We invite you all to join us at the 10th Securitisation Summit, 2022 on 27th May 2022. You are sure to meet the who’s-who of the Indian structured finance space – the originators, investors, rating agencies, legal counsels, accounting experts, global experts, and of course, regulators. The details can be accessed here.
-Financial Services Division (finserv@vinodkothari.com)
[This version dated 24th September, 2021. We are continuing to develop the write-up further – please do come back]
On September 24, 2021, the RBI released Master Direction – Reserve Bank of India Securitisation of Standard Assets) Directions, 2021 (‘Directions’)[1]. The same has been released after almost 15 months of the comment period on the draft framework issued on June 08, 2020[2]. This culminates the process that started with Dr. Harsh Vardhan committee report in 2019[3].
It is said that capital markets are fast changing, and regulations aim to capture a dynamic market which quite often leads the regulation than follow it. However, the just-repealed Guidelines continued to shape and support the securitisation market in the country for a good 15 years, with the 2012 supplements mainly incorporating the response to the Global Financial Crisis (GFC). Read more →
finserv@vinodkothari.com
Our other articles on the topic can be accessed through below link:
Aanchal Kaur Nagpal and Parth Ved (corplaw@vinodkothari.com)
More often than not, the term ‘lending activities’ instantaneously brings the ‘Reserve Bank of India’ (‘RBI’) to mind. However, lending business is not the domain of RBI alone. Amidst multiple RBI guidelines governing numerous financial institutions, the state legislations on money-lending have become long forgotten.
Money-lending laws were introduced with an intention to curb non-regulated indigenous lenders from charging exorbitant interest rates to borrowers. These laws typically require licensing of money lenders, impose a ceiling on rate of interest that money lenders can charge, and generally provide that a court shall not take cognizance of a matter filed by an unlicensed money lender.
While financial entities such as non-banking financial companies (‘NBFCs’), banks, insurance companies etc. have been exempted from obtaining money-lending licence as these are regulated by other laws, the question arises whether non-regulated entities undertaking the ‘business’ of lending would require to register under the money-lending laws.
Although there is a strong network of financial institutions, recourse to such institutions, at most times, is not accessible to the rural parts of the country. Further, it is difficult for banks to extend loans to small farmers due to their rigid requirements for KYC and collateral. Money lenders perform a gap-filling function as they majorly cater to a class of borrowers whom other financial institutions, including banks, cannot reach.
Since they have been such an important link between the formal lending sector and the informal borrowing sector, there was a need for a strong framework to regulate their working. According to Entry 30 of List II (i.e. State List) of the Seventh Schedule to the Constitution of India, the State Legislature has exclusive power to make laws on activities relating to money-lending. To regulate the transactions of money-lending in the State of Maharashtra, the state legislature has enacted Maharashtra Money-Lending (Regulation) Act, 2014 (‘Money Lending Act’). However, other states too, have their respective money-lending laws. Our article deals with provisions under the Maharashtra Money Lending Law.
The Money Lending Act states that no money lender shall carry on the business of money-lending except in the area for which he has been granted a licence. The term used here is “business of money-lending”. Business of money-lending is defined as the business of advancing loans whether in cash or kind and whether or not in connection with, or in addition to any other business.
The above definition provides clarity on the following aspects – 
This raises an important question as to what constitutes ‘business of money-lending’. Are there any lending transactions which are excluded from its purview? The money lending laws exclude certain kinds of loans and lenders. Accordingly, below we discuss various transactions which may not be classified as business of money-lending:
Including secluded or isolated lending transactions in the definition of money-lending business could result in classification of any loan of any amount given by anyone as a business of money-lending. Surely this could not have been the intention of the legislature. Recognising this, the Hon’ble Bombay High Court in Mandubai Vitthoba Pawar v. The State of Maharashtra & Ors. observed:
“11. …for constituting a business of money lending there has to be a continuous and systematic activity by application of labour or skill with a view of earning income and then it could be called “business”. In order to do business of money lending, it would be necessary for the State to point out multiple activities of money lending done by the petitioner. Merely referring to one isolated transaction claimed to be a loan transaction or money lending would not be enough to attract the provisions of the Act and to brand the petitioner to be a person involved in business of money lending without having any license.”
This was again reiterated in Uttam Bhikaji Belkar vs The State of Maharashtra. This makes it clear that there has to be a continuous lending activity with profit motive to constitute a business of money-lending. If this condition is satisfied, the money lender has to obtain a valid license to carry on such business. Therefore, providing one-time loans with no intention to carry on the business of lending money, will not trigger the requirement of adhering to the money lending laws.
The intention of a company giving an Inter-corporate Deposit (ICD) is not to engage in a money-lending transaction but to earn a surplus on the idle funds available with them. In Pennwali India Ltd. and others vs Registrar of Companies it was observed that there exists a relationship of a debtor and a creditor in both cases – loans and deposits. But ICDs could also be for safe-keeping or as a security for the performance of an obligation undertaken by the depositor. Further, in the case of ICD, which is payable on demand, the deposit would become payable when a demand is made. In Housing and Urban Development Corporation Ltd. v. Joint Commissioner of Income Tax, the Hon’ble Income Tax Appellate Tribunal, Delhi Bench held:
“22. …the two expressions loans and deposits are to be taken different and the distinction can be summed up by stating that in the case of loan, the needy person approaches the lender for obtaining the loan therefrom. The loan is clearly lent at the terms stated by the lender. In the case of deposit, however, the depositor goes to the depositee for investing his money primarily with the intention of earning interest.”
Therefore, the money-lending transactions shall not include ICD and companies shall not be required to obtain a license for undertaking such transactions.
In lending transactions between companies within the same group, the intention is not to earn interest on such loan but to facilitate availability of funds to the group company for furtherance of business. Further, loans by companies are governed by Section 186 of the Companies Act, 2013. Section 2(13)(i) of the Money Lending Act states that “a loan does not include a loan to, or by, or deposit with any corporation (being a body not falling under any of the other provisions of this clause), established by or under any law for the time being in force which grants any loan or advance in pursuance of that Act”. Including such transactions under the scope of money-lending business would not be in line with the objects of the Money Lending Act which is to prevent the harassment to the farmers-debtors at the hands of the money lenders or to curb charging exorbitant interest rates.
Parking of or investing idle funds in fixed deposits with Banks is in the nature of investments to earn a surplus on idle funds. Further, since regulation of banking and financial corporations is a matter of List I (i.e. Union List) of the Seventh Schedule to the Constitution of India, Section 2(13)(h) of the Money Lending Act explicitly states that “a loan shall not include a loan to, or by, a bank”, thereby excluding Banks from its purview.
The term money lender, as defined in the Money Lending Act, includes individuals, HUF, companies, unincorporated bodies of individuals who carry on the business of money-lending or have a principal business place in Maharashtra.
However, it has excluded from its purview, non-banking financial companies (NBFC) since they are regulated by RBI under Chapter IIIB of the Reserve Bank of India Act, 1934.
Further, other regulated entities such as insurance companies, banks etc. from its purview.
Our write-up giving a detailed analysis of the definition of NBFC can be accessed here.
Accordingly, NBFCs shall not be required to obtain a license to carry out money-lending business in the State of Maharashtra.
Lending in multiple states
In case a company lends in multiple states, it will have to adhere to provisions under the money lending laws of each such State.
Consequences of non-registration
Section 39 of the Money Lending Act states that whoever carries on the business of money-lending without obtaining a valid licence, shall be punished with –
Even though getting a valid license under the Money Lending Act helps money lenders to carry on business lawfully and have legal recourse against the defaulters, one of the major reasons for non-registration is the ceiling on interest rate. Many lenders are not even aware about the requirement of such registration. Considering the serious nature of punishment for lending money without a valid license, it’s imperative for entities to identify if they are undertaking business of money-lending and whether they have a valid license to do so.
Corplaw Team | corplaw@vinodkothari.com
Amendment in Foreign Exchange Management (NDI) Rules, 2019 effective August 19, 2021- https://egazette.nic.in/WriteReadData/2021/229165.pdf
DPIIT Press Note on June 14, 2021 amending the FDI Policy for Insurance companies which shall be effective from date of FEMA notification – https://dpiit.gov.in/sites/default/files/pn2-2021.pdf
Consequential amendment in Indian Insurance Companies (Foreign Investment) Rules, 2015 are on May 19, 2021 – https://financialservices.gov.in/sites/default/files/Indian%20Insurance%20Companies%20(Foreign%20Investment%20)(amendment)%20Rules,%202021.pdf
Insurance (Amendment) Act, 2021 is passed on March 25, 2021 to increase FDI limit – https://financialservices.gov.in/sites/default/files/Insurance%20(Amendment)%20Act%202021%2025_3_2021.pdf
Proposes segregation of regulatory and the operational part in rules and regulations respectively
FCS Vinita Nair |Senior Partner, Vinod Kothari & Company
Investments by Indian entities outside India is a very common phenomenon and several companies have presence outside India by virtue of forming a Joint Venture (‘JV’) and Wholly Owned Subsidiaries (‘WOS’)
With the enforcement of amendment proposed in Finance Act, 2015 in October, 2019[1] powers vested with Central Government (CG) and Reserve Bank of India (RBI) with respect to permissible Capital Account Transaction were revisited. Power to frame rules relating to Non-Debt instruments (‘NDI’) were vested with CG and to frame regulations relating to debt instruments were vested with RBI. The scope of NDI inter alia covers all investment in equity instruments in incorporated entities: public, private, listed and unlisted; acquisition, sale or dealing directly in immoveable property.
RBI intends to combine erstwhile FEMA (Transfer or Issue of Foreign Security) Regulations, 2004[2] (‘erstwhile ODI regulations’) and FEMA (Acquisition and Transfer of immoveable property outside India) Regulations, 2015[3] into FEMA (Non-debt Instruments – Overseas Investment) Rules, 2021[4] (‘NDI Rules’) and FEMA (Overseas Investment) Regulations, 2021[5] (‘OI Regulations’) and has rolled out the draft regulations for public comments to be sent by August 23, 2021[6].
NDI Rules will provide the regulatory framework for making of overseas investment covering the permissions, conditions for making overseas investment, restrictions from making Overseas Direct Investment (‘ODI’), pricing guidelines, transfer, liquidation and restructuring of ODI. While the NDI Rules will be framed by CG, however, the same will be administered by the RBI.
OI Regulations, on the other hand, will provide only the operational part covering conditions for undertaking Financial Commitment (‘FC’), other than investment in equity capital, consideration in case of acquisition or transfer of equity capital of a Foreign Entity (‘FE’), mode of payment, obligations of Persons Resident in India (‘PRII’), reporting requirements, consequence of delay in reporting and restrictions on further FC/ transfer.
Under the erstwhile ODI regulations, currently in force, there is a concept of direct investment outside India in JV and WOS that excludes portfolio investment and FC. NDI Rules combine the two to define FC and separately defines the term Overseas Portfolio Investment (‘OPI’). Overseas Investment (‘OI’) is FC + OPI.
The classification as ODI depends on the nature of instruments in which investment is made, the nature of the entity in which investment is made and whether control has been acquired or not.
The diagram below provides a snapshot of the same.
The NDI Rules provides investments that require prior approval of Central Government, RBI and NOC from lender banks/ regulatory body etc. The Erstwhile ODI Regulations only mandated prior approval of RBI in case eligibility conditions stipulated were not met by the Indian party or resident individual.
Our other videos and write-ups may be accessed below:
YouTube:
https://www.youtube.com/channel/UCgzB-ZviIMcuA_1uv6jATbg
Other write-up relating to corporate laws:
https://vinodkothari.com/category/corporate-laws/fema/
[1] https://egazette.nic.in/WriteReadData/2019/213265.pdf
[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=2126&Mode=0
[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10257&Mode=0
[4] https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=4024
[5] https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=4023
[6] https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=52026
Payal Agarwal, Executive, Vinod Kothari & Company ( payal@vinodkothari.com )
RBI has recently, vide its notification dated 23rd July, 2021 (hereinafter called the “Amendment Notification”), revised the regulatory restrictions on loans and advances given by banks to directors of other banks and the related entities. The Amendment Notification has brought changes under the Master Circular – Loans and Advances – Statutory and Other Restrictions (hereinafter called “Master Circular”). The Amendment Notification provides for increased limits in the loans and advances permissible to be given by banks to certain parties, thereby allowing the banks to take more prudent decisions in lending.
Section 20 of the Banking Regulation Act, 1949 (hereinafter called the “BR Act”) puts complete prohibition on banks from entering into any commitment for granting of loan to or on behalf of any of its directors and specified other parties in which the director is interested. The Master Circular is in furtherance of the same and specifies restrictions and prohibitions as below –
*since the same does not fall within the meaning of loans and advances for this Master Circular
The Master Circular further specifies some persons/ entities that can be given loans and advances upto a specified limit without the approval of Board, subject to disclosures in the Board’s Report of the bank. The Amendment Notification has enhanced the limits for some classes of persons specified.
| Serial No. | Category of person | Existing limits specified under Master Circular | Enhanced limits under Amendment Notification |
| 1 | Directors of other banks | Upto Rs. 25 lacs | Upto Rs. 5 crores for personal loans
(Please note that the enhancement is only in respect of personal loans and not otherwise) |
| 2 | Firm in which directors of other banks interested as partner/ guarantor | Upto Rs. 25 lacs | No change |
| 3 | Companies in which directors of other banks hold substantial interest/ is a director/ guarantor | Upto Rs. 25 lacs | No change |
| 4 | Relative(other than spouse) and minor/ dependent children of Chairman/ MD or other directors | Upto Rs. 25 lacs | Upto Rs. 5 crores |
| 5 | Relative(other than spouse) and minor/ dependent children of Chairman/ MD or other directors of other banks | Upto Rs. 25 lacs | Upto Rs. 5 crores |
| 6 | Firm in which such relatives (as specified in 4 or 5 above) are partners/ guarantors | Upto Rs. 25 lacs | Upto Rs. 5 crores |
| 7 | Companies in which relatives (as specified in 4 or 5 above) are interested as director or guarantor or holds substantial interest if he/she is a major shareholder | Upto Rs. 25 lacs | Upto Rs. 5 crores |
The Master Circular was released on 1st July, 2015, which is more than 5 years from now. Considering the inflation over time, the limits have become kind of vague and ambiguous and required to be revisited. Moreover, the population all over the world is facing hard times due to the Covid-19 outbreak. At this point of time, such relaxation can be looked upon as the need of the hour.
The Master Circular uses the term “substantial interest” to generally regulate in the context of lending to companies in which a director is substantially interested.
The relevant places where the term has been used are as below –
| Completely prohibited | Allowed with conditions | |
| Section 20(1) of the BR Act – for companies in which directors are substantially interested | Para 2.2.1.2. of Master Circular – for companies in which directors of other banks are substantially interested – upto a limit of Rs. 25 lacs without prior approval of Board
|
|
| Para 2.1.2.2. of Master Circular – for companies in which directors are substantially interested | Para 2.2.1.4. of Master Circular – for the companies in which the relatives of directors of any bank are substantially interested – upto Rs. 25 lacs without prior approval of Board | After amendment, the para stands modified as – for the companies in which the relatives of directors of any bank are major shareholders – upto Rs. 5 crores without prior approval of Board |
While the Amendment Notification itself provides for the meaning of “major shareholder”, the meaning of “substantial interest” for the purposes of the Master Circular has to be taken from Section 5(ne) of the BR Act which reads as follows –
The above definition provides for a maximum limit of shareholding as Rs. 5 lacs, exceeding which a company falls into the list of a company in which director is substantially interested. The net effect is that a lot of companies fall into the radar of this provision and therefore, ineligible to take loans or advances from banks.
However, the Amendment Notification provides an explanation to the meaning of “major shareholder” as –
“The term “major shareholder” shall mean a person holding 10% or more of the paid-up share capital or five crore rupees in paid-up shares, whichever is less.”
This eases the strict limits because of which several companies may fall outside the periphery of the aforesaid restriction. Having observed the meaning of both the terms it is clear that while ‘substantial interest’ lays down strict limits and therefore, covers several companies under the prohibition list, the term ‘major shareholder’ eases the limit and makes several companies eligible to receive loans and advances from the bank subject to requisite approvals thereby setting a more realistic criteria.
The BR Act was enacted about half a century ago when the amount of Rs. 5 lacs would have been substantial, but not at the present length of time. Keeping this in mind, while RBI has substituted the requirement of “substantial interest” to “major shareholder” in one of the clauses, the other clauses and the principal Act are still required to comply with the “substantial interest” criteria, thereby, keeping a lot of companies into the ambit of restricted/ prohibited class of companies in the matter of loans and advances from banks.
The Amendment Notification has the effect of inserting a new proviso to the extant Master Circular which specifies as below –
“Provided that a relative of a director shall also be deemed to be interested in a company, being the subsidiary or holding company, if he/she is a major shareholder or is in control of the respective holding or subsidiary company.”
This has the effect of including both holding and subsidiary company as well within the meaning of company by providing that a major shareholder of holding company is deemed to be interested in subsidiary company and vice versa.
The Amendment Notification allows the banks to lend upto Rs. 5 crores to directors of other banks provided the same is taken as personal loans. The meaning of “personal loans” has to be taken from the RBI circular on harmonisation of banking statistics which provides the meaning of personal loans as below –
Personal loans refers to loans given to individuals and consist of (a) consumer credit, (b) education loan, (c) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), and (d) loans given for investment in financial assets (shares, debentures, etc.).
Other terms used in the Amendment Notification such as “major shareholder” and “control” has also been defined. The meaning of “major shareholder” has already been discussed in the earlier part of this article. The meaning of “control” has been aligned with that under the Companies Act, 2013.
Overall, the Amendment Circular is a welcoming move by the financial market regulator. However, as pointed out in this article, several monetary limits under the BR Act have become completely incohesive and therefore, needs revision in the light of the current situation.
Abhirup Ghosh | abhirup@vinodkothari.com
It is not uncommon to have Indianised version of global dishes when introduced in India, and we are very good in creating fusion food. We have a paneer pizza, and we have a Chinese bhel. As covered bonds, the European financial instrument with over 250 years of history were introduced in India, its look and taste may be quite different from how it is in European market, but that is how we introduce things in India.
It is also interesting to note that regulatory attempts to introduce covered bonds in India did not quite succeed – the National Housing Bank constituted Working Group on Securitisation and Covered Bonds in the Indian Housing Finance Sector, suggested some structures that could work in the Indian market[1] and thereafter, the SEBI COBOSAC also had a separate agenda item on covered bonds. Several multilateral bodies have also put their reports on covered bonds[2].
However, the market did not wait for regulators’ intervention, and in the peak of the liquidity crisis of the NBFCs, covered bonds got uncovered – first slowly, and now, there seems to be a blizzard of covered bond issuances. Of course, there is no legislative bankruptcy remoteness for these covered bonds.
There are two types of covered bonds, first, the legislative covered bonds, and second, the contractual covered bonds. While the former enjoys a legislative support that makes the instrument bankruptcy remote, the latter achieves bankruptcy remoteness through contractual features.
To give a brief understanding of the instrument, a standard covered bond issuance would reflect the following:
Therefore, covered bond is a half-way house, and lies mid-way between a secured corporate bond and the securitized paper. The table below gives comparison of the three instruments:
| Covered bonds | Securitization | Corporate Bonds | |
| Purpose | Essentially, to raise liquidity | Liquidity, off balance sheet, risk management,
Monetization of excess profits, etc. |
To raise liquidity |
| Risk transfer | The borrower continues to absorb default risk as well as prepayment risk of the pool | The originator does not absorb default risk above the credit support agreed; prepayment risk is usually transferred entirely to investors. | The borrower continues to absorb default risk as well as prepayment risk of the pool |
| Legal structure | A direct and unconditional obligation of the issuer, backed by creation of security interest. Assets may or may not be parked with a distinct entity; bankruptcy remoteness is achieved either due to specific law or by common law principles | True sale of assets to a distinct entity; bankruptcy remoteness is achieved by isolation of assets | A direct and unconditional obligation of the issuer, backed by creation of security interest. No bankruptcy remoteness is achieved. |
| Type of pool of assets | Mostly dynamic. Borrower is allowed to manage the pool as long as the required “covers” are ensured. From a common pool of cover assets, there may be multiple issuances. | Mostly static. Except in case of master trusts, the investors make investment in an identifiable pool of assets. Generally, from a single pool of assets, there is only issuance. | Dynamic. |
| Maturity matching | From out of a dynamic pool, securities may be issued over a period of time | Typically, securities are matched with the cashflows from the pool. When the static pool is paid off, the securities are redeemed. | From out of a dynamic pool, securities may be issued over a period of time. |
| Payment of interest and principal to investors | Interest and principal are paid from the general cashflows of the issuer | Interest and principal are paid from the asset pool | Interest and principal are paid from the general cashflows of the issuer. |
| Prepayment risk | In view of the managed nature of the pool, prepayment of loans does not affect investors | Prepayment of underlying loans is passed on to investors; hence investors take prepayment risk | Prepayment risk of the pool does not affect the investors, as the same is absorbed by the issuer. |
| Nature of credit enhancement | The cover, that is, excess of the cover assets over the outstanding funding. | Different forms of credit enhancement are used, such as excess spread, subordination, over-collateralization, etc. | No credit enhancement. Usually, the cover is 100% of the pool principal and interest payable. |
| Classes of securities | Usually, a single class of bonds are issued | Most transactions come up with different classes of securities, with different risk and returns | Single class of bonds are issued. |
| Independence of the ratings from the rating of the issuer | Theoretically, the securities are those of the issuer, but in view of bankruptcy-proofing and the value of “cover assets”, usually AAA ratings are given | AAA ratings are given usually to senior-most classes, based on adequacy of credit enhancement from the lower classes. | There is no question of independent rating. |
| Off balance sheet treatment | Not off the balance sheet | Usually off the balance sheet | Not applicable. |
| Capital relief | Under standardized approaches, will be treated as on-balance sheet retail portfolio, appropriately risk weighted. Calls for regulatory capital | Calls for regulatory capital only upto the retained risks of the seller | Not applicable |
This article would briefly talk about the issuance of Covered bonds world-wide and in India, and what are the distinctive features of the issuances in India.
Since most volumes for covered bonds came from Europe, there has been a decline due to supply side issues. This is evident from the latest data on Euro-Denominated Covered bonds Volume. The performance in FY 2020 and FY 2021 has been subdued mainly due to COVID-19. Though, the volumes suffered significantly in the Q3 and Q4 of FY 20, but returned to moderate levels by the beginning of FY 2021.
The figure below shows Euro-Denominated Covered bond Issuances until Q2 2021.
Source: Dealogic[3]
Countries like Denmark, Germany, Sweden continues to be dominant markets for covered bond issuances. The countries in the Asia-Pacific region like Japan, Singapore, and Australia continues to report moderate level of activities. In North America, Canada represents all the whole of the issuance, with no issuances in the USA.
The tables below would show the trend of issuances in different jurisdictions in 2019 (latest available data):
Source: ECBC Factbook 2020[4]
In India, the struggle to introduce covered bonds started way back in 2012, when the National Housing Bank formed a working group[5] to promote RMBS and covered bonds in the Indian housing finance market. Though the outcome of the working group resulted in some securitisation activity, however, nothing was seen on covered bonds.[6]
Some leading financial institutions attempted to issue covered bonds in the Indian market, but they failed. Lastly, FY 2019 witnessed the first instance of covered bonds, which was backed by vehicle loans.
In India, issuance of covered bonds witnessed a sharp growth in FY 2021, as the numbers increased to INR 22 Bn, as against INR 4 Bn in FY 2020. Even though the volume of issuances grew, the number of issuers failed to touch the two-digit mark. The issuances in FY 2021 came from 9 issuers, whereas, the issuances in FY 2020 were from only 2 issuers. Interestingly, all were non-banking financial companies, which is a stark contrast to the situation outside India.
The figure below shows the growth trajectory of covered bonds in India:
Source: ICRA, VKC Analysis
The growth in the FY 2021 was catapulted by the improved acceptance in Indian market in the second half of the year, given the uncertainty on the collections due to the pandemic, and the additional recourse on the issuer that the instrument offers, when compared to a traditional securitisation transaction.
Almost 75% of the issuances were done by issuers have ‘A’ rating, the following could be the reasons for such:
The Indian covered bonds market is however, significantly different from other jurisdictions. Traditionally, covered bonds are meant to be long term papers, however, in India, these are short to medium term papers. Traditionally covered bonds are backed by residential mortgage loans, however, in India the receivables mostly non-mortgages, gold loans and vehicle loans being the most popular asset classes.
In terms of investors too, the Indian market has shown differences. Globally, long term investors like pension funds and insurance companies are the most popular investor classes, however, in India, so far only Family Wealth Offices and High Net-worth Individuals have invested in covered bonds so far.
Another distinct feature of the Indian market is that a significant share of issuances carry market linked features, that is, the coupon rate varies with the market conditions and the issuers’ ability to meet the security cover requirements.
But the most important to note here is that unlike any other jurisdiction, covered bonds don’t have a legislative support in India. In Europe, the hotspot for covered bonds, most of the countries have legislations declaring covered bonds as a bankruptcy-remote instruments. In India, however, the bankruptcy-remoteness is achieved through product engineering by doing a legal sale of the cover pool to a separate trust, yet retaining the economic control in the hands of the issuer until happening of some pre-decided trigger events, and not with the help of any legislative support. In some cases, the legal sale is done upfront too.
Considering the importance and market acceptability of the instrument, rating agencies in India have laid down detailed rating methodologies for covered bonds[7].
Covered Bonds issued in India will not match most of the features of a traditional covered bond issued in Europe, however, the fact that finally the investors community in India has started recognizing it as an investment opportunity is very encouraging.
The real economics of covered bonds will come to the fore only when the market grows with different classes of investors, like the mutual funds, pension funds, insurance companies etc. in the demand side, which seems a bit far-fetched for now.
[1] A working group was constituted by the National Housing Bank to promote RMBS and Covered Bonds, the report of the working group can be viewed here: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf
[2] In 2014-15, the Asian Development Bank appointed Vinod Kothari Consultants to conduct a Study on Covered Bonds and Alternate Financing Instruments for the Indian Housing Finance Segment
[3] https://www.icmagroup.org/resources/market-data/Market-Data-Dealogic/#14
[4] https://hypo.org/app/uploads/sites/3/2020/10/ECBC-Fact-Book-2020.pdf
[5] A working group was constituted by the National Housing Bank to promote RMBS and Covered Bonds, the report of the working group can be viewed here: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf
[6] Vinod Kothari Consultants has been a strong advocate for a legal recognition of Covered Bonds in India. They were involved in the initiatives taken by the NHB to recognize Covered Bonds as a bankruptcy remote instrument in India.
[7] The rating methodology adopted by ICRA Ratings can be viewed here: https://www.icra.in/Rating/ShowMethodologyReport/?id=709
The rating methodology adopted by CRISIL can be viewed here: https://www.crisil.com/mnt/winshare/Ratings/SectorMethodology/MethodologyDocs/criteria/crisils%20criteria%20for%20rating%20covered%20bonds.pdf
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Our Video on Covered Bonds can be viewed here <https://www.youtube.com/watch?v=XyoPcuzbys4>
Some resources on Covered Bonds can be accessed here –
Introduction to Covered Bonds by Vinod Kothari: http://vinodkothari.com/2015/01/introduction-to-covered-bonds-by-vinod-kothari/
The Name is Bond. Covered Bond. By Vinod Kothari: http://www.vinodkothari.com/wp-content/uploads/covered-bonds-article-by-vinod-kothari.pdf
NHB’s Working Paper on Covered Bonds: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf
RBI proposes uniform regulatory framework for the Microfinance Sector ( finserv@vinodkothari.com )
The microfinance sector, in India, has proved to be fundamental for promoting financial inclusion by extending credit to low-income groups that are traditionally not catered to by lending institutions. The essential features of microfinance loans are that they are of small amounts, with short tenures, extended without collateral and the frequency of loan repayments is greater than that for traditional commercial loans. These loans are generally taken for income-generating activities, although they are also provided for consumption, housing and other purposes. There exist various market players in the microfinance industry viz. scheduled commercial banks, small finance banks, co-operative banks, various NBFCs extending microfinance loans and NBFCs-MFIs.
The microfinance industry has reached 6 crores of live borrowers base the end of the calendar year of 2020. Book size of the microfinance industry as on 31st December is 228,818 crore[1]. The sector grew by 16% from December 2019 to December 2020 (based on outstanding loan portfolio size) and has witnessed phenomenal growth over the last two decades.
Source- SIDBI Microfinance Pulse Report, April 2021
Source- SIDBI Microfinance Pulse Report, April 2021
While banks are leading by contributing 42% towards total portfolio outstanding and 39% towards active loans, NBFC-MFIs are the second highest contributors in the microfinance sector. When compared to the total portfolio size of all microfinance lenders, NBFC-MFIs only contribute to a little over 30% of the total size. However, the framework regulating microfinance has been made applicable solely to NBFC-MFIs (‘NBFC-MFI Regulations’ as provided under the respective Master Directions) while the other lenders that hold a lion’s share of the sector are not subjected to similar regulatory conditions/ restrictions. These include cap on multiple lending, ceiling on maximum lending amount, various customer protection measures etc. Absence of regulatory control has led to various problems such as multiple lending by borrowers resulting in overindebtedness, increased defaults, coercive recovery methods by lenders at the prejudice of borrowers etc.
As a solution to the same, RBI has issued a consultative paper on regulation of microfinance on June 14, 2021[2] (‘Consultation Paper’) with an intention to harmonise the regulatory frameworks for various regulated lenders (‘RE’s) in the microfinance space while also proposing a slew of changes to the existing norms for NBFC-MFIs and NBFCs.
RBI has invited comments, suggestions and feedback on the proposed regulation by July 31, 2021 from all stakeholders. The proposed norms intend to have uniform regulations applicable to microfinance loans provided by all entities regulated by the RBI and are aimed at protecting the microfinance borrowers from over-indebtedness as well as enabling competitive forces to bring down the interest rates by empowering the borrowers to make an informed decision. The key proposals of the Consultative Document have been discussed herein below in this article:
MFIs encompass a host of financial institutions engaged in advancing loans to low-income groups. However, except NBFC-MFIs, none of the other entities are regulated by microfinance-specific regulations.
Resultantly, RBI has proposed to introduce a common regulatory framework for all microfinance lending institutions, irrespective of their form. The intent behind the same is to ensure that all lenders under the microfinance sector are subject to the same rules. This would not only protect borrower interest but also ensure that all lenders are operating on a level playing field thereby passing the benefit of competition to the ultimate borrower. Further, considering the total indebtedness of borrowers vis-a-vis their repayment capacity seems more fitting rather than indebtedness only from NBFC-MFIs.
RBI has proposed to revise the definition of ‘microfinance loans’ and in order to avoid over-indebtedness and multiple lending, the same is proposed to be applied uniformly to all entities regulated by the RBI (REs) and operating in the microfinance sector.
Common definition of microfinance borrowers
Under extant regulations for NBFC-MFIs, a microfinance borrower is identified by annual household income not exceeding ₹1,25,000 for rural and ₹2,00,000 for urban and semi-urban areas. In order to ensure a common definition, the said criteria for classification is proposed to be extended to all regulated entities (REs).
RBI has proposed to base the threshold on the income of the entire household rather than that of an individual, similar to the existing guidelines for NBFC-MFIs. The reason being that income in such households is usually assumed to be pooled.
For this purpose, ‘household’ shall mean a group of persons normally living together and taking food from a common kitchen. Even though the determination of the actual composition of a household shall be left to the judgment of the head of the household, more emphasis has been advised to be placed on ‘normally living together’ than on ‘ordinarily taking food from a common kitchen’. Note that a household differs from a family. Households include persons who ordinarily live together and therefore may include persons who are not related by blood, marriage or adoption but living together, while a family may comprise persons who are living apart from the household.
Methodology for assessment of household income
Assessment of household income in a predominant cash-based economy might pose certain difficulties. However, applying a uniform methodology may not be appropriate for such assessment, especially of low-income households, since the practice may differ based on the different types of borrowers and lenders. The same should be left at the discretion of the lender in the form of a policy. However, broad parameters/ factors may be provided. These can include deriving income from expenditure patterns, assessment of the borrower’s occupation and the ordinary remuneration flowing thereof, assessment of cash flows etc.
One of the major risks in microlending has been the issue of overborrowing, with nearly 35% of the borrowers having access to two or more lenders.(source PWC report)
It is proposed to link the loan amount to household income in terms of debt-income ratio. The payment of interest and repayment of principal for all outstanding loans of the household at any point of time is proposed to be capped at 50% of the household income i.e. total indebtedness of any borrower will not increase 50% of his/her total income. This has been proposed keeping in mind various factors such as –
However, individual REs will be permitted to adopt a conservative threshold as per their own assessments and Board approved policy. Since, the level of indebtedness for a particular borrower is proposed to be regulated, the current stipulation that limits lending by not more than two NBFC-MFIs to the same borrower will no longer be required.
Grandfathering of existing facilities
The aforesaid threshold shall become effective from the date of introduction of the proposed regulations. However, existing loans to the households which are not complying with the limit of 50% of the household income, shall be allowed to mature. Although, in such cases, no new loans will be provided to such households till the limit is complied with.
Microfinance borrowers belong to the low income group and generally do have the available assets to be provided as collateral for availing financial facilities. The assets possessed by them are usually those that are essential for their survival and losing them in case of a default will be detrimental to their existence. Therefore, it has been proposed that to extend the collateral free nature of microfinance loans, as applicable to NBFC-MFIs, to all REs.
In case of NBFC-MFIs, the borrowers are allowed prepayment without charging any penalty. It has now been proposed that microfinance borrowers of all REs shall be provided with the right of prepayment without attracting penalty.
As per the extant regulations, microfinance borrowers of NBFC-MFIs are permitted to repay weekly, fortnightly or monthly instalments as per their choice. With a view to keep the repayment pattern at the discretion of the borrowers that will suit their repayment capacity and/or preference, all REs will be required to provide repayment periodicity to such borrowers as per a Board approved policy.
RBI had issued a Discussion Paper on ‘Revised Regulatory Framework for NBFCs – A Scale-Based Approach’ on January 22, 2021 proposing to revise the minimum net owned fund (NOF) limit for all NBFCs including NBFC-MFIs, from ₹2 crore to ₹20 crore.
At present, NBFC-MFIs are required to have a minimum NOF of ₹5 crore (₹2 crore for NBFC-MFIs registered in the North Eastern Region). RBI has sought the view of stakeholders whether the proposed minimum NOF of ₹20 crore for NBFCs under scale-based regulations is appropriate for NBFC-MFIs or not.
The evolution of regulatory framework for NBFCs may recall, the NOF requirement for NBFCs was Rs 25 lacs in 1990s. Then, it was increased to Rs 2 crores, Rs. 5 crores in case of NBFC-MFIs. The regulator is now proposing to increase the same to Rs 20 crores – a 10 fold increase. The underlying rationale is to have a stronger entry barrier, and to ensure that NBFCs have the initial capital for investing in technology, manpower and establishment. However, such a sharp hike in entry point requirement will keep smaller NBFCs out of the fray. Smaller NBFCs, especially NBFC-MFIs, have been doing a useful job in financial inclusion and having a stricter entrance will only prove to demotivate the sector. You may read further on the scalar based approach framework by RBI in our article here.
Section 8 companies engaged in micro-finance and not accepting public deposits, are exempt from obtaining registration under section 45IA of the RBI Act, 1934 as well as from complying with sections 45-IB (Maintenance of percentage of assets) and 45-IC (Reserve Fund).
The exemption is applicable to all not-for-profit NBFC-MFIs that meet the above criteria irrespective of their size. However, it has been proposed to bring Section 8 companies above a certain threshold in terms of balance sheet size (say, asset size of ₹100 crore and above) under the regulatory ambit of the RBI. This is because Section 8 companies are dependent on public funds including borrowings from banks and other financial institutions for their funding needs and any risk of failure in these companies will have a resultant impact on the financial sector.
Further, not-for profit MFIs operate in an almost similar manner to that of for-profit MFIs but the latter enjoys exemptions from various requirements. The mandatory requirement for registration will ensure that not-for-profit MFIs with considerably large asset size, are effectively regulated.
The revised criteria for exemption is proposed to be as under:
‘Exemption from Sections 45-IA, 45-IB and 45-IC of the RBI Act, 1934 shall be available to a micro finance company which is
In order to be classified as a ‘qualifying asset’, a loan is required to satisfy the following criteria:
The following changes have been proposed –
Owing to an overall restriction based on debt-income ratio of 50% for all REs, the restriction of lending by only two NBFC-MFIs to a borrower will be withdrawn.
Given the vulnerable nature of the borrowers of microfinance loans, the NBFC-MFI regulations imposed an interest cap to prevent exorbitant interest rates charged to such borrowers.
The interest rate cap prescribes multiple ceilings rather than a single one. Accordingly, NBFC-MFIs have been permitted to charge interest with a maximum margin cap of 10% and 12% over and above the cost of funds, depending on the size of loan portfolio (₹100 crore threshold) or 2.75 times of the average base rate of five largest commercial banks, whichever is lower.
The latter criterion provides a linkage with the prevailing interest rate in the economy and ensures that higher borrowing costs for NBFC-MFIs with riskier business models are not transmitted to the end borrowers. Further, NBFC-MFIs are not permitted to levy any other charge except for a processing fee (capped at 1% of the loan amount) and actual cost of insurance to ensure that interest rate ceilings are not bypassed by NBFC-MFIs through other hidden charges.
However, the regulatory ceiling on interest rate is applicable only to NBFC-MFIs. Nearly 70% of the microfinance sector, comprising banks and small finance banks, is deregulated in terms of pricing. It has also been observed that an unintended consequence of creating a regulatory prescribed benchmark for the rest of the entities operating in the microfinance segment. Lenders, such as banks, though having a lower cost of funds, still charge a higher interest rate. This has led to borrowers being deprived of benefits of economies of scale and competition in the microfinance market.
The provision of such interest rate ceilings was suitable in an environment where NBFC-MFIs were the primary lenders. However, currently, as discussed, NBFC-MFIs contribute to only 30%. Proposing a fixed benchmark for interest rate in the microfinance industry may not be appropriate considering the differences in the cost of funds, financial or otherwise, among different types of entities.
Based on the above rationale, it has been proposed to remove such interest rate ceiling limits and align the interest rate model for NBFC-MFIs with that of regular NBFCs. NBFC-MFIs will now be permitted to adopt interest rates based on a Board approved policy while adhering to fair practice code to ensure disclosure and transparency. However, necessary regulation must also be put in place to avoid charging usurious interest rates. The intention is to enable the market mechanism to reduce the lending rates for the entire microfinance sector.
The above relaxation from interest rate ceiling, comes with its own set of fair practice norms to ensure transparency and protecting interests of borrowers.
To allow borrowers to make an informed decision, REs will mandatorily be required to disclose pricing information by way of a standardised and simplified disclosure format (specified under table III of the Consultation Paper). Such information will enable borrowers to compare interest rates as well as other fees associated with a microfinance loan in a more readable and understandable manner. The pricing related fact sheet shall be provided to every prospective borrower before on-boarding.
Boards of all REs will be required to frame suitable internal principles and procedures for determining interest rates and other charges to arrive at an all-inclusive usurious interest rate.
All REs will be required to display the minimum, maximum and average interest rates charged by them on microfinance loans. The manner of display is still to be prescribed.
The above information will also be incorporated in returns submitted to RBI and shall be subjected to the supervisory scrutiny.
[1] Source- SIDBI Microfinance Pulse Report, April 2021
[2] https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=51725