Partial credit enhancement scheme gets off to a flying start

Abhirup Ghosh

abhirup@vinodkothari.com

The Government of India, with an intent to infuse liquidity in the financial sector, in the Union Budget, 2019, proposed to provide partial credit guarantee for sale of high quality assets of good NBFCs/ HFCs to public sector banks. Subsequently, on 10th August 2019, the FinMin launched the scheme[1].

Initially, there were various ambiguities in the scheme, however, later on, the same were clarified by the Government and the Reserve Bank of India. The start had to be slow and it took almost a month to figure things out and keep the systems in place, meanwhile an industry forum was also organised by the Indian Securitisation Foundation and Edelweiss Group to deliberate on the various issues surrounding the matter. However, close to the end of the second quarter, the product gained traction and reported volume of close Rs. 17,000 crores have already been done, with another Rs. 15,000 crores worth deals in the pipeline.

This has come as a relief for all the financial sector entities, as the banks are now keen to look at NBFC assets, considering that – a) the pool of loans are of good quality[2], b) additionally, the GOI will provide a first loss guarantee on the pool of assets. AA rating is itself treated as a good rating and with an additional sovereign guarantee over that, the transaction technically becomes risk free in the hands of the purchasing bank.

As per market sources, majority of the transactions are being priced in the range of 9%-10%.  Considering the level of stress the financial sector is going through, the transactions are being priced decently.

Some ambiguities still linger on

Though the transactions are being processed seamlessly, however, some ambiguities with respect to accounting treatment of the transaction are still worrying the financial institutions. The transaction being a mix of securitisation and direct assignment transaction throws new challenges. One of the key issues in case of any direct assignment/ securitisation transaction is whether the transaction would result in de-recognition of financial assets from the books of the originator. The de-recognition principles are laid down in Para 3.2 of Ind AS 109. These principles allow an entity to remove financial assets from its books either based on substantial transfer of risks and rewards, or based on a surrender of control. If the risks and rewards are substantially retained, de-recognition is denied. While the conditions of assessing whether there has been a substantial transfer of risks and rewards are subjective, there is substantial amount of global guidance on the subject.

Since Indian securitisation transactions involve credit enhancements normally to the extent of AAA-ratings, and sweep all residual excess spread, most of the securitisation transactions as currently done fail to transfer risks and rewards in the pool of assets, and consequently, do not lead to de-recognition of financial assets. However, in case of direct assignment transactions, the transfer of assets presumably leads to pari passu transfer of risks and rewards in the assets. Therefore, the same leads to de-recognition of assets transferred by the originator to the buyer.

In case of transfers under this Scheme, the assets must be rated as high as AA, which is impossible to achieve unless there is a tranching of pool done. This signifies that the first loss support to the pool would come from the originator or from a third party. There is certainly a strong element of risk retention by the originator. Correspondingly, the excess spread is also retained by the originator. However, whether the same would be regarded as “substantially all the risks and rewards” in the pool is still questionable. The very need for a sovereign guarantee signifies that there is a left over risk which requires to be covered by the Government guarantee..

Therefore, the transaction seems to be splitting the overall risks of the pool into 3 pieces – partially, retention by the originator, partially going to the GoI, and the remaining or super-senior part, going to the bank. It may be noted that if there is a significant transfer of risks, then it may not be separately necessary to establish a transfer of rewards as well, as risks and rewards are concomitant.

This, however, is subject to interpretation and there is a strong likelihood of different opinions in this regard. One shall have to wait for the finalisation of quarterly accounts of the major financial institutions to understand the direction in which the industry is inclined to.

The other ambiguity that continues is regarding the guarantee commission. On the apparent reading of the scheme, it seems that guarantee commission to be paid to the GOI, has to paid annually, however, another school of thought believes that the guarantee commission will have to be paid only once during the lifetime of the transaction. A clarification in this regard from the GOI will be very helpful.

Impact on other structured finance transactions

Interestingly, this scheme has, so far, not hampered the otherwise booming securitisation industry. The first half of the FY 2020 has reported recorded approximately Rs 1 lakh crores worth transactions, which is 48% year on year growth.

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

[2] As per the Scheme, the pool should be highly rated. It should be rated at least AA even before the government guarantee.

Sale assailed: NBFC crisis may put Indian securitisation transactions to trial

-By Vinod Kothari (vinod@vinodkothari.com)

Securitisation is all about bankruptcy remoteness, and the common saying about bankruptcy remoteness is that it works as long as the entities are not in bankruptcy! The fact that any major bankruptcy has put bankruptcy remoteness to challenge is known world-over. In fact, the Global Financial Crisis itself put several never-before questions to legality of securitisation, some of them going into the very basics of insolvency law[1]. There have been spate of rulings in the USA pertaining to transfer of mortgages, disclosures in offer documents, law suits against trustee, etc.

The Indian securitisation market has faced taxation challenges, regulatory changes, etc. However, it has so far been immune from any questions at the very basics of either securitisability of assets, or the structure of securitisation transactions, or issues such as commingling of cashflows, servicer transition, etc. However, sitting at the very doorstep of defaults by some major originators, and facing the spectrum of serious servicer downgrades, the Indian securitisation market clearly faces the risk of being shaken at its basics, in not too distant future.

Before we get into these challenges, it may be useful to note that the Indian securitisation market saw an over-100% growth in FY 2019 with volumes catapulting to INR 1000 billion. In terms of global market statistics, Indian market may now be regarded as 2nd largest in ex-Japan Asia, only after China.

Since the blowing up of the ILFS crisis in the month of September 2018, securitisation has been almost the only way of liquidity for NBFCs. Based on the Budget proposal, the Govt of India launched, in Partial Credit Guarantee Scheme, a scheme for partial sovereign guarantee for AA-rated NBFC pools. That scheme seems to be going very well as a liquidity breather for NBFCs. Excluding the volumes under the partial credit enhancement scheme, securitisation volumes in first half of the year have already crossed INR 1000 billion.

In the midst of these fast rising volumes, the challenges on the horizon seem multiple, and some of them really very very hard. This write up looks at some of these emerging developments.

Sale of assets to securitisation trusts questioned

In an interim order of the Bombay High court in Edelweiss AMC vs Dewan Housing Finance Corporation Limited[2], the Bombay High court has made certain observations that may hit at the very securitisability of receivables.  Based on an issue being raised by the plaintiff, the High Court has directed the company DHFL to provide under affidavit details of all those securitisation transactions where receivables subject to pari passu charge of the debentureholders have been assigned, whether with or without the sanction of the trustee for the debentureholders.

The practice of pari passu floating charge on receivables is quite commonly used for securing issuance of debentures. Usually, the charge of the trustees is on a blanket, unspecific common pool, based on which multiple issuances of debentures are covered. The charge is usually all pervasive, covering all the receivables of the company. In that sense, the charge is what is classically called a “floating charge”.

These are the very receivables that are sold or assigned when a securitisation transaction is done. The issue is, given the floating nature of the charge, a receivable originated automatically becomes subject to the floating charge, and a receivable realised or sold automatically goes out of the purview of the charge. The charge document typically requires a no-objection confirmation of the chargeholder for transactions which are not in ordinary course of business. But for an NBFC or an HFC, a securitisation transaction is a mode of take-out and very much a part of ordinary course of business, as realisation of receivables is.

If the chargeholder’s asset cover is still sufficient, is it open for the chargeholder to refuse to give the no-objection confirmation to another mode of financing? If that was the case, any chargeholder may just bring the business of an NBFC to a grinding halt by refusing to give a no-objection.

The whole concept of a floating charge and its priority in the event of bankruptcy has been subject matter of intensive discussion in several UK rulings[3]. There have been discussions on whether the floating charge concept, a judge-made product of UK courts, can be eliminated altogether from the insolvency law[4].

In India, the so-called security interest on receivables is not really intended to be a security device – it is merely a regulatory compliance with company law rules under which unsecured debentures are treated as “deposits”[5]. The real intent of the so-called debenture trust document is maintenance of an asset cover, which may be expressed as a covenant, even otherwise, in case of an unsecured debenture issuance. The fact is that over the years, the Indian bond issuance market has not been able to come out of the clutches of this practice of secured debenture issuance.

While bond issuance practices surely need re-examination, the burning issue for securitisation transactions is – if the DHFL interim ruling results into some final observations of the court about need for the bond trustee’s NOC for every securitisation transaction, all existing securitisation transactions may also face similar challenges.

Servicer-related downgrades

Rating agencies have recently downgraded two notches from AAA ratings several pass-through certificate transactions of a leading NBFC. The rationale given in the downgrade action, among other things, cites servicer risks, on the ground that the originator has not been able to obtain continuous funding support from banks. While absence of continuing funding support may affect new business by an NBFC, how does it affect servicing capabilities of existing transactions, is a curious question. However, it seems that in addition to the liquidity issue, which is all pervasive, the rating action in the present case may have been inspired by some internal scheme of arrangement proposed by the NBFC in question.

This particular downgrades may, therefore, not have a sectoral relevance. However, what is important is that the downgrades are muddying the transition history of securitisation ratings. From the classic notion that securitisation ratings are not susceptible to originator-ratings, the dependence of securitisation transactions to pure originator entity risks such as internal funding strengths or scheme of arrangement puts a risk which is usually not considered by securitisation investors. In fact, the flight to securitisation and direct assignments after ILFS crisis was based on the general notion that entity risks are escaped by securitisation transactions.

Servicer transitions

The biggest jolt may be a forced servicer transition. In something like RMBS transactions, outsourcing of collection function is still easy, and, in many cases, several activities are indeed outsourced. However, if it comes to more complicated assets requiring country-wide presence, borrower franchise and regular interaction, if servicer transition has to be forced, the transaction will be worse than originator bankruptcy.

Questions on true sale

The market has been leaning substantially on the “direct assignment” route. Most of the direct assignments are seen by the investors are look-alikes and feel-alikes of a loan to the originator, save and except for the true-sale opinion. Investors have been linking their rates of return to their MCLR. Investors have been viewing the excess spread as a virtual credit support, which is actually not allowed as per RBI regulations. Pari-passu sharing of principal and interest is rarely followed by the market transactions.

If the truth of the sale in most of the direct assignment transactions is questioned in cases such as those before the Bombay High court, it will not be surprising to see the court recharacterise the so-called direct assignments as nothing but disguised loans. If that was to happen in one case of a failed NBFC, not only will the investors lose the very bankruptcy-remoteness they were hoping for, the RBI will be chasing the originators for flouting the norms of direct assignment which may have hitherto been ignored by the supervisor. The irony is – supervisors become super stringent in stressful times, which is exactly where supervisor’s understanding is required more than reprimand.

Conclusion

NBFCs are passing through a very strenuous time. Delicate handling of the situation with deep understanding and sense of support is required from all stakeholders. Any abrupt strong action may exacerbate the problem beyond proportion and make it completely out of control. As for securitisation practitioners, it is high time to strengthen practices and realise that the truth of the sale is not in merely getting a true sale opinion.

Other Related Articles:


[1] For example, in a Lehman-related UK litigation called Perpetual Trustees vs BNY Corporate Trustee Services, the typical clause in a synthetic securitisation diverting the benefit of funding from the protection buyer (originator – who is now in bankruptcy) to the investors, was challenged under the anti-deprivation rule of insolvency law. Ultimately, UK Supreme Court ruled in favour of securitisation transactions.

[2] https://www.livelaw.in/pdf_upload/pdf_upload-365465.pdf. Similar observations have been made by the same court in Reliance Nippon Life AMC vs  DHFL.

[3] One of the leading UK rulings is Spectrum Plus Limited, https://www.bailii.org/uk/cases/UKHL/2005/41.html. This ruling reviews whole lot of UK rulings on floating charges and their priorities.

[4] See, for example, R M Goode, The Case for Abolition of the Floating Charge, in Fundamental Concepts of Commercial Law (50 years of Reflection, by Goode)

[5] Or partly, the device may involve creation of a mortgage on a queer inconsequential piece of land to qualify as “mortgage debentures” and therefore, avail of stamp duty relaxation.

Lenders’ piggybacking: NBFCs lending on Fintech platforms’ guarantees

-Vinod Kothari

(vinod@vinodkothari.com)

Among the disruptive Fintech practices, app-based lending is certainly notable. The scenario of an app-based lending is somewhat like this – a prospective borrower goes to an app platform, fills up some information. At the background, the app collects and collates the information including credit scores of the individual, may be the individual’s contact bases in social networks, etc. Finally, the loan is sanctioned in a jiffy, mostly within minutes.

The borrower interacts with the platform, but does the borrower know that the loan is actually not coming from the platform but from some NBFC? Whether the borrower knows or cares for who the lender is, the fact is that mostly, the technology provider (platform) and the funding provider (lender) are not the same. It may be two entities within the same group, but more often than not, the lender is an NBFC which is simply originating the loan based on the credit comfort provided by the platform.

The relation between the platform and the lender may take one of the following forms: (a) platform simply is procuring or referring the credit; the platform has no credit exposure at all; (b) the platform is acting as a sourcing agent, and is also providing a credit support, say in form of a first-loss guarantee for a certain proportion of the pool of loans originated through the platform; (c ) the platform provides full credit support for all the loans originated through the platform, and in return, the lender allows the platform to retain all the actual returns realised through the pool of loans, over an and above a certain “portfolio IRR”.

Option (a) is pure sourcing arrangement; however, it is quite unlikely that the lender will be willing to trust the platform’s credit scoring, unless there is significant skin-in-the-game on the part of the platform.

If it is a case of option (c ) [which, incidentally, seems quite common, the loan is actually put on the books of the lender, but the credit exposure is on the platform. The lender’s exposure is, in fact, on the platform, and not the borrower. The situation seems to be quite close to a “total rate of return swap”, a form of a credit derivative, whereby parties synthetically replace the exposure and the actual rate of return in a portfolio of loans by a pre-agreed “total rate of return”.

Our objective in this article is to examine whether there are any regulatory concerns on the practice as in case of option (c ) . Option c is an exaggeration; there may be a case such as option (b). But since option (b) is also a first loss guarantee with a substantial thickness, it is almost akin to the platform absorbing virtually all the risks of the credit pool originated through the platform.

Before we get into the regulatory concerns, it is important to understand what are the motivations of each of the parties in this bargain.

Platform’s motivations

The motivation on the part of the platform is clear – the platform makes the spreads between the agreed portfolio IRR with the lender, and the actual rate of return on the loan pool, after absorbing all the risk of defaults. Assume, the small-ticket personal loan is being given at an interest rate of 30%, and the agreed portfolio IRR with the lender is 14%, the platform is entitled to the spread of 16%. If some of the loans go bad, as they indeed do, the platform is still left with enough of juice to be a compensation for the risks taken by it.

The readiness on the part of the platform is also explained by the fact that the credibility of the platform’s scoring is best evidenced by the platform agreeing to take the risk – it is like walking the talk.

Lender’s motivations

The lender’s motivations are also easy to understand – the lender is able to disburse fast, and at a decent rate of return for itself, while taking the risk in the platform.  In fact, several NBFCs and banks have been motivated by the attractiveness of this structure.

Are there any regulatory concerns?

The potential regulatory concerns may be as follows:

  • De-facto, synthetic lending by an entity that is not a regulated NBFC
  • Undercapitalised entity taking credit risk
  • Skin-in-the-game issue
  • A CDS, but not regulated as a CDS
  • Financial reporting issues
  • Any issues of conflict of interest or misalignment of incentives
  • Good borrowers pay for bad borrowers
  • KYC or outsourcing related issues.

Each of these issues are examined below.

Synthetic lending by an unregulated entity

It is common knowledge that NBFCs in India require registration. The platform in the instant case is not giving a loan. The platform is facilitating a loan – right from origination to credit risk absorption. Correspondingly, the platform is earning a spread, but the activity is technically not a “financial activity”, and the spread not a “financial income”; hence, the platform does not require regulatory registration.

Per contra, it could be argued that the platform is essentially doing a synthetic lending. The position of the platform is economically similar to an entity that is lending money at 30% rate of interest, and refinancing itself at 14%. There will be a regulatory arbitrage being exploited, if such synthetic lending is not treated at par with formal lending.

But then, there are whole lot of equity-linked or property-linked swaps, where the returns of an investment in equities, properties or commodities, are swapped through a total rate of return swaps, and in regulatory parlance, the floating income recipient is not regarded as investor in equities, properties or commodities. Derivatives do transform one asset into another by using synthetic technology – in fact, insurance-linked securities allow capital market investors to participate in insurance risk, but it cannot be argued that such investors become insurance companies.

Undercapitalised entities taking credit risk

It may be argued that the platform is not a regulated entity; yet, that is where the actual credit risk is residing.  Unlike NBFCs, the platform does not require any minimum capitalisation norms or risk-weighted capital asset requirements. Therefore, there is a strong potential for risk accumulation at the platform’s level, with no relevant capital requirements. This may lead to a systemic stability issue, if the platforms become large.

There is a merit in the issue. If fintech-based lending becomes big, the exposure taken by fintech entities on the loans originated through them, on which they have exposure, may be treated at par with loans actually held on the balance sheet of the fintech. As in case of financial entities, there are norms for converting off-balance sheet assets into their on-balance sheet equivalents, the same system may be adopted in this case.

Skin-in-the game issue

Post the Global Financial Crisis, one of the regulatory concerns was skin-in-the-game. In light of this, the RBI has imposed minimum holding period, and minimum risk retention requirements in case of direct assignments as well as securitisation.

The transaction of guarantee discussed above may seem like the exposure being shifted by the platform to the NBFC. However, the transaction is not at all comparable with an assignment of a loan. Here, the lending itself is originated on the books of the NBFC/lender. The lender has the ultimate discretion to agree to lend or not. The credit decision is that of the lender; hence, the loan is originated by the lender, and not acquired. The lender is mitigating the risk by backing it up with the guarantee of the platform – but this is not a case of an assignment.

There is a skin-in-the-game on either side. For the platform, the guarantee is the skin-in-the-game; for the NBFC, the exposure in the platform becomes its stake.

A CDS, but not regulated as a CDS

The transaction has an elusive similarity to a credit default swap (CDS) contract. It may be argued that the guarantee construct is actually a way to execute a derivative contract, without following CDS guidelines provided by the RBI.

In response, it may be noted that a derivative is a synthetic trading in an exposure, and is not linked with an actual exposure. For example, a protection buyer in a CDS may not be having the exposure for which he is buying protection, in the same way as a person acquiring a put option on 100 gms of gold at a certain strike price may not be having 100 gms of gold at all. Both the persons above are trying to create a synthetic position on the underlying.

Unlike derivatives, in the example of the guarantee above, the platform is giving guarantee against an actual exposure. The losses of the guarantor are limited to actual losses suffered by the lender. Hence, the contract is one of indemnity (see discussion below), and cannot be construed or compared to a derivative contract. There is no intent of synthetic trading in credit exposure in the present case.

Financial reporting issues:

It may be argued that the platform is taking same exposure as that of an actual lender; whereas the exposure is not appearing on the balance sheet of the platform. On the other hand, the actual exposure of the lender is on the platform, whereas what is appearing on the balance sheet of the lender is the loan book.

The issue is one of financial reporting. IFRSs clearly address the issue, as a financial guarantee is an on-balance sheet item, at its fair value. If the platform is not covered by IFRSs/IndASes, then the platform will be reflecting the guarantee as a contingent liability on its balance sheet.

Conflicts of interest or misalignment of incentives:

During the prelude to the Global Financial Crisis, a commonly-noted regulatory concern was misalignment of incentives – for instance, a subprime mortgage lender might find it rewarding to lend to a weak credit and capture more excess spread, while keeping its exposure limited.

While that risk may, to some extent, remain in the present guarantee structure as well, but there are at least 2 important mitigants. First, the ultimate credit decision is that of the NBFC. Secondly, if the platform is taking full credit recourse, then there cannot be a misalignment of incentives.

Good borrowers pay for bad borrowers

It may be argued that eventually, the platform is compensating itself for the risk of expected losses by adding to the cost of the lending. Therefore, the good borrowers pay for the bad borrowers.

This is invariably the case in any form of unsecured lending. The mark-up earned by the lender is a compensation for risk of expected losses. The losses arise for the loans that don’t pay, and are compensated by those that do.

KYC or outsourcing related issues

Regulators may also be concerned with KYC or outsourcing related issues. As per RBI norms “NBFCs which choose to outsource financial services shall, however, not outsource core management functions including Internal Audit, Strategic and Compliance functions and decision-making functions such as determining compliance with KYC norms for opening deposit accounts, according sanction for loans (including retail loans) and management of investment portfolio.”

Usually the power to take credit decisions vests with the lender. However, in case the arrangement between the lender and the platform is such that the platform performs the decision-making function, the same shall amount to outsourcing of core management function of the NBFC, which is expressly disallowed by the RBI. The relevant extract from the KYC Master Directions is as follows:

“REs shall ensure that decision-making functions of determining compliance with KYC norms are not outsourced.”

Is it actually a guarantee?

Before closing, it may be relevant to raise a legal issue – is the so-called guarantee by the platform actually a guarantee?

In the absence of tripartite agreement between the parties, the arrangement cannot be said to be a contract of guarantee. Here the involvement is of only two parties in the arrangement i.e. the guarantor and the lender.

It was held in the case of K.V. Periyamianna Marakkayar and others vs Banians And Co.[1] that “Section 126 of the Indian Contract Act which defines a contract of guarantee though it does not say expressly that the debtor should be a party to the contract clearly implies, that there should be three parties to it namely the surety, the principal-debtor and the creditor ; otherwise it will only be a contract of indemnity. Section 145 which enacts that in every contract of guarantee there is an implied promise by the principal debtor to indemnify the surety clearly shows that the debtor and the surety are both parties to such a contract ; for it will be strange to imply in a contract a promise between persons who are not parties to it.”

Accordingly, the said arrangement maybe termed as a contract of indemnity wherein the platform agrees to indemnify the lender for the losses incurred on account of default by the borrower.

Conclusion

Fintech-based lending is here to stay, and grow. Therefore, risk participation by Fintech does not defeat the system – rather, it promotes lending and adds to the credibility of the Fintech’s risk assessment. Over period of time, the RBI may evolve appropriate guidelines for treating the credit exposure taken by the platforms as a part of their credit-equivalent assets.

 

 

[1] https://indiankanoon.org/doc/1353940/

Draft guidelines for on tap licensing of SFBs: decoded

-Kanakprabha Jethani | Executive

(kanak@vinodkothari.com)

The Reserve Bank of India (RBI) has issued draft guidelines for ‘on tap’ licensing of Small Finance Banks (SFBs). The guidelines are largely similar to the existing guidelines for licensing of SFBs. However, the major difference is that the licensing will be allowed ‘on tap’. Further, there are certain changes in the eligibility requirements as well. The following write-up intends to answer all the questions relating to licensing of SFBs under the new ‘on tap’ mechanism.

What is ‘on-tap’ licensing?

Under the existing framework, the RBI issues licences for SFBs in batches i.e. all the applications are reviewed in a decided time frame and approvals for a number of SFBs are issued at once. The RBI doesn’t give out approvals as and when applications are received. Rather, when sufficient number of applications are received, they are reviewed at once and the applications that satisfy RBI’s criteria are issued with licenses.

Under the ‘on-tap’ mechanism, RBI will initiate the review of applications as and when they are received. Individual applications will be reviewed and licenses will be issued accordingly.

Who is eligible to apply?

Eligible Promoters:
Resident individuals Atleast 10 years’ experience in banking and finance sector at senior level
Professionals who are Indian citizens Atleast 10 years’ experience in banking and finance sector at senior level
Companies/societies owned and controlled by residents Having successful track record of running their business for atleast 5 years
Conversion:
Existing NBFCs, Micro Finance Institutions (MFIs), Local Area Banks (LABs) -in private sector + controlled by residents + successful track record of running the business for atleast 5 years
Primary Urban Co-operative Banks (UCBs) As per the scheme for voluntary transition.
Fit and Proper Criteria:
Promoters/ promoter group Past record of sound credentials and integrity, financial soundness and successful track record of professional experience or of running their business for atleast 5 years

Who cannot apply?

Joint ventures by different promoter groups for purpose of setting up SFB. Public sector entities, large industrial houses or business groups, bodies set up under state legislature, state financial corporations, etc. Group with assets of Rs. 5000 crores or more+ non financial business accounting for 40% or more

What will be the structure of SFB?

An SFB maybe floated either as a standalone entity or under a holding company, which shall act as the promoting entity of the bank. Such holding company shall be a Non-Operative Financial Holding Company (NOHFC) or be registered with the RBI as NBFC-CIC.

What activities can an SFB carry out?

Primarily, an SFB is allowed to carry out basic banking activities.

Apart from the primary functions, SFBs can also undertake non-risk sharing simple financial activities, not requiring commitment of their own funds, after obtaining approval of the RBI. Also, they are allowed to become Category II Authorised Dealer in foreign exchange business.

An activity that involves commitment of funds of the SFB, such as issue of credit cards, shall not be allowed.

What will be the capital structure in SFB?

Minimum paid-up equity capital:
All applicants Rs. 200 crores
For UCBs converting into SFB Initially Rs. 100 crores, which shall be required to be increased to Rs. 200 crores within 5 years
Capital Adequacy Ratio:
Tier I capital 7.5% of total risk-weighted assets
Tier II capital Maximum 100% of tier I capital
Capital 15% of total risk- weighted assets
Promoters Contribution:
Promoters’ holding Minimum 40% of paid-up voting equity capital

·         Bring down to 30% in 10 years

·         Bring down to 15% in 15 years

In case of conversion of NBFC/MFI to SFB, if promoters’ shareholding is maintained below 40% but above 26% due to regulatory requirements or otherwise, the same shall be acceptable. Provided that promoters’ shareholding doesn’t fall below 20%.
Lock-in on promoters’ minimum holding 5 years
If promoters’ shareholding > 40% Bring down to 40%

·         within 5 years from commencement of business (in case of other SFB)

·         within 5 years from the date paid-up capital of Rs. 200 crores is reached (in case of conversion from UCB)

No person other than promoters shall be allowed to hold more than 10% of the paid-up equity capital.
Foreign Shareholding:
Under automatic route Upto 49%
Government route Beyond 49% upto 74%
Atleast 26% of the paid-up equity capital should be held by resident shareholders.

Will the SFB be listed?

An application for listing of the SFB can be made voluntarily after obtaining approval of the RBI. However, on reaching a paid-up equity capital of Rs. 500 crores, listing shall be made mandatory.

What will be the compliance requirements for SFBs?

  • Have in place a robust risk management system.
  • Prudential norms as applicable to commercial banks shall be applicable.
  • 75% of Adjusted Net Bank Credit (ANBC) shall be extended to priority sectors.
  • The maximum loan size to a single person or group shall not be more than 10% of SFB’s capital funds.
  • The maximum investment exposure to a single person or group shall not be more than 15% of SFB’s capital funds.
  • Atleast 50% of loan portfolio should consist of small size loans (upto Rs. 25 lakhs per borrower).
  • There should be no exposure of the SFB to its promoters, shareholder holding 10% or more of the paid-up capital, and relatives of promoters.
  • Payments bank may make application to set up an SFB, provided that both the banks shall be under NOHFC structure.
  • SFB cannot be a Business Correspondent of other banks.

Are there any specific compliance requirements for NBFCs/MFIs/LABs converting into SFB?

Following are the specific requirements to be complied with in case of conversion from NBFC/MFI/LAB:

  • Have minimum paid-up capital of Rs. 200 crores. In case of deficiency, infuse the differential capital within 18 months.
  • Convert the branches of NBFC/MFI to branches of the SFB within 3 years from commencement of operations.
  • In case any floating charges stand in the balance sheet of the NBFC/MFI, the same shall be allowed to be carried until the related borrowings are matured.

How to make an application to set up an SFB?

An application shall be made to the RBI in Form III along with a business plan and detailed information of the existing as well as proposed structure, a project report regarding viability of the business of SFB and any other relevant information. The application shall be submitted to the RBI in physical form in an envelope superscripted “Application for Small Finance Bank” addressed to the Chief General Manager of the RBI.

In case, the application satisfies the RBI criteria, the fact of approval shall be placed on the RBI website. In case, the application is rejected, the applicant will be barred from making fresh application for a period of three years from such rejection.

 

Sharing of Credit Information to Fintech Companies: Implications of RBI Bar

-Financial Services Division | Vinod Kothari Consultants Pvt. Ltd.

(finserv@vinodkothari.com)

The RBI recently wrote a letter, dated 16th September, 2019, to banks and NBFCs, censuring them over what seems to have been a prevailing practice – sharing of credit information sourced by NBFCs from Credit Information Companies (CICs), to fintech companies. The RBI reiterated that such sharing of information was not permissible, citing several provisions of the law, and expected the banks/NBFCs to affirm steps taken to ensure compliance within 15 days of the RBI’s letter.

This write-up intends to discuss the provisions of the Credit Information Companies (Regulation) Act, 2005 [CICRA], and related provisions, and the confidentiality of credit information of persons, and the implications of the RBI’s letter referred to above.

Fintech companies’ model

Much of the new-age lending is enabled by automated lending platforms of fintech companies. The typical model works with a partnership between a fintech company and an NBFC. The fintech company is the sourcing partner, and the NBFC is the funding partner. A borrower goes to the platform of the fintech company which provides a user-friendly application process, consisting of some basic steps such as providing the aadhaar card or PAN card details, and a photograph. Now, having got the individual’s basic details, the fintech company may either source the credit score of the individual from one of the CICs, or may use its own algorithm. If the fintech company wants to access the data stored with the CICs, it will have to rely on one of its partner NBFCs, since CIC access is currently allowed to financial sector entities only, who have to mandatorily register themselves as members of all four CICs.

It is here that the RBI sees an issue. If the NBFC allows the credit information sourced from the CIC to be transferred to a fintech company, there is an apparent question as to whether such sharing of information is permissible under the law or not.

We discuss below the provisions of the law relating to use of credit information.

Confidentiality of credit information

By virtue of the very relation between the customer and a banker, a banker gets access to the financial information of its customers. Very often, an individual may not even want to share his financial data even with close family members, but the banker any way has access to the same, all the time. If the banker was to share the financial details of a customer, it would be a clear intrusion into the individual’s privacy, and that too, arising out of a fiduciary relationship.

Therefore, the principle, which has since been reiterated by courts in numerous cases, was developed by UK courts in an old ruling in Tournier v National Provincial and Union Bank of England [1924] 1 KB 461. Halsbury’s Laws of England, Vol 1, 2nd edition, says: “It is an implied term of the contract between a banker and his customer that the banker will not divulge to third persons, without the consent of the customer, express or implied, either the state of the customer’s account, or any of his transactions with the bank or any information relating to the customer acquired through the keeping of his account, unless the banker is compelled to do so by order of a Court, or the circumstances give rise to a public duty of disclosure or the protection of the banker’s own interests requires it.

The above law is followed in India as well.

In Shankarlal Agarwalla v. State Bank of India and Anr. AIR 1987 Cal 29[1], it was held that compulsion to disclose must be confined to the regular exercise by the proper officer to actual legal power to compel disclosure.

In case any information is disclosed without a legal compulsion to disclose, the same is wrongful on the part of the lender.

Credit Information Companies and sharing of information

When an RBI Working Group set up in 1999 under the chairmanship of N. H. Siddiqui recommended the formation of CICs in India, the question of confidentiality of credit information was discussed. It was noted by the Working Group that all over the world, there are regulatory controls on sharing of information by credit bureaus:

The Credit Information Bureaus, all over the world, function under a well defined regulatory framework. Where the Bureaus have been set up as part of the Central Bank, the regulatory framework for collection of information, access to that information, privacy of the data, etc., is provided by the Central Bank. Where Bureaus have been set up in the private sector, existence of separate laws ensure protection to the privacy and access to the data collected by the Bureau. In the U.S.A. where Credit Information Bureaus have been set up in the private sector, collection and sharing of information is governed by the provisions of the Fair Credit Reporting Act, 1971 (as amended by the Consumer Credit Reporting Reform Act of 1996). The Fair Credit Reporting Act is enforced by the Federal Trade Commission, a Federal Agency of the U.S. Govt. In the U.K., Credit Bureaus are licensed by the Office of the Fair Trading under the Consumer Credit Act of 1974. The Bureaus are also registered with the Office of the Data Protection Registrar, appointed under the Data Protection Act, 1984 (replaced by the Data Protection Commissioner under the new Act of 1998). In Australia, neither the Reserve Bank of Australia nor the Australian Prudential Regulation Authority (APRA) plays a role in promoting, developing, licensing or supporting Credit Bureaus. APRA holds annual meetings with the major Bureaus in Australia. The sharing of information relating to customers is regulated in Australia by the Privacy Act. This Act is administered by the Privacy Commissioner, who is vested with the responsibility of framing guidelines for protection of privacy principles and to ensure that Bureaus in Australia conform to these guidelines. In New Zealand, a situation similar to that of Australia exists. In Sri Lanka, the Bureau was formed by an Act of Parliament at the initiative of the Central Bank. A Deputy Governor of the Central Bank is the Chairman of the Bureau in Sri Lanka and the Bank is also represented on the Board of the Bureau by a senior officer. In Hong Kong, the Hong Kong Monetary Authority (HKMA), though not being directly involved in the setting up of a credit referencing agency has issued directions to all the authorised institutions recommending their full participation in the sharing and using of credit information through credit referencing agencies within the limits laid down by the Code of Practice on Consumer Credit Data formulated by the Privacy Commissioner. HKMA also monitors the effectiveness of the credit referencing services in Hong Kong, in terms of the amount of credit information disclosed to such agencies, and the level of participating in sharing credit information by authorised institutions.[2]

The inherent safeguards in the CIC Law

CICRA provides the privacy principles which shall guide the CICs, credit institutions and Specified Users in their operations in relation to collection, processing, collating, recording, preservation, secrecy, sharing and usage of credit information. In this regard, the purpose of obtaining information, guidelines for access to credit information of customers, restriction on use of information, procedures and principles for networking of CICs, credit institutions and specified users, etc. must be clearly defined.

Further, no person other than authorised person is allowed to have access to credit information under CICRA. Persons authorised to access credit information are CICs, credit institutions registered with the CICs and other persons as maybe specified by the RBI through regulations.

The Credit Information Companies Regulations provide that other persons who maybe allowed to access credit information are insurance companies, IRDAI, cellular service providers, rating agencies and brokers registered with SEBI, SEBI itself and trading members registered with Commodity Exchange.

Clearly, fintech companies or technology service providers are not authorised to access credit information. Access of information by such companies is a clear violation of CICRA.

Secrecy of customer information: duty of the lender

Paget on the Law of Banking observed that out of the duties of the banker towards the customer among those duties may be reckoned the duty of secrecy. Such duty is a legal one arising out of the contract, not merely a moral one. Breach of it therefore gives a claim for nominal damages or for substantial damages if injury is resulted from the breach.

Further, in case of Kattabomman Transport Corporation Ltd. V. State Bank of India, the Calcutta High Court held that the banker was under a duty to maintain confidentiality. An appeal[3] was filed against this ruling, the outcome of which was the information maybe disclosed by the banks, only when there is a higher duty than the private duty.

NBFCs providing access to the fintech companies is undoubtedly a private duty and thus, is a breach of duty on the part of the lender.

The case of Fintech Companies and NBFC partnership:

The letter of the RBI under discussion, dated 17th September, 2019, has been seen as a challenge to the working of the fintech companies. However, to understand in what way does this affect the working of fintech companies, we need to understand several situations.

Before coming to the same, it must be noted that the RBI’s 17th September circular is not writing a new law. The law on sharing of credit information has always been there, and the inherent protection is very much a part of the CICRA itself. The RBI circular is, at best, a regulatory cognition of an existing issue, and is a note of caution to NBFCs, who, in their enthusiasm to generate business, may not disregard the provisions of the law.

The situations may be as follows:

  • Fintech company using its own algorithm: In this case, the fintech company is relying upon its own proprietary algorithm. It is not relying on any credit bureau information. Therefore, there is no question of any credit information being shared. In fact, even if the fintech uses the score developed by it, without relying on CIC data, with other entities, it is a proprietary information, which may be shared.
  • NBFC sharing credit information with Fintech company, which is sourcing partner for the NBFC: If the NBFC is sharing information with a fintech company, with the intent of using the information for its own lending, can it be argued that there is a breach of the provisions of the CICRA? It may be noted that regulation 9 of the CIC Regulations requires CICs to protect credit information from unauthorised access. As already discussed, access by such fintech companies is unauthorised.
  • NBFC sharing credit information with Fintech company, which is not partnering with the NBFC: In case, the NBFC is not partnering with the NBFC and is still sharing credit information, there seems to be no reason for such sharing other than information trading. Several NBFCs have at many instances, been reported to have engaged in information trading for additional income.
  • NBFC sharing credit information with another NBFC/bank, which is a co-lender: The NBFC may authorise its co-lender to obtain credit information from CICs and the same shall not be an unauthorised access of information, since the co-lender is also a credit institution and is registered with CICs.
  • Bank sharing credit information with another NBFC which is a sourcing partner and not a c0-lender: If the sourcing partner is a member of CICs, it may access the credit information directly from the CICs. If the sourcing partner is not a member of CICs, sharing of credit information is violation of customer privacy, and thus, shall not be allowed.

Conclusion

The credit bureau reports are actually being exchanged in the system without much respect to the privacy of the individual’s data. With the explosion of information over the net, it may even be difficult to establish as to where the information is coming from. Privacy and confidentiality of information is at stake. At the same time, the very claim-to-existence of fintech entities is their ability to process a credit application within no time. Whether there is an effective way to protect the sharing of information stored with CICs is a significant question, and the RBI’s attention to this is timely and significant.

 

[1] https://indiankanoon.org/doc/1300997/

[2] https://www.rbi.org.in/scripts/PublicationReportDetails.aspx?ID=76

[3] https://indiankanoon.org/doc/908914/

 

Partial Credit Guarantee Scheme

A Business Conclave on  “Partial Credit Guarantee Scheme” was organised by Indian Securitisation Foundation jointly with Edelweiss on September 16,2019 in Mumbai.

On this occasion, the presentation used by Mr. Vinod Kothari is being given here:

http://vinodkothari.com/wp-content/uploads/2019/09/partial-credit-enhancement-scheme-.pdf

 

We have authored few articles on the topic that one might want to give a read. The links to such related articles are provided below:

The cult of easy borrowing: New age NBFCs ride high on tempting loan offers

-Rahul Maharshi and Kanakprabha Jethani

(finserv@vinodkothari.com)

 

“यावज्जीवेत्सुखं जीवेत् ऋणं कृत्वा घृतं पिबेत् |

भस्मीभूतस्य देहस्य पुनरागमनं कुतः ||”

The ancient couplet from the Charvak Darshan, in Indian mythology is popularly known as the philosophy of life. There are various interpretations of the above, in general, the meaning of the above couplet gives us a saying that “One should live luxuriously, as long as he is alive, and to attain the same, one may even live on credit and in debt. Because once you are dead and cremated, it is foolish to think about afterlife and rebirth.”

It is seen today that the financial services industry is taking the above couplet too seriously and making the borrowers flooded with opportunities and facilities to burden them with debt in one click. Even the person who is unwilling to enter into a debt trap is somewhat lured by the “instant loan” facilities given by numerous NBFCs these days.

Whilst the Indian economy facing a slowdown and banks in India showing significant falls in their lending volumes, the NBFCs engaged in e-lending are displaying an inverse relation to the trend. The NBFCs have been showing extravagant growth in their lending volumes. On one hand banks are tightening the lending norms considering the current state of the economy, NBFCs seem to be doing reckless lending and reporting exceptionally high lending volumes. The financial market seems to be showing a transition from secured lending to unsecured lending, from corporate finance to personal finance, from paperwork to digitisation. This transition is the reason behind such a drastic shift of lending volumes.

CURRENT STATE OF LENDING TRANSACTIONS

NBFCs are crossing milestones, making new records everyday. A leading NBFC reported disbursal of Rs. 550 crores in 3,50,000 loan transactions and has been consistently disbursing loans over Rs. 80 crores every month[1]. Another NBFC reported an existing customer base of 1.1 million. An app-based lender NBFC has 100 million downloads of its app and has disbursed around Rs. 700 crores in FY 19 with an expectation of increasing the amount of disbursals to Rs. 2,000 crores in FY 20[2].

On the contrary, banks are showing a completely opposite picture. Under the 59-minute loan scheme introduced by the Prime Minister for small entities (having turnover upto Rs. 25 crores) to avail loans of amount upto Rs. 5 crores from banks within an hour, only 50,706 loans were given approval in the FY 19. The growth rates in the banking sector are lowering. The growth in retail loans fell down to 15.7% in April 2019 as compared to 19.1% in April 2018. The growth rate in credit card loans has also shown a decline of 8.8%[3].

UNDERSTANDING THEIR BUSINESS MODEL

NBFCs do unsecured lending of small-ticket size loans, usually personal in nature. The market tends to be more inclined towards obtaining finance from such NBFCs. The basic features of loans provided by NBFCs can be understood through following points:

  • Unsecured: The loans provided by NBFCs doing e-lending are generally unsecure loans. The borrower or the customer is not required to provide any security for obtaining such loans. Thus, even if borrowers have no assets at all, they can still obtain loans.
  • Instant: These NBFCs process the loans within a very short period (‘superfast processing’ as they call it) and the disbursement is made within a period ranging from 5 minutes to 3 days depending on the size of the loan. There is no requirement of long procedures as required to be followed in case of bank loans.
  • Digital: Usually, these NBFCs have an app-based or website based platform through which they provide such loans. The KYC process is also carried out through the app or website itself.
  • High-interest rates: The interest rates on such loans are very high as compared to the interest rates on loans provided by banks. The rates usually range from 15% p.a. to 130% p.a.
  • Small-ticket size: The loan size is generally small ranging from Rs. 500 to Rs, 50,000
  • Short-term loans: The term of loan is also short. Repayment is required on weekly, fortnightly or monthly basis.
  • Credit Score based decisions: The lending decisions made by NBFCS are largely dependent on the credit score of the borrower. A strong network of Credit Information Companies (CICs) stores the credit information of the borrowers and the borrower making default of even a single day would be barred from accessing any other e-lending platform as well. However, for first time borrowers, the only way to check credit standing is their bank statement.
  • Source of funds: NBFCs get their funds from banks as well as bigger size NFCs and Private Equity investors.
  • Purpose: These loans are provided mostly for personal purposes like marriage ceremonies, buying a car, medical issues, travel etc.
  • Innovation: Each of the e-lending platform has a different model. While some involve students in their marketing activities, some have tied-up with sellers and buyers to finance transactions between them and some tying up with different brands to finance their operations.

NBFCs BRUSHING OFF THE REGULATIONS: THEIR OWN SWEET WAYS

The operational structures of such loans are in defiance of many requirements of the RBI Directions. One can see disparity from the RBI Directions in many ways. Following are the areas where most of the NBFCs take their own sweet ways:

  • KYC process: As per the KYC Master Directions an authorised representative of the lender NBFC to physically visit and originally see and verify the KYC details of the borrower. There are further requirements of maintaining the KYC records and carrying out Customer Due Diligence (CDD) which the NBFCs fail (refuse) to comply with in the hurry of their “superfast processing”.
  • Fair Practice Code (FPC): The FPC requires lender NBFCs to display annualised interest rates in all their communications with the borrowers. However, most of the NBFCs show monthly interest rates in the name of their “marketing strategy”.
  • Risk Management: The Directions require the NBFCs to assess the risk before granting loans to borrowers, which is overlooked while providing speedy disbursals.
  • Recovery Process: NBFCs do not even have properly defined recovery process. They are just making rapid disbursals ignorant of whether these loans will be repaid.
  • Risk to personal information: Many NBFCs obtain access to the personal information such as text messages and social media profile of the borrower by way of incorporating clauses in this regard in the detailed terms and conditions of the loan agreement.

RISKS TO THE BORROWERS

The borrowers face several risks under such loan transactions, ranging from personal to financial such as:

  • Many borrowers usually don’t read the entire set of terms and conditions and end up granting the NBFCs access to their personal information. Privacy of the borrower is at stake as information trading is yet another business that the NBFCs may secretly engage into posing a threat to borrowers’ personal information.
  • The lucrative advertising strategies of these NBFCs might make a borrower take loans for purposes which otherwise would not have been a necessity or priority for the borrower. Hence, the borrower tends to borrow without any actual requirement because a demand has been created by the lender NBFCs.
  • The interest rates are very high on such loans. In case the amount of loan is high, the borrower is unable to pay the huge amount of interest and thus has to take another loan to repay the first.
  • The credit score of the borrower may get affected at the slightest delay in repayment, even if the amount of loan is as small as Rs. 500. Thus the credibility of borrower is at a risk of degradation.

THE BUBBLE OF ATTRACTION: PLAYING WITH THE PSYCHOLOGY

Even in existence of such high interest rates, why is a borrower more attracted to loans from NBFCs? The only answer one finds to this is the ease and the fact that they are instant. In an era where everyone wants everything in a jiffy, be it food or health solutions, being attracted to instant loans is a very natural thing.

For example you meet an accident and don’t have money for treatment to be done, take a loan. You are shopping and suddenly realise you forgot your purse, take a loan.

The most crucial thing is that these NBFCs do not monitor the end use of the loan amounts disbursed. So a borrower may specify any purpose for the loan, which he might not actually use the loan for. Moreover, the high interest rates are not noticed by the borrowers as most of the NBFCs show monthly interest rates rather than the yearly rates in their communications on the app or the website.

Many borrowers usually don’t read the entire set of terms and conditions and end up granting these NBFCs access to their personal information. Information trading is yet another business that the NBFCs may secretly engage into posing a threat to borrowers’ information.

The NBFCs are rightly playing the psychology game by becoming a friend in need for the borrowers. No matter how high the interest rates maybe or how risky the transaction maybe, it is a handy help whenever needed.

Furthermore, the advertisements made by these NBFCs are so catchy that they may lure a person who might not really be in need of finance. The catchy phrases like “make your dream wedding come true”, “let the wanderlust in you come alive” create a “need” for the customer to become a borrower. Marriage functions, travel and luxuries things are the Indian way of showing richness and the abovementioned philosophy wraps people in a comfortable blanket of justification to remain under debt-burden.

ALL OUR MONEY INTO THE BLACK HOLE

While lending to businesses results in more capital formation and growth of the economy. Personal lending mostly results in wasteful expenditure. Further, the interest rates being so high, many a times the borrowers obtain another loan to pay the previous loan and gets trapped into the vicious circle of obtaining and repaying loans. The increasing lending volumes are not an indication of overall growth of the economy. Most of the purposes for which such loans are availed are consumption-based and have no value-addition. All the money taken on loan is being used in consumption-based expenditure and not in value-addition activities and thus even after such high lending volumes, the growth of the economy is just disappearing into the black hole.

CONCLUSION

While on one hand, such loans are helping us in need, on the other hand they are luring us to take unnecessary debt burden. The lender NBFCs are under the risk of regulatory action by the regulators since many of them are in non-compliance with regulatory requirements. The borrowers are under the risk of pressing themselves under unnecessary debt burden and huge interest costs. The recovery procedures of these NBFCs are very lenient but due to the high interest costs, the cost of funds is readily recovered by the lender NBFC. Even when banks have tried to provide quick loans under 59-minutes loan scheme, they have failed to do away with the procedural requirements such as document submission and are still regarded as “slow-loans” considering the super-fast loans being provided by NBFCs within 5 minutes.

Though immensely helpful, these loans have a potential to impact the economy in such a manner that it seems to be beneficial while it’s actually not. The borrowers are happily floating in the bubble of “instant loans” which is definitely going to burst in no time.

 

[1] Source: Economic Times

[2] Source: CNBC

[3] Source: Business Standard

Introduction of Digital KYC

Anita Baid (anita@vinodkothari.com)

The guidelines relating to KYC has been in headlines for quite some time now. Pursuant to the several amendments in the regulations, the KYC process of using Aadhaar through offline modes was resumed for fintech companies. The amendments in the KYC Master Directions[1] allowed verification of customers by offline modes and permitted NBFCs to take Aadhaar for verifying the identity of customers if provided voluntarily by them, after complying with the conditions of privacy to ensure that the interests of the customers are safeguarded.

Several amendments were made in the Prevention of Money laundering (Maintenance of Records) Rules, 2005, vide the notification of Prevention of Money laundering (Maintenance of Records) Amendment Rules, 20191 issued on February 13, 2019[2] (‘February Notification’) so as to allow use of Aadhaar as a proof of identity, however, in a manner that protected the private and confidential information of the borrowers.

The February Notification recognised proof of possession of Aadhaar number as an ‘officially valid document’. Further, it stated that whoever submits “proof of possession of Aadhaar number” as an officially valid document, has to do it in such a form as are issued by the Authority. However, the concern for most of the fintech companies lending through online mode was that the regulations did not specify acceptance of KYC documents electronically. This has been addressed by the recent notification on Prevention of Money-laundering (Maintenance of Records) Third Amendment Rules, 2019 issued on August 19, 2019[3] (“August Notification”).

Digital KYC Process

The August Notification has defined the term digital KYC as follows:

“digitial KYC” means the capturing live photo of the client and officially valid document or the proof of possession of Aadhaar, where offline verification cannot be carried out, along with the latitude and longitude of the location where such live photo is being taken by an authorised officer of the reporting entity as per the provisions contained in the Act;

Accordingly, fintech companies will be able to carry out the KYC of its customers via digital mode.

The detailed procedure for undertaking the digital KYC has also been laid down. The Digital KYC Process is a facility that will allow the reporting entities to undertake the KYC of customers via an authenticated application, specifically developed for this purpose (‘Application’). The access of the Application shall be controlled by the reporting entities and it should be ensured that the same is used only by authorized persons. To carry out the KYC, either the customer, along with its original OVD, will have to visit the location of the authorized official or vice-versa. Further, live photograph of the client will be taken by the authorized officer and the same photograph will be embedded in the Customer Application Form (CAF).

Further, the system Application shall have to enable the following features:

  1. It shall be able to put a water-mark in readable form having CAF number, GPS coordinates, authorized official’s name, unique employee Code (assigned by Reporting Entities) and Date (DD:MM:YYYY) and time stamp (HH:MM:SS) on the captured live photograph of the client;
  2. It shall have the feature that only live photograph of the client is captured and no printed or video-graphed photograph of the client is captured.

The live photograph of the original OVD or proof of possession of Aadhaar where offline verification cannot be carried out (placed horizontally), shall also be captured vertically from above and water-marking in readable form as mentioned above shall be done.

Further, in those documents where Quick Response (QR) code is available, such details can be auto-populated by scanning the QR code instead of manual filing the details. For example, in case of physical Aadhaar/e-Aadhaar downloaded from UIDAI where QR code is available, the details like name, gender, date of birth and address can be auto-populated by scanning the QR available on Aadhaar/e-Aadhaar.

Upon completion of the process, a One Time Password (OTP) message containing the text that ‘Please verify the details filled in form before sharing OTP’ shall be sent to client’s own mobile number. Upon successful validation of the OTP, it will be treated as client signature on CAF.

For the Digital KYC Process, it will be the responsibility of the authorized officer to check and verify that:-

  1. information available in the picture of document is matching with the information entered by authorized officer in CAF;
  2. live photograph of the client matches with the photo available in the document; and
  3. all of the necessary details in CAF including mandatory field are filled properly.

Electronic Documents

The most interesting amendment in the August Notification is the concept of “equivalent e-document”. This means an electronic equivalent of a document, issued by the issuing authority of such document with its valid digital signature including documents issued to the digital locker account of the client as per rule 9 of the Information Technology (Preservation and Retention of Information by Intermediaries Providing Digital Locker Facilities) Rules, 2016 shall be recognized as a KYC document. Provided that the digital signature will have to be verified by the reporting entity as per the provisions of the Information Technology Act, 2000.

The aforesaid amendment will facilitate a hassle free and convenient option for the customers to submit their KYC documents. The customer will be able to submit its KYC documents in electronic form stored in his/her digital locker account.

Further, pursuant to this amendment, at several places where Permanent Account Number (PAN) was required to be submitted mandatorily has now been replaced with the option to either submit PAN or equivalent e-document.

Submission of Aadhaar

With the substitution in rule 9, an individual will now have the following three option for submission of Aadhaar details:

  • the Aadhaar number where,
    1. he is desirous of receiving any benefit or subsidy under any scheme notified under section 7 of the Aadhaar (Targeted Delivery of Financial and Other subsidies, Benefits and Services) Act, 2016 or
    2. he decides to submit his Aadhaar number voluntarily
  • the proof of possession of Aadhaar number where offline verification can be carried out; or
  • the proof of possession of Aadhaar number where offline verification cannot be carried out or any officially valid document or the equivalent e-document thereof containing the details of his identity and address;

Further, along with any of the aforesaid options the following shall also be submitted:

  1. the Permanent Account Number or the equivalent e-document thereof or Form No. 60 as defined in Income-tax Rules, 1962; and
  2. such other documents including in respect of the nature of business and financial status of the client, or the equivalent e-documents thereof as may be required by the reporting entity

The KYC Master Directions were amended on the basis in the February Notification. As per the amendments proposed at that time, banking companies were allowed to verify the identity of the customers by authentication under the Aadhaar Act or by offline verification or by use of passport or any other officially valid documents. Further distinguishing the access, it permitted only banks to authenticate identities using Aadhaar. Other reporting entities, like NBFCs, were permitted to use the offline tools for verifying the identity of customers provided they comply with the prescribed standards of privacy and security.

The August Notification has now specified the following options:

  1. For a banking company, where the client submits his Aadhaar number, authentication of the client’s Aadhaar number shall be carried out using e-KYC authentication facility provided by the Unique Identification Authority of India;
  2. For all reporting entities,
    1. where proof of possession of Aadhaar is submitted and where offline verification can be carried out, the reporting entity shall carry out offline verification;
    2. where an equivalent e-document of any officially valid document is submitted, the reporting entity shall verify the digital signature as per the provisions of the IT Act and take a live photo
    3. any officially valid document or proof of possession of Aadhaar number is submitted and where offline verification cannot be carried out, the reporting entity shall carry out verification through digital KYC, as per the prescribed Digital KYC Process

It is also expected that the RBI shall notify for a class of reporting entity a period, beyond which instead of carrying out digital KYC, the reporting entity pertaining to such class may obtain a certified copy of the proof of possession of Aadhaar number or the officially valid document and a recent photograph where an equivalent e-document is not submitted.

The August Notification has also laid emphasis on the fact that certified copy of the KYC documents have to be obtained. This means the reporting entity shall have to compare the copy of the proof of possession of Aadhaar number where offline verification cannot be carried out or officially valid document so produced by the client with the original and record the same on the copy by the authorised officer of the reporting entity. Henceforth, this verification can also be carried out by way of Digital KYC Process.


[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11566#F4

[2] http://egazette.nic.in/WriteReadData/2019/197650.pdf

[3] http://egazette.nic.in/WriteReadData/2019/210818.pdf

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

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

 

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

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

Brief nature of the transaction:

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

Brief characteristics of the Pool

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

Data requirement

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

Documentation

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

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

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