The Rise of Stablecoins amidst Instability

-Megha Mittal

(mittal@vinodkothari.com

The past few years have witnessed an array of technological developments and innovations, especially in Fintech; and while the world focused on Bitcoins and other cryptos, a new entrant ‘Stablecoin’ slowly crept its way into the limelight. With the primary motive of shielding its users from the high volatility associated with cryptos, and promises of boosting cross-border payments and remittance, ‘Stablecoins’ emerged in 2018, and now have become the focal point of discussion of several international bodies including the Financial Standards Board (FSB), G20, Financial Action Task Force (FATF) and International Organization of Securities Commission (IOSCO).

Additionally, the widespread notion that the desperate need of cross-border payments and remittances during the ongoing COVID-crisis may prove to be a defining moment for stablecoins, has drawn all the more attention towards the need of establishing regulations and legal framework pertaining to Stablecoins.

In this article, we shall have an insight as to what Stablecoins, (Global Stable Coinss) are, its modality, its current status of acceptance by the international bodies, and how the ongoing COVID crisis, may act as a catalyst for its rise.

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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

finserv@vinodkothari.com

Background

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.

Conclusion

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.

[1] https://www.ausbanking.org.au/covid-19/the-business-relief-package/

[2] https://www.legislation.gov.au/Details/C2020A00027

[3] https://www.legislation.gov.au/Details/F2020L00309

[4] https://www.legislation.gov.au/Details/F2020N00034

[5] https://www.aofm.gov.au/

Asset classification standstill and other liquidity support measures- RBI Governor’s Statement of 17th April, 2020

Team Financial Services, Vinod Kothari Consultants P Ltd. 

finserv@vinodkothari.com 

[Published on April 17, 2020 and updated as on May 6, 2020]

The nationwide lockdown was imposed by the Government of India from March 25, 2020. Since then, the RBI has taken a number of steps to ensure normal business functioning by the entire banking sector. The first address by the RBI governor on March 27, 2020[1] introduced several measures to deal with the disruption including, grant of a three months moratorium on term loans and the infusion of liquidity by way of TLTRO scheme.

The RBI Governor’s address on April 17, 2020[2] is intended to introduce further measures to maintain adequate liquidity in the financial system, facilitate and incentivise bank credit flows and ease financial stress. Subsequently, the RBI has issued a Notification on the issue.

Below is an analysis of the second round of regulatory relief granted by the RBI. As for the moratorium on loan payments provided by the March 27 notification, we have covered the same at length- see write-up here

For the ease of reading we have divided the FAQs into broad categories. We shall keep on updating the FAQs based on the detailed guidelines and clarifications issued by RBI in this regard, from time to time.

Liquidity Measures

Targeted Long Term Operations (TLTRO) 2.0

1. What is TLTRO?

Targeted Long Term Repo Operations or TLTRO, is a variation of LTRO, launched by the RBI in order to manage the liquidity in the financial sector. The TLTRO is a much refined version of LTRO, through which the RBI attempts to extend liquidity in targeted segments, in this case, the NBFCs. TLTRO was introduced first time on February 27, 2020[3] by the RBI, where it had promised repo auctions worth Rs. 1 lakh crore. Until this press release, RBI has already conducted three repo auctions injecting a total Rs. 75,041 crores worth to ease liquidity constraints in the banking system and de-stress financial markets.

Our detailed write up on the subject can be read here.

2a. What are the avenues in which the funds availed by banks under TLTRO 2.0 can be invested?

As stated above, the main intention behind TLTRO is to inject liquidity in the financial system. As per the notification[4] issued by the RBI for TLTRO 2.0 the funds raised through TLTRO have to be invested in investment grade bonds, commercial paper, and non-convertible debentures of NBFCs. Further, the funds raised through these auctions have to be deployed within a maximum period of 1 month.

2b. What is the prescribed timeline for deployment of funds under the scheme?

Based on the feedback received from banks and taking into account the disruptions caused by COVID-19, the time available for deployment of funds under the TLTRO 2.0 scheme has been extended from 30 working days to 45 working days from the date of the operation.

2c. What happens if a bank fails to deploy the funds availed under the TLTRO 2.0 scheme in specified securities within the stipulated timeframe?

Funds that are not deployed within this extended time frame will be charged interest at the prevailing policy repo rate plus 200 bps for the number of days such funds remain un-deployed. The incremental interest liability will have to be paid along with regular interest at the time of maturity.

3a. Is there a minimum investment limit for small and medium NBFCs?

At least 50 per cent of the total amount availed must be invested in small and mid-sized NBFCs and MFIs.

3b. Will the specified eligible instruments have to be acquired up to fifty per cent from primary market issuances and the remaining fifty per cent from the secondary market?

There is no such condition applicable for funds availed under TLTRO 2.0.

4. What is the criteria to be classified as a small or medium sized NBFC?

Small NBFCs: NBFCs having an asset size of Rs. 500 crore or below

Medium sized NBFCs: NBFCs having asset size between Rs. 500 crores and Rs. 5,000 crores.

5. For the purpose of determining the aforesaid asset based criteria, the asset size shall be considered as on  which date?

The asset size shall be determined as per the latest audited balance sheet of the investee institution/company.

6. How will the 50% be appropriated among small NBFCs, medium NBFCs and NBFC MFIs?

The 50% shall be apportioned as given below:

  • 10% – securities/instruments issued by Micro Finance Institutions (MFIs);
  • 15% – securities/instruments issued by NBFCs with asset size of Rs.500 crore and below;
  • 25% – securities/instruments issued by NBFCs with assets size between Rs.500 crores and Rs.5,000 crores.

7. How will the asset size be determined for the purpose of the aforesaid limits?

The asset size shall be determined as per the latest audited balance sheet of the NBFC.

8. When will the first auction under TLTRO 2.0 be conducted?

The first auction under TLTRO 2.0 will be conducted on April 23, 2020. The auction window will open for a period of one hour from 10:30 am to 11:30 am.

9a. How will the Investments made by the banks, under this scheme be classified?

Investments made under this facility will be classified as held to maturity (HTM) even in excess of 25 percent of total investment permitted to be included in the HTM portfolio. Exposures under this facility will not be reckoned under the Large Exposure Framework (LEF).

9b. Will the specified securities acquired from TLTRO funds and kept in HTM category be included in computation of Adjusted Net Bank Credit (ANBC) for the purpose of determining priority sector targets/sub-targets?

In order to incentivise banks’ investment in the specified securities of these entities, it has been decided that a bank can exclude the face value of such securities kept in the HTM category from computation of adjusted non-food bank credit (ANBC) for the purpose of determining priority sector targets/sub-targets. This exemption is only applicable to the funds availed under TLTRO 2.0.

10. What is the maturity restriction on the securities to be acquired under the scheme?

As per the FAQs released by the RBI for TLTROs[5], there is no maturity restriction on the securities. However, the outstanding amount of securities purchased using the funds availed under TLTRO should not fall below the amount availed under TLTRO scheme. This implies that the securities purchased should be maintained in the bank’s HTM portfolio at all times till maturity of TLTR.

11. How can an NBFC apply to avail the benefit under the scheme?

The funds injected through these auctions are ultimately meant for the NBFCs. NBFCs intending to utilise the benefits of this scheme will have to apply to banks, participating in these auctions, with their proposal to subscribe to the permitted instruments issued by them.

Refinancing Facilities

12. From where can an NBFC avail the refinancing facility?

RBI has provided special refinance facilities for an amount of Rs. 15,000 crore to SIDBI for on-lending/refinancing.

13. Is there anything earmarked for HFCs?

Yes, the RBI has announced a special refinancing facility of Rs. 10000 crores for the National Housing Bank which will be used only to refinance the housing finance companies.

14a. What will be the lending rate for such a refinance facility?

Advances under this facility will be charged at the RBI’s policy repo rate at the time of availment.

14b. Can all NBFCs avail the finance under the Special Liquidity Support Scheme?

The Scheme has three segments, out of which, two segments are for NBFCs and one for SCBs and SFBs.

The first part of the Scheme is for NBFC-ICCs and the second part of the Scheme is for NBFC-MFIs. The eligibility criteria for these two categories of NBFCs have been discussed below:

  • NBFC-ICC or NBFC-MFI ( In case of MFIs, they may be registered as society, trust or section-8 company)
  • Carrying on the business of an NBFC for the past 3 years;
  • Minimum NOF- 20 crores;
  • Minimum Asset size- 50 crores;
  • Minimum investment grade rating (BBB- or above); In case of MFI, also have minimum MFI grading of “MfR5”
  • Compliance with all regulatory requirements;
  • NBFC/ any of its promoters must not be in RBI’s defaulter/blacklist list;
  • Statutory CRAR is maintained at all times during the past 24 months.

14c. For what purpose, the finance availed from such scheme can be used?

The funds availed can be used for on-lending to MSMEs by the NBFCs and microfinance borrowers by NBFC-MFIs.

14d. What will be the tenor of such facility?

The tenor for such facility shall be 90 days,with a bullet repaymentat the end. Usually, the loans to MSMEs are more than 90 days tenor, therefore, the question is – if the tenor of the loans extended by the NBFCs are more than 90 days, how will the funds obtained under this Scheme be refunded timely. The logical answer to this question is that the NBFCs will have to arrange for alternative financing sources during these 90 days and use the funds to repay the facility under this Scheme. Therefore, it seems that the intent is to provide a bridge funding facility to the NBFCs for the time being.

Further, SIDBI has vide circular dated April 24, 2020, extended the repayment period of loans to NBFCs and MFIs, to one year from the 90-day period.

14e. Whether such facility will be secured?

The nature of the loans shall be based on the existing norms of SIDBI.

14f. Is there any cap on processing fee?

The processing fee shall be 0.10 % of the sanctioned loan amount subject to a maximum of Rs. 5 lakhs (including GST).

14g. How can NBFCs apply to avail benefit of such scheme?

There is no prescribed procedure for making application to SIDBI for availing funds under such scheme. Eligible NBFCs may apply to SIDBI to avail funds from the scheme.

Regulatory Measures

Asset Classification

15. What is meant by asset classification standstill?

Asset classification standstill means there will be no movement, deterioration or upgradation, in the asset classification during a given period of time. In the given context, the ageing of the loan default, that is, the days past due (DPD) status, will remain on a standstill mode, as if the time clock has stopped running during the period of the moratorium.

Our detailed write up on the issue can be read here.

Our analysis of the Delhi HC and Bombay HC ruling in this regard may also be read here.

16. How to determine the qualifying loan accounts for relaxation under this circular?

All loan accounts for which lending institutions decide to grant moratorium or deferment, and which were standard as on March 1, 2020.

17. The loan moratorium notification came on 27th March. For many companies, the payment for March was, say, due on 5th March. Therefore, the moratorium was effectively granted only for the payments due on 5th April and 5th May. Does such NBFC still have the right to keep the NPA clock on hold for accounts which were in default on 1st March, 2020?

In our view, the moratorium period uniformly began for all financial institutions on 1st March and continues upto 31st May. The moratorium is the result of an external event – hence, it is not something which is based on entity-level payment schedules. That the borrowers have paid the instalments due on 5th March does not impact the moratorium – moratorium simply implies the customer has the option of not paying, but he has chosen to pay, that is his discretion.

Therefore, in this case in point, the NPA clock will still be on hold from 1st March to 31st May.

18. How will the asset classification be carried out?

As per the guidelines[6] provided by the RBI, the asset classification relaxation is provided only if the account was to move from standard to sub-standard category during the moratorium period from March 1, 2020 to May 31, 2020. However, if the account was within the NPA category already, the benefit of the relaxation will not be available.

Effectively the circular stalls the dip in the asset classification by 3 months.

19. To what installment dues does the relaxation apply?

The relaxation applies to:

  1. Dues payable between 1st March, 2020 and 31st May, 2020
  2. Dues payable before 1st March that are classified as standard as on 1st March
  3. Dues payable after 31st May, will be covered by the existing instructions with regard to NPA recognition unless the lender grants a voluntary relaxation in accordance with the RBI Guidelines

20. Does a standard loan account as on March 1, 2020 include SMA classified accounts?

In case of assets showing signs of distress as on March 1, 2020, such as SMA1 and SMA2, the relaxation will still be available since they are classified as standard assets.

 21. Will the standstill be applicable in case of extension of the EMI dates for installments falling due after May 31, 2020?

The standstill will be applicable for all accounts for which lending institutions decide to grant moratorium or deferment, and which were standard as on March 1, 2020.

Considering the disruption caused across the globe, the Company may consider extension of the EMI dates for installments falling due after May 31, 2020.

The reason for granting such relaxation is not related to any specific borrower’s financial difficulty because of any economic or legal reasons. The reason for such relaxation would be the disruption caused across an entire class of borrowers and not any individual borrower. Hence, this would not be considered as “restructuring” and will not require any asset classification downgrade merely because of restructuring. However, if the borrower does not pay the “restructured debt” as well, then asset classification norms will apply.

22. An NBFC has the following borrower accounts with DPDs marked, how will the NPA classification be impacted in case of non-payment

DPD as on March 01, 2020 NPA declaration (in case moratorium has been granted) NPA declaration (in case moratorium has not been granted)
0 31st August, 2020 31st May, 2020
30 31st July, 2020 30th April, 2020
60 30th June, 2020 31st March, 2020
90 1st March, 2020 1st March, 2020
120 Already NPA Already NPA

 23. Will the delayed instalments accrue in the books of accounts?

The accounting entries with regard to accrual of the instalments will depend on the grant of moratorium, that is, accrual will happen as per the modified contractual terms. However, as regards income recognition, NBFCs that have moved to IndAS recognise income based on the “effective interest rate” method. As long as the effective interest rate has been maintained after restructuring, income recognition will continue at that rate, even during the moratorium period.

24. Can a lender take enforcement action on account of non-payments during the breather period?

In case there was a default, and there were remedies available to the lender as on 1st March already, the same will not be affected.

As regards the period of moratorium, since the contractual obligation of the borrower has been modified, there is no default unless the borrower defaults on the restructured obligations.

As regards the use of powers under SARFAESI, the same depends on “NPA classification” in books of account. Since the loan will not be classified as NPA, there will be a bar on SARFAESI action as well.

Provisioning requirement

25. Para 5 of the RBI Notification talks about a provisioning requirement. This, on first reading, seems to suggest that the provisioning requirement will be applicable to all the loans which have been given the benefit of moratorium. Is this understanding correct?

No, this understanding is not correct. Note the words “In respect of accounts in default but standard where provisions of paragraphs (2) and (3) above are applicable, and asset classification benefit is extended, lending institutions shall make general provisions of not less than 10 per cent of the total outstanding of such accounts.. [Emphasis supplied].

The meaning of this is not to include every loan which was >0 DPD on 1st March. The intent of this is only such loans, which, but for the standstill of the asset classification, would have turned into NPA.

In case of March 31, 2020 quarter, only loans which were at least 60 DPD on 1st March would have become NPA. Therefore, 5% general provisioning will be required only for such loans as were >59 DPD on 1st March, 2020.

26. There are some who have argued that the 10% general provision (spread over two quarters) will be applicable to both SMA1 as well as SMA2. Do you agree with this view?

Respectfully, we do not agree with this view. This view will be counter-intuitive. There is no provisioning required until the asset reaches substandard status. An account which was SMA1 (>30 days on 1st March) would not have become NPA on 31st March. Hence, the question of any degradation to NPA would not have arisen. Nor would there have been any provisioning requirement (except for the 0.40% required for all assets). The moratorium has not made the SMA1 loans worse in any manner. Therefore, there is no question of the RBI obliging banks to make a provision, which was not required before the 17th April Notification.

The 5% provision (for Q4 of 2020) may only be applicable where, but for the 17th April notification, the account would have become NPA. That would be the case in case of those accounts which were SMA2 on 1st March, 2020.

Note: A substantial confusion was prevailing on this issue. We had given a precise reasoning for our view above. As per a Report, the RBI also eventually seems to have agreed to our view above. That is, the general provisioning requirement is applicable, as on 31st March, 2020, only to those accounts which were SMA2 on 1st March, 2020.

27. What about the quarter of 30th June, 2020?

The quarter of June 30 may be a tough one. The general provisioning requirement is to be spread over 2 quarters. Hence, the situation may be illustrated in the Table below:

Position as on 31st March, 2020

DPD as on March 01, 2020 DPD on 31st March, 2020 Whether 5% general loss provision in the Q4, 2020 required?
0 31 No question
30 61 No, because there would have been no slippage of asset classification, even in absence of the Notification
60 91 Yes, 5% general loss provision required
90 121 Account was an NPA; 10% provision required

 

Position as on 30th June, 2020

DPD as on March 01, 2020 DPD on 30th June, 2020 Explanation Whether 5% general loss provision in the Q4, 2020 required?
0 91 During the moratorium, from 1st March to 31st May, customer paid nothing. In June, customer pays one months’ payment There was no payment obligation during the moratorium since there was a loan modification. There was no default on 1st March. The customer has cleared his obligations of June. Hence, the account is completely in order – the 90 DPD is actually the obligations during moratorium, which has been deferred. No provisioning at all
30 121 The customer did not clear his default of 30 days which was past due on 1st March. When the moratorium is over, he pays one single instalment of loan. Based on FIFO principle, the obligation that was past due on 1st March has been cleared on 30th June. Nothing became due during March, April and May. Hence, this loan has not taken the benefit of standstill. Hence, no general provision required.
60 151 The customer has paid only one instalment in June, whereas, on 1st March, he has obligation to pay for 2 months. Therefore, obligation as on 1st March achieves a vintage of at least 120 days on 30th June. There was a provision of 5% already made in Q4, 2020. An additional 5% general loss provision will be required in Q1, 2021.
90 181 The account was already an NPA Not covered by general loss provisions.

 28. What is the meaning of general loss provision? How is it different from a provision for NPAs?

General loss provision is a general prudential provision. It does not cause the value of gross assets to be reduced. It does not require the asset to be classified as an NPA. The general loss provision will be treated as a part of Tier 2 capital.

29. Is it proper to say that the general provisioning requirement of the 17th April notification creates a pressure on the regulatory capital of banks?

The general loss requirement certainly hits the revenues of the banks, but it is treated as a part of Tier 2. Hence, essentially, what is happening is, the provision eats into Tier 1 capital, but fills the same in Tier 2. If the bank had inadequate or potentially weak Tier 1, the general loss provision will create an issue.

30. Will there be any impact on the provision for accounts already classified as NPA as on February 29, 2020?

The provisions for accounts already classified as NPA as on February 29, 2020 as well as subsequent ageing in these accounts, shall continue to be made in the usual manner.

31. Will the reporting to CICs also come to a standstill due to the standstill of asset classification?

There will be no reporting to CICs since the SMA status, where applicable, as on March 1, 2020 will remain unchanged till May 31, 2020.

32. What are the disclosure requirements to be ensured by the lender?

The lending institutions shall suitably disclose the following in the ‘Notes to Accounts’ while preparing their financial statements for the half year ending September 30, 2020 as well as for FY 2019-20 and 2020-2021:

(i) Respective amounts in SMA/overdue categories, where the moratorium/deferment was extended;

(ii) Respective amount where asset classification benefits is extended;

(iii) Provisions made during the Q4FY2020 and Q1FY2021;

(iv) Provisions adjusted during the respective accounting periods against slippages and the residual provisions.

Impairment requirement for NBFCs

33. What is the relevance of para 17 of the Governor’s statement as regards NBFCs? Is it giving discretion to NBFCs regarding how much moratorium can they offer?

Para 17 of the Governor’s statement (relevant part) reads:

“NBFCs, which are required to comply with Indian Accounting Standards (IndAS), may be guided by the guidelines duly approved by their boards and as per advisories of the Institute of Chartered Accountants of India (ICAI) in recognition of impairments. In other words, NBFCs have flexibility under the prescribed accounting standards to consider such relief to their borrowers.”

In our view, this has nothing to do with the grant of the moratorium or the standstill on asset classification.This para deals with the recognition of impairment losses, that is, ECL provisions, in the books of those NBFCs which have adopted IndAS 109.

So, to summarise:

  • Moratorium period, 1st March to 31st May, is consistent for all financial entities, including banks.
  • The standstill provisions are also the same for NBFCs.
  • As regards ECL provisions, NBFCs may be guided by accounting guidance.

34. What are the guidelines for recognition of impairments/ECL?

IFRS Foundation has given the following guidance on computation of ECL due to impact of the coronavirus:

“Entities should not continue to apply their existing ECL methodology mechanically. For example, the extension of payment holidays to all borrowers in particular classes of financial instruments should not automatically result in all those instruments being considered to have suffered an SICR”[7] (SICR stands for significant increase in credit risk).”

There have been similar statements from the Basel Committee of Banking Supervision[8] (BCBS) where they have stated the following:

“Banks should use the flexibility inherent in these frameworks to take account of the mitigating effect of the extraordinary support measures related to Covid-19.”

“Regarding the SICR assessment, relief measures to respond to the adverse economic impact of COVID-19 such as public guarantees or payment moratoriums, granted either by public authorities, or by banks on a voluntary basis, should not automatically result in exposures moving from a 12-month ECL to a lifetime ECL measurement.”

As regards ICAI, ICAI has given a common guidance on impact of the pandemic on IFRS[9]. This states: “As a guidance from Appendix A of Ind AS 109: Borrower specific concession(s) given by lenders, on account of economic or contractual reasons relating to the borrower’s financial difficulty, which the lenders would not have otherwise considered. Such a condition to be considered as evidence that a financial asset is credit-impaired.”

The restructuring as permitted by the regulators is not a case of borrower-specific concession. It is given to all borrowers across.

Hence, this by itself cannot be a reason for any movement in the DPD bucket.

Extension of Resolution Timeline

35. What are the existing timelines for resolution of stressed assets?

As per the prudential framework for resolution of stressed assets[10], once an account defaults, a Review Period[11] of 30 days becomes operational. The resolution plan is to be implemented within 180 days after the Review Period. In case of failure to implement the resolution plan within the said 180 days, an additional provision of 20% of the amount outstanding in the account has to be maintained by the lender.

36. Will there be any impact on the Review Period?

The notification[12] issued by the RBI providing extension of 90 days for implementation of resolution plan also provides for a stay on the Review Period. Accordingly, if an account was under review period on March 1, 2020, the Review Period of 30 days shall freeze until May 31, 2020. The calculation of residual Review period shall start from June 01, 2020.

Further, through another notification on May 23, 2020 the RBI extended the period of stay to August 31, 2020. Accordingly, the review period shall resume from September 01, 2020.

 37. What will happen to the accounts whose Review Period has expired but the resolution plan has not been implemented?

For accounts whose Review Period has expired, but the timeline of 180 days for implementing the resolution plan has not expired as on March 1, 2020, the timeline shall be further extended by 90 days.

 38. What will be the implication of extending the period for the resolution plan by 90 days?

Given the current circumstances, delay in implementation of the resolution plan may be due to factors beyond control of the lender. Hence, due to the extension of the said timeline by 90 days, the requirement of maintaining additional provision of 20% gets delayed.

39. Will the deferment of creation of this provision aid the liquidity position of the lenders?

Since, the requirement of maintaining additional provision of 20% gets delayed, the lenders will have relatively more liquidity in hand at this time when liquidity is needed the most.

 40. Will the lender be required to hold an additional provision of 20 per cent if a resolution plan has not been implemented within 210 days from the date of such default?

No, the lender would not be required to hold additional provision of 20% if the resolution plan is not implemented within 210 days.

However, if the resolution plan is not implemented within 210+90= 300 days, an additional provision of 20% would have to be maintained.

41. Are there any disclosure requirements in this regard?

The notification requires the NBFCs to make relevant disclosures in respect of accounts where the resolution period was extended, in the ‘Notes to Accounts’ while preparing their financial statements for the half year ending September 30, 2020 as well as for FY2020 and FY2021.

NBFC Loans to Commercial Real Estate Projects

42.Which loans are defined as loans to Commercial Real Estate Projects?

The definition of loans to Commercial Real Estate has been aligned to Basel II norms, which is based on the source of loan repayment. As per the definition, if the repayment primarily depends on other factors such as operating profit from business operations, quality of goods and services, tourist arrivals etc., the exposure would not be counted as Commercial Real Estate (CRE).

Thus, whether a loan can be defined as a loan to CRE is a subjective matter and would require understanding of the business of the borrower, use of the loan proceeds etc.

43. What are the existing parameters for considering a loan to the commercial real estate sector as restructured?

As per the existing norms, the Date of Commencement of Commercial Operations (DCCO) shall be clearly spelt out at the time of financial closure of the project and the same shall be formally documented. In case the DCCO is extended beyond a period of one year from the predetermined DCCO or the terms of the loan are revised with a motive to provide the borrower with some relief during times of stress, the account is said to be restructured.

Upon restructuring, an account classified as standard would immediately become sub-standard i.e. the asset classification of the account has to be downgraded on restructuring.

44.What do the revised guidelines propose?

In line with the guidelines for banks, the NBFCs are now allowed to extend the DCCO for reasons beyond the control of promoters by an additional one year, over and above the one-year extension permitted in normal course, provided the revised repayment schedule is not extended more than the extension in DCCO .

45. What would be the impact of such an extension?

Considering the current situation, many of the commercial real estate projects may fail to initiate operations for a while. Due to this, the DCCO is likely to extend. As per the existing guidelines, if the DCCO extends for a period above 1 year, the account would become restructured and thus the asset classification would degrade. This would result in accumulation of lower grade assets into the books of NBFCs.

Allowing a time period of 2 years from the predetermined DCCO would provide the borrower with enough time to get back into operations and at the same time the asset classification would not be downgraded in the books of the NBFC.


[1] https://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=3847

[2] https://rbidocs.rbi.org.in/rdocs/Content/PDFs/GOVERNORSTATEMENTF22E618703AE48A4B2F6EC4A8003F88D.PDF

[3] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49360

[4] https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR2237379D65C898244520B79D8889EE42888E.PDF

[5] https://www.rbi.org.in/Scripts/FAQView.aspx?Id=134

[6] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11872&Mode=0

[7] https://cdn.ifrs.org/-/media/feature/supporting-implementation/ifrs-9/ifrs-9-ecl-and-coronavirus.pdf?la=en

[8] https://www.bis.org/press/p200403.htm

[9] https://resource.cdn.icai.org/58829icai47941.pdf

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

[11] During this Review Period of thirty days, lenders may decide on the resolution strategy, including the nature of the RP, the approach for implementation of the RP, etc.

[12] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11871&Mode=0

The Great Lockdown: Standstill on asset classification

– RBI Governor’s Statement settles an unwarranted confusion

Timothy Lopes, Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

Background

In the wake of the disruption caused by the global pandemic, now pitted against the Great Depression of 1930s and hence called The Great Lockdown[1], several countries have taken measures to try and provide stimulus packages to mitigate the impact of COVID-19[2]. Several countries, including India, provided or permitted financial institutions to grant ‘moratorium’, ‘loan modification’ or ‘forbearance’ on scheduled payments of their loan obligations being impacted by the financial hardship caused by the pandemic.

The RBI had announced the COVID-19 Regulatory Package[3] on 27th March, 2020. This package permitted banks and other financial institutions to grant moratorium up to 3 months beginning from 1st March, 2020. We have covered this elaborately in form of FAQs.[4]

However, there was ambiguity on the ageing provisions during the period of moratorium. That is to say,  if an account had a default on 29th February, 2020, whether the said account would continue to age in terms of days past due (DPD) as being in default even during the period of moratorium. Our view was strongly that a moratorium on current payment obligation, while at the same time expecting the borrower to continue to service past obligations, was completely illogical. Such a view also came from a judicial proceeding in the case of Anant Raj Limited Vs. Yes Bank Limited dated April 6, 2020[5]

However, the RBI seems to have had a view, stated in a mail addressed to the IBA,  that the moratorium did not affect past obligations of the customer. Hence, if the account was in default as on 1st March, the DPD will continue to increase if the payments are not cleared during the moratorium period.

Read more

Moratorium on asset classification of past due accounts

– Anita Baid, finserv@vinodkothari.com

(Updated as on 24.04.2020)

Background

Due to sudden out-break and spread of COVID-19 across the globe, economic condition of the financial service sector has been adversely affected. In this regard RBI has issued several guidelines and advisories and brought into place regulatory polices to give benefit to the borrowers to ease the financial crisis. The Reserve Bank of India in its Statement of Development and Regulatory Policies dated March 27, 2020[1] has permitted banks and non-banking financial institutions to provide a moratorium to borrowers for a period of 3 months. Thereafter, the RBI came up with a notification titled COVID 19 Regulatory Package[2] providing a brief guideline about the relaxation. This was followed by the FAQs on RBI’s scheme for a 3-month moratorium on loan repayment[3] issued by the Ministry of Finance.

However, there are still certain issues that are not clear and due to the ambiguity around such issues, banks and NBFCs have been making their own interpretation[4]. One such major issue was with respect to the grant of moratorium to loan accounts having over dues as on March 1, 2020.

Regulatory Package by RBI

Before examining the issue let us understand that the underlying objective of the RBI’s guidelines was to inter-alia ease the financial stress caused by COVID-19 disruptions by relaxing repayment pressures and improving access to working capital. The COVID -19 Regulatory Package provides for rescheduling of the payments in respect of term loans and working capital facilities.

Several contentions have been raised stating that the moratorium is not applicable to the borrowers who are already in default as on March 1, 2020. The argument to support this contention is that the language of the Regulatory Package clearly states that the three month moratorium is applicable only to those instalments which fall due between March 1, 2020 and May 31, 2020. Accordingly, only those borrowers would be covered whose loan account is outstanding as on March 1, 2020 and were properly servicing their account till that date and were not in default.

This was further supported by a clarification issued by letter dated March 31, 2020 by the Chief General Manager-in-charge, Department of Regulation of the RBI to the Chairman, Indian Banks Association, wherein it stated that if a borrower has been in default even before March 1, 2020, such default cannot be said to be as a result of economic fall due pandemic and benefit of moratorium can be extended to such borrower in respect of payment falling due during the period March 1, 2020 to May 31, 2020. However, payments overdue on or before February 29, 2020 will attract the current Income Recognition and Asset Classification Guidelines (IRAC Guidelines)[5].

Such an approach will cause all past due accounts to become NPAs during the disruption period, and therefore, the regulatory recognition of the disruption period as not a case of contractual failure but a case of systemic failure, gets defeated. The relaxation or grant of moratorium presumes that during the period of March 1, 2020 to May 31, 2020, the borrower has not paid due to a systemic disruption. If the logic of disruption applies to the current dues during the moratorium period, the same logic cannot be inapplicable for the past dues.

For example, a borrower had payments due on February 29, 2020 which was 30 DPD. In case he cleared all his dues, say on 31st March, his account, which was, say, 60 DPD on 29th March, would have been a regular standard account. But the borrower was precluded from paying anything during the disruption period. Thus, the opportunity of clearing any past due payment is not available to the borrower during the period of disruption. What is a “default” on 1st March, 2020 continues to be a default, but the ageing of the default cannot increase during the disrupted period. The disruption is not a credit event, perhaps, it is an externality, and admittedly a force majeure. Therefore, the disruption causes a standstill on the obligations of the borrower.

The period of disruption is a period during which the clock of the payments in the system stops. If the ageing of past receivables changes, then the disruption will cause all regular accounts to become irregular. In such a case even a 10 DPD on February 29, 2020 will become an NPA around May 19, 2020. Such an approach will cause all past due accounts to become NPAs during the disruption period, and therefore, the regulatory recognition of the disruption period as not a case of contractual failure but a case of systemic failure, gets defeated.

Delhi High Court Ruling

The recent judgement of the Hon’ble Delhi High Court in the case of Anant Raj Limited Vs. Yes Bank Limited dated April 6, 2020[6] has given a different perspective to the entire situation.

The matter of dispute was the asset classification of the petitioner. The petitioner’s instalment that was due on 01.01.2020 was not paid within 30 days, due to which the account was classified as SMA-1 and thereafter since it was not paid within 60 days, the account was classified as SMA-2. Further, it was contended that since the instalment was not paid till 31.03.2020, the account of the petitioner was liable to be classified as NPA.

The court considered the fact that in view of the pandemic COVID-19, RBI has issued several guidelines and advisories and brought into place regulatory polices to give benefit to the borrowers to ease the financial crisis. The intention of the RBI is to maintain status quo as on March 1, 2020 with regard to all the instalments payment which had to be made post March 1, 2020 till May 31, 2020. Further, the relevant provision of the Regulatory Package with respect to classification of accounts also indicates that the intention of RBI is to maintain status quo with regard to the classification of accounts of the borrowers as they existed as on 01.03.2020. The relevant extract of the judgement is as follows:

  1. The restriction on change in classification as mentioned in the Regulatory Package shows that RBI has stipulated that the account which has been classified as SMA-2 cannot further be classified as a non-performing asset in case the instalment is not paid during the moratorium period i.e. between 01.03.2020 and 31.05.2020 and status quo qua the classification as SMA-2 shall have to be maintained.

This implies that for a period of three months there will be a moratorium from payment of the instalment. However, interest shall continue to accrue on the outstanding payment even during the moratorium period. Further, in case the borrower fails to pay the said instalment after the expiry of moratorium, the asset classification would change as per the IRAC Guidelines.

Bombay High Court Ruling

The Bombay HC has also taken a similar view on the issue of asset classification during moratorium. In the case of ICICI Bank against two real estate companies, namely Transcon Skycity Pvt. Ltd. and Transcon Iconica Pvt. Ltd.[7], the HC has directed ICICI Bank to exclude the period of moratorium amid coronavirus lockdown while computing 90 days for declaration of non-performing assets.

As per the facts of the case, the petitioner companies had availed finance facilities from ICICI Bank, which were to be repaid in instalments, but they failed in repaying two instalments. As per RBI norms, for classification of accounts as NPA, the 90-days period would end during the current lockdown period. The plea of the petitioners was to restrain ICICI Bank from taking any coercive actions against them and sought the court’s declaration that they were entitled to benefits under the RBI’s relief packages permitting lending institutions to allow a three month moratorium on all loan repayments.

It was contented by the petitioners that if the moratorium period is not excluded from the NPA declaration period, the moratorium itself would be meaningless in situations such as those of petitioners. The HC also drew reference to the Delhi HC ruling discussed above, which concluded that the purpose of the moratorium and the entire rationale would be nullified if moratorium isn’t extended for accounts outstanding as on March 1, 2020.

The HC held that the moratorium period of March 1 till May 31, 2020 during which there is a lockdown will stand excluded from the NPA declaration computation until the lockdown is lifted. It further clarified that the relief is co-terminus with the lockdown period and not the declared end of the moratorium. The exclusion from the 90-day NPA-declaration timer and countdown can only therefore operate during the lockdown period and will end upon the complete lifting of the lockdown.

However, the concluding remarks of the order makes this a case specific decision. The HC cautioned that this order will not serve as a precedent for any other case in regard to any other borrower who is in default or any other bank and that each of these cases will have to be assessed on their own merits.

Another Ruling by Delhi HC

The Delhi HC has again addressed the issue of applicability of the moratorium period in the classification of an asset as an NPA. In the case of Shakuntala Educational & Welfare Society v Punjab & Sind Bank[8] the petitioner was a charitable society engaged in the business of technical and higher education which had sought the benefit of the moratorium period for loans that were due on December 31, 2019, and were payable until March 31, 2020.

The petitioner has been diligently making repayments in accordance with the restructured plan of it remaining two terms loan but before the instalments payable in March, 2020, could be paid, the pandemic COVID had set in and consequently the RBI permitted grant of three month moratorium, vide its circular dated March 27, 2020, in respect of all term loans as outstanding on March 1, 2020. The petitioner was liable to make payment of quarterly instalments, and the default qua instalments in respect whereof the respondent is proposing to declare the petitioner’s accounts as NPA had fallen due on 31.12.2019. However, the petitioner expressed its inability to pay as several of its schools run in Uttar Pradesh (UP) were affected by the state government directive by which they could not insist on students making fee payments.

The HC considered the fact that the petitioner still had time to make the payment of the due instalments till March 31, 2020, before which date on account of the lockdown and directive issued by the State Government, it has been prevented from demanding the due fees from the students of its various institutes.

The HC concurred with the view taken in the ruling discussed above that the regulatory package intended to maintain status quo as on 1 March as far as classification of accounts is concerned. Accordingly, an interim relief was granted to petitioner by restraining the respondent bank from declaring the loans as an NPA until the next hearing. The Court, further, agreed to the proposal of the petitioner and added a caveat in this order stating that in case the directive of the UP government prohibiting fee collection is lifted before the next hearing, the petitioner would be liable to pay the pending dues within one week of such lifting.

Though the HC made reference and agreed to the view taken in the earlier ruling of Anant Raj Limited Vs. Yes Bank regarding maintaining status quo due to the moratorium period, however, the judgement was linked to a specific impact of the lockdown that is, the state government directive. In effect, it has delinked the asset degradation from both the lockdown and the moratorium period.

Conclusion

The first judgement of Delhi HC is in favor of extending the moratorium period to loans outstanding before March 1, 2020 by stating maintenance of status quo and justifying the same by a contextual reading of the RBI’s Regulatory Package, however, the orders in the other two cases are fact specific, one of which even reiterates that it cannot be treated as a precedent.

Deterioration to NPA status has manifold consequences, including provisioning requirement that have an impact of the P&L accounts. For NBFCs, their drawing power from banks comes down as NBFCs are not allowed to borrow against past due receivables. This will exacerbate the liquidity issue with NBFCs. Further, under the ECL provisions under IndAS 109, the continuation of default will cause the bucket of the receivables to move from Bucket 1 to Bucket 2, thereby requiring computation of lifetime expected losses. This may mean a huge impact on long-term receivables, as those in case of housing or project loans.

Post the HC judgement, two things have been clarified:

  1. An account already classified as NPA as on 29th Feb remains an NPA.
  2. An account that is not an NPA on 29th Feb and is just classified as SMA then the ageing of the receivable shall not change during the moratorium and any further asset degradation shall not happen.

Accordingly, the possible scenarios can be summarized as follows:

Existing Asset Classification Whether moratorium can be granted? Whether asset classification shall remain stand still?
Standard Asset Yes Yes
SMA-1 Yes Yes
SMA-2 Yes Yes
NPA No No

As per the practice adopted by banks and NBFCs, including HFCs, it seems that most of them have extended the moratorium on all standard loans, irrespective of whether they were overdue as on 1st March, 2020. Further, post the HC ruling, the asset classification of account which has been classified as SMA cannot further be classified as a non-performing asset in case the instalment is not paid during the moratorium period and status quo qua the classification as SMA shall have to be maintained. However, there is a possibility that the ruling may be challenged in a higher court, and the outcome of that ruling could be completely different. Therefore, until this ruling is challenged further or any clarification contrary to this issued by the RBI or any other authority, financial institutions may consider this ruling to frame their policy for account classification.

This article is further being updated in accordance with the RBI Governor’s address on April 17, 2020[9] and a subsequent notification[10] on the issue that has clarified the position once and for all. The RBI circular states that in respect of all accounts classified as standard as on February 29, 2020, even if overdue, the moratorium period, wherever granted, shall be excluded by the lender from the number of days past-due for the purpose of asset classification under the IRAC norms. Effectively the circular stalls the dip in the asset classification by 3 months. Further, the asset classification relaxation is provided only if the account was to move from standard to sub-standard category during the moratorium period from March 1, 2020 to May 31, 2020. However, if the account was within the NPA category already, the benefit of the relaxation will not be available.

 

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49582

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0

[3] https://pib.gov.in/PressReleseDetail.aspx?PRID=1609820

[4] Our detailed FAQs on the subject can be viewed at http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

[5] In terms of the IRAC Guidelines, if an instalment is overdue by a period of 30 days, the borrower’s account is classified as Special Mention Account 1 (SMA-1) and if the instalment is overdue by 60 days, the account is classified as Special Mention Account 2 (SMA-2) and if the instalment is overdue by a period of 90 days, the account is classified as Non-performing Asset (NPA).

[6] W.P.(C) URGENT 5/2020

[7] WRIT PETITION LD-VC NO. 28 OF 2020 and WRIT PETITION LD-VC NO. 30 OF 2020

[8] W.P.(C)2959/2020

[9] https://rbidocs.rbi.org.in/rdocs/Content/PDFs/GOVERNORSTATEMENTF22E618703AE48A4B2F6EC4A8003F88D.PDF

[10] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11872&Mode=0

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

Timothy Lopes, Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

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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Consensual restructuring of debt obligations, due to COVID disruption, not to be taken as default, clarifies SEBI

Vinod Kothari

finserv@vinodkothari.com

The global economy, as also that of India, is passing through a systemic disruption due to the COVID crisis. The Reserve Bank of India in its Seventh Bi-monthly Monetary Policy Statement 2019-20 dated March 27, 2020[1] has permitted banks and non-banking financial institutions to provide a moratorium to borrowers for a period of 3 months.

As a result, cashflows of banks and financial institutions from underlying loans will be disrupted, at least for the period of the moratorium. It is a different thing that the disruption may actually prolong, but 3 months as of now is what is explicitly regarded by the RBI has COVID-driven.

Read more

COVID- 19 AND THE SHUT DOWN: THE IMPACT OF FORCE MAJEURE

-Richa Saraf (richa@vinodkothari.com)

 

COVID- 19 has been declared as a pandemic by the World Heath Organisation[1], and the Ministry of Health and Family Welfare has issued an advisory on social distancing[2], w.r.t. mass gathering and has put travel restrictions to prevent spreading of COVID-19. On 19th February, 2020, vide an office memorandum O.M. No. 18/4/2020-PPD[3], the Government of India has clarified that the disruption of the supply chains due to spread of coronavirus in China or any other country should be considered as a case of natural calamity and “force majeure clause” may be invoked, wherever considered appropriate, following the due procedure.

In view of the current situation where COVID- 19 has a global impact, and is resulting in a continuous sharp decline in the market, it is important to understand the relevance of force majeure clauses, and the effect thereof.

Meaning Of Force Majeure:

The term has its origin from French, meaning “greater force”. Collins Dictionary[4] defines “force majeure” as “irresistible force or compulsion such as will excuse a party from performing his or her part of a contract

The term has been defined in Cambridge Dictionary[5] as follows:

“an unexpected event such as a war, crime, or an earthquake which prevents someone from doing something that is written in a legal agreement”.

In Merriam Webster Dictionary[6], the term has been defined as “superior or irresistible force” and “an event or effect that cannot be reasonably anticipated or controlled”.

In light of COVID- 19, a pertinent question that may arise here is whether COVID- 19 shut down will be regarded as a force majeure event for all the agreements, providing a leeway to the parties claiming impossibility of performance? Further, whether such non-compliance of the terms of the agreement will neither be regarded as a “default committed by any party” nor a “breach of contract”?  The general principle is that an event will be regarded as a force majeure event on fulfilment of the following conditions:

  • An unexpected intervening event occurred: The event should be one which is beyond the control of either of the parties to the agreement, similar to an Act of God;
  • The parties to the agreement assumed such an event would not occur: A party’s non-performance will not be excused where the event preventing performance was expected or was a foreseeable risk at the time of the execution of the agreement; and
  • The unexpected event made contractual performance impossible or impracticable: For instance, can the issuer of debentures say that there is no default if the issuer is unable to redeem the debentures? Whether an event has made contractual performance impossible or impracticable has to be determined on a case-to-case basis. It is to be analysed whether the problem is so severe so as to deeply affect the party, and thereby creating an impossibility of performance. This has to be, however, relative to the counterparty so as to create an impossibility of performance.
  • The parties have taken all such measures to perform the obligations under the agreement or atleast to mitigate the damage: It is required that a party seeking to invoke force majeure clause should follow the requirements set forth the agreement, i.e. to provide notice to the other party as soon as it became aware of the force majeure event, and should concretely demonstrate how the said situation has directly impacted the performance of obligations under the agreement.

To understand this further, let us discuss the precedents laid down in several cases.

Principles in Other Jurisdictions:

Prior to the decision in Taylor vs. Caldwell, (1861-73) All ER Rep 24, the law in England was extremely rigid. A contract had to be performed after its execution, notwithstanding the fact that owing to an unforeseen event, the contract becomes impossible of performance, which was not at the fault of either of the parties to the contract. This rigidity of the common law was loosened somewhat by the decision in Taylor (supra), wherein it was held that if some unforeseen event occurs during the performance of a contract which makes it impossible of performance, in the sense that the fundamental basis of the contract goes, it need not be further performed, as insisting upon such performance would be unjust.

In Gulf Oil Corp. v. FERC 706 F.2d 444 (1983)[7], the U.S. Court of Appeals for the Third Circuit considered litigation stemming from the failure of the oil company to deliver contracted daily quantities of natural gas. The court held that Gulf- as the non- performing party- needed to demonstrate not only that the force majeure event was unforeseeable but also that the availability and delivery of the gas were affected by the occurrence of a force majeure event.

Illustrations: When Is An Event Not Considered As Force Majeure?

Inability to sell at a profit is not the contemplation of the law of a force majeure event excusing performance and a party is not entitled to declare a force majeure because the costs of contract compliance are higher than it would have liked or anticipated. In this regard, the following cases are relevant:

  • In the case of Dorn v. Stanhope Steel, Inc., 534 A.2d 798, 586 (Pa. Super. Ct. 1987)[8], it was observed as follows:

“Performance may be impracticable because extreme and unreasonable difficulty, expense, injury, or loss to one of the parties will be involved. A severe shortage of raw materials or of supplies due to war, embargo, local crop failure, unforeseen shutdown of major sources of supply, or the like, which either causes a marked increase in cost or prevents performance altogether may bring the case within the rule stated in this Section. Performance may also be impracticable because it will involve a risk of injury to person or to property, of one of the parties or of others, that is disproportionate to the ends to be attained by performance. However, “impracticability” means more than “impracticality.” A mere change in the degree of difficulty or expense due to such causes as increased wages, prices of raw materials, or costs of construction, unless well beyond the normal range, does not amount to impracticability since it is this sort of risk that a fixed-price contract is intended to cover.”

  • In Aquila, Inc. v. C.W. Mining 545 F.3d 1258 (2008)[9], Justice Neil Gorsuch authored an opinion for the U.S. Court of Appeals for the 10th Circuit, which excused a coal mining company’s deficient performance under a coal supply contract with a public utility only to the extent that partial force majeure, namely labor dispute, caused deficiency.
  • In  OWBR LLC v. Clear Channel Communications, Inc., 266 F. Supp. 2d 1214[10], it was observed- “To excuse a party’s performance under a force majeure clause ad infinitum when an act of terrorism affects the American populace would render contracts meaningless in the present age, where terrorism could conceivably threaten our nation for the foreseeable future”.
  • In Transatlantic Financing Corp. v. U.S. 363 F.2d 312[11], the D.C. Circuit Court of Appeals affirmed a finding that there was no commercial impracticability where one party sought to recover damages because its wheat shipment was forced to be re-routed due to the closing of the Suez Canal. The Court of Appeals held that because the contract was not rendered legally impossible and it could be presumed that the shipping party accepted “some degree of abnormal risk,” there was no basis for relief.

Some Landmark Rulings in India:

Deliberating on what is to be considered as a force majeure, in the seminal decision of Satyabrata Ghose v. Mugneeram Bangur & Co., 1954 SCR 310[12], the Hon’ble Apex Court had adverted to Section 56 of the Indian Contract Act. The Supreme Court held that the word “impossible” has not been used in the Section in the sense of physical or literal impossibility. To determine whether a force majeure event has occurred, it is not necessary that the performance of an act should literally become impossible, a mere impracticality of performance, from the point of view of the parties, and considering the object of the agreement, will also be covered. Where an untoward event or unanticipated change of circumstance upsets the very foundation upon which the parties entered their agreement, the same may be considered as “impossibility” to do as agreed.

Subsequently, in Naihati Jute Mills Ltd. v. Hyaliram Jagannath, 1968 (1) SCR 821[13], the Supreme Court also referred to the English law on frustration, and concluded that a contract is not frustrated merely because the circumstances in which it was made are altered. In general, the courts have no power to absolve a party from the performance of its part of the contract merely because its performance has become onerous on account of an unforeseen turn of events. Further, in Energy Watchdog v. CERC (2017) 14 SCC 80[14], it was observed as follows:

“37. It has also been held that applying the doctrine of frustration must always be within narrow limits. In an instructive English judgment namely, Tsakiroglou & Co. Ltd. v. Noblee Thorl GmbH, 1961 (2) All ER 179, despite the closure of the Suez canal, and despite the fact that the customary route for shipping the goods was only through the Suez canal, it was held that the contract of sale of groundnuts in that case was not frustrated, even though it would have to be performed by an alternative mode of performance which was much more expensive, namely, that the ship would now have to go around the Cape of Good Hope, which is three times the distance from Hamburg to Port Sudan. The freight for such journey was also double. Despite this, the House of Lords held that even though the contract had become more onerous to perform, it was not fundamentally altered. Where performance is otherwise possible, it is clear that a mere rise in freight price would not allow one of the parties to say that the contract was discharged by impossibility of performance.

38. This view of the law has been echoed in ‘Chitty on Contracts’, 31st edition. In paragraph 14-151 a rise in cost or expense has been stated not to frustrate a contract. Similarly, in ‘Treitel on Frustration and Force Majeure’, 3rd edition, the learned author has opined, at paragraph 12-034, that the cases provide many illustrations of the principle that a force majeure clause will not normally be construed to apply where the contract provides for an alternative mode of performance. It is clear that a more onerous method of performance by itself would not amount to a frustrating event. The same learned author also states that a mere rise in price rendering the contract more expensive to perform does not constitute frustration. (See paragraph 15-158)”

General Force Majeure Clauses in Agreements and the Impact Thereof:

While some of the agreements do have a force majeure clause, one question that may arise is whether the excuse of force majeure event be taken only if there is a specific clause in the agreement or event otherwise? Typically, in all the agreements, whether the promisor is under the obligation to promptly inform the promisee in case of occurrence of any event or incidence, any force majeure event or act of God such as earthquake, flood, tempest or typhoon, etc or other similar happenings, of which the promisor become aware, which is reasonably expected to adversely affect the promisor, or its ability to perform obligations under the agreement.

The terms of the agreement and the intent has to be understood to determine the effect of force majeure clause.  In Phillips P.R. Core, Inc. v. Tradax Petroleum Ltd., 782 F.2d 314, 319 (2d Cir. 1985)[15], it was observed that the basic purpose of force majeure clauses is in general to relieve a party from its contractual duties when its performance has been prevented by a force beyond its control or when the purpose of the contract has been frustrated.

The next question that may arise is whether every force majeure leads to frustration of the contract? For instance, if the agreement was hiring of a car on 24th March, the occurrence of COVID- 19 may just have the impact of altering the timing of performance. In some other cases, the event may only affect one part of the transaction. Therefore, the impact of the force majeure event cannot be generalised and shall vary depending on the nature of transaction.

Usually, occurrence of a force majeure event provides the promisee with a right to terminate the agreement, and take all necessary actions as it may deem fit. For instance, in case of lease, if the lessor considers that there is a risk to the equipment, the lessor may seek for repossession of the leased equipment.

Further, in case the force majeure event frustrates the very intent of the agreement, then the parties are under no obligation to perform the agreement. For instance, if the agreement (or performance thereof) itself becomes unlawful due to any government notification or change in law, which arises after execution of the agreement, then such agreements do not have to be performed at all. In such cases, if the agreement contains a force majeure or similar clause, Section 32 of the Indian Contract Act will be applicable. The said section stipulates that contingent contracts to do or not to do anything if an uncertain future event happens, cannot be enforced by law unless and until that event has happened; If the event becomes impossible, such contracts become void. Even if the agreement does not contain a specific provision to this effect then in such a case doctrine of frustration under Section 56 of the Indian Contract Act shall apply. The section provides that a contract to do an act which, after the contract is made, becomes impossible, or, by reason of some event which the promisor could not prevent, unlawful, becomes void when the act becomes impossible or unlawful.

Impact of COVID- 19 on Loan Transactions:

The Reserve Bank of India has, vide notification No. BP.BC.47/21.04.048/2019-20 dated 27th March, 2020[16], has announced that in respect of all term loans (including agricultural term loans, retail and crop loans), all commercial banks (including regional rural banks, small finance banks and local area banks), co-operative banks, all-India Financial Institutions, and NBFCs (including housing finance companies) are permitted to grant a moratorium of three months on payment of all instalments falling due between 1st March, 2020 and 31st May, 2020. Further, in respect of working capital facilities sanctioned in the form of cash credit/overdraft, the lending institutions have been permitted to defer the recovery of interest applied in respect of all such facilities during the period from 1st March, 2020 upto 31st May, 2020.

Detail discussion on the same has been done in our article “Moratorium on loans due to Covid-19 disruption”, which can be accessed from the link below:

http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

Further, our article “RBI granted moratorium on term loans: Impact on securitisation and direct assignment transactions” can be accessed from the following link:

http://vinodkothari.com/2020/03/rbi-moratorium-on-term-loans-impact-on-sec-and-da-transactions/

 

 

[1] https://www.who.int/emergencies/diseases/novel-coronavirus-2019/events-as-they-happen

[2] https://www.mohfw.gov.in/pdf/SocialDistancingAdvisorybyMOHFW.pdf

[3] https://doe.gov.in/sites/default/files/Force%20Majeure%20Clause%20-FMC.pdf

[4] https://www.collinsdictionary.com/dictionary/english/force-majeure

[5] https://dictionary.cambridge.org/dictionary/english/force-majeure

[6] https://www.merriam-webster.com/dictionary/force%20majeure

[7] https://casetext.com/case/gulf-oil-corp-v-ferc

[8] https://law.justia.com/cases/pennsylvania/supreme-court/1987/368-pa-super-557-0.html

[9] https://www.courtlistener.com/opinion/171400/aquila-inc-v-cw-mining/

[10] https://law.justia.com/cases/federal/district-courts/FSupp2/266/1214/2516547/

[11] https://www.casemine.com/judgement/us/59149a86add7b0493462618f

[12] https://indiankanoon.org/doc/1214064/

[13] https://indiankanoon.org/doc/1144263/

[14] https://indiankanoon.org/doc/29719380/

[15] https://law.justia.com/cases/federal/appellate-courts/F2/782/314/300040/

[16] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0

 

Further content related to Covid-19: http://vinodkothari.com/covid-19-incorporated-responses/

Impact on Expected Credit Loss Model (ECL) amid COVID-19 disruptions

-The test of a Financial Crisis-driven model in times of Global Crisis

By Rahul Maharshi, Financial Services Team , (rahul@vinodkothari.com, finserv@vinodkothari.com)

The disruption throughout the globe due to the COVID-19 disease has caused tremendous uncertainty and difficulty in the financial sector. The Expected Credit Loss (ECL) model was introduced as an aftermath of the 2008 global financial crisis, to curb the loopholes of the incurred loss model and to provide a forward looking approach in the accounting of loan loss provisioning by inclusion of various credit measures. The model which is built up with the focus on credit strength of a particular exposure, is likely to get tested is these testing times.

This write-up is an attempt to explore how the ECL model should be looked given the disruption caused by COVID 19.

The approach to ECL at time of COVID-19 disruption

The ECL model requires application of judgement and differs from entity to entity. Such application of judgement and approaches are considered based on the industrial practices as well as the business environment in which the entity operates. For example, a financial institution may not have an aggressive approach in determination of ECL for the portfolios serving to the affluent sections of the economy as compared to the low credit-score portfolios.

However, conventional assumptions taken in the ECL model may not hold well in the current environment the financial sector across the world is going through. The assumptions of significant increase in credit risk (SICR), at times when there is extension in the repayment structure may be a classical example of SICR which would result in stage-shifting of the credit exposure. But the same would not hold well, in times of such a disruption, where the financial sector regulator has proposed to extend a three month moratorium for repayment of term loans, considering the disruption to the economy.

We arrive at ECL estimates with the help of three primary data points [B5.5.49] –

  • Best available information about the past events;
  • Best available information about the current conditions; and
  • Forecast of economic conditions

In the current COVID-19 disruptions, the entities should actively consider the effects of the COVID-19 disruption as well as the measures taken by the government and regulators in the current situation as well as the prospective measures which would affect the forecast. Such measures should be considered as forward looking “macro-economic information” [B5.5.4] and accordingly be considered by the entities.

However, it is easier said than done, considering the rapid changes and updates in the current stressed environment. But if the ECL estimates are arrived at, after proper consideration of reasonable and supportable information, the same can provide better transparency to the financial statements and aid in providing assurance to the stakeholders.

Ind AS 109 is clear in the assessment of SICR, where the assessment has to be done on the changes in the risk of default occurring over the expected lifetime of a financial instrument. Such an assessment has to be done by the entity based on information that is available to it without undue cost or efforts. The grant of a payment holiday at times of the disruption would not be construed as a change in the risk of default occurring over the expected lifetime of a financial instrument.

Globally, various regulators, Central Bank of various countries have come up with publications and directives for assistance in such times of disruption. Some of the publications and initiatives have been discussed at length below:

Global response to the COVID-19 disruption for sound application of the ECL model

In light of the current COVID-19 disruption, the International Accounting Standards Board (IASB) published[1] a document intending to support the consistent application of the IFRS Standards which are applicable on approximately 120 countries. In its document the IASB has indicated that extension of payment holidays to all borrowers in particular classes of financial instruments should not automatically result in all those instruments being considered to have suffered an SICR.  The assessment of SICR has to be based on information that is available to an entity without undue cost and effort.

The European Central Bank (ECB), the apex banking authority for the 19 European Union countries has also published[2] a document as a guidance for financial institutions in careful implementation of the ECL and avoidance of excessive pro-cyclical assumptions in ECL during the COVID-19 disruptions.

The annexure of the above letter provided guidance for the institutions to take into account when using forecasts to estimate the ECL:

  • The collective assessment of the significant increase in credit risk (SICR);

The ECB perceived deterioration to the GDP outlook could lead to manifold increase in probability of default (PD), in turn leading to transfer of the financial instrument from stage 1 to stage 2.  In times of economic disruptions, such as the COVID-19, even factors usually assessed individually become very sensitive to macroeconomic scenarios. For tackling such a situation, the ECB advised the institutions to :

  • Consider whether a top-down approach to stage transfer can be taken and in the context of that approach, recognise lifetime expected credit losses on a portion of the financial assets for which credit risk is deemed to have increased significantly without the need to identify which individual financial instruments have suffered a SICR.

 

As per para B5.5.6 of IFRS 9 (Ind AS 109) A top-down approach to ECL is such, where the identification of a particular sub-portfolio on the basis of shared risk characteristics that represent customers whose credit risk is expected to have increased significantly, is not possible. In such a case, an assessment can be made of a proportion of the overall portfolio that has SICR since initial recognition.

Example of Top-down approach will be as follows:

Where there is high chance of a risk of default occurring and thus an increase in credit risk, results from an expected increase in interest rates during the expected life of the portfolio held by a financial institution. In such a case, assessing an increase in interest rates of 200 basis points will cause a significant increase in credit risk on 20% of the variable interest-rate portfolio and accordingly, recognition of lifetime ECL on 20% of the variable rate mortgage portfolio, and a loss allowance at an amount equal to 12-month ECL for the remainder of the portfolio.

  • The use of long term macroeconomic forecasts ;and

The IFRS 9 provisions lead to the conclusion that where there is no reliable evidence for specific forecasts, long-term macroeconomic outlooks will provide the most relevant basis for estimation. The ECB provided guidance for financial institutions to:

  • use available historical information, but only as far as this information is representative for the long-term horizon and free of bias;
  • Where historical information depends on macroeconomic variables, consider information covering at least one or more full economic cycles or that is otherwise adjusted to avoid biases, e.g. a recency bias.

 

  • The use of macroeconomic forecast for specific years

To include forward-looking information in ECL models, it is quite a common practice among significant institutions to establish a baseline macroeconomic scenario. In doing so, ECB guided the financial institutions to consider the following:

  • Consider macroeconomic forecasts for specific years and long-term forecasts, as previously described;
  • Factor these two types of forecasts into the baseline scenario with weights based on their respective relevance;
  • Assign more weight to the specific-period macroeconomic forecast for the short-term outlook and systematically reduce that weight as the forecast loses relevance for time horizons in the more distant future;
  • Use the long-term forecast (e.g. the long-term GDP growth rate) whenever the specific forecast has lost relevance.

Institutions that use other scenarios in addition to the baseline scenario are expected to:

  • Estimate the probabilities of these scenarios and their deviation from the baseline according to the above principles;
  • Ensure that the probabilities assigned to scenarios and the deviations of such scenarios beyond the reliable forecasting horizon reflect experience collected over a sufficiently long-term horizon and not be based on specific year projections.

The Basel Committee on Banking Supervision (BCBS)[3] had set out additional measures to reduce the impact of COVID-19 on the global banking system. In its press release, the BCBS reiterated the importance of ECL frameworks, referring to both IFRS 9 and Current Expected Credit Loss Model (CECL) by the Financial Accounting Standards Board (FASB), urging banks to:

“Use the flexibility inherent in these frameworks to take account of the mitigating effect of the extraordinary support measures related to Covid-19.”

BCBS further stated that:

“Extraordinary support measures should be taken into account by banks when they calculate their ECLs.”

“Regarding the SICR assessment, relief measures to respond to the adverse economic impact of Covid-19 such as public guarantees or payment moratoriums, granted either by public authorities, or by banks on a voluntary basis, should not automatically result in exposures moving from a 12-month ECL to a lifetime ECL measurement.”

The approach towards the assessment has to be holistic, considering the effect on all the components considered in the computation of ECL.

The Institute of Chartered Accountants of India (ICAI), as a joint initiative of Accounting standards Board (ASB) and Auditing and Assurance Standards Board (AASB) has come out with a publication ICAI ACCOUNTING & AUDITING ADVISORY Impact of Coronavirus on Financial Reporting and the Auditors Consideration[4] which has provided guidance on various areas of financial reporting and Audit of financial statements, which require particular attention in respect of financial statements for the year 2019-20.

The guidance has provided the following points in relation to impairment losses as per Ind AS 109:

  • Measurement of ECL: the impact on business of borrowers or debtors to impact credit risk parameters in the following ways:
  • Increase in PD due to reduced business activity.
  • Adverse impact on value of collaterals and business cash flows in turn affecting the loss given default (LGD)
  • Full utilisation of undrawn limits and loan commitments in times of disruptions to impact exposure at default (EAD).
  • Entities to develop more than one scenarios considering the potential impact of COVID-19.
  • As a guidance from Appendix A of Ind AS 109: Borrower specific concession(s) given by lenders, on account of economic or contractual reasons relating to the borrower’s financial difficulty, which the lenders would not have otherwise considered. Such a condition to be considered as an evidence that a financial assets is credit-impaired.
  • Entities to consider impact of Prudential Regulatory actions to sustain the economy such as loan repayment holidays, reduction in interest rates etc.
  • Disclosures of the impact of COVID-19 on various credit related aspects such as methods, assumptions and information used in estimating ECL, policies and procedures for valuing collaterals etc.
  • Non-Banking Financial Companies (NBFCs) and Asset Reconstruction Companies (ARCs) should also carefully consider the recent guidance provided by Reserve Bank of India (RBI) on implementation of Ind AS[5]

The major component in ECL computation is the probability of default (PD). To arrive at the PD, we use historical PD by assessing the entities internal credit rating data as well as forward looking-macroeconomic factors in determining PD term structures. While assessing the forward looking PD, entities will have to consider the disruption in the business of the borrowers. Such disruption would have resulted in reduced economic activity, which in turn would have significantly increased the likelihood of default.

The effect of a pandemic on the ECL parameters have been discussed at length below.

The effect on ECL parameters in times of disruptions

The parameters used in reaching to the ECL are:

  • Probability of default (PD)
  • Loss given default (LGD)
  • Exposure at default (EAD)
  • Discount factor (df)

Further the ECL formula can be defined as “ECL= PD*LGD*EAD*df”.

To arrive at the PD, we use historical PD by assessing the entities internal credit rating data as well as forward looking-macroeconomic factors in determining PD term structures. While assessing the forward looking PD, entities will have to consider the disruption in the business of the borrowers. Such disruption would have resulted in reduced economic activity, which in turn would have significantly increased the likelihood of default.

The LGD is the indicator of quantum of loss from a transaction, given that a default occurs.  The LGD takes into consideration the exposure at default and post default classifications, valuation of any collateral as well as allocation of the same. The resultant decline in the economic activities due to lockdowns can have severe effects on the value of collaterals as well as cash flows of the business.

EAD is basically the estimation of the extent to which the financial entity may be exposed to a counterparty in the event of a default and at time of the counterparty’s default. EAD also takes into consideration, the expected payments in future scenarios. In estimation of EAD, the strength of the financial entity, in terms of assets (i.e loan given) and liabilities (i.e. loan taken) are kept in tandem to for assessment of contractual cash flows. However, in such times of disruption, the trend may be for the borrowers to fully exhaust the credit drawing limits and loan commitments, creating stress on the exposures, more so in case of revolving lines of credit facilities.

The discounting of the above components have to be done using the original effective interest rate (EIR). The EIR is arrived at after considering the current interest rate for the facility and adjusting with it, any fee or income charged. In times of such global disruptions, there is always a likelihood that the prevailing market interest rates takes a hit. As already we have seen by the RBI purchasing Rs 10,000 crore in government bonds under the open market operations programme as a measure against the disruption, the same would result in change in the risk free rate as well.

Effect of the moratorium grant on loan repayments on ECL by the RBI[6]

To address the stress in the financial sector caused by COVID-19, several measures have been taken by the RBI to mitigate the burden on debt-servicing caused due to the disruption. These measures include moratorium on term loans, deferring interest payments on working capital and easing of working capital financing. The lending institutions have been permitted to allow a moratorium of three months on payment of all instalments falling due between March 1, 2020 and May 31, 2020. The below explanation specifies effect of the moratorium.

Effect on credit risk and stage shifting

Since the moratorium is to be considered as a repayment holiday where the borrower is granted an option to not pay during the moratorium period, the same cannot be considered as a factor in determining change in the credit risk complexion of the borrower. The provisions of para 5.5.12 of Ind AS 109 are self-explanatory on the point that if there has been a modification of the contractual terms of a loan, then, in order to see whether there has been a SICR, the entity shall compare the credit risk before the modification, and the credit risk after the modification. Sure enough, the restructuring under the disruption scenario is not indicative of any increase in the probability of default.

Accordingly, the same should ideally not be considered as a factor for considering SICR and in turn, should not result in shifting of the financial instruments from one stage to another.

Effect on rebuttable presumptions about credit deterioration

The moratorium granted by the RBI seeks to amend the payment schedule without resulting in a restructuring. There is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due. However, the rebuttal may be offered in case the payments are more than 30 days past due. The very meaning of “past due” is something which is not paid when due. The moratorium amends the payment schedule. What is not due cannot be past due.

Effect on Effective interest rate (EIR) for the loan and income during the moratorium

The whole idea of the modification is to compute the interest for the deferment of EMIs due to moratorium, and to compensate the lender fully for the same. The IRR for the loan after restructuring should, in principle, be the same as that before restructuring. Hence, there should be no impact on the EIR.

As the EIR remains constant, there will be recognition of income for the entire Holiday period. For example, for the month of March, 2020, interest will be accrued. The carrying value of the asset (POS) will stand increased to the extent of such interest recognised. In essence, the P/L will not be impacted

Also, there will not arise any modification gain or loss as per para 5.4.3 of Ind AS 109 since the EIR remains constant.

Requirement of Impairment-testing of financial asset

The revision in the payment schedule does not result in a modification of the financial asset, which could have resulted in an impairment testing of the financial asset. Since the contractual modification in case of the moratorium is not a result of a credit event, the question of any impairment for this reason does not arise.

Conclusion

The concept of ECL being a fallout of the Global Financial Crisis, it will be interesting to see how fairly the model lives up in providing transparency to the users of financial statements at this time of global disruption. It is worth mentioning that ECL, being a reserve built up in good times which could be used in bad ones, the current situation is difficult, creating high levels of uncertainty but certain measures may be adopted by entities in curbing the situation to some extent, such as:

  • Developing more than one scenarios for the potential impact of the COVID-19 disruptions treated as macro-economic information as per para B5.5.4 of Ind AS 109
  • Effect of measures taken by the government and the regulators in the true spirit with which the same is implemented.

[1] https://cdn.ifrs.org/-/media/feature/supporting-implementation/ifrs-9/ifrs-9-ecl-and-coronavirus.pdf?la=en

[2]https://www.bankingsupervision.europa.eu/press/letterstobanks/shared/pdf/2020/ssm.2020_letter_IFRS_9_in_the_context_of_the_coronavirus_COVID-19_pandemic.en.pdf?b543f9408a8480e04748a3b0185d8cf3

[3] https:/www.bis.org/press/p200403.htm and  https://www.bis.org/bcbs/publ/d498.htm

[4] https://resource.cdn.icai.org/58829icai47941.pdf

[5] https://rbidocs.rbi.org.in/rdocs/Notification/PDFs/NOTI170F341D8DE49C04D4B8382D855A9858583.PDF

[6] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0

Actionables arising out of COVID 19- Regulatory Package brought in by RBI

By Team Corporate Laws, (corplaw@vinodkothari.com)

To address the stress in the financial sector caused by COVID-19, several measures have been taken by the RBI as a part of its Seventh Bi-monthly PolicyThe RBI also issued a Press Release on 27th March, 2020 namely, Statement on Developmental and Regulatory Policies followed by a Notification on the same date titled COVID 19- Regulatory Package. These measures are intended to mitigate the burden on debt-servicing caused due to disruptions on account of COVID-19 pandemic such as providing moratorium on term loans, deferring interest payments on working capital and easing of working capital financing. Considering the need of the hour, we have tried to jot down the immediate actionable arising out of the said Notification as below:

Sl. No Sequence of Events/ Actionables
1 Issue notice for calling Board Meeting at a shorter notice via VC mode or circulate the draft policy along with draft resolution for seeking approval through circular resolution.

 

Considering the urgency of the matter, VC may be the most viable option to get the necessary approval of the Board. Notice shall be accompanied with the draft agenda and draft of the policy to be adopted by the Board as per the Notification.

 

Where the company intends to pass resolution by circulation, the company may consider providing lesser time to the Board to revert with their vote on the resolution, instead of seven days from the date of circulation.

2. Conduct of Board Meeting through VC mode/ resolution by circulation to discuss the following

 

a.        to discuss the requirements of the RBI Press Release ‘Statement on Developmental and Regulatory Policies’ dated 27th March, 2020 and RBI Notification pertaining to COVID-19 – Regulatory Package. The significant points are:

i.            Moratorium of three months on payment of instalments in respect of all term loans outstanding as on March 1, 2020 and May 31, 2020;

ii.            Deferment of the recovery of interest applied in respect of all working capital facilities in the form of CC/ OD during the period from March 1, 2020 upto May 31, 2020;

iii.            recalculating  the  ‘drawing power’ in case of working capital facilities sanctioned in the form of CC/OD by reducing the margins and/or by reassessing the working capital cycle- in case applicable

 

b.       To adopt the draft of the Policy circulated to the Board Members. The Policy shall broadly include:

i.            Eligibility of the borrowers;

ii.            Restrictions/ conditions w.r.t rescheduling of payments of term loans and working capital facilities outstanding as on period from March 1, 2020 upto May 31, 2020;

iii.            Restrictions/ conditions w.r.t deferment of the recovery of interest applied in respect of all working capital facilities in the form of CC/OD during the period from March 1, 2020 upto May 31, 2020

iv.            Restrictions/ conditions w.r.t recalculating  the  ‘drawing power’ in case of working capital facilities sanctioned in the form of CC/OD; (in case applicable)

v.            Manner of such re-schedulement/ recalculation/ deferment;

vi.            Grounds for considering deemed acceptance by the eligible borrowers;

vii.            Process to be followed in case of customers do not opt for the re-schedulement/ recalculation;

viii.            Development of an MIS for exposure of INR 5 Cr. or more including the borrower-wise and credit-facility wise information regarding the nature and amount of relief granted;

ix.            Maintenance of records of customers opting/ not opting for the option;

x.            Process to be followed for implementation of the Policy.

 

c.        To authorize an officer to send necessary communication to eligible customer(s);

 

d.       To authorize an officer/ KMP to communicate the aforesaid developments at organizational level and give necessary instructions for the purpose of effective implementation thereof.

3 Prepare minutes of the meeting and circulate to all the Directors;

 

4. Display the Policy on the website of the Company;

 

5. Authorised person to give necessary intimation to the eligible borrowers by email or the tele callers will intimate. Alternatively, the moratorium may be extended to only those borrowers who expressly seek for the same from the lender. Further instructions must be given to the respective departments/ personnel within the organisation to ensure compliance with the policy;

 

6. Maintain record of the borrower communicating their acceptance of the option/ or expressly denying the option/ deemed acceptance in the manner as provided in the Policy;

 

7. Communicate the revised repayment terms and obtain confirmation from the borrower by way or email or telecommunication or such other feasible means. The communication will have to happen immediately, in order to take benefit of the moratorium.

 

 

 


 

press release [https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49582]

Notification [https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0]