Inherent inconsistencies in quantitative conditions for capital relief

Abhirup Ghosh

– Updated as on 16th June, 2020

On 8th June, 2020, RBI issued the Draft Framework for Securitisation of Standard Assets taking into account existing guidelines, Basel III norms on securitisation by the Basel Committee on Banking Supervision as well the Report of the Committee on the Development of Housing Finance Securitisation Market chaired by Dr. Harsh Vardhan.

With this, one of the main areas of concern happens to be capital relief for securitisation. The concerns arise not just for new exposures but also existing securitisation exposures, as Chapter VI (dealing with Capital Requirements) shall come into immediate effect, even for the existing securitisation exposures.

Earlier, due to the implementation of Ind-AS, concerns arose with respect to capital relief treatment as most of the securitisation exposures did not qualify for derecognition under Ind-AS. However, on March 13, 2020, RBI came out with Guidance on implementation of Ind-AS, which clarified the issue by stating that securitised assets not qualifying for derecognition under Ind AS due to credit enhancement given by the originating NBFC on such assets shall be risk weighted at zero percent. However, the NBFC shall reduce 50 per cent of the amount of credit enhancement given from Tier I capital and the balance from Tier II capital.

Once again, the issue of capital relief arises as the draft guidelines may cause an increase in capital requirements for existing exposures.

Capital requirement under the Draft Framework

The Draft Framework lays down qualitative as well as quantitative criteria for determining capital requirements. As per Para 70, lenders are required to maintain capital against all securitisation exposure amounts, including those arising from the provision of credit risk mitigants to a securitisation transaction, investments in ABS or MBS, retention of a subordinated tranche, and extension of a liquidity facility or credit enhancement. For the purpose of capital computation, repurchased securitisation exposures must be treated as retained securitisation exposures.

The general provisions for measuring exposure amount of off-balance sheet exposures are laid down under para 71-78 of the Draft Framework.

The quantitative conditions are however, laid down in paragraphs 79 (a) and (b). The intention here is to delve into the impact of the quantitative conditions only, keeping aside the qualitative conditions for the time being.

Substantial transfer of credit risk:

The first condition (79(a)) is that significant credit risk associated with the underlying exposures of the securities issued by the SPE has been transferred to third parties. Here, significant credit risk will be treated as having transferred if the following conditions are satisfied:

  1. If there are at least three tranches, risk-weighted exposure amounts of the mezzanine securitisation positions held by the originator do not exceed 50% of the risk-weighted exposure amounts of all mezzanine securitisation positions existing in this securitisation;
  2. In cases where there are no mezzanine securitisation positions, the originator does not hold more than 20% of the exposure values of securitisation positions that are first loss positions.

Taking each of the two points at a time.

The first clause contemplates a securitisation structure with at least three tranches – the senior, the mezzanine and the equity. Despite the presence of three tranches, the condition for risk transfer has been pegged with the mezzanine tranche only, however, nothing has been discussed with respect to the thickness of the mezzanine tranche (though the draft Directions has prescribed a minimum thickness for the first loss tranche).

If the language of the draft Directions is retained as is, qualifying for capital relief will become very easy. This can be explained with the help of the following example.

Suppose a securitisation transaction has three tranches, the composition and proportion of which has been provided below:

Tranche Rating Proportion as a part of the total pool Retention by the Originator Effective retention of interest by the Originator
Senior Tranche – A AAA 85% 0% 0%
Mezzanine Tranche – B AA+ 5% 50% 2.5%
Equity/ First Loss Tranche – C Unrated 10% 100% 10%

As may be noticed, both the senior and mezzanine are fairly highly rated as the junior most tranche has a considerable amount of thickness and represents a first loss coverage of 10%. Additionally, it also retains 50% of the Mezzanine tranche. Therefore, effectively, the Originator retains 12.5% of the total pool, yet it will qualify for the capital relief, by virtue of holding upto 50% of the Mezzanine tranche, despite retaining 10% in the form of first loss support.

The second clause contemplates a situation where there are only two tranches – that is, the senior tranche and the equity tranche. The clause says that in absence of a mezzanine tranche, the retention of first loss by the Originator should not be more than 20% of the total first loss tranche.

Given the current market conditions, it will be practically impossible to find an investor for the first loss tranche, hence, the entire amount will have to be retained by the Originator. Also, it is very common to provide over-collateral or cash collateral as first loss supports in case of securitisation transactions, even in such cases a third party’s participation in the first loss piece is technically impossible.

Also, there is a clear conflict between this condition and para 16 of the draft Directions, which gives an impression that the first loss tranche has to be retained by the originator itself, in the form of minimum risk retention.

Therefore, in Indian context, if one were to take a holistic view on the conditions, they are two different extremes. While, in the first case, capital relief is achievable, but in the second case, the availing capital relief is practically impossible. This will make the second condition almost redundant.

In order to understand the rationale behind these conditions, please refer to the discussion on EU Guidelines on SRT below.

Impact on the existing transactions

As noted earlier, this part of the draft Directions shall be applicable on the existing transactions as well. Here it is important to note that currently, most of the transaction structures in India either have only one or two tranches of securities, and only a fraction would have a mezzanine tranche. In all such cases, the entire first loss support comes from the Originator. Therefore, almost none of the transactions will qualify for the capital relief.

In the hindsight, the originators have committed a crime which they were not even aware of, and will now have to pay a price.

The moment, the Directions are finalised, the loans will have to be risk-weighted and capital will have to be provided for.

This will have a considerable impact on the regulatory capital, especially for the NBFCs, which are required to maintain a capital of 15%, instead of 9% for banks.

Thickness of the first loss support:

This requirement states that the minimum first loss tranche should be the product of (a) exposure (b) weighted maturity in years and (c) the average slippage ratio over the last one year.

The slippage ratio is a term often used by banks in India to mean the ratio of standard assets slipping to substandard category. So, if, say 2% of the performing loans in the past 1 year have slipped into NPA category, and the weighted average life of the loans in the pool is, say, 2.5 years (say, based on average maturity of loans to be 5 years), the minimum first loss tranche should be [2% * 2.5%] = 5% of the pool value.

In India, currently the thickness of the first loss support depends on the recommendations of the credit rating agencies (CRAs). Typically, the thresholds prescribed by the CRAs are thick enough, and we don’t foresee any challenge to be faced by the financial institutions with respect to compliance with this point.

EU’s Guidelines on Significant Risk Transfer

The guidelines for evidencing significant risk transfer, as provided in the draft Guidelines, are inspired from the EU’s Guidelines on Significant Risk Transfer. The EU Guidelines emphasizes on significant risk transfer for capital relief and states that a high level, the capital relief to the originator, post securitisation, should commensurate the extent of risk transferred by it in the transaction. One such way of examining whether the risk weights assigned to the retained portions commensurate with the risk transferred or not is by comparing it with the risk weights it would have provided to the exposure, had it acquired the same from a third party.

Where the Regulatory Authority is convinced that the risk weights assigned to the retained interests do not commensurate with the extent of risk transferred, it can deny the capital relief to the originator.

Under three circumstances, a transaction is deemed to have achieved SRT and they are:

  1. Where there is a mezzanine tranche involved in the structure: the originator does not retain more than 50% of the risk weighted exposure amounts of mezzanine securitisation positions, where these are:
  • positions to which a risk weight lower than 1,250% applies; and
  • more junior than the most senior position in the securitisation and more junior than any position in the securitisation rated Credit Quality Step 1 or 2.
  1. Where there is no mezzanine tranche involved in the structure: the originator does not hold more than 20% of the exposure values of securitisation positions that are subject to a deduction or 1,250% risk weight and where the originator can demonstrate that the exposure value of such securitisation positions exceeds a reasoned estimate of the expected loss on the securitised exposures by a substantial margin.
  2. The competent authority may grant permission to an originator to make its own assessment if it is satisfied that the originator can meet certain requirements.

In case, the originator wishes to achieve SRT with the help of 1 & 2, the same has to be notified to the regulator. If as per the regulator, the risk weights assigned by the originator does not commensurate with the risks transferred, the firms will not be able to avail the reduced risk weights.

Underlying assumptions behind the SRT conditions

The underlying assumptions behind the SRT conditions have been elucidated in the EU’s Discussion Paper on Significant Risk Transfer in Securitisation.

  1. Mezzanine test: This is applicable where the transaction has a mezzanine tranche. Usually the first loss tranches are meant to cover up the expected losses in a pool and the mezzanine tranches are meant for covering up the unexpected losses, irrespective of whether the equity/ first loss tranche is retained by the originator or sold off to a third party. The mezzanine test is indifferent with regard to the retention or transfer to third parties of securitisation positions mainly or exclusively covering the EL — given potential losses on these tranches are already completely anticipated through the CET1 deduction/application of 1250% risk weight if they are retained.
  2. First loss test: This is applicable where the transaction does not have a mezzanine tranche. In such a situation, the first loss tranche is expected to cover up the entire expected and unexpected losses. This is clear from the language of the EU SRT guidelines which states, that the securitisation exposure in the first loss tranche must be substantially higher than the expected losses on the securitisation exposure. In this case, due to the pari passu allocation of the actual losses to holders of the securitisation positions that are subject to CET1 deduction/1250% risk weight (irrespective of whether these losses relate to the EL or UL), the first loss test may effectively require the originator to transfer also parts of the EL, depending on the specific structure of the transaction and, in particular, on which portion of the UL is actually covered by the positions subject to CET1 deduction/1250% risk weight

The following graphics will illustrate the conditions better:

In figure 1, the mezzanine tranche is thick enough to cover the entire unexpected losses. If in the present case, 50% of the total unexpected losses are transferred to a third party, then the transaction shall qualify for capital relief.







Unlike in case of figure 1, in figure 2, the mezzanine tranche does not capture the entire unexpected losses. The thickness of the tranche is much less than what it should have been, and the remaining amount of unexpected losses have been included in the first loss tranche itself.

In the present case, even if the mezzanine tranche does not commensurate with the unexpected losses, the transaction will still qualify for capital relief, because, if the first loss tranche is retained by the originator, it will have to be either deducted from CET1/ assign risk weights of 1250%




In figure 3, there is no mezzanine tranche. In the present case, the first loss tranche covers the entire expected as well as the unexpected losses. In order to demonstrate a significant risk transfer, the originator can retain a maximum of 20% of the securitisation exposure.






Currently, the draft Directions do not provide any logic behind the conditions it inserted for the purpose of capital relief, neither are they as elaborate as the ones under EU Guidelines. Some explicit clarity in this regard in the final Directions will provide the necessary clarity.

Also, with respect the mezzanine test, in the Indian context, the condition should be coupled with a condition that the first loss tranche, when retained by the originator, must attract 1250% risk weights or be deducted from CET 1. Only then, the desired objective of transferring significant risks of unexpected losses, will be achieved.

Further, as pointed out earlier in the note, there is a clear conflict in the conditions laid down in the para 16 and that in the first loss test in para 79, which must be resolved.

Comparison on Draft Framework for sale of loans with existing guidelines and task force recommendations

On 8th June, 2020, RBI issued the Draft Comprehensive Framework for Sale of loan exposures for public comments. This draft framework has brought about major changes in the regulatory framework governing direct assignment. One of the major changes is that the framework has removed MRR requirements in case of DA transactions. The framework covers both Sale of Standard Assets as well as stressed assets in separate chapter. We shall be coming up with a separate detailed analysis of sale of stressed assets under the draft framework.
In continuation of our earlier brief write-up titled Originated to transfer – new RBI regime on loan sales permits risk transfer, here we bring a point by point comparative along with our comments on the changes. Further, we have covered the Draft Directions on sale of loans in a Presentation on Draft Directions Sale of Loans.

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Webinar on Securitisation and sale of standard assets: The evolving regulatory regime

2 hours of talk and discussion on

12th June, 2020, from 11.30 to 13.30 hrs


Vinod Kothari

See details here –

Comparison of the Draft Securitisation Framework with existing guidelines and committee recommendations

On 8th June, 2020, RBI issued the Draft Framework for Securitisation of Standard Assets for public comments. This draft Framework has brought about major changes in the regulatory framework governing securitisation. This framework on one hand, brings with itself a few new concepts to securitisation and alters the existing framework on the other. The capital requirements are aligned with that of Basel framework for securitisation, besides the minimum quantitative threshold. We have come up with a detailed analysis of capital requirements under the draft framework in another write up titled ‘Inherent inconsistencies in quantitative conditions for capital relief‘.
In continuation of our earlier brief write-up titled New regime for securitisation and sale of financial assets, here we bring a point by point comparative along with our comments on the changes. Further, we have covered the Draft Directions on securitisation in a Presentation on Draft Directions on Securitisation of Standard Assets. 

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Originated to transfer- new RBI regime on loan sales permits risk transfers

Team, Vinod Kothari Consultants P. Ltd.

Major changes have been proposed by the RBI in the regime on what has become a major part of the business model of NBFCs and MFIs in the country – direct assignments (DAs). We have separately dealt with the Draft Directions on Securitisation of Standard Assets in a write up titled “New regime for securitisation and sale of financial assets

The term DA is so very typical of the Indian scene – globally, the practice of loan trading, loan sales or so-called whole-loan transfers has largely been out of the regulatory domain. However, in India, the motivation to shift from securitisation to DAs were partly the RBI Guidelines of 2006 which regulated securitisation but did not regulate DAs, and partly, the tax issues on securitisation that began prominent around 2011-12 or so. However, the DA model has, over the years, been a sizeable part of securitisation volumes in India, and is the mainstay of transfer of priority-sector loans from NBFCs to banks. Now that NBFCs have been permitted a major push for MSE lending by several GoI schemes, NBFCs are eagerly looking for another round of DA drive, and therefore, it is important to see whether the proposed regulatory regime for loan sales will facilitate NBFC-originated loans to end up on the books of banks and other investors.

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New regime for securitisation and sale of financial assets

Team, Vinod Kothari Consultants

On Monday, 8th June, 2020, the RBI released, for public comments, two separate draft guidelines, one for securitisation of standard assets, and the other for sale of loans. Once implemented, these guidelines will replace the existing regulatory framework that has stood ground, in case of securitisation for the last 14 years, and 8 years in case of direct assignment. We have separately dealt with the Draft Directions on Securitisation of Standard Assets in a write up titled “Originated to transfer- new RBI regime on loan sales permits risk transfers

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US Federal Reserve provides support to senior ABS securities

Timothy Lopes, Executive, Vinod Kothari Consultants

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

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

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

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Australia’s unique Structured Finance Support Fund (SFSF)

– A $15 billion stimulus package for securitisation transactions

Timothy Lopes, Executive, Vinod Kothari Consultants


COVID-19 has pushed the global economy into recession. Many countries have made several policy reforms to address and mitigate the impact of the pandemic. Several countries have provided ‘moratorium’, ‘loan modification’ or ‘forbearance’ on scheduled loan obligations of borrowers.

There is no doubt that this deferment of payment by borrowers of principal and interest cause by moratorium in several countries, will have an impact on the cash flows in securitisation transactions.

Australia is one of the major economies that has provided relief to borrowers in the form of a six month moratorium for small business. Due to the relief provided, the country has also recognized the need for providing support to securitisation transactions which will be affected by the moratorium and has enacted a new legislation, thereby constituting a fund for structured finance.

In this write up we discuss the details of this seemingly new and innovative support mechanism for securitisation transactions.

Moratorium on loans in Australia

The Australian Banking Association (ABA)[1] has provided a moratorium package which extends to all small business loans as well as mortgages. There will be deferment of principal as well as interest for a period of six months. Interest will continue to be accrued, it can then be paid off over the life of the loan once repayments begin again, or the length of the loan can be extended.

In order to be eligible for the same, one must have less than $10 million total debt to all credit providers and needs to be current, and not in arrears as of 1 January 2020.

The Australian Structured Finance Support Fund (SFSF)

On 24th March, 2020, Australia enacted a new law called the Structured Finance Support (Coronavirus Economic Response Package) Act 2020[2] (‘Act’). The Act was supported with the Structured Finance Support (Coronavirus Economic Response Package) Rules 2020[3] (‘Rules’) as well as the Structured Finance Support (Coronavirus Economic Response Package) (Delegation) Direction 2020[4] (‘Delegation’).

The move was part of an announcement made by the Australian Government in this regard to provide continued access to funding markets for small and medium enterprises (SMEs) impacted by the economic effects of the Coronavirus, and to mitigate impacts on competition in consumer and business lending markets.

Pursuant to the Act, a Structured Finance Support Fund has been established with an initial corpus of A$15 billion. The said fund is managed by the Australian Office of Financial Management (AOFM)[5].

Purpose of the Fund

The fund is set up with the purpose of making investment in RMBS, ABS and warehousing facilities to compensate for cashflows deferred as a result of COVID-19 hardship payment holidays being granted to borrowers.

The idea is to invest in securities issued by SPVs who wish to be compensated for the missed interest component of scheduled payments not received from the borrower as a result of the payment holiday granted due to the impact of COVID-19.

This will provide a source of liquidity to securitisation transactions to mitigate the impact of non-payment of interest on account of the moratorium.

Inner mechanics of the fund

Eligible lenders who can access the fund are the following –

  1. A non-ADI lender, (regardless of size); or
  2. An ADI (Authorised Deposit-taking Institution) that does not have the capacity to provide the collateral that is acceptable to the Reserve Bank of Australia (RBA) under a term funding facility (and is not a subsidiary of another ADI that does have access to such a facility).

Authorised Debt Securities –

As per the Act, the fund is permitted to invest in only in ‘authorised debt securities’. As per Section 12 of the Act, –

An authorised debt security is a debt security that:

  • is issued by:
  • a trustee of a trust; or
  • a body corporate that is a special purpose vehicle; and
  • is expressed in Australian dollars; and
  • relates to one or more amounts of credit; and
  • complies with the requirements or restrictions (if any) prescribed by the rules.

The Rules go on to prescribe that for the purpose of Section 12, an authorised debt security must not be a first loss security.

Thus, we are looking at investments made by the fund in the senior most securities issued by an SPV or other securities, which must not be a first loss security.

Investment priority/ decision making –

The Delegation issued, sets out the investment strategies/policies, decision-making criteria and appetite for risk and return for the SFSF. These are designed to assist the fund to prioritise between investments.

As per the Delegation, priority must be given to investments which provide support to smaller lenders.

Setting up a “Forbearance” SPV

The Australian Securitisation Forum (ASF) and AOFM are developing a structure that will enable the SFSF to invest in new senior ranking debt securities issued by a newly constituted “Forbearance” SPV.

That SPV will then advance funds to securitisation trusts and warehouses who wish to draw liquidity advances to compensate for the missed interest component of scheduled payments not received as a result of the borrower being granted a payment holiday or moratorium due to the impact of COVID-19.

The plan of the ASF is to appoint legal counsel to develop a detailed term sheet to describe how an industry wide “Forbearance” SPV can operate subject to the terms of the SFSF legislation and the operational guidelines of the SFSF.  Once established eligible issuers and lenders can be registered to access the “Forbearance” SPV.  It is expected that eligible participants will need to subscribe for junior notes in the “Forbearance” SPV in proportion to their participation and these notes will not cross collateralise the obligations of the other participants.

The ASF expects that the “Forbearance” SPV will appoint an independent party to verify the transfer of eligible COVID-19 receivables to the SPV and reconcile drawdowns and repayments under the liquidity facility, amongst other things.

This is an innovative structure which would identify lenders in need, particularly small lenders and provide the required liquidity by advancing funds to compensate for the impact of the moratorium.


The structured finance industry world over is seen to impacted by payment holidays provided. While in most cases, there would have to be modification in the pay-outs of the securitisation transaction, Australia has recognised the need to support securitisation structures by setting up a Fund with a seemingly large corpus to deal with the issue of moratorium.

So far, the SFSF has announced two investments to date, the first in Firstmac’s 2019-1 RMBS and the second in a Judo Bank warehouse facility. This move along with several other policy measures taken by the Reserve Bank of Australia can only help mitigate the impact of COVID-19 on securitisation structures.






Global Securitisation – Are we heading into a coronavirus credit crisis?

Timothy Lopes, Executive, Vinod Kothari Consultants

The global financial credit crisis of 2007-08 was a result of severe financial distress arising out of high level of sub-prime mortgage lending. Top Credit Rating Agencies (CRA) downgraded majority securitization transactions, slashing ‘AAA’ ratings to ‘Junk’.

Sub-prime borrowers could not repay, lenders were weary of lending further, investors investments in Mortgage Backed Securities (MBS) were stagnant and not reaping any return.

All these factors led to one of the worst financial crisis that affected global economies and not just the US alone. Recovering from such a crisis takes ample amount of time and efforts in the form of policy measures and financial stimulus / bail out packages of the government.

The rapid spread and depth of Coronavirus (COVID-19) outbreak has had severe impact across the globe in a matter of months. Stock markets are witnessing a global sell off. Countries have imposed complete lockdowns countrywide in order to mitigate the impact of this pandemic. Securitisation volumes are likely to witness a drop in light of the pandemic.

Daily, the situation only seems to be getting worse due to the unprecedented outbreak of COVID-19 and its rapid spread. There is absolutely no doubt that the impact on the financial sector and on economies worldwide is / will be a negative one.

As stated by the RBI Governor, in his nationwide address on 27th March, 2020 –

“The outlook is now heavily contingent upon the intensity, spread and duration of the pandemic. There is a rising probability that large parts of the global economy will slip into recession”

The question here is, “Are we headed for another global financial crisis?” We try to analyse this question in this write up, in light of the present scenario.

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