Moratorium on loans due to Covid-19 disruption

Team Financial Services, Vinod Kothari Consultants P Ltd. 

finserv@vinodkothari.com 

[This version dated 2nd April 2020. We shall continue to develop this further based on the text of notification and the clarifications, if any, issued by the RBI ]

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

Further, in this regard the Ministry of Finance has also issued FAQs on RBI’s scheme for a 3-month moratorium on loan repayment.

Legal/contractual nature of the Moratorium

1.     Has the RBI granted a compulsory moratorium?

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

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

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

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

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

4.     What is meant by moratorium on term loan?

Moratorium is a sort of granting of a ’holiday’- it is a repayment holiday where the borrower is granted an option to not pay during the moratorium period. It is a restructuring of the terms of the loan with the mutual consent of the lender and the borrower. The consent of the lender will be in the form the lender’s circular or notice – see below. The consent of the borrower may be obtained by a “deemed consent unless declined” option.

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

Scope and implementation of the moratorium

5.     From what date can the moratorium be granted?

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

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

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

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

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

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

(i) principal and/or interest components;

(ii) bullet repayments;

(iii) Equated Monthly instalments;

(iv) credit card dues.

8.     What shall be the moratorium period?

Lending Institutions may use their discretion to allow a moratorium of upto three months. It is not necessary to provide a compulsory moratorium of three months- it can be less than three months as well. Practically, we envisage that all lenders shall grant a moratorium to all borrowers across board for 3 months.

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

9.     Reading the language of the RBI Notification strictly, it says: “lending institutions” are permitted to grant a moratorium of three months on payment of all instalments1 falling due between March 1, 2020 and May 31, 2020. [Para 2]. The notification nowhere refers to the payments which had already fallen due before March 1. Therefore, will those payments continue to age during the moratorium period? For example, will something which is 30 DPD will become 120 DPD?

As per the contents of the letter dated March 31, 2020 written by RBI to IBA, any amount which was overdue on 29th Feb, 2020, there is no moratorium with respect to those amounts, and therefore, the existing IRAC norms will continue to apply. The RBI contends that there was no disruption in February, and therefore, one cannot bring disruption as the basis for not paying what had fallen due before March 1.

However, in our view, such an interpretation will be completely counter-intuitive. The whole intent behind the moratorium is the disruption in the system due to an externality. If the borrower had an instalment which was 30 days past due on 1st March, it cannot be contended that he will have difficulty in paying his current dues but will have no difficulty in paying what had already become due. But for the systemic disruption, it could well have been that the borrower would have cleared all his dues.

The meaning of the moratorium is that payments do not fall due during the period of the moratorium – whether current or past. Therefore, the moratorium period cannot result into ageing of the past dues. Of course, if the past dues are an overdue rate, the overdue rate may continue. But for the purpose of counting DPD, the moratorium period will have to be excluded.

Taking any other interpretation will frustrate the very purpose of the moratorium. By rules of appropriation, whatever the borrower pays between March 1 and May 31 would have first gone towards clearing his overdues. Hence, a moratorium on the current dues should apply to the existing dues as well.

We have also written to the RBI seeking a clarification on the same and we will continue to update our FAQs if there is any further update on this.

10. How will the moratorium impact the existing loan tenure?

In case a moratorium is granted, the RBI circular states that the repayment schedule for such loans as also the residual tenure, will be shifted across by three months after the moratorium period.

However, in certain cases of long tenure loans (say, home loans), the additional burden on the borrower due to the accrued interest (and interest on such interest) would cause the amount to swell so much that paying the accumulated interest in one go may not be feasible. This may require the lender to convert the accrued interest also into instalments. Converting such accrued interest into manageable instalments is the lender’s prudential call, and should not be taken as a case of restructuring, since the total tenure is going beyond 3 months over the original term.

11. Will the interest accrue during the moratorium period?

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

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

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

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

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

14. Is the moratorium applicable to the following:

(a)  Personal loans

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

(b)  Overdraft facilities

Overdraft facilities allow the account-holder to withdraw more money than what is held in the account. It is a kind of short-term loan facility, which the account-holder shall be required to repay within a specified period of time or at once, depending on the terms of arrangement with the bank. Thus, in case repayment is to be made within a specified tenure , the same qualifies to be term-loan and moratorium shall be applicable on EMIs of such overdraft facility.

(c) An unsecured personal loan extended by a lender through prepaid cards for making payments at partner merchant PoS

Such unsecured personal loans may be repayable in the form of EMIs or a bullet repayment. As discussed above, if repayment is made over a period of time, moratorium is applicable. In case of bullet repayments as well, moratorium may be granted.

(d) Invoice financing

Invoice financing can be of 2 types- (a) Factoring and (b) Asset-based invoice financing.

In case of factoring, the factor purchases the receivables of an entity and pays the amount of receivables reduced by a certain percentage (factoring fee) to the entity. Thereafter, the factor is responsible to recover the money from the debtor of such entity. There is no moratorium in case of commercial invoices.

Another device commonly used is invoice financing i.e. asset-based invoice financing, which  allows a vendor to avail a credit facility  against the security of receivables. Since the underlying here is the commercial receivable, for which there is no moratorium, the same is not covered by the moratorium as being discussed.

(e) Payday loans

Payday loans are unsecured personal credit facilities obtained by salaried individuals against their upcoming pay-cheques. The amount of such facilities is usually limited to a certain part of the borrower’s upcoming salary.

In case of such loans, the repayment term, though very short, is pre-determined and is payable from out of the salary of the individual. As there is no deferral of salary payments, we are of the view that there is no case of disruption here.

(f) Loan against turnover

These loans are extended by the lenders on the basis of expected turnover of a merchant, mostly on e-commerce websites. The intent is to finance the day-to-day business needs of the borrower in order to attain the expected turnover. Thus, such loans are essentially working capital loans. As already discussed, moratorium may be allowed on working capital loans.

(g) Long-term loans

These kinds of loans have a pre-specified term, which is usually greater than 3 years. Needless, to say, being term loans, moratorium shall be allowed on such loans. Such loans are usually secured and may cover the following kinds of loans:

  • Housing loans
  • Equipment finance loans
  • Personal loans
  • Two-wheeler loans
  • Auto-finance loans

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

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

16. Is it possible for the Lender to not provide a moratorium?

Technically, certainly yes. However, borrowers may take advantage of the Ministry of Law circular that the COVID disruption is a case of “force majeure” and FMC does not result in a contractual breach. Hence, lenders will be virtually forced into granting the same.

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

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

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

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

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

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

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

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

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

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

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

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

23. Will such payment be considered as prepayment?

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

24. Is the moratorium applicable to financial lease transactions?

Financial leases are akin to loan transactions and have rental payouts similar to EMIs in case of a term loan. Hence, lessors under a financial lease may confer the benefit of the moratorium under the RBI circular.

25. Is the moratorium applicable to operating lease transactions?

Operating leases are not considered as financial transactions and hence, they shall not be covered under the RBI circular for granting moratorium. However, lessors may, in their wisdom, grant the benefit of moratorium. Note that the NPA treatment in case of operating leases is not the same as in case of loans.

Refer to our various articles on leasing here.

26. A loan was in default already as on 1st March, 2020. The lender has various security interests – say a mortgage, or a pledge. Will the lender be precluded from exercising security interest during the holiday period?

The moratorium is only for what instalments/payments were due from 1st March 2020 upto the period of moratorium conferred by the lender (so, 31st May, in case of a 3 month moratorium). The same does not affect payment obligations that have already fallen due before 1st March. Hence, if there was a default, and there were remedies available to the lender as on 1st March already, the same will not be affected.

However, note that for using the powers under the SARFAESI Act, the facility has to be characterised as non-performing. Unless the facility was already a non-performing loan, the intervening holiday will defer the NPA categorisation. In that case, the use of SARFAESI powers will be deferred until NPA categorisation happens.

Modus operandi for giving effect to the moratorium

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

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

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

You may refer to the list of actionables here.

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

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

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

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

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

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

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

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

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

31. In case the payment has been made by a borrower for the installment due for the month of March 2020, does the lender need to refund the same?

The payments already received may not be considered for the purpose of passing the moratorium relaxation. The lenders have their discretion, but appropriately, these payments may either be regarded as payment of principal as on 1st March, 2020, duly discounted for the time lag between 1st March and the actual repayment date, or the payment already made by the borrower may just be excluded from the moratorium. For example, if the payments fell due on 7th March, and by 15th March, 80% of the payments have already been made, the same may just be excluded from the holiday, thereby granting holiday only for the  payments due on 15th April and 15th May.

NPA classification and restructuring

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

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

In case of standard loan, the moratorium period will not be considered for computing default and hence, it will not result in asset classification downgrade. Our views in this regard have been discussed elaborately above.

As per the FAQs issued by the MoF, it is clear that the benefit of moratorium is available to all such accounts, which are standard assets as on 1st March 2020. Hence, loans already classified as NPA shall continue with further asset classification deterioration during the moratorium period in case of non-payment.

If the account is showing signs of stress on March 1, 2020, it seems remains a stressed account on that date. The moratorium is simply to ameliorate the impact of the disruption. The disruption was not there on March 1, 2020 – hence, the status as on that date does not change due to the moratorium. If a loan was 30 DPD on 1st March, it will become a non-performing loan on 1st May.

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

The RBI contends that there was no disruption in February, and therefore, one cannot bring disruption as the basis for not paying what had fallen due before March 1. The benefit of the moratorium is not applicable for the amounts which were already past due before March 01, 2020..

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

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

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

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

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

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

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

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

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

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

Impact of the Moratorium on accounting under IndAS 109

38. Where there are no repayments during the moratorium period, is it proper to say that the loan will be taken to have “defaulted” or there will be credit deterioration, for the purposes of ECL computation?

The provisions of para 5.5.12 of the IndAS 109 are quite clear on this. If there has been a modification of the contractual terms of a loan, then, in order to see whether there has been a significant increase in credit risk, the entity shall compare the credit risk before the modification, and the credit risk after the modification. Sure enough, the restructuring under the disruption scenario is not indicative of any increase in the probability of default.

39. There are presumptions in para B 5.5.19 and 20 about “past due” leading to rebuttable presumption about credit deterioration. What impact does the moratorium have on the same?

The very meaning of “past due” is something which is not paid when due. The moratorium amends the payment schedule. What is not due cannot be past due.

40. Will the effective interest rate (EIR) for the loan be recomputed on account of the modification of tenure?

The whole idea of the modification is to compute the interest for the deferment of EMIs due to moratorium, and to compensate the lender fully for the same. The IRR for the loan after restructuring should, in principle, be the same as that before restructuring. Hence, there should be no impact on the EIR.

41. What will be the impact of the moratorium for accounting for income during the holiday period?

As the EIR remains constant, there will be recognition of income for the entire Holiday period. For example, for the month of March, 2020, interest will be accrued. The carrying value of the asset (POS) will stand increased to the extent of such interest recognised. In essence, the P/L will not be impacted.

42. If the moratorium is a case of “modification of the financial asset”, is there a case for computing modification gain/loss?

As the EIR remains constant, the question of any modification gain or loss does not arise.

43. Does the “modification of the financial asset”call for impairment testing?

The contractual modification is not the result of a credit event. Hence, the question of any impairment for this reason does not arise.

Impact in case of securitisation transactions

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

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

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

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

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

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

Impact in case of direct assignment transactions

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

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

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

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

Impact in case of co-lending transactions

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

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

 

 

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

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


Our other write-ups relating to covid-19 disruption can be read here- http://vinodkothari.com/covid-19-incorporated-responses/

Other write-ups on NBFCs can be read here- http://vinodkothari.com/nbfcs/

Moving to contactless lending, in a contact-less world

-Kanakprabha Jethani (kanak@vinodkothari.com)

Background

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

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

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

Journey of digitisation

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

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

Milestones in process of digitisation

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

From physical to paperless to contactless: the basic difference

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

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

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

 

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

The manifold repercussions

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

Payments coming to online platforms

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

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

Need for service providers

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

Deliberate and automatic generation of demand

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

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

Opportunities for service providers

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

Platform service providers:

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

Software as a Service (SaaS) providers:

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

Payment service providers:

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

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

Heads-up from the regulator

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

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

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

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

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

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

Way forward

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

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

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

Conclusion

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

 

 

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

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

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

[4] Paperless here means paperless digital financial transactions

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

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

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

 

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

-Abhirup Ghosh

(abhirup@vinodkothari.com)

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

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

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

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

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

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

1.   Things to be done by the BOD

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

2.   Expected Credit Losses (ECL) and prudential norms

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

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

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

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

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

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

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

The questions that arise here are:

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

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

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

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

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

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

3.     Dealing with defaults and significant increase in credit risk

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

4.   Things to be done by the ACB

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

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

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

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

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

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

5.   Computation of Regulatory Capital

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

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

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

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

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

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

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

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

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

6.   Securitisation accounting and prudential norms

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

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

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

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

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

Matters which skipped attention

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

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

 

Read our articles on the topic:

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

 

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

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

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

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

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

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

-Megha Mittal

(mittal@vinodkothari.com

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

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

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

Read more

EASE OF RECOVERY FOR NBFCS?

–  Ministry of Finance relaxes the criteria for NBFCs to be eligible for enforcing security interest under SARFAESI

-Richa Saraf (richa@vinodkothari.com)

 

The Ministry of Finance has, vide notification[1] dated 24.02.2020 (“Notification”), specified that non- banking financial companies (NBFCs), having assets worth Rs. 100 crore and above, shall be entitled for enforcement of security interest in secured debts of Rs. 50 lakhs and above, as financial institutions for the purposes of the said Act.

BACKGROUND:

RBI has, in its Financial Stability Report (FSR)[2], reported that the gross NPA ratio of the NBFC sector has increased from 6.1% as at end-March 2019 to 6.3% as at end September 2019, and has projected a further increase in NPAs till September 2020. The FSR further states that as at end September 2019, the CRAR of the NBFC sector stood at 19.5% (which is lower than 20% as at end-March 2019).

To ensure quicker recovery of dues and maintenance of liquidity, the Finance Minister had, in the Budget Speech, announced that the limit for NBFCs to be eligible for debt recovery under the SARFAESI is proposed to be reduced from Rs. 500 crores to asset size of Rs. 100 crores or loan size from existing Rs. 1 crore to Rs. 50 lakhs[3]. The Notification has been brought as a fall out of the Budget.

Our budget booklet can be accessed from the link below:

http://vinodkothari.com/wp-content/uploads/2020/02/Budget-Booklet-2020.pdf

ELIGIBILITY FOR INITIATING ACTION UNDER SARFAESI

To determine the test for eligible NBFCs, it is first pertinent to understand the terms used in the Notification.

The Notification provides that NBFCs shall be entitled for enforcement of security interest in “secured debts”. Now, the term “secured debt” has been defined under Section 2(ze) of SARFAESI to mean a debt which is secured by any security interest, and “debt” has been defined under Section 2(ha) as follows:

(ha) “debt” shall have the meaning assigned to it in clause (g) of section 2 of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (51 of 1993) and includes-

(i) unpaid portion of the purchase price of any tangible asset given on hire or financial lease or conditional sale or under any other contract;

(ii) any right, title or interest on any intangible asset or licence or assignment of such intangible asset, which secures the obligation to pay any unpaid portion of the purchase price of such intangible asset or an obligation incurred or credit otherwise extended to enable any borrower to acquire the intangible asset or obtain licence of such asset.

Further, Section 2(g) of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, provides that the term “debt” means “any liability (inclusive of interest) which is claimed as due from any person by a bank or a financial institution or by a consortium of banks or financial institutions during the course of any business activity undertaken by the bank or the financial institution or the consortium under any law for the time being in force, in cash or otherwise, whether secured or unsecured, or assigned, or whether payable under a decree or order of any civil court or any arbitration award or otherwise or under a mortgage and subsisting on, and legally recoverable on, the date of the application and includes any liability towards debt securities which remains unpaid in full or part after notice of ninety days served upon the borrower by the debenture trustee or any other authority in whose favour security interest is created for the benefit of holders of debt securities.”

Therefore, NBFCs having asset size of Rs. 100 crores and above as per their last audited balance sheet will have the right to proceed under SARFAESI if:

  • The debt (including principal and interest) amounts to Rs. 50 lakhs or more; and
  • The debt is secured by way of security interest[4].

EFFECT OF NOTIFICATION:

An article of Economic Times[5] dated 07.02.2020 states that:

“Not many non-bank lenders are expected to use the SARFAESI Act provisions to recover debt despite the Union budget making this route accessible to more such lenders due to time-consuming administrative hurdles as well as high loan ticket limit.”

As one may understand, SARFAESI is one of the many recourses available to the NBFCs, and with the commencement of the Insolvency and Bankruptcy Code, the NBFCs are either arriving at a compromise with the debtors or expecting recovery through insolvency/ liquidation proceedings of the debtor. The primary reasons are as follows:

  • SARFAESI provisions will apply only when there is a security interest;
  • NBFCs usually provide small ticket loans to a large number of borrowers, but even though their aggregate exposure, on which borrowers have defaulted, is substantially high, they will not able to find recourse under SARFAESI;
  • For using the SARFAESI option, the lender will have to wait for 90 days’ time for the debt to turn NPA. Then there is a mandatory 60 days’ notice before any repossession action and a mandatory 30 days’ time before sale. Also, the debtor may file an appeal before Debt Recovery Tribunal, and the lengthy court procedures further delay the recovery.

While the notification seems to include a larger chunk of NBFCs under SARFAESI, a significant question that arises here is whether NBFCs will actually utilise the SARFAESI route for recovery?

 

[1] http://egazette.nic.in/WriteReadData/2020/216392.pdf

[2] https://m.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=952

[3] https://www.indiabudget.gov.in/doc/Budget_Speech.pdf

[4] Section 2(zf) “security interest” means right, title or interest of any kind, other than those specified in section 31, upon property created in favour of any secured creditor and includes-

(i) any mortgage, charge, hypothecation, assignment or any right, title or interest of any kind, on tangible asset, retained by the secured creditor as an owner of the property, given on hire or financial lease or conditional sale or under any other contract which secures the obligation to pay any unpaid portion of the purchase price of the asset or an obligation incurred or credit provided to enable the borrower to acquire the tangible asset; or

(ii) such right, title or interest in any intangible asset or assignment or licence of such intangible asset which secures the obligation to pay any unpaid portion of the purchase price of the intangible asset or the obligation incurred or any credit provided to enable the borrower to acquire the intangible asset or licence of intangible asset.

[5] https://economictimes.indiatimes.com/industry/banking/finance/banking/not-many-nbfcs-may-use-sarfaesi-act-to-recover-loan/articleshow/74012648.cms

NBFC Allied Activities: Corporate Insurance Agency and Mutual Fund Distribution

– Harshil Matalia, Executive, Vinod Kothari Consultants Pvt Ltd

finserv@vinodkothari.com

Introduction

Non-Banking Financial Companies (NBFCs) are companies that are principally engaged in financial activities. Financial activities include the activities that result into creation of financial assets in the books of the company or generation of financial income for the company undertaking such activity. NBFCs can engage in non-financial activities as well, as long as such non-financial activity doesn’t become the principal business of such NBFC.[1]

Apart from the financial activities, there are certain other allied activities that NBFCs are allowed to do, subject to certain guidelines prescribed by the Reserve Bank of India (RBI). The RBI Master Directions[2] for NBFCs permit an NBFC to undertake following allied activities:

  1. Insurance Business
  2. Issue of Credit cards
  3. Issue of Co-branded Credit cards
  4. Distribution of Mutual Fund Products.

This article intends to give a brief introduction to Insurance Business and Mutual Fund Distribution activities along with the associated guidelines. With regards to the issue of credit cards, the same is covered under separate article.[3]

Corporate Agent

Overview

According to Section 2(f) of IRDAI (Registration of Corporate Agents) Regulations, 2015[4]  (‘the Regulations’), “Corporate Agent” means any applicant who holds a valid certificate of registration issued by the IRDAI under these regulations for solicitation and servicing of insurance business for any of the specified category of life, general and health.

As per Chapter IV of the Insurance Laws (Amendment) Act, 2015[5], the definition of intermediary or insurance intermediary as specified under Section 2(1)(f) of IRDA Act, 1999 was amended and pursuant to such amendment, ‘Corporate Agent’ had been included in the definition. Therefore, Corporate Agents is considered as an Insurance Intermediary under IRDA Regulations.

Registration requirement

In compliance with Regulation 4(4) of the regulations, NBFC being registered with RBI, is required to obtain NOC from RBI before filing application of becoming Corporate Agent. On receiving NOC, the applicant can ascertain the eligibility norms and directly apply for registration as Corporate Agent with IRDA under any one of the following categories and under each category the company can have an arrangement with a maximum of three insurers to solicit, procure and service their insurance products.

  • Corporate Agent (Life)
  • Corporate Agent (General);
  • Corporate Agent (Health)
  • Corporate Agent (Composite)

Corporate Agent can hold a valid certificate to act as an agent of either life insurers or health insurers or general insurers or combination of any two or all of three in case of composite category.

Corporate Agent is required to appoint a principal officer exclusively for supervising the activities of the Corporate Agent. All the employees of the Corporate Agent who are   proposed to be engaged in soliciting and procuring insurance business are known as ‘specified persons’ and such specified persons and principal officer are required to  fulfil the requirements of qualification, training, passing of examination as specified in the regulations by IRDA from time to time.

RBI guidelines on Corporate Agents activity

NBFC can undertake the insurance agency business without taking approval of RBI by merely complying with following conditions:

  1. An NBFC should not force its customers to purchase insurance products of any specific company of whose assets are financed by such NBFCs.
  2. The publicity material distributed by the NBFC should clarify that participation by the customers in insurance products is on a voluntary basis.
  3. The premium payment cannot be routed  through the NBFC.
  4. Any  risk involved in Insurance business cannot be transferred to NBFC business.

Requirements under FEMA

Para F.8 of Schedule I to Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (NDI Rules) provides as under:

F.8 Insurance
Sl. No Sector/ Activity Sectoral Cap Entry Route
F.8.1 a)      Insurance Company

b)      Insurance Brokers

c)      Third Party Administrators

d)     Surveyors and Loss Assessors

e)      Other Insurance Intermediaries appointed under the provisions of Insurance Regulatory and Development Authority Act, 1999 (41 of 1999).

 49% Automatic
F.8.2 Other Conditions

(a)    Foreign investment in this sector shall be subject to compliance with the provisions of the Insurance Act, 1938 and subject to necessary license or approval from the Insurance Regulatory and Development Authority of India for undertaking insurance and related activities.

 

(c) Where an entity like a bank, whose primary business is outside the insurance area, is allowed by the Insurance Regulatory and Development Authority of India to function as an insurance intermediary, the foreign equity investment caps applicable in that sector shall continue to apply, subject to the condition that the revenues of such entities from their primary (i.e., non-insurance related) business must remain above 50 percent of their total revenues in any financial year.

Accordingly, the NBFC shall additionally comply with IRDA guidelines in relation to extent and conditions for foreign investment in Indian Insurance Companies.

Mutual Fund Distribution

Overview

Mutual Fund Distributor (MFD) facilitates buying and selling of mutual fund units by investors. MFDs act as a link between MFs and investors. They help investors by guiding them to carry out investment transactions and also provide relevant information related to performance of their investment. They earn upfront commission from empanelled asset management companies for bringing investors into the mutual fund schemes.

Association of Mutual Funds in India (AMFI) is a nodal association of mutual funds across India. It is non-profit organisation established with the purpose of developing Indian Mutual Fund industry. It provides useful knowledge and insights regarding mutual funds and investments. Any person who wants to become a MFD should approach AMFI for registration.

Registration requirement

The applicant for MFD must comply with procedural guidelines[6] provided by AMFI. The applicant must obtain AMFI Registration Number (ARN) and its employees that would be engaged in selling and distribution of mutual fund units are required to pass requisite NISM certification and obtain Employee Unique Identification Number (EUIN) from AMFI.

RBI guidelines on MFD activity

In order to become an MFD, an NBFC must comply with the RBI directions along with AMFI procedural guidelines. As per RBI Master Directions[7], NBFCs are required to adhere to the following:

  1. Compliance with SEBI guidelines / regulations, including its code of conduct, if any;
  2. Abstain from forcing its customers to trade in specific mutual fund product sponsored by it;
  3. Clarify in the publicity material distributed by the NBFC that participation by the customers in MF products is on a voluntary basis.
  4.  Act as a link between customer and MF by forwarding application for purchase or sale of units and payment instruments.
  5. Abstain from acquiring units of MFs from the secondary market for sale to its customers and from buying back MF units from its customers;
  6. Ensure distinction between its own investment and investment of customer in cases where NBFC is holding custody of units on behalf of customer.
  7. Frame a Board approved policy regarding undertaking MF distribution and adhere to Know Your Customer (KYC) Guidelines.

Requirements under FEMA

As per Para F.10.1 of Schedule I to NDI Rules, ‘Other Financial Service’ means financial services activities regulated by financial sector regulators, viz., Reserve Bank, Securities and Exchange Board of India, Insurance Regulatory and Development Authority, Pension Fund Regulatory and Development Authority, National Housing Bank or any other financial sector regulator as may be notified by the Government of India. Foreign investment in ‘Other Financial Services’ activities is subject to conditionalities, including minimum capitalization norms, as specified by the concerned Regulator/Government Agency.

‘Other Financial Services’ activities need to be regulated by one of the Financial Sector Regulators. In all such financial services activity which are not regulated by any Financial Sector Regulator or where only part of the financial services activity is regulated or where there is doubt regarding the regulatory oversight, foreign investment up to 100 percent will be allowed under Government approval route subject to conditions including minimum capitalization requirement, as may be decided by the Government.

Conclusion

While RBI has permitted NBFCs to undertake several allied acitivites, there is a need to comply with the specific guidelines provided in relation to each of the activity as well as RBI specific directions/ conditions in this regard.

 

[1] Our presentation that deals with principal business criteria- http://vinodkothari.com/wp-content/uploads/2018/09/Non-Banking-Financial-Companies-An-Overview.pdf

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

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

[4] http://dhc.co.in/uploadedfile/1/2/-1/IRDAI%20(Registration%20of%20Corporate%20Agents)%20Regulations%202015.pdf

 

[5]https://financialservices.gov.in/sites/default/files/The%20Insuance%20Laws%20%28Amendment%29%20Act%202015_0.pdf

 

[6] https://www.amfiindia.com/distributor-corner/become-mutual-fund-distributor

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

An all-embracing guide to identity verification through CKYCR

-Kanakprabha Jethani | Executive

(kanak@vinodkothari.com)

Introduction

Central KYC Registry (CKYCR) is the central repository of KYC information of customers. This registry is a one stop collection of the information of customers whose KYC verification is done once. The Master Direction – Know Your Customer (KYC) Direction, 2016 (KYC Directions)[1] defines CKYCR as “an entity defined under Rule 2(1) of the Rules, to receive, store, safeguard and retrieve the KYC records in digital form of a customer.”

The KYC information of customers obtained by Reporting Entities (REs) (including banks) is uploaded on the registry. The information uploaded by an RE is used by another RE to verify the identity of such customer. Uncertainty as to validity of such verification prevails in the market. The following write-up intends to provide a basic understanding of CKYCR and gathers bits and pieces around identity verification through CKYCR.

Identity verification through CKYCR is done using the KYC identifier of the customer. To carry out such verification, an entity first needs to be registered with the CKYCR. Let us first understand the process of registration with the CKYCR.

Registration on CKYCR

The application for registration shall be made on CKYCR portal. Presently, Central Registry of Securitisation Asset Reconstruction and Security Interest (CERSAI) has been authorized by the Government of India to carry out the functions of CKYCR. Following are the steps to register on CERSAI:

  1. A board resolution should be passed for appointment of the authorised representative. The registering entity shall be required to identify nodal officer, admin and user.
  2. Thereafter, under the new entity registration tab in the live environment of CKYCR, details of the entity, nodal officers, admin and users shall be entered.
  3. Upon submission of the details, the system will generate a temporary reference number and mail will be sent to nodal officer informing the same along with test-bed registration link.
  4. Once registered on the live environment, the entity will have to register itself on the testbed and test the application. It shall have to test all the functionalities as per the checklist provided at https://www.ckycindia.in/ckyc/downloads.html. On completion of the testing, the duly signed checklist at helpdesk@ckycindia.in shall be e-mailed to the CERSAI.
  5. The duly signed registration form along with the supporting documents shall be sent to CERSAI at – 2nd Floor, Rear Block, Jeevan Vihar Building, 3, Parliament Street, New Delhi -110001.
  6. CERSAI will verify the entered details with physical form received. Correct details would mean the CERSAI will authorize and approve the registration application. In case of discrepancies, CERSAI will put the request on hold and the system will send email to the institution nodal officer (email ID provided in Fl registration form). To update the case hyperlink would be provided in the email.
  7. After completion of the testing and verification of documents by CERSAI, the admin and co-admin/user login and password details would be communicated by it.

Obligations in relation to CKYCR

The establishment of CKYCR came with added obligations on banks and REs.  The KYC Directions require banks and REs to upload KYC information of their customers on the CKYCR portal. As per the KYC Directions – “REs shall capture the KYC information for sharing with the CKYCR in the manner mentioned in the Rules, as required by the revised KYC templates prepared for ‘individuals’ and ‘Legal Entities’ as the case may be. Government of India has authorised the Central Registry of Securitisation Asset Reconstruction and Security Interest of India (CERSAI), to act as, and to perform the functions of the CKYCR vide Gazette Notification No. S.O. 3183(E) dated November 26, 2015.

…Accordingly, REs shall take the following steps:

  • Scheduled Commercial Banks (SCBs) shall invariably upload the KYC data pertaining to all new individual accounts opened on or after January 1, 2017 with CERSAI in terms of the provisions of the Prevention of Money Laundering (Maintenance of Records) Rules, 2005.
  • REs other than SCBs shall upload the KYC data pertaining to all new individual accounts opened on or after from April 1, 2017 with CERSAI in terms of the provisions of the Prevention of Money Laundering (Maintenance of Records) Rules, 2005.”

Further, para III and IV of the Operating Guidelines of CKYCR require reporting entities (including banks) to fulfill certain obligations. Accordingly, the reporting entities shall:

  • Register themselves with CKYCR
  • Carry out due diligence and verification KYC information of customer submitting the same.
  • Upload KYC information of customers, in the KYC template provided on CKYCR portal along with scanned copy of Proof of Address (PoA) and Proof of Identity (PoI) after successful verification.
  • Communicate KYC identifier obtained from CKYCR portal to respective customer.
  • Download KYC information of customers from CKYCR, in case KYC identifier is submitted by the customer.
  • Refrain from using information downloaded from CKYCR for purposes other than identity verification.
  • In case of any change in the information, update the same on the CKYCR portal.

In and around verification

Registered entities may download the information from CKYCR portal and use the same for verification. Information can be retrieved using the KYC identifier of the customer. Before we delve into the process of verification and its validity, let us first understand what a KYC identifier is and how would a customer obtain it.

KYC identifier

A KYC Identifier is a 14 digit unique number generated when KYC verification of a customer is done for the first time and the information is uploaded on CKYCR portal. The RE uploading such KYC information on the CKYCR portal shall communicate such KYC Identifier to the customer after uploading his/her KYC information.

Obtaining KYC identifier

When a customer intends to enter into an account-based relationship with a financial institution for the very first time, such financial institution shall obtain KYC information including the Proof of Identity (PoI) and Proof of Address (PoA) of such customer and carry out verification process as provided in the KYC Master Directions. Upon completion of verification process, the financial institution will upload the KYC information required as per the common KYC template provided on the CKYCR portal, along with scanned PoI and PoA, signature and photograph of such customer within 3 days of completing the verification. Different templates are to be made available for individuals, and on the CKYCR portal. Presently, only template for individuals[2] has been made available.

Upon successful uploading of KYC information of the customer on the CKYCR portal, a unique 14 digit number, which is the KYC identifier of the customer, is generated by the portal and communicated to the financial institution uploading the customer information. The financial institution is required to communicate the KYC identifier to respective customer so that the same maybe used by the customer for KYC verification with some other financial institution.

Verification through CKYCR

When a customer submits KYC identifier, the RE, registered with CKYCR portal, enters the same on the CKYCR portal. The KYC documents and other information of the customer available on the CKYCR portal are downloaded. The RE matches the photograph and other details of customer as mentioned in the application form by the customer with that of the CKYCR portal. If both sets of information match, the verification is said to be successful.

Identity Verification through CKYCR- is it valid?

The Operating Guidelines[3] of CKYCR provide that –“Where a customer submits a KYC Identifier to a reporting entity, then such reporting entity shall download the KYC records from the Central KYC Registry by using the KYC Identifier and shall not require a customer to submit the documents again unless:

  1. There is a change in the information of the customer as existing in the records of Central KYC Registry.
  2. The current address of the client is required to be verified.
  3. The reporting entity considers it necessary in order to verify the identity or address of the client, or to perform enhanced due diligence or to build an appropriate risk profile of the client.”

Clearly, when KYC identifier is submitted by the customer, in place of identification documents, the RE shall fetch the KYC information of such customer from CKYCR portal. Since, the KYC information of such person was uploaded on CKYCR portal by another RE after conducting due diligence and undertaking complete verification process, relying on such information is considered as a successful verification process.

Benefits from CKYCR

While imposing various obligations on REs, the CKYCR portal also benefits REs by providing them with an easy way out for KYC verification of their customers. By carrying out verification through KYC Identifier, the requirement of physical interface with the borrower (as required under KYC Master Directions)[4] may be done away with. This might serve as a measure of huge cost savings for lenders, especially in the digital lending era.

Further, CKYCR portals also have de-duplication facility under which KYC information uploaded will go through de-duplication process on the basis of the demographics (i.e. customer name, maiden name, gender, date of birth, mother’s name, father/spouse name, addresses, mobile number, email id etc.) and identity details submitted. The de-dupe process uses normaliser algorithm and custom Indian language phonetics.

  • Where an exact match exists for the KYC data uploaded, the RE will be provided with the KYC identifier for downloading the KYC record.
  • Where a probable match exists for the KYC data uploaded, the record will be flagged for reconciliation by the RE.

Conclusion

Identity verification using the KYC identifier is a cost-effective way of verification and also results into huge cost saving. This method does away with the requirement of physical interface with the customer. Logic being- when the customer would have made the application for entering into account-based relationship, the entity would have obtained the KYC documents and carried out a valid verification process as per the provisions of KYC Master Directions. So, the information based on valid verification is bound to be reliable.

However, despite these benefits, only a handful of entities are principally using this method of verification presently. Lenders, especially FinTech based, should use this method to achieve pace in their flow of transactions.

 

 

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

[2] https://rbidocs.rbi.org.in/rdocs/content/pdfs/KYCIND261115_A1.pdf

[3] https://testbed.ckycindia.in/ckyc/assets/doc/Operating-Guidelines-version-1.1.pdf

[4] Our detailed write-up on the same can also be referred-  http://vinodkothari.com/wp-content/uploads/2020/01/KYC-goes-live-1.pdf

 

Our FAQs on CKYCR may also be referred here- http://vinodkothari.com/2016/09/ckyc-registry-uploading-of-kyc-data/

Our other write-ups on KYC:

 

NBFC Account Aggregator – Consent Gateways

Timothy Lopes, Executive, Vinod Kothari Consultants Pvt. Ltd.

finserv@vinodkothari.com

The NBFC Account Aggregator (NBFC-AA) Framework was introduced back in 2016 by RBI[1]. However the concept of Account Aggregators did exist prior to 2016 as well. Prior to NBFC-AA framework several Account Aggregators (such as Perfios and Yodlee) undertook similar business of consolidating financial data and providing analysis on the same for the customer or a financial institution.

To give a basic understanding, an Account Aggregator is an entity that can pull and consolidate all of an individual’s financial data and present the same in a manner that allows the reader to easily understand and analyse the different financial holdings of a person. At present our financial holdings are scattered across various financial instruments, with various financial intermediaries, which come under the purview of various financial regulators.

For example, an individual may have investments in fixed deposits with ABC Bank which comes under the purview of RBI, mutual fund investments with XYZ AMC which comes under the purview of SEBI and life insurance cover with DEF Insurance Corporation (which comes under the purview of IRDAI.

Gathering all the scattered data from each of these investments and consolidating the same for submission to a financial institution while applying for a loan, may prove to be a time-consuming and rather confusing job for an individual.

The NBFC-AA framework was introduced with the intent to help individuals get a consolidated view of their financial holdings spread across the purview of different financial sector regulators.

Recently we have seen a sharp increase in the interest of obtaining an NBFC-AA license. Ever since the Framework was introduced in 2016, around 8 entities have applied for the Account Aggregator License out of which one has been granted the Certificate of Registration while the others have been granted in-principle[2].

Apart from the above, we have seen interest from the new age digital lending/ app based NBFCs.

In this article we wish to discuss the concerns revolving around data sharing, the reason behind going after an Account Aggregator (AA) license and the envisaged business models.

Going after AA License – The reason

New age lending mainly consists of a partnership model between an NBFC which acts as a funding partner and a fintech company that acts as a sourcing partner. Most of the fintech entities want to obtain the credit scores of the borrower when he/she applies for a loan. However, the credit scores are only accessible by the NBFC partner, since they are mandatorily required to be registered as members with all four Credit Information Companies (CICs).

This is where most NBFCs are facing an issue since the restriction on sharing of credit scores acts as a hurdle to smooth flow of operations in the credit approval process. We have elaborately covered this issue in a separate write up on our website[3].

What makes it different in the Account Aggregator route?

Companies registered as an NBFC-AA with RBI, can pull all the financial data of a single customer from any financial regulator and organise the data to show a consolidated view of all the financial asset holdings of the customer at one place. This data can also be shared with a Financial Information User (FIU) who must be an entity registered with and regulated by any financial sector regulator such as RBI, SEBI, IRDAI, etc. The AA could also perform certain data analytics and present meaningful information to the customer or the FIU.

All of the above is possible only and only with the consent of the customer, for which the NBFC-AA must put in place a well-defined ‘Consent Architecture’.

This data would be a gold mine for NBFCs, who would act as FIUs and obtain the customer’s financial data from the NBFC-AA.

Say a customer applies for a loan through a digital lending app. The NBFC would then require the customer’s financial data in order to do a credit evaluation of the potential borrower and make a decision on whether to sanction the loan or not. Instead of going through the process of requesting the customer to submit all his financial asset holdings data, the customer could provide his consent to the NBFC-AA (which could be set up by the NBFC itself), which would then pull all the financial data of the customer in a matter of seconds. This would not only speed up the credit approval and sanction process but also take care of the information sharing hurdle, as sharing of information is clearly possible through the NBFC-AA route if customer consent is obtained.

The above model can be explained with the following illustration –

What about the Fintech Entity?

Currently the partnership is between the fintech company (sourcing partner) and the NBFC (funding partner). With the introduction of an Account Aggregator as a new company in the group, what would be the role of the fintech entity? Can the information be shared with the fintech company as well as the NBFC?

The answer to the former would be that firstly the fintech company could itself apply for the NBFC-AA license, considering that the business of an NBFC-AA is required to be completely IT driven. However, the fintech company would require to maintain a Net Owned Fund (NOF) of Rs. 2 crores as one of the pre-requisites of registration.

Alternatively the digital lending group could incorporate a new company in the group, who would apply for the NBFC-AA license to solely carry out the business of an NBFC-AA. This would leave the fintech entity with the role of maintaining the app through which digital lending takes place.

The above structures could be better understood with the illustrations below –

To answer the latter question as to whether the information can be shared by the NBFC-AA with the fintech entity as well? The answer is quite clearly spelt out in the Master Directions.

As per the Master Directions, the NBFC-AA can share the customers’ information with a FIU, of course, with the consent of the customer. A FIU means an entity registered with and regulated by any financial sector regulator. Regulated entities are other banks, NBFCs, etc. However, fintech companies are not FIUs as they are not registered with and regulated by any financial sector regulator. An NBFC-AA cannot therefore, share the information with the fintech company.

How to register as an NBFC-AA?

Only a company having NOF of Rs. 2 crores can apply to the RBI for an AA license. However there is an exemption to AAs regulated by other financial sector regulators from obtaining this license from RBI, if they are aggregating only those accounts relating to the financial information pertaining to customers of that particular sector.

Further the following procedure is required to be followed for obtaining the NBFC-AA license –

Consent Architecture

Consent is the most important factor in the business of an NBFC-AA. Without the explicit consent of the customer, the NBFC-AA cannot retrieve, share or transfer any financial data of the customer.

The function of obtaining, submitting and managing the customer’s consent by the NBFC-AA should be in accordance with the Master Directions. As per the Master Directions, the consent of the customer obtained by the NBFC-AA should be a standardized consent artefact containing the following details, namely:-

  1. Identity of the customer and optional contact information;
  2. The nature of the financial information requested;
  • Purpose of collecting such information;
  1. The identity of the recipients of the information, if any;
  2. URL or other address to which notification needs to be sent every time the consent artefact is used to access information
  3. Consent creation date, expiry date, identity and signature/ digital signature of the Account Aggregator; and
  • Any other attribute as may be prescribed by the RBI.

This consent artefact can also be obtained in electronic form which should be capable of being logged, audited and verified.

Further, the customer also has every right to revoke the consent given to obtain information that is rendered accessible by a consent artefact, including the ability to revoke consent to obtain parts of such information. Upon revocation a fresh consent artefact shall be shared with the FIP.

The requirement of consent is essential to the business of the NBFC-AA and the manner of obtaining consent is also carefully required to be structured. Account Aggregators can be said to be consent gateways for FIPs and FIUs, since they ultimately benefit from the information provided.

Conclusion

There are several reasons for the new age digital lending NBFCs to go for the NBFC-AA license, as this would amount to a ‘value added’ to their services since every step in the loan process could be done without the customer ever having to leave the app.

However the question as to whether this model fits into the current digital lending model of the NBFC and Fintech Platform should be given due consideration. The revenue model should be structured in a way that the NBFC-AA reaps benefits out of its services provided to the NBFC.

The ultimate benefit would be a speedy and easier credit approval and sanction process for the digital lending business. Data coupled with consent of the customer would prove more efficient for the new age digital lending model if all the necessary checks and systems are in place.

Links to related write ups –

Account Aggregator: A class of NBFCs without any financial assets – http://vinodkothari.com/2016/09/account-aggregator-a-class-of-nbfc-without-any-financial-assets/

Financial Asset Aggregators: RBI issues draft regulatory directions – http://vinodkothari.com/wp-content/uploads/2017/03/Financial_asset_aggregators_RBI-1.pdf

[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=10598

[2] Source: Sahamati FAQs (Sahamati is a collective of the Account Aggregator System)

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

Sixth Bi-monthly Monetary Policy of RBI: Likely to spur long-term growth

-Kanakprabha Jethani | Executive

(kanak@vinodkothari.com)

The Reserve Bank of India (RBI) released its Sixth Bi-monthly Monetary Policy Statement, 2019-20[1] along with the Statement on Developmental and Regulatory Policies[2] (‘Statement’) on February 06, 2020. The said Statement proposed various measures primarily to spur the growth impulses and push credit offtake. Some of the major proposals are discussed below.

In particular, as our analysis shows, there will be increased opportunities for co-lending between banks and NBFCs.

Enhancing credit to specific sectors

  1. Allowing Scheduled Commercial Banks (SCBs) to deduct from their net demand and time liabilities (NDTL), the equivalent of incremental credit disbursed by them as retail loans for automobiles, residential housing and loans to micro, small and medium enterprises (MSMEs), over and above the outstanding level of credit to these segments as at the end of the fortnight ended January 31, 2020 for maintenance of cash reserve ratio (CRR).

The Reserve maintenance requirement for a bank= CRR*Bank Deposits/NDTL. Due to such reduction from NDTL, the reserve maintenance requirement will be reduced. This will act as a motivating factor for banks to lend more to the aforementioned sectors.  Therefore, banks save the opportunity loss on account of CRR on such incremental lending. Notably, the CRR currently is 4%, and does not fetch any return to the banks. Assuming that a bank may earn 10% interest on the lending to the specific sector, this means a direct improvement in the return to the bank to the extent of 40 bps.

It is important to note that this relaxation is only for loans directly disbursed by the banks. Therefore, acquisition of loan pools by way of direct assignment or purchase of PTCs will not qualify for this.

However, lot of banks have entered into co-lending arrangements with NBFCs. Such arrangements result into a credit originated directly in the books of the bank, and therefore, ought to qualify for the relaxation of the CRR requirement.  Loans for automobiles (which may apparently include both passenger and commercial vehicles) is one segment where NBFC-bank co-lending arrangements may work very well. The same goes for loans to MSMEs.

  1. Pricing of loans to medium enterprises by SCBs to be linked to an external benchmark.

Linking the pricing of loans to an external benchmark, say repo rate, will ensure that interest rates reflect the current market conditions.  The external benchmark rates are currently administered by Financial Benchmark India Pvt. Ltd. (FBIL)

  1. Extension of time limit for one-time restructuring scheme for loans granted to MSMEs to December 31, 2020.

Under this scheme, loans in which there is a default in repayment, but the same is being classified as standard asset in the books of the lender as on January 01, 2020.

Usually, when an account is restructured, the asset classification of such asset is downgraded. However, the accounts restructured under this scheme shall continue to be classified as standard. The restructuring is to be implemented by December 31, 2020 instead of the earlier limit of March 31, 2020. This scheme will enable the defaulted accounts to be restructured without impacting the Balance Sheet of the lender since the provisioning requirements would remain the same.

Regulating the HFCs

  1. Draft revised regulations with respect to HFCs on RBI website by the end of the month, for public comments. Till the new regulations are issued, HFCs shall continue to be regulated by the existing regulations of the National Housing Bank (NHB).

Upon introduction of the new framework, HFCs will come under regulatory control of the RBI and the efforts of NHB may then be focused towards development of housing finance market.

VKC Comment: We will be keeping a watch on these draft guidelines and will come back with analysis as and when these draft regulations are placed on the RBI website.

Relaxing the norms for Asset Classification

  1. Extension of date of commencement of commercial operations (DCCO) of project loans for commercial real estate, delayed for reasons beyond the control of promoters, by another one year, shall not result in downgrading the asset classification.

Due to introduction of this provision, project loans given for commercial real estate will continue to be classified as standard even if there is a default in repayment, in case the DCCO is extended.

Aids to Digital Payment Systems

  1. A Digital Payments Index to be issued to capture the extent of digitisation of payments. The same shall be made available w.e.f July 2020.

This index will reflect the penetration of digital payments in the financial markets.

  1. Framework to establish Self-Regulatory Organisation (SRO) for digital payment systems which will serve as a two-way communication channel between the players and the regulator/supervisor. The framework will be put in place by April 2020.

Establishment of SRO will result into enhanced control and regulation of the digital payments space while simultaneously ensuring reduced bureaucracy and faster resolution of issues.

We will be coming up with detailed analysis of the developments as and when they are introduced.

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49342

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49343