Government credit enhancement for NBFC pools: A Guide to Rating agencies

Vinod Kothari Consultants P Ltd (finserv@vinodkothari.com)

 

The partial credit enhancement (PCE) Scheme of the Government[1], for purchase by public sector banks (PSBs) of NBFC/HFC pools, has been discussed in our earlier write-ups, which can be viewed here and here.

This document briefly puts the potential approach of the rating agencies for rating of the pools for the purpose of qualifying for the Scheme.

Brief nature of the transaction:

  • The transaction may be summarised as transfer of a pool to a PSB, wherein the NBFC retains a subordinated piece, such that the senior piece held by the PSB gets a AA rating. Thus, within the common pool of assets, there is a senior/junior structure, with the NBFC retaining the junior tranche.
  • The transaction is a structured finance transaction, by way of credit-enhanced, bilateral assignment. It is quite similar to a securitisation transaction, minus the presence of SPVs or issuance of any “securities”.
  • The NBFC will continue to be servicer, and will continue to charge servicing fees as agreed.
  • The objective to reach a AA rating of the pool/portion of the pool that is sold to the PSB.
  • Hence, the principles for sizing of credit enhancement, counterparty (servicer) risk, etc. should be the same as in case of securitisation.
  • The coupon rate for the senior tranche may be mutually negotiated. Given the fact that after 2 years, the GoI guarantee will be removed, the parties may agree for a stepped-up rate if the pool continues after 2 years. Obviously, the extent of subordinated share held by the NBFC will have to be increased substantially, to provide increased comfort to the PSB. Excess spread, that is, the excess of actual interest earned over the servicing fees and the coupon may be released to the seller.
  • The payout of the principal/interest to the two tranches (senior and junior), and utilisation of the excess spread, etc. may be worked out so as to meet the rating objective, provide for stepped-up level of enhancement, and yet maintain the economic viability of the transaction.
  • Bankruptcy remoteness is easier in the present case, as pool is sold from the NBFC to the PSB, by way of a non-recourse transfer. Of course, there should be no retention of buyback option, etc., or other factors that vitiate a true sale.
  • Technically, there is no need for a trustee. However, whether the parties need to keep a third party for ensuring surveillance over the transaction, in form of a monitoring agency, may be decided between the parties.

Brief characteristics of the Pool

  • For any meaningful statistical analysis, the pool should be a homogenous pool.
  • Surely, the pool is a static pool.
  • The pool has attained seasoning, as the loans must have been originated by 31st March, 2019.
  • In our view, pools having short maturities (say personal loans, short-term loans, etc.) will not be suitable for the transaction, since the guarantee and the guarantee fee are on annually declining basis.

Data requirement

The data required for the analysis will be same as data required for securitisation of a static pool.

Documentation

  • Between the NBFC and the PSB, there will be standard assignment documentation.
  • Between the Bank and the GoI:
    • Declaration that requirements of Chapter 11 of the GFR have been satisfied.
    • Guarantee documentation as per format given by GOI

[1] http://pib.gov.in/newsite/PrintRelease.aspx?relid=192618

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Government Credit enhancement scheme for NBFC Pools: A win-win for all

Vinod Kothari (vinod@vinodkothari.com)

The so-called partial credit enhancement (PCE) for purchase of NBFC/HFC pools by public sector banks (PSBs) may, if meaningfully implemented, be a win-win for all. The three primary players in the PCE scheme are NBFCs/HFCs (let us collectively called them Originators), the purchasing PSBs, and the Government of India (GoI). The Scheme has the potential to infuse liquidity into NBFCs while at the same time giving them advantage in terms of financing costs, allow PSBs to earn spreads while enjoying the benefit of sovereign guarantee, and allow the GoI to earn a spread of 25 bps virtually carrying no risks at all. This brief write-ups seeks to make this point.

The details of the Scheme with our elaborate questions and answers have been provided elsewhere.

Modus operandi

Broadly, the way we envisage the Scheme working is as follows:

  1. An Originator assimilates a pool of loans, and does tranching/credit enhancements to bring a senior tranche to a level of AA rating. Usually, tranching is associated with securitisation, but there is no reason why tranching cannot be done in case of bilateral transactions such as the one envisaged here. The most common form of tranching is subordination. Other structured finance devices such as turbo amortisation, sequential payment structure, provisions for redirecting the excess spread to pay off the principal on senior tranche, etc., may be deployed as required.
  2. Thus, say, on a pool of Rs 100 crores, the NBFC does so much subordination by way of a junior tranche as to bring the senior tranche to a AA level. The size of subordination may be worked, crudely, by X (usually 3 to 4) multiples of expected losses, or by a proper probability distribution model so as to bring the confidence level of the size of subordination being enough to absorb losses to acceptable AA probability of default. For instance, let us think of this level amounting to 8% (this percentage, needless to say, will depend on the expected losses of respective pools).
  3. Thus, the NBFC sells the pool of Rs 100 crores to PSB, retaining a subordinated 8% share in the same. Bankruptcy remoteness is achieved by true sale of the entire Rs 100 crore pool, with a subordinated share of 8% therein. In bilateral transactions, there is no need to use a trustee; to the extent of the Originator’s subordinated share, the PSB is deemed to be holding the assets in trust for the Originator. Simultaneously, the Originator also retains excess spread over the agreed Coupon Rate with the bank (as discussed below).
  4. Assuming that the fair value (computation of fair value will largely a no-brainer, as the PSB retains principal, and interest only to the extent of its agreed coupon, with the excess spread flowing back to the Originator) comes to the same as the participation of the PSB – 92% or Rs 92 crores, the PSB pays the same to the Originator.
  5. PSB now goes to the GoI and gets the purchase guaranteed by the latter. So, the GoI has guaranteed a purchase of Rs 92 crores, taking a first loss risk of 10% therein, that is, upto Rs 9.20 crores. Notably, for the pool as a whole, the GoI’s share of Rs 9.20 crores becomes a second loss position. However, considering that the GoI is guaranteeing the PSB, the support may technically be called first loss support, with the Originator-level support of Rs 10 crores being separate and independent.
  6. However, it is clear that the sharing of risks between the 3 – the Originator, the GoI and the Bank will be as follows:
  • Losses upto first Rs 8 crores will be taken out of the NBFC’s first loss piece, thereby, implying no risk transfer at all.
  • Losses in excess of Rs 8 crores, but upto a total of Rs 17.20 crores (the GoI guarantee is limited to Rs 9.20 crores), will be taken by GoI.
  • It is only when the loss exceeds Rs 17.20 crores that there is a question of the PSB being hit by losses.
  1. Thus, during the period of the guarantee, the PSB is protected to the extent of 17.2%. Note that first loss piece at the Originator level has been sized up to attain a AA rating. That will mean, higher the risk of the pool, the first loss piece at Originator level will go up to protect the bank.
  2. The PSB, therefore, has dual protection – to the extent of AA rating, from the Originator (or a third party with/without the Originator, as we discuss below), and for the next 10%, from the sovereign.
  3. Now comes the critical question – what will be the coupon rates that the PSB may expect on the pool.
    1. The pool effectively has a sovereign protection. While the protection may seem partial, but it is a tranched protection, and for a AA-rated pool, a 10% thickness of first loss protection is actually far higher than required for the highest degree of safety. What makes the protection even stronger is that the size of the guarantee is fixed at the start of the transaction or start of the financial year, even though the pool continues to amortise, thereby increasing the effective thickness.
    2. Assume risk free rate is R, and the spreads for AAA rated ABS are R +100 bps. Assume that the spreads for AA-rated ABS is R+150 bps.
    3. Given the sovereign protection, the PSB should be able to price the transaction certainly at less than R +100 bps, because sovereign guarantee is certainly safer than AAA. In fact, it should effectively move close to R, but given the other pool risks (prepayment risks, irregular cashflows), one may expect pricing above R.
    4. For the NBFC, the actual cost is the coupon expected by the PSB, plus 25bps paid for the guarantee.
    5. So as long as the coupon rate of the pool for the NBFC is lower than R+75 bps, it is an advantage over a AAA ABS placement. It is to be noted that the NBFC is actually exposing regulatory and economic capital only for the upto-AA risk that it holds.

Win-win for all

If the structure works as above, it is a win-win for all:

  • For the GoI, it is a neat income of 25 bps while virtually taking no real risks. There are 2 strong reasons for this – first, there is a first loss protection by the Originator, to qualify the pool for a AA rating. Secondly, the guarantee is limited only for 2 years. For any pool, first of all, the probability of losses breaching a AA-barrier itself will be close to 1% (meaning, 99% of the cases, the credit support at AA level will be sufficient). This becomes even more emphatic, if we consider the fact that the guarantee will be removed after 2 years. The losses may pile up above the Originator’s protection, but very unlikely that this will happen over 2 years.
  • For the PSB, while getting the benefit of a sovereign guarantee, and therefore, effectively, investing in something which is better than AAA, the PSB may target a spread close to AAA.
  • For the NBFC, it is getting a net advantage in terms of funding cost. Even if the pricing moves close to AAA ABS spreads, the NBFC stands to gain as the regulatory capital eaten up is only what is required for a AA-support.

The overall benefits for the system are immense. There is release of liquidity from the banking system to the economy. Depending on the type of pools Originators will be selling, there may be asset creation in form of home loans, or working capital loans (LAP loans may effectively be that), or loans for transport vehicles. If the GoI objective of buying pools upto Rs 100000 crores gets materialised, as much funding moves from banks to NBFCs, which is obviously already deployed in form of assets. The GoI makes an income of Rs 250 crores for effectively no risk.

In fact, if the GoI gains experience with the Scheme, there may be very good reason for lowering the rating threshold to A level, particularly in case of home loans.

Capital treatment, rating methodologies and other preparations

To make the Scheme really achieve its objectives, there are several preparations that may have to come soon enough:

  • Rating agencies have to develop methodologies for rating this bilateral pool transfer. Effectively, this is nothing but a structured pool transfer, akin to securitisation. Hence, rating methodologies used for securitisation may either be applied as they are, or tweaked to apply to the transfers under the Scheme.
  • Very importantly, the RBI may have to clarify that the AA risk retention by Originators under the Scheme will lead to regulatory capital requirement only upto the risk retained by the NBFC. This should be quite easy for the RBI to do – because there are guidelines for securitisation already, and the Scheme has all features of securitisation, minus the fact that there is no SPV or issuance of “securities” as such.

Conclusion

Whoever takes the first transaction to market will have to obviously do a lot of educating – PSBs, rating agencies, law firms, SIDBI, and of course, DFS. However, the exercise is worth it, and it may not take 6 months as envisaged for the GoI to reach the target of Rs 1 lakh crores.


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Government Guarantee for NBFC Pool Purchases by Banks: Analysis, questions, and gaps

[Updated as on 16th August, 2019]

By Financial Services Division, finserv@vinodkothari.com

The Finance Minister, during the Union Budget 2019-20, proposed to introduce 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[1], 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.

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”.

The Scheme is intended to address the temporary liquidity crunch faced by solvent HFCs/ NBFCs, so that such entities may refinance their assets without having to resort to either distress sale or defaults on account of asset-liability mismatches.

In this write-up we have tried to answer some obvious questions that could arise along with potential answers.

Scope of applicability

  1. When does this scheme come into force?

The Scheme was originally introduced on 10th August, 2019 and has been put to effect immediately.

  1. How long will this Scheme continue to be in force?

The Scheme will 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. This signifies that the parties must complete the assignment and execution of necessary documents for the guarantee (see below) within the stipulated time period.

  1. Who is the beneficiary of the guarantee under the Scheme – the bank or the NBFC?

The bank is the beneficiary. The NBFC is not a party to the transaction of guarantee.

  1. 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.

  1. 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.

  1. Is the guarantee for specifically to be sought for each of the 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. There is no process of master documentation, with simply a confirmation being attached for multiple transactions. .

  1. How does this Scheme rank/compare with other schemes whereby banks may participate into 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
  • Co-lending
  • Loans for on-lending
  • Securitisation

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 AA ratings. 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 AA rated pool on standalone basis, the Scheme may be economically effective.

A major immediate benefit of the Scheme may be to nudge PSBs to start buying NBFC pools. While the guarantee is effective only for 2 years that does not mean, after 2 years, the PSBs will either sell or sell-back the pools. Therefore, in ultimate analysis, PSBs will get comfortable with buying NBFC pools on direct assignment basis.

The Scheme may go to encourage loan pool transfers outside the existing DA discipline.

  1. Is the Scheme 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:

  1. This Scheme is limited to acquisition of pools by PSBs only whereas direct assignment is not limited to either PSBs or banks.
  2. This Scheme envisages that the pool sold to the banks has attained a AA 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.
  3. 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.
  4. 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 completed carved out from the DA Guidelines, and is an alternative to DA or securitisation. .

  1. 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.

Risk transfer 

  1. The essence of a guarantee is risk transfer. So how exactly is the process of risk transfer happening in the present case?

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 presumably 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 AA. See below for discussion as to why this is nearly impossible, particularly in case of retail pools. Therefore, it appears that the pool will have to be credit-enhanced by using one or more devices of credit enhancement, say, 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%.

  1. 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 10% first loss guarantee to assets, amounting to total of ₹ 1 lakh crore. Here it is important to note that the limit of ₹ 1 lakh crore refers to the total amount of assets against which guarantee will be extended and not the total amount of guarantee. The maximum exposure that the Government will take under the Scheme is ₹ 10,000 crores (10% of ₹ 1 lakh crore). Both the amounts, Rs 1 lakh crore, as also Rs 10,000 crores, are the aggregate for the banking system as a whole.

  1. What does 10% first loss guarantee 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. Assume further that each of the loans in the pool are such that if a default occurs, the crystallised loss is 100% (that is, there is nil recovery estimated at the time of recognising the loan as a bad loan). We are also assuming, though impractically, that the loans in the pool are at least AA rated; therefore, the pool gets a AA rating.

Let us say this pool is sold by N to bank B. N retains a 10%  pari passu share of the pool – thereby, the amount of the assets transferred to the B is Rs 900 crores. Assume that the fair value is also Rs 900 crores – that means, B buys the pool at par by paying Rs 900 crores. Assume B gets the acquisition guaranteed under the Scheme.

After its acquisition by B, assume a loan goes bad (see discussion below), and therefore, N allocates a loss of Rs 90 lacs (assuming there is pari passu sharing of losses) to B. B will claim this money by way of a guarantee compensation from GoI. B will keep getting such indemnification from GoI until the total amount paid by GoI reaches Rs. 90 crores (10% of the guaranteed amount). This, based on our hypothetical assumption of each loan having the same size, will mean loss of 100 loans out of the 1000 loans in the pool.

On the other hand, if it was to be understood that the pool will have to be first credit enhanced at the level of N, to attain a credit rating of AA, then N itself may have to provide a first-loss support at the transaction level. This may be, say, by providing a subordination, such that the share of N in the transaction is subordinated, and not pari passu. In that case, the question of any risk transfer to B, and therefore, an indemnification by GoI, will arise only if the amount of losses on account of default exceed the level of first loss support provided by N.

  1. When is a loan taken to have defaulted 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.

  1. 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 outstandings from the borrower should be claimed form the guarantor, so as to indemnify the bank fully. As regards subsequent recoveries from the borrower, see later.

  1. 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.

  1. 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.

  1. 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.

  1. From the viewpoint of maximising the benefit of the guarantee, 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.

  1. 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.

  1. 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 clear 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

  1. 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.

  1. 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.

  1. 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.

Bankruptcy remoteness 

  1. 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.

  1. 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.

  1. 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.

Buyers and sellers 

  1. Who are eligible buyers under this Scheme?

As is evident from the title of the Scheme, 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.

  1. Who are eligible sellers under this Scheme?

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 selle₹ The qualifying criteria laid down therein are:

  1. NBFCs registered with the RBI, except Micro Financial Institutions or Core Investment Companies.
  2. HFCs registered with the NHB.
  3. The NBFC/ HFC must have been able to maintain the minimum regulatory capital as on 31st March, 2019, that is –
    1. For NBFCs – 15%
    2. For HFCs – 12%
  4. The net NPA of the NBFC/HFC must not have exceeded 6% as on 31st March, 2019
  5. 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.
  6. The NBFC/ HFC must not have been reported as a Special Mention Account (SMA) by any bank during year prior to 1st August, 2018.
  1. 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 requirement 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 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 maintained CRAR, and b) have maintained the required amount of capital as on 31st March, 2019, subject to the fulfilment of other conditions.

  1. The eligibility criteria for sellers state that the financial institution must not have been reported as SMA 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 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 thereafter, it will still be eligible as per the Scheme. This makes the situation a little awkward as the whole intention of the Scheme was to facilitate financially sound financial institutions. The word 2018 seems to have come by error – it should have been 2019.

Eligible assets

  1. What are the eligible assets for the Scheme?

The Scheme has explicitly laid down qualifying criteria for eligible assets and they are:

  1. The asset must have been originated on or before 31st March, 2019.
  2. The asset must be classified as standard in the books of the NBFC/ HFC as on the date of the sale.
  3. The pool of assets should have a minimum rating of “AA” or equivalent at fair value without the credit guarantee from the Government.
  4. Each account under the pooled assets should have been fully disbursed and security charge should have been created in favour of the originating NBFCs/ HFCs.
  5. The individual asset size in the pool must not exceed ₹ 5 crore.
  6. The following types of loans are not eligible for assignment for the purposes of this Scheme:
    1. Revolving credit facilities;
    2. Assets purchased from other entities; and
    3. 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.

  1. 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.

  1. 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.

  1. Is there any implication of keeping the cut-off date for originations of loans to be 31st March, 2019?

As per the RBI Guidelines on Securitisation and Direct Assignment, the originators have to comply with minimum holding requirements. The said requirement suggests that an asset can be sold off only if it has remained in the books of the originator for at least 6 months. This Scheme has come into force with effect from 10th August, 2019 and will remain open for 6 months from the commencement.

Already 5 months have passed since the cut-off date, and even if we were to assume that the loan is originated on the cut-off date itself, it would mean that closer to the end of the tenure of the Scheme, the loan will be 11 months seasoning. Such high seasoning requirements might not be motivational enough for the originators to avail this Scheme.

  1. Is there is 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.

  1. 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

 

  1. 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.

  1. What are the permissible terms of transfer under this Scheme?

The Scheme allows the assignment agreement to contain the following:

  1. Servicing rights – It allows the originator to retain the servicing function, including administrative function, in the transaction.
  2. 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

  1. The Scheme requires that the pool must have a rating of AA 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.

  1. The Scheme requires the pool of assets to be highly rated, 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 “AA” or equivalent at fair value prior to the guarantee from the Government. Interestingly, technically, only a security can be rated based on the underlying risks and rewards, and not a pool of assets.  Therefore, how will rating of the pool of assets be carried out still remains a question.

There may be a question of expected loss assessment of a pool. However, unless there is a tranching of the pool done, the question of the pool getting a rating of AA or higher will arise only if all the loans in the pool are of AA or higher rating. This will make the Scheme completely counter-intuitive.

If one were to deduce that there must have been so much of tranching or over-collateralisation done, so as to bring the pool to a AA rating, then the following difficulties arise:

  1. In case of DA transaction, there is no question of any credit enhancement. If the transaction is taken as an independent modality, different from the DA mode, then, effectively, the first loss support comes from the originator in form of subordination or over-collateralisation, and the guarantee of the Government is actually the mezzanine or second-loss support.
  2. If 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 become questionable. The thickness of support required for moving a AA rated pool to a AAA level mostly will not be as high as 10%. Also, the cost of 25 bps for guaranteeing a AA-rated pool will imply that the credit spreads between AA and a AAA-rated pool are at least good enough to absorb a cost of 25 bps. It is notable that the 10% guarantee as well as the guarantee commission are both worked out on the outstanding pool value, first, at the time of the transaction, and thereafter, on 1st As the pool is an amortising one, the impact of amortisation that happens during the financial year will not be captured on the guarantee fee – that is, the fee remains fixed throughout the financial year.

Risk weight and capital requirements

  1. 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

  1. Can the Bank treat the guaranteed pool as having attained a AAA rating?

This seems fair, since, on the top of the presumptive AA rating before the guarantee, there is a guarantee of 10% on a first loss basis. This means there is an added 10% cushion to the bank. The bank;s own exposure may, therefore, certainly be taken to have attained a AAA level. Therefore, the risk weight may now be appropriate to the AAA risk weights (20%).

  1. 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, AA.

Guarantee commission

  1. 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.

  1. 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. Thereafter, on 1st April of the financial year, it is computed on the remaining pool value.

Invocation of guarantee and refund

  1. When can the guarantee be invoked?

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.

  1. 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.

  1. 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.

  1. 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.

  1. 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 amount of received as guarantee, the excess collection will be retained by the purchasing bank.

Modus operandi

  1. 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.

  1. 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:

  1. An NBFC approaches a bank with a static pool, which, based on credit enhancements, or otherwise, has already been uplifted to a rating of AA level.
  2. The NBFC negotiates and finalises its commercials with the bank.
  3. 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.
  4. 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.
  5. DFS shall then make its decision. Once the decision of DFS is made, it shall be communicated to SIDBI and PSB.
  6. At this stage, PSB may consummate its transaction with the NBFC, after collecting the guarantee fees of 25 bps.
  7. PSB shall then execute its guarantee documentation with DFS and pay the money by way of guarantee commission.
  1. 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.

Miscellaneous

  1. 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.

  1. 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:

  1. 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;
  2. 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.

 

[1] http://pib.gov.in/newsite/PrintRelease.aspx?relid=192618

FAQs: NBFCs not to charge foreclosure / pre-payment penalties on floating rate term loans for Individual borrowers

-Kanakprabha Jethani and Julie Mehta

finserv@vinodkothari.com

 

RBI has vide notification[1] dated August 02, 2019 issued a clarification regarding waiver of foreclosure charges/ prepayment penalty on all floating rate term loans sanctioned to individual borrowers, as referred to in paragraph 30(4) of Chapter VI of Master Direction – Non-Banking Financial Company – Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016 and paragraph 30(4) of Chapter V of Master Direction – Non-Banking Financial Company – Non-Systemically Important Non-Deposit taking Company (Reserve Bank) Directions, 2016.

As per the fair practice code, NBFCs cannot charge foreclosure charges/ pre-payment penalties on all floating rate term loans sanctioned to individual borrowers

RBI has further clarified that NBFCs shall not charge foreclosure charges/ pre-payment penalties on any floating rate term loan sanctioned for purposes other than business to individual borrowers, with or without co-obligant(s).

To understand its implication and for further understanding, please refer to the list of ‘frequently asked questions’ listed below:

Basic understanding

  1. What is pre-payment or foreclosure?

 Ans. Prepayment or foreclosure is the repayment of a loan by a borrower, in part or in full ahead of the pre-determined payment schedule.

However, the distinguishing factor is that pre-payment means early payment of scheduled instalments, while foreclosure means early payment of the entire outstanding amount leading to early closure of the loan term. To extend, pre-payment is partial in nature whereas foreclosure is the closure of the loan account before the due-date.

  1. How do foreclosure charges and pre-payment penalties differ?

Ans. Conceptually, both have the same meaning. The only difference is in the terminology as the charges levied at the time of foreclosure are termed as foreclosure charges and charges levied at the time of pre-payment of an instalment are termed as pre-payment penalties.

  1. What is a term loan?

Ans. A term loan means a loan for which the term for repayment is pre-determined. This is unlike a demand loan in which the borrower has to repay on demand of repayment by the lender.

  1. How is a floating rate term loan different from a fixed rate term loan?

Ans. A fixed-rate term loan refers to interest rates that remain locked throughout the loan period, while floating-rate term loan refers to interest rates that are subject to fluctuate owing to certain factors.

  1. How is floating rate determined?

Ans. Lenders determine the floating rate on the basis of certain base rate. Usually, the floating rate is some percentage points more than the base rate. Base rate is determined by taking into account the cost of funds of the lender.

  1. Where do we find such floating rate term loans?

Ans. Floating rates are generally found in loans of long-term as the cost of funds is likely to fluctuate in the long run. However, certain medium term loans also have floating interest rate depending upon the agreement between the lender and borrower.

  1. Can a borrower make pre-payment of a term loan?

 Ans. Courts have, in many cases, given judgements stating that in the absence of specific provision in the agreement between the lender and the borrower (Loan Agreement), the borrower has the inherent right to make pre-payment of a loan. This puts light on the principle that ‘every borrower has an inherent right to free himself from the loan’.[2]

In case a lender requires that the loan amount should not be prepaid, such a restriction must be expressly mentioned in the Loan Agreement.

  1. Can a lender levy foreclosure charges/pre-payment penalty?

Ans. Unlike the provisions relating to pre-payment of loan by the borrower, the provisions for levy of foreclosure charges/pre-payment penalties are largely governed by the terms of the Loan Agreement. A lender can levy only those charges which form part of the Loan Agreement.

If provisions for levy of foreclosure charges/pre-payment penalties are expressly mentioned in the Loan Agreement, the lender can levy such charges/penalty. In absence of such provision, the lender does not have the right to levy such charges/penalty.

Further, for entities regulated by RBI, it is mandatory to mention all kinds of charges and penalties applicable to a loan transaction in the loan application form.

  1. What happens on prepayment of loan?

 Ans. Pre-payment of loan amount by the borrower has dual-impact. One is saving of interest cost and the other is reduction in the loan period. When a borrower pre-pays the loan, huge interest cost is saved, specifically in case of personal loans, where the interest rates are quite high.

  1. Why are borrowers charged in event of pre-payment?

Ans. Lenders pre-determine a schedule in terms of the specified term of a loan, including the repayment schedule, and the interest expectation. An early prepayment disrupts this schedule and also means that the borrower has to pay lesser interest (since interest is calculated from the time the loan is disbursed, till it is repaid).

Pre-payment charges are used as a client retention tool to discourage borrowers to move to other lenders, who may offer better interest for transferring the outstanding amount. It puts a limitation to the number of choices a customer can have due to market competition.

To compensate for such loss, pre-payment charges exist.

  1. What is the rate at which pre-payment charges are imposed?

Ans. The rate is determined by the opportunity cost foregone due to pre-payment/foreclosure. The future cash flows are discounted at a relatively lower rate and accordingly imposed. The rate differs from bank to bank depending on their relevant factors and policies. For example: several banks charge early repayment penalties up to 2-3% of the principal amount outstanding.

  1. How do banks benefit from the pre-payment penalties?

Ans. The prepayment penalty is not charged with the motive to generate revenue, but to recover costs incurred due to mismatch in assets and liabilities. It is believed that when long-term loans are offered to borrowers, lending facility raises long-term deposits to match their assets and liabilities on their balance sheet. So when the loans are pre-paid with respect to their scheduled payments, lenders continue to have long-term deposits on their books, leading to a mismatch

  1. What are the other factors that need to be kept in mind for pre-payment or foreclosure of loan?

Ans. The applicable rate at which penalty shall be charged is a major factor as it should not result in higher cost to the borrower. Other factors include the process of undergoing pre-payment/foreclosure, lock-in period associated with the option, documentation etc.

  1. What has been clarified?

Ans. Earlier, the FPC provided that NBFCs shall not charge foreclosure charges/prepayment penalties from individuals on floating rate term loans.

The clarification that has been provided by the RBI is that the foreclosure charges/prepayment penalties shall not be charged floating rate term loans, provided to individuals for purposes other than business i.e. personal purposes loans

Applicability

  1. On whom will this restriction be applicable?

Ans. The change shall be applicable to all kinds of NBFCs, including systemically important as well as non-systemically important NBFCs who are into business of lending to individuals. However, NBFCs engaged in lending to non-individuals only are not required to comply with this requirement.

  1. What kinds of loans will be covered?

Ans. All floating rate term loans provided to individuals for purposes other than business shall be covered under the said restriction.

  1. How will the lender define that loan is for purposes other than business?

 Ans. Before extending loans, documentation and background checks are performed. This process includes specification of the purpose for which the loan is taken. This gives a clear picture of the nature of the agreement and helps distinguish between business purpose and personal purposes.

  1. Why is this restriction on floating rate term loans only and not on fixed rate terms loans?

 Ans. Fixed rate loans involve no fluctuations in interest rates in the entire loan term. Thus in case of pre-payment, the interest foregone can be computed and realised to evaluate pre-payment penalties to be imposed.

While floating rate loans involve fluctuations based on the underlying benchmark and thus interest foregone cannot be estimated. There lies no confirmation of the lender being in the loss position. There is no way to realise interest rate sulking or hiking. Thus there is no basis on which overall loss might be estimated. In response to this situation, restrictions are on floating rate term loans and not on fixed rate term loans.

  1. Are there any other entities under similar restriction?

 Ans. RBI has put restrictions, similar to this, on banks and Housing Finance Companies as well. Banks are not permitted to charge foreclosure charges / pre-payment penalties on home loans / all floating rate term loans, for purposes other than business, sanctioned to individual borrowers. HFCs are not permitted to charge foreclosure charges/ pre-payment penalties in case of foreclosure of floating interest rate housing loans or housing loans on fixed interest rate basis which are pre-closed by the borrowers out of their own sources.

  1. When does this clarification come to effect?

Ans. It is noteworthy that this is a clarification (and not a separate provision) issued by the RBI in respect of a provision which is already a part of RBI Master Directions for NBFCs. Therefore, this clarification is deemed to be in effect from the date the corresponding provision was issued by the RBI by way of a notification[3] i.e. August 01, 2014.

Implication

  1. What is the borrower’s perspective?

Ans. Borrower’s may choose to pre-pay due to their personal obligations/burden, or if they obtain their funds which were earlier stuck, or by borrowing from a cheaper source to repay. This waive off of penalty charges, might be a sign of relief to them as they would get out of the obligation of an existing loan arrangement by paying off early and save the compounding interests and explore from the other options available in the market.

  1. What will happen after such clarification?

Ans. Prior to this clarification, the provision seemed to be providing a safe shelter to individual borrowers where they could foreclose or pre-pay any loan taken by them. Sometimes, the borrowers misused this facility by availing funds at a lower cost from some other lender to pre-pay the loans of higher interest rate. This resulted in disruptions in the forecasts of lenders, sometimes also resulting in loss to the lender.

This clarification limits the benefit of pre-payment to loans of personal nature only which are not availed very frequently by a borrower and are generally prepaid when borrowers have genuine savings or capital inflows.

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11647&Mode=0

[2] https://indiankanoon.org/doc/417200/

[3] http://pib.nic.in/newsite/PrintRelease.aspx?relid=107879

RBI eases end-use ECB norms for Corporates and NBFCs

Timothy Lopes, Executive, Vinod Kothari & Company

Introduction

The Reserve Bank of India (RBI) has wide press release[1] dated 30. 07. 2019 revised the framework for External Commercial Borrowings based on feedback from stakeholders, and in consultation with the Government of India, by relaxing the end-use restrictions with a view to ease the norms for Corporates and NBFC’s. The changes brought about can be found in the RBI Circular[2] on External Commercial Borrowings (ECB) Policy – Rationalisation of End-use Provisions dated 30. 07. 2019

Corporate sector continue to face liquidity crunch and this move from RBI is certainly a welcome move.

ECB are commercial loans raised by eligible borrowers from the recognised lenders for the permitted end use prescribed by RBI.

The ECB framework in India is mainly governed by the Foreign Exchange Management Act, 1999 (FEMA). Various provisions in respect of this type of borrowing are also included in the Foreign Exchange Management (Borrowing and Lending) Regulations, 2018[3] framed under FEMA.

The RBI has also issued directions and instructions to Authorised Persons, which are compiled and contained in the Master Direction – External Commercial Borrowings, Trade Credit, and Structured Obligations[4].

Relaxation granted in end-use restrictions

 

In the earlier framework as covered in the Master Direction – External Commercial Borrowings, Trade Credit, and Structured Obligations (Master Directions), ECB proceeds could not be utilized for working capital purposes, general corporate purposes and repayment of Rupee loans except when the ECB was availed from foreign equity holder for a minimum average maturity period (MAMP) of 5 years.

Further on-lending out of ECB proceeds for real estate activities, investment in capital market, Equity investment, working capital purposes, general corporate purposes, repayment of rupee loans was also prohibited. These restrictions were made under the end-uses (Negative list) of the Master Direction.

With a view to further liberalize the ECB Framework in view of current hardship being faced by corporate sector; RBI has decided to relax these end-use restrictions.

Accordingly the said relaxations by RBI reflect as under:

Revised ECB Framework
Particulars ECBs Availed from By Permitted End-uses MAMP
Erstwhile Provision Foreign Equity Holder Eligible Borrower ·         Working capital purposes

·         General corporate purposes or,

·         Repayment of Rupee loans

5 Years
Amended Provision Recognised Lenders* Eligible Borrower ·         Working capital purposes and,

·         General corporate purposes

10 Years
Recognised Lenders* NBFC’s ·         On-lending for:

o   Working Capital purposes and,

o   General Corporate Purpose

10 Years
Recognised Lenders* Eligible Borrowers including NBFC’s ·         Repayment of Rupee loans availed domestically for capital expenditure and,

·         On-lending for above purpose by NBFC’s

7 Years
Recognised Lenders* Eligible Borrowers including NBFC’s ·         Repayment of Rupee loans availed domestically for purposes other than capital expenditure and,

·         On-lending for above purpose by NBFC’s

10 Years
*ECBs will be permitted to be raised for above purposes from recognised lenders except foreign branches/ overseas subsidiaries of Indian Banks and subject to Para 2.2 of the Master Direction dealing with limit and leverage.

 

Relaxation for Corporate borrowers classified as SMA-2 or NPA

 

Further, Eligible Corporate Borrowers are now permitted to avail ECB for repayment of Rupee loans availed domestically for capital expenditure in manufacturing and infrastructure sector if classified as Special Mention Account (SMA-2) or Non-Performing Assets (NPA), under any one time settlement with lenders.

Permission to Lender Banks to assign loans to ECB lenders

Lender banks are also permitted to sell, through assignment, such loans to eligible ECB lenders, except foreign branches/ overseas subsidiaries of Indian banks, provided, the resultant ECB complies with all-in-cost, minimum average maturity period and other relevant norms of the ECB framework.

These permissions would reduce the burden of the lender banks who classified borrower’s account as SMA-2 or NPA.

Conclusion

Liberalization of the ECB policy by RBI acts as a step toward increased access to global markets by eligible Indian borrowers. In the current scenario of an economic slowdown, these changes come as a push upwards for the Indian economy.

Besides the above-mentioned changes in the Master Direction, all other provisions of the ECB policy remain unchanged.

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=47736

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11636&Mode=0

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11441&Mode=0

[4] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11510#1

Introspection of RBI’s new requirement for greater inspection

-Finserv Division

finserv@vinodkothari.com

 

The Union Budget 2019 had many odd talking points, especially for the banking and financial sector. From proposed recapitalization of public sector banks, relief in levy of Securities Transaction Tax (STT), proposing changes in factoring laws to increased supervision of NBFCs among others, this year’s budget created mixed emotions. One of the major changes that took everyone by surprise was granting exceptional power to the Reserve Bank of India for regulating and supervising non-banking financial companies (NBFC). One can say much of it is inspired by the ILFS saga.

In this article, we intend to pick up one such insertion in the Reserve Bank of India Act, 1934 which, we think, has escaped critic’s eye, that is section 45NAA. This, according to the author, is likely to have an overarching impact not only on the NBFCs but also on their non-financial group companies if any.

Insertion of section 45NAA

While much have been said about the other insertions in the RBI Act, that is, RBI’s right to remove directors or supersede the Board of the NBFC or initiative resolution of the NBFCs, one section which has been devoid of the much deserved attention is section 45NAA.

The section allows the RBI to inspect or audit of the books of all the group companies of an NBFC, including the non-financial entities in the group.

The text of the law has been provided below:

“45NAA. (1) The Bank may, at any time, direct a non-banking financial company to annex to its financial statements or furnish separately, within such time and at such intervals as may be specified by the Bank, such statements and information relating to the business or affairs of any group company of the non-banking financial company as the Bank may consider necessary or expedient to obtain for the purposes of this Act.

(2) Notwithstanding anything to the contrary contained in the Companies Act, 2013, the Bank may, at any time, cause an inspection or audit to be made of any group company of a non-banking financial company and its books of account.”

In other words, the RBI will be able to assess and inspect the books of non-financial institutions like manufacturing or service companies, even though its jurisdiction implicitly lies within the domain of financial institutions.

Despite being a recent addition to the NBFC sector, extended auditing power by the RBI is a prevalent norm in banking. The following is an excerpt of Section 29A from the Banking Regulation Act[1], 1949, which provides the power to the RBI on similar lines:

“(2) Notwithstanding anything to the contrary contained in the Companies Act, 1956(1 of 1956), the Reserve Bank may, at any time, cause an inspection to be made of any associate enterprise of a banking company and its books of account jointly by one or more of its officers or employees or other persons along with the Board or authority regulating such associate enterprise.”

However, there is a slight difference between the aforesaid provisions. On one hand, section 45NAA pertaining to NBFCs refer to the books of accounts of ‘group companies’ whereas, section 29A pertaining to banks refer to ‘associate enterprises’. To gauge the similarities between the sections, one has to look into the definition of the terms. The following is an excerpt from Section 45NAA-

(a) “group company” shall mean an arrangement involving two or more entities related to each other through any of the following relationships, namely:––

(i) subsidiary— parent (as may be notified by the Bank in accordance with Accounting Standards);

(ii) joint venture (as may be notified by the Bank in accordance with Accounting Standards);

(iii) associate (as may be notified by the Bank in accordance with Accounting Standards);

(iv) promoter-promotee (under the Securities and Exchange Board of India Act, 1992 or the rules or regulations made thereunder for listed companies);

(v) related party;

(vi) common brand name (that is usage of a registered brand name of an entity by another entity for business purposes); and

(vii) investment in equity shares of twenty per cent. and above in the entity;

(b) “Accounting Standards” means the Accounting Standards notified by the Central Government under section 133, read with section 469 of the Companies Act, 2013 and subsection (1) of section 210A of the Companies Act, 1956.”

Further, the relevant extract of section 29A of the Banking Regulations Act, relating to associate enterprises, is reproduced herein below-

“associate enterprise” in relation to a banking company includes an enterprise which–

(i) is a holding company or a subsidiary company of the banking company; or

(ii) is a joint venture of the banking company; or

(iii) is a subsidiary company or a joint venture of the holding company of the banking company; or

(iv) controls the composition of the Board of Directors or other body governing the banking company; or

(v) exercises, in the opinion of the Reserve Bank, significant influence on the banking company in taking financial or policy decisions; or

(vi) is able to obtain economic benefits from the activities of the banking company.

Despite some similarities in the two definitions, scope of “group companies” appear to be wider given the inclusion of related parties (defined under Ind AS-24[2]) and entities using a common brand or registered name. The meaning of the term “related party” has been obtained from Ind AS 24 and the same has numerous connotations including subsidiary, associates or entities upon which the reported entity has significant power of influence.

Undoubtedly, this is based on the learnings from the large number of scams that surfaced lately, especially the ones involving financial sector entities, but the amount of the power that has been bestowed upon the RBI is enormous. The intention is to allow RBI free access to all areas if it suspects anything foul happening in an NBFC.

Conclusion

A greater scrutinizing power bestowed to the RBI through section 45NAA has both positive, and, otherwise connotations. The power can be extended to inspect into corporate malpractices like accounting frauds, restrictive investment practices and undisclosed related party transactions through subsidiaries and associates that the RBI has reason to suspect. On the other hand, it also gives RBI discretionary powers to intervene and effect changes in private, non-financial companies on trivial grounds of misconduct, which is not always desirable. Control and corruption are opposite sides of the same coin. The coin has been flipped. Only time will show, on which side it lands.

[1] https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/BANKI15122014.pdf

[2] http://www.mca.gov.in/Ministry/pdf/Ind_AS24.pdf

Ind AS vs Qualifying Criteria for NBFCs-Accounting requirements resulting in regulatory mismatch?

-Financial Services Division and IFRS Division,  (finserv@vinodkothari.com  ifrs@vinodkothari.com)

The transition of accounting policies for the non-banking financial companies (NBFCs) is on the verge of being completed. As was laid down in the implementation guide issued by the Ministry of Corporate Affairs, the Indian Accounting Standard (Ind AS) was to be implemented in the following manner:

Non-Banking Financial Companies (NBFCs)
Phase I

 

 From 1st April, 2018 (with comparatives for the periods ending on 31st  March, 2018)
·         NBFCs having net worth of rupees five hundred crore or more (whether listed or unlisted)
·         holding, subsidiary, joint venture and associates companies of above NBFC other than those already covered under corporate roadmap shall also apply from said date
Phase II From 1st April, 2019 (with comparatives for the periods ending on 31st March, 2019)
·         NBFCs whose equity and/or debt securities are listed or in the process of listing on any stock exchange in India or outside India and having net worth less than rupees five hundred crore

 

·         NBFCs that are unlisted companies, having net worth of rupees two-hundred and fifty crore  or more but less than rupees five hundred crore
·         holding, subsidiary, joint venture and associate companies of above other than those already covered under the corporate roadmap
· Unlisted NBFCs having net worth below two-hundred and fifty crore shall not apply Ind AS.

· Voluntary adoption of Ind AS is not allowed (allowed only when required as per roadmap)

· Applicable for both Consolidated and Individual Financial Statements

As may be noted, the NBFCs have been classified into three major categories – a) Large NBFCs (those with net worth of ₹ 500 crores or more), b) Mid-sized NBFCs (those with net worth of ₹ 250 crores – ₹ 500 crores) and c) Small NBFCs (unlisted NBFCs with net worth of less than ₹ 250 crores).

The implementation of Ind AS for Large NBFCs has already been completed, and those for Mid-sized NBFCs is in process; the Small NBFCs are anyways not required implementation.

The NBFCs are facing several implementation challenges, more so because the regulatory framework for NBFCs have not undergone any change, despite the same being closely related to accounting framework. Several compliance requirements under the prudential norms are correlated with the financial statements of the NBFCs, however, several principles in Ind AS are contradictory in nature.

One such issue of contradiction relates to determination of qualifying assets for the purpose of NBFC classification. RBI classifies NBFCs into different classes depending on the nature of the business they carry on like Infrastructure Finance Companies, Factoring Companies, Micro Finance Companies and so on. In addition to the principal business criteria which is applicable to all NBFCs, RBI has also laid down special conditions specific to the business carried on by the different classes of NBFCs. For instance, the additional qualifying criteria for NBFC-IFCs are:

(a) a minimum of 75 per cent of its total assets deployed in “infrastructure loans”;

(b) Net owned funds of Rs.300 crore or above;

(c) minimum credit rating ‘A’ or equivalent of CRISIL, FITCH, CARE, ICRA, Brickwork Rating India Pvt. Ltd. (Brickwork) or equivalent rating by any other credit rating agency accredited by RBI;

(d) CRAR of 15 percent (with a minimum Tier I capital of 10 percent)

Similarly, there are conditions laid down for other classes of NBFCs as well. The theme of this article revolves the impact of the Ind AS implementation of the conditions such as these, especially the ones dealing with sectoral deployment of assets or qualifying assets. But before we examine the specific impact of Ind AS on the compliance, let us first understand the implications of the requirement.

Relevance of sectoral deployment of funds/ qualifying assets for NBFCs

The requirement, such as the one discussed above, that is, of having 75% of the total assets deployed in infrastructure loans by the company happens to be a qualifying criteria. IFCs are registered with the understanding that they will operate predominantly to cater the requirements of the infrastructure sector and therefore, their assets should also be deployed in the infrastructure sector. However, once the thresholds are satisfied, the remaining part of the assets can be deployed elsewhere, as per the discretion of the NBFC.

The above requirement, in its simplest form, means to have intentional and substantial amount of the total assets of the NBFC in question to be deployed in the infrastructure area, both, at the time of registration, as well as a regulatory requirement, which has to be met over time. Breaching the same would result in non-fulfilment of the RBI regulations.

Impact of Ind AS on the qualifying criteria

The above requirement might seem simple, however, with the implementation of Ind AS on NBFC, there can be important issues which might result in the breach of the above requirement.

With the overall slogan of “Substance over Form”, and promoting “Fair Value Accounting” and an aim to make the financial statements more transparent and just, Ind AS have been implemented. However, the same fair value accounting can result in a mismatch of regulatory requirement, to such an extent that the repercussion may have a serious impact on the existence of being an NBFC.

As already stated above, once an NBFC satisfies the qualifying criteria, it can deploy the remaining assets anywhere as per its discretion. Let us assume a case, where the remaining assets are deployed in equity instruments of other companies. All this while, under the Indian GAAP, investments in equity shares were recorded in the books of accounts as per their book value, but with the advent of Ind AS, most of these investments are now required to be recorded on fair values. This logic not only applies in case of equity instruments, but in other classes of financial instruments, other than those eligible for classification as per amortised cost method.

The problem arises when the fair value of the financial instruments, other than the NBFC category specific loans like infrastructure loans, exceed the permitted level of diversification (in case of IFC – 25% of the total assets). Such a situation leads to a question whether this will breach the qualifying criteria for the NBFC. A numeric illustration to understand the situation better has been provided below:

Say, an NBFC-IFC, having a total asset size of Rs. 1,000 crores would be required to have 75% of the total assets deployed in infrastructure loans i.e. Rs. 750 crores. The remaining Rs. 250 crores is free for discretionary deployments. Let us assume that the entire Rs. 250 crores have been deployed in other financial assets.

Now, say, after fair valuation of such other financial assets, the value of such assets increases to ₹ 500 crores, this will lead to the following:

Under Indian GAAP Under Ind AS
Amount

(in ₹ crores)

As per a % of total assets Amount

(in ₹ crores)

As per a % of total assets
Infrastructure Loans 750 75% 750 60%
Other financial assets 250 25% 500 40%
Total assets 1000 100% 1250 100%

 

Therefore, if one goes by the face of the balance sheet of the NBFC, there is a clear breach as per the Ind AS accounting, as the qualifying asset comes down to 60% as against the required level of 75%. However, is it justified to take such a view?

The above interpretation is counter-intuitive.

It may be noted that the stress is on “deployment” of its assets by an IFC. Merely because the value of the equity has appreciated due to fair valuation, it cannot be argued that the IFC has breached its maximum discretionary investment limits. The deployment was only limited to 25% or so to say that even though the fair value of the exposure has gone up but the real exposure of the NBFC is only to the extent of 25%. Under Ind AS, the fair value of an exposure may vary but the real exposure will remain unchanged.

Taking any other interpretation will be counter-intuitive. If the equity in question appreciates in value, and if the fair value is captured as the value of the asset in the balance sheet, the IFC will be required to increase its exposure on infrastructure loans. But the IFC in question may be already fully invested, and may not have any funding capability to extend any further infrastructure loans. Under circumstances, one cannot argue that the IFC must be forced to disinvest its equities to bring down its investment in equities, particularly as the same had nothing to do with “deployment” of funds.

This is further fortified by Para 10. Accounting of Investments, Chapter V- Prudential Regulations of the Master Direction – Non-Banking Financial Company – Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016 about valuation of equities:

“Quoted current investments for each category shall be valued at cost or market value whichever is lower”.

Hence, the RBI Regulations have been framed keeping in view the historical cost accounting. There is no question of taking into consideration any increase in fair value of investments.

Conclusion

Therefore, it is safe to say that while determining the compliance with qualifying criteria, one must consider real exposures and not fair value of exposures as the same is neither in spirit of the regulations nor seems logical. This will however be tested over time as we are sure the regulator will have its own say in this, however, until anything contrary is issued in this regard, the above notion seems logical.

Union Budget 2019-20: Impact on Corporate and Financial sector

RBI to strengthen corporate governance for Core Investment Companies.

Vinod Kothari

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

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

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

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

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

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

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

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

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

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

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

Project Rupee Raftaar: An Analysis