STEERING COMMITTEE REPORT ON DIGITAL LENDING: ISSUES AND SOLUTIONS

– Richa Saraf (legal@vinodkothari.com)

The Department of Economic Affairs has recently shared the report of the Steering Committee[1] which discusses the various issues faced by fintech companies. This write up tries to focus on the issues in relation to online lending, and the recommendations given by the Steering Committee on the same.

Verifying the Authenticity of User:

RBI already provides for guidelines pertaining to Know Your Customer (KYC), specifying Originally Seen and Verified (OSV) norms, laying down conditions for non-face to face KYC, and in fact the e- KYC process was simplified with the advent of Aadhaar. However, the Aadhaar verdict by the Apex Court has adversely affected the fintech industry, and the Steering Committee has observed that there is need to explore alternatives for physical KYC. The following are the key recommendations in this regard:

  • Offline Authentication Process: These days smartphones are equipped with biometric enabled multi-factor authentication, therefore, technology may be put to use for the purpose of KYC and authentication of the user. Some fintech companies have already come up with various unconventional mode of KYC, such as video based KYC, obtaining validated electronic versions of KYC related documents through DigiLocker, etc., as an additional layer of protection, authentication of the user can also be done by sending an OTP at the registered mobile number of the user, or by using geo location, which indicates the IP address of the user. The Committee has also recognised some of these options in its Discussion Paper, provided the same is subject to prior customer consent.
  • Central Data Registry: In the light of representations made by various stakeholders, the Committee has expressed that e-KYC has the potential to reduce customer on-boarding and servicing costs significantly, and has, therefore, recommended that all financial sector regulators fix deadlines for on boarding existing KYC data to the Central KYC registry, making KYC a complete digital and paperless process.
  • Other non- traditional way of data exchange: The Discussion Paper also mentions about the usage of the Application Programme Interface (API), for facilitating real time information sharing; India Stack[2] being one such API, where digital records move with an individual’s digital identity, eliminating the need for massive amount of paper collection and storage.

Determination of Borrower’s creditworthiness:

The Steering Committee has noted how the poor and the unbanked are often unable to access credit due to the lack of formal credit history and/ or non-availability of significant information/ document. The following are the key recommendations in this regard:

  • Data sharing in the finance industry: The Committee believes that APIs must be used for cloud storing of data, and the same should be open, to ensure equal access to all those who wish to build on or rely on this data. For instance, an India Agri Stack can be built, such that lenders can evaluate the creditworthiness of agricultural borrowers. This stack can include a farmer’s borrowing history, land ownership data, income data, among other information. Additional APIs to facilitate research and the creation of applications may include: Government departments and local government bodies unified stack; land registry and state land records; ownership/fitness/loan/mortgage/enforcement records to provide transparency to transactions; and so on. Further, India MSME Stack may be built for MSME financing related data.
  • Digitisation of land records: The Digital India- Land Records Modernisation Program[3] is aimed at national integration of all land related data across the country in order to provide conclusive titles, including details such as characteristics of the land, mortgages, encumbrances, ownership and other rights, etc., enabling financial services companies to make informed decisions about lending.
  • Reliance on Informal Modes: Fintech companies are using a variety of sources for collecting customer information and advanced data analytics to access customer credibility, for instance obtaining data from social media usage, web browser history, financial transaction behaviour, product purchase behaviour, etc. from the mobile phones of prospective borrowers. Some companies are also resorting to psychometric tests to build the customer’s profile.

For agri- loans specifically, to access the credit score of a borrower, it is suggested that companies use permutation and combination of the alternate data which may be available, such as weather forecasts and records, agronomic surveys, accessing the demographic, geographic, financial and social information of the customer, farmer progressiveness and such like. Referring to a Chinese agricultural fintech company Nongfenqi, which generates credit scores on the basis of interaction with customers’ business partners, fellow customers and villagers, the Committee has observed that the default rate in such model is merely 0.1%. In order to increase access to credit and to stabilise the growth of such practices, the Committee has recommended that Ministry of Economics and Information Technology (MEITY) and TRAI to formulate a policy to enable such practices through a formal, consent-based mechanism.

  • Usage of Artificial Intelligence (AI): AIs afford an opportunity to gain insight into customer behaviour pattern, thereby aiding in determination of their creditworthiness. Equifax[4] is one credit information agency, which gives potential lenders an overall insight on the borrower’s credit health through Neuro Decision Technology. It claims to predict the likelihood of a business incurring severe delinquency, charge-off or bankruptcy on financial accounts within the next 12 months. Vantage Score Solution[5], which claims to predict the likelihood of the borrower repaying the borrowed money, also used AI to develop a model for people with thinner credit profiles.

 The Steering Committee has also recognised AI for modernising the credit scoring methodology and approach.

Execution of agreements online:

Fintech entities have been vigorously using e- mode for entering into transactions; for instance, providing app- based loan, on a click. While one may contend that click- wrap agreements are prone to fraud, since the user is not known, and thus, cannot be relied upon, such may the case in any mode of execution. Most of the time in litigations, it is not uncommon for parties to challenge the authenticity of agreement, claiming that the acceptance by mail was not sent by him, that the signature is forged, etc. While physical signatures may be examined by way of forensic, it is difficult to verify whether a click- wrap agreement was actually entered into by the parties or was a mere mistake on the part of either of the parties.

While e-agreements are generally held as valid and enforceable in the courts, for high stake transactions, parties have apprehensions on the enforceability in case of default of loan or non- compliance of any of the terms, and therefore, they still insist on wet signatures on physical agreements. The Steering Committee has discussed about re-engineering of legal processes for the digital world. The Committee suggests that insistence on wet signatures on physical loan agreements be replaced by paperless legal alternatives, as these can enable cutting costs and time in access to finance, repayment, recovery, etc., for businesses and financial service companies. To achieve the goal of paperless economy also the requirement of physical loan agreements are unwanted. The Committee has, therefore, recommended that the Department of Legal Affairs should review all such legal processes that have a bearing on financial services and consider amendments permitting digital alternatives in cases such as power-of-attorney, trust deeds, wills, negotiable instrument, other than a cheque, any other testamentary disposition, any contract for the sale or conveyance of immovable property or any interest in such property, etc., (where IT Act is not applicable), compatible with electronic service delivery by financial service providers.

Other recommendations w.r.t. lending industry:

(a) Enhancing competition by way of referral pool:

The Committee recommends that all financial sector regulators may study the potential of open data access among their respective regulated entities, for enabling competition in the provision of financial services; RBI may encourage banks to make available databases of rejected credit applications available on a consent-basis to a neutral marketplace of alternate lenders. In line with the Open Data Regulations in the UK banking sector, the Committee further recommends that RBI may consider making available bank data (such as transaction and account history data) to fintech firms through APIs.

(b) Data privacy risks:

The Committee notes that the data sharing between entities is also subject to privacy laws, and while the Ministry of Science and Technology has already formulated the National Data Sharing and Accessibility Policy[6], and MEITY is the nodal Ministry to implement the policy, the same needs wider acceptance and implementation. The Committee has further recommended that a taskforce in the Ministry of Finance may be set up with the participation of the regulators and suitable recommendations may be made to safeguard the interests of consumers.

The Committee has expressed that the provisions of the Data Protection Bill, 2018[7] may have far-reaching implications on the growth of fintech sector, and has therefore, recommended that regulators should urgently review the existing regulatory framework with respect to data protection and privacy concerns, in keeping with emerging data privacy legislation in India.

 

[1]https://dea.gov.in/sites/default/files/Report%20of%20the%20Steering%20Committee%20on%20Fintech_2.pdf

[2] https://indiastack.org/

[3] http://dilrmp.gov.in/#

[4] https://www.equifax.co.in/

[5] https://www.vantagescore.com/

[6] https://dst.gov.in/sites/default/files/nsdi_gazette_0.pdf

[7] https://meity.gov.in/writereaddata/files/Personal_Data_Protection_Bill,2018.pdf

Our related write-ups can be viewed here:

 

Please find below the link for other write-ups relating to Fintechs.

http://vinodkothari.com/category/financial-services/fintech/

Moving towards digital India: Are e-agreements valid?

     –Anita Baid and Richa Saraf (legal@vinodkothari.com)

Introduction

With the evolution of technology, the way of executing documents have also evolved. With the increasing demand for modern, convenient methods for entering into binding transactions, electronic agreements and electronic signature have gained a lot of momentum in recent years. Technological developments have not only changed the ways in which these transactions are entered into but the execution process has also revolutionised significantly.

Speaking about e- agreements, while there has been various case laws, wherein email between parties has also been accepted as a binding contract, the validity and enforceability of click- wrap agreements still continues to be a cause of concern. The recent report of the Steering Committee on Fintech Issues[1] has also discussed about re-engineering of legal processes for the digital world. The Committee suggests that insistence on wet signatures on physical loan agreements be replaced by paperless legal alternatives, as these can enable cutting costs and time in access to finance, repayment, recovery, etc., for businesses and financial service companies. To achieve the goal of paperless economy also the requirement of physical loan agreements are unwanted. The Committee has, therefore, recommended that the Department of Legal Affairs should review all such legal processes that have a bearing on financial services and consider amendments permitting digital alternatives in cases such as power-of-attorney, trust deeds, wills, negotiable instrument, other than a cheque, any other testamentary disposition, any contract for the sale or conveyance of immovable property or any interest in such property, etc., (where IT Act is not applicable), compatible with electronic service delivery by financial service providers.

In this article, we have discussed the legal validity of electronic agreements and electronic signatures.

Validity of E- Agreement as per the Contract Act, 1872[2]

Section 10 of the Contract Act lays down as to what agreements are contracts. It states:

All agreements are contracts if they are made by the free consent of parties competent to contract, for a lawful consideration and with a lawful object, and are not hereby expressly declared to be void.”

Contracts executed electronically are also governed by the basic principles provided in the Contract Act, which mandates that a valid contract should have been entered with a free consent and for a lawful consideration between two majors. The intent of the parties is, therefore, relevant.

In case of click wrap agreements also, if the terms and conditions are provided to the user (offer) and he confirms to the same by ticking on “I Agree” (acceptance), then he shall be held liable to honour the obligations under the contract.

Recognition of E- Agreement and Digital Signature under the Information Technology Act, 2000[3]

Section 10A of the IT Act expressly provides for validity of contracts formed through electronic means and states that-

“Where in a contract formation, the communication of proposals, the acceptance of proposals, the revocation of proposals and acceptances, as the case may be, are expressed in electronic form or by means of an electronic record, such contract shall not be deemed to be unenforceable solely on the ground that such electronic form or means was used for that purpose.”

An e-agreement subsequent to its execution is stored/recorded with the executing parties in electronic form, and is considered as an electronic record under the IT Act. In this regard, it is relevant to refer to Section 2(1)(t) of the IT Act, which defines an electronic record as “data, record or data generated, image or sound stored, received or sent in an electronic form or micro film or computer generated micro fiche”.

The terms electronic signature and digital signature have been defined under the IT Act.

In fact, the IT Act quite comprehensively covers the legalities of digital signature certificates (DSCs). Section 5 of the IT Act gives electronic signatures their legal character.

“5. Legal recognition of electronic signatures: Where any law provides that information or any other matter shall be authenticated by affixing the signature or any document shall be signed or bear the signature of any person, then, notwithstanding anything contained in such law, such requirement shall be deemed to have been satisfied, if such information or matter is authenticated by means of electronic signature affixed in such manner as may be prescribed by the Central Government. “

Considering that the IT Act has recognised e-signatures as legal and binding, the same may also form a strong basis for initiating litigation before a court of law.

Recognition of E- Agreement and E- Signature under Stamp Acts

While a majority of state stamp laws do not specifically include electronic records within their ambit, some state stamp duty laws do recognise “electronic records” within the purview of “instrument”. For instance, Section 2(l) of the Maharashtra Stamp Act, 1958[4] specifically refers to electronic records in the definition of the term “instrument” as under:

instrument includes every document by which any right or liability is, or purports to be, created, transferred, limited, extended, extinguished or recorded, but does not include a bill of exchange, cheque, promissory note, bill of lading, letter of credit, policy of insurance, transfer of share, debenture, proxy and receipt;

Explanation. – The term “document” also includes any electronic record as defined in clause (t) of sub-section (1) of section 2 of the Information Technology Act, 2000.

The Maharashtra E-Registration and E-Filing Rules, 2013[5] also make appending of electronic signature or biometric thumb print mandatory, thereby further giving recognition and legal validity to e-contract and e- signature. The Indian Penal Code, the Banker’s Book of Evidence Act 1891 and the Reserve Bank of India Act, 1934 also contain provisions in relation to such electronic contracts which contain digital signature.

Admissibility of E- agreements as evidence?

Under the Evidence Act, 1872[6], an e-agreement has the same legal effect as a paper based agreement. The definition of “evidence” as provided under Section 3 of the Evidence Act includes “all documents including electronic records produced for the inspection of the court.” Section 65B(1) of the Evidence Act provides that any information contained in an electronic record which is printed on a paper, stored, recorded or copied in optical or magnetic media produced by a computer shall be deemed to be also a document and shall be admissible in any proceedings, without further proof or production of the original, as evidence of any contents of the original or of any fact stated therein of which direct evidence would be admissible”.

Further, Section 47A of the Evidence Act stipulates that when the Court has to form an opinion as to the electronic signature of any person, the opinion of the Certifying Authority which has issued the electronic Signature Certificate is a relevant fact, and Section 85B of the Evidence Act stipulates that unless the contrary is proved, the Court shall presume that-

  • the secure electronic record has not been altered since the specific point of time to which the secure status relates;
  • the secure digital signature is affixed by subscriber with the intention of signing or approving the electronic record.

Global Laws

UNCITRAL Model Law on Electronic Signatures[7]

In 1996, the United Nations Commission on International Trade Law (UNCITRAL) adopted the Model Law on Electronic Commerce to bring uniformity in the law in different countries. Based on which, India enacted the Information Technology Act, 2000. Subsequently, in 2001, as an addition to the existing Model Law, a Model Law on Electronic Signatures was adopted by the General Assembly of UNICTRAL.

Article 2 (a) of the Model Law defines electronic signatures as below:

“Electronic signature” means data in electronic form in, affixed to or logically associated with, a data message, which may be used to identify the signatory in relation to the data message and to indicate the signatory’s approval of the information contained in the data message;”

The Model Law has further examined various electronic signature techniques being used, and has broadly recognised two categories of electronic signatures-

  • Digital Signatures relying on public-key cryptography; and
  • Electronic Signatures relying on techniques other than public-key cryptography.

UK Law Commission- Consultation Paper on Making a Will[8]

The Law Commission has considered various forms of e- signatures such as typed names and digital images of handwritten signatures, passwords and PINs, biometrics, and digital signatures. The following are the key discussions in the Consultation Paper with respect to alternative modes of signature:

  • A rudimentary electronic signature may consist of a typed name in an electronic document, or a digital image of a handwritten signature. Such digital images may be produced by a scan or a photograph of the signature. However, there is a high risk of fraud in these forms of e- signature, as any person can copy the signature of any other person.
  • A biometric signature is a type of electronic signature that measures a unique physical attribute of the signatory in order to authenticate a document. For instance, fingerprints, retina scan, voice recognition, facial recognition. A biodynamic manuscript signature is also a type of biometric signature that is increasingly being used, where the unique way by which a person signs is recorded by way of various parameters including speed, pressure, and even the angle of the stylus, however, the reliability of biodynamic signatures varies on the systems used to record and analyse them.

Conclusion

On a combined reading of the national and international laws, it can be said that e-agreements are valid and enforceable in the courts, however, since the risk associated with e-signatures are high, for high stake transactions, parties still insist on wet signatures on physical agreements. For fintech entities, who have been vigorously using e- mode of documentation and execution, in order to avoid fraud or forgery, e- signatures can be used with an additional layer of security, for instance, by verifying the electronic signature via sending an OTP at the registered mobile number, or by using geo location, to capture the IP address, or such other mechanism to track the detail of the electronic device from where the e-signature has been affixed. Such two-tier verification process shall also ensure authenticity of the signatory.

 

[1] https://dea.gov.in/sites/default/files/Report%20of%20the%20Steering%20Committee%20on%20Fintech_2.pdf

[2] https://indiacode.nic.in/bitstream/123456789/2187/3/a1872___9pdf.pdf

[3] https://indiacode.nic.in/bitstream/123456789/1999/3/A2000-21.pdf

[4]https://indiacode.nic.in/bitstream/123456789/6916/1/maharashtra_stamp_act_%28lx_of_1958%29_%28modified_upto_05.12.2018%29.pdf

[5] http://igrmaharashtra.gov.in/writedata/PDF/e-Registration%20and%20e-Filing%20Rules%202013.pdf

[6] http://legislative.gov.in/sites/default/files/A1872-01.pdf

[7] https://www.uncitral.org/pdf/english/texts/electcom/ml-elecsig-e.pdf

[8] https://s3-eu-west-2.amazonaws.com/lawcom-prod-storage-11jsxou24uy7q/uploads/2017/07/Making-a-will-consultation.pdf

 

Our other write-ups on e-agreements and fintech lending can be referred here:

  • http://vinodkothari.com/wp-content/uploads/2019/03/Single-point-collection-of-stamp-duty.pdf
  • http://vinodkothari.com/articles-fintech-startups/

 

Personal revolving lines of credit by NBFCs: nuances and issues

By Kanakprabha Jethani | Executive

Vinod Kothari Consultants P. Ltd.

(kanak@vinodkothari.com)

Personal loans by NBFCs are mostly extended as revolving lines of credit. Most of these facilities are originated by use of online apps. The lender will be quite keen, if there were no regulatory obstacles, to provide this line of credit by way of a credit card, or virtual credit card. However, there are regulatory barriers to NBFCs issuing credit cards. Therefore, NBFCs end up giving revolving lines of credit. However, the lurking issue is – if a credit card is also an instance of a revolving line of credit, is revolving line of credit an alternative to a card or virtual card, and if so, are there regulatory issues in NBFCs giving personal revolving lines of credit?

The issue is not whether the credit is personal, or for business purposes, for instance, a working capital line of credit. There is a general notion that NBFCs cannot extend working capital lines of credit, while they may give working capital loans.

It is important to examine this issue at length – as is done in this article.

Revolving line of credit: explained

A revolving line of credit is a mode of lending wherein the lender agrees to lend an amount equal to or less than a pre-determined credit limit, as approved for the borrower. The parameters for fixing the limit may be the credit appraisal of the borrower, or, as in case of working capital, the asset liability gap. The borrower may continue to use the line of credit – he may keep repaying, in which case the drawn amount comes down, and then he may re-draw, when the drawn amount goes up. The credit limit gets restored on repayment being made by the borrower. Such line of credit maybe secured or unsecured, depending on the agreement between lender and the borrower. The line of credit is essentially governed by the agreement between the parties. The term “revolving” does not imply that the line of credit is not subject to a review, or repayment. Each line of credit has a review period. If the lender decides not to revolve the line of credit, then the line of credit becomes a term loan, and has to be paid down as per the terms of agreement between the lender and the borrower.

For certain types of facilities, a revolving line of credit is aptly suitable. While, in case of businesses, working capital is best financed by a line of credit, in case of personal finance also, the ability to draw based on a line of credit extends the finances of the borrower, and allows him the flexibility to tap into the funding when needed, and pay it off when not needed. There is, of course, a standing commitment on the part of the lender to provide the facility amount the amount of the limit, for which lenders may charge a continuing commitment charge.

A line of credit implies a commitment to disburse. To the extent of the amount already disbursed, there is a funded facility. To the extent of the limit sanctioned but not yet availed, there is an unfunded commitment to disburse. Undisbursed or partly disbursed loans are common in case of term loans as well – for example, a home loan may take a substantial time to get disbursed.

Similarities between a credit card and revolving line of credit

A credit card is a payment card which the borrower may use for making payments at point of sale. The lender makes payment on behalf of the borrower and then recovers the same from the borrower. A detailed explanation of features of credit cards maybe referred to in one of our write-ups[1].

A revolving line of credit shares some of its features with a credit card, due to which they are seen as equivalents. The similarities between both the modes are as follows:

  • Borrowers can take the disbursement as and when needed.
  • The lender, in both cases, always reserves the right to reduce the credit limit.
  • The lender has to maintain optimum amount of working capital to meet the disbursement demands of the borrowers.
  • The credit limit is restored on repayment being made.

Disparity between credit card and revolving line of credit

Based on usual practice of the market, the following are the key points:

  • Security: A revolving line of credit maybe secured or unsecured, whereas, a credit card is always unsecured.
  • End-use restrictions: There are no restrictions on end use of funds in case of a credit card. However, in a line of credit, the end use is restricted by mentioning the purpose for availing the loan in the loan agreement. Of course, the purpose may be generic – for example, personal use or general business use.
  • Restriction w.r.t. withdrawal of fund: A revolving line of credit does not require a purchase to be made in order to get the funds disbursed. It allows money to be transferred into bank account for any reason without requiring an actual transaction. Whereas, in case of a credit card, payments can be made at Point of Sale (PoS) only and thus, it requires an actual transaction for the disbursement to be made..
  • Interest Period: In case of credit card, if repayment is made within a specified term, no interest is usually charged. However, after the specified period, a high rate of interest is charged. While on the other hand, in case of a revolving line of credit, the interest is calculated from the day of disbursement being made at a comparatively lower rate.
  • Credit Limit: As a market practice, revolving line of credit maybe availed for business purposes or personal purposes and thus, has higher credit limits as compared to a credit card which is generally used for personal purposes only.
  • Manner of Repayment: In case of credit card, funds once availed have to be repaid within a specified period of time, in lump sum. On the other hand, when credit is availed from a revolving line of credit, the same is repaid by the borrower in instalments.
  • Risks: Credit cards come with the risk of theft, misuse etc. However, the same maybe done away with, in case of virtual credit cards.

The fundamental difference

The abovementioned differences are, in essence, surficial. They are based on practices of the market, which may easily be reshaped suiting the needs of the parties. What is the key difference between a card, virtual card and a revolving line of credit? ​

A logical difference that one finds is that while in case of a credit card, the borrower uses it to make payments to third parties, in case of a revolving line of credit, the disbursements are made to the account of the borrower from where the borrower may use it for the required purpose. A credit card is an instrument: it can be used to settle payments, and therefore, becomes a part of the payment and settlement system. A straight line of credit may be tapped by the borrower. After tapping the line, the borrower may use it for making payments and settlements. But the line of credit itself is not an instrument of settling payments.

Therefore, fundamentally, while a revolving line of credit is a promise by lender to the borrower, a credit card is a promise by the lender to the world at large. A lender in case of a line of credit is obliged to make disbursement to the borrower, and only the borrower has a recourse against the lender. However, in case of issue of credit cards, the issuer or the lender is obliged to make payments to any authorized merchant who supplies goods and services against the card.

The burning question- Can NBFCs extend revolving line of credit?

Logical answer

The distinction between a revolving line of credit and credit card has already been highlighted above. Further, it is also quite evident from the above discussion that a credit card has wider risks than that of a revolving line of credit. In case of a revolving line of credit, the failure on the part of the lender to disburse the sanctioned amount impacts the borrower. However, if a card issuer defaults, it may affect all those merchants who might have used the card to supply goods and services. There may be a contagion impact, and therefore, the failure of a card issuer has systemic implications. Thus, capital adequacy, solvency and liquidity are far greater issues for a card issuer, than in case of a plain lender against revolving line of credit.

The above discussion leads one to conclude that there are no specific concerns in case of granting of a revolving line of credit. The only concern may be the exposure on account of the sanctioned but undisbursed amount, for which off-balance sheet credit conversion factors exist.

Regulatory support

The above logic may further be supported by the provisions of the Prudential Framework for Resolution of Stressed Assets[2], wherein the Reserve Bank of India (RBI) has recognized the practice of extending revolving line of credit by NBFCs. Following is the relevant extract from the said framework which is applicable on Scheduled Commercial Banks (excluding RRBs), All India Term Financial Institutions, Small Finance Banks, Deposit taking NBFCs and Systemically Important NBFCs (‘NBFC-SI’):

In the case of revolving credit facilities like cash credit, the SMA sub-categories will be as follows:

SMA Sub-categories Basis for classification – Outstanding balance remains continuously in excess of the sanctioned limit or drawing power, whichever is lower, for a period of:
SMA-1 31-60 days
SMA-2 61-90 days

So, firstly there are no express restrictions on extending revolving line of credit and secondly, the RBI recognizes such credit in its frameworks. Therefore, it is safe to take this recognition as a provenance to allowability of extending revolving line of credit by NBFCs.

Further, the provisions relating to restructuring of accounts of borrowers by NBFCs as per the Master Directions also recognize extension of revolving cash credit. It recognizes that roll-over of short-term loans based on actual requirement of borrower and not as a concession considering the credit weakness of the borrower, shall not be considered as restructuring of accounts. For-this purpose, short-term loans shall not include properly assessed regular Working Capital Loans like revolving Cash Credit or Working Capital Demand Loans. The relevant extract is as follows:

“In the cases of roll-over of short-term loans, where proper pre-sanction assessment has been made, and the roll-over is allowed based on the actual requirement of the borrower and no concession has been provided due to credit weakness of the borrower, then these shall not be considered as restructured accounts.

**

Further, Short Term Loans for the purpose of this provision do not include properly assessed regular Working Capital Loans like revolving Cash Credit or Working Capital Demand Loans.”

Concerns on maintenance of capital

In case of line of credit, the disbursements are to be made as and when the borrower requires, therefore, the NBFC should maintain adequate capital and liquidity to meet such abrupt demands. The RBI Master Directions take care of the solvency concerns of the NBFCs extending revolving line of credit. Liquidity standards, internally set by the NBFC under the ALM process, also contain safeguards by taking the undisbursed amount of committed facilities as “required funding”.

The Master Directions for NBFC-SI[3] requires the NBFC-SIs to maintain a Capital to Risk Assets Ratio (CRAR) of 15%. It provides the detailed methodology of how the risk-weighting of assets is to be done to meet the CRAR requirement.

Following is the extract from the said methodology:

Instrument Credit Conversion Factor
Other commitments (e.g., formal standby facilities and credit lines) with an original maturity of:

 

up to one year

over one year

 

 

 

20

50

Similar commitments that are unconditionally cancellable at any time by the applicable NBFC without prior notice or that effectively provide for automatic cancellation due to deterioration in a borrower’s credit worthiness  

 

0

 

Thus, depending on the terms of the revolving line of credit, a credit conversion factor will be multiplied to the total amount of obligation and the capital will be maintained accordingly.

Further, the Master Directions for Non-Systemically Important NBFCs (NBFC-NSIs)[4] require the NBFC-NSIs to maintain a leverage ratio of 7. Leverage Ratio shall mean Total outside Liabilities/ Owned Funds.

The definition of Total Outside Liabilities can be derived from Master Directions for Core Investments Companies (CICs)[5] which is as follows:

“outside liabilities” means total liabilities as appearing on the liabilities side of the balance sheet excluding ‘paid up capital’ and ‘reserves and surplus’, instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue but including all forms of debt and obligations having the characteristics of debt, whether created by issue of hybrid instruments or otherwise, and value of guarantees issued, whether appearing on the balance sheet or not.”

Due to the leverage restriction, NBFC-NSIs shall also automatically be restricted from lending more than its capacity.

Nuts and bolts to the structure of revolving line of credit

From the above discussion, it is clear that NBFCs may extend revolving line of credit. However, from the prudence perspective, following are certain essentials that must be kept in mind by the NBFCs while extending a revolving line of credit:

  • It is advisable for the lender to retain the right to unconditionally cancel the commitment of revolving line of credit. In such case, the credit conversion factor for such exposure shall be “0”.
  • The terms of the line of credit must provide for review and reset as the lender may deem fit.
  • The lender must ensure that it maintains liquidity to meet abrupt calls for disbursement by the borrower.
  • In case the tenure of revolving line of credit is pre-determined, the credit conversion factor shall accordingly be taken as 20 or 50.

Conclusion

Though there are similarities between features of a credit card and a revolving line of credit, but the differences are not skin-deep. Further, it may also be argued that the RBI Master Directions recognize NBFCs extending line of credit, by providing expressly for prudential framework for SMA classification for revolving line of credit.

 

[1] http://vinodkothari.com/2018/07/credit-cards-and-emi-cards-from-an-nbfc-viewpoint/

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

[3]https://rbidocs.rbi.org.in/rdocs/notification/PDFs/45MD01092016B52D6E12D49F411DB63F67F2344A4E09.PDF

[4] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MD44NSIND2E910DD1FBBB471D8CB2E6F4F424F8FF.PDF

[5] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/39MD440D125D51C2451295A5CA7D45EF09B9.PDF

Lenders’ piggybacking: NBFCs lending on Fintech platforms’ guarantees

-Vinod Kothari

(vinod@vinodkothari.com)

Among the disruptive Fintech practices, app-based lending is certainly notable. The scenario of an app-based lending is somewhat like this – a prospective borrower goes to an app platform, fills up some information. At the background, the app collects and collates the information including credit scores of the individual, may be the individual’s contact bases in social networks, etc. Finally, the loan is sanctioned in a jiffy, mostly within minutes.

The borrower interacts with the platform, but does the borrower know that the loan is actually not coming from the platform but from some NBFC? Whether the borrower knows or cares for who the lender is, the fact is that mostly, the technology provider (platform) and the funding provider (lender) are not the same. It may be two entities within the same group, but more often than not, the lender is an NBFC which is simply originating the loan based on the credit comfort provided by the platform.

The relation between the platform and the lender may take one of the following forms: (a) platform simply is procuring or referring the credit; the platform has no credit exposure at all; (b) the platform is acting as a sourcing agent, and is also providing a credit support, say in form of a first-loss guarantee for a certain proportion of the pool of loans originated through the platform; (c ) the platform provides full credit support for all the loans originated through the platform, and in return, the lender allows the platform to retain all the actual returns realised through the pool of loans, over an and above a certain “portfolio IRR”.

Option (a) is pure sourcing arrangement; however, it is quite unlikely that the lender will be willing to trust the platform’s credit scoring, unless there is significant skin-in-the-game on the part of the platform.

If it is a case of option (c ) [which, incidentally, seems quite common, the loan is actually put on the books of the lender, but the credit exposure is on the platform. The lender’s exposure is, in fact, on the platform, and not the borrower. The situation seems to be quite close to a “total rate of return swap”, a form of a credit derivative, whereby parties synthetically replace the exposure and the actual rate of return in a portfolio of loans by a pre-agreed “total rate of return”.

Our objective in this article is to examine whether there are any regulatory concerns on the practice as in case of option (c ) . Option c is an exaggeration; there may be a case such as option (b). But since option (b) is also a first loss guarantee with a substantial thickness, it is almost akin to the platform absorbing virtually all the risks of the credit pool originated through the platform.

Before we get into the regulatory concerns, it is important to understand what are the motivations of each of the parties in this bargain.

Platform’s motivations

The motivation on the part of the platform is clear – the platform makes the spreads between the agreed portfolio IRR with the lender, and the actual rate of return on the loan pool, after absorbing all the risk of defaults. Assume, the small-ticket personal loan is being given at an interest rate of 30%, and the agreed portfolio IRR with the lender is 14%, the platform is entitled to the spread of 16%. If some of the loans go bad, as they indeed do, the platform is still left with enough of juice to be a compensation for the risks taken by it.

The readiness on the part of the platform is also explained by the fact that the credibility of the platform’s scoring is best evidenced by the platform agreeing to take the risk – it is like walking the talk.

Lender’s motivations

The lender’s motivations are also easy to understand – the lender is able to disburse fast, and at a decent rate of return for itself, while taking the risk in the platform.  In fact, several NBFCs and banks have been motivated by the attractiveness of this structure.

Are there any regulatory concerns?

The potential regulatory concerns may be as follows:

  • De-facto, synthetic lending by an entity that is not a regulated NBFC
  • Undercapitalised entity taking credit risk
  • Skin-in-the-game issue
  • A CDS, but not regulated as a CDS
  • Financial reporting issues
  • Any issues of conflict of interest or misalignment of incentives
  • Good borrowers pay for bad borrowers
  • KYC or outsourcing related issues.

Each of these issues are examined below.

Synthetic lending by an unregulated entity

It is common knowledge that NBFCs in India require registration. The platform in the instant case is not giving a loan. The platform is facilitating a loan – right from origination to credit risk absorption. Correspondingly, the platform is earning a spread, but the activity is technically not a “financial activity”, and the spread not a “financial income”; hence, the platform does not require regulatory registration.

Per contra, it could be argued that the platform is essentially doing a synthetic lending. The position of the platform is economically similar to an entity that is lending money at 30% rate of interest, and refinancing itself at 14%. There will be a regulatory arbitrage being exploited, if such synthetic lending is not treated at par with formal lending.

But then, there are whole lot of equity-linked or property-linked swaps, where the returns of an investment in equities, properties or commodities, are swapped through a total rate of return swaps, and in regulatory parlance, the floating income recipient is not regarded as investor in equities, properties or commodities. Derivatives do transform one asset into another by using synthetic technology – in fact, insurance-linked securities allow capital market investors to participate in insurance risk, but it cannot be argued that such investors become insurance companies.

Undercapitalised entities taking credit risk

It may be argued that the platform is not a regulated entity; yet, that is where the actual credit risk is residing.  Unlike NBFCs, the platform does not require any minimum capitalisation norms or risk-weighted capital asset requirements. Therefore, there is a strong potential for risk accumulation at the platform’s level, with no relevant capital requirements. This may lead to a systemic stability issue, if the platforms become large.

There is a merit in the issue. If fintech-based lending becomes big, the exposure taken by fintech entities on the loans originated through them, on which they have exposure, may be treated at par with loans actually held on the balance sheet of the fintech. As in case of financial entities, there are norms for converting off-balance sheet assets into their on-balance sheet equivalents, the same system may be adopted in this case.

Skin-in-the game issue

Post the Global Financial Crisis, one of the regulatory concerns was skin-in-the-game. In light of this, the RBI has imposed minimum holding period, and minimum risk retention requirements in case of direct assignments as well as securitisation.

The transaction of guarantee discussed above may seem like the exposure being shifted by the platform to the NBFC. However, the transaction is not at all comparable with an assignment of a loan. Here, the lending itself is originated on the books of the NBFC/lender. The lender has the ultimate discretion to agree to lend or not. The credit decision is that of the lender; hence, the loan is originated by the lender, and not acquired. The lender is mitigating the risk by backing it up with the guarantee of the platform – but this is not a case of an assignment.

There is a skin-in-the-game on either side. For the platform, the guarantee is the skin-in-the-game; for the NBFC, the exposure in the platform becomes its stake.

A CDS, but not regulated as a CDS

The transaction has an elusive similarity to a credit default swap (CDS) contract. It may be argued that the guarantee construct is actually a way to execute a derivative contract, without following CDS guidelines provided by the RBI.

In response, it may be noted that a derivative is a synthetic trading in an exposure, and is not linked with an actual exposure. For example, a protection buyer in a CDS may not be having the exposure for which he is buying protection, in the same way as a person acquiring a put option on 100 gms of gold at a certain strike price may not be having 100 gms of gold at all. Both the persons above are trying to create a synthetic position on the underlying.

Unlike derivatives, in the example of the guarantee above, the platform is giving guarantee against an actual exposure. The losses of the guarantor are limited to actual losses suffered by the lender. Hence, the contract is one of indemnity (see discussion below), and cannot be construed or compared to a derivative contract. There is no intent of synthetic trading in credit exposure in the present case.

Financial reporting issues:

It may be argued that the platform is taking same exposure as that of an actual lender; whereas the exposure is not appearing on the balance sheet of the platform. On the other hand, the actual exposure of the lender is on the platform, whereas what is appearing on the balance sheet of the lender is the loan book.

The issue is one of financial reporting. IFRSs clearly address the issue, as a financial guarantee is an on-balance sheet item, at its fair value. If the platform is not covered by IFRSs/IndASes, then the platform will be reflecting the guarantee as a contingent liability on its balance sheet.

Conflicts of interest or misalignment of incentives:

During the prelude to the Global Financial Crisis, a commonly-noted regulatory concern was misalignment of incentives – for instance, a subprime mortgage lender might find it rewarding to lend to a weak credit and capture more excess spread, while keeping its exposure limited.

While that risk may, to some extent, remain in the present guarantee structure as well, but there are at least 2 important mitigants. First, the ultimate credit decision is that of the NBFC. Secondly, if the platform is taking full credit recourse, then there cannot be a misalignment of incentives.

Good borrowers pay for bad borrowers

It may be argued that eventually, the platform is compensating itself for the risk of expected losses by adding to the cost of the lending. Therefore, the good borrowers pay for the bad borrowers.

This is invariably the case in any form of unsecured lending. The mark-up earned by the lender is a compensation for risk of expected losses. The losses arise for the loans that don’t pay, and are compensated by those that do.

KYC or outsourcing related issues

Regulators may also be concerned with KYC or outsourcing related issues. As per RBI norms “NBFCs which choose to outsource financial services shall, however, not outsource core management functions including Internal Audit, Strategic and Compliance functions and decision-making functions such as determining compliance with KYC norms for opening deposit accounts, according sanction for loans (including retail loans) and management of investment portfolio.”

Usually the power to take credit decisions vests with the lender. However, in case the arrangement between the lender and the platform is such that the platform performs the decision-making function, the same shall amount to outsourcing of core management function of the NBFC, which is expressly disallowed by the RBI. The relevant extract from the KYC Master Directions is as follows:

“REs shall ensure that decision-making functions of determining compliance with KYC norms are not outsourced.”

Is it actually a guarantee?

Before closing, it may be relevant to raise a legal issue – is the so-called guarantee by the platform actually a guarantee?

In the absence of tripartite agreement between the parties, the arrangement cannot be said to be a contract of guarantee. Here the involvement is of only two parties in the arrangement i.e. the guarantor and the lender.

It was held in the case of K.V. Periyamianna Marakkayar and others vs Banians And Co.[1] that “Section 126 of the Indian Contract Act which defines a contract of guarantee though it does not say expressly that the debtor should be a party to the contract clearly implies, that there should be three parties to it namely the surety, the principal-debtor and the creditor ; otherwise it will only be a contract of indemnity. Section 145 which enacts that in every contract of guarantee there is an implied promise by the principal debtor to indemnify the surety clearly shows that the debtor and the surety are both parties to such a contract ; for it will be strange to imply in a contract a promise between persons who are not parties to it.”

Accordingly, the said arrangement maybe termed as a contract of indemnity wherein the platform agrees to indemnify the lender for the losses incurred on account of default by the borrower.

Conclusion

Fintech-based lending is here to stay, and grow. Therefore, risk participation by Fintech does not defeat the system – rather, it promotes lending and adds to the credibility of the Fintech’s risk assessment. Over period of time, the RBI may evolve appropriate guidelines for treating the credit exposure taken by the platforms as a part of their credit-equivalent assets.

 

 

[1] https://indiankanoon.org/doc/1353940/

Sharing of Credit Information to Fintech Companies: Implications of RBI Bar

-Financial Services Division | Vinod Kothari Consultants Pvt. Ltd.

(finserv@vinodkothari.com)

The RBI recently wrote a letter, dated 16th September, 2019, to banks and NBFCs, censuring them over what seems to have been a prevailing practice – sharing of credit information sourced by NBFCs from Credit Information Companies (CICs), to fintech companies. The RBI reiterated that such sharing of information was not permissible, citing several provisions of the law, and expected the banks/NBFCs to affirm steps taken to ensure compliance within 15 days of the RBI’s letter.

This write-up intends to discuss the provisions of the Credit Information Companies (Regulation) Act, 2005 [CICRA], and related provisions, and the confidentiality of credit information of persons, and the implications of the RBI’s letter referred to above.

Fintech companies’ model

Much of the new-age lending is enabled by automated lending platforms of fintech companies. The typical model works with a partnership between a fintech company and an NBFC. The fintech company is the sourcing partner, and the NBFC is the funding partner. A borrower goes to the platform of the fintech company which provides a user-friendly application process, consisting of some basic steps such as providing the aadhaar card or PAN card details, and a photograph. Now, having got the individual’s basic details, the fintech company may either source the credit score of the individual from one of the CICs, or may use its own algorithm. If the fintech company wants to access the data stored with the CICs, it will have to rely on one of its partner NBFCs, since CIC access is currently allowed to financial sector entities only, who have to mandatorily register themselves as members of all four CICs.

It is here that the RBI sees an issue. If the NBFC allows the credit information sourced from the CIC to be transferred to a fintech company, there is an apparent question as to whether such sharing of information is permissible under the law or not.

We discuss below the provisions of the law relating to use of credit information.

Confidentiality of credit information

By virtue of the very relation between the customer and a banker, a banker gets access to the financial information of its customers. Very often, an individual may not even want to share his financial data even with close family members, but the banker any way has access to the same, all the time. If the banker was to share the financial details of a customer, it would be a clear intrusion into the individual’s privacy, and that too, arising out of a fiduciary relationship.

Therefore, the principle, which has since been reiterated by courts in numerous cases, was developed by UK courts in an old ruling in Tournier v National Provincial and Union Bank of England [1924] 1 KB 461. Halsbury’s Laws of England, Vol 1, 2nd edition, says: “It is an implied term of the contract between a banker and his customer that the banker will not divulge to third persons, without the consent of the customer, express or implied, either the state of the customer’s account, or any of his transactions with the bank or any information relating to the customer acquired through the keeping of his account, unless the banker is compelled to do so by order of a Court, or the circumstances give rise to a public duty of disclosure or the protection of the banker’s own interests requires it.

The above law is followed in India as well.

In Shankarlal Agarwalla v. State Bank of India and Anr. AIR 1987 Cal 29[1], it was held that compulsion to disclose must be confined to the regular exercise by the proper officer to actual legal power to compel disclosure.

In case any information is disclosed without a legal compulsion to disclose, the same is wrongful on the part of the lender.

Credit Information Companies and sharing of information

When an RBI Working Group set up in 1999 under the chairmanship of N. H. Siddiqui recommended the formation of CICs in India, the question of confidentiality of credit information was discussed. It was noted by the Working Group that all over the world, there are regulatory controls on sharing of information by credit bureaus:

The Credit Information Bureaus, all over the world, function under a well defined regulatory framework. Where the Bureaus have been set up as part of the Central Bank, the regulatory framework for collection of information, access to that information, privacy of the data, etc., is provided by the Central Bank. Where Bureaus have been set up in the private sector, existence of separate laws ensure protection to the privacy and access to the data collected by the Bureau. In the U.S.A. where Credit Information Bureaus have been set up in the private sector, collection and sharing of information is governed by the provisions of the Fair Credit Reporting Act, 1971 (as amended by the Consumer Credit Reporting Reform Act of 1996). The Fair Credit Reporting Act is enforced by the Federal Trade Commission, a Federal Agency of the U.S. Govt. In the U.K., Credit Bureaus are licensed by the Office of the Fair Trading under the Consumer Credit Act of 1974. The Bureaus are also registered with the Office of the Data Protection Registrar, appointed under the Data Protection Act, 1984 (replaced by the Data Protection Commissioner under the new Act of 1998). In Australia, neither the Reserve Bank of Australia nor the Australian Prudential Regulation Authority (APRA) plays a role in promoting, developing, licensing or supporting Credit Bureaus. APRA holds annual meetings with the major Bureaus in Australia. The sharing of information relating to customers is regulated in Australia by the Privacy Act. This Act is administered by the Privacy Commissioner, who is vested with the responsibility of framing guidelines for protection of privacy principles and to ensure that Bureaus in Australia conform to these guidelines. In New Zealand, a situation similar to that of Australia exists. In Sri Lanka, the Bureau was formed by an Act of Parliament at the initiative of the Central Bank. A Deputy Governor of the Central Bank is the Chairman of the Bureau in Sri Lanka and the Bank is also represented on the Board of the Bureau by a senior officer. In Hong Kong, the Hong Kong Monetary Authority (HKMA), though not being directly involved in the setting up of a credit referencing agency has issued directions to all the authorised institutions recommending their full participation in the sharing and using of credit information through credit referencing agencies within the limits laid down by the Code of Practice on Consumer Credit Data formulated by the Privacy Commissioner. HKMA also monitors the effectiveness of the credit referencing services in Hong Kong, in terms of the amount of credit information disclosed to such agencies, and the level of participating in sharing credit information by authorised institutions.[2]

The inherent safeguards in the CIC Law

CICRA provides the privacy principles which shall guide the CICs, credit institutions and Specified Users in their operations in relation to collection, processing, collating, recording, preservation, secrecy, sharing and usage of credit information. In this regard, the purpose of obtaining information, guidelines for access to credit information of customers, restriction on use of information, procedures and principles for networking of CICs, credit institutions and specified users, etc. must be clearly defined.

Further, no person other than authorised person is allowed to have access to credit information under CICRA. Persons authorised to access credit information are CICs, credit institutions registered with the CICs and other persons as maybe specified by the RBI through regulations.

The Credit Information Companies Regulations provide that other persons who maybe allowed to access credit information are insurance companies, IRDAI, cellular service providers, rating agencies and brokers registered with SEBI, SEBI itself and trading members registered with Commodity Exchange.

Clearly, fintech companies or technology service providers are not authorised to access credit information. Access of information by such companies is a clear violation of CICRA.

Secrecy of customer information: duty of the lender

Paget on the Law of Banking observed that out of the duties of the banker towards the customer among those duties may be reckoned the duty of secrecy. Such duty is a legal one arising out of the contract, not merely a moral one. Breach of it therefore gives a claim for nominal damages or for substantial damages if injury is resulted from the breach.

Further, in case of Kattabomman Transport Corporation Ltd. V. State Bank of India, the Calcutta High Court held that the banker was under a duty to maintain confidentiality. An appeal[3] was filed against this ruling, the outcome of which was the information maybe disclosed by the banks, only when there is a higher duty than the private duty.

NBFCs providing access to the fintech companies is undoubtedly a private duty and thus, is a breach of duty on the part of the lender.

The case of Fintech Companies and NBFC partnership:

The letter of the RBI under discussion, dated 17th September, 2019, has been seen as a challenge to the working of the fintech companies. However, to understand in what way does this affect the working of fintech companies, we need to understand several situations.

Before coming to the same, it must be noted that the RBI’s 17th September circular is not writing a new law. The law on sharing of credit information has always been there, and the inherent protection is very much a part of the CICRA itself. The RBI circular is, at best, a regulatory cognition of an existing issue, and is a note of caution to NBFCs, who, in their enthusiasm to generate business, may not disregard the provisions of the law.

The situations may be as follows:

  • Fintech company using its own algorithm: In this case, the fintech company is relying upon its own proprietary algorithm. It is not relying on any credit bureau information. Therefore, there is no question of any credit information being shared. In fact, even if the fintech uses the score developed by it, without relying on CIC data, with other entities, it is a proprietary information, which may be shared.
  • NBFC sharing credit information with Fintech company, which is sourcing partner for the NBFC: If the NBFC is sharing information with a fintech company, with the intent of using the information for its own lending, can it be argued that there is a breach of the provisions of the CICRA? It may be noted that regulation 9 of the CIC Regulations requires CICs to protect credit information from unauthorised access. As already discussed, access by such fintech companies is unauthorised.
  • NBFC sharing credit information with Fintech company, which is not partnering with the NBFC: In case, the NBFC is not partnering with the NBFC and is still sharing credit information, there seems to be no reason for such sharing other than information trading. Several NBFCs have at many instances, been reported to have engaged in information trading for additional income.
  • NBFC sharing credit information with another NBFC/bank, which is a co-lender: The NBFC may authorise its co-lender to obtain credit information from CICs and the same shall not be an unauthorised access of information, since the co-lender is also a credit institution and is registered with CICs.
  • Bank sharing credit information with another NBFC which is a sourcing partner and not a c0-lender: If the sourcing partner is a member of CICs, it may access the credit information directly from the CICs. If the sourcing partner is not a member of CICs, sharing of credit information is violation of customer privacy, and thus, shall not be allowed.

Conclusion

The credit bureau reports are actually being exchanged in the system without much respect to the privacy of the individual’s data. With the explosion of information over the net, it may even be difficult to establish as to where the information is coming from. Privacy and confidentiality of information is at stake. At the same time, the very claim-to-existence of fintech entities is their ability to process a credit application within no time. Whether there is an effective way to protect the sharing of information stored with CICs is a significant question, and the RBI’s attention to this is timely and significant.

 

[1] https://indiankanoon.org/doc/1300997/

[2] https://www.rbi.org.in/scripts/PublicationReportDetails.aspx?ID=76

[3] https://indiankanoon.org/doc/908914/

 

The cult of easy borrowing: New age NBFCs ride high on tempting loan offers

-Rahul Maharshi and Kanakprabha Jethani

(finserv@vinodkothari.com)

 

“यावज्जीवेत्सुखं जीवेत् ऋणं कृत्वा घृतं पिबेत् |

भस्मीभूतस्य देहस्य पुनरागमनं कुतः ||”

The ancient couplet from the Charvak Darshan, in Indian mythology is popularly known as the philosophy of life. There are various interpretations of the above, in general, the meaning of the above couplet gives us a saying that “One should live luxuriously, as long as he is alive, and to attain the same, one may even live on credit and in debt. Because once you are dead and cremated, it is foolish to think about afterlife and rebirth.”

It is seen today that the financial services industry is taking the above couplet too seriously and making the borrowers flooded with opportunities and facilities to burden them with debt in one click. Even the person who is unwilling to enter into a debt trap is somewhat lured by the “instant loan” facilities given by numerous NBFCs these days.

Whilst the Indian economy facing a slowdown and banks in India showing significant falls in their lending volumes, the NBFCs engaged in e-lending are displaying an inverse relation to the trend. The NBFCs have been showing extravagant growth in their lending volumes. On one hand banks are tightening the lending norms considering the current state of the economy, NBFCs seem to be doing reckless lending and reporting exceptionally high lending volumes. The financial market seems to be showing a transition from secured lending to unsecured lending, from corporate finance to personal finance, from paperwork to digitisation. This transition is the reason behind such a drastic shift of lending volumes.

CURRENT STATE OF LENDING TRANSACTIONS

NBFCs are crossing milestones, making new records everyday. A leading NBFC reported disbursal of Rs. 550 crores in 3,50,000 loan transactions and has been consistently disbursing loans over Rs. 80 crores every month[1]. Another NBFC reported an existing customer base of 1.1 million. An app-based lender NBFC has 100 million downloads of its app and has disbursed around Rs. 700 crores in FY 19 with an expectation of increasing the amount of disbursals to Rs. 2,000 crores in FY 20[2].

On the contrary, banks are showing a completely opposite picture. Under the 59-minute loan scheme introduced by the Prime Minister for small entities (having turnover upto Rs. 25 crores) to avail loans of amount upto Rs. 5 crores from banks within an hour, only 50,706 loans were given approval in the FY 19. The growth rates in the banking sector are lowering. The growth in retail loans fell down to 15.7% in April 2019 as compared to 19.1% in April 2018. The growth rate in credit card loans has also shown a decline of 8.8%[3].

UNDERSTANDING THEIR BUSINESS MODEL

NBFCs do unsecured lending of small-ticket size loans, usually personal in nature. The market tends to be more inclined towards obtaining finance from such NBFCs. The basic features of loans provided by NBFCs can be understood through following points:

  • Unsecured: The loans provided by NBFCs doing e-lending are generally unsecure loans. The borrower or the customer is not required to provide any security for obtaining such loans. Thus, even if borrowers have no assets at all, they can still obtain loans.
  • Instant: These NBFCs process the loans within a very short period (‘superfast processing’ as they call it) and the disbursement is made within a period ranging from 5 minutes to 3 days depending on the size of the loan. There is no requirement of long procedures as required to be followed in case of bank loans.
  • Digital: Usually, these NBFCs have an app-based or website based platform through which they provide such loans. The KYC process is also carried out through the app or website itself.
  • High-interest rates: The interest rates on such loans are very high as compared to the interest rates on loans provided by banks. The rates usually range from 15% p.a. to 130% p.a.
  • Small-ticket size: The loan size is generally small ranging from Rs. 500 to Rs, 50,000
  • Short-term loans: The term of loan is also short. Repayment is required on weekly, fortnightly or monthly basis.
  • Credit Score based decisions: The lending decisions made by NBFCS are largely dependent on the credit score of the borrower. A strong network of Credit Information Companies (CICs) stores the credit information of the borrowers and the borrower making default of even a single day would be barred from accessing any other e-lending platform as well. However, for first time borrowers, the only way to check credit standing is their bank statement.
  • Source of funds: NBFCs get their funds from banks as well as bigger size NFCs and Private Equity investors.
  • Purpose: These loans are provided mostly for personal purposes like marriage ceremonies, buying a car, medical issues, travel etc.
  • Innovation: Each of the e-lending platform has a different model. While some involve students in their marketing activities, some have tied-up with sellers and buyers to finance transactions between them and some tying up with different brands to finance their operations.

NBFCs BRUSHING OFF THE REGULATIONS: THEIR OWN SWEET WAYS

The operational structures of such loans are in defiance of many requirements of the RBI Directions. One can see disparity from the RBI Directions in many ways. Following are the areas where most of the NBFCs take their own sweet ways:

  • KYC process: As per the KYC Master Directions an authorised representative of the lender NBFC to physically visit and originally see and verify the KYC details of the borrower. There are further requirements of maintaining the KYC records and carrying out Customer Due Diligence (CDD) which the NBFCs fail (refuse) to comply with in the hurry of their “superfast processing”.
  • Fair Practice Code (FPC): The FPC requires lender NBFCs to display annualised interest rates in all their communications with the borrowers. However, most of the NBFCs show monthly interest rates in the name of their “marketing strategy”.
  • Risk Management: The Directions require the NBFCs to assess the risk before granting loans to borrowers, which is overlooked while providing speedy disbursals.
  • Recovery Process: NBFCs do not even have properly defined recovery process. They are just making rapid disbursals ignorant of whether these loans will be repaid.
  • Risk to personal information: Many NBFCs obtain access to the personal information such as text messages and social media profile of the borrower by way of incorporating clauses in this regard in the detailed terms and conditions of the loan agreement.

RISKS TO THE BORROWERS

The borrowers face several risks under such loan transactions, ranging from personal to financial such as:

  • Many borrowers usually don’t read the entire set of terms and conditions and end up granting the NBFCs access to their personal information. Privacy of the borrower is at stake as information trading is yet another business that the NBFCs may secretly engage into posing a threat to borrowers’ personal information.
  • The lucrative advertising strategies of these NBFCs might make a borrower take loans for purposes which otherwise would not have been a necessity or priority for the borrower. Hence, the borrower tends to borrow without any actual requirement because a demand has been created by the lender NBFCs.
  • The interest rates are very high on such loans. In case the amount of loan is high, the borrower is unable to pay the huge amount of interest and thus has to take another loan to repay the first.
  • The credit score of the borrower may get affected at the slightest delay in repayment, even if the amount of loan is as small as Rs. 500. Thus the credibility of borrower is at a risk of degradation.

THE BUBBLE OF ATTRACTION: PLAYING WITH THE PSYCHOLOGY

Even in existence of such high interest rates, why is a borrower more attracted to loans from NBFCs? The only answer one finds to this is the ease and the fact that they are instant. In an era where everyone wants everything in a jiffy, be it food or health solutions, being attracted to instant loans is a very natural thing.

For example you meet an accident and don’t have money for treatment to be done, take a loan. You are shopping and suddenly realise you forgot your purse, take a loan.

The most crucial thing is that these NBFCs do not monitor the end use of the loan amounts disbursed. So a borrower may specify any purpose for the loan, which he might not actually use the loan for. Moreover, the high interest rates are not noticed by the borrowers as most of the NBFCs show monthly interest rates rather than the yearly rates in their communications on the app or the website.

Many borrowers usually don’t read the entire set of terms and conditions and end up granting these NBFCs access to their personal information. Information trading is yet another business that the NBFCs may secretly engage into posing a threat to borrowers’ information.

The NBFCs are rightly playing the psychology game by becoming a friend in need for the borrowers. No matter how high the interest rates maybe or how risky the transaction maybe, it is a handy help whenever needed.

Furthermore, the advertisements made by these NBFCs are so catchy that they may lure a person who might not really be in need of finance. The catchy phrases like “make your dream wedding come true”, “let the wanderlust in you come alive” create a “need” for the customer to become a borrower. Marriage functions, travel and luxuries things are the Indian way of showing richness and the abovementioned philosophy wraps people in a comfortable blanket of justification to remain under debt-burden.

ALL OUR MONEY INTO THE BLACK HOLE

While lending to businesses results in more capital formation and growth of the economy. Personal lending mostly results in wasteful expenditure. Further, the interest rates being so high, many a times the borrowers obtain another loan to pay the previous loan and gets trapped into the vicious circle of obtaining and repaying loans. The increasing lending volumes are not an indication of overall growth of the economy. Most of the purposes for which such loans are availed are consumption-based and have no value-addition. All the money taken on loan is being used in consumption-based expenditure and not in value-addition activities and thus even after such high lending volumes, the growth of the economy is just disappearing into the black hole.

CONCLUSION

While on one hand, such loans are helping us in need, on the other hand they are luring us to take unnecessary debt burden. The lender NBFCs are under the risk of regulatory action by the regulators since many of them are in non-compliance with regulatory requirements. The borrowers are under the risk of pressing themselves under unnecessary debt burden and huge interest costs. The recovery procedures of these NBFCs are very lenient but due to the high interest costs, the cost of funds is readily recovered by the lender NBFC. Even when banks have tried to provide quick loans under 59-minutes loan scheme, they have failed to do away with the procedural requirements such as document submission and are still regarded as “slow-loans” considering the super-fast loans being provided by NBFCs within 5 minutes.

Though immensely helpful, these loans have a potential to impact the economy in such a manner that it seems to be beneficial while it’s actually not. The borrowers are happily floating in the bubble of “instant loans” which is definitely going to burst in no time.

 

[1] Source: Economic Times

[2] Source: CNBC

[3] Source: Business Standard

Introduction of Digital KYC

Anita Baid (anita@vinodkothari.com)

The guidelines relating to KYC has been in headlines for quite some time now. Pursuant to the several amendments in the regulations, the KYC process of using Aadhaar through offline modes was resumed for fintech companies. The amendments in the KYC Master Directions[1] allowed verification of customers by offline modes and permitted NBFCs to take Aadhaar for verifying the identity of customers if provided voluntarily by them, after complying with the conditions of privacy to ensure that the interests of the customers are safeguarded.

Several amendments were made in the Prevention of Money laundering (Maintenance of Records) Rules, 2005, vide the notification of Prevention of Money laundering (Maintenance of Records) Amendment Rules, 20191 issued on February 13, 2019[2] (‘February Notification’) so as to allow use of Aadhaar as a proof of identity, however, in a manner that protected the private and confidential information of the borrowers.

The February Notification recognised proof of possession of Aadhaar number as an ‘officially valid document’. Further, it stated that whoever submits “proof of possession of Aadhaar number” as an officially valid document, has to do it in such a form as are issued by the Authority. However, the concern for most of the fintech companies lending through online mode was that the regulations did not specify acceptance of KYC documents electronically. This has been addressed by the recent notification on Prevention of Money-laundering (Maintenance of Records) Third Amendment Rules, 2019 issued on August 19, 2019[3] (“August Notification”).

Digital KYC Process

The August Notification has defined the term digital KYC as follows:

“digitial KYC” means the capturing live photo of the client and officially valid document or the proof of possession of Aadhaar, where offline verification cannot be carried out, along with the latitude and longitude of the location where such live photo is being taken by an authorised officer of the reporting entity as per the provisions contained in the Act;

Accordingly, fintech companies will be able to carry out the KYC of its customers via digital mode.

The detailed procedure for undertaking the digital KYC has also been laid down. The Digital KYC Process is a facility that will allow the reporting entities to undertake the KYC of customers via an authenticated application, specifically developed for this purpose (‘Application’). The access of the Application shall be controlled by the reporting entities and it should be ensured that the same is used only by authorized persons. To carry out the KYC, either the customer, along with its original OVD, will have to visit the location of the authorized official or vice-versa. Further, live photograph of the client will be taken by the authorized officer and the same photograph will be embedded in the Customer Application Form (CAF).

Further, the system Application shall have to enable the following features:

  1. It shall be able to put a water-mark in readable form having CAF number, GPS coordinates, authorized official’s name, unique employee Code (assigned by Reporting Entities) and Date (DD:MM:YYYY) and time stamp (HH:MM:SS) on the captured live photograph of the client;
  2. It shall have the feature that only live photograph of the client is captured and no printed or video-graphed photograph of the client is captured.

The live photograph of the original OVD or proof of possession of Aadhaar where offline verification cannot be carried out (placed horizontally), shall also be captured vertically from above and water-marking in readable form as mentioned above shall be done.

Further, in those documents where Quick Response (QR) code is available, such details can be auto-populated by scanning the QR code instead of manual filing the details. For example, in case of physical Aadhaar/e-Aadhaar downloaded from UIDAI where QR code is available, the details like name, gender, date of birth and address can be auto-populated by scanning the QR available on Aadhaar/e-Aadhaar.

Upon completion of the process, a One Time Password (OTP) message containing the text that ‘Please verify the details filled in form before sharing OTP’ shall be sent to client’s own mobile number. Upon successful validation of the OTP, it will be treated as client signature on CAF.

For the Digital KYC Process, it will be the responsibility of the authorized officer to check and verify that:-

  1. information available in the picture of document is matching with the information entered by authorized officer in CAF;
  2. live photograph of the client matches with the photo available in the document; and
  3. all of the necessary details in CAF including mandatory field are filled properly.

Electronic Documents

The most interesting amendment in the August Notification is the concept of “equivalent e-document”. This means an electronic equivalent of a document, issued by the issuing authority of such document with its valid digital signature including documents issued to the digital locker account of the client as per rule 9 of the Information Technology (Preservation and Retention of Information by Intermediaries Providing Digital Locker Facilities) Rules, 2016 shall be recognized as a KYC document. Provided that the digital signature will have to be verified by the reporting entity as per the provisions of the Information Technology Act, 2000.

The aforesaid amendment will facilitate a hassle free and convenient option for the customers to submit their KYC documents. The customer will be able to submit its KYC documents in electronic form stored in his/her digital locker account.

Further, pursuant to this amendment, at several places where Permanent Account Number (PAN) was required to be submitted mandatorily has now been replaced with the option to either submit PAN or equivalent e-document.

Submission of Aadhaar

With the substitution in rule 9, an individual will now have the following three option for submission of Aadhaar details:

  • the Aadhaar number where,
    1. he is desirous of receiving any benefit or subsidy under any scheme notified under section 7 of the Aadhaar (Targeted Delivery of Financial and Other subsidies, Benefits and Services) Act, 2016 or
    2. he decides to submit his Aadhaar number voluntarily
  • the proof of possession of Aadhaar number where offline verification can be carried out; or
  • the proof of possession of Aadhaar number where offline verification cannot be carried out or any officially valid document or the equivalent e-document thereof containing the details of his identity and address;

Further, along with any of the aforesaid options the following shall also be submitted:

  1. the Permanent Account Number or the equivalent e-document thereof or Form No. 60 as defined in Income-tax Rules, 1962; and
  2. such other documents including in respect of the nature of business and financial status of the client, or the equivalent e-documents thereof as may be required by the reporting entity

The KYC Master Directions were amended on the basis in the February Notification. As per the amendments proposed at that time, banking companies were allowed to verify the identity of the customers by authentication under the Aadhaar Act or by offline verification or by use of passport or any other officially valid documents. Further distinguishing the access, it permitted only banks to authenticate identities using Aadhaar. Other reporting entities, like NBFCs, were permitted to use the offline tools for verifying the identity of customers provided they comply with the prescribed standards of privacy and security.

The August Notification has now specified the following options:

  1. For a banking company, where the client submits his Aadhaar number, authentication of the client’s Aadhaar number shall be carried out using e-KYC authentication facility provided by the Unique Identification Authority of India;
  2. For all reporting entities,
    1. where proof of possession of Aadhaar is submitted and where offline verification can be carried out, the reporting entity shall carry out offline verification;
    2. where an equivalent e-document of any officially valid document is submitted, the reporting entity shall verify the digital signature as per the provisions of the IT Act and take a live photo
    3. any officially valid document or proof of possession of Aadhaar number is submitted and where offline verification cannot be carried out, the reporting entity shall carry out verification through digital KYC, as per the prescribed Digital KYC Process

It is also expected that the RBI shall notify for a class of reporting entity a period, beyond which instead of carrying out digital KYC, the reporting entity pertaining to such class may obtain a certified copy of the proof of possession of Aadhaar number or the officially valid document and a recent photograph where an equivalent e-document is not submitted.

The August Notification has also laid emphasis on the fact that certified copy of the KYC documents have to be obtained. This means the reporting entity shall have to compare the copy of the proof of possession of Aadhaar number where offline verification cannot be carried out or officially valid document so produced by the client with the original and record the same on the copy by the authorised officer of the reporting entity. Henceforth, this verification can also be carried out by way of Digital KYC Process.


[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11566#F4

[2] http://egazette.nic.in/WriteReadData/2019/197650.pdf

[3] http://egazette.nic.in/WriteReadData/2019/210818.pdf

Private virtual currencies out: India may soon see regulated virtual currency

-Kanakprabha Jethani | executive

kanak@vinodkothari.com

Background

A high-level Inter-ministerial Committee (IMC) (‘Committee’) was constituted under the chairmanship of Secretary, Department of Economic Affairs (DEA) to study the issues related to Virtual Currencies (VCs) and propose specific action to be taken in this matter. The Committee came up with its recommendations[1] recently. These recommendations include, among other things, ban on private VCs, examination of technologies underlying VCs and their impact on financial system, viability of issue of  ‘Central Bank Digital Currency (CBDC)’ as  legal tender in India, and potential of digital currency in the near future.

The following write-up deals with an all-round study of the recommendations of the committee and their probable impacts on the financial systems and the economy as a whole.

Major recommendations of the Committee.

The report of the Committee focuses on Distributed Ledger Technologies (DLT) or blockchain technology and their use to facilitate transactions in VCs and their relation to financial system. Following are the major recommendations of the Committee.

  • DEA should identify uses of DLT and various regulators should focus on developing appropriate regulations regarding use of DLT in their respective areas.
  • All private cryptocurrencies should be banned in India.
  • Introduction of an official digital currency to be known as Central bank digital currency (CBDC) which shall be acceptable as legal tender in India.
  • Blockchain based systems may be considered by Ministry of Electronics and Information Technology (MEITY) for building low-cost KYC systems.
  • DLT may be used for collection of stamp duty in the existing e-stamping system.

Why were these recommendations needed?

  • DLT uses independent computers (called ‘nodes’), linked together through hash function, to record, share and synchronise transactions in their respective distributed ledgers. The detailed structure of DLTs and their functions and uses can be referred to in our other articles.[2]

Among its various benefits such as data security, privacy, permanent data retention, this system addresses one major issue linked to digital currency which is the problem of double-spend i.e. a digital currency can be spent more than once as digital data can be easily reproduced. In DLT, authenticity of a transaction can be verified by the user and only validated transactions form a block under this mechanism.

  • Many companies have been using Initial Coin Offerings (ICO) as a medium to raise money by issuing digital tokens in exchange of fiat money or a widely accepted cryptocurrency. This way of raising money has been bothering regulators as it has no regulatory backing and such system can collapse any time. The regulators also fail to reckon whether ICO can be even considered as a security or how it should be taxed.
  • Some countries allow use of VCs as a mode of payment but no country in the world accepts VCs as legal tender. In India, however, no such permissions are granted to VCs. Despite the non-acceptability of VCs in India, investors have been actively investing in VCs like bitcoin, which is a sign of danger for the economy as it is draining the financial systems of fiat money. Further, they pose a risk over the financial system as they are highly volatile, with no sovereign backing and no regulators to oversee. It has been witnessed in the recent years that there have been detrimental implications on the economy due to volatility of VCs such as bitcoins. the same has been dealt with in detail in our report[3] on Bitcoins. They are also suspected to have been facilitating criminal activities by providing anonymity to the transactions as well as to the persons involved.
  • The future is of digitisation. An economy with everything running on physical basis will not survive in the competitive world. A universally accepted system for digital payments would require digitisation of currency as well.

What is the regulatory philosophy in the world?

As a mode of payment: Countries like Switzerland, Thailand, Japan and Canada permit VCs as a mode of payment while New York requires persons using VCs to take prior registration with a specified authority. Russia allows only barter exchange through use of virtual currency which means that such exchange can only take place when routed through barter exchanges of Russia. China prohibits use of VCs as a mode of payment.

For investment purposes: Russia, Switzerland, Thailand, New York and Canada permit investment in VCs and have in place frameworks to regulate such investments. Further, countries like Russia, Thailand, japan, New York and Canada have also allowed setting up of crypto exchanges and have a framework for regulating the setting up and operations such exchange and subsequent trading of VCs on them. On the other hand, China altogether prohibits investments and trading in VCs and the law of Switzerland is silent as to allowing setting up of crypto exchanges.

Further, China has imposed a strict ban on any activity in cryptocurrencies and has also taken measures to prohibit crypto mining activities in its jurisdiction. No country in the world has allowed acceptance of virtual currency as legal tender. It is noteworthy that though Japan and Thailand allow transactions in VCs, such transactions are restricted to approved cryptocurrencies only.

Tunisia and Ecuador have issued their own blockchain based currency called eDinar and SISTEMA de Dinero Electronico respectively. Venezuela has also launched an oil-based cryptocurrency.

Issue of official digital currency

Sensing the keen inclination of financial systems towards technological innovation and witnessing declining use of physical currency in various countries, the Committee is of the view that a sovereign backed digital currency is required to be issued which will be treated at par with any other legal tender of the country.

Various legislations of the country need to be reviewed in this direction. This would include amendments to the definition of “Coin” as per Coinage Act for clarifying whether digital currency issued by RBI shall be included in the said definition. Further, on issue of such currency, it must be approved to be a “bank note” as per section 25 of RBI Act through notification in Gazette of India.

Various regulators would also be required to amend their respective regulations to align them in the direction of allowing use of such digital currency as an accepted form of currency.

Key features of CBDC are expected to be as follows:

  • The access to CBDC will be subject to time constraints as decided in the framework regulating the same.
  • CBDC will be designed to provide anonymity in the transaction. However, the extent of anonymity will depend on the decisions of the issuing authority.
  • Two models are under consideration for defining transfer mechanism for CBDC. One is account-based model which will be centralised and other one is value-based model which will be decentralised model. Hybrid variants may also be considered in this regard.
  • Contemplations as to have interest-bearing or non-interest-bearing CBDC are going on. An interest-bearing CBDC would allow value addition whereas non-interest bearing CBDC will operate as cash.

Why should DLT be used in financial systems?

  • Intermediation: Usually, in payment systems, there are layers of intermediation that add to cost of transaction. Through DLT, the transaction will be executed directly between the nodes with no intermediary which would then reduce the transaction costs. Further, in cross-border transactions through intermediaries, authorisations require a lot of time and result in slow down of transaction. This can also be done away through DLT.
  • KYC: Keeping KYC records and maintaining the same requires huge amounts of data to be stored and updated regularly. Various entities undergoing the same KYC processes, collecting the same proofs of identity from the same person for different transactions result in duplication of work. Through a blockchain based KYC record, the same record can be made available to various entities at once, while also ensuring privacy of data as no centralised entity will be involved. Loan appraisal: A blockchain technology can largely reduce the burden of due-diligence of loan applicant as the data of customers’ earlier loan transactions is readily available and their credit standing can be determined through that.
  • Trading: In trading, blockchain based systems can result in real-time settlement of transactions rather than T+2 settlement system as prevailing under the existing stock exchange mechanism. Since all the transactions are properly recorded, it provides an easier way of post-trade regulatory reporting.
  • Land registries and property titles: A robust land registry system can be established through use of blockchain mechanism which will have the complete history of ownership records and other rights relating to the property which would facilitate transfer of property as well as rights related to it.
  • E-stamping: A blockchain based system would ease out the process of updation of records across various authorities involved and would eliminate the need of having a central agency for keeping records of transaction.
  • Financial service providers: They can be benefited by the concept of ‘localisation of data’ due to which their data is protected from cyber-attacks and theft. Our article[4] studies implementation of blockchain technology in financial sector.

What will be the challenges?

  1. For implementation of DLT: Though a wide range of benefits can be reaped out of implementation of DLT in various aspects of financial systems, it has still not been implemented because there are a few hindrances that remain and are expected to continue even further. Some of the challenges that are slowing the pace of transition towards this technology are as follows:
  • Lack of technological equipment to handle volumes of transactions on blockchains and to ensure data security at the same time.
  • Absence of centralised infrastructure or central entity to regulate implementation of DLT in the financial system. Also, the existing regulators lack the expertise to oversee proper implementation.
  • First, a comprehensive regulatory framework needs to be in place that ensures governance in implementation. The framework will need to address concerns like jurisdiction in case of cross border ledgers, point of finality of transactions etc.
  1. For common digital currency: Decisions regarding validation function, settlement, transfer, value-addition etc. are of crucial importance and would require extensive study. Factors that might be hampering issue of such currency are as follows:
    • Having in place a safe and secure blockchain network and robust technology to handle the same will require significant investments.
    • High volumes of transactions may not be supported and might result in delays in processing.
    • In case an interest bearing CBDC is issued, it would pose great threat over the commercial banking system as the investors will be more inclined towards investing in CBDCs instead of bank deposits.
    • This is also likely to increase competition in the market and lower the profitability of commercial banks. Commercial banks may rely on overseas wholesale funding which might result in downturn of such banks in overseas market.
  2. For banning of private cryptocurrencies: A circular issued by the RBI has already banned its regulated entities from dealing in VCs. Many other countries have also banned dealing in VCs. Despite such restrictions, entities continue to deal in VCs because their speculative motives drive the dealing in VCs to a great extent.

Conclusion

The recommendations of the Committee intend to ensure safety of financial systems and simultaneously urge the growth of the system through innovation and technological advances. Rising above the glorious scenes of these recommendations, one realises that achieving this is a far-fetched reality. One needs to accept the fact that India still lacks in technology and systems sufficient to support innovations like blockchain. Various reports have already shown that operation of blockchains consumes huge volumes of energy, which can be the biggest issue for the energy-scarce India. India needs to work in order to strengthen its core before flapping its wings towards such sophisticated innovation.

[1] https://dea.gov.in/sites/default/files/Approved%20and%20Signed%20Report%20and%20Bill%20of%20IMC%20on%20VCs%2028%20Feb%202019.pdf

[2] http://vinodkothari.com/2019/06/blockchain-technology-its-applications-in-financial-sector/

http://vinodkothari.com/2019/06/an-introduction-to-smart-contracts-guest-post/

[3] http://vinodkothari.com/wp-content/uploads/2017/08/Bitcoints-India-Report.pdf

[4] http://vinodkothari.com/2019/07/blockchain-based-lending-a-peer-to-peer-approach/

RBI to strengthen corporate governance for Core Investment Companies.

Vinod Kothari

As a part of the Bi-monthly Monetary Policy on 6th June, 2019, the RBI’s review of Development and Regulatory Policies [https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=47226] proposed to set up a working group to strengthen the regulatory framework for core investment companies (CICs). The RBI states: “Over the years, corporate group structures have become more complex involving multiple layering and leveraging, which has led to greater inter-connectedness to the financial system through their access to public funds. Further, in light of recent developments, there is a need to strengthen the corporate governance framework of CICs. Accordingly, it has been decided to set up a Working Group to review the regulatory guidelines and supervisory framework applicable to CICs.”

Core investment companies are group holding vehicles, which hold equities of operating or financial companies in a business group. These companies also give financial support in form of loans to group companies. However, CICs are barred from dealing with companies outside the group or engaging in any other business operation.

Currently as per the data as on 30th April, 2019, there are only 58 registered CICs in the country. There may be some unregistered CICs as well, since those not having “public funds” do not require registration.

If a CIC is not holding “public funds” (a broad term that includes bank loans, inter-corporate deposits, NCDs, CP, etc.), the CIC is exempt from registration requirement. Presumably such CICs are also excluded from any regulatory sanctions of the RBI as well. However, it is quite common for CICs to access bank loans or have other forms of debt for funding their investments. Such CICs require registration and come under the regulatory framework of the RBI, if their assets are worth Rs 100 crores or more.

Corporate governance norms applicable to systemically important NBFCs are currently not applicable to CICs.

The RBI has observed that CICs are engaged in layering of leverage. This observation is correct, as very often, banks and other lenders might have lent to CICs. The CICs, with borrowed money, use the same for infusing capital at the operating level below, which, once again, becomes the basis for leveraging. Thus, leveraged funds become basis for leverage, thereby creating multiple layers of leverage.

While agreeing with the contention of the RBI, one would like to mention that currently, the regulatory definition of CICs is so stringent that many of the group holding companies qualify as “investment companies” (now, credit and investment companies) and not CICs. There is a need to reduce the qualifying criteria for definition of CICs to 50% of investments in equities of group companies. This would ensure that a large number of “investment companies” will qualify as CICs, based on predominance of their investments, and would be viewed and regulated as such.

Prominent among the registered CICs are entities like Tata Sons, L&T Finance Holdings, JSW Investments, etc. The extension of corporate governance norms to CICs is unlikely to benefit any, but impact all.

The Reserve Bank has accordingly constituted the Working Group to Review Regulatory and Supervisory Framework for Core Investment Companies on 3rd July, 2019 [https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR43DDEE37027375423E989F2C08B3491F4F.PDF]. The Terms of Reference (ToR) of the Working Group are given below:

  • To examine the current regulatory framework for CICs in terms of adequacy, efficacy and effectiveness of every component thereof and suggest changes therein.
  • To assess the appropriateness of and suggest changes to the current approach of the Reserve Bank of India towards registration of CICs including the practice of multiple CICs being allowed within a group.
  • To suggest measures to strengthen corporate governance and disclosure requirements for CICs
  • To assess the adequacy of supervisory returns submitted by CICs and suggest changes therein
  • To suggest appropriate measures to enhance RBI’s off-sight surveillance and on-site supervision over CICs.
  • Any other matter incidental to the above.

As per the press release, the Working Group shall submit its report by October 31, 2019.