Leveling the playing field for all Microfinance Lenders

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RBI proposes uniform regulatory framework for the Microfinance Sector ( finserv@vinodkothari.com )

The microfinance sector, in India, has proved to be fundamental for promoting financial inclusion by extending credit to low-income groups that are traditionally not catered to by lending institutions. The essential features of microfinance loans are that they are of small amounts, with short tenures, extended without collateral and the frequency of loan repayments is greater than that for traditional commercial loans. These loans are generally taken for income-generating activities, although they are also provided for consumption, housing and other purposes. There exist various market players in the microfinance industry viz. scheduled commercial banks, small finance banks, co-operative banks, various NBFCs extending microfinance loans and NBFCs-MFIs.

The microfinance industry has reached 6 crores of live borrowers base the end of the calendar year of 2020. Book size of the microfinance industry as on 31st December is 228,818 crore[1]. The sector grew by 16% from December 2019 to December 2020 (based on outstanding loan portfolio size) and has witnessed phenomenal growth over the last two decades.

Source- SIDBI Microfinance Pulse Report, April 2021

Source- SIDBI Microfinance Pulse Report, April 2021

While banks are leading by contributing 42% towards total portfolio outstanding and 39% towards active loans, NBFC-MFIs are the second highest contributors in the microfinance sector. When compared to the total portfolio size of all microfinance lenders, NBFC-MFIs only contribute to a little over 30% of the total size. However, the framework regulating microfinance has been made applicable solely to NBFC-MFIs (‘NBFC-MFI Regulations’ as provided under the respective Master Directions) while the other lenders that hold a lion’s share of the sector are not subjected to similar regulatory conditions/ restrictions. These include cap on multiple lending, ceiling on maximum lending amount, various customer protection measures etc. Absence of regulatory control has led to various problems such as multiple lending by borrowers resulting in overindebtedness, increased defaults, coercive recovery methods by lenders at the prejudice of borrowers etc.

As a solution to the same, RBI has issued a consultative paper on regulation of microfinance on June 14, 2021[2] (‘Consultation Paper’) with an intention to harmonise the regulatory frameworks for various regulated lenders (‘RE’s) in the microfinance space while also proposing a slew of changes to the existing norms for NBFC-MFIs and NBFCs.

RBI has invited comments, suggestions and feedback on the proposed regulation by July 31, 2021 from all stakeholders. The proposed norms intend to have uniform regulations applicable to microfinance loans provided by all entities regulated by the RBI and are aimed at protecting the microfinance borrowers from over-indebtedness as well as enabling competitive forces to bring down the interest rates by empowering the borrowers to make an informed decision. The key proposals of the Consultative Document have been discussed herein below in this article:

Regulations for all Microfinance Loans

MFIs encompass a host of financial institutions engaged in advancing loans to low-income groups. However, except NBFC-MFIs, none of the other entities are regulated by microfinance-specific regulations.

Resultantly, RBI has proposed to introduce a common regulatory framework for all microfinance lending institutions, irrespective of their form. The intent behind the same is to ensure that all lenders under the microfinance sector are subject to the same rules. This would not only protect borrower interest but also ensure that all lenders are operating on a level playing field thereby passing the benefit of competition to the ultimate borrower. Further, considering the total indebtedness of borrowers vis-a-vis their repayment capacity seems more fitting rather than indebtedness only from NBFC-MFIs.

Common definition of ‘Microfinance’ for all REs

RBI has proposed to revise the definition of ‘microfinance loans’ and in order to avoid over-indebtedness and multiple lending, the same is proposed to be applied uniformly to all entities regulated by the RBI (REs) and operating in the microfinance sector.

 

Annual Household Income Threshold

Common definition of microfinance borrowers

Under extant regulations for NBFC-MFIs, a microfinance borrower is identified by annual household income not exceeding ₹1,25,000 for rural and ₹2,00,000 for urban and semi-urban areas. In order to ensure a common definition, the said criteria for classification is proposed to be extended to all regulated entities (REs).

RBI has proposed to base the threshold on the income of the entire household rather than that of an individual, similar to the existing guidelines for NBFC-MFIs. The reason being that income in such households is usually assumed to be pooled.

For this purpose, ‘household’ shall mean a group of persons normally living together and taking food from a common kitchen. Even though the determination of the actual composition of a household shall be left to the judgment of the head of the household, more emphasis has been advised to be placed on ‘normally living together’ than on ‘ordinarily taking food from a common kitchen’. Note that a household differs from a family. Households include persons who ordinarily live together and therefore may include persons who are not related by blood, marriage or adoption but living together, while a family may comprise persons who are living apart from the household.

Methodology for assessment of household income

Assessment of household income in a predominant cash-based economy might pose certain difficulties. However, applying a uniform methodology may not be appropriate for such assessment, especially of low-income households, since the practice may differ based on the different types of borrowers and lenders. The same should be left at the discretion of the lender in the form of a policy. However, broad parameters/ factors may be provided. These can include deriving income from expenditure patterns, assessment of the borrower’s occupation and the ordinary remuneration flowing thereof, assessment of cash flows etc.

Criteria dropped from the existing definition –

  1. Absolute cap on the permissible amount of loan to be extended, is no longer relevant due to linking of loan to income in terms of debt-income ratio and therefore has been removed;
  2. Minimum tenure requirement is also to be be removed since longer tenures for larger loans will not be appropriate (since the absolute cap for amount of loans has been removed);
  • The existing NBFC-MFI regulations require at least 50% of the total amount of loans extended by NBFC-MFIs to be given for income generation. This means part (i.e. maximum of 50 per cent) of the aggregate amount of loans may be extended for other purposes such as housing repairs, education, medical and other emergencies. However, aggregate amount of loans given to a borrower for income generation should constitute at least 50 per cent of the total loans from the NBFC-MF. It has been realised that while microfinance loans should ideally be used for income-generating activities, placing too much emphasis on the same may lead to borrowers availing informal and more expensive modes of lending for their other financial needs. Therefore, the said requirement not being conducive, has been proposed to be removed;
  1. Restriction on lending by two NBFC-MFIs to be dropped due to overall restriction in terms of debt-income ratio (discussed below).

Maximum Permissible level of indebtedness in terms of debt-income ratio

One of the major risks in microlending has been the issue of overborrowing, with nearly 35% of the borrowers having access to two or more lenders.(source PWC report)

It is proposed to link the loan amount to household income in terms of debt-income ratio.  The payment of interest and repayment of principal for all outstanding loans of the household at any point of time is proposed to be capped at 50% of the household income i.e. total indebtedness of any borrower will not increase 50% of his/her total income. This has been proposed keeping in mind various factors such as –

  • Low savings therefore taking into account that half of their income should be available to meet their other expenses necessary for survival
  • Possibility of repayment towards other forms of informal lending from friends and family
  • Likely inflation of income to avail higher loans.

However, individual REs will be permitted to adopt a conservative threshold as per their own assessments and Board approved policy. Since, the level of indebtedness for a particular borrower is proposed to be regulated, the current stipulation that limits lending by not more than two NBFC-MFIs to the same borrower will no longer be required.

Grandfathering of existing facilities

The aforesaid threshold shall become effective from the date of introduction of the proposed regulations. However, existing loans to the households which are not complying with the limit of 50% of the household income, shall be allowed to mature. Although, in such cases, no new loans will be provided to such households till the limit is complied with.

Collateral-free loans

Microfinance borrowers belong to the low income group and generally do have the available assets to be provided as collateral for availing financial facilities. The assets possessed by them are usually those that are essential for their survival and losing them in case of a default will be detrimental to their existence. Therefore, it has been proposed that to extend the collateral free nature of microfinance loans, as applicable to NBFC-MFIs, to all REs.

Prepayment Penalty

In case of NBFC-MFIs, the borrowers are allowed prepayment without charging any penalty. It has now been proposed that microfinance borrowers of all REs shall be provided with the right of prepayment without attracting penalty.

Repayment Schedule

As per the extant regulations, microfinance borrowers of NBFC-MFIs are permitted to repay weekly, fortnightly or monthly instalments as per their choice. With a view to keep the repayment pattern at the discretion of the borrowers that will suit their repayment capacity and/or preference, all REs will be required to provide repayment periodicity to such borrowers as per a Board approved policy.

Minimum NOF for NBFC-MFIs

RBI had issued a Discussion Paper on ‘Revised Regulatory Framework for NBFCs – A Scale-Based Approach’ on January 22, 2021 proposing to revise the minimum net owned fund (NOF) limit for all NBFCs including NBFC-MFIs, from ₹2 crore to ₹20 crore.

At present, NBFC-MFIs are required to have a minimum NOF of ₹5 crore (₹2 crore for NBFC-MFIs registered in the North Eastern Region). RBI has sought the view of stakeholders whether the proposed minimum NOF of ₹20 crore for NBFCs under scale-based regulations is appropriate for NBFC-MFIs or not.

The evolution of regulatory framework for NBFCs may recall, the NOF requirement for NBFCs was Rs 25 lacs in 1990s. Then, it was increased to Rs 2 crores, Rs. 5 crores in case of NBFC-MFIs. The regulator is now proposing to increase the same to Rs 20 crores – a 10 fold increase. The underlying rationale is to have a stronger entry barrier, and to ensure that NBFCs have the initial capital for investing in technology, manpower and establishment. However, such a sharp hike in entry point requirement will keep smaller NBFCs out of the fray. Smaller NBFCs, especially NBFC-MFIs, have been doing a useful job in financial inclusion and having a stricter entrance will only prove to demotivate the sector.  You may read further on the scalar based approach framework by RBI in our article here.

Revised Definition of ‘microfinance’ for ‘not for profit’ Companies

Section 8 companies engaged in micro-finance and not accepting public deposits, are exempt from obtaining registration under section 45IA of the RBI Act, 1934 as well as from complying with sections 45-IB (Maintenance of percentage of assets) and 45-IC (Reserve Fund).

The exemption is applicable to all not-for-profit NBFC-MFIs that meet the above criteria irrespective of their size.  However, it has been proposed to bring Section 8 companies above a certain threshold in terms of balance sheet size (say, asset size of ₹100 crore and above) under the regulatory ambit of the RBI. This is because Section 8 companies are dependent on public funds including borrowings from banks and other financial institutions for their funding needs and any risk of failure in these companies will have a resultant impact on the financial sector.

Further, not-for profit MFIs operate in an almost similar manner to that of for-profit MFIs but the latter enjoys exemptions from various requirements. The mandatory requirement for registration will ensure that not-for-profit MFIs with considerably large asset size, are effectively regulated.

The revised criteria for exemption is proposed to be as under:

‘Exemption from Sections 45-IA, 45-IB and 45-IC of the RBI Act, 1934 shall be available to a micro finance company which is

  1. engaged in micro financing activities i.e. providing collateral-free loans to households with annual household income of ₹1,25,000 and ₹2,00,000 for rural and urban/semi urban areas respectively, provided the payment of interest and repayment of principal for all outstanding loans of the household at any point of time does not exceed 50 per cent of the household income;
  2. registered under Section 8 of the Companies Act, 2013;
  3. not accepting public deposits; and
  4. having asset size of less than ₹100’

Review of Specific Regulations for NBFC-MFIs

Qualifying Asset Criteria

In order to be classified as a ‘qualifying asset’, a loan is required to satisfy the following criteria:

  1. Loan which is disbursed to a borrower with household annual income not exceeding ₹1,25,000 and ₹2,00,000 for rural and urban/semi-urban households respectively;
  2. Loan amount does not exceed ₹75,000 in the first cycle and ₹1,25,000 in subsequent cycles;
  • Total indebtedness of the borrower does not exceed ₹1,25,000 (excluding loan for education and medical expenses);
  1. Minimum tenure of 24 months for loan amount exceeding ₹30,000;
  2. Collateral free loans without any prepayment penalty;
  3. Minimum 50 per cent of aggregate amount of loans for income generation activities;
  • Flexibility of repayment periodicity (weekly, fortnightly or monthly) at borrower’s choice.

The following changes have been proposed –

  1. The household income limits have been retained under the revised definition of microfinance loans and made applicable to all REs
  2. Absolute cap is no longer relevant due to linking of loan to income in terms of debt-income ratio
  • Minimum tenure requirement to be removed since longer tenures for larger loans will not be appropriate (since the absolute cap for amount of loans has been removed)
  1. Collateral free loans and absence of prepayment penalty have been retained in the revised definition.
  2. The existing NBFC-MFI regulations require at least 50% of the total amount of loans extended by NBFC-MFIs to be given for income generation. This means part (i.e. maximum of 50 per cent) of the aggregate amount of loans may be extended for other purposes such as housing repairs, education, medical and other emergencies. However, aggregate amount of loans given to a borrower for income generation should constitute at least 50 per cent of the total loans from the NBFC-MF. It has been realised that while microfinance loans should ideally be used for income-generating activities, placing too much emphasis on the same may lead to borrowers availing informal and more expensive modes of lending for their other financial needs. Therefore, the said requirement not being conducive, has been proposed to be removed.

Limit of lending by two NBFC-MFIs

Owing to an overall restriction based on debt-income ratio of 50% for all REs, the restriction of lending by only two NBFC-MFIs to a borrower will be withdrawn.

Pricing of Credit by NBFC-MFIs

Given the vulnerable nature of the borrowers of microfinance loans, the NBFC-MFI regulations imposed an interest cap to prevent exorbitant interest rates charged to such borrowers.

The interest rate cap prescribes multiple ceilings rather than a single one. Accordingly, NBFC-MFIs have been permitted to charge interest with a maximum margin cap of 10% and 12% over and above the cost of funds, depending on the size of loan portfolio (₹100 crore threshold) or 2.75 times of the average base rate of five largest commercial banks, whichever is lower.

The latter criterion provides a linkage with the prevailing interest rate in the economy and ensures that higher borrowing costs for NBFC-MFIs with riskier business models are not transmitted to the end borrowers. Further, NBFC-MFIs are not permitted to levy any other charge except for a processing fee (capped at 1% of the loan amount) and actual cost of insurance to ensure that interest rate ceilings are not bypassed by NBFC-MFIs through other hidden charges.

However, the regulatory ceiling on interest rate is applicable only to NBFC-MFIs. Nearly 70% of the microfinance sector, comprising banks and small finance banks, is deregulated in terms of pricing. It has also been observed that an unintended consequence of creating a regulatory prescribed benchmark for the rest of the entities operating in the microfinance segment. Lenders, such as banks, though having a lower cost of funds, still charge a higher interest rate. This has led to borrowers being deprived of benefits of economies of scale and competition in the microfinance market.

The provision of such interest rate ceilings was suitable in an environment where NBFC-MFIs were the primary lenders. However, currently, as discussed, NBFC-MFIs contribute to only 30%. Proposing a fixed benchmark for interest rate in the microfinance industry may not be appropriate considering the differences in the cost of funds, financial or otherwise, among different types of entities.

Based on the above rationale, it has been proposed to remove such interest rate ceiling limits and align the interest rate model for NBFC-MFIs with that of regular NBFCs.  NBFC-MFIs will now be permitted to adopt interest rates based on a Board approved policy while adhering to fair practice code to ensure disclosure and transparency. However, necessary regulation must also be put in place to avoid charging usurious interest rates. The intention is to enable the market mechanism to reduce the lending rates for the entire microfinance sector.

Fair Practice Norms

The above relaxation from interest rate ceiling, comes with its own set of fair practice norms to ensure transparency and protecting interests of borrowers.

  1. Disclosure of information on pricing

To allow borrowers to make an informed decision, REs will mandatorily be required to disclose pricing information by way of a standardised and simplified disclosure format (specified under table III of the Consultation Paper). Such information will enable borrowers to compare interest rates as well as other fees associated with a microfinance loan in a more readable and understandable manner. The pricing related fact sheet shall be provided to every prospective borrower before on-boarding.

  1. Board Policy for determining charges including interest rate

Boards of all REs will be required to frame suitable internal principles and procedures for determining interest rates and other charges to arrive at an all-inclusive usurious interest rate.

  1. Display of interest rates

All REs will be required to display the minimum, maximum and average interest rates charged by them on microfinance loans. The manner of display is still to be prescribed.

  1. Scrutiny by RBI

The above information will also be incorporated in returns submitted to RBI and shall be subjected to the supervisory scrutiny.

[1] Source- SIDBI Microfinance Pulse Report, April 2021

[2] https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=51725

Basics of Factoring in India

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– Megha Mittal, Associate ( mittal@vinodkothari.com )
Factoring as an age-old concept has stood the test of time as it enabled businesses to resolve the cash flow issues, rendered liquidity, facilitated uninterrupted services and cushioned businesses against the lag in the billing cycles. Also the merit of the product lies in the simplicity of the concept which is well understood and accepted. 
The principles of factoring work broadly on the seller selling the receivables of a debtor to a specialised financial intermediary called a factor. The sale of the receivables happens at a discount and transfers the ownership of the receivables to the factor who shall on purchase of receivables, collect the dues from the debtor instead of the seller doing so, enabling the seller to receive upfront funds from the factor.  This allows companies to release the working capital required for holding receivables. 

Read more →

Restructuring of restructuring: Post 1st April NPAs may be upgraded as Standard under ResFra 2.0

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– Anita Baid (anita@vinodktohari.com)

Source: FIDC’s letter to RBI dated June 3, 2021 seeking clarification on clause of Resolution framework – 2.0 relating to Individuals and Small Businesses and disclosures in the balance sheet read along with the RBI response via email dated June 7, 2021. Though called a clarification it actually makes a substantive positive change which is a silent realisation that there is substantial deterioration of performance of loans during the second wave of Covid-19.

The Reserve Bank of India (RBI) had proposed two restructuring frameworks on May 05, 2021- one for individuals and small businesses (‘Notification 31’) and the other one for MSMEs (‘Notification 32’). The intent of both frameworks is to allow restructuring of the loan account in distress due to the second wave of Covid-19.

Pursuant to the restructuring of the eligible loan account (under the respective framework) the standard classification of the assets can be retained. However, there are certain disparities between the two notifications in terms of eligibility criteria, process, etc.

One of the major distinctions is the fact that under Notification 31, there is no relaxation provided to borrowers who have slipped into NPA between the period from March 31, 2021 to the date of invocation. Hence, such loan accounts, which have become NPA from 1st April to the invocation date, irrespective of being restructured in compliance with the provisions of  Notification 31 will continue to be classified as NPA. However, whereby the loan account slipped into NPA classification between the date of invocation and implementation of resolution plan, such account can be upgraded to standard classification as on date of implementation of resolution plan. This position is different in case of MSMEs coming under Notification 32, wherein the borrowers who have slipped into NPA between the period from March 31, 2021, till the date of implementation shall be upgraded to standard.

The aforesaid interpretation was coming clear from the language of para 16 of Notification 31, which states as follows-

  1. If a resolution plan is implemented in adherence to the provisions of this circular, the asset classification of borrowers’ accounts classified as Standard may be retained as such upon implementation, whereas the borrowers’ accounts which may have slipped into NPA between invocation and implementation may be upgraded as Standard, as on the date of implementation of the resolution plan.

As per the language, the asset classification can be retained as standard- this would mean the account which was standard as on the date of implementation has to be retained as standard. However, if the same has degraded to sub-standard category, the upgradation as standard is allowed only if it slipped into NPA between invocation and implementation. Hence, it could be inferred that the slippage before the invocation would not get the relief of upgradation upon restructuring.

This was a huge demotivation of the lenders who intend to restructure the loan accounts under Notification 31. Consequently, representation was made by the Finance Industry Development Council (FIDC) bringing to the notice of RBI that the restructuring notification for individuals and small businesses omits, though maybe unintentionally, to benefit the customers who may have slipped into NPA between April 1 and May 5 as it refers to invocation date and implementation date.

The eligible loan accounts of individuals and small businesses which were standard as on March 31, 2021 can be restructured under Notification 31 if the restructuring is invoked by September 30, 2021. Further, there is a likelihood that such an account may have slipped into NPA between April 1, 2021 till the date of invocation. Though Notification 32  for MSMEs clearly provides for an upgradation to account which might have slipped into NPA from March 1, 2021 till the implementation, however, similar relief was missing from Notification 31.

The RBI has, however, vide an email communication to the FIDC on June 7, 2021, clarified that the loan accounts that may have slipped into NPA between April 1, 2021 and the date of implementation, on the same lines as mentioned in Notification 32 for MSMEs, can be upgraded as standard assets on implementation of the resolution plan.

This would be a relief for not just the borrower but also the lenders who would not hesitate to restructure eligible and potential loan accounts, even if they have turned into NPA by the time the RBI notifications were issued.

Refer to our article on restructuring:

RBI means to halt second wave of borrower defaults: Announces ResFra 2.0

 

List of Disclosures Requirements Applicable to NBFCs

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Srl No Particular Clause Reference Remarks
List of Disclosure in Annual Report – As per RBI Direction
1 NBFCs shall disclose in their annual reports the details of the auctions conducted during the financial year including the number of loan accounts, outstanding amounts, value fetched and whether any of its sister concerns participated in the auction. Para 27(4) (d)-Loans against security of single product – gold jewellery Applicable for Gold loan business
2
 Non-deposit taking NBFC with asset size of ₹ 500 crore and above issuing PDI, shall make suitable disclosures in their Annual Report about : Annex XVII
(i) Amount of funds raised through PDI during the year and outstanding at the close of the financial year;
(ii) Percentage of the amount of PDI of the amount of its Tier I Capital;
(iii) Mention the financial year in which interest on PDI has not been paid in accordance with clause 1(viii) above.		 Terms and Conditions Applicable to Perpetual Debt Instruments (PDI) for Being Eligible for Inclusion in Tier I capital Applicable for NBFCs issuing PDIs
2A Details of all material transactions with related parties shall be disclosed in the annual report along with policy on dealing with Annual Report Para 4.3 – Annex IV, Master Directions
2B (i) Remunerarion of Directors (Para 4.5)
(ii) a Management Discussion and Analysis report		 Para 4.3 – Annex IV, Master Directions
Disclosure in Financial Statements- as per RBI Direction
3
 Disclosure in the balance sheet
The provision towards standard assets need not be netted from gross advances but shall be shown separately as ‘Contingent Provisions against Standard Assets’ in the balance sheet. Master Directions Para 14
Every applicable NBFCshall separately disclose in its balance sheet the provisions made as per these Directions without netting them from the income or against the value of assets.

The provisions shall be distinctly indicated under separate heads of account as under:-
(i) provisions for bad and doubtful debts; and
(ii) provisions for depreciation in investments.

 Master Direction Para 17 (1) and (2)
In addition to the above every applicable NBFCshall disclose the following particulars in its Balance Sheet:
(i) Capital to Risk Assets Ratio (CRAR);
(ii) Exposure to real estate sector, both direct and indirect; and
(iii) Maturity pattern of assets and liabilities.		 Master Direction Para 17 (5)
4 Indicative List of Balance Sheet Disclosure for non-deposit taking NBFCs with Asset Size ₹500 Crore and Above and Deposit Taking NBFCs (hereinafter called as Applicable NBFCs) Annex XIV Please refer Annex XIV
5
 Disclosures to be made by the Originator in Notes to Annual Accounts Guidelines on Securitisation Transactions
The Notes to Annual Accounts of the originating NBFCs shall indicate the outstanding amount of securitised assets as per books of the SPVs sponsored by the NBFC and total amount of exposures retained by the NBFC as on the date of balance sheet to comply with the MRR. These figures shall be based on the information duly certified by the SPV’s auditors obtained by the originating NBFC from the SPV. These disclosures shall be made in the format given in Appendix 2.
6
 LRM Framework
An NBFC shall publicly disclose information (Appendix I) on a quarterly basis on the official website of the company and in the annual financial statement as notes to account that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position. Guidelines on Liquidity Risk Management Please refer Appendix I
7
 LCR Disclosure Standards
NBFCs in their annual financial statements under Notes to Accounts, starting with the financial year ending March 31, 2021, shall disclose information on LCR for all the four quarters of the relevant financial year. The disclosure format is given in the Appendix I. Data must be presented as simple averages of monthly observations over the previous quarter (i.e., the average is calculated over a period of 90 days). However, with effect from the financial year ending March 31, 2022, the simple average shall be calculated on daily observations.
NBFCs should provide sufficient qualitative discussion (in their annual financial statements under Notes to Accounts) around the LCR to facilitate understanding of the results and data provided. Please refer Appendix I (Part B)
8
 Schedule to the balance sheet Master Direction Clause 19
Every applicable NBFC shall append to its balance sheet prescribed under the Companies Act, 2013, the particulars in the schedule as set out in Annex IV.
9
 Participation in Currency Options Master Direction Clause 83
Disclosures shall be made in the balance sheet regarding transactions undertaken, in accordance with the guidelines issued by SEBI.
10
 Participation in Currency Futures Master Direction Clause 94
Disclosures shall be made in the balance sheet relating to transactions undertaken in the currency futures market, in accordance with the guidelines issued by SEBI.
11
 Disclosure for Restructured Accounts Master Direction Annex VII
With effect from the financial year ending March 2014 NBFCs shall disclose in their published annual Balance Sheets, under “Notes on Accounts”, information relating to number and amount of advances restructured, and the amount of diminution in the fair value of the restructured advances as per the format given in Appendix – 4
12 Disclosures relating to fraud in terms of the notification issued by Reserve Bank of India
14
 Moratorium Circular
The lending institutions shall suitably disclose the following in the ‘Notes to Accounts’ while preparing their financial statements for the half year ending September 30, 2020 as well as the financial years 2019-20 and 2020-2021:

(i) Respective amounts in SMA/overdue categories, where the moratorium/deferment was extended, in terms of paragraph 2 and 3;

(ii) Respective amount where asset classification benefits is extended.

(iii) Provisions made during the Q4FY2020 and Q1FY2021 in terms of paragraph 5;

(iv) Provisions adjusted during the respective accounting periods against slippages and the residual provisions in terms of paragraph 6.

 Para 10 COVID19 Regulatory Package – Asset Classification and Provisioning
15
 Disclosure under sector – Restructuring of Advances, Circular
NBFCs shall make appropriate disclosures in their financial statements, under ‘Notes on Accounts’, relating to the MSME accounts restructured under these instructions as per the following format:

No. of accounts restructured Amount (₹ in million)

 Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances
16
 Lending institutions publishing quarterly statements shall, at the minimum, make disclosures as per the format prescribed in Format-A Para 52 of Resolution Framework for COVID-19-related Stress In the financial statements for the quarters ending March 31, 2021, June 30, 2021 and September 30, 2021
16A (i) registration/ licence/ authorisation, by whatever name called, obtained from other financial sector regulators;
(ii) ratings assigned by credit rating agencies and migration of ratings during the year;
(iii) penalties, if any, levied by any regulator;
(iv) information namely, area, country of operation and joint venture partners with regard to joint ventures and overseas subsidiaries and
(v) Asset-Liability profile, extent of financing of parent company products, NPAs and movement of NPAs, details of all off-balance sheet exposures, structured products issued by them as also securitization/ assignment transactions and other disclosures		 Para 73 – Master Directions (Ref. Annexure XIV)
Other Disclosure
17 Report on-line to stock exchanges on a quarterly basis, information on the shares pledged against LAS, in their favour, by borrowers for availing loans 22 of Master Directions In format as given in Annex V for Master Direction.
18 Quarterly statement to RBI on change of directors, and a certificate from the Managing Director of the applicable NBFC that fit and proper criteria in selection of the directors has been followed 72 of Master Direction The statement must be sent 15 days of the close of the respective quarter. The statement for the quarter ending March 31, shall be certified by the auditors
19 On a quarterly basis, NBFCs shall report “total exposure” in all cases where they have assumed exposures against borrowers in excess of the normal single / group exposure limits due to the credit protections obtained by them through CDS, guarantees or any other permitted instruments of credit risk transfer Para 8 of Guidelines for Credit Default Swaps – NBFCs as users
Website Disclosure
20
 Public disclosure
An NBFC shall publicly disclose information (Appendix I) on a quarterly basis on the official website of the company that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position. Guidelines on Liquidity Risk Management Please refer Appendix I
21 NBFCs are required to disclose information on their LCR every quarter Para 6 LCR Framework To be made on website
Additional Disclosures w.r.t. COVID-19
22 Lending institutions publishing quarterly financial statements shall, at the minimum, shall make disclosures in their financial statements for the quarters ending September 30, 2021 and December 31, 2021. The resolution plans implemented in terms of Part A of this framework should also be included in the continuous disclosures required as per Format-B prescribed in the Resolution Framework – 1.0. As per format prescribed in Format-X
23 The number of borrower accounts where modifications were sanctioned and implemented in terms of Clause 22 above, and the aggregate exposure of the lending institution to such borrowers may also be disclosed on a quarterly basis,
24 The credit reporting by the lending institutions in respect of borrowers where the resolution plan is implemented under Part A of this window shall reflect the “restructured due to COVID-19” status of the account

A Guide to Accounting of Collateral and Repossessed Assets

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-Financial Services Team ( finserv@vinodkothari.com )

The purpose of reporting in accordance with International Financial Reporting Standards (IFRS) is to provide financial information about the reporting entity that is useful to various stakeholders in making decisions about providing resources to the entity.

To satisfy the objective of IFRS/Ind AS reporting, to a large extent, based on estimates, judgements and models rather than exact depictions. In other words, the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability.

Understanding Collateral

Collateral is one or more assets that a borrower offers to a lender as security for a loan, with the intent that if the borrower defaults in making the promised loan payments, the lender has the right to seize the collateral, sell the same and realise the amounts due. Since collateral offers   a security to the lender should the borrower default, loans that are secured by collateral typically carry lower interest rates than unsecured loans.

Needless to say, secured lending forms a very important segment of the world of finance.

Although the legal rights that flow from collateral are typically specified in the loan agreement, law in some jurisdictions might specify particular overriding rights, obligations, restrictions, etc. In some cases, at the commencement of the loan, collateral is physically transferred from the borrower to the lender. These security interests are called possessory security interests – a pledge is an example of a possessory security interest. There are other types of security interests which are non-possessory, which are known as hypothecation, lien or charge in different jurisdictions. A mortgage in English and Indian law has a different connotation – it creates a property right in favour of the lender to secure the loan; hence, it results into transfer of specific title[1].

Irrespective of the form of collateral, it is clear that collateral is merely security interest, and not property interest. While covenants of security documentation may differ, the most common security document allows the lender to sell or cause the sale of the collateral upon default of the borrower.

Accounting of Collateral

Secured Loans:

When a financial institution (FI) extends a secured facility, it recognises  loan as its asset, as the benefits accruing to the entity would be on account of loan provided. The security would only act as backstop measure in case the performance of the loan deteriorates.  Further, the entity’s interest lies in the loan not in the charged asset.

However, this does not imply that security on a loan would go unnoticed while accounting for the loan asset. Collateral and other credit risk mitigants are important factors in an entity’s estimate of Expected credit losses (ECL).

Consequently, IFRS 7 Financial Instruments: Disclosures specifies that an entity must disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the end of the reporting period and how those risks have been managed by the entity (paragraphs 31 and 32). When relevant, an entity’s risk management disclosure would include its policies and procedures for taking collateral and for monitoring the continuing effectiveness of collateral in mitigating counterparty credit risk. Paragraph 35K of IFRS 7 requires information that will enable users of financial statements to understand the effect of collateral and other credit enhancements on the amount of expected credit losses.

The Division III of Schedule III to the Companies Act, 2013 prescribes a separate disclosure for secured and unsecured advances. Further the impairment loss allowance for both asset categories is also presented along with the specific asset  .

In short, disclosure of the collateral and credit enhancements is an important disclosure. The existence of the collateral itself may not change the carrying value of the loan, but it may have repercussions on the value of the ECL, as also, in case of fair-valued loans, on the risk-adjusted value by impacting the credit spread that is deployed as a part of the discounting rate.

Collateral and SPPI test

Simply payment of principal and interest (SPPI) test is one of the two tests that are required to be passed for a financial asset to be classified either as subsequently measured at Amortised Cost or at FVOCI. The test says that the contractual cash flows from the asset, on specified dates, should comprise only of principal payments and interest payments on the principal amount outstanding.

Paragraph BC4.206(b) of the Basis for Conclusions on IFRS 9 explains the IASB’s view that financial assets can still      meeting the SPPI test, i.e., the contractual cash flows may consist solely payments of principal and interest, even though they are collateralised by assets.     . Consequently, in performing the SPPI test an entity disregards the possibility that the collateral might be foreclosed in the future unless the entity acquired the instrument with the intention of controlling the collateral.

Accounting of Repossessed Assets

Assume the following facts: FI had a loan of Rs 1000 outstanding, which was in default. FI forecloses and repossesses the collateral, say a machinery, which is valued Rs 700 on the date of repossession. FI keeps the machinery pending disposal, and on the reporting date, the machinery is still in stock. Eventually, in the next reporting period, the machinery is sold, say for a net realisation of Rs 600.

Several questions arise – on the date of repossession, can FI remove loan to the extent of Rs 700 and debit it to machinery held for sale? What happens to the loss of Rs 100 on the sale – is it loss related to the loan, or loss related to disposal of machinery?

Questions like this are faced by financial institutions all the time.

Though accounting standards provide ample guidance on taking cognizance of collateral, specifically for credit risk assessment and asset recognition, the clarity is lost at the issue of accounting for repossessed assets. Accounting standards do not provide a clear view on how an asset should be treated when the entity enforces its right to foreclose and repossess the asset, and the asset is pending disposal. If the disposal of the asset has already been done, then the question of any accounting for collateral does not arise, as the collateral has already      been disposed off. However, the accounting for the collateral itself, as discussed below, will affect the accounting for the disposal as well.

As regards accounting for the repossession of the collateral, some guidance comes from the Para B5.5.55 of IFRS 9/Ind AS 109 :

“…….Any collateral obtained as a result of foreclosure is not recognised as an asset that is separate from the collateralised financial instrument unless it meets the relevant recognition criteria for an asset in this or other Standards.”

The extract clarifies that mere fact that the asset is repossessed would not make it eligible for being recognised as an asset on the books, as the entity’s interest still lies in recovery loan, the entity would have no interest in the asset if not for dues under the loan.

Further, Para 7 of IAS 16 / Ind AS 16 states that

“The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:

(a) it is probable that future economic benefits associated with the item will flow to the entity; and

(b) the cost of the item can be measured reliably”

Hence, the FI can capitalise and record only such assets whose future economic benefits would accrure to the financial institution in question, that is, the lender. PPE classification is possible  It may also be possible for an entity to hold the asset as an investment property, for disposal. There may be cases where the collateral may consist of shares, securities or other financial assets, or may consist of stock in trade or receivables.

Irrespective of the type of asset, the key question would be – has the lender acquired a property interest in the collateral, so as to have risks and rewards in the same, or the lender has simply acquired possession over the collateral for causing disposal?

Legal rights in case of collateral

The accounting here is impacted by the legal rights in case of collateral. To  reiterate, we are stating here generic legal position, and it is possible that collateral documents bring rights of the lender which are differential. Further, the legal rights may vary depending upon the kind of security interest being created on the assets, e.g. a pledge would differ from a mortgage.

In the case of Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd[2] the Supreme Court, while also indicating the very distinction between a pawn and a mortgage, observed that even after a pledge is enforced, the  legal title to the goods pledged  would not  vest in the pawnee. the pawnee has only a special  property. A pawnee has no right of foreclosure since he never had absolute ownership at law and his equitable title cannot exceed what  is specifically granted by  law. The right  to property vests in the pledged only so far as is necessary  to secure the debt.[3]

Although, pledge has to be differentiated from a mortgage which wholly passes the thing in the property conveyed[4] However, as noted in     , Narandas Karsondas vs. S.A Kamtam and Anr[5] it is important to note that the mortgagor does not lose the right of redemption until the sale is complete by registration. In selling the property, the mortgagee is not acting as the agent of the mortgagor but under a different (read: superior) claim. No equity or right in property is created in favour of the purchaser by the contract between the mortgagee and the proposed purchaser.

We have mentioned above that the legal rights of a lender differ (a) based on the law of the jurisdiction, as also consistent practices; (b) legal documentation. For instance, in case of mortgage, the common law provides two different rights of a mortgagee – the decree of sale and the decree of foreclosure [Section 67 of Transfer of Property Act, 1882]      Decree of sale implies that the mortgagee may simply cause the sale of the mortgaged property. Decree of foreclosure is foreclosure of the mortgagor’s      right of redemption, and the mortgagee, therefore, becoming absolute owner of the property. There are exceptional circumstances when this is possible, for example, in case of a mortgage by conditional sale.

In case of pledges too, while the general rule as set out in Lallan Prasad vs Rahmat Ali[6]  and GTL Textiles vs IFCI Ltd.[7] is that the pledgee only has the right to cause sale.

In case of US practices, it is quite a common practice of mortgage lenders to hold the foreclosed property as Real Estate Owned.

Thus, there can be two situations:

  • Case 1 – Lender acquires the asset as means of recovery and does not acquire  any risk and reward in the property;
  • Case 2 – Lender acquirers the property in the full and final settlement of the loan.

Our analysis of broad principles is as follows:

Acquisition as means of recovery

The lender could repossess the property as a result of the borrower’s default with the intention securing the possession of the collateral. The seeking of possession of the collateral is simply seeking the custody of the collateral. This is preventive – to ensure that the asset or its value is not  prejudiced. This is intent when a court, receiver, arbitrator or similar agency seeks control over the collateral. The intent is custodial and not proprietary. The actual sale proceeds of the asset, as and when disposed of by the lender, will go to the credit of the borrower; any amounts received in excess of the mortgage balance will be refunded to the borrower; and any shortfall remains the obligation of the borrower.

The FI may continue to charge interest on the outstanding balance. The lender remains exposed to interest rate risk on the  collateral but is not exposed directly to property price risk.

In such cases, there is no question of the loan being set off against the value of the collateral, until the collateral is actually disposed off. While giving the particulars  of the collateral, the lender may separately classify collateral in possession of the lender, as distinct from collateral which is in possession of the borrower or third parties. However, the classification of the loan remains unchanged.

Acquisition of proprietary interest in the collateral:

The lender could repossess the property, which in terms of the law or contract, gives the lender absolute rights in the property. The lender may have the right to collect the unrealised amount from the borrower, or the obligation to refund the excess, if any,  realised, but the issue is, does the lender acquire proprietary interest in the collateral, and whether the lender now is exposed to the risks and rewards, or the variability in the value of the collateral?

However, FASB has prescribed following guidelines to determine whether the charged asset would replace the loan asset. The FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure[8]  provides that “a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either upon

(1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or

(2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. “

In line with above, where the entity has acquired complete right over the asset there is no doubt that the loan account is closed, and the entity now hold interest entirely in the repossessed asset. Hence the company shall derecognise the loan asset and recognise the charged asset in their books. Whether the asset will be a real asset, financial asset, stock in trade, receivables, PPE or other investment property, will depend on the asset and the intent of the entity in holding it till disposal.

Accounting for repossession of the collateral:

In the above case, the entity should fair value the collateral on the date of seeking repossession, and to the extent of the fair value, the asset should be debited, crediting the loan. Whether the asset will continue to be subjected to fair valuation, or historical cost valuation, will depend on the applicable accounting standard for the type of asset in question.

any subsequent movement in the value of the collateral will affect the entity, and not the borrower.

Conclusion

Given the current stress in the economy, the rates of default on loans collateralized by all kinds of properties – residential real estate, commercial real estate, vehicles, consumer durables, etc., have zoomed up. There will be substantial collateral calls in time to come, and therefore, the need to have clarity on accounting for collateral is more today than ever before.

This article has tried to fill an apparent gap in literature on accounting for collateral. We will want to develop this article further, with numerical examples, by way of further updates.

[1] Different forms of security interests are discussed at length in Vinod Kothari: Securitisation, Asset Reconstruction and Enforcement of Security Interests. Lexis Nexis publication

[2] Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd

[3] Gtl Limited vs Ifci Ltd

[4] Lallan Prasad vs Rahmat Ali

[5] Narandas Karsondas vs. S.A Kamtam and Anr

[6] Lallan Prasad vs Rahmat Ali

[7] GTL Textiles vs IFCI Ltd

[8] FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure

 

FAQs on refund of interest on interest

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-Financial Services Division (finserv@vinodkothari.com)

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

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

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

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Understanding regulatory intricacies of Payment Aggregator business

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-Siddarth Goel (finserv@vinodkothari.com)

Abstract

The penetration of electronic retail payments has witnessed a steep surge in the overall payment volumes during the latter half of the last decade. One of the reasons accorded to this sharp rise in electronic payments is the exponential growth in online merchant acquisition space. An online merchant is involved in marketing and selling its goods and/or services through a web-based platform. The front-end transaction might seem like a simple buying-selling transaction of goods or services between a buyer (customer) and a seller (merchant). However, the essence of this buying-selling transaction lies in the payment mode or methodology of making/accepting payments adopted between the customer and the merchant. One of the most common ways of payment acceptance is that the merchant establishes its own payment integration mechanism with a bank such that customers are enabled to make payments through different payment instruments. In such cases, the banks are providing payment aggregator services, but the market is limited usually to the large merchants only. Alternatively, merchants can rely upon third-party service providers (intermediary) that facilitate payment collection from customers on behalf of the merchant and thereafter remittance services to the merchant at the subsequent stage – this is regarded as a payment aggregation business.

The first guidelines issued by the RBI governing the merchant and payment intermediary relationship was in the year 2009[1]. Over the years, the retail payment ecosystem has transformed and these intermediaries, participating in collection and remittance of payments have acquired the market-used terminology ‘Payment Aggregators’. In order to regulate the operations of such payment intermediaries, the RBI had issued detailed Guidelines on Regulation of Payment Aggregators and Payment Gateways, on March 17, 2020. (‘PA Guidelines’)

The payment aggregator business has become a forthcoming model in the online retail payments ecosystem. During an online retail payment by a customer, at the time of checkout vis-à-vis a payment aggregator, there are multiple parties involved. The contractual parties in one single payment transaction are buyer, payment aggregator, payment gateway, merchant’s bank, customer’s bank, and such other parties, depending on the payment mechanism in place. The rights and obligations amongst these parties are determined ex-ante, owing to the sensitivity of the payment transaction. Further, the participants forming part of the payment system chain are regulated owing to their systemic interconnectedness along with an element of consumer protection.

This write-up aims to discuss the intricacies of the regulatory framework under PA Guidelines adopted by the RBI to govern payment aggregators and payment gateways operating in India. The first part herein attempts to depict growth in electronic payments in India along with the turnover data by volumes of the basis of payment instruments used. The second part establishes a contrast between payment aggregator and payment gateway and gives a broad overview of a payment transaction flow vis-à-vis payment aggregator. The third part highlights the provisions of the PA Guidelines and establishes the underlying internationally accepted best principles forming the basis of the regulation. The principles are imperative to understand the scope of regulation under PA Guidelines and the contractual relationship between parties forming part of the payment chain.

Market Dynamics

The RBI in its report stated that the leverage of technology through the use of mobile/internet electronic retail payment space constituted around 61% share in terms of volume and around 75% in share in terms of value during FY 19-20.[2] The innovative payment instruments in the retail payment space, have led to this surge in electronic payments. Out of all the payment instruments, the UPI is the most innovative payment instrument and is the spine for growth in electronic payments systems in India. Chart 1 below compares some of the prominent payment instruments in terms of their volumes and overall compounded annual growth rate (CAGR) over the period of three years.

The payment system data alone does not show the complete picture. In conformity with the rise in electronic payment volumes, as per the Government estimates the overall online retail market is set to cross the $ 200 bn figure by 2026 from $ 30 bn in 2019, at an expected CAGR of 30 %.[4] India ranks No. 2 in the Global Retail Development Index (GRDI) in 2019. It would not be wrong to say, the penetration of electronic payments could be due to the presence of more innovative products, or the growth of online retail has led to this surge in electronic payments.

What are Payment Aggregators and Payment Gateways?

The terms Payment Aggregator (‘PA’) and Payment Gateways (‘PG’) are at times used interchangeably, but there are differences on the basis of the function being performed. Payment Aggregator performs merchant on-boarding process and receives/collects funds from the customers on behalf of the merchant in an escrow account. While the payment gateways are the entities that provide technology infrastructure to route and/or facilitate the processing of online payment transactions. There is no actual handling of funds by the payment gateway, unlike payment aggregators. The payment aggregator is a front-end service, while the payment gateway is the back-end technology support. These front-end and back-end services are not mutually exclusive, as some payment aggregators offer both. But in cases where the payment aggregator engages a third-party service provider, the payment gateways are the ‘outsourcing partners’ of payment aggregators. Thereby such payments are subject to RBI’s outsourcing guidelines.

PA Transaction Flow

One of the most sought-after electronic payments in the online buying-selling marketplace is the payment systems supported by PAs. The PAs are payment intermediaries that facilitate e-commerce sites and merchants in accepting various payment instruments from their customers. A payment instrument is nothing but a means through which a payment order or an instruction is sent by a payer, instructing to pay the payee (payee’s bank). The familiar payment instruments through which a payment aggregator accepts payment orders could be credit cards, debit cards/PPIs, UPI, wallets, etc.

Payment aggregators are intermediaries that act as a bridge between the payer (customer) and the payee (merchant). The PAs enable a customer to pay directly to the merchant’s bank through various payment instruments. The process flow of each payment transaction between a customer and the merchant is dependent on the instrument used for making such payment order. Figure 1 below depicts the payment transaction flow of an end-to-end non-bank PA model, by way of Unified Payment Interface (UPI) as a payment instrument.

In an end-to-end model, the PA uses the clearing and settlement network of its partner bank. The clearing and settlement of the transaction are dependent on the payment instrument being used. The UPI is the product of the National Payments Corporation of India (NPCI), therefore the payment system established by NPCI is also quintessential in the transaction. The NPCI provides a clearing and settlement facility to the partner bank and payer’s bank through the deferred settlement process. Clearing of a payment order is transaction authorisation i.e., fund verification in the customer’s bank account with the payer’s bank. The customer/payer bank debits the customer’s account instantaneously, and PA’s bank transfers the funds to the PA’s account after receiving authorisation from NPCI. The PA intimates the merchant on receipt of payment and the merchant ships the goods to the customer. The inter-bank settlement (payer’s bank and PA’s partner bank) happens at a later stage via deferred net-settlement basis facility provided by the NPCI.

The first leg of the payment transaction is settled between the customer and PA once the PA receives the confirmation as to the availability of funds in the customer’s bank account. The partner bank of PA transfers the funds by debiting the account of PA maintained with it. The PA holds the exposure from its partner bank, and the merchant holds the exposure from the PA. This explains the logic of PA Guidelines, stressing on PAs to put in place an escrow mechanism and maintenance of ‘Core Portion’ with escrow bank. It is to safeguard the interest of the merchants onboarded by the PA. Nevertheless, in the second leg of the transaction, the merchant has its right to receive funds against the PA as per the pre-defined settlement cycle.

Regulatory approach towards PAs and PGs

The international standards and best practices on regulating Financial Market Infrastructure (FMI) are set out in CPSS-IOSCO principles of FMI (PFMI).[5] A Financial Market Infrastructure (FMI) is a multilateral system among participating institutions, including the operator of the system. The consumer protection aspects emerging from the payment aggregation business model, are regulated by these principles. Based on CPSS-IOSCO principles of (PFMI), the RBI has described designated FMIs, and released a policy document on regulation and supervision of FMIs in India under its regulation on FMIs in 2013.[6] The PFMI stipulates public policy objectives, scope, and key risks in financial market infrastructures such as systemic risk, legal risk, credit risk, general business risks, and operational risk. The Important Retail Payment Systems (IRPS) are identified on the basis of the respective share of the participants in the payment landscape.  The RBI has further sub-categorised retail payments FMIs into Other Retail Payment Systems (ORPS). The IRPS are subjected to 12 PFMI while the ORPS have to comply with 7 PFMIs. The PAs and PGs fall into the category of ORPS, regulatory principles governing them are classified as follows:

These principles of regulation are neither exclusive nor can said to be having a clear distinction amongst them, rather they are integrated and interconnected with one another. The next part discusses the broad intention of the principles above and the supporting regulatory clauses in PA Guidelines covering the same.

Legal Basis and Governance framework

The legal basis principle lays the foundation for relevant parties, to define the rights and obligations of the financial market institutions, their participants, and other relevant parties such as customers, custodians, settlement banks, and service providers. Clause 3 of PA Guidelines provides that authorisation criteria are based primarily on the role of the intermediary in the handling of funds. PA shall be a company incorporated in India under the Companies Act, 1956 / 2013, and the Memorandum of Association (MoA) of the applicant entity must cover the proposed activity of operating as a PA forms the legal basis. Henceforth, it is quintessential that agreements between PA, merchants, acquiring banks (PA’s Partners Bank), and all other stakeholders to the payment chain, clearly delineate the roles and responsibilities of the parties involved. The agreement should define the rights and obligations of the parties involved, (especially the nodal/escrow agreement between partner bank and payment aggregator). Additionally, the agreements between the merchant and payment aggregator as discussed later herein are fundamental to payment aggregator business. The PA’s business rests on clear articulation of the legal basis of the activities being performed by the payment aggregator with respect to other participants in the payment system, such as a merchant, escrow banks, in a clear and understandable way.

Comprehensive Management of Risk

The framework for the comprehensive management of risks provides for integrated and comprehensive view of risks. Therefore, this principle broadly entails comprehensive risk policies, procedures/controls, and participants to have robust information and control systems. Another connecting aspect of this principle is operational risk, arising from internal processes, information systems and disruption caused due to IT systems failure. Thus there is a need for payment aggregator to have robust systems, policies to identify, monitor and manage operational risks. Further to ensure efficiency and effectiveness, the principle entails to maintain appropriate standards of safety and security while meeting the requirements of participants involved in the payment chain. Efficiency is resources required by such payment system participants (PAs/PGs herein) to perform its functions. The efficiency includes designs to meet needs of participants with respect to choice of clearing and settlement transactions and establishing mechanisms to review efficiency and effectiveness. The operational risk are comprehensively covered under Annex 2 (Baseline Technology-related Recommendation) of the PA Guidelines. The Annex 2, inter alia includes, security standards, cyber security audit reports security controls during merchant on-boarding. These recommendations and compliances under the PA Guidelines stipulates standard norms and compliances for managing operational risk, that an entity is exposed to while performing functions linked to financial markets.

KYC and Merchant On-boarding Process

An important aspect of payment aggregator business covers merchant on-boarding policies and anti-money laundering (AML) and counter-terrorist financing (CFT) compliance. The BIS-CPSS principles do not govern within its ambits certain aspects like AML/CFT, customer data privacy. However, this has a direct impact on the businesses of the merchants, and customer protection. Additionally, other areas of regulation being data privacy, promotion of competition policy, and specific types of investor and consumer protections, can also play important roles while designing the payment aggregator business model. Nevertheless, the PA Guidelines provide for PAs to undertake KYC / AML / CFT compliance issued by RBI, as per the “Master Direction – Know Your Customer (KYC) Directions” and compliance with provisions of PML Act and Rules. The archetypal procedure of document verification while customer on-boarding process could include:

  • PA’s to have Board approved policy for merchant on-boarding process that shall, inter-alia, provide for collection of incorporation certificates, constitutional document (MoA/AoA), PAN and financial statements, tax returns and other KYC documents from the merchant.
  • PA’s should take background and antecedent checks of the merchants, to ensure that such merchants do not have any malafide intention of duping customers, do not sell fake/counterfeit/prohibited products, etc.

PAs shall ensure that the merchant’s site shall not save customer’s sensitive personal data, like card data and such related data. Agreement with merchant shall have provision for security/privacy of customer data.

Settlement and Escrow

The other critical facet of PA business is the settlement cycle of the PA with the merchants and the escrow mechanism of the PA with its partner bank. Para 8 of PA Guidelines provide for non-bank PAs to have an escrow mechanism with a scheduled bank and also to have settlement finality. Before understanding the settlement finality, it is important to understand the relevance of such escrow mechanisms in the payment aggregator business.

Escrow Account

Surely there is a bankruptcy risk faced by the merchants owing to the default by the PA service provider. This default risk arises post completion of the first leg of the payment transaction. That is, after the receipt of funds by the PA from the customer into its bank account. There is an ultimate risk of default by PA till the time there is final settlement of amount with the merchant. Hence, there is a requirement to maintain the amount collected by PA in an escrow account with any scheduled commercial bank. All the amounts received from customers in partner bank’s account, are to be remitted to escrow account on the same day or within one day, from the date amount is debited from the customer’s account (Tp+0/Tp+1). Here Tp is the date on which funds are debited from the customer’s bank account.  At end of the day, the amount in escrow of the PA shall not be less than the amount already collected from customer as per date of debit/charge to the customer’s account and/ or the amount due to the merchant. The same rules shall apply to the non-bank entities where wallets are used as a payment instrument.[7] This essentially means that PA entities should remit the funds from the PPIs and wallets service provider within same day or within one day in their respective escrow accounts. The escrow banks have obligation to ensure that payments are made only to eligible merchants / purposes and not to allow loans on such escrow amounts. This ensures ring fencing of funds collected by the PAs, and act as a deterrent for PAs from syphoning/diverting the funds collected on behalf of merchants. The escrow agreement function is essentially to provide bankruptcy remoteness to the funds collected by PA’s on behalf of merchants.

Settlement Finality

Settlement finality is the end-goal of every payment transaction. Settlement in general terms, is a discharge of an obligation with reference of the underlying obligation (whatever parties agrees to pay, in PA business it is usually INR). The first leg of the transaction involves collection of funds by the PA from the customer’s bank (originating bank) to the PA escrow account. Settlement of the payment transaction between the PA and merchant, is the second leg of the same payment transaction and commences once funds are received in escrow account set up by the PA (second leg of the transaction).

Settlement finality is the final settlement of payment instruction, i.e. from the customer via PA to the merchant. Final settlement is where a transfer is irrevocable and unconditional. It is a legally defined moment, hence there shall be clear rules and procedures defining the point of settlement between the merchant and PA.

For the second leg of the transaction, the PA Guidelines provide for different settlement cycles:

  1. Payment Aggregator is responsible for the delivery of goods/service– The settlement cycle with the merchant shall not be later than one day from the date of intimation to PA of shipment of goods by the merchant.
  2. Merchant is responsible for delivery– The settlement cycle shall not be later than 1 day from the date of confirmation by the merchant to PA about delivery of goods to the customer.
  3. Keeping the amount by the PA till the expiry of refund period– The settlement cycle shall not be later than 1 day from the date of expiry of the refund period.

These settlement cycles are mutually exclusive and the PA business models and settlement structure cycle with the merchants could be developed by PAs on the basis of market dynamics in online selling space. Since the end-transaction between merchant and PA is settled on a contractually determined date, there is a deferred settlement, between PA and the merchant.  Owing to the rules and nature of the relationship (deferred settlement) is the primary differentiator from the merchants proving the Delivery vs. Payment (DvP) settlement process for goods and services.

Market Concerns

Banks operating as PAs do not need any authorisation, as they are already part of the the payment eco-system, and are also heavily regulated by RBI. However, owing to the sensitivity of payment business and consumer protection aspect non-bank PA’s have to seek RBI’s authorisation. This explains the logic of minimum net-worth requirement, and separation of payment aggregator business from e-commerce business, i.e. ring-fencing of assets, in cases where e-commerce players are also performing PA function. Non-bank entities are the ones that are involved in retail payment services and whose main business is not related to taking deposits from the public and using these deposits to make loans (See. Fn. 7 above).

However, one could always question the prudence of the short timelines given by the regulator to existing as well as new payment intermediaries in achieving the required capital limits for PA business. There might be a trade-off between innovations that fintech could bring to the table in PA space over the stringent absolute capital requirements. While for the completely new non-bank entity the higher capital requirement (irrespective of the size of business operations of PA entity) might itself pose a challenge. Whereas, for the other non-bank entities with existing business activities such as NBFCs, e-commerce platforms, and others, achieving ring-fencing of assets in itself would be cumbersome and could be in confrontation with the regulatory intention. It is unclear whether financial institutions carrying financial activities as defined under section 45 of the RBI Act, would be permitted by the regulator to carry out payment aggregator activities. However, in doing so, certain additional measures could be applicable to such financial entities.

Conclusion

The payment aggregator business models in India are typically based on front-end services, i.e. the non-bank entitles are aggressively entering into retail payment businesses by way of providing direct services to merchants. The ability of non-bank entitles to penetrate into merchant onboarding processes, has far overreaching growth potential than merchant on-boarding processes of traditional banks. While the market is at the developmental stage, nevertheless there has to be a clear definitive ex-ante system in place that shall provide certainty to the payment transactions. The CPSS-IOSCO, governing principles for FMIs lays down a good principle-based governing framework for lawyers/regulators and system participants to understand the regulatory landscape and objective behind the regulation of payment systems. PA Guidelines establishes a clear, definitive framework of rights between the participants in the payment system, and relies strongly on board policies and contractual arrangements amongst payment aggregators and other participants. Therefore, adequate care is necessitated while drafting escrow agreements, merchant-on boarding policies, and customer grievance redressal policies to abide by the global best practices and meet the objective of underlying regulation. In hindsight, it will be discovered only in time to come whether the one-size-fits-all approach in terms of capital requirement would prove to be beneficial for the overall growth of PA business or will cause a detrimental effect to the business space itself.

 

[1] RBI, Directions for opening and operation of Accounts and settlement of payments for electronic payment transactions involving intermediaries, November 24, 2009. https://www.rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=5379

[2] Payment Systems in India – Booklet (rbi.org.in)

[3] https://m.rbi.org.in/Scripts/AnnualReportPublications.aspx?Id=1293

[4] https://www.investindia.gov.in/sector/retail-e-commerce

[5] The Bank for International Settlements (BIS), Committee on Payment and Settlement Systems (CPSS) and International Organisation of Securities Commissions (IOSCO) published 24 principles for financial market infrastructures and  and responsibilities of central banks, market regulators and other authorities. April 2012 <https://www.bis.org/cpmi/publ/d101a.pdf>

[6]Regulation and Supervision of Financial Market Infrastructures, June 26, 2013 https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=2705

[7] CPMI defines non-banks as “any entity involved in the provision of retail payment services whose main business is not related to taking deposits from the public and using these deposits to make loans”  See, CPMI, ‘Non-banks in retail Payments’, September 2014, available at <https://www.bis.org/cpmi/publ/d118.pdf>

 

Our other related articles:

Overview of Regulatory Framework of Payment and Settlement Systems in India by Anita Baid – Vinod Kothari Consultants

RBI to regulate operation of payment intermediaries – Vinod Kothari Consultants

Major recommendations of the Committee on Payment Systems on Payment and Settlement System Bill, 2018 – Vinod Kothari Consultants

Risk-based Internal Prescription for Audit Function

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Qasim Saif | Executive (finserv@vinodkothari.com)

Updated as on June 11, 2021

Introduction

It is a well-known fact that an independent and effective internal audit function is of special importance to all corporates for mitigation of their risk. And it has increased importance for a financial sector entity as it provides for reasonable assurance to the board and its senior management regarding the quality and effectiveness of the entity’s internal control, risk management, and governance framework.

Given the current relatively uncertain economic environment which has put significant pressure on debt servicing capabilities of corporates and businesses, there is a need to critically examine the existing portfolio and take an account of the related risk management and accounting practices.

This on-going stressed situation coupled with the uncertain economic environment and the increased global regulatory watch requires financial institutions to critically evaluate the quality of their regulatory submissions, risk model, capital adequacy, and conduct in the financial markets.

In recent times, Non-Banking Financial Companies (NBFCs) / Urban Co-operative Banks (UCBs) have grown in size and have become systemically important in the economy given their increased participation in the financial credit market. Just like banks, NBFCs and UCBs face similar risks by virtue of being engaged in financial intermediation activities, hence, it makes sense that their internal audit systems should also broadly align while keeping in mind the principle of proportionality.

Applicability

Earlier this year, RBI had issued RBIA Framework for Strengthening Governance Arrangements for commercial banks, local area banks, small finance banks, and payment banks on 7th January 2021[1].

To increase focus on the risk management function of NBFCs/UCBs, the RBI on 3rd February 2021[2] issued a circular prescribing the requirement for Risk-Based Internal Audit (RBIA Framework). The requirements prescribed under the circular are to be implemented by 31st March 2022.The said circular is applicable on-

The framework for NBFCs and UCBs draws largely from the framework for banks.

The circulars clearly indicates that RBI is now accepting a more stringent attitude towards risk management and audit, specifically given the challenges faced due to Covid -19. It seems like Covid-19 acted as a wake-up alarm to increase focus on risk management and its mitigation by financial sector entities.

Applicability on Housing Finance Companies (HFCs)

The RBI circular did not specifically state the applicability of RBIA Framework on HFCs. Hence the same was open for interpretation by the stakeholders and so there were 2 different school of thoughts on this. First is that since HFCs are also a class of NBFCs so the circular should also be applicable on HFCs. However, a counter interpretation was that the Master Direction for Housing Finance Company (which assembles all applicable regulations at one place) which was notified on February 17, 2021[3] (after the given 3rd February circular), did not include compliance with RBIA Framework. Accordingly, the coverage of the RBIA Framework did not seem to be applicable on HFCs. The interpretation by the stakeholders resultied in diverse practices in the market.

However, RBI on 11th June, 2021 has issued a circular stating “On a review, it has been decided that the provisions of the aforesaid circular (circular dated 3rd February, 2021) shall be applicable to all deposit taking HFCs, irrespective of their size and non-deposit taking HFCs with asset size of ₹5,000 crore and above.

Considering the above clarification from RBI, HFCs shall now be required to be undertake Risk Based Internal Audit and put in place RBIA framework by June 30, 2022.

Risk Based Internal Audit: A Sub-set of Risk Management Framework

An essential characteristic of an effective RBIA Framework would be that it should be a connecting link between various components of risk management framework and should provide for reasonable assurance that organisation’s internal controls, risk management, and governance related systems and processes are adequate to deal with risk faced by it.

The internal audit function should ideally be targeted towards contributing to the overall improvement of the organization’s governance, risk management, and control processes using a systematic and disciplined approach.

The circular provides that internal audit function is an integral part of sound corporate governance and is considered as the third line of defence. The inference for different lines of defence for risk management may be drawn from the RBIA circular for Banks, which provides as follows-

Based on the recent developments and emerging trends, the focus areas for robust internal audit should ideally inter-alia the following components-

The internal audit function in NBFCs/UCBs has generally been concentrated on accounting requirements and regulatory compliance etc. However, considering the market developments, testing limited to these factors may not be sufficient. Therefore, the current framework includes, above aspects along with, an evaluation of the risk management systems and control procedures in various areas of operations. This will help in anticipating areas of potential risks and mitigating such risks.

The RBIA should be conducted based on a RBIA plan which is required to be formulated after considering the elements of risk management framework of the entity.

Actionable

As mentioned above, reasonable amount of time is provided to NBFCs/UCBs to prepare for effective implementation of the RBIA Framework, that is, by 31st March 2022. However, though the requirements are to be complied by the end of next financial year, the preparedness for the same must be initiated immediately. A list of actionable on the part of NBFCs/UCBs has been provided below for reference:

Role and responsibilities of functionaries

It is a well understood notion that to get a particular task done, a fixed responsibility centre should be set-up, this enables proper implementation and also increases the efficiency of the implementation. Considering the same RBI has prescribed for responsibilities of senior management, Board and Audit committee to ensure proper implementation of RBIA Framework.  The allotted role and responsibilities shall be as follows-

Board of Directors / Audit Committee of Board

The Board of Directors (the Board) / Audit Committee of Board (ACB) of NBFCs/UCBs shall have the primary responsibility of overseeing the internal audit function in the organization. The major responsibility of the Board and ACB would be to establish and further review the RBIA systems.

The RBIA policy is to be formulated with the approval of the Board and would be disseminated widely within the organization. The policy should be consistent with the size and nature of the business undertaken, the complexity of operations and should factor in the elements of internal audit. The ACB and Board would further review the performance of RBIA and shall also formulate and maintain a quality assurance and improvement program that covers all aspects of the internal audit function.

Senior Management

The senior management shall be responsible for implementation of the systems established by the board and ACB.

The senior management shall ensure adherence to the internal audit policy guidelines as approved by the Board and development of an effective internal control function that identifies, measures, monitors, and reports all risks faced. The senior management shall ensure audit reports is placed before the ACB/Board. Further, a consolidated position of major risks faced by the organization shall be presented at least annually to the ACB/Board, based on inputs from all forms of audit.

The senior management shall also be responsible for establishing a comprehensive and independent internal audit function that should promote accountability and transparency. It shall ensure that the RBIA Function is adequately staffed with skilled personnel of right aptitude and attitude who are periodically trained to update their knowledge, skill, and competencies.

Internal Audit Function: Major Elements

The RBIA Framework broadly provides for a comprehensive internal audit function the major elements and their requirements are summarised as follows-

Risk Matrix

A risk matrix is a matrix that is used during risk assessment to define the level of risk by considering the category of probability or likelihood as against the category of consequence severity. This is a simple mechanism to increase visibility of risks and assist in management decision making.

The circular requires that the RBIA function should consider risk matrix while setting up action plan. Further, certain risk mentioned shall be given enhanced attention during the RBIA, the matrix and areas of focus are marked red in graph below-

Outsourcing of the Internal Audit Function

The internal audit function cannot be outsourced. However, where required, experts including former employees can be hired on a contractual basis subject to the ACB/Board being assured that such expertise does not exist within the audit function of the NBFC/UCB. Any conflict of interest in such matters shall be recognised and effectively addressed.

Monitoring and follow up

Monitoring and follow-up actions form an integral part of entire internal control system to ensure effective functioning of the procedures. Accordingly, the process as well as findings under the RBIA Framework should be regularly monitored. The said responsibility lies with the Board and Senior Management, as discussed above.

[1] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=12011&Mode=0

[2] https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR10365F8B4F9BF8FE4A209F3BD7FD1D62B7D9.PDF

[3] Our write up on the topic “RBI consolidates directions for Housing Finance Companies http://vinodkothari.com/2021/02/rbi-consolidates-directions-for-housing-finance-companies/”

[4] Our write up on the top “Risk management policy” https://vinodkothari.com/2021/10/risk-management-policy-a-tool-of-risk-management/

Factoring Law Amendments backed by Standing Committee

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-Megha Mittal 

[finserv@vinodkothari.com]

In the backdrop of the expanding transaction volumes, and with a view to address the still prevalent delays in payments to sellers, especially MSMEs, the Factoring Regulation (Amendment) Bill, 2020 (‘Amendment Bill’) was introduced in September, 2020, so as to create a broader and deeper liquid market for trade receivables.

The proposed amendments have been reviewed and endorsed by the Standing Committee of Finance chaired by Shri. Jayant Sinha, along with some key recommendations and suggestions to meet the objectives as stated above.  In this article, we discuss the observations and recommendations of the Standing Committee Report  in light of the Amendment Bill.

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