Lenders’ piggybacking: NBFCs lending on Fintech platforms’ guarantees

-Vinod Kothari

(vinod@vinodkothari.com)

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

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

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

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

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

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

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

Platform’s motivations

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

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

Lender’s motivations

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

Are there any regulatory concerns?

The potential regulatory concerns may be as follows:

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

Each of these issues are examined below.

Synthetic lending by an unregulated entity

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

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

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

Undercapitalised entities taking credit risk

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

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

Skin-in-the game issue

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

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

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

A CDS, but not regulated as a CDS

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

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

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

Financial reporting issues:

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

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

Conflicts of interest or misalignment of incentives:

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

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

Good borrowers pay for bad borrowers

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

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

KYC or outsourcing related issues

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

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

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

Is it actually a guarantee?

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

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

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

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

Conclusion

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

 

 

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

Draft guidelines for on tap licensing of SFBs: decoded

-Kanakprabha Jethani | Executive

(kanak@vinodkothari.com)

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

What is ‘on-tap’ licensing?

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

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

Who is eligible to apply?

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

Who cannot apply?

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

What will be the structure of SFB?

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

What activities can an SFB carry out?

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

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

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

What will be the capital structure in SFB?

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

·         Bring down to 30% in 10 years

·         Bring down to 15% in 15 years

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

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

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

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

Will the SFB be listed?

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

What will be the compliance requirements for SFBs?

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

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

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

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

How to make an application to set up an SFB?

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

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

 

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

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

(finserv@vinodkothari.com)

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

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

Fintech companies’ model

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

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

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

Confidentiality of credit information

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

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

The above law is followed in India as well.

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

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

Credit Information Companies and sharing of information

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

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

The inherent safeguards in the CIC Law

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

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

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

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

Secrecy of customer information: duty of the lender

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

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

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

The case of Fintech Companies and NBFC partnership:

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

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

The situations may be as follows:

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

Conclusion

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

 

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

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

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

 

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