UPDATE: No GST input if supplier doesn’t upload details of output: GST Council amends CGST rules to curb ineligible credit availing

-Rahul Maharshi

(rahul@vinodkothari.com) (finserv@vinodkothari.com)

The GST council in its 37th Meeting held on 20th September, 2019, had proposed to make amendments in the CGST Rules, 2017 (“Rules”) pertaining to matters relating to the extension of due date of filing of GSTR-3B GSTR-1 as well as voluntary requirement of filing of GST Annual return for registered person whose aggregate turnover is less than Rs. 2 crores.

One of the major amendment proposed was to restrict the claiming of input tax credit by the recipient, in case of mismatch in details uploaded by the supplier, to the extent of 20% over and above the value of uploaded details by the supplier.

The above proposed amendment has been brought into force through notification 49/2019- Central Tax   [1] whereby the input credit availed by a registered person, the details of which have not been uploaded by the suppliers vide GSTR-1, the same should not exceed 20% of the eligible credit that has been uploaded by the suppliers.

As per the insertion in the CGST rules, 2017, viz. sub-rule (4) of rule 36:

“(4) Input tax credit to be availed by a registered person in respect of invoices or debit notes, the details of which have not been uploaded by the suppliers under sub-section (1) of section 37, shall not exceed 20 per cent. of the eligible credit available in respect of invoices or debit notes the details of which have been uploaded by the suppliers under sub-section (1) of section 37.”

For example, as per the books of the recipient, there is an input tax credit of Rs. 5,000 for a particular month from a particular supplier against 5 tax invoices having the GST component of Rs. 1,000 each.  Post the amendment, the following scenarios shall arise:

Case-1: In case the supplier has uploaded all 5 invoices:

In case the supplier has duly uploaded the details of all the 5 invoices through filing the GSTR-1 for the particular month, the auto-populated GSTR-2A will have the details of all such invoices and accordingly the recipient will be eligible to claim the input tax credit of all 5 invoices

Case-2: In case the supplier has uploaded 3 invoices:

In case the supplier has uploaded less than 5 invoices, i.e. 3 invoices having GST component of Rs. 3,000, the recipient will be eligible to claim input tax credit at a maximum of Rs. 3,600 (viz. 3,000+20% of 3,000= 3,600).

Case-3: In case the supplier has not uploaded any invoice:

In case the supplier has not uploaded any invoice in the GSTR-1 of the respective month, the recipient will not be eligible to claim the input tax credit in that particular month. However, the recipient may claim the input as soon as the supplier uploads the details in the GSTR-1 and corresponding details reflect in the auto-populated GSTR-2A.

As a result of the said amendment, the recipient will be required to monitor the duly uploading of the invoices by the supplier in a more stringent manner, since omission of the same will result in reduction in claiming of input tax credit by the recipient.

Also, an important point of concern will be the change in accounting of the input tax credit in the books of the recipient. The excess claim over 20% of the eligible input tax credit will require allocation against the invoices of which the input tax credit would pertain to.

Continuing the above example viz. Case 2, where the supplier has uploaded 3 invoices, how will the recipient allocate the said portion of 20% viz. Rs. 600 if the recipient claims input tax credit at the excess of 20%. The recipient has to allocate the said amount against portion of particular invoices.

The above move may be seen as a way to monitor the claiming of inputs by the recipients as well as a check on the supplier for uploading the returns on a regular basis. However, there are pertinent issues which require further clarification from the department.

 

[1] http://www.cbic.gov.in/resources//htdocs-cbec/gst/notfctn-49-central-tax-english-2019.pdf;jsessionid=15BA096E92769114F368D806E28B8FF5

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.

 

Partial Credit Guarantee Scheme

A Business Conclave on  “Partial Credit Guarantee Scheme” was organised by Indian Securitisation Foundation jointly with Edelweiss on September 16,2019 in Mumbai.

On this occasion, the presentation used by Mr. Vinod Kothari is being given here:

http://vinodkothari.com/wp-content/uploads/2019/09/partial-credit-enhancement-scheme-.pdf

 

We have authored few articles on the topic that one might want to give a read. The links to such related articles are provided below:

Introduction of Digital KYC

Anita Baid (anita@vinodkothari.com)

The guidelines relating to KYC has been in headlines for quite some time now. Pursuant to the several amendments in the regulations, the KYC process of using Aadhaar through offline modes was resumed for fintech companies. The amendments in the KYC Master Directions[1] allowed verification of customers by offline modes and permitted NBFCs to take Aadhaar for verifying the identity of customers if provided voluntarily by them, after complying with the conditions of privacy to ensure that the interests of the customers are safeguarded.

Several amendments were made in the Prevention of Money laundering (Maintenance of Records) Rules, 2005, vide the notification of Prevention of Money laundering (Maintenance of Records) Amendment Rules, 20191 issued on February 13, 2019[2] (‘February Notification’) so as to allow use of Aadhaar as a proof of identity, however, in a manner that protected the private and confidential information of the borrowers.

The February Notification recognised proof of possession of Aadhaar number as an ‘officially valid document’. Further, it stated that whoever submits “proof of possession of Aadhaar number” as an officially valid document, has to do it in such a form as are issued by the Authority. However, the concern for most of the fintech companies lending through online mode was that the regulations did not specify acceptance of KYC documents electronically. This has been addressed by the recent notification on Prevention of Money-laundering (Maintenance of Records) Third Amendment Rules, 2019 issued on August 19, 2019[3] (“August Notification”).

Digital KYC Process

The August Notification has defined the term digital KYC as follows:

“digitial KYC” means the capturing live photo of the client and officially valid document or the proof of possession of Aadhaar, where offline verification cannot be carried out, along with the latitude and longitude of the location where such live photo is being taken by an authorised officer of the reporting entity as per the provisions contained in the Act;

Accordingly, fintech companies will be able to carry out the KYC of its customers via digital mode.

The detailed procedure for undertaking the digital KYC has also been laid down. The Digital KYC Process is a facility that will allow the reporting entities to undertake the KYC of customers via an authenticated application, specifically developed for this purpose (‘Application’). The access of the Application shall be controlled by the reporting entities and it should be ensured that the same is used only by authorized persons. To carry out the KYC, either the customer, along with its original OVD, will have to visit the location of the authorized official or vice-versa. Further, live photograph of the client will be taken by the authorized officer and the same photograph will be embedded in the Customer Application Form (CAF).

Further, the system Application shall have to enable the following features:

  1. It shall be able to put a water-mark in readable form having CAF number, GPS coordinates, authorized official’s name, unique employee Code (assigned by Reporting Entities) and Date (DD:MM:YYYY) and time stamp (HH:MM:SS) on the captured live photograph of the client;
  2. It shall have the feature that only live photograph of the client is captured and no printed or video-graphed photograph of the client is captured.

The live photograph of the original OVD or proof of possession of Aadhaar where offline verification cannot be carried out (placed horizontally), shall also be captured vertically from above and water-marking in readable form as mentioned above shall be done.

Further, in those documents where Quick Response (QR) code is available, such details can be auto-populated by scanning the QR code instead of manual filing the details. For example, in case of physical Aadhaar/e-Aadhaar downloaded from UIDAI where QR code is available, the details like name, gender, date of birth and address can be auto-populated by scanning the QR available on Aadhaar/e-Aadhaar.

Upon completion of the process, a One Time Password (OTP) message containing the text that ‘Please verify the details filled in form before sharing OTP’ shall be sent to client’s own mobile number. Upon successful validation of the OTP, it will be treated as client signature on CAF.

For the Digital KYC Process, it will be the responsibility of the authorized officer to check and verify that:-

  1. information available in the picture of document is matching with the information entered by authorized officer in CAF;
  2. live photograph of the client matches with the photo available in the document; and
  3. all of the necessary details in CAF including mandatory field are filled properly.

Electronic Documents

The most interesting amendment in the August Notification is the concept of “equivalent e-document”. This means an electronic equivalent of a document, issued by the issuing authority of such document with its valid digital signature including documents issued to the digital locker account of the client as per rule 9 of the Information Technology (Preservation and Retention of Information by Intermediaries Providing Digital Locker Facilities) Rules, 2016 shall be recognized as a KYC document. Provided that the digital signature will have to be verified by the reporting entity as per the provisions of the Information Technology Act, 2000.

The aforesaid amendment will facilitate a hassle free and convenient option for the customers to submit their KYC documents. The customer will be able to submit its KYC documents in electronic form stored in his/her digital locker account.

Further, pursuant to this amendment, at several places where Permanent Account Number (PAN) was required to be submitted mandatorily has now been replaced with the option to either submit PAN or equivalent e-document.

Submission of Aadhaar

With the substitution in rule 9, an individual will now have the following three option for submission of Aadhaar details:

  • the Aadhaar number where,
    1. he is desirous of receiving any benefit or subsidy under any scheme notified under section 7 of the Aadhaar (Targeted Delivery of Financial and Other subsidies, Benefits and Services) Act, 2016 or
    2. he decides to submit his Aadhaar number voluntarily
  • the proof of possession of Aadhaar number where offline verification can be carried out; or
  • the proof of possession of Aadhaar number where offline verification cannot be carried out or any officially valid document or the equivalent e-document thereof containing the details of his identity and address;

Further, along with any of the aforesaid options the following shall also be submitted:

  1. the Permanent Account Number or the equivalent e-document thereof or Form No. 60 as defined in Income-tax Rules, 1962; and
  2. such other documents including in respect of the nature of business and financial status of the client, or the equivalent e-documents thereof as may be required by the reporting entity

The KYC Master Directions were amended on the basis in the February Notification. As per the amendments proposed at that time, banking companies were allowed to verify the identity of the customers by authentication under the Aadhaar Act or by offline verification or by use of passport or any other officially valid documents. Further distinguishing the access, it permitted only banks to authenticate identities using Aadhaar. Other reporting entities, like NBFCs, were permitted to use the offline tools for verifying the identity of customers provided they comply with the prescribed standards of privacy and security.

The August Notification has now specified the following options:

  1. For a banking company, where the client submits his Aadhaar number, authentication of the client’s Aadhaar number shall be carried out using e-KYC authentication facility provided by the Unique Identification Authority of India;
  2. For all reporting entities,
    1. where proof of possession of Aadhaar is submitted and where offline verification can be carried out, the reporting entity shall carry out offline verification;
    2. where an equivalent e-document of any officially valid document is submitted, the reporting entity shall verify the digital signature as per the provisions of the IT Act and take a live photo
    3. any officially valid document or proof of possession of Aadhaar number is submitted and where offline verification cannot be carried out, the reporting entity shall carry out verification through digital KYC, as per the prescribed Digital KYC Process

It is also expected that the RBI shall notify for a class of reporting entity a period, beyond which instead of carrying out digital KYC, the reporting entity pertaining to such class may obtain a certified copy of the proof of possession of Aadhaar number or the officially valid document and a recent photograph where an equivalent e-document is not submitted.

The August Notification has also laid emphasis on the fact that certified copy of the KYC documents have to be obtained. This means the reporting entity shall have to compare the copy of the proof of possession of Aadhaar number where offline verification cannot be carried out or officially valid document so produced by the client with the original and record the same on the copy by the authorised officer of the reporting entity. Henceforth, this verification can also be carried out by way of Digital KYC Process.


[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11566#F4

[2] http://egazette.nic.in/WriteReadData/2019/197650.pdf

[3] http://egazette.nic.in/WriteReadData/2019/210818.pdf

Injeti Srinivas’s Committee: Changes recommended in provisions of Corporate Social Responsibility

Government credit enhancement for NBFC pools: A Guide to Rating agencies

Vinod Kothari Consultants P Ltd (finserv@vinodkothari.com)

 

The partial credit enhancement (PCE) Scheme of the Government[1], for purchase by public sector banks (PSBs) of NBFC/HFC pools, has been discussed in our earlier write-ups, which can be viewed here and here.

This document briefly puts the potential approach of the rating agencies for rating of the pools for the purpose of qualifying for the Scheme.

Brief nature of the transaction:

  • The transaction may be summarised as transfer of a pool to a PSB, wherein the NBFC retains a subordinated piece, such that the senior piece held by the PSB gets a AA rating. Thus, within the common pool of assets, there is a senior/junior structure, with the NBFC retaining the junior tranche.
  • The transaction is a structured finance transaction, by way of credit-enhanced, bilateral assignment. It is quite similar to a securitisation transaction, minus the presence of SPVs or issuance of any “securities”.
  • The NBFC will continue to be servicer, and will continue to charge servicing fees as agreed.
  • The objective to reach a AA rating of the pool/portion of the pool that is sold to the PSB.
  • Hence, the principles for sizing of credit enhancement, counterparty (servicer) risk, etc. should be the same as in case of securitisation.
  • The coupon rate for the senior tranche may be mutually negotiated. Given the fact that after 2 years, the GoI guarantee will be removed, the parties may agree for a stepped-up rate if the pool continues after 2 years. Obviously, the extent of subordinated share held by the NBFC will have to be increased substantially, to provide increased comfort to the PSB. Excess spread, that is, the excess of actual interest earned over the servicing fees and the coupon may be released to the seller.
  • The payout of the principal/interest to the two tranches (senior and junior), and utilisation of the excess spread, etc. may be worked out so as to meet the rating objective, provide for stepped-up level of enhancement, and yet maintain the economic viability of the transaction.
  • Bankruptcy remoteness is easier in the present case, as pool is sold from the NBFC to the PSB, by way of a non-recourse transfer. Of course, there should be no retention of buyback option, etc., or other factors that vitiate a true sale.
  • Technically, there is no need for a trustee. However, whether the parties need to keep a third party for ensuring surveillance over the transaction, in form of a monitoring agency, may be decided between the parties.

Brief characteristics of the Pool

  • For any meaningful statistical analysis, the pool should be a homogenous pool.
  • Surely, the pool is a static pool.
  • The pool has attained seasoning, as the loans must have been originated by 31st March, 2019.
  • In our view, pools having short maturities (say personal loans, short-term loans, etc.) will not be suitable for the transaction, since the guarantee and the guarantee fee are on annually declining basis.

Data requirement

The data required for the analysis will be same as data required for securitisation of a static pool.

Documentation

  • Between the NBFC and the PSB, there will be standard assignment documentation.
  • Between the Bank and the GoI:
    • Declaration that requirements of Chapter 11 of the GFR have been satisfied.
    • Guarantee documentation as per format given by GOI

[1] http://pib.gov.in/newsite/PrintRelease.aspx?relid=192618

Other Related Articles :

Government Credit enhancement scheme for NBFC Pools: A win-win for all

Vinod Kothari (vinod@vinodkothari.com)

The so-called partial credit enhancement (PCE) for purchase of NBFC/HFC pools by public sector banks (PSBs) may, if meaningfully implemented, be a win-win for all. The three primary players in the PCE scheme are NBFCs/HFCs (let us collectively called them Originators), the purchasing PSBs, and the Government of India (GoI). The Scheme has the potential to infuse liquidity into NBFCs while at the same time giving them advantage in terms of financing costs, allow PSBs to earn spreads while enjoying the benefit of sovereign guarantee, and allow the GoI to earn a spread of 25 bps virtually carrying no risks at all. This brief write-ups seeks to make this point.

The details of the Scheme with our elaborate questions and answers have been provided elsewhere.

Modus operandi

Broadly, the way we envisage the Scheme working is as follows:

  1. An Originator assimilates a pool of loans, and does tranching/credit enhancements to bring a senior tranche to a level of AA rating. Usually, tranching is associated with securitisation, but there is no reason why tranching cannot be done in case of bilateral transactions such as the one envisaged here. The most common form of tranching is subordination. Other structured finance devices such as turbo amortisation, sequential payment structure, provisions for redirecting the excess spread to pay off the principal on senior tranche, etc., may be deployed as required.
  2. Thus, say, on a pool of Rs 100 crores, the NBFC does so much subordination by way of a junior tranche as to bring the senior tranche to a AA level. The size of subordination may be worked, crudely, by X (usually 3 to 4) multiples of expected losses, or by a proper probability distribution model so as to bring the confidence level of the size of subordination being enough to absorb losses to acceptable AA probability of default. For instance, let us think of this level amounting to 8% (this percentage, needless to say, will depend on the expected losses of respective pools).
  3. Thus, the NBFC sells the pool of Rs 100 crores to PSB, retaining a subordinated 8% share in the same. Bankruptcy remoteness is achieved by true sale of the entire Rs 100 crore pool, with a subordinated share of 8% therein. In bilateral transactions, there is no need to use a trustee; to the extent of the Originator’s subordinated share, the PSB is deemed to be holding the assets in trust for the Originator. Simultaneously, the Originator also retains excess spread over the agreed Coupon Rate with the bank (as discussed below).
  4. Assuming that the fair value (computation of fair value will largely a no-brainer, as the PSB retains principal, and interest only to the extent of its agreed coupon, with the excess spread flowing back to the Originator) comes to the same as the participation of the PSB – 92% or Rs 92 crores, the PSB pays the same to the Originator.
  5. PSB now goes to the GoI and gets the purchase guaranteed by the latter. So, the GoI has guaranteed a purchase of Rs 92 crores, taking a first loss risk of 10% therein, that is, upto Rs 9.20 crores. Notably, for the pool as a whole, the GoI’s share of Rs 9.20 crores becomes a second loss position. However, considering that the GoI is guaranteeing the PSB, the support may technically be called first loss support, with the Originator-level support of Rs 10 crores being separate and independent.
  6. However, it is clear that the sharing of risks between the 3 – the Originator, the GoI and the Bank will be as follows:
  • Losses upto first Rs 8 crores will be taken out of the NBFC’s first loss piece, thereby, implying no risk transfer at all.
  • Losses in excess of Rs 8 crores, but upto a total of Rs 17.20 crores (the GoI guarantee is limited to Rs 9.20 crores), will be taken by GoI.
  • It is only when the loss exceeds Rs 17.20 crores that there is a question of the PSB being hit by losses.
  1. Thus, during the period of the guarantee, the PSB is protected to the extent of 17.2%. Note that first loss piece at the Originator level has been sized up to attain a AA rating. That will mean, higher the risk of the pool, the first loss piece at Originator level will go up to protect the bank.
  2. The PSB, therefore, has dual protection – to the extent of AA rating, from the Originator (or a third party with/without the Originator, as we discuss below), and for the next 10%, from the sovereign.
  3. Now comes the critical question – what will be the coupon rates that the PSB may expect on the pool.
    1. The pool effectively has a sovereign protection. While the protection may seem partial, but it is a tranched protection, and for a AA-rated pool, a 10% thickness of first loss protection is actually far higher than required for the highest degree of safety. What makes the protection even stronger is that the size of the guarantee is fixed at the start of the transaction or start of the financial year, even though the pool continues to amortise, thereby increasing the effective thickness.
    2. Assume risk free rate is R, and the spreads for AAA rated ABS are R +100 bps. Assume that the spreads for AA-rated ABS is R+150 bps.
    3. Given the sovereign protection, the PSB should be able to price the transaction certainly at less than R +100 bps, because sovereign guarantee is certainly safer than AAA. In fact, it should effectively move close to R, but given the other pool risks (prepayment risks, irregular cashflows), one may expect pricing above R.
    4. For the NBFC, the actual cost is the coupon expected by the PSB, plus 25bps paid for the guarantee.
    5. So as long as the coupon rate of the pool for the NBFC is lower than R+75 bps, it is an advantage over a AAA ABS placement. It is to be noted that the NBFC is actually exposing regulatory and economic capital only for the upto-AA risk that it holds.

Win-win for all

If the structure works as above, it is a win-win for all:

  • For the GoI, it is a neat income of 25 bps while virtually taking no real risks. There are 2 strong reasons for this – first, there is a first loss protection by the Originator, to qualify the pool for a AA rating. Secondly, the guarantee is limited only for 2 years. For any pool, first of all, the probability of losses breaching a AA-barrier itself will be close to 1% (meaning, 99% of the cases, the credit support at AA level will be sufficient). This becomes even more emphatic, if we consider the fact that the guarantee will be removed after 2 years. The losses may pile up above the Originator’s protection, but very unlikely that this will happen over 2 years.
  • For the PSB, while getting the benefit of a sovereign guarantee, and therefore, effectively, investing in something which is better than AAA, the PSB may target a spread close to AAA.
  • For the NBFC, it is getting a net advantage in terms of funding cost. Even if the pricing moves close to AAA ABS spreads, the NBFC stands to gain as the regulatory capital eaten up is only what is required for a AA-support.

The overall benefits for the system are immense. There is release of liquidity from the banking system to the economy. Depending on the type of pools Originators will be selling, there may be asset creation in form of home loans, or working capital loans (LAP loans may effectively be that), or loans for transport vehicles. If the GoI objective of buying pools upto Rs 100000 crores gets materialised, as much funding moves from banks to NBFCs, which is obviously already deployed in form of assets. The GoI makes an income of Rs 250 crores for effectively no risk.

In fact, if the GoI gains experience with the Scheme, there may be very good reason for lowering the rating threshold to A level, particularly in case of home loans.

Capital treatment, rating methodologies and other preparations

To make the Scheme really achieve its objectives, there are several preparations that may have to come soon enough:

  • Rating agencies have to develop methodologies for rating this bilateral pool transfer. Effectively, this is nothing but a structured pool transfer, akin to securitisation. Hence, rating methodologies used for securitisation may either be applied as they are, or tweaked to apply to the transfers under the Scheme.
  • Very importantly, the RBI may have to clarify that the AA risk retention by Originators under the Scheme will lead to regulatory capital requirement only upto the risk retained by the NBFC. This should be quite easy for the RBI to do – because there are guidelines for securitisation already, and the Scheme has all features of securitisation, minus the fact that there is no SPV or issuance of “securities” as such.

Conclusion

Whoever takes the first transaction to market will have to obviously do a lot of educating – PSBs, rating agencies, law firms, SIDBI, and of course, DFS. However, the exercise is worth it, and it may not take 6 months as envisaged for the GoI to reach the target of Rs 1 lakh crores.


Other related articles:

GOI’s attempt to ease out liquidity stress of NBFCs and HFCs: Ministry of Finance launches Scheme for Partial Credit Guarantee to PSBs for acquisition of financial assets

Abhirup Ghosh  (abhirup@vinodkothari.com)

The Finance Minister, during the Union Budget 2019-20, promised to introduce a partial credit guarantee scheme so as to extend relief to the NBFC during the on-going liquidity crisis. The proposal laid down in the budget was a very broad statement and were subject to several speculations. At last on 13th August, 2019[1], the Ministry of Finance came out with a press release to announce the notification in this regard dated 10th August, 2019, laying down specifics of the scheme.

The scheme will be known by “Partial Credit Guarantee offered by Government of India (GoI) to Public Sector Banks (PSBs) for purchasing high-rated pooled assets from financially sound Non-Banking Financial Companies (NBFCs)/Housing Finance Companies (HFCs)”, however, for the purpose of this write-up we will use the word “Scheme” for reference.

The Scheme is intended to address temporary asset liability mismatch of solvent HFCs/ NBFCs, owing to the ongoing liquidity crisis in the non-banking financial sector, without having to resort to distress sale of their assets.

In this regard, we intend to discuss the various requirements under the Scheme and analyse its probable impact on the financial sector.

Applicability:

The Scheme has been notified with effect from 10th August, 2019 and will remain open for 6 months from or until the period by which the maximum commitment by the Government in the Scheme is fulfilled, whichever is earlier.

Under the Scheme, the Government has promised to extend first loss guarantee for purchase of assets by PSBs aggregating to ₹ 1 lakh crore. The Government will provide first loss guarantee of 10% of the assets purchased by the purchasing bank.

The Scheme is applicable for assignment of assets in the course of direct assignment to PSBs only. It is not applicable on securitisation transactions.

Also, as we know that in case of direct assignment transactions, the originators are required to retain a certain portion of the asset for the purpose of minimum retention requirement; this Scheme however, applies only to the purchasing bank’s share of assets and not on the originators retained portion. Therefore, if due to default, the originator incurs any losses, the same will not be compensated by virtue of this scheme.

Eligible sellers:

The Scheme lays down criteria to check the eligibility of sellers to avail benefits under this Scheme, and the same are follows:

  1. NBFCs registered with the RBI, except Micro Financial Institutions or Core Investment Companies.
  2. HFCs registered with the NHB.
  3. The NBFC/ HFC must have been able to maintain the minimum regulatory capital as on 31st March, 2019, that is –
    • For NBFCs – 15%
    • For HFCs – 12%
  4. The net NPA of the NBFC/HFC must not have exceeded 6% as on 31st March, 2019
  5. The NBFC/ HFC must have reported net profit in at least one out of the last two preceding financial years, that is, FY 2017-18 and FY 2018-19.
  6. The NBFC/ HFC must not have been reported as a Special Mention Account (SMA) by any bank during year prior to 1st August, 2018.

Some observations on the eligibility criteria are:

  1. Asset size of NBFCs for availing benefits under the Scheme: The Scheme does not provide for any asset size requirement for an NBFC to be qualified for this Scheme, however, one of the requirement is that the financial institution must have maintained the minimum regulatory capital requirement as on 31st March, 2019. Here it is important to note that requirement to maintain regulatory capital, that is capital risk adequacy ratio (CRAR), applies only to systemically important NBFCs.

Only those NBFCs whose asset size exceeds Rs. 500 crores singly or jointly with assets of other NBFCs in the group are treated as systemically important NBFCs. Therefore, it is safe to assume that the benefits under this Scheme can be availed only by those NBFCs which – a) are required to maintained CRAR, and b) have maintained the required amount of capital as on 31st March, 2019, subject to the fulfilment of other conditions.

  1. Financial health of originator after 1st August, 2018 – The eligibility criteria for sellers state that the financial institution must not have been reported as SMA by any bank any time during 1 year prior to 1st August, 2018, the apparent question that arises here is what happens if the originator moves into SMA status after the said date. If we go by the letters of the Scheme, if a financial institution satisfies the condition before 1st August, 2018 but becomes SMA thereafter, it will still be eligible as per the Scheme. This makes the situation a little awkward as the whole intention of the Scheme was to facilitate financially sound financial institutions. This seems to be an error on the part of the Government, and it surely must not have meant to situations such as the one discussed above. We can hopefully expect an amendment in this regard from the Government.

Eligible assets

Pool of assets satisfying the following conditions can be assigned under the Scheme:

  1. The asset must have been originated on or before 31st March, 2019.
  2. The asset must be classified as standard in the books of the NBFC/ HFC as on the date of the sale.
  3. The pool of assets should have a minimum rating of “AA” or equivalent at fair value without the credit guarantee from the Government.
  4. Each account under the pooled assets should have been fully disbursed and security charge should have been created in favour of the originating NBFCs/ HFCs.
  5. NBFCs/HFCs can sell up to a maximum of 20% of their standard assets as on 31.3.2019 subject to a cap of Rs. 5,000 crore at fair value. Any additional amount above the cap of Rs. 5,000 crore will be considered on pro ratabasis, subject to availability of headroom.
  6. The individual asset size in the pool must not exceed Rs. 5 crore.
  7. The following types of loans are not eligible for assignment for the purposes of this Scheme:
    1. Revolving credit facilities;
    2. Assets purchased from other entities; and
  • Assets with bullet repayment of both principal and interest

Our observations on the eligibility criteria are as follows:

  1. Rating of the pool: The Scheme states that the pools assigned should be highly rated, that is, should have ratings of AA or equivalent prior to the guarantee. Technically, pool of assets are not rated, it is the security which is rated based on the risks and rewards of the underlying pools. Therefore, it is to be seen how things will unfold. Also, desired rating in the present case is quite high; if an originator is able to secure such a high rating, it might not require the assistance under this Scheme in the first place. And, the fact that the originators will have to pay guarantee commission of 25 bps. Therefore, only where the originators are able to secure a significantly lower cost from the banks for a higher rating, that would also cover the commission paid, will this Scheme be viable; let alone be the challenges of achieving an AA rating of the pool.
  2. Cut-off date of loan origination to be 31st March, 2019: As per the RBI Guidelines on Securitisation and Direct Assignment, the originators have to comply with minimum holding requirements. The said requirement suggests that an asset can be sold off only if it has remained in the books of the originator for at least 6 months. This Scheme has come into force with effect from 10th August, 2019 and will remain open for 6 months from the commencement.

Considering that already 5 months since the cut-off date has already passed, even if we were to assume that the loan is originated on the cut-off date itself, it would mean that closer to the end of the tenure of the Scheme, the loan will be 11 months seasoning. Such high seasoning requirements might not be motivational enough for the originators to avail this Scheme.

  1. Maximum cap on sell down of receivables: The Scheme has put a maximum cap on the amount of assets that can be assigned and that is an amount equal to 20% of the outstanding standard assets as on 31st March, 2019, however, the same is capped to Rs. 5000 crores.

It is pertinent to note that the Scheme also allows additional sell down of loans by the originators, beyond the maximum cap, however, the same shall depend on the available headroom and based on decisions of the Government.

Invocation of guarantee and guarantee commission

Guarantee commission

As already stated earlier, in order to avail benefits under this Scheme, the originator will have to incur a fee of 25 basis points on the amount guaranteed by the Government. However, the payment of the same shall have to be routed through the purchasing bank.

Invocation of guarantee

The guarantee can be invoked any time during the first 24 months from the date of assignment, if the interest/ principal has remained overdue for a period of more than 90 days.

Consequent upon a default, the purchasing bank can invoke the guarantee and recover its entire exposure from the Government. It can continue to recover its losses from the Government, until the upper cap of 10% of the total portfolio is reached. However, the purchasing bank will not be able to recover the losses if – (a) the pooled assets are bought back by the concerned NBFCs/HFCs or (b) sold by the purchasing bank to other entities.

The claims of the purchasing bank will be settled with 5 working days from the date of claim by the Government.

However, if the purchasing bank, by any means, recovers the amount subsequent to the invocation of the guarantee, it will have to refund the amount recovered or the amount received against the guarantee to the Government within 5 working days from the date of recovery. Where the amount recovered is more than amount of received as guarantee, the excess collection will be retained by the purchasing bank.

Other features of the Scheme

  1. Reporting requirement – The Scheme provides for a real-time reporting mechanism for the purchasing banks to understand the remaining headroom for purchase of such pooled assets. The Department of Financial Services (DFS), Ministry of Finance would obtain the requisite information in a prescribed format from the PSBs and send a copy to the budget division of DEA, however, the manner and format of reporting has not been notified yet.
  2. Option to buy-back the loans – The Scheme allows the originator to retain an option to buy back its assets after a specified period of 12 months as a repurchase transaction, on a right of first refusal basis. This however, is contradictory to the RBI Guidelines on Direct Assignment, as the same does not allow any option to repurchase the pool in a DA transaction.
  3. To-do for the NBFCs/ HFCs – In order to avail the benefits under the Scheme, the following actionables have to be undertaken:
    1. The Asset Liability structure should restructured within three months to have positive ALM in each bucket for the first three months and on cumulative basis for the remaining period;
    2. At no time during the period for exercise of the option to buy back the assets, should the CRAR go below the regulatory minimum. The promoters shall have to ensure this by infusing equity, where required.

[1] http://pib.gov.in/newsite/PrintRelease.aspx?relid=192618

Other Related Articles:

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