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

-Kanakprabha Jethani and Julie Mehta

finserv@vinodkothari.com

 

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

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

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

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

Basic understanding

  1. What is pre-payment or foreclosure?

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

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

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

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

  1. What is a term loan?

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

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

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

  1. How is floating rate determined?

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

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

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

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

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

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

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

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

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

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

  1. What happens on prepayment of loan?

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

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

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

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

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

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

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

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

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

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

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

  1. What has been clarified?

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

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

Applicability

  1. On whom will this restriction be applicable?

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

  1. What kinds of loans will be covered?

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

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

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

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

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

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

  1. Are there any other entities under similar restriction?

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

  1. When does this clarification come to effect?

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

Implication

  1. What is the borrower’s perspective?

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

  1. What will happen after such clarification?

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

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

 

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

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

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

RBI eases end-use ECB norms for Corporates and NBFCs

Timothy Lopes, Executive, Vinod Kothari & Company

Introduction

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

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

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

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

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

Relaxation granted in end-use restrictions

 

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

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

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

Accordingly the said relaxations by RBI reflect as under:

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

·         General corporate purposes or,

·         Repayment of Rupee loans

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

·         General corporate purposes

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

o   Working Capital purposes and,

o   General Corporate Purpose

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

·         On-lending for above purpose by NBFC’s

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

·         On-lending for above purpose by NBFC’s

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

 

Relaxation for Corporate borrowers classified as SMA-2 or NPA

 

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

Permission to Lender Banks to assign loans to ECB lenders

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

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

Conclusion

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

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

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

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

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

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

Unregulated Deposit Banning Bill passed by Lok Sabha,2019

 

The Unregulated Deposit Banning Bill, 2019[1] was introduced in the Lok Sabha on 24th July, 2019 and has since been passed.

The Bill enacts into law the provisions promulgated by a Presidential Ordinance[2] from 21st February 2019.

From our preliminary comparison, it appears that the Bill is largely the same as the text of the Ordinance.

However, a very significant, though very vague, amendment is the insertion of section 41 in the Bill which provides as under: “The provisions of this Act shall not apply to deposits taken in the ordinary course of business”

Of course, one will keep wondering as to what does this provision imply? What exactly is deposit taking in ordinance course of business? Is it to exclude deposits or loans taken for business purposes? Notably, almost all the so-called deposits that were taken during the Chit funds scam in West Bengal were apparently for some business purpose, though they were effectively nothing but money-for-money transactions. While the intent of this exception may be quell fears expressed across the country by small businesses that even taking of loans for business purposes will be barred, the provision does not jell with the meaning of excluded deposits which gives very specific carve-outs.

Also, one may potentially argue that deposit-taking itself may be a business. Or, deposits sourced may be used for money-lending business, which is also a deposit taken in ordinary course of business.

Basically, the insertion of this provision in section 41 may completely rob the statute of its intent and impact, even though it has an understandable purpose.

Please see our write ups on the Ordinance

 


[1] http://164.100.47.4/BillsTexts/LSBillTexts/PassedLoksabha/182C_2019_LS_Eng.pdf
[2]https://www.prsindia.org/sites/default/files/bill_files/Banning%20of%20Unregulated%20Deposit%20Schemes%20Ordinance%2C%202019.pdf

Introspection of RBI’s new requirement for greater inspection

-Finserv Division

finserv@vinodkothari.com

 

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

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

Insertion of section 45NAA

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

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

The text of the law has been provided below:

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

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

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

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

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

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

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

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

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

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

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

(v) related party;

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

Car Leasing In India: ‘Breaking the Stereotypical Definition Of Luxury’

Julie Mehta (julie@vinodkothari.com)

Introduction

Who thought hiring was even an option to enjoy the luxury of having to use a car. But with the world undergoing a paradigm shift, it untapped its energies into providing and establishing better services for its customers, leasing has paved its way into existence. Most of the industries have adopted this concept and structured their services accordingly in order to provide the best they can to their customers, but that requires huge understanding of their needs. A commoner would always be awed by the immensely developing technology and the environment around them but limited resources makes them take a step back from the thought of availing such services. The market had its solution as hiring and renting came into picture. This has ensured dreams do come true.

Car has always been a luxury at least in most parts of India because of the fact that India still in its developing stage and there still remains a big gap between the rich and the poor and the middle income families fall nowhere. Indians have been developed with the mind state that not everyone can afford everything and thus one should limit their demands keeping in mind their pocket potential. The concept of hiring and renting is not only limited to houses and properties but with the advent of MNC’s and startup companies, they have widened the scope of bringing in the concept of hiring even furniture, vehicles, electronic equipment’s, etc.

Earlier, the concept of car leasing was only limited to corporate senior executives that was earlier known as ‘corporate leasing’ and was common for the luxury car brands. But slowly it has trickled down and become accessible to commoners and middle income families. Companies like Mahindra & Mahindra made some of its models available for leasing. Following this concept, several other car brands like Hyundai, TATA group and luxury brands like BMW, Mercedes etc. have also opened their doors to providing the lease facilities.

Car leasing and rental is one of the most lucrative and fast growing segment of the automobile sector in India even though it currently represents only 4-5% of the market in terms of absolute number of vehicles, but its future prospects are strong enough.

Factors like increasing popularity of app-cab providers like Ola, Uber, Zoom car cab booking facilities, rapid urbanization, relocation of rural population into cities, adds on to the potential of car leasing in India.

[1]The growth of the market in India is to ensure manifold growth in its CAGR by 15-20% in the coming ten years and further on making hiring of cars simpler eventually with current worth of Rs. 1500 crores. Most car making companies are making 40% of its business from leasing cars. This has largely helped change the mentality of customers and imbibed the fact that ‘why buy when you can lease it’.

 

Yellow number plates or white number plates?

People remain apprehensive about the color of the number plate they use in the car. While a yellow number plates denotes commercial use, white number represents personal use. People taking cars on lease will of course want white number plates on their cars.

The current legal framework for registration of motor vehicles allow cars taken on lease for personal use to bear white number plates.

In case of a car taken on lease, the lessee is the person having possession of the vehicle and hence, the ‘owner’ as per the Motor Vehicles Act, 1988. Further, since it is the lessee who is actually using the car and the same has not been given on hire or used for any other commercial purpose, the car shall have a white number plate.

 

Global Status of Car Leasing

Globally, car leasing and hiring has been prevalent and growing for many years now. The analysts have forecasted that in the coming years, the global leasing market is to grow at a CAGR of 13-15%. This is gaining momentum due to the development of new mobility concepts by car leasing companies. For example, telematics was introduced in leased vehicles to monitor their usage on the job, another technological development was the installation of navigation in the leased vehicles making it more convenient for the lessor. People want change and with such facilities where there is an added benefit of not burning the pockets of customers, the lease scheme always works to hire cars on lease and cancel the contract anytime to shift on to better and advanced models of cars.[2]

The new trends dominating the global markets are the introduction of electric vehicle leasing and environment friendly cars that lead to sustainable development in the car manufacturing industries as well in the overall environmental situation. Such facilities encourage people to be more socially responsible and to do their bit towards the betterment of the society and also getting the leasing benefit out of it. Governments across the world are offering subsidies and tax benefits to encourage and boost the penetration of electric vehicles in their fleet. They have also introduced the concept of leasing old cars which helps reduce wastage as well as optimum usage. It is offered at a highly considerate premium and is attractive for low income customers. The global leasing market is fast moving with efficient strategies that ensures further growth too.

 

[3]Why has Leasing gained popularity in recent times?

GST introduction has come out to be a source of relief in time of distress for the Indian markets and consumers due to the stiff tax system of the country resulting in poor market functioning. With the introduction of ‘Goods and Services Tax’ on July 1, 2017, times have changed for the consumers, dealers as well as manufactures and has helped bring stability and balance in the economy by considering every person and their transaction at par, with the motive to bridge the gap between rich and poor in the long run. Evaluating their benefits below taking into consideration automobile industry:

  • To the consumers: The new tax regime has resulted in significant reduction in the tax rates imposed on the end consumers in comparison to the previous tax system.
  • To the dealers: The benefit of claiming the tax paid earlier benefits the dealers with the introduction of GST provides an added advantage to the dealers.
  • To the manufacturers: In recent times, car manufacturing companies have marked a fall in their sales which has led to dwindling profits. With the increasing exposure to car leasing, manufacturers have found their resort to stabilise their performance. This option induces customers to opt for leasing, thereby ensuring good business to the car manufacturers.
 CAR TYPE GST RATES COMPENSATION CESS TOTAL
Small Cars 28% 1% or 3% (depending on capacity) 29% or 31%
Mid-segment Cars 28% 15% 43%
Large Cars 28% 17% 45%
Sports Utility Vehicles (SUV’s) 28% 22% 50%
Electric Cars 12% N.A. 12%

Numerical Comparison

To understand the calculation of Loan EMIs and Lease rentals, we structure an example with the concept of residual model to distinguish the calculations of both the alternatives.

Any loan transaction requires an initial down payment to the seller after which installments follow on monthly/quarterly/annually basis. The down payment creates an extra outflow on part of the buyer on loan along with additional installments. While no down payment is required in case of a lease that makes its overall outflow on the lower side in comparison to a loan.

Plus, in case of a lease transaction, the lessor takes an exposure on the residual value of the asset, this brings down the lease rentals per month.

In the example below, with the assumption of different rates of residual value, we understand that with the every increase in the percentage of residual value, the lease rentals of the operating lease borne by lessee comes down. This implies lower the term of the lease contract, lesser value of the asset is used, and thus lesser are thee lease rentals.

Details of the Vehicle  
Unit Cost 1000000.00
GST rate 28%
Compensation Cess 17%
Rate of GST 45%
GST 450000.00
Total 1450000.90
When Residual Value is considered to be 20%
Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 20% 200000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 39,718.75  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 30,343.75  
Add: GST on rentals ₹ 13,654.69  
Total inflow ₹ 43,998.44  
 
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

When Residual Value is considered to be 25%
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 25% 250000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 39,000.00  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 29,625.00  
Add: GST on rentals ₹ 13,331.25  
Total inflow ₹ 42,956.25  
When the Residual Value is considered to be 30%
Loan arrangement    
Loan amount 1450000.90  
Processing fees 3.80% 55100.0342
Expected Residual Value 0% 0
Tenure 48  
IRR 18%  
EMI ₹ 42,593.78  

 

Operating lease arrangement    
Basic price 1000000.00  
Add GST on purchase (ITC eligible) 450000.00  
Funding Amount 1450000.00  
Processing fees 3.80% 55100.00
Expected Residual Value 30% 300000.00
Tenure 48  
IRR 18%  
Lease Rentals (RV not factored) ₹ 42,593.75  
Lease Rentals (before passing GST benefit) ₹ 38,281.25  
Input tax credit percentage 100%  
Less: GST benefit ₹ 9,375.00  
Lease Rentals (after passing GST benefit) ₹ 28,906.25  
Add: GST on rentals ₹ 13,007.81  
Total inflow ₹ 41,914.06  

 

Conclusion

The major differentiating factors between a lease and a loan is that the former gives the right to use the asset without any upfront down payment, however, in case of the latter, there is an upfront down payment. Leasing works better when the lessor takes exposure on a handsome amount of residual value. Otherwise, it will turn out to be costlier than loan.

In the coming years, the car leasing market in India will be prospering as most car brands have now started to expand their services to even leasing now, which wasn’t prevalent until the last 4-5 years. With this competitive spirit, many more well developed brands would undertake this strategy to enhance customer base. The statistics of no: of cars being sold is going through a falling spree currently and is expected to fall further. But the leasing market will be flourishing on the other hand. It provides the ‘Best of Both Worlds’ to the customers as well as benefits the owner who still retain the ownership of the cars and gain benefit out of it.

 

[1] http://www.businessworld.in/article/-India-s-Car-Leasing-Market-Is-Worth-Rs-1-5K-Cr-Poised-For-15-20-CAGR-/27-05-2017-119041/

[2] www.statista.com

[3]http://www.cbic.gov.in/resources//htdocs-cbec/gst/notification05-compensation-cess-rate.pdf;jsessionid=B47A84DD8CE463AF356CD17117E2316B

[4]https://www.statista.com/outlook/270/119/car-rentals/india#market-arpu

 

 

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

RBI to strengthen corporate governance for Core Investment Companies.

Vinod Kothari

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

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

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

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

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

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

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

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

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

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

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

Project Rupee Raftaar: An Analysis

Prudential Framework for Resolution of Stressed Assets: New Dispensation for dealing with NPAs

By Vinod Kothari [vinod@vinodkothari.com]; Abhirup Ghosh [abhirup@vinodkothari.com]

With the 12th Feb., 2018 having been struck down by the Supreme Court, the RBI has come with a new framework, in form of Directions[1], with enhanced applicability covering banks, financial institutions, small finance banks, and systematically important NBFCs. The Directions apply with immediate effect, that is, 7th June, 2019.

The revised framework [FRESA – Framework for Resolution of Stressed Accounts] has much larger room for discretion to lenders, and unlike the 12th Feb., 2018 circular, does not mandate referral of the borrowers en masse to insolvency resolution. While the RBI has reserved the rights, under sec.  35AA of the BR Act, to refer specific borrowers to the IBC, the FRESA gives liberty to the members of the joint lenders forum consisting of banks, financial institutions, small finance banks and systemically important NBFCs, to decide the resolution plan. The resolution plan may involve restructuring, sale of the exposures to other entities, change of management or ownership of the borrower, as also reference to the IBC.

Timelines

The resolution timelines have 2 components – a Review Period and Resolution Period.

The first period, of 30 days, starts immediately in case of borrowers having aggregate exposure of Rs 2000 crores or more from the banking system, and in case of borrowers with aggregate exposure of Rs 1500 crores to Rs 2000 crores, it starts from 1st Jan 2020. For borrowers with aggregate borrowings of less than Rs 1500 crores, there is no defined timeline as of now – thereby leaving all small moderate loan sizes out of the scope of the FRESA.

During the review period, the lenders will have presumably agreed on the resolution plan. The plan itself has 6 months of implementation.

The 6 months’ implementation timeline is not a hard timeline. If the timeline is breached, the impact is additional provisioning. If the implementation fails the 6 month deadline, there is an additional provision of 20% for period upto 1 year from the end of the review period, and 35% for period beyond 1 year.

Directions are centered around banks

Though the FRESA has made applicable to scheduled commercial banks, AIFIs, small finance banks and NBFCs, however, the same revolves around banks and financial institutions. For the framework to get triggered, the borrower must be reported as default by either an SCB, AIFI or small finance bank. The provisions under the paragraph shall not get triggered with an NBFC declaring an account as default.

Similarly, for reckoning the amount outstanding credit for determining the reference date for implementation, only the credit exposures of the SCBs, AIFIs and small finance banks have to be considered.

It seems these Directions have been made applicable to NBFCs, only to bind them by the proceedings under FRESA, in case of borrowers having multiple lenders.

Mechanics of the FRESA

On an account being declared as default, the lenders will, within a period of 30 days, have to review the account and decide the course of action on the account. That is, during this period, an RP will have to be prepared. The lenders can either resolve the stress under this framework or take legal actions for resolution and recovery.

If the lenders decide to resolve the stress under this framework, ICA must be signed among them. The ICA must provide for the approving authority of the RP, the rights and duties of the majority lenders, safety and security of the dissenting lenders.

Upon approval of the RP, the same must be implemented within a period of 180 days in the manner prescribed in the Directions. After the implementation, the same must be monitored during the monitoring period and the extended specified period, discussed below.

Implementation conditions for RPs

The implementation of RPs also comes with several conditions. The pre-requisites of implementing an RP are:

  1. Where there are multiple lenders involved, approval of 75% of the lenders by value and 60% of the lender by number must have been obtained.
  2. The RPs must be independently rated – where the aggregate exposure is ₹ 1 billion or above, at least from 1 credit rating agency; and where the aggregate exposure is ₹ 5 billion or above, at least from 2 credit rating agencies. The rating obtained from the CRAs must be RP4 or better[2].
  3. The borrower should not be in default as on 180th day from the end of Review Period.
  4. An RP involving restructuring/ change in ownership, shall be deemed to be implemented only if,
    1. All the legal document have been executed by the lenders in consonance with the RP;
    2. The new capital structure and/ or changes in the terms and conditions of the loans get duly reflected in the books of the borrower;
    3. The borrower is not in default with any of the lenders

Restructuring with several covenants

Restructuring was no brainer earlier and was the device to keep bad loans on the books without any action.

The FRESA provides that upon restructuring, the account [having an aggregate exposure of more than Rs 100 crores] will be upgraded to standard status only on investment grade by at least one rating agency (two in case of aggregate exposure of Rs 500 crores and above). Also, after restructuring, the account should at least pay off 10% of the aggregate exposure.

Prudential norms in case of restructuring/ change in ownership

  1. In case of restructuring –
    1. Upon restructuring, the account will be immediately be downgraded to sub-standard and the NPAs shall continue to follow the asset classification norms as may be applicable to them.
    2. The substandard restructured accounts can be upgraded only after satisfactory performance during the following period:
      1. Period commencing from the date of implementation of the RP up to the date by which 10% of the outstanding credit facilities have been repaid (monitoring period); or
      2. 1 year from the date of commencement of the first payment of interest or principal, whichever is later.
    3. However, for upgradation, fresh credit ratings, as specified above,  will have to be obtained.
    4. If the borrower fails to perform satisfactorily during this period, an additional provision of 15% will have to be created by all the lenders at the end of this period.
    5. In addition to above, the account will have to be monitored for an extended period upto the date by which 20% of the outstanding credit facilities have been repaid. If the borrower defaults during this period, then a fresh RP will have to be required. However, an additional 15% provision will have to be created at the end of the Review Period.
    6. Any additional finance approved under the RP, shall be booked as “standard asset” in the books of the lender during the monitoring period, provided the account performs satisfactorily. In case, the account fails to perform satisfactorily, the same shall be downgraded to the same category as the restructured debt.
    7. Income in case of restructured standard assets should be booked on accrual basis, in case of sub-standard assets should be booked on cash basis.
    8. Apart from the additional provisioning mentioned above, the lenders shall follow their normal provisioning norms.
  2. In case of change of ownership, the accounts can be retained as standard asset after the change in ownership under FRESA or under IBC. For change in ownerships under this framework, following are the pre-requisites:
    1. The lenders must carry out due diligence of the acquirer and ensure compliance with section 29A of the IBC.
    2. The new promoter must acquire at least 26% of the paid up equity capital of the borrower and must be its single largest shareholder.
    3. The implementation must be carried out within the specified timelines.
    4. The new promoter must be in control of the borrower.
    5. The account must continue to perform satisfactorily during the monitoring period, failing which fresh review period shall get triggered. Also, it is only upon satisfactory performance during this period that excess provisions can be reversed.
  3. Reversal of additional provisions:
    1. In case, the RP involves only payment of overdues, the additional provisions may be reversed only of the borrower remains not in default for a period of 6 months from the date of clearing the overdues with all its lenders.
    2. In case, the RP involves restructuring/ change in ownership outside IBC, the additional provisions created against the exposure will be reversed upon implementation of the RP.
    3. In case, the lenders initiate insolvency provisions against the borrower, then half of the provisions created against the exposure will be reversed upon submission of application and the remaining amount may be reversed upon admission of the application.
    4. In case, the RP involves assignment/ debt recovery, the additional provision may be reversed upon completion of the assignment/ debt recovery.

Exceptions

Project loans where date of commencement of commercial operations (DCCO) has been deferred, will be excluded from the scope of the circular.

Hierarchy of periods

  • Review period – 30 days for preparing the resolution plan
  • Implementation period – 6 months from the end of the review period – for implementing the resolution plan
  • Monitoring period for upgradation – 1 year from date of commencement of first payment of interest or principal or reduction of aggregate exposure by 10%, whichever is later
  • Specified period – until the aggregate exposure is repaid by at least 20% – if there is a default, a fresh resolution plan will be required.

Other provisions of the FRESA

Some common instructions from the earlier directions have been retained in this framework as well, namely:

  1. Identification of an account under various special mention accounts. Where the default in account is between 1-30 days, the same must be treated as SMA-0. Where the default is between 31-60 days, it must be reported as SMA-1. Where the default is between 61-90 days, it must be reported as SMA-2.
  2. Reporting requirements to CRILC for accounts with aggregate exposure of ₹ 50 million will continue.
  3. The framework requires the lenders to adopt a board approved policy in this regard.
  4. For actions by the lenders with an intention to conceal the actual status of accounts or evergreen the stressed accounts, will be subjected to stringent supervisory / enforcement actions as deemed appropriate by the Reserve Bank, including, but not limited to, higher provisioning on such accounts and monetary penalties. Further, references under IBC can also be made.
  5. Disclosures under notes to accounts have to be made by the lenders with respect to accounts dealt with under these Directions.
  6. The scope of the term “restructuring” has been expanded under the Directions.
  7. Sale and leaseback transaction involving the assets of the borrower shall be treated as restructuring if the following conditions are met:
    1. The seller of the assets is in financial difficulty;
    2. Significant portion, i.e. more than 50 per cent, of the revenues of the buyer from the specific asset is dependent upon the cash flows from the seller; and
    3. 25 per cent or more of the loans availed by the buyer for the purchase of the specific asset is funded by the lenders who already have a credit exposure to the seller.
  8. If borrowings/export advances (denominated in any currency, wherever permitted) for the purpose of repayment/refinancing of loans denominated in same/another currency are obtained:
    1. From lenders who are part of Indian banking system (where permitted); or
    2. with the support (where permitted) from the Indian banking system in the form of Guarantees/Standby Letters of Credit/Letters of Comfort, etc., such events shall be treated as ‘restructuring’ if the borrower concerned is under financial difficulty.
  9. Exemptions from restrictions on acquisition of non-SLR securities with respect to acquisition of non-SLR securities by way of conversion of debt.
  10. Exemptions from SEBI (ICDR) Regulations with respect to pricing of equity shares.

Withdrawal of earlier instructions

The following instructions, earlier issued by the RBI have been withdrawn with immediate effect:

Framework for Revitalising Distressed Assets, Corporate Debt Restructuring Scheme, Flexible Structuring of Existing Long Term Project Loans, Strategic Debt Restructuring Scheme (SDR), Change in Ownership outside SDR, and Scheme for Sustainable Structuring of Stressed Assets (S4A) stand withdrawn with immediate effect. Accordingly, the Joint Lenders’ Forum (JLF) as mandatory institutional mechanism for resolution of stressed accounts.

[1] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=11580&Mode=0

[2] The Directors lay down various categories ratings. RP4 resembles debt facilities carrying moderate risk with respect to timely servicing of financial obligations.

Large Exposures Framework: New RBI rules to deter banks’ concentric lending

-Kanakprabha Jethani |Executive
Vinod Kothari Consultants

Background

The RBI has made some crucial amendments to the Large Exposures Framework (LEF) by notification dated June 03, 2019. These changes are intended to align with global practices, such as look through approach for identifying exposures, determination of the group of “connected” counterparties, to name a few.

The LEF, announced by the RBI vide its notification dated December 01, 2016[1] and amended through notification dated June 03, 2019[2], is applicable with effect from April 1, 2019. However, the provisions relating to Introduction of economic interdependence criteria in definition of connected counterparties and non-centrally cleared derivatives exposures shall become applicable from April 1, 2020. This framework is likely to widen the scope of the definition of group of connected counterparties on one hand, and narrowing down the same by expanding the scope of exempted counterparties. Further, look-through approach demarcates between direct or indirect exposure of banks in various counterparties.

More about the LEF

A bank may have exposure to various large borrowers, and of group of entities that are related to each other. This exposure in large borrowers, whether singularly or by way of different related entities, results in concentration of bank’s exposure in the same group, thus increasing the credit risk of the bank. There have been examples of large banking failures throughout the world. In the words of the Basel Committee on Banking Supervision-

“Throughout history there have been instances of banks failing due to concentrated exposures to individual counterparties (eg Johnson Matthey Bankers in the United Kingdom in 1984, the Korean banking crisis in the late 1990s). Large exposures regulation has been developed as a tool for limiting the maximum loss a bank could face in the event of a sudden counterparty failure to a level that does not endanger the bank’s solvency.”

To deal with the risk arising out of such concentration, there has to be in place limits on concentration in a single borrower or a borrower group. Accordingly, after considering various frameworks being included in local laws and banking regulations and recommendations of committees such as Basel Committee on Banking Supervision, ‘Supervisory framework for measuring and controlling large exposures’[3] was issued by the said committee. The same was adopted by the RBI in respect of banks in India.

The Large Exposure Framework (LEF) shall be applied by banks at group level (considering assets and liabilities of borrower and its subsidiaries, joint ventures and associates) as well as at solo level (considering the capital strength and risk profile of borrower only).

Reporting of large exposure: As per the LEF, large exposure shall mean exposure of 10% or more of the eligible capital base of the bank in a single counterparty or a group of counterparties. The same shall be reported to Department of Banking Supervision, Central Office, Reserve Bank of India.

Limit on large exposure: the maximum exposure of a bank in a single counterparty shall not be more than 20% of its eligible capital base at any time. This limit shall be raised to 25% of bank’s eligible capital base in case of a group of counterparties.

Eligible capital base, in this reference shall mean the aggregate of Tier 1 capital as defined in Basel III – Capital Regulation[4] as per the latest balance sheet of the company, infusion of capital under Tier I after the published balance sheet date and profits accrued during the year which are not in deviation of more than 25% from the average profit of four quarters.

Applicability

The LEF shall be applicable on all scheduled commercial banks in India, with respect to their counterparties only.

The LEF has become applicable with effect from April 1, 2019. The revised guidelines on LEF shall also become applicable from the same date with retrospective effect except for the provisions of economic interdependence and non-centrally cleared derivative exposures.

What sort of borrowers are affected?

The revised guidelines have an impact on the borrowers who used to take advantage of different entities and hide behind the corporate veil to avail funding. The introduction of economic interdependence as a criteria for determining connected counterparties ensures that no same persons, whether promoters or management avail facilities through other entity.

Further, borrowers who operate as special purposes vehicles, securitisation structures or other structures having investments in underlying assets would also be affected as the banks will now look-through the structure to identify the counterparty corresponding the underlying asset.

However, the LEF does not address issues relating to lending to any specific sector or such other exposures.

What happens to affected borrowers?

The borrowers taking advantage of corporate veil will no more be able to avail funds in the covers of veil. The entities having same or related parties in their management shall not be able to avail funds exceeding the exposure limit. This would result in shrinkage of the availability of borrowed funds that would have otherwise been available to the entities. Also, entities operating as aforementioned structures, are likely to face contraction of borrowed fund availability.

Global framework

The global framework on large exposures called the Supervisory framework for measuring and controlling large exposures became applicable from 1st Jan 2019. The key features of the global framework are as follows:

  • Norms for determining scope of counterparties and exemptions thereto.
  • Specification of limits of large exposures and reporting requirements.
  • The sum of exposure to a single borrower or a group of connected borrowers shall not exceed 25% of bank’s available capital base.
  • If a G-SIB (Global systemically Important Banks) shall not exceed exposure limit of 15% of its available capital base in another G-SIB.
  • Principles for measurement of value of exposures.
  • Techniques for mitigation of credit risk.
  • Treatment of sovereign exposures, interbank exposures, exposures on covered bonds collective investment schemes, securitisation vehicles or other structures having underlying assets and in central counterparties been specified.

“Connected” borrowers

A bank shall lend within concentration limits prescribed in the LEF. For this purpose, the aggregate of concentration in all the connected counterparties shall be considered. Basically, connected counterparties are those parties which have such a relationship among themselves, either by way of control or interdependence, that failure of one of them would result in failure of the other too. The LEF provides the following criteria for determining the “connected” relationship between counterparties.

  • Control- where one of the counterparties has direct or indirect control over the other, ‘Control maybe determined considering the following:
    • holding 50% or more of total voting rights
    • having significant influence in appointment of managers, supervisors etc.
    • significant influence on senior management
    • where both the counterparties are controlled by a third party
    • Qualitative guidance on determining control as provided in accounting standards.
    • Common owners, shareholders, management etc.
  • Economic interdependence- where if one of the counterparties is facing problems in funding or repayment, the other party would also be likely to face similar difficulties. Following criteria has to be considered for determining economic interdependence between entities:
    • Where 50% or more of gross receipts or expenditures is derived from the counterparty
    • Where one counterparty has guaranteed exposure of the other either fully or partly
    • Significant part of one counterparty’s output is purchased by the other
    • When the counterparties share the source of funds to repay their loans
    • When the counterparties rely on same source of funding

Look through approach

In case of investing vehicles such as collective investment vehicles, securitisation SPVs and other cases such as mutual funds, venture capital funds, alternative investment funds, investment in security receipts, real estate investment trusts, infrastructure investment trusts etc., the recognition of exposures will be done on a see-through or look-through approach. The meaning of look-through approach is the underlying exposures will be recognised in constituents of the pool or the fund, rather than the fund.

When banks invest in structures which themselves have exposures to underlying assets, the bank shall determine if it is able to look-through the structure. If the bank is able to look-through and the exposure of bank in each of the underlying asset of the structure is equal to or above 0.25% of its eligible capital base, the bank must identify specific counterparties corresponding to the underlying asset. The exposure of bank in each of such underlying assets shall be added to the bank’s overall exposure in the corresponding counterparty.

Further, if the exposure in each of the underlying assets is less than 0.25% of bank’s eligible capital base, the exposure maybe assigned to the structure itself.

However, if a bank is unable to identify underlying counterparties in a structure:

  • bank’s exposure in that structure is 0.25% or more of its eligible capital base, the bank shall assign such exposure in the name of “unknown client”.
  • bank’s exposure in that structure is less than 0.25% of its eligible capital base, the exposure shall be assigned to the structure itself.

However, if the exposure of bank in the structure is less than 0.25% of the eligible capital base of the bank, the total exposure maybe assigned to the structure itself, as a distinct counterparty, rather than looking through the structure and assigning it to corresponding counterparties.

Overall impact of the LEF

The primary objective of LEF is to limit the concentration of bank in a single group of borrowers. By specifying criteria for large exposures, determination of “connected” relationship, reporting to RBI, ways to mitigate risk etc. the LEF intends to reduce credit risk of banks caused due to concentration in a single borrower or a group of borrowers.

The application of provisions of LEF will reduce the concentration risk of banks which in turn would result in reduction of credit risk of the bank. It would also result in increased monitoring by the RBI on the lending practices of banks. It is likely to reduce the instances of default in repayments, which have become a routine practice nowadays.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10757&Mode=0

[2] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=11573&Mode=0

[3] https://www.bis.org/publ/bcbs283.pdf

[4] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=9859&Mode=0