FAQs on refund of interest on interest

-Financial Services Division (finserv@vinodkothari.com)

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

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

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

FAQs

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

Applicability on Lenders:

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

The RBI Circular is directed to the following lenders :

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

2. What exactly is the relief to be given?

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

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

3. How exactly is the relief to be given?

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

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

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

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

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

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

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

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

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

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

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

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

Facility Covered

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

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

Accounts not eligible for Relief under RBI Circular:

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

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

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

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

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

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

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

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

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

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

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

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

There was:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Then in such cases:

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

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

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

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

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

Note that guarantee commission is not subject to a moratorium

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

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

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

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

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

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

Borrowers covered

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

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

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

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

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

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

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

Computation

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

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

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

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

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

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

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

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

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

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

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

Accounting Provision

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

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

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

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

 

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

Presentation on scalar regulatory framework for the NBFC sector

The video of “Round table discussion on RBI’s proposed regulatory framework for NBFCs” can be viewed here 

Our write-up on the topic titled “Scalar regulatory framework for the NBFC sector” can be viewed here

 

About time to unfreeze NPA classification and reporting

-Siddarth Goel (finserv@vinodkothari.com)

Introduction

The COVID pandemic last year was surely one such rare occurrence that brought unimaginable suffering to all sections of the economy. Various relief measures granted or actions taken by the respective governments, across the globe, may not be adequate compensation against the actual misery suffered by the people. One of the earliest relief that was granted by the Indian government in the financial sector, sensing the urgency and nature of the pandemic, was the moratorium scheme, followed by Emergency Credit Line Guarantee Scheme (ECLGS). Another crucial move was the allowance of restructuring of stressed accounts due to covid related stress. However, every relief provided is not always considered as a blessing and is at times also cursed for its side effects.

Amid the various schemes, one of the controversial matter at the helm of the issue was charging of interest on interest on the accounts which have availed payment deferment under the moratorium scheme. The Supreme Court (SC) in the writ petition No 825/2020 (Gajendra Sharma Vs Union of India & Anr) took up this issue. In this regard, we have also earlier argued that government is in the best position to bear the burden of interest on interest on the accounts granted moratorium under the scheme owing to systemic risk implications.[1] The burden of the same was taken over by the government under its Ex-gratia payment on interest over interest scheme.[2]

However, there were several other issues about the adequacy of actions taken by the government and the RBI, filed through several writ petitions by different stakeholders. One of the most common concern was the reporting of the loan accounts as NPA, in case of non-payment post the moratorium period. The borrowers sought an extended relief in terms of relaxation in reporting the NPA status to the credit bureaus. Looking at the commonality, the SC took the issues collectively under various writ petitions with the petition of Gajendra Sharma Vs Union of India & Anr. While dealing with the writ petitions, the SC granted stay on NPA classification in its order dated September 03, 2020[3]. The said order stated that:

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

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

The legal ambiguity

The aforesaid order dated September 03, 2020, has also led to the creation of certain ambiguities amongst banks and NBFCs. One of them being that whether post disposal of WP No. 825/2020 Gajendra Sharma (Supra), the order dated September 03, 2020, should also nullify. While another ambiguity being that whether the stay is only for those accounts that have availed the benefit under moratorium scheme or does it apply to all borrowers.

It is pertinent to note that the SC was dealing with the entire batch of writ petitions while it passed the common order dated September 03, 2020. Hence, the ‘stay on NPA classification’ by the SC was a common order in response to all the writ petitions jointly taken up by the court. Thus, the stay order on NPA classification has to be interpreted broadly and cannot be restricted to only accounts of the petitioners or the accounts that have availed the benefit under the moratorium scheme. As per the order, the SC held that accounts that have not been declared/classified NPA till August 31, 2020, shall not be downgraded further until further orders. This relaxation should not just be restricted to accounts that have availed moratorium benefit and must be applied across the entire borrower segment.

The WP No. 825/2020 Gajendra Sharma (Supra) was disposed of by the SC in its judgment dated November 27, 2020[4], whereby in the petition, the petitioner had prayed for direction like mandamus; to declare moratorium scheme notification dated 27.03.2020 issued by Respondent No.2 (RBI) as ultra vires to the extent it charges interest on the loan amount during the moratorium period and to direct the Respondents (UOI and RBI) to provide relief in repayment of the loan by not charging interest during the moratorium period.

The aforesaid contentions were resolved to the satisfaction of the petitioner vide the Ex-gratia Scheme dated October 23, 2020. However, there has been no express lifting of the stay on NPA classification by the SC in its judgment. Hence, there arose a concern relating to the nullity of the order dated September 03, 2020.

The other writ petitions were listed for hearing on December 02, 2020, by the SC via another order dated November 27, 2020[5]. Since then the case has been heard on dates 02, 03, 08, 09, 14, 16, and 17 of December 2020. The arguments were concluded and the judgment has been reserved by the SC (Order dated Dec 17, 2020[6]).

As per the live media coverage of the hearing by Bar and Bench on the subject matter, at the SC hearing dated December 16, 2020[7], the advocate on behalf of the Indian Bank Association had argued that:

It is undeniable that because of number of times Supreme Court has heard the matter things have progressed. But how far can we go?

I submit this matter must now be closed. Your directions have been followed. People who have no hope of restructuring are benefitting from your ‘ don’t declare NPA’ order.

Therefore, from the foregoing discussion, it could be understood that the final judgment of the SC is still awaited for lifting the stay on NPA classification order dated September 03, 2020.

Interim Dilemma

While the judgment of the SC is awaited, and various issues under the pending writ petitions are yet to be dealt with by the SC in its judgment, it must be reckoned that banking is a sensitive business since it is linked to the wider economic system. The delay in NPA classification of accounts intermittently owing to the SC order would mean less capital provisioning for banks. It may be argued that mere stopping of asset classification downgrade, neither helps a stressed borrower in any manner nor does it helps in presenting the true picture of a bank’s balance sheet. There is a risk of greater future NPA rebound on bank’s balance sheets if the NPA classification is deferred any further. It must be ensured that the cure to be granted by the court while dealing with the respective set of petitions cannot be worse than the disease itself.

The only benefit to the borrower whose account is not classified NPA is the temporary relief from its rating downgrade, while on the contrary, this creates opacity on the actual condition of banking assets. Therefore, it is expected that the SC would do away with the freeze on NPA classification through its pending judgment. Further, it is always open for the government to provide any benefits to the desired sector of the economy either through its upcoming budget or under a separate scheme or arrangement.

THE VERDICT

[Updated on March 24, 2021]

The SC puts the final nail to almost a ten months long legal tussle that started with the plea on waiver of interest on interest charged by the lenders from the borrowers, during the moratorium period under COVID 19 relief package.  From the misfortunes suffered by the people at the hands of the pandemic to economic strangulation of people- the battle with the pandemic is still ongoing and challenging. Nevertheless, the court realised the economic limitation of any Government, even in a welfare state. The apex court of the country acknowledged in the judgment dated March 23, 2020[8], that the economic and fiscal regulatory measures are fields where judges should encroach upon very warily as judges are not experts in these matters. What is best for the economy, and in what manner and to what extent the financial reliefs/packages be formulated, offered and implemented is ultimately to be decided by the Government and RBI on the aid and advice of the experts.

Thus, in concluding part of the judgment while dismissing all the petitions, the court lifted the interim relief granted earlier- not to declare the accounts of respective borrowers as NPA. The last slice of relief in the judgement came for the large borrowers that had loans outstanding/sanctioned as on 29.02.2020 greater than Rs.2 crores. The court did not find any rationale in the two crore limit imposed by the Government for eligibility of borrowers, while granting relief of interest-on-interest (under ex-gratia scheme) to the borrowers.[9] Thus, the court directed that there shall not be any charge of interest on interest/penal interest for the period during moratorium for any borrower, irrespective of the quantum of loan. Since the NPA stay has been uplifted by the SC, NBFCs/banks shall accordingly start classification and reporting of the defaulted loan accounts as NPA, as per the applicable asset classification norms and guidelines.

Henceforth, the CIC reporting of the defaulted loan accounts (NPA) must also be done. Surely, the said directions of the court would be applicable only to the loan accounts that were eligible and have availed moratorium under the COVID 19 package. [10]

The lenders should give credit/adjustment in the next instalment of the loan account or in case the account has been closed, return any amount already recovered, to the concerned borrowers.

Given that the timelines for filing claims under the ex-gratia scheme have expired, it is expected that the Government would be releasing extended/updated operational guidelines in this regard for adjustment/ refund of the interest in interest charged by the lenders from the borrowers.

 

 

[1] http://vinodkothari.com/2020/09/moratorium-scheme-conundrum-of-interest-on-interest/

[2] http://vinodkothari.com/2020/10/interest-on-interest-burden-taken-over-by-the-government/#:~:text=Blog%20%2D%20Latest%20News-,Compound%20interest%20burden%20taken%20over%20by%20the%20Central%20Government%3A%20Lenders,pass%20on%20benefit%20to%20borrowers&text=Of%20course%2C%20the%20scheme%2C%20called,2020%20to%2031.8.

[3] https://main.sci.gov.in/supremecourt/2020/11127/11127_2020_34_16_23763_Order_03-Sep-2020.pdf

[4] https://main.sci.gov.in/supremecourt/2020/11127/11127_2020_34_1_24859_Judgement_27-Nov-2020.pdf

[5] https://main.sci.gov.in/supremecourt/2020/11127/11127_2020_34_1_24859_Order_27-Nov-2020.pdf

[6] https://main.sci.gov.in/supremecourt/2020/11162/11162_2020_37_40_25111_Order_17-Dec-2020.pdf

[7] https://www.barandbench.com/news/litigation/rbi-loan-moratorium-hearings-live-from-supreme-court-december-16

[8] https://main.sci.gov.in/supremecourt/2020/11162/11162_2020_35_1501_27212_Judgement_23-Mar-2021.pdf

[9] Compound interest burden taken over by the Central Government: Lenders required to pass on benefit to borrowers – Vinod Kothari Consultants

[10] Moratorium on loans due to Covid-19 disruption – Vinod Kothari Consultants; also see Moratorium 2.0 on term loans and working capital – Vinod Kothari Consultants

 

 

Impact of restructuring on ECL computation

-Aanchal Kaur Nagpal (aanchal@vinodkothari.com)

Introduction

The disruption throughout the globe due to the COVID-19 pandemic has hit the Indian economy as well significantly. The financial sector has experienced a massive blow due to the impact of the pandemic on the credit worthiness and repayment capacity of the overall general public. RBI has responded through various measures including allowing moratorium period, providing resolution framework for stressed accounts due to COVID-19 and numerous other measures.

The retail borrower segment of several banks and NBFCs has also been adversely affected by the disruption and hence, the lenders are contemplating ways to extend certain benefits to such borrowers them under the various circulars issued by the RBI and government. In this regard, restructuring or modification in terms of a loan is being done for economic or legal reasons, relating to the borrower’s financial difficulty. However, such restructuring may also have implications on the books of accounts, especially for IndAS compliant entities.

The following note discusses the meaning of ‘restructuring’ and it impact on the credit risk of the borrower.

Meaning of Restructuring

As per RBI norms on Restructuring of Advances by NBFC, A restructured account is one where the NBFC, for economic or legal reasons relating to the borrower’s financial difficulty, grants to the borrower concessions that the NBFC would not otherwise consider.

As per the Basel guidelines on prudential treatment of problem assets –definitions of nonperforming exposures and forbearance, definition of forbearance is as follows:

4.1. Identification of forbearance

  1. Forbearance occurs when:
  • a counterparty is experiencing financial difficulty in meeting its financial commitments; and
  • a bank grants a concession that it would not otherwise consider, irrespective of whether the concession is at the discretion of the bank and/or the counterparty. A concession is at the discretion of the counterparty (debtor) when the initial contract allows the counterparty (debtor) to change the terms of the contract in their favour (embedded forbearance clauses) due to financial difficulty.

The meaning of restructuring is modification in terms of a loan, which is done for economic or legal reasons, relating to the borrower’s financial difficulty. Usually, restructuring may be of various types. A credit weakness related restructuring is one which is done to assist the borrower to continue to service the facility. If such restructuring was not done, potentially, the borrower may not have been able to service the facility. Therefore, this is done with a view to avert a default. Yet another type of restructuring is a preponement of payments or early clearance of a loan. A third example has been given in the definition itself – for example, passing on the benefit of any interest rate increase or decrease in case of floating rate loans.

Change in credit risk

Under Indian Accounting Standard (Ind AS) 109 Financial Instruments (‘IndAS 109’), Expected Credit Loss (ECL) provision is computed for the loan accounts and it is important to determine whether restructuring should be considered as a factor in determining change in the credit risk characteristic of the borrower.

Significant Increase in Credit Risk (SICR), in the context of IFRS 9, is a significant change in the estimated Default Risk (over the remaining expected life of the financial instrument). The term ‘significant’ is not defined in IFRS-9 and thus SICR is determined using various internal and external indicators. The provisions of para 5.5.12 of IndAS 109[1] are self-explanatory on the point that if there has been a modification of the contractual terms of a loan, then, in order to see whether there has been a SICR, the entity shall compare the credit risk before the modification, and the credit risk after the modification.

While SICR indicators usually suffice during normal circumstances, but adjusting to the ‘new normal’ would require ‘new’ ways to consider SICR. The most important question that arises is whether modification in the loan terms to avoid a credit default due to COVID-19 disruption would lead to SICR.

International Guidance

  • As per the International Monetary Fund Report on The Treatment of Restructured Loans for FSI Compilation,

The BCBS (2017) defines loan forbearance as a situation in which (1) a counterparty is experiencing financial difficulty in meeting its financial commitments, and (2) a bank grants a concession that it would not otherwise consider, whether or not the concession is at the discretion of the bank and/or the counterparty. The Guide defines restructured loans as loans arising from rescheduling and refinancing of the original loan. Therefore, all forbearance measures are loan restructuring, but not all loan restructurings are forbearance measures.

Recently, in response to COVID-19 shock, the BCBS (2020) has clarified that when borrowers accept the terms of a payment moratorium (public or granted by banks on a voluntary basis) or have access to other relief measures such as public guarantees, these developments may not automatically lead to the loan being categorized as forborne. At the same time, banks would still need to assess the likelihood of the borrower’s rescheduled payments after the moratorium period ends.

  • The Indian Accounting Standard Board also released a clarification under ‘IFRS 9 and Covid-19’[2] stating that,

Entities should not continue to apply their existing ECL methodology mechanically. For example, the extension of payment holidays to all borrowers in particular classes of financial instruments should not automatically result in all those instruments being considered to have suffered an SICR.

  • According to the European Banking Authority’s Final Report on ‘Guidelines on reporting and disclosure of exposures subject to measures applied in response to the COVID‐19 crisis’[3],

More precisely, moratoria on loan payments that are in accordance with the EBA Guidelines on legislative and non‐legislative moratoria on loan repayments applied in the light of the COVID‐ 19 crisis do not trigger forbearance classification and the assessment of distressed structuring of loans and advances benefiting from these moratoria and they do not automatically lead to default classification. For example, if a performing loan is subject to a moratorium compliant with the GL on moratoria, which brings contractual changes to the terms of the loan, in the existing supervisory reporting this loan will continue to be reported under the category of performing exposures with no specific indication of the measures applied. However, it is also emphasised that the credit institutions should continue the monitoring and where necessary the unlikeliness to pay assessment of loans and advances that fall under the scope of these moratoria.

  • The Prudential Regulatory Authority of the Bank of England sent letters[4] to CEOs of various Banks guiding the following –

Our expectation is that eligibility for, and use of, the UK Government’s policy on the extension of payment holidays should not automatically, other things being equal, result in the loans involved being moved into Stage 2 or Stage 3 for the purposes of calculating ECL or trigger a default under the EU Capital Requirements Regulation (CRR). This expectation extends to similar schemes to respond to the adverse economic impact of the virus.

We do not consider the use of a Covid-19 related payment holiday by a borrower to trigger the counting of days past due or generate arrears under CRR. We also do not consider the use of such a payment holiday to result automatically in the borrower being considered unlikely to pay under CRR.

Firms are reminded to apply sound risk management practices regarding the identification of defaults. Firms should continue to assess borrowers for other indicators of unlikeliness to pay, taking into consideration the underlying cause of any financial difficulty and whether it is likely to be temporary as a result of Covid-19 or longer term

Our expectation is that a covenant breach or waiver of a covenant relating to a modification of the audit report attached to audited financial statements because of the Covid-19 pandemic should not automatically, other things being equal, trigger a default under CRR or result in a move of the loans involved into Stage 2 or Stage 3 for the purposes of calculating ECL. This expectation extends to other covenant breaches and waivers of covenants with a direct link to the Covid-19 pandemic.

A breach of the covenants of a credit contract is a possible indication of unlikeliness to pay under the CRR definition of default. However, a covenant breach does not automatically trigger a default. Rather, firms have scope to assess covenant breaches on a case-by-case basis and determine whether they indicate unlikeliness to pay.

  • The Accounting Standards Board of Canada[5] also took note of the guidance provided by IASB on guidance on applying IFRS 9 Financial Instrument. Further, it also took note of the guidance[6] provided by the Office of the Superintendent of Financial Institutions (OFSI) in Canada and specified that the guidance is consistent with the requirements in IFRS 9 and should thus be considered along with the guidance provided by the IASB. The OFSI, through its guidance, provided the following in relation to applying IFRS in extraordinary circumstances –

IFRS 9 is principles-based and requires the use of experienced credit judgement. Consistent with OSFI’s IFRS 9 Financial Instruments and Disclosures guideline, OSFI is providing guidance on three specific aspects of the accounting for Expected Credit Losses (ECLs) due to the exceptional circumstances arising from COVID-19. Deposit taking Institutions (DTIs) should also consider any additional guidance provided by the International Accounting Standards Board on the application of IFRS 9 in relation to COVID-19.

Under the IFRS 9 ECL accounting framework, DTIs should consider both quantitative and qualitative information, including experienced credit judgment, in assessing for significant increase in credit risk. In OSFI’s view, the utilization of a payment deferral program should not result in an automatic trigger, all things being equal, for significant increase in credit risk.

  • The International Public Sector Accounting Standards Board (IPSASB) released QnA[7] to provide insight into the financial reporting issues associated with COVID-19 government responses, and the relevant International Public Sector Accounting Standards (IPSAS). According to the same,

Given the economic severity associated with COVID-19, entities will need to review their portfolio of financial assets and assess whether an impairment is necessary.

Considering the aforesaid guidelines, all restructuring should not automatically be implied as SICR and the same should be based on facts after analyzing the background of credit worthiness of the borrower.

In case the restructuring is done under the disruption scenario then the same is not indicative of any increase in the probability of default. Accordingly, the same should ideally not be considered as a factor for considering SICR. Thus, if the restructuring is done for accounts that are stressed as a direct result of COVID-19, then the same shall not be treated as SICR.

However, if the restructuring is granted as a generalized option to all customers without any attention paid to reasons for such credit weakness, then the same is done to merely avoid credit difficulty or default of such borrowers which may not necessarily be caused by COVID-19.

Further, something like moratorium, which is granted for a systemic disruption such as a crisis of payment and settlements, natural calamities, etc. is for non-economic reasons, and therefore, may not be likened with a credit-weakness-related restructuring. In the current scenario, the general assumption may be that the credit default is directly associated with the COVID-19 pandemic in most cases.

Restructuring to all borrowers at a class level

A financial institution may also intend to modify the terms of the loan for the entire class as against a particular individual. If the underlying reason for such modification is the financial difficulty faced by the entire class due to Covid disruption, such that the modification is to tide over such difficulty and continue to service the loan, in our view, this will amount to restructuring and lead to a downgrade of asset classification. The underlying rationale is that a loan is a credit decision which is made looking at the prevailing situation at the time of extension of the credit. If the payment schedule is adjusted to take into consideration any change in situations that has happened subsequent to the grant of the credit, the same should be a case of deterioration in the credit quality of the loan. While going by the language of the regulation it seems to refer to only individual cases of restructuring, however, the fact that the entire class of borrower is facing the financial difficulty cannot be overlooked. Merely because the restructuring has been done for a class of borrowers does not mean the restructuring is not to avert a potential default.

Usually, the need for restructuring is identified at the individual exposure level to which concessions are granted due to financial difficulties of the respective borrower. Taking a decision to provide relief to an entire class of borrower instead of considering individual restructuring of each borrower account is a matter of prudence, which must be taken without compromising the interest of the Company, that is the lender.

Impact on IND AS treatment

Based on the aforesaid discussion, it can be inferred that the restructuring under the disruption scenario is not indicative of any increase in the probability of default. Accordingly, the same should ideally not be considered as a factor for considering SICR and in turn, should not result in shifting of the financial instruments from one stage to another. However, in case the account showed signs of credit weakness even before the restructuring, then there should be a shift from one stage to another.

Our related articles–

 

[1] If the contractual cash flows on a financial asset have been renegotiated or modified and the financial asset was not derecognised, an entity shall assess whether there has been a significant increase in the credit risk of the financial instrument in accordance with paragraph 5.5.3 by comparing:

(a) the risk of a default occurring at the reporting date (based on the modified contractual terms); and

(b) the risk of a default occurring at initial recognition (based on the original, unmodified contractual terms).

[2] ifrs-9-ecl-and-coronavirus.pdf

[3] Microsoft Word – Guidelines on Covid -19 measures reporting and disclosure.docx (europa.eu)

[4] Dear CEO Letter on Covid-19 IFRS 9 Capital Requirements and Loan Covenants (bankofengland.co.uk)

[5] IFRS 9 Expected Credit Losses and COVID-19 (frascanada.ca)

[6] OSFI Actions to Address Operational Issues Stemming from COVID-19 (osfi-bsif.gc.ca)

[7] IPSASB-Staff-QA-COVID-19-Relevant-Accounting-Guidance_0.pdf (ifac.org)

RBI all set to regulate the HFCs

Introduction

The provisions of National Housing Bank Act, 1987 were amended w.e.f August 09, 2019 pursuant to the Finance Act, 2019 thereby shifting the power to govern Housing finance Companies (HFCs) from National Housing Bank (NHB) to the Reserve Bank of India (RBI). Consequently, the RBI on June 17, 2020, issued a draft for review of extant regulatory framework for HFCs[1] (‘Proposed Framework’), and had invited comments from the industry on the same. After considering the inputs received from the industry, the RBI, on October 22, 2020 issued the Regulatory Framework for HFCs[2] (‘Regulations’).

The Regulations intend to align the regulatory framework for HFCs with the one prevalent for NBFCs. In this write-up we bring out the significant features of the regulatory framework for HFCs.

Existing regulations to continue

The Regulations state that the existing guidelines issued by the NHB applicable to HFCs shall continue to be applicable unless the relevant provision has been provided for in the Regulations.

Though all major provisions have already been covered in the Regulations, however, certain aspects shall continue to be governed by NHB regulations such as provisions relating to transfer to reserve fund, maintenance of percentage of assets and concept of Tier I and Tier II capital. Better clarity in regards to the extant regulations that would continue to apply to HFCs would be apparent once the revised Master Directions for HFCs is issued.

Are exemptions from provisions of the RBI Act really exemptions?

The Regulations exempt HFCs from complying with the provisions of Chapter III B of the Reserve Bank of India Act, 1934 (RBI Act), except for the registration and Net Owned Funds (NOF) requirements. Further, specific exemption has been granted from the provisions of section 45-IB and 45-IC of the RBI Act, in place of which section 29B and 29C of the National Housing Bank Act, 1987 (NHB Act) shall continue to remain applicable.

Sections 29B and 29C of the NHB Act contain the same provisions as that of sections 45-IB and 45-IC of the RBI Act respectively. Hence, in essence there is no separate requirement for HFCs and the same is in line with the corresponding provisions applicable on NBFCs.

Accordingly, both NBFCs and HFCs will be on the same page since the provisions of section 45-IB and 45-IC of RBI Act are corresponding to that of section 29B and 29C of NHB Act.

Harmonisation in phased manner

Para 3 of the Proposed Framework stated that harmonisation of certain provisions such as capital adequacy requirements, Income Recognition, Asset Classification and Provisioning (IRACP) norms, concentration norms, limits on exposure to Commercial Real Estate (CRE) & Capital Market (CME) etc. shall be done in a phased manner. The Regulations, with respect to para 3, have remained silent for the time being and have stated that the same shall be issued in the upcoming two years.

Principal Business Criteria (PBC)

 

As per the Regulations, in order to be classified as an HFC, following criteria shall be required to be satisfied:

  • A company incorporated under the Companies Act, 2013;
  • Must be an NBFC i.e. financial assets are more than 50% of total assets and financial income is 50% or more of total income;
  • Housing Finance Assets should be 60% or more;
  • At least 50% of total assets should be towards housing finance for individuals;

Prior to the amendment in the Finance Act, the term ‘principal business’ was not referred to in the NHB Act. For the purposes of registration, NHB was recognizing companies as HFCs if such a company had, as one of its principal objects, transacting the business of providing finance for housing (directly or indirectly).  Now, the identification and registration of an HFC shall be based on meeting the PBC rather than just mentioning the same as one of the principal objects in its charter documents. Further, the requirement of minimum concentration towards ‘individuals’ is a new concept and possibly to protect the HFCs from systemic exposures.

The PBC prescribed in the Proposed Framework stated that at least 50% of ‘net assets’ shall be in the nature of qualifying assets. However, the income criteria was based on total income. Net assets means total assets reduced by cash and bank balances and money market instruments. However, gross income would include interest and other income earned from bank balances and money market instruments as well, that have been excluded from the computation of net assets. Hence, there was no parity between both the comparative bases. Vinod Kothari Consultants (VKC) had sent recommendation to the RBI suggesting to bring both the bases at parity. The RBI has considered the same and has accordingly revised the bases to total asset and total income. A company will be treated as an NBFC if its financial assets are more than 50 per cent of its total assets (netted off by intangible assets) and income from financial assets should be more than 50 per cent of the gross income. Further, for an HFC, it must have 60% of the total asset towards providing finance for housing and 50% of the total assets towards individual housing finance.

Timeline for achieving the PBC

The proposed framework provides the following timelines for achieving the aforesaid PBC

Timeline Minimum percentage of total assets towards housing finance Minimum percentage of total assets towards housing finance for individuals
March 31, 2022 50 40
March 31, 2023 55 45
March 31, 2024 60 50

Existing HFCs, which currently do not fulfill the said criteria shall meet the same within the above mentioned timelines. For this purpose, the HFCs shall be required to submit a Board approved roadmap (as discussed in the ‘Actionables Box’). In case of failure to do so/achieve the PBC specific to housing loans as per the timelines, the HFC shall be treated as NBFC – Investment and Credit Companies (NBFC-ICC) and shall be required to approach the RBI for conversion to NBFC-ICC.

Definition of Housing Finance

The definition of Housing Finance provided in the Regulations is the same as that provided in the Proposed Framework for ‘qualifying asset’. Further, there is a clarification provided in the Regulations stating- “Integrated housing project comprising some commercial spaces (e.g. shopping complex, school, etc.) can be treated as residential housing, provided that the commercial area in the residential housing project does not exceed 10 percent of the total Floor Space Index (FSI) of the project.”

The aforesaid concept of integrated housing project has been drawn from the NHB Directions.

The detailed analysis of the definition of qualifying asset as compared to the erstwhile definition of Housing Finance may be referred here- http://vinodkothari.com/2020/06/comparison-between-the-proposed-and-existing-regulatory-framework-for-hfcs/

NOF requirement

The Proposed Framework stated that HFCs shall maintain a minimum NOF of Rs. 20 crores of more. The same has been retained in the Regulations. The existing NOF requirements for HFCs is Rs. 10 crores and hence, existing HFCs having a lower NOF shall be required to increase their NOF to Rs. 15 crores by March 31, 2022 and Rs. 20 crores by March 31 2023. Further, they are required to submit a statutory auditor’s certificate (as discussed in the ‘Actionables Box’). In case of failure to do so, the registration of the HFC shall be cancelled/ converted into NBFC-ICC upon request of the HFC for the same.

Definition of Tier I and Tier II Capital

The Proposed Framework provided for inclusion of PDIs in the definition of TIer I and Tier II Capital. The Regulations are silent on the same, hence, the existing definition as per the NHB Directions shall continue to be applicable

Liquidity Risk Framework (LRM) and Liquidity Coverage Ratio (LCR)

The Proposed Framework extended the applicability of the provisions of LRM and LCR to HFCs. VKC had recommended that the same should be made applicable in a phased manner. Considering the said recommendation, the RBI has clarified that the provisions of LCR are required to be met in a phased manner as per the following timelines:

 

It is noteworthy here that while the milestones for NBFC start from December 1, 2020, the milestones for HFCs shall commence from December 1, 2021. The LRM and LCR framework for NBFCs was introduced on November 4, 2020 and NBFCs were given a time period of more than a year to implement the LCR. Similarly, HFCs have also been given time to implement the same.

Exposure to group companies

The Proposed Framework provided for restriction on dual financing i.e. HFCs may choose to lend only at one level. That is, the HFC can either undertake an exposure on the group company in real estate business or lend to retail individual home buyers in the projects of group entities, but not do both.

The Proposed Regulations lacked clarity as to whether it extends to all kinds of group entities or only such entities which are engaged in real estate. VKC had made a recommendation to clarify the same since the Proposed Regulations used the phrase “HFC decides to take any exposure in its group entities”. It now seems clear that the intention is to cover in general all companies in a group engaged in real estate business and not just the group of the respective HFC.

Further, the language of the Regulations refers to group companies, however, the same shall also include any company engaged in real estate business. Hence, the HFC may either have an exposure towards a company engaged in real estate business or lend to retail individual home buyers in the projects of such company.

Considering the requirement for HFCs to do lend a major part of their portfolio to individuals and this restriction on dual financing, it seems that builder lending will be discouraged. In the present state of housing industry in the country, this should not be the intention of the regulator.

Further, the maximum exposure an HFC may have on a single entity in a group of companies shall be 15% of its owned funds and for the group shall be 25% of owned funds. These provisions are similar to the concentration norms applicable to NBFCs. However, these refer to exposure to a group engaged in real estate business. Further, the RBI shall release concentration norms for all exposures of HFCs in due course of time.

Loan To Value Ratio (LTV) requirements

The following LTV requirements have been laid down in the Regulations:

  • For loan against shares (LAS) – 50%
  • Loans against security of gold jewellery – 75%

The LTV requirement for LAS is in line with the guidelines for NBFCs and the Proposed Framework, however, the LTV requirement for gold loans was not specified in the Proposed Framework and is a new insertion.

Levy of Foreclosure Charges

The Regulations bar HFCs from charging foreclosure charges on floating rate term loans sanctioned for purposes other than business to individual borrowers. Below figure explains how foreclosure charges may/may not be charges by HFCs:

Immediate Actionables for HFCs

 

S.no. Actionable
1. All HFCs shall submit RBI a Board approved plan within three months including a roadmap to fulfil the Principal Business Criteria and timeline for such transition
2 HFCs whose NOF is currently below Rs 20 crore, will be required to submit a statutory auditor’s certificate to RBI within a month evidencing compliance with the prescribed levels as at the end of the period mentioned by RBI for complying the same. That is in the month of April, 2022 and April, 2023.

 

3. The HFCs to whom LRM framework would be applicable (more than 100 cr asset size) shall make public disclosures on quarterly basis on their website in the format given in Appendix-1 of the guidelines

HFC Vs NBFC’

A quick comparative of the provisions applicable for HFCs and NBFCs can be seen below:

Provisions/Guidelines NBFCs HFCs Similarity/

Difference

PBC 50-50 criteria In addition to 50-50 criteria, 60-50 criteria also applicable Different- Additional criteria to be fulfilled
NOF Requirement 2 crores 20 crores Different
Applicable guidelines for fraud control Master Direction – Monitoring of Frauds in NBFCs (Reserve Bank) Directions, 2016 Master Direction – Monitoring of Frauds in NBFCs (Reserve Bank) Directions, 2016 Same
Applicability of guidelines on Information Technology Master Direction – Information Technology Framework for the NBFC Sector dated June 08, 2017. Master Direction – Information Technology Framework for the NBFC Sector dated June 08, 2017. Same
Definition of public deposits As per Master Directions on Acceptance of Public Deposits Similar to that for NBFCs along with an additional point- any amount received from NHB or any public housing agency shall also be exempted from the definition of public deposit. Similar- except for an additional insertion
Implementation of Indian Accounting Standards Circular on Implementation of Indian Accounting Standards dated March 13, 2020[3] Circular on Implementation of Indian Accounting Standards dated March 13, 2020 Same
LTV Requirements for Loan Against Shares 50% 50% Same
LTV Requirements for Gold Loans 75% 75% Same
Levy of foreclosure charges NBFCs shall not impose foreclosure charges/ pre-payment penalties on any floating rate term loan sanctioned for purposes other than business to individual borrowers HFCs shall not impose foreclosure charges/ pre-payment penalties on any floating rate term loan sanctioned for purposes other than business to individual borrowers Same
Guidelines on Securitization Transactions and reset of Credit Enhancement As per Master Directions for NBFCs and other applicable circulars As applicable to NBFCs Same
Managing Risks and Code of Conduct in Outsourcing of Financial Services As per Master Directions for NBFCs As applicable to NBFCs Same
Guidelines on Liquidity Coverage Ratio As per Master Directions for NBFCs As applicable to NBFCs, as per timelines mentioned above Same
Guidelines on Liquidity Risk Management Framework: As per Master Directions for NBFCs As applicable to NBFCs Same
Exposure of HFCs to group companies engaged in real estate business: 15% of Owned Funds to single entity 25% to a group There are similar concentration norms for lending and investment Similar

 

[1] https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=959

[2] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT605BE165AA9E8043EFA087339829CCF469.PDF

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

Our related write-ups:

Electronic Mortgages: Towards a new trend in paperless mortgage lending

– Vinod Kothari

vinod@vinodkothari.com

Paperless lending based on e-agreements and electronic documentation seems to be the future. The mortgage market is seeing the emergence of electronic mortgage note called ENotes. ENotes, which are issued as electronic negotiable instruments, have become popular in the US mortgage market. The COVID pandemic has given strong push the popularity of contactless and paperless lending format in the mortgage market too.

Like the transfer of shares and bonds world-over has been replaced by demat trades, the replacement of paper mortgages may be replaced by electronic version, sooner than one can imagine.

Electronic documentation has been given legal validity in most countries world-over. The USA passed the Uniform Electronic Transactions Act (UETA) way back in 2000, and Electronic Signatures in Global and National Commerce Act (commonly known as the ESIGN Act) in the year 2000. Most countries have similar enabling laws[1]. These laws grant legal validity to electronic mortgage documentation too. Armed with this power, US national mortgage depository MERS® introduced electronic mortgages almost 16 years ago[2].  The Mortgage Industry Standards Maintenance Organization® (MISMO) eMortgage Community of Practice was formed in 2001 to develop standards for efficient eMortgage processes, transactions, and XML data protocol. However, eNotes surged during the pandemic months. It is reported that by end of May, 2020, there were 597,139 eNotes, with the numbers for Q1 of 2020 being 300% of the corresponding quarter in the previous year.

Concept of ENotes

The typical mortgage creation process in US practice, based on a loan for purchase of a house (“purchase money loan”) involves the creation of promissory note whereby the borrower passes possession/control of property documents to the lender, for the purpose of securing a loan. If the mortgage is transferred by the original lender, the promissory note is “indorsed” to the transferee. Under the ENote format, the mortgage is electronically signed and registered with MERS. The electronic mortgage is stored in an electronic vault maintained by MERS[3]. As the mortgage changes hands by way of transfer of the mortgage, the original lender’s name is replaced by transferee – as would have happened in case of dematerialised shares.

UETA and E-Sign laws facilitated the creation of electronic negotiable instruments by the concept of “transferable records”, which was intended to be an electronic version of the mortgage promissory note[4]. The transferable record methodology involves a depository called “controller” of the note, who is responsible for recording, registering and evidencing the transfers of interest in the note.

Judicial recognition of ENotes

Rulings such as New York Community Bank v. McClendon, 29 N.Y.S.3d 507 (N.Y. App. Div. 2016), and Rivera v. Wells Fargo Bank, N.A., 189 So. 3d 323, 329 (Fla. Dist. Ct. App. 2016) have recognised the right of an assignee of an eNote in taking foreclosure action. Courts have held that the assignee needs to establish that it is either the controller of the authoritative copy of the ENote or is the beneficiary thereof, and produces the paper trail of the transfers leading up to the right of the assignee.

Market acceptability of ENotes

Fannie Mae[5] and Ginnie Mae[6] started accepting ENotes. Ginnie Mae has started accepting ENotes only recently and as part of the initial phase, issuers may apply to participate as e-Issuers and begin securitizing government-backed mortgages comprised of digital collateral with Ginnie Mae approval.

However, it is stated that the real push to ENotes came in 2018 when Quicken Loans initiated a complete process of end-to-end electronic mortgage closing, called e-closing[7]. Quicken Loans launched a digital mortgage product called Rocket Mortgage, in November, 2015, presumably one that allows closing a mortgage in less than 10 minutes. In less than 2 years, Quicken Loans became the largest mortgage lender in the USA.

Remote Notarisation – the other part of the digital mortgage eco-system

To prove that a document is authentic in all its aspects, notarization is necessary. The new system of Remote Online Notarization (“RON”) was adopted back in 2010.

RON typically allows documents to be notarized in electronic form with the signer signing with an electronic signature and appearing before a commissioned electronic notary online via audio-video technology. This allows anyone with an Internet connection to get documents signed and notarized online.

This process has several benefits in terms of security and fraud prevention. RON has had growing acceptance in the US.

It is said that before Covid-19, ENotes were growing at a modest pace as the industry collaborated on solutions to facilitate broader adoption, including acceptance of RON[8].

Other Benefits of ENotes

Apart from the benefits already discussed above, the growing acceptance of ENotes has much to do with several other benefits as well, such as, reducing the operational costs, faster turnaround times, faster signing process, improved data quality and validation, etc.

These give ENotes the push towards a completely paperless mortgage process apart from the convenience factor.

Conclusion

Considering the more than $9 trillion size of US mortgage industry, digital mortgage lending is still a long way to go. Digital mortgages are still less than 5% of the total mortgage originations, whereas digital personal loans are close to 60% of the total loan originations.

The growing acceptance of ENotes is certainly providing the push required from the traditional to a completely “e” driven mortgage process.

[1] The eIDAS Regulation (Electronic Identification and Authentication and Trust Services) is the e-sign law in the EU. The Personal Information Protection and Electronic Documents Act (PIPEDA) is a similar law in Canada. The Electronic Transactions Act 1999 is the governing law in Australia.

[2] Refer to https://www.mersinc.org/index

[3] For a white paper on the ENote methodology, see here: https://www.mersinc.org/publicdocs/eNote_White_Paper.pdf

[4] See section 15 of UETA

[5] https://www.fanniemae.com/deliveremortgage/

[6] https://www.ginniemae.gov/newsroom/Pages/PressReleaseDispPage.aspx?ParamID=203

[7] https://www.housingwire.com/articles/48774-the-fully-digital-mortgage-has-truly-arrived-as-use-of-enotes-skyrockets-by-nearly-5000/

[8] https://cib.db.com/insights-and-initiatives/flow/trust-and-agency/digital-mortgages-come-of-age.htm#2

Extension of FPC on lending through digital platforms

A new requirement or reiteration by the RBI?

– Anita Baid (finserv@vinodkothari.com)

Ever since its evolution, the basic need for fintech entities has been the use of electronic platforms for entering into financial transactions. The financial sector has already witnessed a shift from transactions involving huge amount of paper-work to paperless transactions[1]. With the digitalization of transactions, the need for service providers has also seen a rise. There is a need for various kinds of service providers at different stages including sourcing, customer identification, disbursal of loan, servicing and maintenance of customer data. Usually the services are being provided by a single platform entity enabling them to execute the entire transaction digitally on the platform or application, without requiring any physical interaction between the parties to the transaction.

The digital application/platform based lending model in India works as a partnership between a tech platform entity and an NBFC. The technology platform entity or fintech entity manages the working of the application or website through the use of advanced technology to undertake credit appraisals, while the financial entity, such as a bank or NBFC, assumes the credit risk on its balance sheet by lending to the customers who use the digital platform[2].

In recent times many digital platforms have emerged in the financial sector who are being engaged by banks and NBFCs to provide loans to their customers. Most of these platforms are not registered as P2P lending platform since they assist only banks, NBFCs and other regulated AIFIs to identify borrowers[3]. Accordingly, electronic platforms serving as Direct Service Agents (DSA)/ Business Correspondents for banks and/or NBFCs fall outside the purview of the NBFC-P2P Directions. Banks and NBFCs have th following options to lend-

  1. By direct physical interface or
  2. Through their own digital platforms or
  3. Through a digital lending platform under an outsourcing arrangement.

The digitalization of credit intermediation process though is beneficial for both borrowers as well as lenders however, concerns were raised due to non-transparency of transactions and violation of extant guidelines on outsourcing of financial services and Fair Practices Code[4]. The RBI has also been receiving several complaints against the lending platforms which primarily relate to exorbitant interest rates, non-transparent methods to calculate interest, harsh recovery measures, unauthorised use of personal data and bad behavior. The existing outsourcing guidelines issued by RBI for banks and NBFCs clearly state that the outsourcing of any activity by NBFC does not diminish its obligations, and those of its Board and senior management, who have the ultimate responsibility for the outsourced activity. Considering the same, the RBI has again emphasized on the need to comply with the regulatory instructions on outsourcing, FPC and IT services[5].

We have discussed the instructions laid down by RBI and the implications herein below-

Disclosure of platform as agent

The RBI requires banks and NBFCs to disclose the names of digital lending platforms engaged as agents on their respective website. This is to ensure that the customers are aware that the lender may approach them through these lending platforms or the customer may approach the lender through them.

However, there are arrangements wherein the platform is not appointed as an agent as such. This is quite common in case of e-commerce website who provide an option to the borrower at the time of check out to avail funding from the listed banks or NBFCs. This may actually not be regarded as outsourcing per se since once the customer selects the option to avail finance through a particular financial entity, they are redirected to the website or application of the respective lender. The e-commerce platform is not involved in the entire process of the financial transaction between the borrower and the lender. In our view, such an arrangement may not be required to be disclosed as an agent of the lender.

Disclosure of lender’s name

Just like the lender is required to disclose the name of the agent, the agent should also disclose the name of the actual lender. RBI has directed the digital lending platforms engaged as agents to disclose upfront to the customer, the name of the bank or NBFC on whose behalf they are interacting with them.

Several fintech platforms are involved in balance sheet lending. Here, the lending happens from the balance sheet of the lender however, the fintech entity is the one assuming the risk associated with the transaction. Lender’s money is used to lend to customers which shows up as an asset on the balance sheet of the lending entity. However, the borrower may not be aware about who the actual lender is and sees the platform as the interface for providing the facility.

Considering the risk of incomplete disclosure of facts the RBI mandates the disclosure of the lender’s name to the borrower. In this regard, the loan agreement or the GTC must clearly specify the name of the actual lender and in case of multiple lender, the name along with the loan proportion must be specified.

Issuance of sanction letter

Another requirement prescribed by the RBI is that immediately after sanction but before execution of the loan agreement, a sanction letter should be issued to the borrower on the letter head of the bank/ NBFC concerned.

Issue a sanction letter to the borrower on the letterhead of the NBFC may seem illogical since the lending happens on the online platform. The sanction letter may be shared either through email or vide an in-app notification or otherwise. Such sanction letter shall be issued on the platform itself immediately after sanction but before execution of the loan agreement.

Further, 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’. This practice though have not been highlighted by the RBI must be taken seriously.

Sharing of loan agreement

The FPC laid down by RBI requires that a copy of the loan agreement along with a copy each of all enclosures quoted in the loan agreement must be furnished to all borrowers at the time of sanction/ disbursement of loans. However, in case of lending done over electronic platforms there is no physical loan agreement that is executed.

Given that e-agreements are generally held as valid and enforceable in the courts, there is no such insistence on execution of physical agreements. The electronic execution versions are more feasible in terms of cost and time involved. In fact in most of the cases, the loan agreements are mere General Terms and Conditions (GTC) in the form of click wrap agreements.

Usually, the terms and conditions of the loan or the GTC is displayed on the platform wherein the acceptance of the borrower is recorded. In such a circumstance, necessary arrangements should be made for the borrower to peruse the loan agreement at any time. The loan agreement may also be in the form of a mail containing detailed terms and conditions, along with an option for the borrower to accept the same.

The requirement from compliance perspective is to ensure that the borrower has access to the executed loan agreement and all the terms and conditions pertaining to the loan are captured therein.

Monitoring by the lender

Effective oversight and monitoring should be ensured over the digital lending platforms engaged by the banks/ NBFCs. As RBI does not regulate the platform entities, hence the only way to regulate the transaction is though the lenders behind these platforms.

The outsourcing guidelines require the retention of ultimate control of the outsourced activity with the lender. Further, the platform should not impede or interfere with the ability of the NBFC to effectively oversee and manage its activities nor shall it impede the RBI in carrying out its supervisory functions and objectives. These should be captured in the servicing agreement as well as be implemented practically.

Grievance Redressal Mechanism (GRM)

Much of the new-age lending is enabled by automated lending platforms of fintech companies. The fintech company is the sourcing partner, and the NBFC is the funding partner. However, the grievance of the customer may range from issue with the usage of platform to the non-disclosure of the terms of loan.

A challenge that may arise is to segregate the grievance on the basis of who is responsible for the same- the platform or the lender. There must be proper mechanism to ensure such segregation and adequate efforts shall be made towards creation of awareness about the grievance redressal mechanism.

[1] Read our detailed write up here- http://vinodkothari.com/2020/03/moving-to-contactless-lending/

[2] Read our detailed write up here- http://vinodkothari.com/2020/03/fintech-regulatory-responses-to-finnovation/

[3] RBI’s FAQs on P2P lending platform- https://www.rbi.org.in/Scripts/FAQView.aspx?Id=124

[4] Read our detailed write up here- http://vinodkothari.com/2019/09/the-cult-of-easy-borrowing/

[5] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11920&Mode=0