Regulator’s move to repair the NBFC sector

-Mridula Tripathi

(finserv@vinodkothari.com)

The evolving impact on people’s health has casted a threat on their livelihoods, the businesses in which they work, the wider economy, and therefore the financial system. The outbreak of this pandemic is nothing like the crisis faced by the economies in the year 2007-08 and imperils the stability of the financial system. The market conditions have forced traders to take aggressive steps exposing the system to great volatility thereby resulting in crashing asset values. Combating the pandemic and safeguarding the economy, the financial sectors across the globe have witnessed numerous reforms to hammer the aftermaths of the global crisis. Read more

Special Liquidity Facility for Mutual Funds

By Anita Baid (finserv@vinodkothari.com)

[Posted on April 27, 2020 and updated on April 30, 2020]

The Reserve Bank of India (RBI) has been vigilantly taking necessary measures and steps to mitigate the economic impact of Covid-19 and preserve financial stability. The capital market of our country has also been exposed to the disruption. The liquidity strains on mutual funds (MFs) has intensified for the high-risk debt MF segment due to redemption or closure of some debt MFs. This was witnessed when Franklin Templeton Mutual Fund[1] announced the winding up of six yield-oriented, managed credit funds in India, effective April 23, citing severe market dislocation and illiquidity caused by the coronavirus. Sensing the need of the hour and in order to ease the liquidity pressures on MFs, RBI has announced a special liquidity facility for Mutual Funds (SLF-MF)[2] of Rs. 50,000 crore.

Under the SLF-MF, the RBI shall conduct repo operations of 90 days tenor at the fixed repo rate. The SLF-MF is on-tap and open-ended, wherein banks shall submit their bids to avail funding on any day from Monday to Friday (excluding holidays) between 9 AM and 12.00 Noon. The scheme shall be open from April 27, 2020 till May 11, 2020 or up to utilization of the allocated amount, whichever is earlier. An LAF Repo issue will be created every day for the amount remaining under the scheme after deducting the cumulative amount availed up to the previous day from the sanctioned amount of Rs. 50,000 crores. The bidding process, settlement and reversal of SLF-MF repo would be similar to the existing system being followed in case of LAF/MSF. Further, the RBI will further review the timeline and amount, depending upon market conditions.

As per the press release, the RBI will provide funds to banks at lower rates and banks can avail funds for exclusively meeting the liquidity requirements of mutual funds in the following ways:

  • extending loans, and
  • undertaking outright purchase of and/or repos against the collateral of investment grade corporate bonds, commercial papers (CPs), debentures and certificates of Deposit (CDs) held by MFs.

Accordingly, the funds availed by banks from the RBI at the repo window will be used to extend loans to MFs, buy outright investment grade corporate bonds or CPs or CDs from them or extend the funds against collateral through a repo.

The RBI has further vide its notification dated April 30, 2020, extended the regulatory benefits under the SLF-MF scheme to all banks, irrespective of whether they avail funding from the RBI or deploy their own resources under the scheme. Banks meeting the liquidity requirements of MFs by any of the aforesaid methods, shall be eligible to claim all the regulatory benefits available under SLF-MF scheme without the need to avail back to back funding from the RBI under the SLF-MF.

It is important to note that in terms of regulation 44(2) of the SEBI (Mutual Funds) Regulations, 1996[3], a MF shall not borrow except to meet temporary liquidity needs of the MFs for the purpose of repurchase, redemption of units or payment of interest or dividend to the unit holders and, further, the mutual fund shall not borrow more than 20% of the net asset of the scheme and for a duration not exceeding six months.

As per the aforesaid SEBI regulations, MFs should normally meet their repurchase/redemption commitments from their own resources and resort to borrowing only to meet temporary liquidity needs. Therefore, under the SLF-MF scheme as well banks will have to be judicious in granting loans and advances to MFs only to meet their temporary liquidity needs for the purpose of repurchase/redemption of units within the ceiling of 20% of the net asset of the scheme and for a period not exceeding 6 months. While banks will decide the tenor of lending to /repo with MFs, the minimum tenor of repo with RBI will be for a period of three months.

Similar to the incentives given to the banks in case of LTRO schemes, the following shall be available for banks extending funding under the SLF-MF-

  1. the liquidity support availed under the SLF-MF would be eligible to be classified as held to maturity (HTM) even in excess of 25% of total investment permitted
  2. Exposures under this facility will not be reckoned under the Large Exposure Framework (LEF)
  3. The face value of securities acquired under the SLF-MF and kept in the HTM category will not be reckoned for computation of adjusted non-food bank credit (ANBC) for the purpose of determining priority sector targets/sub-targets
  4. Support extended to MFs under the SLF-MF shall be exempted from banks’ capital market exposure limits.

The RBI’s move is much needed to ease the liquidity stress on the MF industry. However, as has been seen in the TLRTO 2.0 auctions, banks are taking a cautious approach before using this facility provided by RBI. However, it is expected that this will ensure easing of liquidity and also boost investor sentiment.

 

[1] With assets worth more than Rs 86,000 crore as of the end of March, Franklin Templeton is the ninth largest mutual fund in the country

[2] https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=49728

[3] Last updated on March 6, 2020- https://www.sebi.gov.in/legal/regulations/mar-2020/securities-and-exchange-board-of-india-mutual-funds-regulations-1996-last-amended-on-march-06-2020-_41350.html

Loan products for tough times

-Vinod Kothari (vinod@vinodkothari.com)

Economic recoveries in the past have always happened by increasing the supply of credit for productive activities. This is a lesson that one may learn from a history of past recessions and crises, and the efforts made by policymakers towards recovery. [See Appendix]

The above proposition becomes more emphatic where the disruption is not merely economic – it is widespread and has affected common life, as well as working of firms and entities. There will be major effort, expense and investment required for restarting economic activity. Does moratorium merely help?  Moratorium possibly helps avoiding defaults and insolvencies, but does not help in giving the push to economic activity which is badly needed. Entities will need infusion of additional finance at this stage.

The usual way governments and policy-makers do this is by releasing liquidity in the banking system. However, there are situations where the banking system fails to be an efficient transmission device for release of credit, for reasons such as stress of bad loans in the banking system, lack of efficient decision-making, etc.

In such situations, governments and central banks may have to do direct intervention in the market. Governments and central banks don’t do lending – however, they create institutions which promote lending by either banks or quasi-banks. This may be done in two ways – one, by infusion of money directly, and two, by ways of sovereign guarantee, so as to do credit risk transfer to the sovereign. The former method has the limit of availability of resources – governments have budgetary limitations, and increased public debt may turn counter-productive in the long-run. However, credit risk transfer can be an excellent device. Credit risk transfer also seems to be creating, synthetically, the same exposure as in case of direct lending by the sovereign; however, there are major differences. First, the sovereign does not have to go for immediate borrowings. Second and more important, the perceived risk transfer, where credit risk is shifted to the sovereign, may not actually hit in terms of credit losses, if the recovery efforts by way of the credit infusion actually bear fruit.

The write-up below suggests a product that may be supported by the sovereign in form of partial credit risk guarantee.

Genesis of the loan product

For the sake of convenience, let us call this product a “wrap loan”. Wrap-around mortgage loans is a practice prevalent in the US mortgage market, but our “wrap loan” is different. It is a form of top-up loan, which does not disturb the existing loan terms or EMI, and simply wraps the existing loan into a larger loan amount.

Let us assume the following example of, say, a loan against a truck or a similar asset:

Original Loan amount 1000000
Rate of interest 12%
Tenure 60 Months
EMIs ₹ 22,244.45
Number of months the loan has already run 24 Months
Number of remaining months of original loan term 36 Months
Principal outstanding (POS) on the date of wrap loan ₹ 6,69,724.82

For the sake of convenience, we have not considered any moratorium on the loan[1]. The customer has been more or less regular in making payments. As on date, he has paid 24 EMIs, and is left with 36. Now, to counter the impact of the disruption, the lender considers an additional loan of Rs 50000/-. Surely, for assessing the size of the wrapper loan, the lender will have to consider several things – the LTV ratio based on the increased exposure and the present depreciated value of the asset, the financial needs of the borrowers to restart his business, etc.

With the additional infusion of Rs 50000, the outstanding exposure now becomes Rs 719725/-. We assume that the lender targets a slightly higher interest for the wrapper part of the loan of Rs 50000, say 14%. The justification for the higher interest can be that this component is unsecured. However, we do not want the existing EMI, viz., Rs 22244/- to be changed. That is important, because if the EMIs were to go up, there will be increasing pressure on the revenues of the borrower, and the whole purpose of the wrap loan will be frustrated.

Therefore, we now work the increased loan tenure, keeping the EMIs the same, for recovering the increased principal exposure. The revised position is as follows:

POS on the date of wrap loan ₹ 6,69,724.82
Additional loan amount 50000
Interest on the additional loan 14%
Blended interest rate 12.139%
Revised loan tenure 39.39 months
total maturity in months (rounded up) 40 months
Number of whole months                        39 months
Fractional payment for the last month ₹ 8,664.67

Note that the blended rate is the weighted average, with interest at the originally-agreed rate of 12% on the existing POS, and 14% on the additional amount of lending. The revised tenure comes to 39.39 months, or 40 months. There will be full payment for 39 months, and a fractional payment in the last month.

Thus, by continuing his payment obligation for 3-4 more months, the borrower can get Rs. 50000/- cash, which he can use to restart his business operations.

The multiplier impact that this additional infusion of cash may have in his business may be substantial.

Partial Sovereign Guarantee for the Wrapper Loan

Now, we bring the key element of the structure. The lender, say a bank or NBFC, will generally be reluctant to take the additional exposure of Rs 50000, though on a performing loan. However, this may be encourage by the sovereign by giving a guarantee for the add-on loan.

The guarantee may come with minimal actual risk exposure to the sovereign, if the structure is devised as follows:

  • The sovereign’s portion of the total loan exposure, Rs 719725, is only Rs 50000, which is less than 10%. A safe limit of 10% of the size of the existing exposure may be kept, so that lenders do not aggressively push top-up loans.
  • Now, the sovereign’s portion, which is only Rs 50000/- (and in any case, limited to 10%), may either be a pari-passu share in the total loan, or may be structured as a senior share.
  • If it is a pari-passu share, the question of the liability for losses actually coming to the sovereign will arise at the same time as the lender. However, if the share of the sovereign is a senior share, then the sovereign will get to share losses only if the recoveries from the loan are less than Rs 50000.

The whole structure may be made more practical by moving from a single loan to a pool of loans. The sovereign guarantee may be extended to a pool of similar loans, with a prescription of a minimum number, maximum concentration per loan, and other diversity parameters. The moment we move from a single loan to a pool of loans, the sharing of losses between the sovereign and the originator will now be on a pool-wide basis. Even if the originator takes a first loss share of, say, 10%, and the sovereign’s share comes thereafter, the chances of the guarantee hitting the sovereign will be very remote.

And of course, the sovereign may also charge a reasonable guarantee fee for the mezzanine guarantee.

Since the wrapper loan is guaranteed by the sovereign, the lender may hope to get risk weight appropriate for a sovereign risk. Additional incentives may be given to make this lending more efficient.

Appendix

Economic recovery from a crisis and the role of increased credit supply: Some global experiences

  1. Measures by FRB during following the Global Financial Crisis:

The first set of tools, which are closely tied to the central bank’s traditional role as the lender of last resort, involve the provision of short-term liquidity to banks and other depository institutions and other financial institutions. A second set of tools involved the provision of liquidity directly to borrowers and investors in key credit markets. As a third set of instruments, the Federal Reserve expanded its traditional tool of open market operations to support the functioning of credit markets, put downward pressure on longer-term interest rates, and help to make broader financial conditions more accommodative through the purchase of longer-term securities for the Federal Reserve’s portfolio.’[2]

  1. Liquidity shocks may cause reverse disruption in the financial chain:

‘During a financial crisis, such “liquidity shock chains” can operate in reverse. Firms that face tightening financing constraints as a result of bank credit contraction may withdraw credit from their customers. Thus, they pass the liquidity shock up the supply chain; that is, their customers might cut the credit to their customers, and so on…..Thus, the supply chains might propagate the liquidity shocks and exacerbate the impact of the financial crisis.’[3]

  1. Measures taken during Global Financial Crisis – US Fed publication – From Credit Crunches to Financial Crises:

Therefore, many of the policy remedies proposed to alleviate credit crunches were, in fact, used during the early stages of the 2008 financial crisis to mitigate potential credit availability problems. These remedies included capital infusions into troubled banks, the provision of liquidity facilities by the Federal Reserve, and, in the initial stress test, a primary focus on raising bank capital rather than allowing banks to shrink assets to maintain, or regain, required capital ratios.[4]

  1. Observations of Banca Italia on the 2008 Crisis

‘First, the effect of credit supply on value added is not detectable in the years before the great recession, indicating that credit supply is more relevant during an economic downturn. Second, the reduction in credit supply also explains the decline in employment even if the estimated effect is lower than that on value added. As a result, we can also detect a significant impact on labor productivity, while there is no effect on exports and on firm demographics. Third, the role of credit supply does vary across firms’ size, economic sectors, degree of financial dependence and, consequently, across geographical areas. Specifically, the impact is concentrated among small firms and among those operating in the manufacturing and service sectors. The impact is also stronger in the provinces that depend more heavily on external finance’[5]

 

[1] In fact, the wrap loan could have been an effective alternative to the moratorium

[2] https://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm

[3] http://siteresources.worldbank.org/INTRANETTRADE/Resources/TradeFinancech01.pdf

[4] https://www.bostonfed.org/-/media/Documents/Workingpapers/PDF/economic/cpp1505.pdf

[5] https://www.bancaditalia.it/pubblicazioni/temi-discussione/2016/2016-1057/en_tema_1057.pdf

 

Our other content relating to COVID-19 disruption may be referred here: http://vinodkothari.com/covid-19-incorporated-responses/

Our FAQs on moratorium may be referred here: http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

Restructuring of debt securities not to be treated as default, clarifies SEBI

-Financial Services Division (finserv@vinodkothari.com)

Unprecedented crises call for unprecedented measures; the good thing is that all regulators are responding soon enough to the need for tweaking regulations, valuation rules, provisioning norms, accounting norms, and so on, to allow companies to adjust themselves to the new world that we are being ushered in.

SEBI has come up with a Circular no SEBI/HO/IMD/DF3/CIR/P/2020/70 dated 23rd April, 2020[1] (Circular), to the effect that mutual funds will not have to treat restructuring of a debt security as a case of “default”. With this, the funds have been able to avert having to make as much as 50% provision for what was deemed as a case of default.

It is notable that there have been court rulings whereby companies have evoked the “force majeure” clause to seek breather to repayment of debt securities[2].

Given the sensitiveness of the situation, this Circular has come as breather for a lot of financial sector entities, especially the ones actively engaged in securitisation, and ofcourse mutual funds. This write-up intends to first set a context to the Circular and then discuss the potential impact of the Circular.

Deemed Default in Case of Restructuring and Valuation Rules

A circular on valuation of money market and debt securities[3] issued by SEBI stated that “Any extension in the maturity of a money market or debt security shall result in the security being treated as “Default”, for the purpose of valuation”.

As per the valuation norm, mentioned above, mutual funds are required to take a haircut on the value of debt securities declared as default. In this regard, AMFI[4] has issued benchmarks for haircuts, based on which the valuation agencies are required to consider haircut as high as 50%, thereby reducing the value of the securities to half.

This circular turned out to be a major stumbling block for the mutual funds while extending the tenure of PTC transactions vis-à-vis the RBI’s moratorium on term loans in the wake of COVID 19 pandemic. The same has been discussed at length in the following section.

Restructuring of Pass Through Certificates

On March 27, 2020, the Reserve Bank of India (RBI) introduced COVID-19 Regulatory Package[5]  which provided for moratorium on payment of instalments for term loans falling due between 1st March, 2020 and 31st May, 2020[6]. The moratorium has to be extended to all the loans, irrespective of whether they have been sold off by the originators by way of securitisation or direct assignment.

The moratorium as per the RBI’s framework, forced the originators to alter the payout structures originally agreed with the investors under PTC/ DA transactions, so as to pass on effect of moratorium to the investors as well. However, the problem arose when the matter was placed before mutual funds. The mutual funds are major investors in PTCs, representing approximately 43% of securitisation issuances in India[7]. The mutual funds became wary of any extension or modification in the terms of the PTCs, due to apprehensions on valuation losses due to reasons discussed earlier in this write-up.

This created a deadlock between the originators and mutual funds (as investors). On one hand, there was a pressure on the originators to extend moratorium across all the borrowers, on the other hand, the mutual funds were apprehensive in accepting the revised terms due to a potential valuation loss.[8]

Considering the situation, the SEBI issued the Circular to address the issues with respect to valuation of debt securities.

Restructuring of Debentures

Restructuring by deferral of the maturity is something that may be done in case of debentures as well. Debentures may have been (a) private placed; or (b) publicly offered. The former is the more common route for mutual funds to invest.

Any change in the terms of issue amounts to modification of rights of debenture-holders. There is no provision under the Companies Act or SEBI regulations dealing with modification of rights of debenture-holders. Therefore, such modification can be done subject to and in accordance with the terms of issue.

Typically, in case of private placement, the consent of debenture-holders, either directly or through the debenture trustees, is required to be obtained. On the part of the Company, the power to modify the terms usually reside with the Board of Directors or are delegated by the Board to a Committee or a person or persons.

In case of publicly offered debentures, in addition to obtaining the above mentioned consent, compliance with provisions of SEBI LODR Regulations is also required to be ensured.

How can Debenture Issuers Make Use of the SEBI Circular?

  • The restructuring must be solely on account of the COVID crisis. It should be possible to demonstrate that the asset pool or ALM arrangement, but for the impact of the crisis, was adequate enough to take care of the scheduled maturity of the bond.
  • It should be possible to demonstrate that the underlying asset cover still remains healthy, and conditions such as asset cover etc. are benign complied with.
  • The necessary formalities of obtaining required consents must have been done.

If these conditions are fulfilled, a bond issuer may be able to get the consent of the investors without the investors having to provide deep haircuts on account of a deemed default.

Specific Provisions of the Circular

  • An extension of term of a security would not be considered as a default only when the valuation agency is of a view that such delay in payment or extension of maturity has  arisen  solely  due  to  COVID-19 pandemic  lockdown  and/or  in  light  of  the  moratorium  permitted  by  the RBI.
  • In case of difference in the valuation of securities provided by two valuation agencies, the conservative valuation i.e. the lower of the two values shall be accepted.
  • The relief from attraction of provision of default shall be limited to the period the moratorium is in operation.
  • AMCs shall continue to be responsible for true and fairness of valuation of securities.

Conclusion

Due to the obvious outcome of reduction in value of the assets, the mutual funds, as investors of debentures or PTCs, had been rejecting the proposals of issuers/originators/servicers as the case maybe with respect grant of moratorium to the borrowers. Mostly the Mutual Funds which are major investors in PTCs have been denying the grant of moratorium benefit to the borrowers owing to the reduction in value of AUM that would follow. With introduction of this Circular, the problem of taking deep haircuts on the value on account of deemed default stand resolved.

Mutual Funds are now expected to give a green signal on grant of moratorium by lenders. This would help to finally meet the objective of providing relief to the country at the time of the current crisis.

 

 

 

 

[1] https://www.sebi.gov.in/legal/circulars/apr-2020/review-of-provisions-of-the-circular-dated-september-24-2019-issued-under-sebi-mutual-funds-regulations-1996-due-to-the-covid-19-pandemic-and-moratorium-permitted-by-rbi_46549.html

[2] Our write-up dealing with Force Majeure clauses in agreements may be referred here: http://vinodkothari.com/2020/03/covid-19-and-the-shut-down-the-impact-of-force-majeure/

[3] https://www.sebi.gov.in/legal/circulars/sep-2019/valuation-of-money-market-and-debt-securities_44383.html

[4] https://docs.utimf.com/v1/AUTH_5b9dd00b-8132-4a21-a800-711111810cee/UTIContainer/Standard%20Hair%20Cut%20matrix__AMFI20190606-110846.pdf

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

[6] Our detailed FAQs relating to the moratorium may be viewed here: http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

[7] http://vinodkothari.com/2020/01/shadow-banking-in-india/

[8] Issue discussed at length in a virtual conference organised by Indian Securitisation Foundation: Agenda and minutes may be referred on the following links:

http://vinodkothari.com/2020/04/virtual-conference-on-impact-of-rbis-moratorium-on-ptc-transactions/

http://vinodkothari.com/2020/04/minutes-of-the-isf-virtual-conference/

Guidance on money laundering and terrorist financing risk assessment

-Financial Services Division (finserv@vinodkothari.com)

Background

The Reserve Bank of India (RBI) introduced an amendment[1] to Master Direction – Know Your Customer (KYC) Direction, 2016 (‘KYC Directions’)[2] requiring Regulated Entities (REs) to carry out money laundering (ML) and terrorist financing (TF) risk assessment exercises periodically. This requirement shall be applicable with immediate effect and the first assessment has to be carried out by June 30, 2020.

Carrying out ML and TF risk assessment is a very subjective matter and there is no thumb rule to be followed for the same. There is no uniformity on procedures of risk assessment, however, they may be guided by a set of broad principles. The following write-up intends to explore guidance principles enumerated by international bodies and suggest principles to be followed by financial institutions in India, specifically NBFCs, for carrying out risk assessment exercise.

Origin of the concept

The concept of ML and TF risk assessment arises from the recommendations of Financial Action Task Force (FATF). FATF has also provided detailed guidance on TF Risk Assessment[3]. Due to the inter-linkage between ML and TF, the guidelines also serve the purpose of guiding ML risk assessment. TF risk is defined as-

A TF risk can be seen as a function of three factors: threat, vulnerability and consequence. It involves the risk that funds or other assets intended for a terrorist or terrorist organisation are being raised, moved, stored or used in or through a jurisdiction, in the form of legitimate or illegitimate funds or other assets.”

Global practices for ML/TF risk assessment

Based on FATF recommendations, many jurisdictions have prepared and published risk assessment procedures. India is yet to come up with the same.

For example, the National risk assessment of money laundering and terrorist financing[4] is the guidance published by the UK government. It provides sector specific guidance for risk assessment. The sector specific guidance is further granulated keeping in view the specific threats to certain parts of the sector.

The guidance provided by the Republic of Serbia[5] is a generalised one providing broad guidance to all sectors for risk assessment.

In Germany, financial institutions are classified on the basis of potential risk of ML/TF identified by them (considering the factors such as location, scope of business, product structure, customers’ profile and distribution structure) and the intensity of supervision by regulator is based on such risk categorisation.

Risk assessment process by NBFC

The risk assessment of a financial sector entity such as an NBFC, need not be complex, but should be commensurate with the nature and size of its business. For smaller or less complex NBFCs where the customers fall into similar categories and/or where the range of products and services are very limited, a simple risk assessment might suffice. Conversely, where the loan products and services are more complex, where there are multiple subsidiaries or branches offering a wide variety of products, and/or their customer base is more diverse, a more sophisticated risk assessment process will be required.

Based on the guiding principles provided by the FATF and specific guidance issued by FATF for banking and financial sector[6], the process of risk assessment by NBFCs may be divided into following stages:

Stage 1: Collection of information

The risk assessment shall begin with collecting of information on a wide range of variables including information on the general criminal environment, TF and terrorism threats, TF vulnerabilities of specific sectors and products, and the jurisdiction’s general AML capacity

The information may be collected externally or internally. In India, Directorate of Enforcement is the body which deals with ML and TF matters and has collection of information and list of terrorists. Further, the information may also be obtained from Central Bureau of Investigation.

Stage 2: Threat identification

Based on the information collected, jurisdiction and sector specific threats should be identified. Threat identification should be based on the risks identified on the national level, however, shall not be limited to the same. It should also be commensurate to the size and nature of business of the entity.

For individual NBFCs, it should take into account the level of inherent risk including the nature and complexity of their loan products and services, their size, business model, corporate governance arrangements, financial and accounting information, delivery channels, customer profiles, geographic location and countries of operation. The NBFC should also look at the controls in place, including the quality of the risk management policy, the functioning of the internal oversight functions etc.

Stage 3: Assessment of ML/TF vulnerabilities

This stage involves determination of the how the identified threats will impact the entity. The information obtained should be analysed in order to assess the probability of risks occurring. Based on the assessment, ML/TF risks should be classified as low, medium and high impact risks.

While assessing the risks, following factors should be considered:

  • The nature, scale, diversity and complexity of their business;
  • Target markets;
  • The number of customers already identified as high risk;
  • The jurisdictions the entity is exposed to, either through its own activities or the activities of customers, especially jurisdictions with relatively higher levels of corruption or organised crime, and/or deficient AML/CFT controls and listed by RBI or FATF;
  • The distribution channels, including the extent to which the entity deals directly with the customer or relies third parties to conduct CDD;
  • The internal audit and regulatory findings;
  • The volume and size of its transaction.

The NBFCs should complement this information with information obtained from relevant internal and external sources, such as operational/business heads and lists issued by inter-governmental international organisations, national governments and regulators.

The risk assessment should be approved by senior management and form the basis for the development of policies and procedures to mitigate ML/TF risk, reflecting the risk appetite of the NBFC and stating the risk level deemed acceptable. It should be reviewed and updated on a regular basis. Policies, procedures, measures and controls to mitigate the ML/TF risks should be consistent with the risk assessment.

Stage 4: Analysis of ML/TF threats and vulnerabilities

Once potential TF threats and vulnerabilities are identified, the next step is to consider how these interact to form risks. This could include a consideration of how identified domestic or foreign TF threats may take advantage of identified vulnerabilities. The analysis should also include assessment of likely consequences.

Stage 5: Risk Mitigation

Post the analysis of threats and vulnerabilities, the NBFC must develop and implement policies and procedures to mitigate the ML/TF risks they have identified through their individual risk assessment. Customer due diligence (CDD) processes should be designed to understand who their customers are by requiring them to gather information on what they do and why they require financial services. The initial stages of the CDD process should be designed to help NBFCs to assess the ML/TF risk associated with a proposed business relationship, determine the level of CDD to be applied and deter persons from establishing a business relationship to conduct illicit activity.

Focus on CDD procedure

While entering into a relationship with the customer, carrying out Customer Due Diligence (CDD) is the initial step. It is during the CDD process that the identity of a customer is verified and risk based assessment of the customer is done. While assessing credit risks, financial entities should also assess ML/TF risks. The CDD procedures and policies should suitably include checkpoints with respect to ML and TF.

The risk classification of the customer, as discussed above, should also be done based on the CDD carried out. The CDD procedure, apart from verifying the identity of the customer, should also go a few steps further to understand the nature of business or activity of the customer. Measures should be taken to prevent the misuse of legal persons for money laundering or terrorist financing.

In case of medium or high risk customers, or unusual transactions, the entities should also carry out transaction due diligence to identify source and application of funds, beneficiary of the transaction, purpose etc.

NBFCs should document and state clearly the criteria and parameters used for customer segmentation and for the allocation of a risk level for each of the clusters of customers. Criteria applied to decide the frequency and intensity of the monitoring of different customer segments should also be transparent. Further, the NBFC must maintain records on transactions and information obtained through the CDD measures. The CDD information and the transaction records should be made available to competent authorities upon appropriate authority.

Some examples of enhanced and simplified due diligence measures are as follows:

Enhanced Due Diligence (EDD)

  • obtaining additional identifying information from a wider variety or more robust sources and using the information to inform the individual customer risk assessment
  • carrying out additional searches (e.g., verifiable adverse media searches) to inform the individual customer risk assessment
  • commissioning an intelligence report on the customer or beneficial owner to understand better the risk that the customer or beneficial owner may be involved in criminal activity
  • verifying the source of funds or wealth involved in the business relationship to be satisfied that they do not constitute the proceeds from crime
  • seeking additional information from the customer about the purpose and intended nature of the business relationship

Simplified Due Diligence (SDD)

  • obtaining less information (e.g., not requiring information on the address or the occupation of the potential client), and/or seeking less robust verification, of the customer’s identity and the purpose and intended nature of the business relationship
  • postponing the verification of the customer’s identity
Ongoing CDD and Monitoring

Ongoing monitoring means the scrutiny of transactions to determine whether the transactions are consistent with the NBFC’s knowledge of the customer and the nature and purpose of the loan product and the business relationship.

Monitoring also involves identifying changes to the customer profile (for example, their behaviour, use of products and the amount of money involved), and keeping it up to date, which may require the application of new, or additional, CDD measures. Monitoring transactions is an essential component in identifying transactions that are potentially suspicious. Monitoring should be carried out on a continuous basis or triggered by specific transactions. It could also be used to compare a customer’s activity with that of a peer group. Further, the extent and depth of monitoring must be adjusted in line with the NBFC’s risk assessment and individual customer risk profiles

Reporting

The NBFCs should have the ability to flag unusual movement of funds or transactions for further analysis. Further, it should have appropriate case management systems so that such funds or transactions are scrutinised in a timely manner and a determination made as to whether the funds or transaction are suspicious. Funds or transactions that are suspicious should be reported promptly to the FIU and in the manner specified by the authorities. There must be adequate processes to escalate suspicions and, ultimately, report to the FI.

Internal Controls

Adequate internal controls are a prerequisite for the effective implementation of policies and processes to mitigate ML/TF risk. Internal controls include appropriate governance arrangements where responsibility for AML/CFT is clearly allocated and there are controls to test the overall effectiveness of the NBFC’s policies and processes to identify, assess and monitor risk. It is important that responsibility for the consistency and effectiveness of AML/CFT controls be clearly allocated to an individual of sufficient seniority within the NBFC to signal the importance of ML/TF risk management and compliance, and that ML/TF issues are brought to senior management’s attention.

Recruitment and Training

NBFCs should check that personnel they employ have integrity and are adequately skilled and possess the knowledge and expertise necessary to carry out their function, in particular where staff are responsible for implementing AML/CFT controls. The senior management who is responsible for implementation of a risk-based approach should understand the degree of discretion an NBFC has in assessing and mitigating its ML/TF risks. In particular, it must be ensured that the employees and staff have been trained to assess the quality of a NBFC’s ML/TF risk assessments and to consider the adequacy, proportionality and effectiveness of the NBFC’s AML policies, procedures and internal controls in light of this risk assessment. Adequate training would allow them to form sound judgments about the adequacy and proportionality of the AML controls.

Stage 6: Follow-up and maintaining up-to-date risk assessment

Once assessed, the impact of the risk shall be recorded and measures to mitigate the same should be provided for. The information that forms basis of the risk assessment process should be timely updated and the entire risk assessment procedure should be carried out in case of major change in the information.

The compliance officer of the NBFC should have the necessary independence, authority, seniority, resources and expertise to carry out these functions effectively, including the ability to access all relevant internal information. Additionally, there should be an independent audit function carried out to test the AML/CFT programme with a view to establishing the effectiveness of the overall AML/CFT policies and processes and the quality of NBFC’s risk management across its operations, departments, branches and subsidiaries, both domestically and, where relevant, abroad.

 

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11873&Mode=0

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

[3] https://www.fatf-gafi.org/media/fatf/documents/reports/Terrorist-Financing-Risk-Assessment-Guidance.pdf

[4] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/655198/National_risk_assessment_of_money_laundering_and_terrorist_financing_2017_pdf_web.pdf

[5] https://www.nbs.rs/internet/english/55/55_7/55_7_4/procena_rizika_spn_e.pdf

[6] http://www.fatf-gafi.org/media/fatf/documents/reports/Risk-Based-Approach-Banking-Sector.pdf

 

Our other write-ups on NBFCs may be viewed here: http://vinodkothari.com/nbfcs/

Write-rps relating to KYC and Anti-money laundering may also be referred:

 

The Rise of Stablecoins amidst Instability

-Megha Mittal

(mittal@vinodkothari.com

The past few years have witnessed an array of technological developments and innovations, especially in Fintech; and while the world focused on Bitcoins and other cryptos, a new entrant ‘Stablecoin’ slowly crept its way into the limelight. With the primary motive of shielding its users from the high volatility associated with cryptos, and promises of boosting cross-border payments and remittance, ‘Stablecoins’ emerged in 2018, and now have become the focal point of discussion of several international bodies including the Financial Standards Board (FSB), G20, Financial Action Task Force (FATF) and International Organization of Securities Commission (IOSCO).

Additionally, the widespread notion that the desperate need of cross-border payments and remittances during the ongoing COVID-crisis may prove to be a defining moment for stablecoins, has drawn all the more attention towards the need of establishing regulations and legal framework pertaining to Stablecoins.

In this article, we shall have an insight as to what Stablecoins, (Global Stable Coinss) are, its modality, its current status of acceptance by the international bodies, and how the ongoing COVID crisis, may act as a catalyst for its rise.

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US Federal Reserve provides support to senior ABS securities

Timothy Lopes, Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

Measures to maintain and strengthen credit flow to consumers is an important part of regulatory initiatives to contain the effects of the COVID crisis. Asset-backed securities and structured finance instrument are recognised as important instruments that connect capital market resources with the market for loans and financial assets. Underscoring the relevance of securitization to the flow of credit to consumers, the US Federal Reserve has set up a USD 100 billion loan facility, called Term Asset-backed Securities Loan Facility, 2020 [TALF] for lending against asset backed securities, issued on or after 23rd March, 2020.

Note that equivalent of TALF 2020 was set up post the Global Financial Crisis (GFC) as well, in 2008[1].

It is also notable that global financial supervisors have attempted to help financial intermediaries stay firm, partly by helping structured finance transactions. The example of the Australian regulators setting up a Structured Finance Support Fund (SFSF)[2] is one such regulatory measure. Another example is the Canada Mortgage Bond Purchase Program initiated by the Bank of Canada[3].

Read more