– Vinod Kothari

[Vinod Kothari is an internationally recognised expert on securitisation-related matters. Author of Securitisation: The Financial Instrument of the New Millennium, Vinod Kothari has lectured on securitisation in several countries including India, Hong Kong, Sri Lanka, Jordan and Egypt. Vinod Kothari's website on securitisation, at is one of the most popular resources on the subject.]

The report of the RBI's in-house working group on securitisation is a welcome development. The report mulls several legislative changes and appropriate tax structure for securitisation.

The securitisation revolution has taken over the financial world. Securitisation is labeled as "the financial instrument of the new millennium". Coming at the very eve of the new millennium, the RBI should immediately act upon the report of the Working Group and pave the way for securitisation transactions.

India is a laggard in introduction of securitisation rules. Even the neighbouring country Pakistan has already introduced securitisation rules and notified them in December this year. Thailand, Korea, Japan, Italy, Portugal, etc. have all enacted securitisation rules. In Italy, notably, the securitisation law passed in April this year has led to a virtual avalanche of transactions. Most governments have seen securitisation as a development to invigorate debt markets, allow banks a restructuring option, introduce secondary debt markets, etc.

Basic applications of securitisation:

Though securitisation as an instrument originated in the mortgage markets in USA and was primarily instrument in allowing mortgage finance companies an option to sell off their mortgages to investors in capital markets, the concept has found a host of other applications. Wherever you have a stream of cashflows in future, you can see a securitisation possibility. Nay, there have been several applications of securitisation even in the field of insurance.

Though internationally, securitisation volumes are still mainly concentrated in mortgage markets, it is the banks which have found it to be the most conducive way restructuring their balance sheets. Recently, Morgan Stanley securitised NPAs of Japanese banks and many were surprised as the response the issue got from investors World-over. Several Italian banks have also parceled their bad loans on to the capital market.

It might surprise many as to who would possibly buy a bunch of bad loans? Answer: most bad loans are, after all, not that bad. They might be covered by securities. When the loans are handed over to a specialised agency whose only job is to recover them and to pass over the money to the investors, the time and attention the collection gets increases manifold the chances of good recovery. Besides, in most bad loan securitisation, the originating bank takes a subordinated interest so as to provide first claim on the cashflows to the outside investors. In other words, the possible recoverable part of the loans is realised in form of investments by external investors, and the rest is a write-off for the originating bank. The bank can, thus, trim is balance sheet and concentrate on creating fresh transactions rather than carrying a load of deadwood.

Needless to say, Indian banks would find securitisation a handy instrument. The asset reconstruction fund idea has not worked, as that would really be transferring bad loans from one pocket to the other. Rather, if the loans are sold to investors in the capital market, it would make recoveries far smarter.

The report of the Working Group:

The report of the working group stresses on creating legal environment for securitisation. It suggests changes for the short-term, medium-term and long-term.

It must be borne in mind that the current legal set up in India is not hostile to securitisation transactions at all. India is a common law country, and most common law countries, such as Hong Kong, Australia and Singapore, are into securitisation without any legal changes at all.

There are only very trivial legal changes that are essential, but they are highly technical in nature and are unlikely to stop the securitisation revolution even if not attended to. One, for example, is whether the ability to proceed under the Debt Recovery Tribunal procedure would extend to a securitisation SPV if a bank transfers its loans to an SPV. The intent could not have been otherwise, but may be a technical amendment to the relevant law would be required.

The basic legal framework of the law is, however, securitisation-friendly. The Transfer of Property Law in India, as for most other common law countries, requires a compulsory conveyance for securitisation transactions. This automatically brings in stamping issues, but 5 of the leading states have already notified special stamp duty rates for securitisation transactions. Others might do so in course of time.

The general structure of the income-tax law in the country permits a tax-transparent treatment for pass-through securitisations. Tax transparent treatments means taxation of the income of the investors, and not that of the SPV. In case of pay-through securitisation, the SPV is a taxable entity in most countries, and there is no special case in India to warrant tax free status for the SPV.

Are the legislative changes necessary?

The trouble with too much of a legislative change is that this retards action. While there is nothing in the present legal setup that should stop securitisation transactions, the investment bankers community would nevertheless wait for the legislative changes the RBI working group has proposed.

To my mind, all that is required in the short-term is:

(a) a clarification from the RBI permitting banks to invest in securitised instruments;

(b) framing of guidelines on the capital adequacy treatment for the banks that securitise their loans;

(c) norms on investment by foreign investors into securitisation instruments.

The suggested changes in the several laws that the working group has referred to are not essential in nature; they could follow in course of time. There is no point in keeping the impulse for securitisation on hold till the changes take place.

Limit SEBI's role to disclosure requirements

Among the suggestions the working group has given, there is a point on the SPV's structure. The Group has been open-minded enough to allow entities to choose the appropriate structure – a trust, a company, an AOP, etc. However, there is no point in equating a securitisation SPV with a mutual fund. That would be mixing up absolutely unconnected instruments. A mutual fund is a collective investment vehicle that keeps investing in capital market instruments on an ongoing basis. A securitisation SPV is a "special purpose" vehicle – its only purpose is to invest in the receivables offloaded by the originator. It does not keep switching over from one form of investment to another. It invests the investors' money into receivables of one and only one originator.

Therefore, it is inappropriate to compare an SPV with a mutual fund. It is equally inappropriate to impose minimum capital requirements for SPVs. In most securitisation transactions, the SPVs are thinly capitalised entities. In certain stratified securitisations, there is an element of equity contribution put by the originator, but that is only a credit enhancement provided to the transaction, which is best left to the originator and the rating agencies, and there is no business the regulator has in insisting on capital requirements.

Similarly, requirements of registering SPVs with SEBI are meaningless. SEBI can lay down disclosure norms applicable in case of public offers. Private placements should be free of any such norms as it is a domestic concern of the issuer and the investors. It must be realised that most securitisation investors world-over are institutional investors and they do not need protection from SEBI-type bodies as in case of capital market issues.

Capital adequacy requirements crucial:

If banks are to get into securitisation activity, the RBI must immediately frame capital adequacy norms. Such norms are in place in the USA in form of the FIDC's and the FRB's guidelines, in the UK in form of FSA's detailed guidelines, and in Singapore in form of the MAS's norms. The template is available, and the RBI can easily learn from experience of others.