– Vinod Kothari
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Like the transfer of shares and bonds world-over has been replaced by demat trades, the replacement of paper mortgages may be replaced by electronic version, sooner than one can imagine.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. 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. 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. 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. 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 and Ginnie Mae 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. 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.
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.
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.
 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.
 For a white paper on the ENote methodology, see here: https://www.mersinc.org/publicdocs/eNote_White_Paper.pdf
 See section 15 of UETA
A new requirement or reiteration by the RBI?
– Anita Baid (firstname.lastname@example.org)
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. 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.
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. 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-
- By direct physical interface or
- Through their own digital platforms or
- 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. 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.
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.
 Read our detailed write up here- http://vinodkothari.com/2020/03/moving-to-contactless-lending/
 Read our detailed write up here- http://vinodkothari.com/2020/03/fintech-regulatory-responses-to-finnovation/
 RBI’s FAQs on P2P lending platform- https://www.rbi.org.in/Scripts/FAQView.aspx?Id=124
 Read our detailed write up here- http://vinodkothari.com/2019/09/the-cult-of-easy-borrowing/
– Henil Shah and Harshil Matalia (email@example.com)
The Finance Act, 2019 amended the provisions of National Housing Bank, 1987 w.e.f August 09, 2019 thereby shifting the power to govern Housing finance Companies (HFCs) from National Housing Bank (NHB) to the Reserve Bank of India (RBI). Later, the RBI in its press release dated August 13, 2019 stated that HFCs shall be considered as a separate category of NBFCs.
A regulatory framework governing HFCs was long awaited. With a view to bring uniformity in the regulatory framework for HFCs and NBFCs, the RBI on 17th June, 2020 issued the report containing proposed changes in the regulatory framework for HFCs. The same is open for public opinions till 15th July,2020.
We have compared the proposed guidelines for HFCs with the existing guidelines.
|Sr. No.||Current Provisions Applicable to HFCs||Proposed Provisions||Remarks|
|Defining the phrase ‘providing finance for housing’ or ‘housing finance’|
|1||The NHB Directions defined the term “housing finance company” as a company incorporated under the Companies Act, 1956 which primarily transacts or has as one of its principal objects, the transacting of the business of providing finance for housing, whether directly or indirectly. However, the term ‘providing finance for housing’ or ‘housing finance’ was not formally defined.
There was a NHB Circular dated September 26, 2011 which provided an illustrative list of loans which can be classified as housing/ non housing loans-
1. Loans to individuals or group of individuals including co-operative societies for construction/ purchase of new dwelling units.
|It has been proposed to define ‘Housing Finance” or “providing finance for housing” to mean financing, for purchase/ construction/ reconstruction/ renovation/ repairs of residential dwelling units, which includes:
a. Loans to individuals or group of individuals including co-operative societies for construction/ purchase of new dwelling units.
|The proposed list is largely similar to the illustrative list prescribed by NHB earlier. However, the list prescribed as ‘qualifying asset’ for HFCs seems to focus more on individual borrowers. It has also excluded the following-
a. Loans for shopping complexes, markets and such other centers catering to the day to day needs of the residents of the housing colonies and forming part of a housing project
b. Loans provided to the bodies constituted for undertaking repairs to houses;
c. Investment in the guarantee/non-guaranteed bonds and debentures of NHB/HUDCO in the primary market, provided investment in non-guaranteed bonds is made only if guaranteed bonds are not availableThe idea behind laying out the periphery of ‘housing loans’ is to ensure consistency and certainty in ‘principality’ of business of the HFCs. Only such loans, which “qualify” as “housing loans” would be treated as “qualifying assets” for the purpose of determining “principality” of business of the entity, as we see below.
Specifically, loans given for furnishing dwelling units, loans given against mortgage of property for any purpose other than buying/ construction of a new dwelling unit/s or renovation of the existing dwelling unit/s, have been regarded as non-housing loans.
An entity which falls short of such qualifying assets below 50% cannot be regarded as HFC. This provision is also expected to minimise the practice of giving mortgage loans (LAP-type loans) by HFCs, which would often be granted to meet working capital requirements, etc. of other entities and not for housing purposes; thereby restricting the portfolio deviations of the HFC.
|Defining ‘principal business’ and ‘qualifying assets’ for HFCs|
|2||The term ‘principal business’ was not referred in NHB Act prior to the amendment vide Finance Act . Further, for the purposes of registration, NHB was recognizing companies as HFCs if such company has, as one of its principal objects, transacting of the business of providing finance for housing (directly or indirectly)||The principality test for HFCs has been proposed as follows (both these tests are required to be satisfied as the determinant factor for principal business):
(a) Not less than 50% of net assets are in the nature of ‘qualifying assets’ of which at least 75% should be towards individual housing loans as prescribed. Here, net assets shall mean total assets other than cash and bank balances and money market instruments
(b) Not less than 50% of the gross income is income from financial assetsQualifying Assets refer to ‘housing finance’ or ‘providing finance for housing’ as mentioned above
|With the amendment to NHB Act, there was a need to define the term ‘principal business’ for HFCs. The concept of ‘qualifying asset’ is similar to that in case of NBFC-MFIs wherein they are specifically focused on micro lending. Though in spirit the HFCs would primarily focus on housing loans only however, the HFCs offering home loans along with other related products would now be required to maintain the principality of individual housing loans.
The requirement of minimum concentration towards ‘individuals’ is a new concept and possibly to protect the HFCs from systemic exposures. Further, principality is to be differentiated from ‘ordinary’ – that is, the guidelines do not prohibit the HFCs from providing non-housing loans- it limits the same. The remaining 50% can be extended in the form of non-housing loans, including LAP. An HFC which falls short of such qualifying asset criteria has to get registration as NBFC-ICC – consequentially, all laws applicable to such NBFC-ICC shall apply to the HFC.
|Classification of HFCs as Systemically Important and Non-systemically Important entities|
|3||As per the current scenario a common set of regulations are applicable for all HFCs irrespective of asset size and ownership||In order to introduced a graded approach as applicable to NBFCs in general the proposed changes tend to classify HFCs if following categories:
1. All deposit taking HFCs (HFCs-D) irrespective of asset size and all non-deposit HFCs (HFCs-ND) with asset size of over INR 500 crores as systemically important HFCs;
|The existing regulations for HFCs are similar to NBFCs. The larger HFCs may continue with existing regulations under NHB regulations or be harmonised with NBFC-SI regulations. However, there are separate regulations for deposit taking NBFCs which might become applicable on deposit taking HFCs as well. For the non-systemically important HFCs, it is proposed to bring the regulations at par with Master Directions for NBFC-ND-non-SI|
|Minimum Net Owned Fund Requirement|
|4||For a company to commence or carry a principal business of housing finance it shall have a minimum net owned fund of INR 10 Crore.||Minimum net owned fund (NOF) requirement is proposed to be increased from 10 Crore to 20 crore.
Existing HFC shall be given a time period of 1 year to reach NOF of INR 15 Crore and another 1 year to reach INR 20 Cr minimum NOF mark
|The increased capital requirement is to strengthen the capital base of the HFCs.
However, as compared to an NBFC the NOF requirement is very high. The registration requirement for both NBFC-ICC and HFC will also be the same- they will have to apply to the RBI.
An important question that will arise here is that why should an entity register as an HFC- given the fact that even an NBFC-ICC can extend housing loan, one would have to consider the various factors to carry on housing finance as a principle activity under an HFC or non principal activity under an NBFC-ICC. As per the provisions of section 29A and 2(d) of the NHB Act read along with the RBI guidelines issued in this regard, an HFC will have to satisfy the principality of 50% housing loans as well as 75% loans to individuals.
|Harmonising definitions of Capital (Tier I & Tier II) with that of NBFCs|
|5||Tier- I Capital is defined under Para 2(1)(zf) of HFCs Master Directions as:
“Tier-I capital” means owned fund as reduced by investment in shares of other housing finance companies and in shares, debenture, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, ten percent of the owned fund;Tier- I Capital is defined under Para 2(1)(zg) of HFCs Master Directions as:
“Tier-II capital” includes the following:-
(i) preference shares (other than those compulsorily convertible into equity);
(ii) revaluation reserves at discounted rate of fifty five percent;
(iii) 10[general provisions (including that for standard assets) and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, to the extent of one and one fourth percent of risk weighted assets];
(iv) hybrid debt;
(v) subordinated debt
to the extent the aggregate does not exceed Tier-I capital;
|As per Para 3 (xxxii) and 3 (xxxiii) of Master Directions for NBFC-ND-SI
“Tier I Capital” means owned fund as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, ten per cent of the owned fund; and perpetual debt instruments issued by a non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such company as on March 31 of the previous accounting year;
“Tier II capital” includes the following: (a) preference shares other than those which are compulsorily convertible into equity; (b) revaluation reserves at discounted rate of fifty five percent; (c) General provisions (including that for Standard Assets) and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, to the extent of one and one fourth percent of risk weighted assets; (d) hybrid debt capital instruments; (e) subordinated debt; and (f) perpetual debt instruments issued by a non-deposit taking non-banking financial company which is in excess of what qualifies for Tier I Capital, to the extent the aggregate does not exceed Tier I capital.
|It is proposed to align the definitions of capital (both Tier I and Tier II) of HFCs with that of NBFC, specifically PDIs shall form part of HFCs capital (both Tier I and Tier II) component on the same lines as NBFCs. However, with the following differences-
1.PDIs shall be treated as Tier I/ Tier II capital only by HFCs-ND-SI
|6||Public deposits is defined under Para 2(1)(y) of the NHB Directions, 2010||Subject to alignment of Public deposit provisions of HFC with NBFC following shall be:
Additions to the existing exemptions from public deposits:
1. Rehabilitation Industries Corporation of India Ltd.
2. Corporation established by or under any Statute; or a cooperative society registered under the Cooperative Societies Act of any StateDeletion from the list of exemptions applicable to HFCs
1. Japan Bank for International Cooperation (JBIC)
2. Kreditanstalt fur Wiederaufbau (KfW)
In addition to changes pursuant to the alignment, any amount received by the HFCs from NHB or any public housing agency shall be exempted
|There are no major changes arising from the alignment of definitions of public deposits, however it seems that at the time of alignment this may be taken care off.|
|Liquidity Risk framework and LCR|
|7||Under the present scenario HFCs are required to follow Guideline for Asset Liability Management System issued by NHB via Policy Circular No. 35 dated 11th October, 2011||Guidelines for Liquidity risk management framework (LRM) and liquidity coverage ratio (LCR) as notified by the RBI on 04th November, 2019 applicable to NBFCs shall be extended to HFCs-ND with asset size of more than 100 crores and all HFCs-D subject to supervisory review of internal controls required to put in place by HFCs (Refer our presentation on LRM here- http://vinodkothari.com/2019/11/liquidity-risk-framework/)||Actionable from the Liquidity Risk Management Framework:
1. HFCs will be required to edit the current ALM policy or adopt a new LRM framework.
However question arises in relation to the applicability of LCR as same is applicable in NBFCs-D and NBFC-ND-SI with asset size of 5000 crore or more whereas the its proposed to extended the guidelines in case of HFCs to all the HFCs-D and HFCs-ND-SI with asset Size of INR 100 crore or more. RBI may look into difference in applicability criteria while notifying the same.
|Group entities Engaged in real estate business|
|8||Current provisions applicable to HFC does not contain any restrictions relating to double financing.||HFCs exposure to the below mentioned activity shall be mutually exclusive:
1. Group company in real estate business or
2. Lend to retail individual home buyers in the project of group entitiesAny direct or indirect exposure in group entity shall be limited 15% of owned funds for a single entity in the group and 25% of owned fund for all such group entities.
As regards to extending of loans to individuals, who chose to buy housing units from entities in the group, Arm’s length principle shall be followed in letter and spirit
|The proposition is that 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 laguage of the notification is not very clear that it is referrring to internal group or external group as well- our view is that the restriction should not be just for internal group but also for external group.
Further, the limit on ‘Group Exposure’ seems to include both housing and non-housing loans to such group entity. Also, the limits are more stringent than the existing concentration norms, which provide the limit for lending and investment of upto 25% of the owned fund to a single party and 40% of its owned fund to a single group of parties.
There is an exemption in the existing concentration norms for investment and lending to group comanies to the extent it has been reduced from the owned funds. Hence, the limit of 15% and 25% may not be relvant if the HFC has already knocked off the exposure from its owned funds. This must be clarified by the RBI.
Since, the intent is to stop double finance that is to say ongoing exposure should not be there on both- in case funding has been extended to the builder then already the flat is funded, however, after construction once the loan is repaid by the builder, the individual may be given loan for the flat- this should not be regarded as double financing.
In case of loans to individual, the HFC must satisfy the arms’ length requirement for retail loans to group’s customers. This mutual exclusion clause does not seems to apply to companies outside group and their retail customers – but in case the intent is to bar double financing, the external group companies must also be included.
|Monitoring of frauds|
|9||Applicable as per NHB policy circular No. 92 dated February 05, 2019||Applicable as per Master Direction – Monitoring of Frauds in NBFCs (Reserve Bank) Directions, 2016.||HFCs should comply with the master directions for monitoring of frauds, however all reports in the formats given in Master Directions may continue to be forwarded to NHB, New Delhi.|
|10||Chapter IV para 2 – Frauds committed by unscrupulous borrowers:
Frauds committed by unscrupulous borrowers including companies, partnership firms/proprietary concerns and/or their directors/partners, Group of Associations, Trusts etc. by various methods including the following:
(a) Diversion of funds outside the borrowing units,
(b) lack of interest or criminal neglect on the part of borrowers, their partners, etc.,
(c) due to managerial failure leading to the unit becoming sick and due to laxity in effective supervision over the operations in borrowal accounts on the part of the HFC functionaries rendering the advance difficult of recovery.
|As per Master Directions:
Frauds committed by unscrupulous borrowers including companies, partnership firms/proprietary concerns and/or their directors/partners by various methods including the following:
(a) Fraudulent discount of instruments;
(b) Fraudulent removal of pledged stocks/disposing of hypothecated stocks without the NBFCs knowledge/inflating the value of stocks in the stock statement and drawing excess finance;
(c) Diversion of funds outside the borrowing units, lack of interest or criminal neglect on the part of borrowers, their partners, etc. and also due to managerial failure leading to the unit becoming sick and due to laxity in effective supervision over the operations in borrowal accounts on the part of the NBFC functionaries rendering the advance difficult of recovery.
|Same as earlier. However, additionally the following 2 points would be henceforth applicable:
(a) Fraudulent discount of instruments;
(b) Fraudulent removal of pledged stocks/disposing of hypothecated stocks without the NBFCs knowledge/inflating the value of stocks in the stock statement and drawing excess finance.
|11||Chapter VI para 2(iii) – Quarterly Review of Frauds:
All the frauds involving an amount of INR. 50 lakh and above should be monitored and reviewed by the Audit Committee of the Board of HFCs. The periodicity of the meetings of the Committee may be decided according to the number of cases involved. However, the Committee should meet and review as and when a fraud involving an amount of INR. 50 lakh and above comes to light.
|As per Master Directions:
All the frauds involving an amount of INR 1 crore and above should be monitored and reviewed by the Audit Committee of the Board (ACB) of NBFCs. The periodicity of the meetings of the Committee may be decided according to the number of cases involved. However, the Committee should meet and review as and when a fraud involving an amount of INR 1 crore and above comes to light.
|Limit of INR 50 lakh would be increased to INR 1 crore as per Master Directions.|
|12||Chapter – VII – Provisioning Pertaining to Fraud Accounts||No such provisioning requirement under master directions.||The Master directions as applicable to NBFCs do not provide for any specific provisioning requirement pertaining to the account classifed as fruad.|
|Information Technology Framework|
|14||As per NHB policy circular No. 90 dated June 15, 2018:
Information Technology framework for HFCs is categorised into 2 parts:
Section A – For public deposit accepting HFCs and HFCs not accepting public deposit with asset size INR 100 crore and above;
Section B – HFCs not accepting public deposit with asset size below INR 100 crore.
|As provided under Master Direction – Information Technology Framework for the NBFC Sector where:
Section A would apply to Systemically important HFCs;
|Currently applicability of IT framework for HFCs is segregated based on asset size of INR 100 crores. However, henceforth the applicability would be based on asset size of INR 500 crores, i.e. by segregating HFCs into systemically and non-systemically important category.|
|15||Para 5.4 – Periodicity of IS Audit:
The periodicity of IS audit should ideally be based on the size and operations of the HFC but may be conducted at least once in two years.
|As per Master Directions – The periodicity of IS audit should ideally be based on the size and operations of the HFC but may be conducted at least once in a year.||All HFCs would be required to conduct IS audit at least once in a year as per Master Directions. This however is recomendatory.|
|16||No guidelines prescribe by NHB||Provisions of Annex XXII of NBFC-ND-SI Directions, 2016 shall be extended to cover the HFCs||In the absence of any specific guidelines, the HFCs were already complying with the RBI guidelines on securitization and direct assignment. This would avoid any confusion in terms of the applicability of the securitisation guidelines. However, the existing RBI guidelines are also proposed to undergo amendments|
|Lending against Shares|
|17||Under the current ambit of HFC provisions there are no guidelines in place for lending against the security of shares by HFCs||Provisions as specified in Para 22 of NBFC-ND-SI Directions, 2016 shall mutatis mutandis be applicable to the HFCs||HFCs would be required to comply with the following while lending against shares:
1. Maintain Loan to Value (LTV) ratio of 50% at all times. Any shortfall would require to be made good within 7 working days.
2. In case where lending is being done for investment in capital markets, accept only Group 1 securities as collateral for loans of value more than INR 5 lakh.
3. Report on-line to stock exchanges on a quarterly basis, information on the shares pledged in their favour, by borrowers for availing loans in format as given in Annex V of Master Directions..
|Managing Risks and Code of Conduct in Outsourcing of Financial Services|
|18||There are no guidelines have been prescribed for HFCs with regard to outsourcing of Financial Services||Provisions of Annex XXV of NBFC-ND-SI Directions, 2016 shall be extended to cover the HFCs||HFCs will have to comply with the guidelines for outsourcing of financial services|
|19||As per NHB policy circular No. 36 dated October 18, 2010 and NHB policy circular No. 43 dated October 19, 2011
HFCs should not charge pay-payment levy or penalty on pre-closure of housing loans under the following situations.
1. Where the housing loan is on floating interest rate basis and the loan is preclosed through any source.
|No foreclosure charges/prepayment penalties shall be levied on any floating rate term loan sanctioned for purposes other than business to individual borrowers with or without co-obligants. It is proposed to extend these instructions to HFCs.||There are no regulations prescribed for HFCs for not levying the foreclosure charge for non-housing loans such as in case of term loans availed for other than business purpose. Hence, it is proposed to extend these instructions to HFCs as well. This would ensure uniformity with regard to repayment of various term loans by borrowers. Though the language is not very clear and hence, it seems that the foreclosure charges shall be waived off for all floating rate term loans to individual borrowers, including housing loans as well.|
|Implementation of Indian Accounting Standards|
|20||NBFCs as covered in rule 4 of the Companies (Indian Accounting Standards) Rules, 2015 are required to comply with IndAS.
As per the Rule 2(1)(g) of the above mentioned rules, all the HFCs are covered under the definition of NBFCs thereby required to comply with IndAS.
The RBI has also provided guidance on implementation of Indian Accounting Standards by NBFCs (including HFCs).
|RBI instructions issued vide circular dated 13th March, 2020 on implementation of IndAS to be extended to HFCs||The RBI circular was applicable to NBFCs as covered in rule 4 of the Companies (Indian Accounting Standards) Rules, 2015 which already includes HFCs under the definition of NBFCs.
However, there was confusion wrt its applicability on HFCs. The proposed change further clarifies the applicability of the said RBI circular to HFCs.
Our write-up on implementation of IndAs for NBFCs may alos be refereed here– http://vinodkothari.com/2020/03/guidance-on-implementation-of-ind-as-by-nbfcs/
Our other write-ups may be viewed here:
-Anita Baid (firstname.lastname@example.org)
In 2019, pursuant to the amendments proposed by the Finance Act, 2019, it was proposed to shift the regulations of Housing Finance Companies (HFCs) from National Housing Bank (NH) to the Reserve Bank of India (RBI). Further, the RBI had in its press release stated that HFCs will be treated as one of the categories of Non-Banking Financial Companies (NBFCs) for regulatory purposes with effect from August 09, 2019. It was expected that the RBI shall carry out a review of the extant regulatory framework applicable to HFCs and come out with revised regulations in due course, and till such time HFCs shall continue to comply with the directions and instructions issued by NHB.
In this regard, the RBI has undertaken a review and has identified a few changes which are proposed to be prescribed for HFCs. While certain guidelines in the NBFC Master Directions is proposed to be made straight away applicable to HFCs, in some other cases, changes have been proposed to ensure a seamless shift in the regulations. Most of these regulations are not new to the world at large, banks and NBFCs are already complying with the guidelines issued by the RBI on similar lines. The scope has now been extended to include HFCs under its ambit.
Some of the major changes proposed by the new regulator have been discussed herein below-
Defining the phrase ‘providing finance for housing’ or ‘housing finance’
The NHB Directions defined the term “housing finance company” [section 2(d)] as a company incorporated under the Companies Act, 1956 which primarily transacts or has as one of its principal objects, the transacting of the business of providing finance for housing, whether directly or indirectly. However, the term ‘providing finance for housing’ or ‘housing finance’ was not formally defined. It has been proposed to define the said terms to mean financing, for purchase/ construction/ reconstruction/ renovation/ repairs of residential dwelling units. Further, an illustrative list has been provided to determine the loans that would fall under the category of housing finance.
There was a NHB Circular dated September 26, 2011 which provided an illustrative list of loans which can be classified as housing/ non housing loans. The comparative table showing the difference is provided herein below:
|Illustrative list prescribed in 2011||Proposed list of ‘Qualifying Asset’|
|a. Loans to individuals or group of individuals including co-operative societies for construction/ purchase of new dwelling units.
b. Loans for purchase of old dwelling units.
c. Loans to individuals for purchasing old/new dwelling units by mortgaging existing dwelling units.
d. Loans for purchase of plots for construction of residential dwelling units provided a declaration is obtained from the borrower that he intends to construct a house on the said plot, with the help of bank/HFC finance or otherwise, within a period of three years from the availment of the said loan.
e. Loans for renovation/ reconstruction of existing dwelling units.
f. Lending to professional builders for construction of residential dwelling units.
g. Lending to public agencies including state housing boards for construction residential dwelling units.
h. Loans to corporates/ Government (through loans for employee housing)
i. Loans for construction of educational, health, social, cultural or other institutions/ centers, which are part of a housing project and which are necessary for the development of settlements or townships;
j. Loans for shopping complexes, markets and such other centers catering to the day to day needs of the residents of the housing colonies and forming part of a housing project;
k. Loans for construction meant for improving the conditions in slum areas for which credit may be extended directly to the slum-dwellers on the guarantee of the Government, or indirectly to them through the State Governments;
l. Loans given for slum improvement schemes to be implemented by Slum Clearance Boards and other public agencies;
m. Loans provided to the bodies constituted for undertaking repairs to houses;
n. Investment in the guarantee/non-guaranteed bonds and debentures of NHB/HUDCO in the primary market, provided investment in non-guaranteed bonds is made only if guaranteed bonds are not available
|a. Loans to individuals or group of individuals including co-operative societies for construction/ purchase of new dwelling units.
b. Loans to individuals for purchase of old dwelling units.
c. Loans to individuals for purchasing old/ new dwelling units by mortgaging existing dwelling units.
d. Loans to individuals for purchase of plots for construction of residential dwelling units provided a declaration is obtained from the borrower that he intends to construct a house on the plot within a period of three years from the date of availing of the loan.
e. Loans to individuals for renovation/ reconstruction of existing dwelling units.
f. Lending to public agencies including state housing boards for construction of residential dwelling units.
g. Loans to corporates/ Government agencies (through loans for employee housing).
h. Loans for construction of educational, health, social, cultural or other institutions/centres, which are part of housing project in the same complex and which are necessary for the development of settlements or townships;
i. Loans for construction of houses and related infrastructure within the same area, meant for improving the conditions in slum areas for which credit may be extended directly to the slum-dwellers on the guarantee of the Government, or indirectly to them through the State Governments;
j. Loans given for slum improvement schemes to be implemented by Slum Clearance Boards and other public agencies;
k. Lending to builders for construction of residential dwelling units
The proposed list is similar to the illustrative list prescribed by NHB earlier. However, the list prescribed as ‘qualifying asset’ for HFCs seems to focus more on individual borrowers. It has also excluded the following-
- Loans for shopping complexes, markets and such other centers catering to the day to day needs of the residents of the housing colonies and forming part of a housing project
- Loans provided to the bodies constituted for undertaking repairs to houses;
- Investment in the guarantee/non-guaranteed bonds and debentures of NHB/HUDCO in the primary market, provided investment in non-guaranteed bonds is made only if guaranteed bonds are not available
Specifically, loans given for furnishing dwelling units, loans given against mortgage of property for any purpose other than buying/ construction of a new dwelling unit/s or renovation of the existing dwelling unit/s, have been regarded as non-housing loans. This was mentioned in the 2011 circular as well.
The idea behind laying out the periphery of ‘housing loans’ is to ensure consistency and certainty in ‘principality’ of business of the HFCs. Only such loans, which “qualify” as “housing loans” would be treated as “qualifying assets” for the purpose of determining “principality” of business of the entity, as we see below.
An entity which falls short of such qualifying assets below 50% cannot be regarded as HFC. This provision is also expected to minimise the practice of giving mortgage loans (LAP-type loans) by HFCs, which would often be granted to meet working capital requirements, etc. of other entities and not for housing purposes; thereby restricting the portfolio deviations of the HFC. The specific definition of housing finance would avoid confusion and ensure better governance as well as reporting for HFCs.
Defining principal business and qualifying assets
The amendment to section 29 A of the NHB Act vide Finance Act, 2019 provided as follows:
(1) Notwithstanding anything contained in this Chapter or in any other law for the time being in force, no housing finance institution which is a company shall commence housing finance as its principal business or carry on the business of housing finance as its principal business without—
(a) obtaining a certificate of registration issued under this Chapter; and
(b) having the net owned fund of ten crore rupees or such other higher amount, as the Reserve Bank may, by notification, specify.
Prior to the amendment in Finance Act, the term ‘principal business’ was not referred in NHB Act. Further, for the purposes of registration, NHB was recognizing companies as HFCs if such company had, as one of its principal objects, transacting of the business of providing finance for housing (directly or indirectly). With the aforesaid amendment to NHB Act, there was a need to define the term ‘principal business’ for HFCs. The principal business criteria for NBFCs is well known- an NBFC must have financial assets more than 50% of its total assets and income from financial assets must be more than 50% of the gross income. The same has been proposed to be extended to HFCs as well along with the concept ‘qualifying assets’ which would mean asset qualifying as ‘housing finance’ or ‘providing finance for housing’
The principality test for HFCs has been proposed as follows (both these tests are required to be satisfied as the determinant factor for principal business):
- Not less than 50% of net assets are in the nature of ‘qualifying assets’ of which at least 75% should be towards individual housing loans as prescribed. Here, net assets shall mean total assets other than cash and bank balances and money market instruments
- Not less than 50% of the gross income is income from financial assets
The RBI has also proposed the following timeline for achieving the aforesaid principality:
|Timeline||At least 50% of net assets as qualifying assets i.e., towards housing finance||At least 75% of qualifying assets towards housing finance for individuals|
|March 31, 2022||50%||60%|
|March 31, 2023||–||70%|
|March 31, 2024||–||75%|
The concept of ‘qualifying asset’ is similar to that in case of NBFC-MFIs wherein they are specifically focused on micro lending. Though in spirit the HFCs would primarily focus on housing loans only however, the HFCs offering home loans along with other related products would now be required to maintain the principality of individual housing loans. Further, the requirement of minimum concentration towards ‘individuals’ is a new concept and possibly to protect the HFCs from systemic exposures. Though the guidelines do not intend to prohibit the HFCs from providing non-housing loans, however, it limits the same. The remaining 50% can be extended in the form of non-housing loans, including LAP. An HFC which falls short of such qualifying asset criteria has to get registration as NBFC-ICC and consequentially, all laws applicable to such NBFC-ICC shall apply to the HFC.
Classifying HFCs into SIs and NSIs
At present, HFC regulations are common for all HFCs irrespective of their asset size and ownership. It is proposed to issue HFC regulations by classifying them as systemically important and non-systemically important.
- Non-deposit taking HFCs (HFC-ND) with asset size of ₹500 crore & above and all deposit taking HFCs (HFCD), irrespective of asset size, will be treated as systemically important HFCs-
- The larger HFCs may continue with existing regulations under NHB regulations or be harmonised with NBFC-SI regulations
- However, there are separate regulations for deposit taking NBFCs which might become applicable on deposit taking HFCs as well
- Non-deposit taking HFCs with asset size below ₹500 crore will be treated as non-systemically important HFCs (HFC-non-SI)-
- For the non-systemically important HFCs, it is proposed to bring the regulations at par with Master Directions for NBFC-ND-non-SI
The existing regulations for HFCs are similar to NBFCs. The intention is to bring the non-systemically important HFCs at par with NBFC-NSI and hence, the applicability of the existing Master Directions for NBFC-ND-NSI can be extended to HFC-non-SI as well.
Minimum Net Owned Fund (NOF)
It is proposed to increase the minimum NOF for HFCs from the current requirement of ₹10 crore to ₹20 crore. For existing HFCs the glide path would be to reach ₹15 crore within 1 year and ₹20 crore within 2 years.
The increased capital requirement is to strengthen the capital base of the HFCs. However, as compared to an NBFC the NOF requirement is very high. The registration requirement for both NBFC-ICC and HFC will also be the same, since both will have to apply to the RBI.
An important question that will arise here is that why should an entity register as an HFC- given the fact that even an NBFC-ICC can extend housing loan, one would have to consider the various factors to carry on housing finance as a principle activity under an HFC or non-principal activity under an NBFC-ICC. As per the provisions of section 29A and 2(d) of the NHB Act (mentioned earlier) read along with the RBI guidelines issued in this regard, an HFC will have to satisfy the principality of 50% housing loans as well as 75% loans to individuals.
In order to address concerns on double financing due to lending to construction companies in the group and also to individuals purchasing flats from the latter, it is proposed to provide the option to the concerned HFC to choose to lend only at one level. The proposition is that 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 language of the notification is not very clear that it is referring to internal group or external group as well, however, it seems that the restriction should not be just for internal group but also for external group.
In case the HFC decides to take any exposure in its group entities (lending and investment) directly or indirectly, such exposure cannot be more than
- 15 per cent of owned fund for a single entity in the group and
- 25 per cent of owned fund for all such group entities.
The aforesaid limit on ‘Group Exposure’ seems to include both housing and non-housing loans to such group entity. Also, the limits are more stringent than the existing concentration norms, which provide the limit for lending and investment of upto 25% of the owned fund to a single party and 40% of its owned fund to a single group of parties. There is an exemption in the existing concentration norms for investment and lending to group companies to the extent it has been reduced from the owned funds. Hence, the limit of 15% and 25% may not be relevant if the HFC has already knocked off the exposure from its owned funds. This must be clarified by the RBI.
Since, the intent is to stop double finance that is to say ongoing exposure should not be there on both- in case funding has been extended to the builder then already the flat is funded, however, after construction once the loan is repaid by the builder, the individual may be given loan for the flat- this should not be regarded as double financing.
As regards to extending loans to individual, it is required that the HFC must satisfy the arms’ length requirement for retail loans to group’s customers. However, this mutual exclusion clause does not seems to apply to companies outside group and their retail customers – but in case the intent is to bar double financing, the external group companies must also be included.
In case of NBFCs, no foreclosure charges/pre-payment penalties is levied on any floating rate term loan sanctioned for purposes other than business to individual borrowers with or without co-obligors.
In case of HFCs, the foreclosure penalty is waived off in case of housing loans depending on the category of borrower and the source of funds for prepayment. The probable scenarios are provided herein below:
|Rate of Interest||Borrower/ Co-borrower||Source of pre-closure funding||Levy of foreclosure
/ prepayment penalty
|Individual||Own source **||No|
|HUF/Sole Proprietor/Company/Firm||Own source **||No|
|Floating||Individual||Own source **||No|
|HUF/Sole Proprietor/Company/Firm||Own source **||Yes|
|Dual Rate/ Special Rate
(Combination of fixed and floating)
|Individual||Own source **||Pre-closure norms applicable to fixed/floating rate shall apply depending on whether at the time of pre-closure, the loan is on fixed or floating rate.
|HUF/Sole Proprietor/Company/Firm||Own source **|
*Fixed rate loan is one where the rate is fixed for the entire tenure of the loan.
**The expression “own sources” for the purpose means any source other than by borrowing from a bank/HFC/NBFC and/or a financial institution.
There are no regulations prescribed for HFCs for not levying the foreclosure charge for non-housing loans such as in case of term loans availed for other than business purpose. Hence, it is proposed to extend these instructions to HFCs as well. This would ensure uniformity with regard to repayment of various term loans by borrowers. Though the language is not very clear and hence, it seems that the foreclosure charges shall be waived off for all floating rate term loans to individual borrowers, including housing loans as well.
Other provisions to be made applicable to HFCs
- It is proposed to align the definitions of capital (both Tier I and Tier II) of HFCs with that of NBFCs. It is proposed to align the definitions of capital (both Tier I and Tier II) of HFCs with that of NBFC, specifically PDIs shall form part of HFCs capital (both Tier I and Tier II) component on the same lines as NBFCs. However, with the following differences-
- PDIs shall be treated as Tier I/ Tier II capital only by HFCs-ND-SI
- PDIs or any other debt capital instrument in the nature of PDIs already issued by HFCs-D and HFCs-non-SI shall be reckoned as Tier I/Tier II for a period not exceeding 3 year
Further, since HFCs are treated as a category of NBFCs for regulatory purposes, investments in shares of other HFCs and also in other NBFCs (whether forming part of group or not), shall be reduced from the Tier I capital to the extent it exceeds, in aggregate along with other exposures to group companies, ten per cent of the owned fund of HFC.
- It is proposed to align the definition of public deposit as given under RBI Master Direction with an addition that any amount received by HFCs from NHB or any public housing agency shall also be exempt from the definition of public deposit.
- It is proposed to extend the Liquidity Risk Management (LRM) guidelines to all non-deposit taking HFCs with asset size of ₹100 crore & above and all deposit taking HFCs. There is however, no mention about the applicability of LCR framework. It seems that the same shall also be extended to HFCS with asset size of ₹5000 crore or more in a phased manner. The LRM framework was recently introduced for NBFCs in November, 2019 and the extension to HFCs would require similar actionable.
- It is proposed to make the fraud reporting directions applicable to HFCs in place of present guidelines issued by NHB. However, the reporting requirement shall continue to be submitted to the NHB itself. The limits for quarterly review by Audit Committee would also be revised to that applicable on NBFCs, that is, ₹1crore as against the existing ₹50 lacs for HFCs.
- It is proposed that the Information Technology (IT) Framework for NBFCs shall be extended to HFCs and the existing guidelines issued by NHB in this regard would be withdrawn. The existing IT framework for HFCs were categorised into two parts- for public deposit accepting HFCs and HFCs not accepting public deposit with asset size Rs. 100 crore and above; and for HFCs not accepting public deposit with asset size below Rs. 100 crore. However, the proposed applicability of IT framework would be on the basis of classification as systemically important or non-systemically important HFC.
- It is proposed to bring all HFCs (systemically important and non-systemically important) under the ambit of guidelines on securitisation transaction as applicable to NBFCs, which is proposed to undergo amendments. In the absence of any specific guidelines, the HFCs were already complying with the RBI guidelines on securitization and direct assignment. This would avoid any confusion in terms of the applicability of the securitisation guidelines.
- It is proposed to extend instructions applicable to NBFCs to lend against the collateral of listed shares to HFCs as well, who do not have any guidelines in this regard at present.
- It is proposed to extend the guidelines with regard to outsourcing of Financial Services for NBFCs, to all HFCs.
- It has been proposed that the RBI instructions on Implementation of Indian Accounting Standards will be extended to HFCs. The RBI circular was applicable to NBFCs as covered in rule 4 of the Companies (Indian Accounting Standards) Rules, 2015 which already includes HFCs under the definition of NBFCs. However, there was confusion wrt its applicability on HFCs. The proposed change further clarifies the applicability of the said RBI circular to HFCs.
Harmonizing the regulations
There are certain major differences between extant regulations of the HFCs and that for NBFCs. It is being proposed to harmonise these regulations in a phased manner over a period of two to three years:
- Capital requirements (CRAR and risk weights)
The minimum CRAR prescribed for HFCs currently is 12% and which was to be progressively increased to 14% by March 31, 2021 and to 15% by March 31, 2022. Further, the risk Review of extant regulatory framework for Housing Finance companies (HFCs) weights for assets of HFCs are in the range of 30% to 125% based on asset classification, LTV, type of borrower, etc. However, for NBFCs, the minimum CRAR is 15% and risk weights are broadly under 0%, 20% and 100% categories.
- Income Recognition, Asset Classification and Provisioning (IRACP) norms
The major differences in provisioning norms applicable to standard, substandard and doubtful assets in HFCs’ books. In case of standard loans, the HFCs are required to create a provision ranging from 0.4% to 2% and for substandard the requirement is 15%, whereas, in case of NBFC-ND-SI, the provision is 0.4% for standard and 10% for sub-standard.
- Norms on concentration of credit / investment
The credit concentration norms for NBFCs and HFCs are similar. NBFCs enjoy certain exceptions in this regard which was also introduced for HFCs in 2018.
- Limits on exposure to Commercial Real Estate (CRE) & Capital Market (CME)
The limits prescribed for HFCs for exposure to CRE by way of investment in land & building shall not be more than 20% of capital fund and for CME shall not be more than 40% of net worth total exposure of which direct exposure should be 20% of net worth. However, there are no limits prescribed for NBFCs.
- Regulations on acceptance of Public Deposits
- Period of public deposit (12 months to 120 months for HFCs against 12 months to 60 months for NBFCs),
- Ceiling on quantum of deposit (3 times of NOF for HFCs against 1.5 times for NBFCs with minimum investment grade rating),
- Interest on premature repayment of deposits (ranging from 1% to 4% below prescribed rate for HFCs as against 2% to 3% below prescribed rate for NBFCs depending upon duration and prescription of rate),
- Maintenance of liquid assets (13% for HFCs against 15% for NBFCs), etc.
Though HFCs are now another form of NBFCs, the RBI draft proposes to carve out a slightly separate set of rules for the HFCs in certain cases. Further, the proposed harmonisation of regulations will be done over a period of two years and till such time the HFCs will follow the extant NHB norms. Thus enabling the HFCs a breather period and to ensure seamless transition.
Other relevant articles-
 Our snapshot on the same can be read here- https://vinodkothari.com/wp-content/uploads/2019/11/Liquidity-risk-framework.pdf
A point by point comparative of the existing in proposed guidelines may be viewed here:
-by Smriti Wadehra
-Updated as on 29th September, 2020
Pursuant the proposal of Union Budget of 2019-20, the MCA vide notification dated 16th August, 2019 amended the provisions of Companies (Share Capital and Debentures) Rules, 2014 .(You may also read our analysis on the notification at Link to the article) The said amended Rules faced a lot of apprehensions, especially, from the NBFCs as the notification which was initially expected to scrap off the requirement of creation of DRR for publicly issued debentures had on the contrary, rejuvenated a somewhat settled or exempted requirement of creation of debenture redemption fund as per Rule 18(7) for NBFCs as well.
As per the notification, the Ministry imposed the requirement for parking liquid funds, in form of a debenture redemption fund (DRF) to all bond issuers except unlisted NBFCs, irrespective of whether they are covered by the requirement of DRR or not. In this regard, considering the ongoing liquidity crisis in the entire financial system of the Country, parking of liquid funds by NBFCs was an additional hurdle for them.
Creation of DRR is somewhat a liberal requirement than creation of DRF, this is because, where the former is merely an accounting entry, the latter is investing of money out of the Company. Further, the fact the notification dated 16th August, 2019 casted exemption from the former and not from the latter, created confusion amidst companies. The whole intent of amending the Rule was to motivate NBFCs to explore bond markets, however, the requirement of parking liquid funds outside the Company as high as 15% of the amount of debentures of the Company was acting as a deterrent for raising funds by the NBFCs.
Considering the representations received from various NBFCs and the ongoing liquidity crunch in the economy of the Country along with added impact of COVID disruption, the Ministry of Corporate Affairs has amended the provisions of Rule 18 of Companies (Share Capital and Debenture) Rules, 2014 vide notification dated 5th June, 2020 to exempt listed companies coming up with private placement of debt securities from the requirement of creation of DRF.
What is DRR and DRF?
Section 71(4) read with Rule 18(1)(c) of the Companies (Share Capital and Debentures) Rules, 2014 requires every company issuing redeemable debentures to create a debenture redemption reserve (“referred to as DRR”) of at least 25%/10% (as the case maybe) of outstanding value of debentures for the purpose of redemption of such debentures.
Some class of companies as prescribed, has to either deposit, before April 30th each year, in a scheduled bank account, a sum of at least 15% of the amount of its debentures maturing during the year ending on 31st March of next year or invest in one or more securities enlisted in Rule 18(1)(c) of Debenture Rules (‘referred to as DRF’).
The notification has mainly exempted two class of companies from the requirement of creation of DRF:
- Listed NBFCs registered with RBI under section 45-IA of the RBI Act, 1934 and for Housing Finance Companies registered with National Housing Bank and coming up with issuance of debt securities on private placement basis.
- Other listed companies coming up with issuance of debt securities on private placement basis.
However, the unlisted non-financial sector entities have been left out. In a private placement, the securities are issued to pre-selected investors. Raising debt through private placement is a midway between raising funds through loan and debt issuances to public. Like in case of bilateral loan arrangements, but unlike in case of public issue, the investors get sufficient time to assess the credibility of the issuer in private placements, since the investors are pre-identified.
The intent behind DRF is to protect the interests of the investors, usually when retail investors are involved, with respect to their claims on maturity falling due within a span of 1 year. This is not the case for investors who have invested in privately placed securities, where the investments are made mostly by institutional investors.
Further, companies chose issuance through private placement for allotment of securities privately to pre-identified bunch of persons with less hassle and compliances. Hence, the requirement of parking funds outside the Company frustrates the whole intent.
Further, it is a very common practice to roll-over the bond issuances, hence, it is not that commonly bonds are repaid out of profits; the funds are raised from issuance of another series of securities. This is a corporate treasury function, and it seems very unreasonable to convert this internal treasury function to a statutory requirement.
Though, in our view, the relaxation provided in case of private issuance of debt securities is definitely a relief, especially during this hour of crisis, but we are not clear about the logic behind excluding unlisted non-financial sector entities.
Even though, the financial sector (76%) entities dominate the issuance of corporate bonds, however, the share of the non-financial sector entities (24%) is not insignificant. Therefore, ideally, the exemption in case of private placements should be extended to unlisted non-financial sector entities as well.
A brief analysis of the amendments is presented below:
Pursuant to the MCA notification dated 16th August, 2019, the below mentioned class of companies were required to either deposit or invest atleast 15% of amount of debentures maturing during the year ending on 31st March, 2020 by 30th April, 2020. This has been extended till 31st December, 2020 for this FY 2019-20 by MCA due to the COVID-19 outbreak. However, pursuant to the amendment introduced by MCA notification dated 5th June, 2020 the status of DRF requirement stands as amended as follows:
|Particulars||DRF requirement as MCA circular dated 16th August, 2019||DRF requirement as per MCA circular dated 5th June, 2020|
|Listed NBFCs which have issued debt securities by way of public issue||Yes.||Yes. Deposit or invest before 31st December, 2020|
|Listed NBFCs which have issued debt securities by way of private placement||Yes||Not required as exempted.|
|Listed entities other than NBFC which have issued debt securities by way of private placement||Yes||Not required as exempted|
|Listed entities other than NBFC which have issued debt securities by way of public issue||Yes||Yes. Deposit or invest before 31st December, 2020|
|Unlisted companies other than NBFC||Yes.||Yes. Deposit or invest before 31st December, 2020|
Please note that the aforesaid shall be applicable from 12th June, 2020 i.e. the date of publication of the notification in the official gazette. In this regard, if for instance companies which have been specifically exempted pursuant to the recent notification, have already invested or deposited their funds to fulfil the DRF requirement may liquidated the funds as they are no longer statutorily require to invest in such securities.
Synopsis of DRR and DRF provisions
A brief analysis of the DRR and DRF provisions as amended by the MCA notification dated 16th August, 2019 and 5th June, 2020 has been presented below:
|Sl. No.||Particulars||Type of Issuance||DRR as per erstwhile provisions||DRR as per amended provisions||DRF as per erstwhile provisions||DRF as per amended provisions|
|1.||All India Financial Institutions||Public issue/private placement||×||×||×||×|
|2.||Banking Companies||Public issue/private placement||×||×||×||×|
|Listed NBFCs registered with RBI under section 45-IA of the RBI Act, 1934 and HFC registered with National Housing Bank||Public issue||√
25% of value of outstanding debentures
|4.||Unlisted NBFCs registered with RBI under section 45-IA of the RBI Act, 1934 and HFC registered with National Housing Bank||Private Placement||
|Other listed companies||Public Issue||√
25% of value of outstanding debentures
25% of value of outstanding debentures
|6.||Other unlisted companies||Private Placement||√
25% of value of outstanding debentures
10% of the value of outstanding debentures
 This table includes analysis of provisions of DRR and DRF as per CA, 2013 and amendments introduced vide MCA notification dated 16th August, 2019 and 5th June, 2020.
Erstwhile provisions- Provisions before amendment vide MCA circular dated 16th August, 2019
Amended provisions- Provisions after including amendments introduced vide MCA circular 5th June, 2020
-Financial Services Division (email@example.com)
The Finance Minister has, in the month of May, 2020, announced a slew of measures as a part of the economic stimulus package for self-reliant India. Among various schemes introduced in the package, one was the Emergency Credit Line Guarantee Scheme (ECLGS, ‘Scheme’), which intends to enable the flow of funds to MSMEs. This is the so-called Rs 300000 crore scheme. The scheme was further amended on 4th August 2020 for widening the scope of the said scheme
Under this Scheme the GoI, through a trust, will guarantee loans provided by banks and Financial Institutions (FIs) to Individuals MSMEs and MUDRA borrowers. The Scheme aims to extend additional funding of Rs. 3 lakh crores to eligible borrowers in order to help them through the liquidity crunch faced by them due to the crisis.
Based on the information provided by the Finance Minister about this Scheme, the press release issued in this regard and the operating guidelines scheme documents issued subsequently, we have prepared the below set of FAQs. There is also a set of FAQs prepared by NCGTC – we have relied upon these as well.
In brief, the Guaranteed Emergency Line of Credit [GECL] is a scheme whereby a lender [referred to as Member Lending Institution or MLI in the Scheme] gives a top-up loan of 20% of the outstanding facility as on 29th February, 2020. This top up facility is entirely guaranteed by NCGTC. NCGTC is a special purpose vehicle formed in 2014 for the purpose of acting as a common trustee company to manage and operate various credit guarantee trust funds.
[Vinod Kothari had earlier recommended a “wrap loan” for restarting economic activity – http://vinodkothari.com/2020/04/loan-products-for-tough-times/. The GECL is very close to the idea of the wrap loan.]
Essentially, the GECL will allow lenders to provide additional funding to business entities and individual businessman. The additional funding will run as a separate parallel facility, along with the main facility. The GECL loan will have its own term, moratorium, EMIs, and may be rate of interest as well. Of course, the GECL will share the security interest with the original facility, and will rank pari passu, with the main facility, both in terms of cashflows as in terms of security interest.
The major questions pertaining to the GECL are going to be about the eligible borrowers to whom GECL may be extended, and the allocation of cashflows and collateral with the main facility. Operationally, issues may also centre round the turnaround time, after disbursement, for getting the guarantee cover, and whether the guarantee cover shall be in batch-processed, or processed loan-by-loan. Similarly, there may be lots of questions about how to encash claims on NCGTC.
Eligible Lenders and eligible borrowers
- What is the nature of GECL?
The GECL shall be an additional working capital term loan (in case of banks and FIs), and additional term loan (in case of NBFCs) provided by the MLIs to Eligible Borrowers. The GECL facility may run upto 20% of the loan outstanding on 29th February, 2020.
The meaning of “working capital term loan” is that the amount borrowed may be used for general business purposes by the borrower.
- Who are the MLIs/eligible lenders under the Scheme?
For the purpose of the Scheme MLIs/eligible lenders include:
- All Scheduled Commercial Banks. Other banks such as RRBs, co-operative banks etc. shall not be eligible lenders.
- Financial Institutions (FIs), defined under section 45-I(c) of the RBI Act, 1934. The term all-India Financial Institutions” now includes Exim Bank, NABARD, SIDBI and NHB, none of which are extending primary loans. Hence, the term “financial institutions” as per sec. 45I (c) of the RBI Act will essentially refer to NBFCs, covered below..
III. Non-Banking Financial Companies (NBFCs), registered with the RBI and which have been in operation for a period of 2 years as on 29th February, 2020.
- What is the meaning of NBFC having been in operation for 2 years? Are we referring to 2 years from the date of incorporation of the Company, or 2 years from the date of getting registration with the RBI as an NBFC, or 2 financial years?
The language of the scheme indicates that the NBFC must be in operation for 2 years (and not financial years) as on 29th February, 2020. Thus, the period of 2 years shall be counted from the starting of operations after getting registration as an NBFC.
Usually, the RBI while granting registration requires the NBFC to start operations within a period of six months of getting registration. It also requires the NBFC to intimate to RBI that it has commenced operations. Logically, the 2 years’ time for starting of operations should be read from the date of commencement of operations
- Does the NBFC have to be a systemically important company? Or any NBFC, whether SI or not, will qualify?
The asset size of the NBFC would not matter. The NBFC must only hold a valid certificate of registration issued by RBI in order to be eligible under the scheme (and in operation for 2 years). Thus, whether SI or not, any NBFC will qualify.
- Is it necessary that the NBFC must be registered with the RBI?
Yes, the eligibility criteria specifically requires the NBFC to be registered.
- Will the following qualify as MLIs?
- HFCs: HFCs fall under the definition of financial institutions provided under the eligibility criteria for lenders. While HFCs essentially grant home loans, HFCs are permitted to have other types of loans within a limit of 50% of their assets. Hence, if the HFC has facilities that qualify for the purpose of the Scheme, an HFC will also qualify as MLI. This is further clarified in the FAQs 44 as well.
- MFIs: MFIs are a class of NBFCs and thus, eligible as MLIs. However, it is to be seen if the nature of loans granted by the MFI will be eligible for the purpose of the Scheme.
- CICs: CICs again are a class of NBFCs and thus, eligible as MLIs. However, they can grant loans to their group companies only.
- Companies giving fin-tech credit to consumers: The nature of the loan will mostly be by way of personal loans or consumer credit. While the lender may qualify, but the facility itself may not.
- Gold loan companies: Mostly, the loan is a personal loan and does not relate to a business purpose. Hence, the loan will not qualify.
- Is it possible for a bank to join as co-lender in case of a loan given by an NBFC? To be more precise, the primary loan is on the books of the NBFC. Now, the NBFC wants to give the GECL facility along with a bank as a co-lender. Is that possible?
In our view, that should certainly be possible. However, in our view, in that case, the rate of interest charged to the borrower should be the blended rate considering the interest rate caps for the bank [9.25%] and the NBFC [14%].
- Who are the eligible borrowers (Eligible Borrower or Borrower)?
The Eligible Borrowers shall be entities/individuals fulfilling each of the following features :
- Nature of the activity/facility: Our understanding is that Scheme is meant only for business loans. Hence, the nature of activity carried by the entity must be a business, and the facility must be for the purpose of the business.
- Scale of business: Business enterprises /MSMEs. The term MSME has a wide definition and we are of the view that it is not necessary for the borrower to be registered for the purpose of MSME Development Act. Please see our detailed resources on the meaning of MSMEs here: http://vinodkothari.com/2020/05/resources-on-msme/.In addition, the word “business enterprises” is also a wide term – see below.
- Existing customer of the MLI: The borrower must be an existing customer of the MLI as on 29th Feb., 2020. That is, there must be an existing facility with the borrower.
- Size of the existing facility: The size of the existing facility, that is, the POS, as on 29th Feb. 2020, should be upto Rs 50 crores.
- Turnover for FY 2019-20: The turnover of the Eligible Borrower, for financial year 2019-20, should be upto Rs 250 crores. In most cases, the financial statements for FY 2019-20 would not have been ready at the time of sanctioning the GECL. In that case, the MLI may proceed ahead based on a borrower’s declaration of turnover.
- GST registration: Wherever GST registration is mandatory, the entity must have GST registration.
- Performance of the loan: As on 29th Feb., 2020, the existing facility must not be more than 59 DPD.
- Further, Business Enterprises / MSMEs/Individuals would include loans covered under Pradhan Mantri Mudra Yojana extended on or before 29.2.2020, and reported on the MUDRA portal. All eligibility conditions including the condition related to Days past due would also apply to PMMY loans.
- Who are eligible Mudra borrowers?
Mudra borrowers are micro-finance units who have availed of loans from Banks/NBFCs/MFIs under the Pradhan Mantri Mudra Yojna (PMMY) scheme.
- Do Eligible Borrowers have to have any particular organisational form, for example, company, firm, proprietorship, etc?
No. There is no particular organisational form for the Eligible Borrower. It may be a company, firm, LLP, proprietorship, etc.
Note that the Scheme initially used the expression: “all Business Enterprises / MSME institution borrower accounts”. From the use of the words “business enterprises” or “institution borrower account”, it was contended that individuals are excluded. In Para 7 of the Operational Guidelines on the website of NCGTC, it mentioned that “Loans provided in individual capacity are not covered under the Scheme”. However, the very same para also permitted a business run as a proprietorship as an eligible case of business enterprise.
Hence, there was a confusion between a business owned/run by an individual, and a loan taken in individual capacity. The latter will presumably mean a loan for personal purposes, such as a home loan, loan against consumer durables, car loan or personal loan. As opposed to that, a loan taken by a business, even though owned by an individual and not having a distinctive name than the individual himself, cannot be regarded as a “loan provided in individual capacity”.
For instance, many SRTOs, local area retail shops etc are run in the name of the proprietor. There is no reason to disregard or disqualify such businesses. It is purpose and usage of the loan for business purposes that matters.
To ensure clarity, the revised operational guidelines include business loans taken by individuals for their own businesses in the ambit of scheme, Further, individual would be required to fulfil eligibility criteria for the borrower.
- What is the meaning of the term “business enterprise” which is defined as one of the Eligible Borrowers?
The term “ business enterprise” has been used repetitively in the Scheme, and is undefined. In our view, its meaning should be the plain business meaning– enterprises which are engaged in any business activity. The word “business activity” should be taken broadly, so as to give an extensive and purposive interpretation to fulfil the intent of the Scheme. Clearly, the Scheme is intended to encourage small businesses which are the backbone of the economy and which may help create “self reliant” India.
Having said this, it should be clear that the idea of the Scheme is not to give loans for consumer durables, personal use vehicles, consumer loans, personal loans, etc. While taking the benefit of the Scheme, the MLI should bear in mind that the intent of the lending is to spur economic activity. There must be a direct nexus between the granting of the facility and economic/business activity to be carried by the Eligible Borrower.
- One of the Eligible Borrowers is an MSME. Is it necessary that the entity is registered i.e. has a valid Udyog Aadhaar Number, as required under the MSMED Act?
The eligibility criteria for borrowers does not specifically require the MSMEs to be registered under the MSMED Act. Thus, an unregistered MSME may also be an Eligible Borrower under the scheme.
- For the borrowers to give a self-declaration of turnover for FY 2019-20, is there a particular form of declaration?
There is no particular form. However, we suggest something as simple as this:
To whomsoever it may concern
Sub: Declaration of Turnover
I/ We………………………………….. (Name of Authorized Signatory), being ……………………..(Designation) of …………………………………………………. (Legal Name as per PAN) do hereby state that while the financial statements for the FY 2019-20 have not still been prepared or finalised, based on our records, the turnover of the abovementioned entity/unit during the FY 2019-2 will be within the value of Rs 250 crores.
Signed …………. Date:…………………
- One of the important conditions for the Eligible Borrower is that the Borrower must not be an NPA, or SMA 2 borrower. For finding the DPD status of the existing facility, how do we determine the same in the following cases?
- My EMIs are due on 10th of each month. On 10th Feb., 2020, the borrower had two missing EMIs, viz., the one due on 10th Jan. 2020 and the one due on 10th Feb., 2020. Is the Borrower an Eligible Borrower on 29th Feb., 2020?
The manner of counting DPD is – we need to see the oldest of the instalments/ principal/interest due on the reckoning date. Here, the reckoning date is 29th Feb. On that date, the oldest overdue instalment is that of 10th Jan. This is less than 59 DPD. Hence, the borrower is eligible.
- My EMIs are due on the 1st of each month. The borrower has not paid the EMIs due on 1st Jan. and 1st Feb., 2020. Is the Borrower an Eligible Borrower on 29th Feb., 2020?
On the reckoning date, the oldest instalment is that of 1st Jan. 2020. Since the reckoning date is 29th Feb., we will be counting only one two dates – 1st Jan and 29th Feb. The time lag between the two adds to exactly 59 days. The borrower becomes ineligible if the DPD status is more than 59 days. Hence, the borrower is eligible.
- Is the Scheme restrictive as to the nature of the existing facility? Can the GECL be different from the existing facility?
It does not seem relevant that the GECL should be of the same nature/type or purpose as the primary facility. We have earlier mentioned that the purpose of the GECL is to support the business/economic activity of the borrower.
However, there may be issues where the existing facility itself would not have been eligible for the Scheme. For instance, if the existing facility was a car loan to a business entity (say, an MSME), can the GECL be eligible if the same is granted for working capital purposes? Intuitively, this does not seem to be covered by the Scheme. Once again, the intent of the Scheme is to provide “further” or additional funding to a business. Usually, the so-called further or additional funding for a business may come from a lender who had facilitated business activity by the primary facility.
Hence, in our view, the primary as well as the GECL facility should be for business purposes.
- Is there a relevance of the residual tenure of the primary facility? For example, if the primary facility is maturing within the next 6 months, is it okay for the MLI to grant a GECL for 4 years?
There does not seem to be a correlation between the residual term of the primary facility and the tenure of the GECL facility. The GECL seems to be having a term of 4 years, irrespective of the original or residual term of the primary facility.
Of course, the above should be read with our comments above about the primary facility as well as the GECL to be for business purposes.
- A LAP loan was granted to a business entity/Individual. The loan was granted against a self-owned house, but the purpose of the loan was working capital for the retail trade business carried by the borrower. Will this facility be eligible for GECL?
Here, the purpose of the loan, and the nature of collateral supporting the loan, are different, but what matters is the end-use or purpose of the loan. The collateral is a self-occupied house. But that does not change the purpose of the loan, which is admittedly working capital for the retail trade activity.
Hence, in our view, the facility will be eligible for GECL, subject to other conditions being satisfied.
- I have an existing borrower B, who is a single borrower as on 29th Feb 2020. I now want to grant the GECL loan to C, who would avail the loan as a co-borrower with B. Can I lend to B and C as co-borrowers?
It seems that even loans extended to co-obligors or co-applicants also qualify.
We may envisage the following situations:
- The primary facility was granted to B and C. B is an Eligible Borrower. The GECL is now being granted to B and C. This is a good case for GECL funding, provided B remains the primary applicant. In co-applications, the co-borrowers have a joint and several obligations, and the loan documentation may not make a distinction between primary and secondary borrower. However, one needs to see the borrower who has utilised the funding.
- The primary facility was granted to B who is an Eligible Borrower. The GECL is now being granted to B and C. This is a good case for GECL funding if B is the primary applicant. See above for the meaning of “primary” applicant.
- The primary facility was granted to B, who is a director of a company, where C, the company, joined as a co-applicant. C is an Eligible Borrower. The GECL is now being granted to C. This is a good case for GECL funding since the GECL funding is to C and C is an Eligible Borrower.
- When can GECL be sanctioned? Is there a time within which the GECL should be sanctioned?
The Scheme shall remain in operation till 31st October, 2020, or till such time as the maximum amount of loans covered by NCGTC reaches Rs 300000 crores. Accordingly, it can be inferred that the GECL must be sanctioned during the period of the operation of Scheme, that is during the period from May 23, 2020 to 31st October, 2020, or till an amount of Rs. 3 lakh crore is sanctioned under GECL, whichever is earlier.
- How can an MLI keep track of how much is the total amount of facilities guaranteed by NCGTC?
Understandably, there may be mechanisms of either dissemination of the information by NCGTC, or some sort of a pre-approval of a limit by NCGTC.
- Whether the threshold limit of outstanding credit of Rs. 50 crores, will have to be seen across all the lenders, the borrower is currently dealing with, or with one single lender?
The Scheme specifically mentions that the limit of Rs. 50 crores shall be ascertained considering the borrower accounts of the business enterprises/MSMEs with combined outstanding loans across all MLIs. For the purpose of determining whether the combined exposure of all MLIs is Rs 50 crores or not, the willing MLI may seek information about other loans obtained by the borrower.
- For the threshold limit of outstanding credit of Rs. 50 crores, are we capturing only eligible borrowings of the borrower, or all debt obligations?
Logically, all business loans, that is, loans/working capital facilities or other funded facilities availed for business purposes should be aggregated. For instance:
- Unfunded facilities, say, L/Cs or guarantees, do not have to be included.
- Non-business loans, say, car loans, obtained by the entity do not have to be included as the same are not for business purposes.
- What is the meaning of MSME? Is it necessary that the Eligible Borrower should be meeting the definition of MSME as per the Act?
The Scheme uses the term MSME, but nowhere has the Scheme made reference to the definition of MSME under the MSMED Act, 2006. Therefore, it does not seem necessary for the Eligible Borrower to have registration under the MSMED Act. Further, even if the entity in question is not meeting the criteria of MSME under the Act, it may still be satisfying the criteria of “business enterprise” with reference to turnover and borrowing facilities. Hence, the reference to the MSMED Act seems unimportant.
However, for the purpose of ease of reference, we are giving below the meaning of MSME as per the definition of MSMEs provided in the MSMED Act, 2006 (‘Act’):
|Enterprise||Manufacturing sector [Investment in plant and machinery (Rs.)]||Service sector [Investment in equipment (Rs.)]|
|Small||Not exceeding 25 lakhs||Not exceeding 10 lakhs|
|Micro||Exceeding 25 lakhs but does not exceed 5 crores||Exceeding 10 lakhs but does not exceed 2 crores|
|Medium||Exceeding 5 crores but not exceeding 10 crores||Exceeding 2 crores but does not exceed 5 crores|
The above definition has been amended by issue of a notification dated June 1, 2020. As per the amendment such revised definition shall be applicable with effect from July 01, 2020. Accordingly, w.e.f. such date, following shall be the definition of MSMEs:
|Enterprise||Investment in plant and machinery or equipment (in Rs.)||Turnover (in Rs.)|
|Micro||Upto 1 crore||Upto 5 crores|
|Small||Upto 10 crores||Upto 50 crores|
|Medium||Upto 50 crores||Upto 250 crores|
- The existing schemes laid down by the CGTMSE, CGS-I and CGS-II, cover the loans extended to MSE retail traders. Will the retail traders be eligible borrowers for this additional facility?
The Scheme states that a borrower is eligible if the borrower has –
(i) total credit outstanding of Rs. 50 Crore or less as on 29th Feb 2020;
(ii) turnover for 2019-20 was upto Rs. 250 Cr;
(iii) The borrower has a GST registration where mandatory.
Udyog Aadhar Number (UAN) or recognition as MSME is not required under this Scheme.
Hence, even retail traders fulfilling the eligibility criteria above would be eligible under the scheme.
- If the borrower does not have any existing credit facility as on 29th February, 2020, will it still be able to avail fresh facility(ies) under this Scheme?
Looking at the clear language of the Scheme, it seems that existence of an outstanding facility is a prerequisite to avail credit facility under the Scheme. The intent of the Scheme is to provide additional credit facility to existing borrowers.
- I have a borrower to whom I have provided a sanction before 29th February, 2020; however, no disbursement could actually take place within that date. Will such a borrower qualify for the Scheme?
Since the amount of GECL is related to the POS as on 29th Feb., 2020, there is no question of such a borrower qualifying.
- The Scheme seems to refer to the facility as a “working capital term loan” in case of banks/FIs and “additional term loan” in case of NBFCs. Does that mean the MLIs cannot put any end-use restrictions on utilisation of the facility by the Eligible Borrowers?
It is counter-intuitive to think that the MLI cannot put end-use restrictions. Ensuring that the funds lent by the MLI are used for the purpose for which the facility has been extended is an essential prudential safeguard for a lender. It should be clear that the additional facility has been granted for restarting business, following the disruption caused by the COVID crisis. There is no question of the lender permitting the borrower to use the facility for extraneous or irrelevant purposes.
Terms of the GECL Facility
- What are the major terms of the GECL Facility?
The major terms are as follows:
- Amount of the Facility: Up to 20% of the POS as on 29th Feb., 2020. Note that the expression “upto” implies that the MLI/borrower has discretion in determining the actual amount of top up funding, which may go upto 20%.
- Tenure of the Facility: 4 years. See below about whether the parties have a discretion as to tenure.
- Moratorium: 12 months. During the moratorium, both interest and principal will not be payable. Hence, the first payment due under the top up facility will be on the anniversary of the facility.
- Amortisation/repayment term: 36 months.
- Mode of repayment: While the Scheme says that the principal shall be payable in 36 installments, it should not mean 36 equal instalments of principal. The usual EMI, wherein the instalment inclusive of interest is equated, works well in the financial sector. Hence, EMI structure may be adopted. However, if the parties prefer equated repayment of principal, and the interest on declining balances, the same will also be possible. Note that in such case, the principal at the end of 12 months will have the accreted interest component for 12 months’ moratorium period as well.
- Collateral: The Scheme says that no additional collateral shall be asked for the purposes of the GECL. In fact, given the sovereign guarantee, it may appear that no additional collateral is actually required. [However, see comment below on dilution of the collateral as a result of the top-up funding].
- Rate of interest: The rate of interest is capped as follows – In case of banks/ – Base lending rate + 100 bps, subject to cap of 9.25% p.a. In case of NBFCs, 14% p.a.
- Processing/upfront fees: None
- As regards the interest rate, is it possible that the MLI has the benefit under any interest rate subvention scheme as well?
Yes. This scheme may operate in conjunction with any interest rate subvention scheme as well.
- Is the tenure of the GECL facility non-negotiably fixed at 4 years or do the parties have discretion with respect to the same? For example, if the borrower agrees to a term of 3 years, is that possible?
It seems that the Scheme has a non-negotiable tenure of 4 years. Of course, the Scheme document does say the parties may agree to a prepayment option, without any prepayment penalty. However, in view of the purpose of the Scheme, that is, to restart business activity in the post-COVID scenario, it does not seem as if the purpose of the Scheme will be accomplished by a shorter loan tenure.
- Is it possible for MLI to lend more than 20%, but include only 20% for the benefit of the guarantee?
Minus the Scheme, nothing stopped a lender from giving a top-up lending facility on a loan. Therefore, the wrapped portion of the GECL facility is 20% of the loan, but if the lender so wishes to give further loan, there is nothing that should restrain the lender from doing so.
- The Scheme document provides that the collateral for the primary loan shall be shared pari passu with the GECL facility. What does the sharing of the collateral on pari passu basis mean?
Para 11 of the Scheme document says: “…facility granted under GECL shall rank pari passu with the existing credit facilities in terms of cash flows and security”. The concept of pari passu sharing of the security, that is, the collateral, may create substantial difficulties in actual operation, since the terms of repayment of the primary facility and the GECL facility are quite divergent.
To understand the basic meaning of pari passu sharing, assume there is a loan of Rs 100 as on 29th Feb., 2020, and the MLI grants an additional loan of Rs 20 on 1st June, 2020. Assume that the value of the collateral backing the primary loan is Rs 125. As and when the GECL is granted, the value of this collateral will serve the benefit of the primary loan as well as the GECL facility. In that sense, there is a dilution in the value of the security for the primary loan. This, again, is illogical since the primary does not have a sovereign wrap, while the GECL facility has.
What makes the situation even worse is that due to amortizing nature of the primary loan, and the accreting nature of the GECL facility during the moratorium period, the POS of the primary facility will keep going down, while the POS of the GECL facility will keep going up. It may also be common that the primary facility will run down completely in a few months (say 2 years), while the GECL facility is not even half run-down. In such a situation, the benefit of the collateral will serve the GECL loan, in proportion to the amount outstanding of the respective facilities. Obviously, when the primary facility is fully paid down, the collateral serves the benefit of the GECL facility only.
- The Scheme provides that the primary facility and the GECL facility shall rank pari passu, in terms of cash flows. What is the meaning of pari passu sharing of cashflows?
The sharing of cashflows on pari passu basis should mean, if there are unappropriated payments made by the borrower, the payment made by the borrower should be split between the primary facility and the GECL facility on proportionate basis, proportional to the respective amounts falling/fallen due.
For instance, in our example taken in Q 15 above, assume the borrower makes a payment in the month of July 2020. The entire payment will be taken to the credit of the primary loan since the GECL loan is still in moratorium.
Say, in the month of July 2021, an aggregate payment is made by the borrower, but not sufficient to discharge the full obligation under the primary facility and the GECL facility. In this case, the payment made by the borrower will be appropriated, in proportion to the respective due amounts (that is, due for the month or past overdues) for the primary facility and the GECL facility.
- Given the fact that the payments for the GECL are still being collected by the MLI, who also has a running primary facility with the same borrower, is there any obligation on the part of the MLI to properly appropriate the payments received from the borrower between the primary and the GECL facility?
Indeed there is. The difficulty arises because there are two facilities with the borrower, one is naked, and the other one wrapped. The pari passu sharing of cashflows will raise numerous challenges of appropriation. Since the claim is against the sovereign, there may be a CAG audit of the claims settled by the NCGTC.
- The Scheme document says that the charge over the collateral has to be created within 3 months from the date of disbursal. What is the meaning of this?
If the existing loan has a charge securing the loan, and if the same security interest is now serving the benefit of the GECL facility as well, it will be necessary to modify the charge, such that charge now covers the GECL facility as well. As per Companies Act, the time for registration of a modification is thirty days, and there is an additional time of ninety days.
- Say the primary loan is a working capital loan given to a business and has a residual tenure of 24 months. The loan is secured by a mortgage of immovable property. Now, GECL facility is granted, and the same has a tenure of 48 months. After 24 months, when the primary loan is fully discharged, can the borrower claim the release of the collateral, that is, the mortgage?
Not at all. The grant of the GECL facility is a grant of an additional facility, with the same collateral. Therefore, until the GECL loan is fully repaid, there is no question of the borrower getting a release of the collateral.
- Should there be a cross default clause between the primary loan and the GECL loan?
In our view, the collateral is shared by both the facilities on pari passu basis. Hence, there is no need for a cross default clause.
- What are the considerations that should prevail with the borrower/MLI while considering the quantum of the GECL facility?
The fact that the GECL facility is 100% guaranteed by the sovereign may encourage MLIs to consider the GECL facility as risk free, and go aggressively pushing lending to their existing borrowers. However, as we have mentioned above, the pari passu sharing of the collateral results into a dilution of collateral for the primary facility. Hence, MLIs should use the same time-tested principles of lending in case of GECL as well – capacity, collateral, etc.
For the borrower as well, the borrower eventually has to pay back the loan. In case of NBFCs, the loan is not coming cheap – it is coming at a cost of 14%. While for the lender, the risk may be covered by the sovereign guarantee, the risk of credit history impairment for the borrower is still the same.
Hence, we suggest both the parties to take a considered call. For the lender, the consideration should still be the value of the collateral, considering the amount of the top up facility. In essence, the top up facility does not mechanically have to be 20% -the amount may be carefully worked out.
- Does the disbursal of the GECL facility have to be all in cash, or can it be adjusted partly against the borrower’s obligations, say for any existing overdues? Can it be partly given to MLI as a security deposit?
While the disbursal should appropriately be made by the MLI upfront, if the borrower uses the money to settle existing obligations with the MLI, that should be perfectly alright.
- In case the borrower has multiple loan accounts with multiple eligible lenders, how will such borrower avail facility under GECL?
It is clarified that a borrower having multiple loan accounts with multiple lenders can avail GECL. The GECL will have to be availed either through one lender or each of the current lenders in proportion depending upon the agreement between the borrower and the MLI.
Further, In case the borrower wishes to take from any lender an amount more than the proportional 20% of the outstanding credit that the borrower has with that particular lender, a No Objection Certificate (NOC) would be required from the lender whose share of ECLGS loan is proposed to be extended by a specific lender. Further, it would be necessary for the specific lender to agree to provide ECLGS facility on behalf of such of the lenders.
- The Scheme has consistently talked about an opt-out facility for the GECL scheme. What exactly is the meaning of the opt-out facility?
In our understanding, the meaning is, except for those borrowers who opt out of the facility, the lender shall consider the remaining borrowers as opting for the facility. However, there cannot be a case of automatic lending, as a loan, after all, is a mutual obligation of the borrower towards the lender. Hence, there has to be explicit agreement on the part of the borrower with the lender.
Of course, a wise borrower may also want to negotiate a rate of interest with the lender.
- What documentation are we envisaging as between the MLI and the borrower?
At least the following:
- Additional loan facility documentation, whether by a separate agreement, or annexure to the master facility agreement executed already by the borrower.
- Modification of charge.
Income recognition, NPA recognition, risk weighting and ECL computation
- During the period of the moratorium on the GECL facility, will income be recognised?
Of course, yes. In case of lenders following IndAS 109, the income will be recognised at the effective interest rate. In case of others too, there will be accrual of income.
- Once we give a GECL loan, we will have two parallel facilities to the borrower – the primary loan and the GECL loan. Can it be that one of these may become an NPA?
The GECL loan will have a moratorium of 12 months – hence, nothing is payable for the first 12 months. The primary facility may actually be having upto 59 DPD overdues at the very start of the scheme itself. Hence, it is quite possible that the primary facility slips into an NPA status.
As a rule, if a facility granted to a borrower has become an NPA, then all facilities granted to the same borrower will also be characterised as NPAs.
Therefore, despite the 100% sovereign guarantee, the facility may still be treated as an NPA, unless there is any separate dispensation from the RBI.
- If the GECL facility becomes an NPA, whether by virtue of being tainted due to the primary loan or otherwise, does it mean the MLI will have to create a provision?
As regards the GECL facility, any provision is for meeting the anticipated losses/shortfalls on a delinquent loan. As the GECL is fully guaranteed, in our view, there will be no case for creating a provision.
- Will there be any expected credit loss [ECL] for the GECL facility?
In view of the 100% sovereign guarantee, this becomes a case of risk mitigation. In our view, this is not a case for providing for any ECL.
- Will the 40 bps general loss provision for standard assets have to be created for the GECL loans too?
Here again, our view is that the facility is fully sovereign-guaranteed. Hence, there is no question of a prudential build up of a general loss provision as well. The RBI should come out with specific carve out for GECL loans.
- Will capital adequacy have to be created against GECL assets?
The RBI issued a notification on June 22, 2020 stating that since the facilities provided under the Scheme are backed by guarantee from GoI, the same shall be assigned 0% risk weight, in the books of MLIs.
Guarantor and the guarantee
- Who is the guarantor under the Scheme?
The Guaranteed Emergency Credit Line (GECL) or the guarantee under the Scheme shall be extended by National Credit Guarantee Trustee Company Limited (NCGTC, ‘Trust’).
- What is National Credit Guarantee Trustee Company Ltd (NCGTC)?
NCGTC is a trust set up by the Department of Financial Services, Ministry of Finance to act as a common trustee company to manage and operate various credit guarantee trust funds. It is a company incorporated under the Companies Act, 1956.
- What is the role of NCGTC?
The role of NCGTC is to serve as a single umbrella organization which handles multiple guarantee programmes of the GoI covering different cross-sections and segments of the economy like students, micro entrepreneurs, women entrepreneurs, SMEs, skill and vocational training needs, etc.
Presently, NCGTC manages 5 credit guarantee schemes that deal with educational loans, skill development, factoring, micro units etc.
- To what extent will the guarantee be extended?
The guarantee shall cover 100% of the eligible credit facility.
- Whether the guarantee will cover both principal and interest components of the credit facility?
Yes, the Scheme shall cover both the interest as well as the principal amount of the loan.
- What will be the guarantee fee?
The NCGTC shall charge no guarantee fee from the Member Lending Institutions (MLIs) in respect of guarantee extended against the loans extended under the Scheme.
- Are eligible lenders required to be registered with the NCGTC to become MLIs?
Usually, eligible lenders under such schemes are required to enter into an agreement with the trust extending the guarantee, to become their members. In this scheme, the eligible lenders are required to provide an undertaking to the NCGTC, in the prescribed format, in order to become MLIs.
- What is the procedure for obtaining the benefit of guarantee under the Scheme?
The MLI shall, within 90 days from a borrower account under the scheme turning NPA, inform the date on which such account turned NPA. On such intimation, NCGTC shall pay 75% of the guaranteed amount to the MLI i.e. 75% of the default amount.
The rest 25% shall be paid on conclusion of recovery proceedings or when the decree gets time barred, whichever is earlier.
Securitisation, direct assignment and co-lending
- The loan, originated by the NBFC, has been securitised. Is it possible for the NBFC to give a GECL facility based on the POS of the securitised loan?
On the face of it, there is nothing that stops a lender from giving a further facility, in addition to the one that has been securitised. However, in the present case, there will be modification of the existing charge document, whereby the charge will be extended to the top up GECL loan as well. This amounts to a dilution of the security available for the primary loan. In our view, this will require specific consent of the PTC investors, through the trustee.
Note that FAQ 35 by NCGTC seems to be talking about off-balance sheet facility. Many securitisation transactions are actually on the balance sheet. Further, even if the original facility has gone off the balance sheet, the additional funding being given by the originator-servicer will be on-the-balance sheet.
Any interpretation of the guarantee scheme has to serve the purpose for which the scheme was envisaged – which is, clearly, to provide additional liquidity to borrowers affected by the disruption. There can be no suggestion that borrowers whose loans have been securitised will not need additional liquidity. Hence, the Scheme intends to wrap all additional lendings done by the lender, within the limits of 20%.
- The loan, originated by the NBFC, has been assigned to the extent of 90% to a bank. Is it possible for the NBFC to give a GECL facility based on the POS of the partly-assigned loan?
Same reasoning as above. Here again, FAQ 40 by NCGTC is talking about the entity on whose books the loan currently is. NCGTC’s view about the loan being on the books of a lender is seemingly overshadowed by accounting concepts which have drastically changed over time. For example, a loan which has been a matter of a DA transaction is actually partly on the books of the original lender, and partly on the books of the assignee. One cannot expect the assignee to be giving the additional line of credit, as the assignee is, practically speaking, a mere passive investor. The assignee does not have the franchise/relation with the borrower, which the originator has. To contend that the assignee bank should extend the additional facility is actually to deny the facility to the borrower completely, for no fault of the borrower and for no gain for the system. Since it is the original lender who maintains the relation with the borrower, it is original lender only who may extend the facility.
- Is it possible for the NBFC to originate the GECL facility, and securitise/assign the same? Will the assignee have the benefit of the GoI guarantee?
There is nothing in the Scheme for assignment of the benefit of guarantee. Typically, unless the guarantee agreement says to the contrary, the benefit of a security or guarantee is assignable along with the underlying loan. However, the guarantee agreement between NCGTC and the lender will be critical in determining this.
 The scheme earlier required the MSMEs to obtain UAN (i.e. get registered) in order to avail benefit under the same. However the same was recently done away with through a notification issued on February 5, 2020. Link to the notification- https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11803&Mode=0
Our related write-ups may be referred here:
-Financial Service Division (firstname.lastname@example.org)
Updated as on August 18, 2020
The write-up below covers version 2.0 of the Partial Credit Guarantee Scheme [PCG Scheme, or PCGS, or simply, the Scheme; version 2 is referred to herein as PCG 2.0 for the sake of distinction from its earlier version, which we refer to PCGS 1.0].
PCGS 1.0 was announced by the Finance Minister, during the Union Budget 2019-20, introducing a partial credit guarantee scheme so as to extend relief to NBFCs during the on-going liquidity crisis. The proposal laid down in the Budget was a very broad statement. On 13th August, 2019 the Ministry of Finance came out with a Press Release to announce the notification in this regard, dated 10th August, 2019, laying down specifics of the scheme.
PCGS 1.0 was only a moderate success, as literally no transactions were conducted under the Scheme until November, 2019. Various stakeholders represented to the MOF to remove the bottlenecks in the structure. Subsequently, on 11th December, 2019, the Union Cabinet approved amendments to the Scheme (Amendments).
The scheme, known as “Partial Credit Guarantee offered by Government of India (GoI) to Public Sector Banks (PSBs) for purchasing high-rated pooled assets from financially sound Non-Banking Financial Companies (NBFCs)/Housing Finance Companies (HFCs)”, is referred to, for the purpose of this write, as “the Scheme”.
PCGS 2.0 was introduced by the Finance Minister as a part of her Rs 20-lakh Crore stimulus package, announced on 13th May, 2020 to provide liquidity to NBFCs, HFCs and MFIs with low credit rating. The Union Cabinet approved the sovereign portfolio guarantee of up to 20% of first loss for purchase of Bonds or Commercial Papers (CPs) with a rating of AA and below (including unrated paper with original/ initial maturity of up to one year) issued by NBFCs/ MFCs/MFIs, by Public Sector Banks through an extension of the PCGS 1.0. PCGS 2.0 has been put in the form of FAQs as well as press-release on the website of the Ministry of Finance.
While PCGS 1.0 was intended to address the temporary liquidity crunch faced by solvent HFCs/ NBFCs, PCGS 2.0 is premised on the continuing problems faced by NBFCs/HFCs/MFIs. The Press Release of the GoI says: “COVID-19 crisis and consequent lockdown restrictions are likely to have a negative impact on both collections and fresh loan disbursements, besides a deleterious effect on the overall economy. This is anticipated to result not only in asset quality issues for the NBFC/ HFC/ MFI sector, but also low loan growth as well as higher borrowing costs for the sector, with a cascading effect on Micro, Small and Medium Enterprises (MSMEs) which borrow from them. While the RBI moratorium provides some relief on the assets side, it is on the liabilities side that the sector is likely to face increasing challenges. The extension of the existing Scheme will address the liability side concerns. In addition, modifications in the existing PCGS will enable wider coverage of the Scheme on the asset side also. Since NBFCs, HFCs and MFIs play a crucial role in sustaining consumption demand as well as capital formation in small and medium segment, it is essential that they continue to get funding without disruption, and the extended PCGS is expected to systematically enable the same.”
PCGS 2.0 covers both the asset side as well as the liability side. PCGS 1.0 was limited to the asset side, for guaranteeing the purchase of “pooled assets” from NBFCs. PCGS 2.0 covers the liability side as well – permitting banks to purchase CPs/ bonds issued by NBFCs/HFCs/MFIs (Finance Companies). Therefore, both the banks as well as Finance Companies will have to make a careful comparison between pool assignments, versus liability issuance. We intend to provide a comparative view of the same in our analysis below.
In this write-up we have tried to answer some obvious questions that could arise along with potential answers. This write-up should be read in conjunction with our earlier write ups on the PCGS 1.0 here.
Scope of applicability
- When does this scheme come into force?
The Scheme was originally introduced on 10th August, 2019 and has been put to effect immediately. The modifications in the Scheme were made applicable with effect from 11th December, 2019.
PCGS 2.0 was announced by the GoI vide a note dated 20th May, 2020.
- Currently, the Scheme has two distinct elements – purchase of asset pools, and purchase of CPs/bonds issued by finance companies. How do these different funding options compare for both the finance companies, and the investing banks?
PCGS 2.0 has added the CP/bond element into the Scheme basically for providing short-term, sovereign-guaranteed liquidity support for redeeming liabilities maturing within 6 months from the date of issue of the CP/bonds. Therefore, the CP/bond guarantee is essentially a liability management option.
On the other hand, the asset pool purchase gives ability to NBFCs to release liquidity locked in assets, and gives them long-term resources for on-lending.
CP is typically issued for a tenure upto 12 months. Bonds for the purpose of the Scheme are also short-term bonds, with a maturity of 9 to 18 months. Hence, in either case, the finance company is simply shifting its existing redemption liability by 9 to 18 months.
Asset pools will have a minimum rating requirement, whereas in case of short-term paper issuance, there is a maximum rating requirement. In fact, PSBs are allowed to purchase unrated paper as well, if the tenure is within 12 months.
A tabular comparison between pool purchases and paper purchase may run as follows:
|Pool Purchases||Paper Purchases|
|Nature of the transaction||Sale of pool of loans by finance companies to PSBs. PSBs get a first loss guarantee from GoI||Acquisition of a pool of CP/bonds (paper) by PSBs, issued by finance companies. PSBs get a first loss guarantee from GoI|
|Eligible finance companies||NBFCs and HFCs. MFIs are not eligible||MFIs are also eligible|
|Purpose/purport of the transaction||The finance company refinances its pool, thereby releasing liquidity. The liquidity can be used for on-lending||The purported use of the funding is for meeting an imminent liability redemption. The issuance of the paper is connected with liabilities maturing within next 6 months.
The liability itself may be either repayment of a term loan, redemption of any debt security, or otherwise.
|Rating requirement||Minimum rating of BBB+||Maximum rating of AA. Unrated paper also qualifies|
|Tenure of the loans/paper||There is no stipulation of the tenure of the underlying loans. The guarantee is valid for a period of 24 months only.||Paper should have maturity of 9 to 18 months.|
|Extent of cover by GoI||10% of the pool purchased by PSBs||20% of the portfolio of paper purchased by the PSBs|
|Ramp up period||Loan pools may be acquired upto 31st March, 2021||Paper may be acquired within 3 months|
|Impact on asset liability mismatch||Repayment of the pool is on a pass-through basis to the PSB. Hence, there is no ALM||Repayment will be on a bullet maturity basis. Hence, there will be an ALM issue.|
|Bankruptcy remoteness||Pool purchases take exposure on the underlying pool, and are therefore, bankruptcy-remote qua the NBFC.||Paper purchase is paper issued by the NBFC and hence, the PSB takes exposure in the issuer.|
2A. Will bonds or CPs issued in secondary market be eligible for purchase under the Scheme?
The Scheme specifically mentions that the bonds/CPs issued by financial companies shall be eligible assets to be purchased under the Scheme. The term ‘issue’ clearly indicates that the bonds/CPs shall be purchased from the primary market only.
- How long will this Scheme continue to be in force?
Originally, PCGS 1.0 was supposed to remain open for 6 months from the date of issuance of this Scheme or when the maximum commitment of the Government, under this Scheme, is achieved, whichever is earlier. However, basis the Amendments discussed above, the Scheme was extended till 20th June, 2020. The Amendments also bestowed upon the Finance Minister power to extend the tenure by upto 3 months.
PCGS 2.0 has two distinct elements – (a) Purchase of Pooled assets; (b) Purchase of bonds/CPs issued by Finance companies. For Part (a), that is, purchase of pooled assets, the Scheme is now extended to 31st March, 2021. For purchase of paper by the PSBs, the PSB has to acquire the paper within 3 months of the announcement. Taking the announcement date of the Scheme to be 20th May, the paper should be acquired by the PSBs within 20th August, 2020.
- Who is the beneficiary of the guarantee under the Scheme – the bank or the NBFC?
The bank (and that too, PSB only) is the beneficiary. The NBFC is not a party to the transaction of guarantee. This is true both for pool purchases as well as paper purchases.
- Does a bank buying pools from NBFCs/HFCs (Financial Entities) automatically get covered under the Scheme?
No. Since a bank/ Financial Entities may not want to avail of the benefit of the Scheme, the Parties will have to opt for the benefit of the guarantee. The bank will have to enter into specific documentation, following the procedure discussed below.
- In case of Paper Purchases, is the guarantee applicable to paper issued by different finance companies?
Yes. The guarantee is for a portfolio of finance company paper acquired by the PSB. For example, a PSB buys the following paper issued by different finance companies:
X Ltd bonds with maturity of 18 months Rs 200 crores
Y Ltd CP having maturity of 9 moths Rs 100 crores
C Ltd bonds having maturity of 12 moths Rs 450 crores
D Ltd CP having maturity of 6 months Rs 50 crores
Total portfolio Rs 800 crores
The bank may get the entire paper, adding to Rs 800 crores, guaranteed by GoI. The guaranteed amount is Rs 800 crores, and the maximum loss payable by the GoI is 20%, that is, Rs 160 crores.
- What is the relevance of pooling of paper, in case of paper purchases?
In case of paper purchases, the guarantee is on a pool of paper, that is, on an aggregate basis. In all such aggregation transactions, unless the pool becomes granular, the first loss guarantee may become highly inadequate.
For example, in the illustration taken in Q5 above, the loss is limited to Rs 160 crores, being 20% of the guaranteed amount. If the bonds issued by C Ltd default, Rs 450 crores would be in default, while the guarantee by the GoI will be only upto Rs 160 crores.
In the same case, had the total portfolio of Rs 800 crores were, say, to consist of 10 issuances of Rs 80 crores each, 2 out of the 10 issuers will be fully covered by the guarantee. Though the conditions of a binomial distribution are inapplicable in the present case (as the pool has a high level of correlation risk), but the probability of more than 2 defaults in a pool of 10 issues seems much lower than the probability of a major issuer out of a non-granular pool defaulting. Hence, PSBs, in their own interest, may want to build up a granular pool consisting of several issuers.
Of course, the ramp up time for all that is highly inadequate – only 3 months from the scheme announcement. From past experience, it should be clear that that much time is lost even in dissemination of understanding – from MOF to SIDBI to the PSBs, and more so because of communication difficulties in the present situation.
- What does the Bank have to do to get covered by the benefit of guarantee under the Scheme?
The procedural aspects of the guarantee under the Scheme are discussed below.
- Is the guarantee specifically to be sought for each of the asset pools acquired by the Bank or is it going to be an umbrella coverage for all the eligible pools acquired by the Bank?
The operational mechanism requires that there will be separate documentation every time the bank wants to acquire a pool from a financial entity in accordance with the Scheme. Hence it appears that the guarantee is for a pool from a specific finance company.
In case of paper purchases, the situation is different – there, the guarantee is for a pool of paper issued by different finance companies.
- How does this Scheme, relating to asset pool purchases, rank/compare with other schemes whereby banks may participate in originations done by NBFCs/HFCs?
The RBI has lately taken various initiatives to promote participation by banks in the originations done by NBFCs/ HFCs. The following are the available ways of participation:
- Direct assignments
- Loans for on-lending
Direct assignments and securitisation have been there in the market since 2012, however, recently, once the liquidity crisis came into surface, the RBI relaxed the minimum holding period norms in order to promote the products.
Co-lending is also an alternative product for the co-origination by banks and NBFCs. In 2018, the RBI also released the guidelines on co-origination of priority sector loans by banks and NBFCs. The guidelines provide for the modalities of such originations and also provide on risk sharing, pricing etc. The difficulty in case of co-origination is that the turnaround time and the flexibility that the NBFCs claimed, which was one of their primary reasons for a competitive edge, get compromised.
The third product, that is, loans for on-lending for a specific purpose, has been in existence for long. However, recent efforts of RBI to allow loans for on-lending for PSL assets have increased the scope of this product.
This Scheme, though, is meant to boost specific direct assignment transactions, but is unique in its own way. This Scheme deviates from various principles from the DA guidelines and is, accordingly, intended to be an independent scheme by itself.
The basic use of the Scheme is to be able to conduct assignment of pools, without having to get into the complexity of involving special purpose vehicles, setting enhancement levels only so as to reach the desired ratings as per the Scheme. The effective cost of the Financial Entities doing assignments under the Scheme will be (a) the return expected by the Bank for a GoI-guaranteed pool; plus (b) 25 bps. If this effectively works cheaper than opting for a similar rated pool on a standalone basis, the Scheme may be economically effective.
- How does this Scheme, relating to paper purchases, rank/compare with other schemes whereby PSBs may provide liquidity to NBFCs/HFCs/MFIs?
The Scheme should be compared with Special Liquidity Scheme for NBFCs/HFCs. From the skeletal details available [https://pib.gov.in/PressReleasePage.aspx?PRID=1625310], the Special Liquidity Scheme may allow an NBFC/HFC to issue debt instruments by a rating notch-up, based on partial guarantee given by the SPV to be set up for this purpose.
It may seem that the formation of the SPV as well as implementation of the Special Liquidity Scheme may take some time. In the meantime, if a finance company has immediate liquidity concerns for some maturing debt securities, it may use the PCG scheme.
However, a fair assessment may be that the PCGS 2.0 will be largely useful for pool purchases, rather than paper purchases. This is so because in case of paper purchases, the ramp up period of 3 months will elapse very soon, giving PSBs very little time to approach SIDBI for getting limits. In any case, the ramp up of the pool of paper has to happen first, before the PSB can get the guarantee. This may demotivate PSBs from committing to buy the paper issued by finance companies.
- Is the Scheme for Pool Purchases an alternative to direct assignment covered by Part B of the 2012 Guidelines, or is it by itself an independent option?
While intuitively one would have thought that the Scheme is a just a method of risk mitigation/facilitation of the DA transactions which commonly happen between banks and Financial Entities, there are several reasons based on which it appears that this Scheme should be construed as an independent option to banks/ Financial Entities:
- This Scheme is limited to acquisition of pools by PSBs only whereas direct assignment is not limited to either PSBs or banks.
- This Scheme envisages that the pool sold to the banks has attained a BBB+ rating at the least. As discussed below, that is not possible without a pool-level credit enhancement. In case of direct assignments, credit enhancement is not permissible.
- Investments in direct assignment are to be done by the acquirer based on the acquirer’s own credit evaluation. In case of the Scheme, the acquisition is obviously based on the guarantee given by the GoI.
- There is no question of an agreement or option to acquire the pool back after its transfer by the originator. The Scheme talks about the right of first refusal by the NBFC if the purchasing bank decides to further sell down the assets at any point of time.
Therefore, it should be construed that the Scheme is completely carved out from the DA Guidelines, and is an alternative to DA or securitisation. The issue was clarified by the Reserve Bank of India vide its FAQs on the issue.
- Is this Scheme applicable to Securitisation transactions as well?
Assignment of pool of assets can be happen in case of both direct assignment as well as securitisation transaction. However, the intention of the present scheme is to provide credit enhancements to direct assignment transactions only. The Scheme does not intend to apply to securitisation transactions; however, the credit enhancement methodology to be deployed to make the Scheme work may involve several structured finance principles akin to securitisation.
- In case of Paper Purchases, does the PSB have the benefit of security from underlying assets?
In case of CP, the same is unsecured; hence, the question of any security does not arise. In case of bonds, security may be obtained, but given the short-term nature of the instrument, and the fact that the security is mostly by way of a floating charge, the security creation may not have much relevance.
- Between a bond and a CP, what should a PSB/finance company prefer?
The obvious perspective of the finance company as well as the bank may be to go for the maximum tenure permissible, viz., 18 months. CP has a maturity limitation. Hence, the obvious choice will be to go for bonds.
- A finance company has maturity liabilities over the next few months. However, it has sufficient free assets also. Should it prefer to sell a pool of assets, or for a short-term paper issuance?
The question does not have a straight answer. In case the finance company goes for paper issuance, it keeps its assets still available, may be for using the same for a DA/securitisation transaction. However, from the viewpoint of flexibility in use of the funds, as also the elimination of ALM risk, a finance company should consider opting for the pool sale option.
16A. As per the Scheme documents pertaining to Paper Purchase, the issuance of Paper may be done for repaying liabilities. What is the construct of the term “liability”? Can it, for example, include payment to securitisation investors?
Securitisation is a self-liquidating liability which liquidates based on the pool cashflows. The issuer does not repay securitisation liability. However, the facility may otherwise be used for payment of any of the financial obligations of the issuer.
- The essence of a guarantee is risk transfer. So how exactly is the process of risk transfer happening in case of pool purchases?
The risk is originated at the time of loan origination by the Financial Entities. The risk is integrated into a pool. Since the transaction is a direct assignment (see discussion below), the risk transfer from the NBFC to the bank may happen either based on a pari passu risk sharing, or based on a tranched risk transfer.
The question of a pari passu risk transfer will arise only if the pool itself, without any credit enhancement, can be rated BBB+. Again, there could be a requirement of a certain level of credit enhancements as well, say through over-collateralisation or subordination.
Based on whether the share of the bank is pari passu or senior, there may be a risk transfer to the bank. Once there is a risk transfer on account of a default to the bank, the bank now transfers the risk on a first-loss basis to the GoI within the pool-based limit of 10%.
- How does the risk transfer happen in case of paper purchase?
In case of paper purchase, the risk will arise in case of “failure to service on maturity”. As we discussed earlier, it is presumed that the paper will have a bullet maturity. Hence, if the finance entity is not able to redeem the paper on maturity, the PSB may claim the money from the GoI, upto a limit of 20% for the whole of the pool.
- Let us say, at the time of original guarantee for Paper Purchase, the Pool of paper had a total exposure of Rs 800 crores. Out of the same, Rs 100 crores has successfully been redeemed by the issuer. Is it proper to say that the guarantee now stands reduced to 20% of Rs 700 crores?
No. The guarantee is on a first loss basis for the whole pool, amounting to Rs 800 crores. Hence, the guaranteed amount will remain 20% of Rs 800 crores.
- What is the maximum amount of exposure, the Government of India is willing to take through this Scheme?
Under this Scheme, the Government has agreed to provide (a) 10% first loss guarantee to pool purchase; and (b) 20% guarantee for paper purchases. The total exposure of the Govt has been fixed at a cap of ₹ 10,000 crores.
With the 20% first loss cover in case of paper, it may be seem that the paper will eat the up the total capacity under the Scheme fast. However, as we have discussed above, we do not expect the paper purchases will materalise to a lot of extent in view of the ramp up time of 3 months.
- What does 10% first loss guarantee in case of Pool Purchase signify?
Let us first understand the meaning for first loss guarantee. As the name suggests, the guarantor promises to replenish the first losses of the financier upto a certain level. Therefore, a 10% first loss guarantee would signify that any loss upto 10% of the total exposure of the acquirer in a particular pool will be compensated by the guarantor.
Say for example, if the size of pool originated by NBFC N is Rs. 1000 crores, consisting of 1000 borrowers of Rs. 1 crore each. The terms of the guarantee say that the PSB may make a claim against the GoI once the PSB suffers a loss on account of the loan being 91 DPD or more.
Since the GoI is guaranteeing the losses suffered by the PSB, one first needs to understand the terms between the PSB and the finance company. Quite likely, the finance company will have to provide at least 2 pool level enhancements to lift the rating of the pool sold to the bank to the BBB+ level – excess spread, and some degree of over-collateralisation or first loss support. Hence, to the extent the loans in the pool go delinquent, but are taken care of by the excess spread present in the pool, or the over-collateralisation/first loss support available in the pool, there is no question of any loss being transferred to the PSB. If there is no loss taken by the PSB, there is no question of reaching out to the GoI for the guarantee. It is only when the PSB suffers a loss that the PSB will reach out to the GoI for making payment, in terms of the guarantee.
- When is a loan taken to have defaulted, in case of Pool Purchases, for the purpose of the Scheme?
Para D of the Scheme suggests that the loan will be taken as defaulted when the interest and/or principal is overdue by more than 90 days. It further goes to refer to crystallisation of liability on the underlying borrower. The meaning of “crystallisation of liability” is not at all clear, and is, regrettably, inappropriate. The word “crystallisation” is commonly used in context of floating charges, where the charge gets crystallised on account of default. It is also sometimes used in context of guarantees where the liability is said to crystallise on the guarantor following the debtor’s default. The word “underlying borrower” should obviously mean the borrower included in the pool of loans, who always had a crystallised liability. In context, however, this may mean declaration of an event of default, recall of the loan, and thereby, requiring the borrower to repay the entire defaulted loan.
- On occurrence of “default” as above, will be the Bank be able to claim the entire outstanding from the underlying borrower, or the amount of defaulted interest/principal?
The general principle in such cases is that the liability of the guarantor should crystallise on declaration of an event of default on the underlying loan. Hence, the whole of the outstanding from the borrower should be claimed from the guarantor, so as to indemnify the bank fully. As regards subsequent recoveries from the borrower, see later.
- Does the recognition of loss by the bank on a defaulted loan have anything to do with the excess spreads/interest on the other performing loans? That is to say, is the loss with respect to a defaulted loan to be computed on pool basis, or loan-by-loan basis?
A reading of para D would suggest that the claiming of compensation is on default of a loan. Hence, the compensation to be claimed by the bank is not to be computed on pool basis. However, any pool-level enhancement, such as excess spread or over-collateralisation, will have to be exhausted first.
- Can the guarantee be applicable to a revolving purchase of loans by the bank from the NBFC, that is, purchase of loans on a continuing basis?
No. The intent seems clearly to apply the Scheme only to a static pool.
- If a bank buys several pools from the same NBFC, is the extent of first loss cover, that is, 10%, fungible across all pools?
No. The very meaning of a first loss cover is that the protection is limited to a single, static pool.
- What will the 20% first loss guarantee in case of Paper Purchase signify?
The meaning of first loss guarantee will be the same in case of Paper Purchases, as in case of Pool Purchases. The difference is clearly the lack of granularity in case of Paper purchases, as the exposure is on the issuer NBFC, and not the underlying borrower.
Hence, if the issuer NBFC fails to redeem the paper on maturity, the PSB shall be entitled to claim payment from the guarantor.
- From the viewpoint of maximising the benefit of the guarantee in case of Pool Purchase, should a bank try and achieve maximum diversification in a pool, or keep the pool concentric?
The time-tested rule of tranching of risks in static pools is that in case of concentric, that is, correlated pools, the limit of first loss will be reached very soon. Hence, the benefit of the guarantee is maximised when the pool is diversified. This will mean both granularity of the pool, as also diversification by all the underlying risk variables – geography, industry or occupation type, type of property, etc.
- Is the same principle of pool diversification applicable to a Paper purchase also?
Yes, absolutely. The guarantee is a tranched-risk cover, upto a first loss piece of 20%. In case of all tranched risk cover, the benefit can be maximised only if the risk is spread across a granular pool.
- Can or should the Scheme be deployed for buying a single loan, or a few corporate loans?
First, the reference to pools obviously means diversified pools. As regards pools consisting of a few corporate loans, as mentioned above, the first loss cover will get exhausted very soon. The principle of tranching is that as correlation/concentricity in a pool increases, the risk shifts from lower tranches to senior tranches. Hence, one must not target using the Scheme for concentric or correlated pools.
- In case of Pool Purchases, on what amount should the first loss guarantee be calculated – on the total pool size or the total amount of assets assigned?
While, as we discussed earlier, there is no applicability of the DA Guidelines in the present case, there needs to be a minimum skin in the game for the selling Financial Entity. Whether that skin in the game is by way of a pari passu vertical tranche, or a subordinated horizontal tranche, is a question of the rating required for attaining the benefit of the guarantee. Therefore, if we are considering a pool of say ₹ 1000 crores, the originator should retain at least ₹ 100 crores (applying a 10% rule – which, of course, will depend on the rating considerations) of the total assets in the pool and only to the extent the ₹ 900 crores can be assigned to the purchasing bank.
The question here is whether the first loss guarantee will be calculated on the entire ₹ 1000 crores or ₹ 900 crores. The intention is guarantee the purchasing banks’ share of cash flows and not that retained by the originator. Therefore, the first loss guarantee will be calculated on ₹ 900 crores in the present case.
Scope of the GoI Guarantee
- In case of Pool Purchases, does the guarantee cover both principal and interest on the underlying loan?
The guarantee is supposed to indemnify the losses of the beneficiary, in this case, the bank. Hence, the guarantee should presumably cover both interest and principal.
- Does the guarantee cove additional interest, penalties, etc.?
Going by Rule 277 (vi) of the GFR, the benefit of the guarantee will be limited to normal interest only. All other charges – additional interest, penal interest, etc., will not be covered by the guarantee.
- In case of Paper Purchases, what all does the guarantee cover?
Once again, the guarantee seems to be for the maturiing amount, as also the accumulated interest.
- How do the General Financial Rules of the Government of India affect/limit the scope of the guarantee?
Para 281 of the GFR provides for annual review of the guarantees extended by the Government. The concerned department, DFS in the present case, will conduct review of the guarantees extended and forward the report to the Budget Division. However, if the Government can take any actions based on the outcome of the review is unclear.
- Does the transaction of assignment of pool from the Financial Entity to the bank have to adhere to any true sale/bankruptcy remoteness conditions?
The transaction must be a proper assignment, and should achieve bankruptcy remoteness in relation to the Financial Entity. Therefore, all regular true sale conditions should be satisfied.
- Can a Financial Entity sell the pool to the bank with the understanding that after 2 years, that is, at the end of the guarantee period, the pool will be sold back to the NBFCs?
Any sale with either an obligation to buyback, or an option to buy back, generally conflicts with the true sale requirement. Therefore, the sale should be a sale without recourse. However, retention of a right of first refusal, or right of pre-emption, is not equivalent to option to buy back. For instance, if, after 2 years, the bank is desirous of selling the pool at its fair value, the NBFC may have the first right of buying the same. This is regarded as consistent with true sale conditions.
- If off-balance sheet treatment from IFRS/Ind-AS viewpoint at all relevant for the purpose of this transaction?
No. Off balance sheet treatment is not relevant for bankruptcy remoteness.
- Is the Pool Purchase transaction subject to bankruptcy risk of the issuer finance company?
Yes, absolutely. There is no bankruptcy remoteness in case of paper purchases.
Short term bond instrument regulations
- What are the specific regulations to be complied with in case of PAPER issuance?
The issuing NBFC/HFC will have to comply with the provisions of Companies Act, 2013. Additionally, depending on the tenure and nature of the PAPER, the regulations issued by RBI for money market instruments shall also be applicable.
- Given the current regulatory framework for short term instruments, is it possible to issue unrated instruments with maturity less than 12 months?
As per the RBI Master Directions for Money Market Instruments, the issuers is required to obtain credit rating for issuance of CP from any one of the SEBI registered CRAs. Further, it is prescribed that the minimum credit rating shall be ‘A3’ as per rating symbol and definition prescribed by SEBI.
Similarly, in case of NCD issuance with tenure upto one year, there is a requirement to obtain credit rating from one of the rating agencies. Further, the minimum credit rating shall be ‘A2’ as per rating symbol and definition prescribed by SEBI.
Buyers and sellers
- Who are eligible buyers under this Scheme?
Both in case of Pool Purchases as also Paper Purchases, only Public Sector Banks are eligible buyers of assets under this Scheme. Therefore, even if a Private Sector Bank acquires eligible assets from eligible sellers, guarantee under this Scheme will still not be available.
This may be keeping in view two points – first, the intent of the Scheme, that is, to nudge PSBs to buy pools from Financial Entities. It is a well-known fact that private sector banks are, as it is, actively engaged in buying pools. Secondly, in terms of GFR of the GoI, the benefit of Government guarantee cannot go to the private sector. [Rule 277 (vii)] Hence, the Scheme is restricted to PSBs only.
- Who are eligible sellers under the Scheme in case of Pool purchases?
The intention of the Scheme is to provide relief from the stress caused due to the ongoing liquidity crisis, to sound HFCs/ NBFCs who are otherwise financially stable. The Scheme has very clearly laid screening parameters to decide the eligibility of the seller. The qualifying criteria laid down therein are:
- NBFCs registered with the RBI, except Micro Financial Institutions or Core Investment Companies
- HFCs registered with the NHB
- The NBFC/ HFC must have been able to maintain the minimum regulatory capital as on 31st March, 2019, that is –
- For NBFCs – 15%
- For HFCs – 12%
- The net NPA of the NBFC/HFC must not have exceeded 6% as on 31st March, 2019
- The NBFC/ HFC must have reported net profit in at least one out of the last two preceding financial years, that is, FY 2017-18 and FY 2018-19.
- The Original Scheme stated that the NBFC/ HFC must not have been reported as a Special Mention Account (SMA) by any bank during the year prior to 1st August, 2018. However, the Amendment even allows NBFC/HFC which may have slipped during one year prior to 1st August, 2018 shall also be allowed to sell their portfolios under the Scheme.
- Who are eligible issuers under the Scheme in case of PAPER purchases?
The intention of the Scheme is to provide relief from the stress caused due to the ongoing liquidity crisis, the eligible issuers are as follow:
- NBFCs registered with the RBI except Government owned NBFCs
- All MFIs which are members of a Self-Regulatory Organisation (SRO) recognized by RBI shall be eligible for purchase of Bonds/ CPs.
- HFCs registered with the NHB except Government owned HFCs.
- In case of pool purchases, can NBFCs of any asset size avail this benefit?
Apparently, the Scheme does not provide for any asset size requirement for an NBFC to be qualified for this Scheme, however, one of the requirements is that the financial institution must have maintained the minimum regulatory capital requirement as on 31st March, 2019. Here it is important to note that the requirement to maintain regulatory capital, that is capital risk adequacy ratio (CRAR), applies only to systemically important NBFCs.
Only those NBFCs whose asset size exceeds ₹ 500 crores singly or jointly with assets of other NBFCs in the group are treated as systemically important NBFCs. Therefore, it is safe to assume that the benefits under this Scheme can be availed only by those NBFCs which – a) are required to maintain CRAR, and b) have maintained the required amount of capital as on 31st March, 2019, subject to the fulfillment of other conditions.
- In case of issuance of bonds/commercial papers, is there a similar capital requirement?
There is no such condition in case of bond and CP issuance.
- In case of pool purchases, the eligibility criteria for sellers state that the financial institution must not have been reported as SMA-1 or SMA-2 by any bank any time during 1 year prior to 1st August, 2018– what does this signify?
As per the prudential norms for banks, an account has to be declared as SMA, if it shows signs of distress without slipping into the category of an NPA. The requirement states that the originator must not have been reported as an SMA-1 or SMA-2 any time during 1 year prior to 1st August, 2018, and nothing has been mentioned regarding the period thereafter.
Therefore, if a financial institution satisfies the condition before 1st August, 2018 but becomes SMA-1 or SMA-2 thereafter, it will still be eligible as per the Scheme. The whole intention of the Scheme is to eliminate the liquidity squeeze due to the ILFS crisis. Therefore, if a financial institution turns SMA after the said date, it will be presumed the financial institution has fallen into a distressed situation as a fallout of the ILFS crisis.
- What are the eligible assets for the Scheme in case of Pool Purchases?
The Scheme has explicitly laid down qualifying criteria for eligible assets and they are:
- The asset must have originated on or before 31st March, 2019.
- The asset must be classified as standard in the books of the NBFC/ HFC as on the date of the sale.
- The original Scheme stated that the pool of assets should have a minimum rating of “AA” or equivalent at fair value without the credit guarantee from the Government. However, through the Amendment, the rating requirement has been brought down to BBB+.
- Each account under the pooled assets should have been fully disbursed and security charges should have been created in favour of the originating NBFCs/ HFCs.
- The individual asset size in the pool must not exceed ₹ 5 crore.
- The following types of loans are not eligible for assignment for the purposes of this Scheme:
- Revolving credit facilities;
- Assets purchased from other entities; and
- Assets with bullet repayment of both principal and interest
- Pools consisting of assets satisfying the above criteria qualify for the benefit of the guarantee. Hence, the pool may consist of retail loans, wholesale loans, corporate loans, loans against property, or any other loans, as long as the qualifying conditions above are satisfied.
- Should the Scheme be deployed for assets for longer maturity or shorter maturity?
Utilising the Scheme for pools of lower weighted average maturity will result into very high costs – as the cost of the guarantee is computed on the original purchase price.
Using the Scheme for pools of longer maturity – for example, LAP loans or corporate loans, may be lucrative because the amortisation of the pool is slower. However, it is notable that the benefit of the guarantee is available only for 2 years. After 2 years, the bank will not have the protection of the Government’s guarantee.
- If there are corporate loans in the pool, where there is payment of interest on regular basis, but the principal is paid by way of a bullet repayment, will such loans qualify for the benefit of the Scheme?
The reference to bullet repaying loans in the Scheme seems similar to those in DA guidelines. In our view, if there is evidence/track record of servicing, in form of interest, such that the principal comes by way of a bullet repayment (commonly called IO loans), the loan should still qualify for the Scheme. However, negatively amortising loans should not qualify.
- Is there any implication of keeping the cut-off date for originations of loans to be 31st March, 2019?
This Scheme came into force with effect from 10th August, 2019 and remained open till 30th June, 2020. The original Scheme also had this cut-off of 31st March, 2019.
Due to the extension, though the timelines have been extended by one year till 31st March, 2021, however, the cut off date has not changed. Therefore, in our view, this scheme will hold good only for long tenure loans, such as mortgage loans.
- Is there any maximum limit on the amount of loans that can be assigned under this Scheme?
Yes, the Scheme has put a maximum cap on the amount of assets that can be assigned and that is an amount equal to 20% of the outstanding standard assets as on 31st March, 2019, however, the same is capped to ₹ 5000 crores.
- Is there a scope for assigning assets beyond the maximum limits prescribed in the Scheme?
Yes, the Scheme states that any additional amount above the cap of ₹ 5,000 crore will be considered on pro rata basis, subject to availability of headroom. However, from the language, it seems that there is a scope for sell down beyond the prescribed limit, only if the eligible maximum permissible limit gets capped to ₹ 5,000 crores and not if the maximum permissible limit is less than ₹ 5000 crores.
The following numerical examples will help us to understand this better:
|Total outstanding standard assets as on 31st March, 2019||₹ 20,000 crores||₹ 25,000 crores||₹ 30,000 crores|
|Maximum permissible limit @ 20%||₹ 4,000 crores||₹ 5,000 crores||₹ 6,000 crores|
|Maximum cap for assignment under this Scheme||₹ 5,000 crores||₹ 5,000 crores||₹ 5,000 crores|
|Amount that can be assigned under this Scheme||₹ 4,000 crores||₹ 5,000 crores||₹ 5,000 crores|
|Scope for further sell down?||No||No||Yes, upto a maximum of ₹ 1,000 crores|
- When will it be decided whether the Financial Entity can sell down receivables beyond the maximum cap?
Nothing has been mentioned regarding when and how will it be decided whether a financial institution can sell down receivables beyond the maximum cap, under this Scheme. However, logically, the decision should be taken by the Government of India of whether to allow further sell down and closer towards the end of the Scheme. However, we will have to wait and see how this unfolds practically.
- What are the permissible terms of transfer under this Scheme?
The Scheme allows the assignment agreement to contain the following:
- Servicing rights – It allows the originator to retain the servicing function, including administrative function, in the transaction.
- Buy back right – It allows the originator to retain an option to buy back its assets after a specified period of 12 months as a repurchase transaction, on a right of first refusal basis. Actually, this is not a right to buy back, it is a right of first refusal which the NBFC/ HFC may exercise if the purchasing bank further sells down the assets. See elsewhere for detailed discussion
Rating of the Pool in case of Pool Purchases
- The Scheme requires that the pool must have a rating of BBB+ before its transfer to the bank. Does that mean there be a formal rating agency opinion on the rating of the pool?
Yes. It will be logical to assume that SIDBI or DFS will expect a formal rating agency opinion before agreeing to extend the guarantee.
- The Scheme requires the pool of assets to be rated at least BBB+, what does this signify?
As per the conditions for eligible assets, the pool of assets to be assigned under this Scheme must have a minimum rating of “BBB+” or equivalent at fair value prior to the guarantee from the Government.
There may be a question of expected loss assessment of a pool. Initially, the rating requirement was pegged at “AA” or higher and there was an apprehension that the originators might have to provide a substantial amount of credit enhancement in order to the make the assets eligible for assignment under the Scheme. Subsequently, vide the Amendments, the rating has been brought down to BBB+. The originators may also be required to provide some level of credit enhancements in order to achieve the BBB+ rating.
Unlike under the original Scheme, where the rating requirement was as high as AA, the intent is to provide guarantee only at AA level, then the thickness of the guarantee, that is, 10%, and the cost of the guarantee, viz., 25 bps, both became questionable. The thickness of support required for moving a AA rated pool to a AAA level mostly is not as high as 10%. Also, the cost of 25 bps for guaranteeing a AA-rated pool implied that the credit spreads between AA and a AAA-rated pool were at least good enough to absorb a cost of 25 bps. All these did not seemed and hence, there was not even a single transaction so far.
But now that the rating requirement has been brought down to BBB+, it makes a lot of sense. The credit enhancement level required to achieve BBB+ will be at least 4%-5% lower than what would have been required for AA pool. Further, the spread between a BBB+ and AAA rated pool would be sufficient to cover up the guarantee commission of 25 bps to be incurred by the seller in the transaction.
Here it is important to note that though the rating required is as low as BBB+, but there is nothing which stops the originator in providing a better quality pool. In fact, by providing a better quality pool, the originator will be able to fetch a much lower cost. Further, since, the guarantee on the pool will be available for only first two years of the transaction, the buyers will be more interested in acquiring higher quality pools, as there could be possibilities of default after the first two years, which is usually the case – the defaults increase towards the end of the tenure.
57A. Will investment grade debt paper of NBFCs/HFCs/MFIs be determined without adjustments for the COVID scenario considering the grading may have been downgraded?
As per the Scheme, the rating of debt paper as on date of transaction would apply. In this regard, a circular issued by SEBI on March 30, 2020 maybe considered, which directs rating agencies to not consider delay in repayments owing to the lockdown as ‘default’. Thus, the rating issued by the credit rating agencies would already adjust the delays owing to COVID disruptions.
Risk weight and capital requirements
- Can the bank, having got the Pool guaranteed by the GoI, treat the Pool has zero% risk weighted, or risk-weighted at par with sovereign risk weights?
No. for two reasons –one the guarantee is only partial and not full. Number two, the guarantee is only for losses upto first 2 years. So it is not that the credit exposure of the bank is fully guaranteed
- What will be the risk weight once the guarantee is removed, after expiry of 2 years?
The risk weight should be based on the rating of the tranche/pool, say, BBB+ or better.
- Is there a guarantee commission? If yes, who will bear the liability to pay the commission?
As already discussed in one of the questions above, the Scheme requires the originators to pay guarantee commission of 25 basis points on the amount of guarantee extended by the Government. Though the originator will pay the fee, but the same will be routed through purchasing bank.
- The pool is amortising pool. Is the cost of 25 bps to be paid on the original purchase price?
From the operational details, it is clear that the cost of 25 bps is, in the first instance, payable on the original fair value, that is, the purchase price.
Invocation of guarantee and refund
- When can the guarantee be invoked in case of Pool Purchases?
The guarantee can be invoked any time during the first 24 months from the date of assignment, if the interest/ principal has remained overdue for a period of more than 90 days.
- When can the guarantee be invoked in the case of Paper Purchases?
There is no maximum time limit in case of Paper Purchases. Hence, the guarantee can be invoked upto maturity. The maximum maturity, of course, is limited to 18 months.
- In case of Pool Purchases, can the purchasing bank invoke the guarantee as and when the default occurs in each account?
Yes. The purchasing bank can invoke the guarantee as and when any instalment of interest/ principal/ both remains overdue for a period of more than 90 days.
- In case of PAPER Purchases, can the purchasing bank invoke the guarantee as and when the default occurs?
Assuming the instruments will have bullet repayment of principal, the answer is yes.
- To what extent can the purchasing bank recover its losses through invocation of guarantee?
When a loan goes bad, the purchasing bank can invoke the guarantee and recover its entire exposure from the Government. It can continue to recover its losses from the Government, until the upper cap of 10% of the total portfolio is reached. However, the purchasing bank will not be able to recover the losses if – (a) the pooled assets are bought back by the concerned NBFCs/HFCs or (b) sold by the purchasing bank to other entities.
- Within how many days will the purchasing bank be able to recover its losses from the Government?
As stated in the Scheme, the claims will be settled within 5 working days.
- In case of pool purchase, what will happen if the purchasing bank recovers the amount lost, subsequent to the invocation of guarantee?
If the purchasing bank, by any means, recovers the amount subsequent to the invocation of the guarantee, it will have to refund the amount recovered or the amount received against the guarantee to the Government within 5 working days from the date of recovery. However, if the amount recovered is more than the amount received as guarantee, the excess collection will be retained by the purchasing bank.
- In case of PAPER Purchase, what will happen if the purchasing bank recovers the amount lost, subsequent to the invocation of guarantee?
If the purchasing bank, by any means, recovers the amount subsequent to the invocation of the guarantee, it will have to refund the amount recovered or the amount received against the guarantee to the Government within 5 working days from the date of recovery. However, if the amount recovered is more than the amount received as guarantee, the excess collection will be retained by the purchasing bank.
- What will be the process for a bank to obtain the benefit of the guarantee?
While the Department of Financial Services (DFS) is made the administrative ministry for the purpose of the guarantee under the Scheme, the Scheme involves the role of SIDBI as the interface between the banks and the GoI. Therefore, any bank intending to avail of the guarantee has to approach SIDBI.
- Can you elaborate on the various procedural steps to be taken to take the benefit of the guarantee?
The modus operandi of the Scheme is likely to be as follows:
- An NBFC approaches a bank with a static pool, which, based on credit enhancements, or otherwise, has already been uplifted to a rating of BBB+ or above level.
- The NBFC negotiates and finalises its commercials with the bank.
- The bank then approaches SIDBI with a proposal to obtain the guarantee of the GOI. At this stage, the bank provides (a) details of the transaction; and (b) a certificate that the requirements of Chapter 11 of General Financial Rules, and in particular, those of para 280, have been complied with.
- SIDBI does its own evaluation of the proposal, from the viewpoint of adherence to Chapter 11 of GFR and para 280 in particular, and whether the proposal is in compliance with the provisions of the Scheme. SIDBI shall accordingly forward the proposal to DFS along with a specific recommendation to either provide the guarantee, or otherwise.
- DFS shall then make its decision. Once the decision of DFS is made, it shall be communicated to SIDBI and PSB.
- At this stage, PSB may consummate its transaction with the NBFC, after collecting the guarantee fees of 25 bps.
- In case of PAPER Purchase, the NBFC/HFC shall have to comply with the extant regulations for issuance of bonds/CPs, under Companies Act, 2013 and as issued by the regulators- RBI or NHB, as the case may be.
- PSB shall then execute its guarantee documentation with DFS and pay the money by way of guarantee commission.
- Para 280(i)(a) of the GFR states that there should be back-to-back agreements between the Government and Borrower to effect to the transaction – will this rule be applicable in case of this Scheme?
Para 280 has been drawn up based on the understanding that guarantee extended is for a loan where the borrower is known by the Government. In the present case, the guarantee is extended in order to partially support a sale of assets and not for a specific loan, therefore, this will not apply.
- Is there any reporting requirement?
The Scheme does provide for a real-time reporting mechanism for the purchasing banks to understand the remaining headroom for purchase of such pooled assets. The Department of Financial Services (DFS), Ministry of Finance would obtain the requisite information in a prescribed format from the PSBs and send a copy to the budget division of DEA, however, the manner and format of reporting has not been notified yet.
- What are to-do activities for the sellers to avail benefits under this Scheme?
Besides conforming to the eligibility criteria laid down in the Scheme, the sellers will also have to carry out the following in order to avail the benefits:
- The Asset Liability structure should restructured within three months to have positive ALM in each bucket for the first three months and on cumulative basis for the remaining period;
- At no time during the period for exercise of the option to buy back the assets, should the CRAR go below the regulatory minimum. The promoters shall have to ensure this by infusing equity, where required.
Amendments to the Scheme
With an intent to extend the benefits of the scheme during the current crisis, a notification dated August 17, 2020 was released by the MoF making certain amendments to the scheme. Through the amendment, the tenure of the scheme has been extended by 3 months. Hence, PSBs can purchase the pools till 19th November, 2020. The crystallisation for the purpose of determining the guarantee shall be done on 19th November, 2020.
Further, investments in bonds/CPs of rating AA and AA- have been allowed upto 50% of the total portfolio of bonds/CPs purchased by the PSB under the scheme. The limit earlier was 25%. This increase would allow more bonds/CPs to come under the scheme and would enable the NBFCs/HFCs/MFIs with investment grade ratings but not very high ratings to procure funding to an extended limit.
Other related articles-
 Including Indian Securitisation Foundation
The Reserve Bank of India, on 13th March, 2020, issued a notification providing guidance on implementation of Indian Accounting Standards by non-banking financial companies. This guidance comes after almost 2 years from the date of commencement of first phase of implementation of Ind AS for NBFCs.
The intention behind this Notification is to ensure consistency in certain areas like – asset classification, provisioning, regulatory capital treatment etc. The idea of the Notification is not to provide detailed guidelines on Ind AS implementation. For areas which the Notification has not dealt with, notified accounting standards, application guidance, educational material and other clarifications issued by the ICAI should be referred to.
The Notification is addressed to all non-banking financial companies and asset reconstruction companies. Since, housing finance companies are now governed by RBI and primarily a class of NBFCs, this Notification should also apply to them. But for the purpose of this write-up we wish to restrict our scope to NBFCs, which includes HFCs, only.
The Notification becomes applicable for preparation of financial statements from the financial year 2019-20 onwards, therefore, it seems the actions to be taken under the Notification will have to be undertaken before 31st March, 2020, so far as possible.
In this article we wish to discuss the outcome the Notification along with our comments on each issue. This article consists of the following segments:
- Things to be done by the Board of Directors (BOD)
- Expected Credit Losses (ECL) and prudential norms
- Dealing with defaults and significant increase in credit risk
- Things to be done by the Audit Committee of the Board (ACB)
- Computation of regulatory capital
- Securitisation accounting and prudential norms
- Matters which skipped attention
1. Things to be done by the BOD
The Notification starts with a sweeping statement that the responsibility of preparing and ensuring fair presentation of the financial statements lies with the BOD of the company. In addition to this sweeping statement, the Notification also demands the BOD to lay down some crucial policies which will be essential for the implementation of Ind AS among NBFCs and they are: a) Policy for determining business model of the company; and b) Policy on Expected Credit Losses.
(A) Board approved policy on business models: The Company should have a Board approved policy, which should articulate and document the business models and portfolios of the Company. This is an extremely policy as the entire classification of financial assets, depends on the business model of the NBFC. Some key areas which, we think, the Policy should entail are:
There are primarily three business models that Ind AS recognises for subsequent measurement of financial assets:
(a) hold financial assets in order to collect contractual cash flows;
(b) hold financial assets in order to collect contractual cash flows and also to sell financial assets; and
(c) hold financial assets for the purpose of selling them.
The assessment of the business model should not be done at instrument-by-instrument level, but can be done at a higher level of aggregation. But at the same time, the aggregation should be not be done at an entity-level because there could be multiple business models in a company.
Further, with respect the first model, the Ind AS states that the business model of the company can still be to hold the financial assets in order to collect contractual cash flows even if some of the assets are sold are expected to be sold in future. For instance, the business model of the company shall remain unaffected due to the following transactions of sale:
(a) Sale of financial assets due to increase in credit risk, irrespective of the frequency or value of such sale;
(b) Sale of cash flows are made close to the maturity and where the proceeds from the sale approximate the collection of the remaining contractual cash flows; and
(c) Sale of financial assets due to other reasons, namely, to avoid credit concentration, if such sales are insignificant in value (individually or in aggregate) or infrequent.
For the third situation, what constitutes to insignificant or infrequent has not been discussed in the Ind AS. However, reference can be drawn from the Report of the Working Group of RBI on implementation of Ind AS by banks, which proposes that there could be a rebuttable presumption that where there are more than 5% of sale, by value, within a specified time period, of the total amortised cost of financial assets held in a particular business model, such a business model may be considered inconsistent with the objective to hold financial assets in order to collect contractual cash flow.
However, we are not inclined to take the same as prescriptive. Business model of an entity is still a question hinging on several relevant factors, primarily the profit recognition, internal reporting of profits, pursuit of securitization/direct assignment strategy, etc. Of course, the volume may be a persuasive factor.
The Notification also requires that the companies should also have a policy on sale of assets held under amortised cost method, and such policy should be disclosed in the financial statements.
(B) Board approved policy on ECL methodology: the Notification requires the companies to lay down Board approved sound methodologies for computation of Expected Credit Losses. For this purpose, the RBI has advised the companies to use the Guidance on Credit Risk and Accounting for Expected Credit Losses issued by Basel Committee on Banking Supervision (BCBS) for reference.
The methodologies laid down should commensurate with the size, complexity and risks specific to the NBFC. The parameters and assumptions for risk assessment should be well documented along with sensitivity of various parameters and assumptions on the ECL output.
Therefore, as per our understanding, the policy on ECL should contain the following –
(a) The assumptions and parameters for risk assessment – which should basically talk about the probabilities of defaults in different situations. Here it is important to note that the assumptions could vary for the different products that the reporting entity offers to its customers. For instance, if a company offers LAP and auto loans at the same time, it cannot apply same set of assumptions for both these products.
Further, the policy should also lay down indicators of significant increase in credit risk, impairment etc. This would allow the reporting entity in determining classifying its assets into Stage 1, Stage 2 and Stage 3.
(b) Backtesting of assumptions – the second aspect of this policy should deal with backtesting of the assumptions. The policy should provide for mechanism of backtesting of assumption on historical data so as to examine the accuracy of the assumptions.
(c) Sensitivity analysis – Another important aspect of this policy is sensitivity analysis. The policy should provide for mechanism of sensitivity analysis, which would predict the outcome based on variations in the assumptions. This will help in identifying how dependant the output is on a particular input.
Further, the Notification states that any change in the ECL model must be well documented along with justifications, and should be approved by the Board. Here it is important to note that there could two types of variations – first, variation in inputs, and second, variation in the model. As per our understanding, only the latter should be placed before the BOD for its approval.
Further, any change in the assumptions or parameters or the ECL model for the purpose of profit smothering shall seriously be frowned upon by the RBI, as it has clearly expressed its opinion against such practices.
2. Expected Credit Losses (ECL) and prudential norms
The RBI has clarified that whatever be the ECL output, the same should be subject to a regulatory floor which in this case would be the provisions required to be created as the IRAC norms. Let us understand the situation better:
The companies will have to compute two types of provisions or loss estimations going forward – first, the ECL as per Ind AS 109 and its internal ECL model and second, provisions as per the RBI regulations, which has to be computed in parallel, and at asset level.
The difference between the two will have to be dealt with in the following manner:
(A) Impairment Reserve: Where the ECL computed as per the ECL methodology is lower than the provisions computed as per the IRAC norms, then the difference between the two should be transferred to a separate “Impairment Reserve”. This transfer will not be a charge against profit, instead, the Notification states that the difference should be appropriated against the profit or loss after taxes.
Interestingly, no withdrawals against this Impairment Reserve is allowed without RBI’s approval. Ideally, any loss on a financial asset should be first adjusted from the provision created for that particular account.
Further, the continuity of this Impairment Reserve shall be reviewed by the RBI going forward.
A large number of NBFCs have already presented their first financial statements as per Ind AS for the year ended 31st March, 2019. There were two types of practices which were followed with respect to provisioning and loss estimations. First, where the NBFCs charged only the ECL output against its profits and disregarded the regulatory provisioning requirements. Second, where the NBFCs computed provisions as per regulatory requirements as well as ECL and charged the higher amount between the two against the profits.
The questions that arise here are:
(a) For the first situation, should the NBFCs appropriate a higher amount in the current year, so as to compensate for the amount not transferred in the previous year?
(b) For the second situation, should the NBFCs reverse the difference amount, if any, already charged against profit during the current year and appropriate the same against profit or loss?
The answer for both the questions is negative. The provisions of the Notification shall have to be implemented for the preparation of financial statements from the financial year 2019-20 onwards, hence, we don’t see the need for adjustments for what has already been done in the previous year’s financial statements.
(B) Disclosure: The difference between the two will have to be disclosed in the annual financial statements of the company, format of which has been provided in the Notification. Going by the format, the loss allowances created on Stage 1, Stage 2 and Stage 3 cases will have to be shown separately, similarly, the provisions computed on those shall also have to be shown separately.
While Stage 1 and Stage 2 cases have been classified as standard assets in the format, Stage 3 cases cover sub-standard, doubtful and loss assets.
Loss estimations on loan commitments, guarantees etc. which are covered under Ind AS but does not require provisioning under the RBI Directions should also be presented.
3. Dealing with defaults and significant increase in credit risk
Estimation of expected losses in financial assets as per Ind AS depends primarily on credit risk assessment and identifying situations for impairment. Considering the importance of issue, the RBI has voiced its opinion on identification of “defaults” and “significant increase in credit risk”.
(A)Defaults: The next issue which has been dealt with in the Notification is the meaning of defaults. Currently, there seems to be a departure between the Ind AS and the regulatory definition of “defaults”. While the former allows the company to declare an account as default based on its internal credit risk assessments, the latter requires that all cases with delay of more than 90 days should be treated as default. The RBI expects the accounting classification to be guided by the regulatory definition of “defaults”.
If a company decides not to impair an account even after a 90 days delay, then the same should be approved by the Audit Committee.
This view is also in line with the definition of “default” proposed by the BASEL framework for IRB framework, which is:
“A default is considered to have occurred with regard to a particular obligor when one or more of the following events has taken place.
(a) It is determined that the obligor is unlikely to pay its debt obligations (principal, interest, or fees) in full;
(b) A credit loss event associated with any obligation of the obligor, such as a charge-off, specific provision, or distressed restructuring involving the forgiveness or postponement of principal, interest, or fees;
(c) The obligor is past due more than 90 days on any credit obligation; or
(d) The obligor has filed for bankruptcy or similar protection from creditors.”
Further, the number of cases of defaults and the total amount outstanding and overdue should be disclosed in the notes to the financial statements. As per the current regulatory framework, NBFCs have to present the details of sub-standard, doubtful and loss assets in its financial statements. Hence, this disclosure requirement is not new, only the sub-classification of NPAs have now been taken off.
(B) Dealing with significant increase in credit risk: Assessment of credit risk plays an important role in ECL computation under Ind AS 109. Just to recapitulate, credit risk assessments can be lead to three possible situations – first, where there is no significant increase in credit risk, second, where there is significant increase in credit risk, but no default, and third, where there is a default. These three outcomes are known as Stage 1, Stage 2 and Stage 3 cases respectively.
In case an account is under Stage 1, the loss estimation has to be done based on probabilities of default during next 12 months after the reporting date. However, if an account is under Stage 2 or Stage 3, the loss estimation has to be done based on lifetime probabilities of default.
Technically, both Stage 1 and Stage 2 cases would fall under the definition of standard assets for the purpose of RBI Directions, however, from accounting purposes, these two stages would attract different loss estimation techniques. Hence, the RBI has also voiced its opinion on the methodology of credit risk assessment for Stage 2 cases.
The Notification acknowledges the presence of a rebuttable presumption of significant increase in credit risk of an account, should there be a delay of 30 days or more. However, this presumption is rebuttable if the reporting entity has reasonable and supportable information that demonstrates that the credit risk has not increased significantly since initial recognition, despite a delay of more than 30 days. In a reporting entity opts to rebut the presumption and assume there is no increase in credit risk, then the reasons for such should be properly documented and the same should be placed before the Audit Committee.
However, the Notification also states that under no circumstances the Stage 2 classification be deferred beyond 60 days overdue.
4. Things to be done by the ACB
The Notification lays down responsibilities for the ACB and they are:
(A) Approval of any subsequent modification in the ECL model: In order to be doubly sure about that any subsequent change made to the ECL model is not frivolous, the same has to be placed before the Audit Committee for their approval. If approved, the rationale and basis of such approval should be properly documented by the company.
(B) Reviewing cases of delays and defaults: As may have been noted above, the following matters will have to be routed through the ACB:
(a) Where the reporting entity decides not to impair an account, even if there is delay in payment of more than 90 days.
(b) Where as per the risk assessment of the reporting entity, with respect to an account involving a delay of more than 30 days, it rebuts that there is no significant increase in credit risk.
In both the cases, if the ACB approves the assumptions made by the management, the approval along with the rationale and justification should be properly documented.
5. Computation of Regulatory Capital
The Notification provides a bunch of clarifications with respect to calculation of “owned funds”, “net owned funds”, and “regulatory capital”, each of which has been discussed here onwards:
(A) Impact of unrealised gains or losses arising on fair valuation of financial instruments: The concept of fair valuation of financial instruments is one of the highlights of IFRS or Ind AS. Ind AS 109 requires fair valuation of all financial instruments. The obvious question that arises is how these gains or losses on fair valuation will be treated for the purpose of capital computation. RBI’s answer to this question is pretty straight and simple – none of these of gains will be considered for the purpose of regulatory capital computation, however, the losses, if any, should be considered. This view seems to be inspired from the principle of conservatism.
Here it is important to note that the Notification talks about all unrealised gains arising out of fair valuation of financial assets. Unrealised gain could arise in two situations – first, when the assets are measured on fair value through other comprehensive income (FVOCI), and second, when the assets are measured on fair value through profit or loss (FVTPL).
In case of assets which are fair valued through profit or loss, the gains or losses once booked are taken to the statement of profit or loss. Once taken to the statement of profit or loss, these gains or losses lose their individuality. Further, these gains or losses are not shown separately in the Balance Sheet and are blended with accumulated profits or losses of the company. Monitoring the unrealised gains from individual assets would mean maintenance of parallel accounts, which could have several administrative implications.
Further, when these assets are finally sold and gain is realised, only the difference between the fair value and value of disposal is booked in the profit and loss account. It is to be noted here that the gain on sale of assets shown in the profit and loss account in the year of sale is not exactly the actual gain realised from the financial asset because a part of it has been already booked during previous financial years as unrealised gains. If we were to interpret that by “unrealised gains” RBI meant unrealised gains arising due to FVTPL as well, the apparent question that would arise here is – whether the part which was earlier disregarded for the purpose of regulatory capital will now be treated as a part of capital?
Needless to say, extending the scope of “unrealised gains” to mean unrealised gains from FVTPL can create several ambiguities. However, the Notification, as it stands, does not contain answers for these.
In addition to the above, the Notification states the following in this regard:
- Even unrealised gains arising on transition to Ind AS will have to be disregarded.
- For the purpose of computation of Tier I capital, for investments in NBFCs and group companies, the entities must reduce the lower of cost of acquisition or their fair value, since, unrealised gains are anyway deducted from owned funds.
- For any other category of investments, unrealised gains may be reduced from the value of asset for the purpose of risk-weighting.
- Netting off of gains and losses from one category of assets is allowed, however, netting off is not allowed among different classes of assets.
- Fair value gains on revaluation of property, plant and equipment arising from fair valuation on the date of transition, shall be treated as a part of Tier II capital, subject to a discount of 55%.
- Any unrealised gains or losses recognised in equity due to (a) own credit risk and (b) cash flow hedge reserve shall be derecognised while determining owned funds.
(B) Treatment of ECL: The Notification allows only Stage 1 ECL, that is, 12 months ECL, to be included as a part of Tier II capital as general provisions and loss reserves. Lifetime ECL shall not be reckoned as a part of Tier II capital.
6. Securitisation accounting and prudential norms
All securitisation transactions undergo a strict test of de-recognition under Ind AS 109. The conditions for de-recognition are such that most of the structures, prevalent in India, fail to qualify for de-recognition due to credit enhancements. Consequently, the transaction does not go off the books.
The RBI has clarified that the cases of securitisation that does not go off the books, will be allowed capital relief from regulatory point of view. That is, the assets will be assigned 0% risk weight, provided the credit enhancement provided for the transaction is knocked off the Tier I (50%) and Tier II (remaining 50%).
There are structures where the level of credit enhancement required is as high as 20-25%, the question here is – should the entire credit support be knocked off from the capital? The answer to this lies in the RBI’s Securitisation Guidelines from 2006, which states that the knocking off of credit support should be capped at the amount of capital that the bank would have been required to hold for the full value of the assets, had they not been securitised, that is 15%.
For securitisation transactions which qualify for complete de-recognition, we are assuming the existing practice shall be followed.
But apart from the above two, there can also be cases, where partial de-recognition can be achieved – fate of such transactions is unclear. However, as per our understanding, to the extent of retained risk, by way of credit enhancement, there should be a knock off from the capital. For anything retained by the originator, risk weighting should be done.
Matters which skipped attention
There are however, certain areas, which we think RBI has missed considering and they are:
- Booking of gain in case of de-recognition of assets: As per the RBI Directions on Securitisation, any gain on sale of assets should be spread over a period of time, on the other hand, the Ind AS requires upfront recognition of gain on sale of assets. The gap between the two should been bridged through this Notification.
- Consideration of OCI as a part of Regulatory Capital: As per Basel III framework, other comprehensive income forms part of Common Equity Tier I [read our article here], however, this Notification states all unrealised gains should be disregarded. This, therefore, is an area of conflict between the Basel framework and the RBI’s stand on this issue.
Read our articles on the topic:
- NBFC classification under IFRS financial statements: http://vinodkothari.com/wp-content/uploads/2018/11/Article-template-VKCPL-3.pdf
- Ind AS vs Qualifying Criteria for NBFCs-Accounting requirements resulting in regulatory mismatch?: http://vinodkothari.com/2019/07/ind-as-vs-qualifying-criteria-for-nbfcs/
- Should OCI be included as a part of Tier I capital for financial institutions?: http://vinodkothari.com/2019/03/should-oci-be-included-as-a-part-of-tier-i-capital-for-financial-institutions/
- Servicing Asset and Servicing Liability: A new by-product of securitization under Ind AS 109: http://vinodkothari.com/2019/01/servicing-asset-and-servicing-liability/
- Classification and reclassification of financial instruments under Ind AS: http://vinodkothari.com/2019/01/classification-of-financial-asset-liabilities-under-ind-as/