy. Accordingly, the lending institution may put in place a policy. The Policy should provide maximum facility to the concerned authority centre in the hierarchy of decision-making so that everything does not become rigid. For instance, the extent of moratorium to be granted, the types of asset classes where the moratorium is to be granted, etc., may be left to the relevant asset managers.

Also, the instructions in the notification must be properly communicated to the staff to ensure its implementation.

Further, you may refer to the list of actionables here.

14. The RBI has mentioned about a Board-approved policy. Obviously, under the present scenario, calling of any Board-meeting is not possible. Hence, how does one implement the moratorium?

Please refer to our article here as to how to use technology for calling board meetings.

15. Is the lending institution required to grant the moratorium to all categories of borrowers?

Since the grant of the moratorium is completely discretionary, the lending institution may grant different moratoriums to different classes of borrowers based on the degree of disruption on a particular category of borrowers. However, the grant of the moratorium to different classes of borrowers should be making an intelligible distinction, and should not be discriminatory.

16. In case the lender intends to extend a moratorium, will it require consent of the borrower and confirmation on the revised repayment schedule?

Based on the policy adopted by the lending institution, the moratorium may be extended to all borrowers or only those who approach the lender in this regard. However, the revised terms must be communicated to the borrower and the acceptance must be recorded.

An option may be provided to the borrower for opting the moratorium. In case the borrower fails to respond or remains silent, it may be considered as deemed confirmation on the moratorium. In case of acceptance by the borrower to opt for moratorium, including deemed acceptance, the revised terms shall be shared which should be accepted by the borrower- either electronically or such other means as per the respective lending practice. Further, the PDC or NACH should not be presented for encashment as per the existing terms.

However, in case the borrower has not opted for the moratorium by his action or otherwise has expressly denied the option, the PDC and NACH shall be encashed as per the existing terms and necessary action can be initiated by the lender in case of dishonour.

17.Is the lender required to obtain fresh PDCs and NACH debit mandates from the borrowers?

An option may be provided to the borrower for opting the moratorium. In case the borrower fails to respond or remains silent, it may be considered as deemed confirmation on the moratorium. In such a case the PDC or NACH should not be presented for encashment as per the existing terms.

However, in case the borrower has not opted for the moratorium by his action or otherwise has expressly denied the option, the PDC and NACH shall be encashed as per the existing terms and necessary action can be initiated by the lender in case of dishonour.

18. Can the lender revise the interest rate while granting extension under the moratorium?

The intent of the moratorium is to ensure relaxation to the borrower due to the disruption caused. However, increase in interest rate is not a relief granted and hence should not be practised as such.

19. Can the moratorium period be different for different loans of the same type? For example, a lender grants a moratorium of 3 months for all loans which are 60-89 DPD, and a moratorium of 2 months for all loans which are 30 -59 DPD as on the effective date.

The moratorium is essentially granted to help the borrowers to tide over a liquidity crisis caused by the corona disruption. In the above example, the scheme seems to be to get over a potential NPA characterisation, which could not be the intent of the relaxation.

20. Will the grant of different moratorium periods be regarded as discrimination by the NBFC?

An NBFC may assess where the disruption is likely to adversely impact the repayment capacity of the borrower and take a call based on such assessment. For example in case of farm sector borrowers and daily wage earners, the disruption will be maximum. However, a salaried employee may not be facing any impact on their repayment capacity.

21. Can a borrower prevail upon a lending institution to grant the moratorium, in case the same has not been granted the lending institution?

The grant of the moratorium is a contractual matter between the lender and the borrower. There is no regulatory intervention in that contract.

22. Can the borrower pay in between the moratorium period?

It is a relief granted to the borrower due to disruption caused by the sudden lockdown. However, the option lies with the borrower to either repay the loan during this moratorium as per the actual due dates or avail the benefit of the moratorium.

23. Will such payment be considered as prepayment?

This will not be considered as prepayment and there will not be any prepayment penalty on the same.

24. What will be the impact on the NPA classification on the following loans:

  1. Standard as on March 1, 2020

  2. NPA as on March 1, 2020

  3. Showing signs of distress as on March 1, 2020

In case of standard loan, the moratorium period will not be considered for computing default and hence, it will not result in asset classification downgrade.

The loan already classified as NPA shall continue with the same classification, however, may be granted an exemption from payment during the moratorium period and there shall not be any further asset classification deterioration during the moratorium period.

If the account is showing signs of stress on March 1, 2020, it seems remains a stressed account on that date. The moratorium is simply to ameliorate the impact of the disruption. The disruption was not there on March 1, 2020 – hence, the status as on that date does not change due to the moratorium.

25. Effectively, are we saying the grant of the moratorium is also a stoppage of NPA classification?

During the period of the moratorium, there is no contractual obligation on the part of the borrower. Therefore, there is a standstill, and hence, there is no NPA classification during this period. Hence, the effect of the moratorium is the same as deferral of the NPA recognition.

26. Is grant of moratorium a type of restructuring of loans?

The moratorium/deferment is being provided specifically to enable the borrowers to tide over the economic fallout from COVID-19. Hence, the same will not be treated as change in terms and conditions of loan agreements due to financial difficulty of the borrowers.

27. What will be the impact on the loan tenure and the EMI due to the moratorium?

Effectively, it would amount to extension of tenure. For example, if a term loan was granted for  a period of 36 months on 1st Jan 2020, and the lender grants a 3 months’ moratorium, the tenure effectively stands extended by 3 months – so it becomes 39 months how.

Since there is an accrual of interest during the period of moratorium, the lender will have to either increase the EMIs (that means, recompute the EMI on the accreted amount of outstanding principal for the remaining number of months), or change the last EMI so as to compensate for the accrual of interest during the period of the moratorium. Since changing of EMIs have practical difficulties (PDCs, standing instructions, etc.), it seems that the latter approach will be mostly used.

28. How will the deferment of interest in the case of working capital facilities impact the asset classification?

Recalculating the drawing power by reducing margins and/or by reassessing the working capital cycle for the borrowers will not result in asset classification downgrade.

The asset classification of term loans which are granted relief shall be determined on the basis of revised due dates and the revised repayment schedule.

29. Will the delayed payment by the borrower due to the moratorium have an impact on its CIBIL score?

The moratorium on term loans, the deferring of interest payments on working capital and the easing of working capital financing will not qualify as a default for the purposes of supervisory reporting and reporting to credit information companies (CICs) by the lending institutions. Hence, there will be no adverse impact on the credit history of the beneficiaries.

30. Will the moratorium be applicable in case of new loans sanctioned after March 1, 2020 during the lockdown period?

Technically, new loans sanctioned after March 1, 2020 are not covered under the press release since it mentioned about loans outstanding as on March 1, 2020. However, based on the RBI circular it can be inferred that the Lending Institution may at its own discretion extend the benefit to such borrowers in case the loan instalments of such new loans are falling due between March 1, 2020 and May 31, 2020.

Impact in case of securitisation transactions

31. There may be securitisation transactions where there are investors who have acquired the PTCs. The servicing is with the originator. Can the originator, as the servicer, grant the benefit of the moratorium? Any consent/concurrence of the trustees will be required? PTC holders’ sanction is required?

Servicer is simply a servicer – that is, someone who enforces the terms of the existing contracts, collects cashflows and remits the same to the investors. Servicer does not have any right to confer any relaxation of terms to the borrowers or restructure the facility.

While the moratorium may not amount to restructuring but there is certainly an active grant of a discretionary benefit to the borrowers. In our view, the servicer by himself does not have that right. The right may be exercised only with appropriate sanction as provided in the deed of assignment/trust deed – either the consent of the trustees, or investor’ consent.

32. Irrespective of whether the moratorium is granted with the requisite consent or not, there may be some missing instalments or substantial shortfall in collections in the months of April, May and June. Is the trustee bound to use the credit enhancements (excess spread, over-collateralisation, cash collateral or subordination) to recover these amounts?

As we have mentioned above, the grant of the moratorium by the servicer will have to require investor concurrence or trustee consent (if the trustee is so empowered under the trust deed/servicing agreement). Assuming that the investors have given the requisite consent (say, with 75% consent), the investors’ consent may also contain a clause that during the period of the moratorium, the investors’ payouts will be deemed “paid-in-kind” or reinvested, such that the expected payments for the remaining months are commensurately increased.

This will be a fair solution. Technically, one may argue that the credit enhancements may be exploited to meet the deficiency in the payments, but utilisation of credit enhancements will only reduce the size of the support, and may cause the rating of the transaction to suffer. Therefore, investors’ consent may be the right solution.

Impact in case of direct assignment transactions

33. There may be direct assignment transactions where there is an assignee with 90% share, and the assignor has a 10% retained interest. Can the assignor/originator, also having the servicer role, grant the benefit of the moratorium? Any consent/concurrence of the assignee will be required?

In our view, the 10% retained interest holder cannot grant the benefit without the concurrence of the 90% interest holder.

34. What will be the impact of the moratorium on the assignee?

Once again, as in case of securitisation transactions, if the grant of the moratorium takes place with assignee consent, the assignee may agree to give the benefit to the borrowers. In that case, the assignee does not have to treat the loans as NPAs merely because of non-payment during the period of the moratorium.

Impact in case of co-lending transactions

35.In case of a co-lending arrangement, can the co-lenders grant differential benefit of the moratorium?

Since the grant of moratorium is discretionary, the co-lenders may intend to grant different moratorium periods to the same borrower. However, that could lead to several complications with respect to servicing, asset classification etc. Hence, it is recommended that all the parties to the co-lending arrangement should be in sync.


[1] https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR21302E204AFFBB614305B56DD6B843A520DB.PDF

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0

 

Moving to contactless lending, in a contact-less world

-Kanakprabha Jethani (kanak@vinodkothari.com)

Background

With the COVID-19 disruption taking a toll on the world, almost two billion people – close to a third of the world’s population being  restricted to their homes, businesses being locked-down and work-from home becoming a need of the hour; “contactless” business is what the world is looking forward to. The new business jargon “contactless” means that the entire transaction is being done digitally, without requiring any of the parties to the transaction interact physically. While it is not possible to completely digitise all business sectors, however, complete digitisation of certain financial services is well achievable.

With continuous innovations being brought up, financial market has already witnessed a shift from transactions involving huge amount of paper-work to paperless transactions. The next steps are headed towards contactless transactions.

The following write-up intends to provide an introduction to how financial market got digitised, what were the by-products of digitisation, impact of digitisation on financial markets, specifically FinTech lending segment and the way forward.

Journey of digitisation

Digitisation is preparing financial market for the future, where every transaction will be contactless. Financial entities and service providers have already taken steps to facilitate the entire transaction without any physical intervention. Needless to say, the benefits of digitisation to the financial market are evident in the form of cost-efficiency, time-saving, expanded outreach and innovation to name a few.

Before delving into how financial entities are turning contactless, let us understand the past and present of the financial entities. The process of digitisation leads to conversion of anything and everything into information i.e. digital signals. The entire process has been a long journey, having its roots way back in 1995, when the Internet was first operated in India followed by the first use of the mobile phones in 2002 and then in 2009 the first smartphones came into being used. It is each of these stages that has evolved into this all-pervasive concept called digitisation.

Milestones in process of digitisation

The process of digitization has seen various phases. The financial market, specifically, the NBFCs have gone through various phases before completely guzzling down digitization. The journey of NBFCs from over the table executions to providing completely contactless services has been shown in the figure below:

From physical to paperless to contactless: the basic difference

Before analysing the impact of digitisation on the financial market, it is important to understand the concept of ‘paperless’ and ‘contactless’ transactions. In layman terms, paperless transactions are those which do not involve execution of any physical documents but physical interaction of the parties for purposes such as identity verification is required. The documents are executed online via electronic or digital signature or through by way of click wrap agreements.

In case of contactless transactions, the documents are executed online and identity verification is also carried out through processes such as video based identification and verification. There is no physical interaction between parties involved in the transaction.

The following table analyses the impact of digitisation on financial transactions by demarcating the steps in a lending process through physical, paperless and contactless modes:

 

Stages Physical process Paperless process Contactless process
Sourcing the customer The officer of NBFC interacts with prospective applicants The website, app or platform (‘Platform’) reaches out to the public to attract customers or the AI based system may target just the prospective customers Same as paperless process
Understanding needs of the customer The authorised representative speaks to the prospects to understand their financial needs The Platform provides the prospects with information relating to various products or the AI system may track and identify the needs Same as paperless process
Suggesting a financial product Based on the needs the officer suggests a suitable product Based on the analysis of customer data, the system suggests suitable product Same as paperless process
Customer on-boarding Customer on-boarding is done upon issue of sanction letter The basic details of customer are obtained for on-boarding on the Platform Same as paperless process
Customer identification The customer details and documents are identified by the officer during initial meetings Customer Identification is done by matching the details provided by customer with the physical copy of documents Digital processes such as Video KYC are used carry out customer identification
Customer due-diligence Background check of customer is done based on the available information and that obtained from the customer and credit information bureaus Information from Credit Information Agencies, social profiles of customer, tracking of communications and other AI methods etc. are used to carry out due diligence Same as paperless process
Customer acceptance On signing of formal agreement By clicking acceptance buttons such as ‘I agree’ on the Platform or execution through digital/electronic signature Same as paperless process
Extending the loan The loan amount is deposited in the customer’s bank account The loan amount is credited to the wallet, bank account or prepaid cards etc., as the case may be Same as paperless process
Servicing the loan The authorised representatives ensures that the loan is serviced Recovery efforts are made through nudges on Platform. Physical interaction is the last resort Same as paperless process. However, physical interaction for recovery may not be desirable.
Customer data maintenance After the relationship is ended, physical files are maintained Cloud-based information systems are the common practice Same as paperless process

The manifold repercussions

The outcome of digitisation of the financial markets in India, was a land of opportunities for those operating in financial market, it has also wiped off those who couldn’t keep pace with technological growth. Survival, in financial market, is driven by the ability to cope with rapid technological advancements. The impact of digitisation on financial market, specifically lending related services, can be analysed in the following phases:

Payments coming to online platforms

With mobile density in India reaching to 88.90% in 2019[1], the adoption of digital payments have accelerated in India, showing a rapid growth at a CAGR of 42% in value of digital payments. The value of digital payments to GDP rose to 862% in the FY 2018-19.

Simultaneously, of the total payments made up to Nov 2018, in India, the value of cash payments stood at a mere 19%. The shift from cash payments to digital payments has opened new avenues for financial service providers.

Need for service providers

With everything coming online, and the demand for digital money rising, the need for service providers has also taken birth. Services for transitioning to digital business models and then for operating them are a basic need for FinTech entities and thus, there is a need for various kinds of service providers at different stages.

Deliberate and automatic generation of demand

When payments system came online, financial service providers looked for newer ways of expanding their business. But the market was already operating in its own comfortable state. To disrupt this market and bring in something new, the FinTech service providers introduced the idea of easy credit to the market. When the market got attracted to this idea, digital lending products were introduced. With time, add-ons such as backing by guarantee, indemnity, FLDG etc. were also introduced to these products.

Consequent to digital commercialization, the need for payment service providers also generated automatically and thus, leading to the demand for digital payment products.

Opportunities for service providers

With digitization of non-banking financial activities, many players have found a place for themselves in financial markets and around. While the NBFCs went digital, the advent of digitization also became the entry gate to other service providers such as:

Platform service providers:

In order to enable NBFCs to provide financial services digitally, platform service providers floated digital platforms wherein all the functions relating to a financial transaction, ranging from sourcing of the customer, obtaining KYC information, collating credit information to servicing of the customer etc.

Software as a Service (SaaS) providers:

Such service providers operate on a business model that offers software solutions over the internet, charging their customers based on the usage of the software. Many of the FinTech based NBFCs have turned to such software providers for operating their business on digital platforms. Such service providers also provide specific software for credit score analysis, loan process automation and fraud detection etc.

Payment service providers:

For facilitating transactions in digital mode, it is important that the flow of money is also digitized. Due to this, the demand for payment services such as payments through cards, UPI, e-cash, wallets, digital cash etc. has risen. This demand has created a new segment of service providers in the financial sector.

NBFCs usually enter into partnerships with platform service providers or purchase software from SaaS providers to digitize their business.

Heads-up from the regulator

The recent years have witnessed unimaginable developments in the FinTech sector. Innovations introduced in the recent times have given birth to newer models of business in India. The ability to undertake paperless and contactless transactions has urged NBFCs to achieve Pan India presence. The government has been keen in bringing about a digital revolution in the country and has been coming up with incentives in forms of various schemes for those who shift their business to digital platforms. Regulators have constantly been involved in recognising digital terminology and concepts legally.

In Indian context, innovation has moved forward hand-in-hand with regulation[2]. The Reserve Bank of India, being the regulator of financial market, has been a key enabler of the digital revolution. The RBI, in its endeavor to support digital transactions has introduced many reforms, the key pillars amongst which are – e-KYC (Know Your Customer), e-Signature, Unified Payment Interface (UPI), Electronic NACH facility and Central KYC Registry.

The regulators have also introduced the concept of Regulatory Sandbox[3] to provide innovative business models an opportunity to operate in real market situations without complying with the regulatory norms in order to establish viability of their innovation.

While these initiatives and providing legal recognition to electronic documents did bring in an era of paperless[4] financial transactions, the banking and non-banking segment of the market still involved physical interaction of the parties to a transaction for the purpose of identity verification. Even the digital KYC process specified by the regulator was also a physical process in disguise[5].

In January 2020, the RBI gave recognition to video KYC, transforming the paperless transactions to complete contactless space[6].

Further, the RBI is also considering a separate regime for regulation of FinTech entities, which would be based on risk-based regulation, ranging from “Disclosure” to “Light-Touch Regulation & Supervision” to a “Tight Regulation and Full-Fledged Supervision”.[7]

Way forward

2019 has seen major revolutions in the FinTech space. Automation of lending process, Video KYC, voice based verification for payments, identity verification using biometrics, social profiling (as a factor of credit check) etc. have been innovations that has entirely transformed the way NBFCs work.

With technological developments becoming a regular thing, the FinTech space is yet to see the best of its innovations. A few innovations that may bring a roundabout change in the FinTech space are in-line and will soon be operable. Some of these are:

  • AI-Driven Predictive Financing, which has the ability to find target customers, keep track on their activities and identify the accurate time for offering the product to the customer.
  • Enabling recognition of Indian languages in the voice recognition feature of verification.
  • Introduction of blockchain based KYC, making KYC data available on a permission based-decentralised platform. This would be a more secure version of data repository with end-to-end encryption of KYC information.
  • Introduction of Chatbots and Robo-advisors for interacting with customers, advising suitable financial products, on-boarding, servicing etc. Robots with vernacular capabilities to deal with rural and semi-urban India would also be a reality soon.

Conclusion

Digital business models have received whole-hearted acceptance from the financial market. Digitisation has also opened gates for different service providers to aid the financial market entities. Technology companies are engaged in constantly developing better tools to support such businesses and at the same time the regulators are providing legal recognition to technology and making contactless transactions an all-round success. This is just the foundation and the financial market is yet to see oodles of innovation.

 

 

[1] https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=19417

[2] https://www.bis.org/publ/bppdf/bispap106.htm

[3] Our write on Regulatory Sandboxes can be referred here- http://vinodkothari.com/2019/04/safe-in-sandbox-india-provides-cocoon-to-fintech-start-ups/

[4] Paperless here means paperless digital financial transactions

[5] Our write-up on digital KYC process may be read here- http://vinodkothari.com/2019/08/introduction-of-digital-kyc/

[6]Our write-up on amendments to KYC Directions may be read here: http://vinodkothari.com/2020/01/kyc-goes-live-rbi-promotes-seamless-real-time-secured-audiovisual-interaction-with-customers/

[7] https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/WGFR68AA1890D7334D8F8F72CC2399A27F4A.PDF

 

Is capital relief allowed for on-balance sheet securitisations?

Timothy Lopes, Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

Non-Banking Financial Companies (NBFCs) have been actively involved in the securitisation market, being one of its major participants at the originating as well as investing front. One of the key motivation of a securitisation transaction is its ability to take the loans off the books of the originator, thereby extending capital relief.

Until the implementation of IFRS or Ind AS in the Indian financial sector, the de-recognition of financial assets from the books of financial institutions was pretty simple; however, with complex conditions for de-recognition under Ind AS 109, almost all securitisation transactions now fail to qualify for de-recognition.

This leads to the key question of whether capital relief will still be available, despite the transactions failing de-recognition test under Ind AS. Through this write-up we intend to explore and address this question.

Situation prior to Ind-AS

Prior to the implementation of Ind-AS, there was no accounting guidance with respect to de-recognition of the financial assets from the books of the financial institutions. However, it was a generally accepted accounting principle that if the transaction fulfilled the true sale condition, then the assets were eligible to go off the books.

The true sale condition came from the RBI Guidelines on Securitisation[1]. The off-balance sheet treatment of the assets led to capital relief for the financial institutions. However, the Guidelines requires knock off, to the extent of credit enhancement provided, from the capital (Tier 1 and Tier 2) of the financial institution.

Post Ind-AS scenario

One of the key highlights of the IFRS 9 or Ind AS 109 is the introduction of the de-recognition criteria for financial instruments. Under Ind AS, a financial asset can be put off the books, only when there is a transfer of substantially all risks and rewards arising out of the assets. This, however, is difficult to prove for the transactions that take place in India because most of the structures practiced in India have high level of first loss credit support from the originators, therefore, evidencing high level of risk retention in the hands of the originator.

As a result, the transactions fail to satisfy the de-recognition test and the financial assets do not go off the books of the financial institutions.

This raises another concern with respect to maintenance of regulatory capital, since the assets are not de-recognized as per accounting standards, although backed by a legal true sale opinion. The apprehension here is whether capital relief would still be available in case the assets are retained on the books as per accounting norms. Capital relief would mean not having to assign any risk weight to or maintain capital for these assets.

RBI guidance on implementation

In the absence of any clarity on the question of capital relief to be availed by NBFCs, the whole idea for securitization was getting frustrated. However, RBI has on March 13, 2020 issued guidance for NBFCs and Asset Reconstruction Companies for implementation of Ind-AS[2].

It has now been clarified by RBI that securitised assets not qualifying for de-recognition under Ind-AS due to credit enhancement given by the originating NBFC on such assets shall be risk weighted at zero percent. This implies that the originating NBFC will not be required to maintain any capital against the securitised portfolio of assets. However, the originator shall still be required to make 50% deduction from Tier 1 and 50% from Tier 2 capital.

The relevant extract of RBI notification states as follows-

vii) Securitised assets not qualifying for de-recognition under Ind AS due to credit enhancement given by the originating NBFC on such assets shall be risk weighted at zero percent. However, the NBFC shall reduce 50 per cent of the amount of credit enhancement given from Tier I capital and the balance from Tier II capital.

Accordingly, the fact that a transaction does not qualify for off-balance sheet treatment shall not be relevant for capital adequacy computation. As long as a securitisation transaction satisfies the conditions laid down in the relevant Securitsation Guidelines the fact that whether it has been de-recognised or not for accounting purposes will not make a difference.

Read our related write ups here –

Securitisation accounting under Ind-AS

Securitisation accounting: disconnects between RBI Guidelines and Ind-AS

Accounting for DA under Ind-AS

[1] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=2723

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11818&Mode=0#AN1

RBI to regulate operation of payment intermediaries

Guidelines on regulation of Payment Aggregators and Payment Gateways issued

-Mridula Tripathi (finserv@vinodkothari.com)

Background

In this era of digitalisation, the role of intermediaries who facilitate the payments in an online transaction has become pivotal. These intermediaries are a connector between the merchants and customers, ensuring the collection and settlement of payment. In the absence of any direct guidelines and adequate governance practices regulating the operations of these intermediaries, there was a need to review the existing instructions issued in this regard by the RBI. Thus, the need of regulating these intermediaries has been considered cardinal by the regulator.

RBI had on September 17, 2019 issued a Discussion Paper on Guidelines for Payment Gateways and Payment Aggregators[1] covering the various facets of activities undertaken by Payment Gateways (PGs) and Payment Aggregators (PAs) (‘Discussion Paper’). The Discussion Paper further explored the avenues of regulating these intermediaries by proposing three options, that is, regulation with the extant instructions, limited regulation or full and direct regulation to supervise the intermediaries.

In this regard, the final guidelines have been issued by the RBI on March 17, 2020 which shall be effective from April 1, 2020[2], for regulating the activities of PAs and providing technology-related recommendations to PGs (‘Guidelines’).

In this article we shall discuss the concept of Payment Aggregator and Payment Gateway. Further, we intend to cover the applicability, eligibility norms, governance practices and reporting requirements provided in the aforesaid guidelines.

Concept of Payment Aggregators and Payment Gateways

In common parlance Payment Gateway can be understood as a software which enables online transactions. Whenever the e-interface is used to make online payments, the role of this software infrastructure comes into picture. Thinking of it as a gateway or channel that opens whenever an online transaction takes place, to traverse money from the payer’s credit cards/debit cards/ e-wallets etc to the intended receiver.

Further, the role of a Payment Aggregator can be understood as a service provider which includes all these Payment Gateways. The significance of the Payment Aggregators lies in the fact that Payment Gateway is a mere technological base which requires a back-end operator and this role is fulfilled by the Payment Aggregator.

A merchant (Seller) providing goods/services to its target customer would require a Merchant Account opened with the bank to accept e-payment. Payment Aggregator can provide the same services to several merchants through one escrow account without the need of opening multiple Merchant Accounts in the bank for each Merchant.

The concept of PA and PG as defined by the RBI is reproduced herein below:

PAYMENT AGGREGATORS (PAs) means the entities which enable e-commerce sites and merchants to meet their payment obligation by facilitating various payment options without creation of a separate payment integration system of their own. These PAs aggregate the funds received as payment from the customers and pass them to the merchants after a certain time period.

PAYMENT GATEWAYS (PGs) are entities that channelize and process an online payment transaction by providing the necessary infrastructure without actual handling of funds.

The Guidelines have also clearly distinguished Payment Gateways as providers of technological infrastructure and Payment Aggregators as the entities facilitating the payment. At present, the existing PAs and PGs have a variety of technological set-up and their infrastructure also keeps changing with time given the business objective for ensuring efficient processing and seamless customer experience. Some of the e-commerce market places have leveraged their market presence and started offering payment aggregation services as well. Though the primary business of an e-commerce marketplace does not come within the regulatory purview of RBI, however, with the introduction of regulatory provisions for PAs, the entities will end up being subjected to dual regulation. Hence, it is required to separate these two activities to enable regulatory supervision over the payment aggregation business.

The extant regulations[3] on opening and operation of accounts and settlement of payments for electronic payment transactions involving intermediarieswe were applicable to intermediaries who collect monies from customers for payment to merchants using any electronic / online payment mode. The Discussion Paper proposed a review of the said regulations and based on the feedback received from market participants, the Guidelines have been issued by RBI.

Coverage of Guidelines

RBI has made its intention clear to directly regulate PAs (Bank & Non-Bank) and it has only provided an indicative baseline technology related recommendation. The Guidelines explicitly exclude Cash on Delivery (CoD) e-commerce model from its purview. Surprisingly, the Discussion Paper issued by RBI in this context intended on regulating both the PAs & PGs, however, since PGs are merely technology providers or outsourcing partners they have been kept out of the regulatory requirements.

The Guidelines come into effect from April 1, 2020, except for requirements for which a specific deadline has been prescribed, such as registration and capital requirements.

Registration requirement

Payment Aggregators are required to fulfil the requirements as provided under the Guidelines within the prescribed timelines. The Guidelines require non-bank entities providing PA services to be incorporated as a company under the Companies Act, 1956/2013 being able of carrying out the activity of operating as a PA, as per its charter documents such as the MoA. Such entities are mandatorily required to register themselves with RBI under the Payment and Settlement Systems Act, 2007 (‘PSSA, 2007’) in Form-A. However, a deadline of June 30, 2021 has been provided for existing non-bank PAs.

Capital requirement

RBI has further benchmarked the capital requirements to be adhered by existing and new PAs. According to which the new PAs at the time of making the application and existing PAs by March 31, 2021 must have a net worth of Rs 15 crore and Rs 25 crore by the end of third financial year i.e. March 31, 2023 and thereafter. Any non-compliance with the capital requirements shall lead to winding up of the business of PA.

As a matter of fact, the Discussion Paper issued by RBI, proposed a capital requirement of Rs 100 crore which seems to have been reduced considering the suggestion received from the market participants.

To supervise the implementation of these Guidelines, there is a certification to be obtained from the statutory auditor, to the effect certifying the compliance of the prescribed capital requirements.

Fit and proper criteria

The promoters of PAs are expected to fulfil fit and proper criteria prescribed by RBI and a declaration is also required to be submitted by the directors of the PAs. However, RBI shall also assess the ‘fit and proper’ status of the applicant entity and the management by obtaining inputs from various regulators.

Policy formulation

The Guidelines further require formulation and adoption of a board approved policy for the following:

  1. merchant on-boarding
  2. disposal of complaints, dispute resolution mechanism, timelines for processing refunds, etc., considering the RBI instructions on Turn Around Time (TAT)
  3. information security policy for the safety and security of the payment systems operated to implement security measures in accordance with this policy to mitigate identified risks
  4. IT policy(as per the Baseline Technology-related Recommendations)

Grievance redressal

The Guidelines have put in place mandatory appointment of a Nodal Officer to handle customer and regulator grievance whose details shall be prominently displayed on the website thus implying good governance in its very spirit. This is similar to the requirement for NBFCs who are required to appoint a Nodal Officer. Also, it is required that the dispute resolution mechanism must contain details on types of disputes, process of dealing with them, Turn Around Time (TAT) for each stage etc.

However, in this context, the Discussion Paper provided for a time period of 7 working days to promptly handle / dispose of complaints received by the customer and the merchant.

Merchant on boarding and KYC compliance

To avoid malicious intent of the merchants, PAs should undertake background and antecedent check of the merchants and are responsible to check Payment Card Industry-Data Security Standard (PCI-DSS) and Payment Application-Data Security Standard (PA-DSS) compliance of the infrastructure of the merchants on-boarded and carry a KYC of the merchants on boarded. It also provides for some mandatory clauses to be incorporated in the agreements to be executed with the merchants.

Risk Management

For the purposes of risk management, apart from adoption of an IS policy, the PAs shall also have a mechanism to monitor, handle and report cyber security incidents and breaches. They are also prohibited to allow online transactions with ATM pin and store customer card credentials on the servers accessed by the merchants and are required to comply with data storage requirements as applicable to Payment System Operators (PSOs).

Reporting Requirements

The Guidelines provide for monthly, quarterly and annual reporting requirement. The annual requirement comprises of certification from a CA and IS audit report and Cyber Security Audit report. The quarterly reporting again provides for certification requirement and the monthly requirement demand a transaction statistic. Also, there shall be reporting requirement in case of any change in management requiring intimation to RBI within 15 days along with ‘Declaration & Undertaking’ by the new directors. Apart from these mainstream reporting requirements there are non-periodic requirements as well.

Additionally, PAs are required to submit the System Audit Report, including cyber security audit conducted by CERTIn empanelled auditors, within two months of the close of their financial year to the respective Regional Office of DPSS, RBI

Escrow Account Mechanism

The Guidelines clearly state that the funds collected from the customers shall be kept in an escrow account opened with any Schedule Commercial Bank by the PAs. And to protect the funds collected from customers the Guidelines state that PA shall be deemed as a ‘Designated Payment System’[4] under section 23A of PSSA, 2007.

Shift from Nodal to Escrow

The Discussion Paper proposed registration, capital requirement, governance, risk management and such other regulations along with the maintenance of a nodal account to manage the funds of the merchants. Further, it acknowledged that in case of nodal accounts, there is no beneficial interest created on the part of the PAs; the fact that they do not form part of the PA’s balance sheet and no interest can be earned on the amount held in these account. The Guidelines are more specific about escrow accounts and do not provide for maintenance of nodal accounts, which seems to indicate a shift from nodal to escrow accounts with the same benefits as nodal accounts and additionally having an interest bearing ‘core portion’. These escrow account arrangements can be with or without a tripartite agreement, giving an option to the merchant to monitor the transactions occurring through the escrow. However, in practice it may not be possible to make each merchant a party to the escrow agreement.

Timelines for settlement to avoid unnecessary delay in payments to Merchants, various timelines have been provided as below:

  1. Amounts deducted from the customer’s account shall be remitted to the escrow account maintaining bank on Tp+0 / Tp+1 basis. (Tp is the date of debit to the customer’s account against good/services purchased)
  2. Final settlement with the merchant
  3. In cases where PA is responsible for delivery of goods / services, the payment to the merchant shall be made on Ts + 1 basis. (Ts is the date of intimation by merchant about shipment of goods)
  4. In cases where merchant is responsible for delivery, the payment to the merchant shall be on Td + 1 basis. (Td is the date of confirmation by the merchant about delivery of goods)
  5. In cases where the agreement with the merchant provides for keeping the amount by the PA till expiry of refund period, the payment to the merchant shall be on Tr + 1 basis. (Tr is the date of expiry of refund period)

Also, refund and reversed transactions must be routed back through the escrow account unless as per contract the refund is directly managed by the merchant and the customer has been made aware of the same. A minimum balance requirement equivalent to the amount already collected from customer as per ‘Tp’ or the amount due to the merchant at the end of the day is required to be maintained in the escrow account at any time of the day.

Permissible debits and credits

Similar to the extant regulations, the Guidelines provide a specific list of debits and credits permissible from the escrow account:

  • Credits that are permitted
  1. Payment from various customers towards purchase of goods / services.
  2. Pre-funding by merchants / PAs.
  3. Transfer representing refunds for failed / disputed / returned / cancelled transactions.
  4. Payment received for onward transfer to merchants under promotional activities, incentives, cashbacks etc.
  • Debits that are permitted
  1. Payment to various merchants / service providers.
  2. Payment to any other account on specific directions from the merchant.
  3. Transfer representing refunds for failed / disputed transactions.
  4. Payment of commission to the intermediaries. This amount shall be at pre-determined rates / frequency.
  5. Payment of amount received under promotional activities, incentives, cash-backs, etc.

The aforesaid list of permitted deposits and withdrawals into an account operated by an intermediary is wider than those allowed under the extant regulations. The facility to pay the amount held in escrow to any other account on the direction of the merchant would now enable cashflow trapping by third party lenders or financier. The merchant will have an option to provide instructions to the PA to directly transfer the funds to its creditors.

The Guidelines expressly state that the settlement of funds with merchants will in no case be co-mingled with other business of the PA, if any and no loans shall be available against such amounts.

No interest shall be payable by the bank on balances maintained in the escrow account, except in cases when the PA enters into an agreement with the bank with whom the escrow account is maintained, to transfer “core portion”[5] of the amount, in the escrow account, to a separate account on which interest is payable. Another certification requirement to be obtained from auditor(s) is for certifying that the PA has been maintaining balance in the escrow account.

Technology-related Recommendations

Several technology related recommendations have been separately provided in the Guidelines and are mandatory for PAs but recommendatory for PGs. These instructions provide for adherence to data security standards and timely reporting of security incidents in the course of operation of a PA. It proposes involvement of Board in formulating policy and a competent pool of staff for better operation along with other governance and security parameters.

Conclusion

With these Guidelines being enforced the online payment facilitated by intermediaries will be regulated and monitored by the RBI henceforth. The prescribed timeline of April 2020 may cause practical difficulties and act as a hurdle for the operations of existing PAs. However, the timelines provided for registration and capital requirements are considerably convenient for achieving the prescribed benchmarks. Since PAs are handling the funds, these Guidelines, which necessitate good governance, security and risk management norms on PAs, are expected to be favourable for the merchants and its customers.

 

[1] https://www.rbi.org.in/scripts/PublicationReportDetails.aspx?ID=943

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11822&Mode=0

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=5379&Mode=0

[4] The Reserve Bank may designate a payment system if it considers that designating the system is in the public interest. The designation is to be by notice in writing published in the Gazette, as per Payment System Regulation Act, 1998

[5] This facility shall be permissible to entities who have been in business for 26 fortnights and whose accounts have been duly audited for the full accounting year. For this purpose, the period of 26 fortnights shall be calculated from the actual business operation in the account. ‘Core Portion’ shall be average of the lowest daily outstanding balance (LB) in the escrow account on a fortnightly (FN) basis, for fortnights from the preceding month 26.

 

 

Our other write ups on NBFCs to be referred here http://vinodkothari.com/nbfcs/

Our other similar articles:

http://vinodkothari.com/2017/04/overview-of-regulatory-framework-of-payment-and-settlement-systems-in-india-by-anita-baid/

Bridging the gap between Ind AS 109 and the regulatory framework for NBFCs

-Abhirup Ghosh

(abhirup@vinodkothari.com)

The Reserve Bank of India, on 13th March, 2020, issued a notification[1] providing guidance on implementation of Indian Accounting Standards by non-banking financial companies. This guidance comes after almost 2 years from the date of commencement of first phase of implementation of Ind AS for NBFCs.

The intention behind this Notification is to ensure consistency in certain areas like – asset classification, provisioning, regulatory capital treatment etc. The idea of the Notification is not to provide detailed guidelines on Ind AS implementation. For areas which the Notification has not dealt with, notified accounting standards, application guidance, educational material and other clarifications issued by the ICAI should be referred to.

The Notification is addressed to all non-banking financial companies and asset reconstruction companies. Since, housing finance companies are now governed by RBI and primarily a class of NBFCs, this Notification should also apply to them. But for the purpose of this write-up we wish to restrict our scope to NBFCs, which includes HFCs, only.

The Notification becomes applicable for preparation of financial statements from the financial year 2019-20 onwards, therefore, it seems the actions to be taken under the Notification will have to be undertaken before 31st March, 2020, so far as possible.

In this article we wish to discuss the outcome the Notification along with our comments on each issue. This article consists of the following segments:

  1. Things to be done by the Board of Directors (BOD)
  2. Expected Credit Losses (ECL) and prudential norms
  3. Dealing with defaults and significant increase in credit risk
  4. Things to be done by the Audit Committee of the Board (ACB)
  5. Computation of regulatory capital
  6. Securitisation accounting and prudential norms
  7. Matters which skipped attention

1.   Things to be done by the BOD

The Notification starts with a sweeping statement that the responsibility of preparing and ensuring fair presentation of the financial statements lies with the BOD of the company. In addition to this sweeping statement, the Notification also demands the BOD to lay down some crucial policies which will be essential for the implementation of Ind AS among NBFCs and they are: a) Policy for determining business model of the company; and b) Policy on Expected Credit Losses.

(A) Board approved policy on business models: The Company should have a Board approved policy, which should articulate and document the business models and portfolios of the Company. This is an extremely policy as the entire classification of financial assets, depends on the business model of the NBFC. Some key areas which, we think, the Policy should entail are:

There are primarily three business models that Ind AS recognises for subsequent measurement of financial assets:

(a) hold financial assets in order to collect contractual cash flows;

(b) hold financial assets in order to collect contractual cash flows and also to sell financial assets; and

(c) hold financial assets for the purpose of selling them.

The assessment of the business model should not be done at instrument-by-instrument level, but can be done at a higher level of aggregation. But at the same time, the aggregation should be not be done at an entity-level because there could be multiple business models in a company.

Further, with respect the first model, the Ind AS states that the business model of the company can still be to hold the financial assets in order to collect contractual cash flows even if some of the assets are sold are expected to be sold in future. For instance, the business model of the company shall remain unaffected due to the following transactions of sale:

(a) Sale of financial assets due to increase in credit risk, irrespective of the frequency or value of such sale;

(b) Sale of cash flows are made close to the maturity and where the proceeds from the sale approximate the collection of the remaining contractual cash flows; and

(c) Sale of financial assets due to other reasons, namely, to avoid credit concentration, if such sales are insignificant in value (individually or in aggregate) or infrequent.

For the third situation, what constitutes to insignificant or infrequent has not been discussed in the Ind AS. However, reference can be drawn from the Report of the Working Group of RBI on implementation of Ind AS by banks[2], which proposes that there could be a rebuttable presumption that where there are more than 5% of sale, by value, within a specified time period, of the total amortised cost of financial assets held in a particular business model, such a business model may be considered inconsistent with the objective to hold financial assets in order to collect contractual cash flow.

However, we are not inclined to take the same as prescriptive. Business model of an entity is still a question hinging on several relevant factors, primarily the profit recognition, internal reporting of profits, pursuit of securitization/direct assignment strategy, etc. Of course, the volume may be a persuasive factor.

The Notification also requires that the companies should also have a policy on sale of assets held under amortised cost method, and such policy should be disclosed in the financial statements.

(B) Board approved policy on ECL methodology: the Notification requires the companies to lay down Board approved sound methodologies for computation of Expected Credit Losses. For this purpose, the RBI has advised the companies to use the Guidance on Credit Risk and Accounting for Expected Credit Losses issued by Basel Committee on Banking Supervision (BCBS)[3] for reference.

The methodologies laid down should commensurate with the size, complexity and risks specific to the NBFC. The parameters and assumptions for risk assessment should be well documented along with sensitivity of various parameters and assumptions on the ECL output.

Therefore, as per our understanding, the policy on ECL should contain the following –

(a) The assumptions and parameters for risk assessment – which should basically talk about the probabilities of defaults in different situations. Here it is important to note that the assumptions could vary for the different products that the reporting entity offers to its customers. For instance, if a company offers LAP and auto loans at the same time, it cannot apply same set of assumptions for both these products.

Further, the policy should also lay down indicators of significant increase in credit risk, impairment etc. This would allow the reporting entity in determining classifying its assets into Stage 1, Stage 2 and Stage 3.

(b) Backtesting of assumptions – the second aspect of this policy should deal with backtesting of the assumptions. The policy should provide for mechanism of backtesting of assumption on historical data so as to examine the accuracy of the assumptions.

(c) Sensitivity analysis – Another important aspect of this policy is sensitivity analysis. The policy should provide for mechanism of sensitivity analysis, which would predict the outcome based on variations in the assumptions. This will help in identifying how dependant the output is on a particular input.

Further, the Notification states that any change in the ECL model must be well documented along with justifications, and should be approved by the Board. Here it is important to note that there could two types of variations – first, variation in inputs, and second, variation in the model. As per our understanding, only the latter should be placed before the BOD for its approval.

Further, any change in the assumptions or parameters or the ECL model for the purpose of profit smothering shall seriously be frowned upon by the RBI, as it has clearly expressed its opinion against such practices.

2.   Expected Credit Losses (ECL) and prudential norms

The RBI has clarified that whatever be the ECL output, the same should be subject to a regulatory floor which in this case would be the provisions required to be created as the IRAC norms. Let us understand the situation better:

The companies will have to compute two types of provisions or loss estimations going forward – first, the ECL as per Ind AS 109 and its internal ECL model and second, provisions as per the RBI regulations, which has to be computed in parallel, and at asset level.

The difference between the two will have to be dealt with in the following manner:

(A) Impairment Reserve: Where the ECL computed as per the ECL methodology is lower than the provisions computed as per the IRAC norms, then the difference between the two should be transferred to a separate “Impairment Reserve”. This transfer will not be a charge against profit, instead, the Notification states that the difference should be appropriated against the profit or loss after taxes.

Interestingly, no withdrawals against this Impairment Reserve is allowed without RBI’s approval. Ideally, any loss on a financial asset should be first adjusted from the provision created for that particular account.

Further, the continuity of this Impairment Reserve shall be reviewed by the RBI going forward.

A large number of NBFCs have already presented their first financial statements as per Ind AS for the year ended 31st March, 2019. There were two types of practices which were followed with respect to provisioning and loss estimations. First, where the NBFCs charged only the ECL output against its profits and disregarded the regulatory provisioning requirements. Second, where the NBFCs computed provisions as per regulatory requirements as well as ECL and charged the higher amount between the two against the profits.

The questions that arise here are:

(a) For the first situation, should the NBFCs appropriate a higher amount in the current year, so as to compensate for the amount not transferred in the previous year?

(b) For the second situation, should the NBFCs reverse the difference amount, if any, already charged against profit during the current year and appropriate the same against profit or loss?

The answer for both the questions is negative. The provisions of the Notification shall have to be implemented for the preparation of financial statements from the financial year 2019-20 onwards, hence, we don’t see the need for adjustments for what has already been done in the previous year’s financial statements.

(B) Disclosure: The difference between the two will have to be disclosed in the annual financial statements of the company, format of which has been provided in the Notification[4]. Going by the format, the loss allowances created on Stage 1, Stage 2 and Stage 3 cases will have to be shown separately, similarly, the provisions computed on those shall also have to be shown separately.

While Stage 1 and Stage 2 cases have been classified as standard assets in the format, Stage 3 cases cover sub-standard, doubtful and loss assets.

Loss estimations on loan commitments, guarantees etc. which are covered under Ind AS but does not require provisioning under the RBI Directions should also be presented.

3.     Dealing with defaults and significant increase in credit risk

Estimation of expected losses in financial assets as per Ind AS depends primarily on credit risk assessment and identifying situations for impairment. Considering the importance of issue, the RBI has voiced its opinion on identification of “defaults” and “significant increase in credit risk”.

(A)Defaults: The next issue which has been dealt with in the Notification is the meaning of defaults. Currently, there seems to be a departure between the Ind AS and the regulatory definition of “defaults”. While the former allows the company to declare an account as default based on its internal credit risk assessments, the latter requires that all cases with delay of more than 90 days should be treated as default. The RBI expects the accounting classification to be guided by the regulatory definition of “defaults”.

 If a company decides not to impair an account even after a 90 days delay, then the same should be approved by the Audit Committee.

This view is also in line with the definition of “default” proposed by the BASEL framework for IRB framework, which is:

“A default is considered to have occurred with regard to a particular obligor when one or more of the following events has taken place.

 (a) It is determined that the obligor is unlikely to pay its debt obligations (principal, interest, or fees) in full;

 (b) A credit loss event associated with any obligation of the obligor, such as a charge-off, specific provision, or distressed restructuring involving the forgiveness or postponement of principal, interest, or fees;

 (c) The obligor is past due more than 90 days on any credit obligation; or

 (d) The obligor has filed for bankruptcy or similar protection from creditors.”

Further, the number of cases of defaults and the total amount outstanding and overdue should be disclosed in the notes to the financial statements. As per the current regulatory framework, NBFCs have to present the details of sub-standard, doubtful and loss assets in its financial statements. Hence, this disclosure requirement is not new, only the sub-classification of NPAs have now been taken off.

(B) Dealing with significant increase in credit risk: Assessment of credit risk plays an important role in ECL computation under Ind AS 109. Just to recapitulate, credit risk assessments can be lead to three possible situations – first, where there is no significant increase in credit risk, second, where there is significant increase in credit risk, but no default, and third, where there is a default. These three outcomes are known as Stage 1, Stage 2 and Stage 3 cases respectively.

 In case an account is under Stage 1, the loss estimation has to be done based on probabilities of default during next 12 months after the reporting date. However, if an account is under Stage 2 or Stage 3, the loss estimation has to be done based on lifetime probabilities of default.

Technically, both Stage 1 and Stage 2 cases would fall under the definition of standard assets for the purpose of RBI Directions, however, from accounting purposes, these two stages would attract different loss estimation techniques. Hence, the RBI has also voiced its opinion on the methodology of credit risk assessment for Stage 2 cases.

The Notification acknowledges the presence of a rebuttable presumption of significant increase in credit risk of an account, should there be a delay of 30 days or more. However, this presumption is rebuttable if the reporting entity has reasonable and supportable information that demonstrates that the credit risk has not increased significantly since initial recognition, despite a delay of more than 30 days. In a reporting entity opts to rebut the presumption and assume there is no increase in credit risk, then the reasons for such should be properly documented and the same should be placed before the Audit Committee.

However, the Notification also states that under no circumstances the Stage 2 classification be deferred beyond 60 days overdue.

4.   Things to be done by the ACB

The Notification lays down responsibilities for the ACB and they are:

(A) Approval of any subsequent modification in the ECL model: In order to be doubly sure about that any subsequent change made to the ECL model is not frivolous, the same has to be placed before the Audit Committee for their approval. If approved, the rationale and basis of such approval should be properly documented by the company.

(B) Reviewing cases of delays and defaults: As may have been noted above, the following matters will have to be routed through the ACB:

(a) Where the reporting entity decides not to impair an account, even if there is delay in payment of more than 90 days.

(b) Where as per the risk assessment of the reporting entity, with respect to an account involving a delay of more than 30 days, it rebuts that there is no significant increase in credit risk.

In both the cases, if the ACB approves the assumptions made by the management, the approval along with the rationale and justification should be properly documented.

5.   Computation of Regulatory Capital

The Notification provides a bunch of clarifications with respect to calculation of “owned funds”, “net owned funds”, and “regulatory capital”, each of which has been discussed here onwards:

(A) Impact of unrealised gains or losses arising on fair valuation of financial instruments: The concept of fair valuation of financial instruments is one of the highlights of IFRS or Ind AS. Ind AS 109 requires fair valuation of all financial instruments. The obvious question that arises is how these gains or losses on fair valuation will be treated for the purpose of capital computation. RBI’s answer to this question is pretty straight and simple – none of these of gains will be considered for the purpose of regulatory capital computation, however, the losses, if any, should be considered. This view seems to be inspired from the principle of conservatism.

 Here it is important to note that the Notification talks about all unrealised gains arising out of fair valuation of financial assets. Unrealised gain could arise in two situations – first, when the assets are measured on fair value through other comprehensive income (FVOCI), and second, when the assets are measured on fair value through profit or loss (FVTPL).

In case of assets which are fair valued through profit or loss, the gains or losses once booked are taken to the statement of profit or loss. Once taken to the statement of profit or loss, these gains or losses lose their individuality. Further, these gains or losses are not shown separately in the Balance Sheet and are blended with accumulated profits or losses of the company. Monitoring the unrealised gains from individual assets would mean maintenance of parallel accounts, which could have several administrative implications.

Further, when these assets are finally sold and gain is realised, only the difference between the fair value and value of disposal is booked in the profit and loss account. It is to be noted here that the gain on sale of assets shown in the profit and loss account in the year of sale is not exactly the actual gain realised from the financial asset because a part of it has been already booked during previous financial years as unrealised gains. If we were to interpret that by “unrealised gains” RBI meant unrealised gains arising due to FVTPL as well, the apparent question that would arise here is – whether the part which was earlier disregarded for the purpose of regulatory capital will now be treated as a part of capital?

Needless to say, extending the scope of “unrealised gains” to mean unrealised gains from FVTPL can create several ambiguities. However, the Notification, as it stands, does not contain answers for these.

In addition to the above, the Notification states the following in this regard:

  • Even unrealised gains arising on transition to Ind AS will have to be disregarded.
  • For the purpose of computation of Tier I capital, for investments in NBFCs and group companies, the entities must reduce the lower of cost of acquisition or their fair value, since, unrealised gains are anyway deducted from owned funds.
  • For any other category of investments, unrealised gains may be reduced from the value of asset for the purpose of risk-weighting.
  • Netting off of gains and losses from one category of assets is allowed, however, netting off is not allowed among different classes of assets.
  • Fair value gains on revaluation of property, plant and equipment arising from fair valuation on the date of transition, shall be treated as a part of Tier II capital, subject to a discount of 55%.
  • Any unrealised gains or losses recognised in equity due to (a) own credit risk and (b) cash flow hedge reserve shall be derecognised while determining owned funds.

(B) Treatment of ECL: The Notification allows only Stage 1 ECL, that is, 12 months ECL, to be included as a part of Tier II capital as general provisions and loss reserves. Lifetime ECL shall not be reckoned as a part of Tier II capital.

6.   Securitisation accounting and prudential norms

All securitisation transactions undergo a strict test of de-recognition under Ind AS 109. The conditions for de-recognition are such that most of the structures, prevalent in India, fail to qualify for de-recognition due to credit enhancements. Consequently, the transaction does not go off the books.

The RBI has clarified that the cases of securitisation that does not go off the books, will be allowed capital relief from regulatory point of view. That is, the assets will be assigned 0% risk weight, provided the credit enhancement provided for the transaction is knocked off the Tier I (50%) and Tier II (remaining 50%).

There are structures where the level of credit enhancement required is as high as 20-25%, the question here is – should the entire credit support be knocked off from the capital? The answer to this lies in the RBI’s Securitisation Guidelines from 2006[5], which states that the knocking off of credit support should be capped at the amount of capital that the bank would have been required to hold for the full value of the assets, had they not been securitised, that is 15%.

For securitisation transactions which qualify for complete de-recognition, we are assuming the existing practice shall be followed.

But apart from the above two, there can also be cases, where partial de-recognition can be achieved – fate of such transactions is unclear. However, as per our understanding, to the extent of retained risk, by way of credit enhancement, there should be a knock off from the capital. For anything retained by the originator, risk weighting should be done.

Matters which skipped attention

There are however, certain areas, which we think RBI has missed considering and they are:

  1. Booking of gain in case of de-recognition of assets: As per the RBI Directions on Securitisation, any gain on sale of assets should be spread over a period of time, on the other hand, the Ind AS requires upfront recognition of gain on sale of assets. The gap between the two should been bridged through this Notification.
  2. Consideration of OCI as a part of Regulatory Capital: As per Basel III framework, other comprehensive income forms part of Common Equity Tier I [read our article here], however, this Notification states all unrealised gains should be disregarded. This, therefore, is an area of conflict between the Basel framework and the RBI’s stand on this issue.

 

Read our articles on the topic:

  1. NBFC classification under IFRS financial statements: http://vinodkothari.com/wp-content/uploads/2018/11/Article-template-VKCPL-3.pdf
  2. Ind AS vs Qualifying Criteria for NBFCs-Accounting requirements resulting in regulatory mismatch?: http://vinodkothari.com/2019/07/ind-as-vs-qualifying-criteria-for-nbfcs/
  3. Should OCI be included as a part of Tier I capital for financial institutions?: http://vinodkothari.com/2019/03/should-oci-be-included-as-a-part-of-tier-i-capital-for-financial-institutions/
  4. Servicing Asset and Servicing Liability: A new by-product of securitization under Ind AS 109: http://vinodkothari.com/2019/01/servicing-asset-and-servicing-liability/
  5. Classification and reclassification of financial instruments under Ind AS: http://vinodkothari.com/2019/01/classification-of-financial-asset-liabilities-under-ind-as/

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11818&Mode=0#F2

[2] https://rbidocs.rbi.org.in/rdocs/Content/PDFs/FAS93F78EF58DB84295B9E11E21A91500B8.PDF

[3] https://www.bis.org/bcbs/publ/d350.pdf

[4] https://rbidocs.rbi.org.in/rdocs/content/pdfs/NOTI170APP130320.pdf

[5] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=2723

Cryptotrading’s tryst with destiny- Supreme Court revives cryptotrading, RBI’s circular struck down

-Megha Mittal

(mittal@vinodkothari.com

April 2018, the Reserve Bank of India (RBI) issued a “Statement on Developmental and Regulatory Policies” (‘Circular’) dated 06.04.2018, thereby prohibiting RBI regulated entities from dealing in/ providing any services w.r.t. virtual currencies, with a 3-month ultimatum to those already engaged in such services. Cut to 4th March, 2020- The Supreme Court of India strikes down RBI’s circular and upheld crypto-trading as valid under the Constitution of India.

Amidst apprehensions of crypto-trading being a highly-volatile and risk-concentric venture, the Apex Court, in its order dated 04.03.2020 observed that RBI, an otherwise staunch critic of cryptocurrencies, failed to present any empirical evidence substantiating cryptocurrency’s negative impact on the banking and credit sector in India; and on the basis of this singular fact, the Hon’ble SC stated RBI’s circular to have failed the test of proportionality.

In this article, the author has made a humble attempt to discuss this landmark judgment and its (dis)advantages to the Indian economy.

Read more

AT1 bonds: blessed with perpetuity or cursed with mortality?: Will Yes Bank write-off sensitise investors to risks of AT1 bonds?

-Financial Services Division

(finserv@vinodkothari.com)

Introduction

In the Yes Bank restructuring proposed by the RBI[1], equity shareholders will not lose all their money, depositors, hopefully, will be fully protected, and other creditors may also sail safe. However, the first casualty is the investors in AT1 bonds, as the same have been fully written off. The returns on AT1 bonds are much lower than those on equity, and only a shade higher than those on Tier 2 bonds; however, in terms of being under the guillotine, they have come even ahead of equity. Sometimes, the risks of investing in an instrument are not understood until there is a casualty. Will the market now become jittery in AT1 investing? Will the cost of AT1 investing go up significantly, so that banks will have to cough up higher servicing costs as they raise AT1 bonds, as compared to Tier 2 bonds, unsecured bonds or secured bonds?

The article discusses the basic features of AT1 bonds and then gets into the impact of the Yes Bank write off on the market for AT1 bonds in India.

Concept of AT1 Bonds

The concept of Additional Tier-1 (AT1) Bonds was introduced by Basel III post the 2008 financial crisis, to protect depositors of a bank on a going concern basis. These bonds are also commonly known as Contingent convertible capital instruments (CoCos)[2]. AT1 or perpetual bonds are quasi debt instruments, which do not have any fixed maturity period. It bears higher risk compared with normal bonds. They are perpetuals as they do not have a redemption date, and are callable at the initiative of the issuer after a minimum period of five years. However, regulators may permit the exercise of call options within the first five years if it can be established that the bank was not in a position to anticipate the event at issuance.

If an issuing bank incurs losses in a financial year, it cannot make coupon payment to its bond holders even if it has enough cash. Further, the essential element of this instrument is that they are hybrid capital securities that absorb losses in accordance with their contractual terms when the capital of the issuing bank falls below a certain level. That is to say, in case the Common Equity Tier-1 (CET 1) ratio falls below a threshold level, the holders of such bonds shall bear the losses without the bank being liquidated.

As per the Basel III requirement, the terms and conditions of AT1 bonds must have a provision that requires such instruments, at the option of the relevant authority, to either be written off or converted into common equity upon the occurrence of the trigger event. Paragraph 55 of Basel III norms provide comprehensive criterions for an instrument to be included in Additional Tier 1 Capital. The relevant extract is reproduced herein below:

Instruments issued by the bank that meet the Additional Tier 1 criteria

  1. The following box sets out the minimum set of criteria for an instrument issued by the bank to meet or exceed in order for it to be included in Additional Tier 1 capital.
Criteria for inclusion in Additional Tier 1 capital
1.        Issued and paid-in
2.        Subordinated to depositors, general creditors and subordinated debt of the bank
3.        Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors
4.        Is perpetual, i.e. there is no maturity date and there are no step-ups or other incentives to redeem
5.        May be callable at the initiative of the issuer only after a minimum of five years:

a.      To exercise a call option a bank must receive prior supervisory approval; and

b.      A bank must not do anything which creates an expectation that the call will be exercised; and

c.      Banks must not exercise a call unless:

                          i.    They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank[3]; or

                        ii.    The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.[4]

6.        Any repayment of principal (eg. through repurchase or redemption) must be with prior supervisory approval and banks should not assume or create market expectations that supervisory approval will be given
7.        Dividend/coupon discretion:

a.      the bank must have full discretion at all times to cancel distributions/payments[5]

b.      cancellation of discretionary payments must not be an event of default

c.      banks must have full access to cancelled payments to meet obligations as they fall due

d.      cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders.

8.        Dividends/coupons must be paid out of distributable items
9.        The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organisation’s credit standing.
10.     The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law.
11.     Instruments classified as liabilities for accounting purposes must have principal loss absorption through either

(i)                conversion to common shares at an objective pre-specified trigger point or

(ii)              a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point. The write-down will have the following effects:

a.    Reduce the claim of the instrument in liquidation;

b.    Reduce the amount re-paid when a call is exercised; and

c.    Partially or fully reduce coupon/dividend payments on the instrument.

12.     Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument
13.     The instrument cannot have any features that hinder recapitalisation, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame
14.     If the instrument is not issued out of an operating entity or the holding company in the consolidated group (eg a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity18 or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Additional Tier 1 capital

Incentive to issue AT1 Bonds

The foremost reasons for issuing AT1 Bonds is the fact that they satisfy the regulatory capital requirements. Most of the investors are private banks, mutual funds and retail investors, having a high risk appetite, while institutional investors are mostly restrained. Since the risk is higher, higher is the yield from these bonds. The rate of return is higher than those of higher-ranked debt instruments of the same issuer. It is dependent on their two factors – the trigger level and the loss absorption mechanism.

Priority order

The claims of the investors in AT1 Bonds and any interest accrued thereon is superior to the claims of investors in equity shares and perpetual non-cumulative preference shares, if any and any other securities that are subordinated to AT 1 Capital in terms of the Basel III Regulations.

However, the claims are subordinated to the claims of depositors, general creditors and any other securities of the issuer that are senior to AT 1 Capital of the Bank in terms of Basel III Regulations. Further, the stand pari passu without preference amongst themselves and other subordinated debt classified as AT1 Capital in terms of Basel III Regulations.

These bonds are neither secured nor covered by any guarantee of the issuer or any of its related entities or any other arrangement that legally or economically enhances the seniority of such claim as compared to the other creditors.

Rating of AT1 Bonds

AT1 Bonds issued by banks are usually rated by rating agencies as plain bonds even if the rating agency uses a tag ‘hybrid’.  However, they are assigned ratings as applicable for bonds. Earlier, the absence of a complete set of credit ratings for AT1 Bonds was a hurdle on its growth path. According to the S&P rating methodology, an AT1 Bond rating should be at least two to three notches below the issuer’s credit rating and cannot exceed BBB+[6]. Further downward notching is applied to instruments with triggers near or at the point of non-viability and to those that have a discretionary trigger. On average, given the higher risk, the rating for these bonds is one to four notches lower than the secured bond series of the same bank. For example, while SBI’s tier II bonds are rated AAA by CRISIL, its tier I long-term bonds are rated AA+.

Pricing and Yield

Though the risk is much more than a plain or any other structured bond, however, usually NBFCs and banks offer about 200-300 basis points higher than similar maturity debentures.

Since these bonds have no maturity date they can continue to pay the coupon forever. The issuer has the option to call back the bonds or repay the principal after a period of five years. While AAA rated tier II bond of a public sector bank may have an interest rate of around 7- 7.5% per annum, its AT1 Bond can carry a rate of around 9- 10% per annum. The attraction for investors is higher yield than secured bonds issued by the same entity. But along with the high yield there are certain risks as well; the option with issuer to skip coupon payment and maintaining a CET1 ratio of 5.125%, failing which the bonds can get written down or get converted into equity.

The pricing of AT1 Bonds is consistent with their position in banks’ capital structures. The main determinants of yields are the mechanical trigger level, the loss absorption mechanism, and the existence of a discretionary trigger.

Classification as AT1 Bonds

In some jurisdictions, the respective domestic law does not allow direct issuance of perpetual debt. There can be the following possible circumstances that may be eligible for recognition as AT 1 capital:

  • Dated instrument having terms and conditions that include an automatic roll-over feature,
  • Instruments with mandatory conversions into common shares on a pre-defined date,
  • Subordinated loans

Dated instruments that include automatic roll-over features are designed to appear as perpetual to the regulator and, simultaneously to appear as having a maturity to the tax authorities and/or legal system. This creates a risk that the automatic roll over could be subject to legal challenge and repayment at the maturity date could be enforced. As such, instruments with maturity dates and automatic roll-over features are not treated as perpetual.

An instrument may be treated as perpetual if it will mandatorily convert to common shares at a pre-defined date and has no original maturity date prior to conversion. However, if the mandatory conversion feature is combined with a call option (i.e. the mandatory conversion date and the call are simultaneous or near simultaneous), such that the bank can call the instrument to avoid conversion, the instrument will be treated as having an incentive to redeem and will not be permitted to be included in AT1 Capital.

Subordinated loans meeting all the criteria required for Additional Tier 1 or Tier 2 capital, can be included in the regulatory capital.

Write down and write-off

AT1 Bonds accounted for as liabilities are required to meet both the requirements for the point of non-viability and the principal loss absorbency requirements. To meet the point of non-viability trigger requirements, the instrument needs to be capable of being permanently written-off or converted to common shares at the trigger event. The trigger event is the earlier of[7]:

  • a decision that a write-off, without which the firm would become non-viable, is necessary, as determined by the relevant authority; and
  • the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority.

Source: CoCos: a primer

The write-down or conversion requirements for Additional Tier 1 instruments accounted for as liabilities, a temporary write-down mechanism is only permitted if it meets the following conditions:

  • The trigger level for write-down/conversion must be at least 5.125% Common Equity Tier 1 (CET1).
  • The write-down/conversion must generate CET1 under the relevant accounting standards and the instrument will only receive recognition in Additional Tier 1 up to the minimum level of CET1 generated by a full write-down/conversion of the instrument.
  • The aggregate amount to be written-down/converted for all such instruments on breaching the trigger level must be at least the amount needed to immediately return the bank’s CET1 ratio to the trigger level or, if this is not possible, the full principal value of the instruments.

Global scenario

AT1 bonds come with the basic feature of protecting the issuer from capital losses. When the issuer is in stress, these bonds extend a helping hand by absorbing the losses. For absorbing the losses, the issuer can either write-off, write-down or convert the AT1 bonds into equity. In fact, the terms of issue of AT1 bonds specifically provide for the method of absorbing losses. Following are a few examples of the methods of absorbing losses provided in the terms of issue of AT1 bonds:

  • Deutsche Bank intends of issue AT1 bonds in 2020[8], which would be subject to write-down provisions if its common equity tier 1 capital ratio will fall below 5.13%. as against 13.6% as of December 31, 2019. The securities are also subject to other loss-absorption features pursuant to the applicable capital rules.
  • Kookmin Bank issued CoCo Bonds in 2019[9] which can be written off in times of stress — with an interest rate of 4.35 per cent.

Companies have, in many instances, written-off or written-down AT1 bonds. Such as:

  • Erste has written-off billions of euros in AT1 bonds in 2014[10].
  • Bank of Jinzhou, in 2019[11], stopped paying coupon on its CoCo Bonds to protect its financial health.

Impact on Market for AT1 Bonds

Among the investors, mostly mutual funds and several individual investors, mostly high net worth individuals (HNIs), are exposed to Yes Bank issued AT 1 Bonds which are designed to absorb losses when the capital of the bank falls below certain levels. As of January 31, 2020, 11 mutual funds had exposure worth Rs 2,819 crore to bonds of the bank. Two schemes of Bank of Baroda Mutual Fund–Baroda Treasury Advantage Fund and Baroda Credit Risk Fund had investments worth Rs 53.69 crore in Tier 1 perpetual bonds of Yes Bank. UTI Mutual Fund holds investments worth nearly Rs 50 crore worth of holding in 9.5% perpetual bonds. Indiabulls Housing Finance had invested Rs 662 crore via AT1 Bonds. Several institutional investors are planning to come together to oppose the central bank’s proposal to write down Yes Bank’s perpetual bonds. Their main contention is that tier-I bonds are senior to equity, and cannot be written down without reducing equity.

Based on the information circulating in the market, the Information Memorandum (IM) of AT1 Bonds has provisions that in case there is a reconstitution or amalgamation of the bank under Sec 45 of Banking Regulation Act 1949, the bank will be deemed as non-viable and trigger for written-down / conversion of the AT1 Bonds will be activated. However, the IM sates it cannot be written down unless equity is also reduced.

AT1 bond holders are treated like equity holders. Hence repayment is not likely for these types of bonds. The Yes Bank scheme shall be an eye opener for the investors and is expected to adversely affect the market for AT1 Bonds. This is the first time ever in India that AT1 Bond investor got a hit on their investments. It is likely that the yield on such similar bonds would increase by around 200 basis points from existing levels.

 

 

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49479

[2] https://www.bis.org/publ/qtrpdf/r_qt1309f.pdf

[3] Replacement issues can be concurrent with but not after the instrument is called.

[4] Minimum refers to the regulator’s prescribed minimum requirement, which may be higher than the Basel III

Pillar 1 minimum requirement.

[5] A consequence of full discretion at all times to cancel distributions/payments is that “dividend pushers” are prohibited. An instrument with a dividend pusher obliges the issuing bank to make a dividend/coupon payment on the instrument if it has made a payment on another (typically more junior) capital instrument or share. This obligation is inconsistent with the requirement for full discretion at all times. Furthermore, the term “cancel distributions/payments” means extinguish these payments. It does not permit features that require the bank to make distributions/payments in kind.

[6] Standard & Poor’s (2011)

[7] https://www.bis.org/press/p110113.pdf

[8] https://finance.yahoo.com/news/deutsche-db-plans-offer-additional-131801196.html

[9] https://www.ft.com/content/523a5e62-9802-11e9-9573-ee5cbb98ed36

[10]https://www.washingtonpost.com/business/a-coco-bond-at-3375percent-the-markets-still-crazy/2020/01/23/7a9435ae-3db6-11ea-afe2-090eb37b60b1_story.html

[11] https://www.wsj.com/articles/ailing-chinese-bank-stops-paying-coupons-on-coco-bonds-11567424965

Fintech Framework: Regulatory responses to financial innovation

Timothy Lopes, Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

The world of financial services is continually witnessing a growth spree evidenced by new and innovative ways of providing financial services with the use of enabling technology. Financial services coupled with technology, more commonly referred to as ‘Fintech’, is the modern day trend for provision of financial services as opposed to the traditional methods prevalent in the industry.

Rapid advances in technology coupled with financial innovation with respect to delivery of financial services and inclusion gives rise to all forms of fintech enabled services such as digital banking, digital app-based lending, crowd funding, e-money or other electronic payment services, robo advice and crypto assets.

In India too, we are witnessing rapid increase in digital app-based lending, prepaid payment instruments and digital payments. The trend shows that even a cash driven economy like India is moving to digitisation wherein cash is merely used as a way to store value as an economic asset rather than to make payments.

“Cash is King, but Digital is Divine.”

  • Reserve Bank of India[1]

The Financial Stability Institute (‘FSI’), one of the bodies of the Bank for International Settlement issued a report titled “Policy responses to fintech: a cross country overview”[2] wherein different regulatory responses and policy changes to fintech were analysed after conducting a survey of 31 jurisdictions, which however, did not include India.

In this write up we try to analyse the various approaches taken by regulators of several jurisdictions to respond to the innovative world of fintech along with analysing the corresponding steps taken in the Indian fintech space.

The Conceptual Framework

Let us first take a look at the conceptual framework revolving in the fintech environment. Various terminology or taxonomies used in the fintech space, are often used interchangeably across jurisdictions. The report by FSI gives a comprehensive overview of the conceptual framework through a fintech tree model, which characterises the fintech environment in three categories as shown in the figure.

Source: FSI report on Policy responses to fintech: a cross-country overview

Let us now discuss each of the fintech activities in detail along with the regulatory responses in India and across the globe.

Digital Banking –

This refers to normal banking activities delivered through electronic means which is the distinguishing factor from traditional banking activities. With the use of advanced technology, several new entities are being set up as digital banks that deliver deposit taking as well as lending activities through mobile based apps or other electronic modes, thereby eliminating the need for physically approaching a bank branch or even opening a bank branch at all. The idea is to deliver banking services ‘on the go’ with a user friendly interface.

Regulatory responses to digital banking –

The FSI survey reveals that most jurisdictions apply the existing banking laws and regulations to digital banking as well. Applicants with a fintech business model must go through the same licensing process as those applicants with a traditional banking business model.

Only a handful of jurisdictions, namely Hong Kong, SAR and Singapore, have put in place specific licensing regimes for digital banks. In the euro area, specific guidance is issued on how credit institution authorisation requirements would apply to applicants with new fintech business models.

Regulatory framework for digital banking in India –

In India, majority of the digital banking services are offered by traditional banks itself, mainly governed by the Payment and Settlement Systems Act, 2007[1], with RBI being the regulatory body overseeing its implementation. The services include, opening savings accounts online even through apps, facilitating instant transfer of funds through the use of innovative products such as the Unified Payments Interface (UPI), which is governed by the National Payments Corporation of India (NPCI), facilitating the use of virtual cards, prepaid payment instruments (PPI), etc. These services may be provided not only by traditional banks alone, but also by non-bank entities.

Fintech balance sheet lending

Typically refers to lending from the balance sheet and assuming the risk on to the balance sheet of the fintech entity. Investors’ money in the fintech entity is used to lend to customers which shows up as an asset on the balance sheet of the lending entity. This is the idea of balance sheet lending. This idea, when facilitated with technological innovation leads to fintech balance sheet lending.

Regulatory responses to fintech balance sheet lending –

As per the FSI survey, most jurisdictions do not have regulations that are specific to fintech balance sheet lending. In a few jurisdictions, the business of making loans requires a banking licence (eg Austria and Germany). In others, specific licensing regimes exist for non-banks that are in the business of granting loans without taking deposits. Only one of the surveyed jurisdictions has introduced a dedicated licensing regime for fintech balance sheet lending.

Regulatory regime in India –

The new age digital app based lending is rapidly advancing in India. With the regulatory framework for Non-Banking Financial Companies (NBFCs), the fintech balance sheet lending model is possible in India. However, this required a net owned fund of Rs. 2 crores and registration with RBI as an NBFC- Investment and Credit Company.

The digital app based lending model in India works as a partnership between a tech platform entity and an NBFC, wherein the tech platform entity (or fintech entity) manages the working of the app through the use of advanced technology to undertake credit appraisals, while the NBFC assumes the credit risk on its balance sheet by lending to the customers who use the app. We have covered this model in detail in a related write up[2].

Loan & Equity Crowd funding

Crowd funding refers to a platform that connects investors and entrepreneurs (equity crowd funding) and borrowers and lenders (loan crowd funding) through an internet based platform. Under equity crowd funding, the platform connects investors with companies looking to raise capital for their venture, whereas under loan crowd funding, the platform connects a borrower with a lender to match their requirements. The borrower and lender have a direct contract among them, with the platform merely facilitating the transaction.

Regulatory responses to crowd funding –

According to the FSI survey, many surveyed jurisdictions introduced fintech-specific regulations that apply to both loan and equity crowd funding considering the similar risks involved, shown in the table below. Around a third of surveyed jurisdictions have fintech-specific regulations exclusively for equity crowd funding. Only a few jurisdictions have a dedicated licensing regime exclusively for loan crowd funding. Often, crowd funding platforms need to be licensed or registered before they can perform crowd funding activities, and satisfy certain conditions.

Table showing regulatory regimes in various jurisdictions

Fintech-specific regulations for crowd funding
Equity Crowd Funding Equity and Loan Crowd Funding Loan Crowd Funding
Argentina           Columbia

Australia             Italy

Austria                Japan

Brazil                   Turkey

China                   United States

Belgium                Peru

Canada                 Philippines

Chile                      Singapore

European Union  Spain

France                   Sweden

Mexico                  UAE

Netherlands         UK

Australia

Brazil

China

Italy

 

Source: FSI Survey

Regulatory regime in India

  1. In case of equity crowd funding –

In 2014, securities market regulator SEBI issued a consultation paper on crowd funding in India[3], which mainly focused on equity crowd funding. However, there was no regulatory framework subsequently issued by SEBI which would govern equity crowd funding in India. At present crowd funding platforms in India have registered themselves as Alternative Investment Funds (AIFs) with SEBI to carry out fund raising activities.

 

  1. In case of loan crowd funding –

The scenario for loan crowd funding, is however, already in place. The RBI has issued the Non-Banking Financial Company – Peer to Peer Lending Platform (Reserve Bank) Directions, 2017[4] which govern loan crowd funding platforms. Peer to Peer Lending and loan crowd funding are terms used interchangeably. These platforms are required to maintain a net owned fund of not less than 20 million and get themselves registered with RBI to carry out P2P lending activities.

 

As per the Directions, the Platform cannot raise deposits or lend on its own or even provide any guarantee or credit enhancement among other restrictions. The idea is that the platform only acts as a facilitator without taking up the risk on its own balance sheet.

Robo- Advice

An algorithm based system that uses technology to offer advice to investors based on certain inputs, with minimal to no human intervention needed is known as robo-advice, which is one of the most popular fintech services among the investment advisory space.

Regulatory responses to robo-advice –

According to the FSI survey, in principle, robo- and traditional advisers receive the same regulatory treatment. Consequently, the majority of surveyed jurisdictions do not have fintech-specific regulations for providers of robo-advice. Around a third of surveyed jurisdictions have published guidance and set supervisory expectations on issues that are unique to robo-advice as compared to traditional financial advice. In the absence of robo-specific regulations, several authorities provide somewhat more general information on existing regulatory requirements.

Regulatory regime in India –

In India, there is no specific regulatory framework for those providing robo-advice. All investment advisers are governed by SEBI under the Investment Advisers Regulations, 2013[5]. Under the regulations every investment adviser would have to get themselves registered with SEBI after fulfilling the eligibility conditions. The SEBI regulations would also apply to those offering robo-advice to investors, as there is no specific restriction on using automated tools by investment advisers.

Digital payment services & e-money

Digital payment services refer to technology enabled electronic payments through different modes. For instance, debit cards, credit cards, internet banking, UPI, mobile wallets, etc. E-money on the other hand would mostly refer to prepaid instruments that facilitate payments electronically or through prepaid cards.

Regulatory responses to digital payment services & e-money –

As per the FSI survey, most surveyed jurisdictions have fintech-specific regulations for digital payment services. Some jurisdictions aim at facilitating the access of non-banks to the payments market. Some jurisdictions have put in place regulatory initiatives to strengthen requirements for non-banks.

Further, most surveyed jurisdictions have a dedicated regulatory framework for e-money services. Non-bank e-money providers are typically restricted from engaging in financial intermediation or other banking activities.

Regulatory regime in India –

The Payment and Settlement Systems Act, 2007 (PSS) of India governs the digital payments and e-money space in India. While several Master Directions are issued by the RBI governing prepaid payment instruments and other payment services, ultimately they draw power from the PSS Act alone. These directions govern both bank and non-bank players in the fintech space.

UPI being a fast mode of virtual payment is however governed by the NPCI which is a body of the RBI.

Other policy measures in India – The regulatory sandbox idea

Both RBI and SEBI have come out with a Regulatory Sandbox (RS) regime[6], wherein fintech companies can test their innovative products under a monitored and controlled environment while obtaining certain regulatory relaxations as the regulator may deem fit.  As per RBI, the objective of the RS is to foster responsible innovation in financial services, promote efficiency and bring benefit to consumers. The focus of the RS will be to encourage innovations intended for use in the Indian market in areas where:

  1. there is absence of governing regulations;
  2. there is a need to temporarily ease regulations for enabling the proposed innovation;
  3. the proposed innovation shows promise of easing/effecting delivery of financial services in a significant way.

RBI has already begun with the first cohort[7] of the RS, the theme of which is –

  • Mobile payments including feature phone based payment services;
  • Offline payment solutions; and
  • Contactless payments.

SEBI, however, has only recently issued the proposal of a regulatory sandbox on 17th February, 2020.

Conclusion

Technology has been advancing at a rapid pace, coupled with innovation in the financial services space. This rapid growth however should not be overlooked by regulators across the globe. Thus, there is a need for policy changes and regulatory intervention to simultaneously govern as well as promote fintech activities, as innovation will not wait for regulation.

While most of regulators around the globe have different approaches to governing the fintech space, the regulatory environment should be such that there is sufficient understanding of fintech business models to enable regulation to fit into such models, while also curbing any unethical activities or risks that may arise out of the fintech business.

[1] https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/86706.pdf

[2] http://vinodkothari.com/2019/09/sharing-of-credit-information-to-fintech-companies-implications-of-rbi-bar/

[3] https://www.sebi.gov.in/sebi_data/attachdocs/1403005615257.pdf

[4] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MDP2PB9A1F7F3BDAC463EAF1EEE48A43F2F6C.PDF

[5] https://www.sebi.gov.in/legal/regulations/jan-2013/sebi-investment-advisers-regulations-2013-last-amended-on-december-08-2016-_34619.html

[6] https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=938

https://www.sebi.gov.in/media/press-releases/feb-2020/sebi-board-meeting_46013.html

[7] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=48550

[1] Assessment of the progress of digitisation from cash to electronic – https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=19417

[2] https://www.bis.org/fsi/publ/insights23.pdf

Securitisation of performing assets: meaning of “homogenous pools”

Timothy Lopes, Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

Standard asset securitisation in India is governed by the RBI securitisation guidelines of 2006[1] and 2012[2]. As one of the essential pre-requisites of a securitisation transaction, the underlying assets should represent the debt obligations of a ‘homogeneous pool’ of obligors. Subject to this condition of homogeneity, all on-balance sheet standard assets (except certain assets prescribed under the guidelines) are eligible for securitisation.

The question, then, arises as to what is the criteria for determining whether a pool of assets is homogeneous? In this write up we analyse the homogeneity criteria in the context of a securitisation transaction based on global understanding.

How is homogeneity assessed?

Basel III norms on Simple Transparent and Comparable (‘STC’) Securitisation transactions[3] lays down factors to be kept in mind while determining homogeneity as follows –

  • In simple, transparent and comparable securitisations, the assets underlying the securitisation should be credit claims or receivables that are homogeneous.
  • In assessing homogeneity, consideration should be given to –
    • Asset type,
    • Jurisdiction,
    • Legal system; and
    • Currency.
  • The nature of assets should be such that investors would not need to analyse and assess materially different legal and/or credit risk factors and risk profiles when carrying out risk analysis and due diligence checks.
  • Homogeneity should be assessed on the basis of common risk drivers, including similar risk factors and risk profiles.
  • Credit claims or receivables included in the securitisation should have standard obligations, in terms of rights to payments and/or income from assets and that result in a periodic and well-defined stream of payments to investors. Credit card facilities should be deemed to result in a periodic and well-defined stream of payments to investors for the purposes of this criterion.
  • Repayment of note-holders should mainly rely on the principal and interest proceeds from the securitised assets. Partial reliance on refinancing or re-sale of the asset securing the exposure may occur provided that re-financing is sufficiently distributed within the pool and the residual values on which the transaction relies are sufficiently low and that the reliance on refinancing is thus not substantial.

The basic intent behind a securitisation transaction is the tranching of risk. In order to tranche the risk, there must be similarity in terms of the risk attributes of the pool. If the risk is not homogeneous across different attributes of the pool the tranching of risk becomes difficult and defeats the intent of the transaction.

Further, the nature of assets in the pool must be homogenous. This means that the assets in the pool should be covered by similar legal risks or credit risks so that the investors need not analyse and assess materially different assets in a pool.

The EU Simple, Transparent and Standardised (‘STS’) securitisation Regulations[4] states the following–

“To ensure that investors perform robust due diligence and to facilitate the assessment of underlying risks, it is important that securitisation transactions are backed by pools of exposures that are homogenous in asset type, such as pools of residential loans, or pools of corporate loans, business property loans, leases and credit facilities to undertakings of the same category, or pools of auto loans and leases, or pools of credit facilities to individuals for personal, family or household consumption purposes.”

“The securitisation shall be backed by a pool of underlying exposures that are homogeneous in terms of asset type, taking into account the specific characteristics relating to the cash flows of the asset type including their contractual, credit-risk and prepayment characteristics. A pool of underlying exposures shall comprise only one asset type. The underlying exposures shall contain obligations that are contractually binding and enforceable, with full recourse to debtors and, where applicable, guarantors.”

Illustrations of a homogeneous pool

Whether a pool of comprising of commercial vehicles, trucks and tractors can be called homogeneous?

Prima facie the pool might appear to be homogeneous, however it is not so. The assets in this pool are different in terms of legal and credit risks. For instance, the credit risk arising out of a commercial vehicle loan and a tractor loan is far from similar, given the nature of the asset, value of assets and repayment power of the borrower of the asset, type of usage to which the asset.

Whether a pool of personal loans, business loans and loans against property can be called homogeneous?

The pool of loans would have to each be analysed individually given the material differences in their nature. Further the nature of collateral in each of these loans may be different leading to different risk attributes. Further it would have to be seen whether these loans have well defined stream of payments as well. Ultimately it is unlikely that this pool can be called homogeneous.

Conclusion

Homogeneity should be assessed from the viewpoint of risk attributes. There must be similarity in the nature of assets as well as collateral to ascertain homogeneity in terms of credit risks. Legal risks must also be analysed and should be homogeneous. These factors ultimately help investors in the due diligence process (while also making the transaction simple, transparent and comparable compliant) as well as make tranching of risks easier.

Read our related write ups on the subject of securitisation –

Basel III requirements for Simple Transparent and Comparable (STC) Securitisation –

http://vinodkothari.com/2020/01/basel-iii-requirements-for-simple-transparent-and-comparable-stc-securitisation/

 

[1] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=2723

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

[3] https://www.bis.org/bcbs/publ/d374.pdf

[4] https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32017R2402&from=en