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FAQs on Resolution of Loan Accounts under COVID-19 stress

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

Background

As a part of measures for combating the effect of COVID-19 on the economy, the Reserve Bank of India (RBI), on August 6, 2020[1], introduced Resolution Framework for COVID-19 Related Stress (‘ResFraCoRS’), a special window for resolution of assets undergoing stress due to COVID-19 disruption[2]. This special window was introduced in addition to the Prudential Framework on Resolution of Stressed Assets issued on June 7, 2019 (FRESA)[3]. We have earlier covered FRESA in a separate write up titled “Prudential Framework for Resolution of Stressed Assets: New Dispensation for dealing with NPAs”[4]

The ResFraCoRS notification (‘Framework’) referred to an expert committee which shall identify suitable parameters, recommend sector specific parameters, recommend financial and non-financial conditions to be incorporated in the RP and to vet the RP as discussed above.

Further, the ResFraCoRS notification requires the RP with an amount of Rs. 1500 crores or more to be vetted by the expert committee.

Based on the recommendations of the expert committee submitted to RBI on September 4, 2020[5], the RBI issued a follow-up circular on September 7, 2020[6], which shall be complied, in addition to and as a part of the ResFraCoRS.

We have prepared below, a set of FAQs on ResFraCoRS, based on the aforementioned circulars issued by the RBI.

Timeline of events under ResFraCoRS

Frequently Asked Questions (FAQs) –

General

1.If loan modification/restructuring is a mutual contract between the lender and the borrower, why should I be seeing the regulatory framework?

True, loan modification is a mutual contract between the lender and the borrower. However, the Prudential Guidelines provide that if a facility is restructured, with a view to avert a credit weakness, then the restructured facility is regarded as a non-performing facility. This is a general feature of prudential regulations that assets are to be immediately classified as substandard upon restructuring. Hence, if a restructuring is done without adherence to the regulatory framework, then the facility will be treated as non-performing, immediately upon restructuring,

2. How does the loan modification help the lender, borrower, or both?

Loan modification restructures the servicing requirements of a loan, so that the borrower may meet the obligations. If the terms of the loan remain unconnected to the cashflows of the borrower, the borrower may not be able to perform. A non-performing borrower soon starts attracting penal clauses of the loan facility, thereby pushing the borrower further into the realm of non-performance. Eventually, the problem becomes incapable of resolution, and may result in insolvency or chronic default. A chronic default, while meaning exorbitant cost on the borrower, also causes a clog on the books of the lender, and eventually, results in an inefficient economy.

A good credit system is what can be serviced – there is no point in creating credit which cannot be serviced. Therefore, a loan modification, where required, should be encouraged.

Applicability – lenders and borrowers

3. On what lenders shall the ResFraCoRS be applicable?

ResFraCoRS shall be applicable on all banks, NBFCs, HFCs, AIFIs etc. who have extended loans to eligible borrowers.

4. Are all NBFCs considered as eligible lenders for the purpose of this Framework?

The FRESA was addressed to only systemically important NBFCs and deposit taking NBFCs. However, the ResFraCoRS, which is a special window to deal with COVID related disruptions is applicable to all NBFCs. Unlike FRESA, the ResFraCoRS deals with personal loans also, and NBFCs are a key provider of personal loans.

5. Who shall be the eligible borrowers?

Following shall be the eligibility criteria for the borrowers:

  • The borrower/loan account should not be falling under the list of ineligible loans/exposures provided in the ResFraCoRS notification;
  • In case of resolution of personal loans, the Loan Account should, as on March 1, 2020, be:
    • classified as ‘standard’ in the books of the lender
    • not be in default for more than 30 days with the lender
  • In case of other than personal loans, the loan account should, as on March 1, 2020, be:
    • classified as ‘standard’ in the books of all the lenders
    • not be in default for more than 30 days with any of the lenders
  • The loan accounts should continue to be classified as ‘standard’ in the books of the lender or all the lenders, as the case may be, till the date of invocation of RP.

5A. What kind of personal loans would be covered under the Covid-19 restructuring window? Would it be applicable to car loans/ education loans, etc.?

Under the framework, personal loans refers to loans given to individuals and consist of –

Sr. No. Type of loan covered Definition/ remarks, if any
a. Consumer credit Consumer credit refers to the loans given to individuals, which consists of –

(a)    loans for consumer durables,

(b)   credit card receivables,

(c)    auto loans (other than loans for commercial use),

(d)   personal loans secured by gold, gold jewellery, immovable property, fixed deposits (including FCNR(B)), shares and bonds, etc., (other than for business / commercial purposes),

(e)    personal loans to professionals (excluding loans for business purposes), and

(f)     loans given for other consumptions purposes (e.g., social ceremonies, etc.).

 

However, it excludes

(a)    education loans,

(b)   loans given for creation/ enhancement of immovable assets (e.g., housing, etc.),

(c)    loans given for investment in financial assets (shares, debentures, etc.), and

(d)   consumption loans given to farmers under KCC.

b. Education loan While the above definition of consumer credit excludes education loans, housing loans and loans for purchase of financial assets, these loans are covered within the overall definition of “Personal Loans”
c. Loans given for creation/ enhancement of immovable assets (e.g., housing, etc.)
d. Loans given for investment in financial assets (shares, debentures, etc.)

Thus looking at the above definition of personal loans, car loans, education loans, and several other types of loan exposures would be covered under ResFraCoRS.

5B. From a lender’s perspective, will an entire category of borrowers be eligible to avail the restructuring benefit?

The restructuring option is applicable for personal loans and other eligible exposures, where the borrower account is classified as standard, but not in default for more than 30 days (SMA-0) as on 1st March, 2020. Accordingly, the restructuring benefit would be applicable only to those who are not excluded under the RBI circular- such as MSME borrower with less than Rs.25crore exposure, are classified as SMA-0 as on March 1, 2020 and are having stress on account of Covid19.

In this regard, an entire category of borrower may be said to be facing stress due to the Covid disruption and subject to fulfillment of the eligibility conditions the restructuring benefit may be extended to them.

6. Is a “financial service provider” an eligible borrower, to avail the benefit of the restructuring under the Framework?

 The ResFraCoRs specifically exclude exposures to financial service providers. Therefore, financial service providers are not eligible borrowers. The definition of the term “financial service provider” has been drawn from the Insolvency and Bankruptcy Code, 2016. Apparently, NBFCs are covered under the definition of Financial Service Provider.

6A. Is the scheme applicable to MSMEs as well?

The scheme is applicable on MSME borrowers whose aggregate exposure to lending institutions collectively, is Rs. 25 crores or more as on March 1, 2020. The reason for the criteria of Rs. 25 crores or more collective exposure is because there is a separate notification for Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances dated August 6, 2020, which is applicable on MSME borrowers having loan limits up to Rs.25 crores.

7. A bank has given a loan to an NBFC, and discovers that due to the prevailing situation, the NBFC will not be able to meet its obligations as they currently exist. Can the bank restructure the facility?

 As stated above, the ResFraCoRS exclude exposures to FSPs. Therefore, the benefits under the said framework shall not be available in case of restructuring of loans extended to such entities.

However, banks can, at their discretion, consider restructuring of loans extended to FSPs, in such case, the general principles relating to restructuring of loans shall apply, including downgrading of account to NPA etc.

8. Under what circumstances or with what underlying motive is the ResFraCoRS applicable?

Any borrower, whose ability to service loan/credit facilities has been disrupted because of the COVID disruption may be covered by the Framework.

In our view, the types of borrowers may be classed into:

  • Those who had credit weakness/deterioration in credit prior to the beginning of the crisis
  • Those who did not demonstrate credit weakness before the COVID disruption (that is, before March 2020) but have had cashflow stress (mild, moderate of severe) during the COVID disruption; once the moratorium period is cover, their business is normal are not having any issues in their ability to service the facility
  • Those who did not demonstrate credit weakness before the COVID disruption (that is, before March 2020) but have had cashflow stress during the COVID disruption, which now seems to having a lasting impact on their servicing ability;
  • Those who did not demonstrate any credit weakness either before, during or after the COVID disruption

In our view, type (a) does not qualify for the present framework, as the intent of the present framework is only to modify those loans that have been disrupted due to the Covid-19 related stress.

Type (b) also does not require any restructuring. During the 6 months of moratorium, a standstill was granted, and that sufficiently helped the borrower. The borrower is back to the same cashflows as before the crisis/

Type (d) borrowers obviously do not require any restructuring.

It is type (c ) where the Framework requires help. That is where the present Framework operates.

To give an example,

  • A personal loan, home loan or car loan was given to a borrower, which was deducted from his monthly salaries. During the month of April to June, the borrower was given a moratorium as his office was shut and the borrower did not get salaries. From the month of July, the office is back in operation and the borrower keeps on getting salaries as before. Obviously there is no need for restructuring in the present case.
  • An infrastructure sector contract had taken a loan for an excavator. The excavator was lying idle during the months of April- June. July -Aug-Sept are typical monsoon months. It is expected that from October, normal construction activity may pick. The borrower’s servicing ability does not require any loan modification.
  • A loan was given for a CRE project. The project was stuck during April to July. While construction has begun in the month of August, however, it is apprehended that the demand for real estate may remain very sluggish at least over the next 12 months. This seems to be an appropriate case for ResFraCoRS.

Further, under the ResFraCoRS, the eligible borrowers may be divided into 3 categories:

  • Category 1- Borrowers of personal loans;
  • Category 2- Other than personal loan borrowers, which have availed loans from a single financial institution only;
  • Category 3- Other than personal loan borrowers, which have availed loans from more than one financial institution;

9. Is it applicable to both term loans as well as working capital facilities?

The eligibility criteria for ResFraCoRS is based on the asset classification of the borrower and not on the type of loan facility. The demarcation of term loans and working capital facility has to be done for the purpose of granting moratorium, however, for considering restructuring under this framework, any exposure to the borrower shall be covered. Hence, irrespective of the loan account being a term loan or working capital facility, in case it fulfills the eligibility criteria and the lenders have established that the stress in the account is due to covid disruption, the loans may be restructured under this framework.

 Formulation of RP

10. The August 6, 2020 as well as the June 7, 2019 circulars refer to a resolution plan – what exactly is a resolution plan?

The objective of a loan modification is not merely to grant concessions – it is to ensure that the terms of the loan are restructured so as to make the loan serviceable, at the same time, without compromising the interests of the lender(s). Hence, the “resolution plan” is the structured approach of the lender in modifying the terms of the loan so as to make the terms mutually agreeable, and mutually beneficial.

Quite often, in cases of large exposures, a resolution plan may involve capitalization of interest, partial conversion of debt into equity, change in terms of security, infusion of capital by the borrower, etc. Therefore, the resolution plan is a comprehensive approach to loan modification.

It is also notable that there are, often, cases of multiple lenders to the same borrower. Therefore, the loan modification is expected to take care of the interests of multiple lenders in a cohesive approach.

11. What are the different options/approaches in the resolution plan?

In case of personal loans covered in Part A, the resolution plans may inter alia include the following:

  • rescheduling of payments;
  • conversion of any interest accrued, or to be accrued, into another credit facility;
  • granting of moratorium, based on an assessment of income streams of the borrower, subject to a maximum of two years.
  • Modifying the overall tenor of the loan.

In case of other exposures covered in Part B, the RP may involve any action / plan / reorganization including, but not limited to:

  • regularisation of the account by payment of all over dues by the borrower entity;
  • sale of the exposures to other entities / investors;
  • sanctioning of additional credit facilities;
  • allowing extension of the residual tenor of the loan;
  • granting moratorium;
  • conversion of debt into instruments such as equity, debentures etc.
  • change in ownership and restructuring, except compromise settlements which shall continue to be governed by the provisions of the Prudential Framework or the relevant instructions, if any, applicable to specific categories of lending institutions.

The resolution plan may also include sanctioning of additional credit facilities to address the financial stress of the borrower on account of Covid19 even if there is no renegotiation of existing debt.

12. What is the meaning of “invocation” of an RP? Who invokes it? Borrower or lender? If there are multiple lenders, can it be invoked by any lender?

In case of personal loans the borrower and lender should agree to proceed with RP. The date on which the borrower and lender agree to proceed with the RP shall be the date of “invocation”.

In case of other exposures, where there is only one lending institution with exposure to the borrower, the decision regarding the request for resolution by the borrower may be taken by the lending institution as per the Board approved policy of the institution and within the contours of this framework.

This is similar to the existing Corporate Debt Restructuring scheme of RBI where the borrower does not have the inherent right to ask the lenders to restructure, however, the borrower may certainly request lenders to consider the same. Further, for this purpose, the date of invocation shall be the date on which both the borrower and lending institution have agreed to proceed with a resolution plan under this framework.

In case of multiple lenders with exposure to the borrower, the resolution process shall be treated as invoked in respect of any borrower if lending institutions –

  • Representing 75% by value of the total outstanding credit facilities (fund based as well non-fund based), and
  • not less than 60% of lending institutions by number agree to invoke the same.

13. The facility is currently not in default. It was within 30 days past due as on 1st March and thereafter, the facility was covered by moratorium. On 1st September, the lender realises that the cashflows of the borrower may be strained. Does the lender have to wait for any default? Can there be restructuring even when there is no default?

In our view, the resolution may be done for an imminent or incipient, or even apprehended default. The whole idea of resolution is to resolve a problem before it becomes unsurmountable. Hence, the fact of any default is not a precondition.

14. Who will frame the repayment plan?

In case of category 1 and 2 borrowers, the lender shall frame the RP. In case of multiple lenders i.e. category 3 borrowers, execution of ICA is a mandatory requirement wherein all the lenders shall agree on a resolution process, based on which a RP shall be formulated. Further, the Expert Committee shall verify the RP implemented in case the aggregate exposure of the lending institutions is Rs. 1500 crore or more.

15. What are the different stages of the loan restructuring process?

  • Realisation that a restructuring is required
  • Invocation of restructuring plan
  • Framing of restructuring plan
  • Signing of an ICA
  • Implementation of the restructuring plan including putting in place an escrow mechanism etc
  • Review period
  • Post-review period

 16. What are the preconditions for invocation of RP?

For categories 1 and 2:

  • The borrower should be eligible; and
  • The borrower and lender should agree to proceed with RP.

For category 3:

  • The borrower should be eligible;
  • Lending institutions representing at least 75 % by value of the total outstanding credit facilities (fund based as well non-fund based) agree to invoke the RP; and
  • At least 60 % of lending institutions by number agree to invoke the RP.

 17. In case of borrowers with business loans, is there any classification/ categorisation of borrowers based on the size of the exposure?

Under the Framework, it may be useful to classify borrowers into the following sizes:

  • Aggregate exposure of Rs 100 crores or more – Independent credit evaluation (ICE) by any one credit rating agency (CRA) authorized by the RBI under FRESA to be carried out.
  • Aggregate exposure of Rs 1500 crores or more- the RP shall be subject to vetting by the expert committee.

18. One of the measures is providing a moratorium on loan repayment. Will this moratorium be a part of the existing moratorium facility provided to borrowers?

The ResFraCoRS notification provides that in cases where moratorium is granted to eligible borrowers, such moratorium shall be subject to a ceiling of 2 years. It is to be noted that the resolution under this framework is independent of any moratorium or other relief provided to the borrowers under other frameworks introduced by the RBI.

Hence, the above mentioned period of 2 years shall be in addition to the earlier moratorium granted to the borrowers. The earlier moratorium is not to be included in this period of 2 years.

This has been further clarified by para 28 of the ResFraCoRS notification, which states that the moratorium shall come into force immediately upon implementation of the resolution plan.

19. Can the debt be converted into equity instruments?

Conversion of debt into equity may be done provided the amortisation schedule and the coupon carried by such debt securities must be similar to the terms of the debt held on the books of the lending institutions, post implementation of the resolution plan.

Further, equity instruments are to be valued at market value, if quoted, or else, should be valued at the lowest value arrived using the book value or discounted cashflow valuation methodologies. Equity instruments, where classified as NPA shall be valued at market value, if quoted, or else, shall be collectively valued at Re.1. [Refer para 19 (c) and (d) of Annex to the Prudential Framework dated 7th June, 2019].

20. Can the debt be converted into NCDs/ preference shares or any other instrument?

Yes, the special window makes it clear that conversion of debt into NCDs or preference shares or any other instrument may be done. The debentures/ bonds would be valued on the YTM basis as per para 3.7.1 of the Master Circular – Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Banks[7] dated July 1, 2015 (as amended from time to time) or would be valued as per other relevant instructions as applicable to specific categories of lending institutions.

In case of conversion of any portion of the debt into any other security, the same shall collectively be valued at Re.1.

ICA and Escrow Arrangement

21. Is signing of Inter-Creditor Agreement (ICA) mandatory?

The notification clarifies that signing of ICA is a mandatory requirement for all lending institutions in all cases involving multiple lending institutions, where the resolution process is invoked.

22. Is there any time limit for signing the ICA?

The ICA should be signed within 30 days of invocation of RP.

 23. What will happen if ICA is not signed within the time limit?

In case the ICA is not signed within the prescribed time limit, the invocation of RP shall lapse. Further, additional provision of 20% will have to be maintained in respect of the carrying debt of the borrower in question, i.e. total outstanding of the borrower to all its lenders.

24. How should escrow accounts be maintained in case of ICA?

Escrow accounts shall be required only in case of category 3 borrowers. Para 10 of the follow-up circular states that the escrow account shall be maintained after implementation of RP on borrower-account level, i.e. the legal entities to which the lending institutions.

25. What are the limitations of the restructuring under the ResFraCoRS Framework?

The main limitation of the restructuring under ResFraCoRS is the tenor restrictiction of 2 years, in case of granting of moratorium under resolution plans. Further, the ratios prescribed under the financial parameters by the expert committee are required to be met by 2022 and on an ongoing basis thereafter. It must be noted that the expert committee suggested that the  TOL/Adjusted TNW and Debt/ EBIDTA ratios should be met by FY 2023. Further, some of the conditions (discussed later) of the Prudential Framework of June, 2019 are also additionally applicable in case of ResFraCoRS.

Relevance of the 7th June 2019 – Prudential Framework for Resolution of Stressed assets

26. Is the COVID-related framework a special case within the 7th June 2019 Directions, or is it an independent restructuring proposition?

The ResFraCoRS is a special window under the 7th June, 2019 – Prudential Framework for Resolution of Stressed Assets issued by RBI. Accordingly, the requirements specified in the Prudential Framework of June, 2019 would also apply in case of ResFraCoRS.

It is further clarified that accounts which do not fulfill the required eligibility conditions to be considered for resolution under the ResFraCoRS may continue to be considered for resolution under the Prudential Framework of June, 2019, or the relevant instructions as applicable to specific category of lending institutions where the Prudential Framework is not applicable.

27. What are the major provisions of the June, 2019 Directions which are applicable to the Covid-related restructuring as well?

The ResFraCoRS specifically mentions that without prejudice to the specific conditions applicable to this facility, all the norms applicable to implementation of a resolution plan, including the mandatory requirement of Inter Creditor Agreements (ICA) and specific implementation conditions, as laid out in the Prudential Framework shall be applicable to all lending institutions for any resolution plan implemented under this facility. Terms used in this document, to the extent not defined in the ResFraCoRS, shall have the same meaning assigned to them in the Prudential Framework.

Accordingly, the following major provisions of the Prudential Framework of June, 2019 would apply to the ResFraCoRS as well –

 

Para No. Particulars Requirement
9 Policy for resolution of stressed assets Lenders must put in place a Board approved policy for resolution of stressed assets.

 

This is apart from the policies mentioned in the COVID-related framework and these may be combined into a single policy as well.

10 Inter Creditor Agreement (ICA) The ICA shall provide that any decision agreed by lenders representing 75% by value of total outstanding credit facilities (fund based as well non-fund based) and 60% of lenders by number shall be binding upon all the lenders.

 

Additionally, the ICA may, inter alia, provide for rights and duties of majority lenders, duties and protection of rights of dissenting lenders, treatment of lenders with priority in cash flows/differential security interest, etc. In particular, the RPs shall provide for payment not less than the liquidation value due to the dissenting lenders.

Further, para 13 of the Prudential Framework dealing with inclusions in the RP are also applicable to ResFraCoRS with some modifications/ exceptions stated in para 27 of ResFraCoRS. Furthermore, it seems that para 16 of the Prudential Framework would also apply in case of ResFraCoRS (para 16 deals with deemed implementation in case of RP involving lenders exiting the exposure by assigning the exposures to third party or a RP involving recovery action).

28. The Prudential Framework mentions other requirements such as “Review Period” and “Prudential Norms”. Would these apply in case of ResFraCoRS?

Para 6 of ResFraCoRS states that all norms applicable to “implementation of a RP” under the Prudential Framework of June, 2019 would apply to ResFraCoRS. Accordingly, prudential norms would not be applicable in case of ResFraCoRS as this is already specifically taken care of in ResFraCoRS itself.

Furthermore, other requirements such as review of the borrowers account within 30 days of default would not apply as the ResFraCoRS already prescribed specific eligibility norms in its framework.

Financial Parameters

29. What financial parameters are to be considered while formulating the RP?

The notification has defined a set of 5 key ratios that must be mandatorily considered while finalising the resolution plan in respect of eligible borrowers. While the mandatory ratios must be followed, lenders have the liberty to consider other financial parameters as well, while finalizing the resolution assumptions in respect of eligible borrowers.

The Key ratios and definitions along with additional remarks on the same are presented below –

 

Sr. No. Key Ratio Definition
1 Total Outside Liabilities / Adjusted Tangible Net Worth (TOL/ATNW)

 

(Ceiling)

Addition of long-term debt, short term debt, current liabilities and provisions along with deferred tax liability divided by tangible net worth net of the investments and loans in the group and outside entities.
Remarks – In respect of those sectors where the sector-specific thresholds have not been specified, lending institutions shall make their own internal assessments regarding TOL/ATNW.

 

Compliance to TOL/ATNW agreed as per the resolution plan is expected to be ensured by the lending institutions at the time of implementation itself.

 

Nevertheless, in all cases, this ratio shall have to be maintained as per the resolution plan by March 31, 2022 and on an ongoing basis thereafter.

 

Wherever the resolution plan envisages equity infusion, the same may be suitably phased-in over this period.

 

Another concern in this regard is that the definition of Adjusted Tangible Net Worth provides for deduction of investments and loans in the group and outside entities. Considering a large proportion of the eligible borrowers for this framework will be infrastructure companies, this could be a major problem. Most of the entities engaged in the infrastructure space operate through SPVs, instead of working directly. Therefore, the majority of their assets are deployed in the equity of the SPVs. If the above definition of ATNW is to be followed, these entities will become ineligible for the purpose of this framework.

2 Total Debt / EBITDA

 

(Ceiling)

Addition of short term and long-term debt divided by addition of profit before tax, interest and finance charges along with depreciation and amortisation.
Remarks –

In respect of those sectors where the sector-specific thresholds have not been specified, lending institutions shall make their own internal assessments regarding Total Debt/ EBITDA.

This shall have to be maintained as per the resolution plan by March 31, 2022 and on an ongoing basis thereafter.

3 Current Ratio

 

(Floor)

Current assets divided by current liabilities
Remarks –

Current ratio in all cases shall be 1.0 and above.

This shall have to be maintained as per the resolution plan by March 31, 2022 and on an ongoing basis thereafter.

4 Debt Service Coverage Ratio (DSCR)

 

(Floor)

For the relevant year addition of net cash accruals along with interest and finance charges divided by addition of current portion of long term debt with interest and finance charges.
Remarks –

This shall have to be maintained as per the resolution plan by March 31, 2022 and on an ongoing basis thereafter.

5 Average Debt Service Coverage Ratio (ADSCR)

 

(Floor)

Over the period of the loan addition of net cash accruals along with interest and finance charges divided by addition of current portion of long term debt with interest and finance charges.
Remarks –

ADSCR shall in all cases be 1.2 and above.

This shall have to be maintained as per the resolution plan by March 31, 2022 and on an ongoing basis thereafter.

30. Are the financial parameters required to be considered in all the cases?

The financial parameters shall be considered in case of RP formulated for borrowers eligible under part B of  ResFraCoRS.  Part B of the ResFraCoRS deals with borrowers falling in categories 2 and 3.

31. What are prescribed thresholds to be maintained in respect to the ratios?

The expert committee has prescribed thresholds specific to the nature of the various industries. The annexure to the follow-up circular contains the ceilings/floors prescribed with respect to 26 sectors/industries.

32. What should be done in case there are no sector-specific parameters prescribed with respect to a certain industry?

While the follow-up circular prescribes ratio limits for a wide variety of industries, certain borrowers may not fall in any of those sectors. Further, in the annexure, certain ratios for some sectors have not been prescribed. For such kinds of borrowers, the lenders shall determine the limits considering the financial situation of the borrower, viability of borrower’s business, and the stress on the borrower. However, the current ratio and DSCR in all cases shall be 1.0 and above, and ADSCR shall be 1.2 and above.

33. The sectors specified in the framework do not include financial services, does this mean financial services entities (such as NBFCs, HFCs, who have availed loans from other NBFCs/banks) are not eligible for restructuring under this framework?

The sector specific ratios are provided as general parameters to be considered while formulating RP. This in no way indicates that the borrowers belonging to such sectors shall not be eligible for restructuring.

In case of borrowers falling in the sectors for which the ratios are not specified, the lender shall decide its own limits based on the assessment of the borrower.

However, please refer to our response on eligibility of loans to FSPs under this framework.

34. Who shall meet the ratios?

The borrower is required to meet the ratios at entity-level and the lenders are required to ensure that the same is being met as per the timelines.

For the real estate sector, the expert committee recommended that the ratios with respect to particular projects be met since the loans are usually granted for a project. However, the RBI, in the follow-up circular has not laid any such provision.

35. At what point of time shall these ratios be considered?

The above mentioned key ratios shall have to be maintained by the borrower as per the resolution plan by March 31, 2022 and on an ongoing basis thereafter.

Additionally, TOL/ATNW shall be required to be maintained by the borrower at the time of implementation of the RP itself, as per the resolution plan by March 31, 2022 and on an ongoing basis thereafter.

36. As discussed above, TOL/ATNW shall be maintained at the time of implementation. What should be done in case the ratio is not met?

In case the TOL/ATNW ratio is not met at the time of implementation, the same may require equity infusion by the promoters or conversion of outstanding debt to equity to meet the criteria.

 37. Several instruments are treated as debt due to Ind-AS, would these instruments be considered to be included in the definition of TOL/ATNW?

The definition of TOL/ATNW provided under the notification dated 07th September, 2020 seems to be hinting towards what is legally considered to be a debt. Thus, for the purposes of TOL/ATNW, instruments considered as a debt as per Ind-AS would not come under this definition.

For instance, redeemable preference shares are considered as a debt as per Ind-AS 32. However, for the purpose of TOL/ATNW, redeemable preference shares would not be considered.

38. What parameters shall be considered other than the ratios prescribed by the follow-up circular?

Lenders shall, in addition to the above mentioned ratios, consider pre-Covid-19 operating and financial performance of the borrower and impact of Covid-19 on its operating and financial performance at the time of finalising the resolution plan. Further, they shall also assess the expected cashflows in subsequent years, to ensure that the ratios will be complied with on an ongoing basis.

39. Should these ratios be met by the borrower at the time before covid?

The ResFraCoRS is for the borrowers whose business is otherwise viable but has been affected due to covid disruption. Hence, financial institutions considering to restructure loan accounts under ResFraCoRS, shall evaluate the financial condition of borrower pre and post covid.

These ratios provide a quantifiable basis for evaluating the financial condition of the borrower. Going by the intent, the borrower should positively meet the ratios before crisis and thereafter reach the ratios in the prescribed time.

40. What if ratios are not met in the pre-covid period?

In case the ratios are not met pre covid, it is an indication that financial strength of the borrower was not very stable even before the crisis. Hence, it is not because of the crisis that the borrower is unable to pay. Considering this, the account of the borrower should not be restructured under ResFraCoRS.

It is noteworthy that the ratios are not the sole indicators of financial strength of a borrower. Several other parameters as suitable to the nature of the borrower should also be considered.

 41. What if out of 5, only 3 ratios are met in the pre-covid period?

In case the borrower meets some of the ratios and not all, the lenders shall assess other parameters as well to evaluate financial condition of the borrower and decide whether restructuring shall be done for such borrower account.

42. In case there is only a single lender to a borrower, what ratios or parameters shall be met by such borrower?

Para 5 of the follow-up circular clearly states that the above mentioned ratios shall be met even in case a borrower has availed loan from only one lending institution. These kinds of borrowers shall fall under category 2 discussed above. Even though certain provisions of the ResFraCoRS may not be applicable on this category, maintenance of ratios shall certainly be applicable.

43. What happens if the borrower fails to meet the ratios at any time after implementation of RP?

If the borrower is unable to meet the prescribed ratios it shall be construed as a default on its part to comply with the terms of the RP. This would result in downgrade of asset classification of the borrower to NPA, with all lending institutions, including those who did not sign the ICA, from the date of implementation of the RP or the date from which the borrower had been classified as NPA before implementation of the plan, whichever is earlier.

Provisioning requirements

44. Para 39 of the Framework states that a provision of 10% shall be applicable on accounts which have been restructured in terms of the Framework. How is the restructuring, under this Framework, then different from any other restructuring?

In case of any other restructuring, the classification of the asset gets downgraded to NPA status. The provision requirement on NPAs may be 10%, but that 10% is for a sub-standard asset.

In case of restructuring under the Framework, if the restructuring is done, the asset retains its standard status. Hence, the 10% provision may be regarded as “general loss provision”

It is also notable that there was no requirement  of the 10% provision under the June 2019 Directions. There were disincentives against not implementing the resolution plan within the timelines in para 17 of the Directions.

45. Will there be a case for reversal of the provision as referred to above?

Yes, half of the provisions may be reversed if the borrower repays 20% of the residual debt outstanding to the lender or lenders as the case maybe, provided the asset has not slipped into NPA post implementation of the RP.

Further, the remaining half may also be reversed when additional 10% of the carrying debt is repaid. However, it shall be ensured that such reversal does not result in reduction of provisions below the provisioning requirements as per IRAC provisions.

Credit information reporting

46. Does the fact of restructuring under the Framework have to be reported to CRILC or anywhere else?

 As per the ResFraCoRS, for the purpose of credit reporting, the accounts shall be treated as restructured if the resolution plan involves renegotiations that would be classified as restructuring under the FRESA. The credit history of the borrowers shall consequently be governed by the respective policies of the credit information companies as applicable to accounts that are restructured.

Other Considerations

47. As per ResFraCoRS, a policy is required to be adopted for resolution of assets under the said framework. Will the follow-up circular require amendment to the policy adopted by a company in this regard?

In our view, considering that the key ratios are mandatory, a suitable modification to the policy would be required to be made.

 48. The follow-up circular talks about gradation of borrowers. On what basis shall the gradation be done?

The follow-up circular states that lenders may carry out a gradation of the borrowers. This gradation shall be done based on the impact of the pandemic on a specific sector or the borrower. As per the recommendation of the expert committee, borrowers may be graded into mild, moderate and severe impact borrowers.

While considering the gradation of the borrowers, the amount and risk involved, extent of legal/regulatory compliances involved in the resolution process etc. should also be factored in.

 49. What is the purpose of such gradation?

Gradation of borrowers based on the severity of impact, extent of compliances and the amount and risks involved, enables the lenders to distinguish the accounts that require more attention. Based on the gradation, lenders may decide upon internal procedures such as delegation, time involvement etc, for various categories of accounts.

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11941&Mode=0#FT2

[2] Our write-up on the Framework may be referred here- http://vinodkothari.com/2020/08/resolution-framework-for-covid-19-related-stress-resfracors/

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

[4] http://vinodkothari.com/2019/06/fresa/

[5] https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1157

[6] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11961&Mode=0

[7] https://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9904#371

Additional relief from COVID-19 disruptions

Based on the recommendations of the Monetary Policy Committee

-Financial Services Division (finserv@vinodkothari.com)

Extension of the restructuring norms for MSME debt

The RBI via a notification on 1st January 2019[1] had allowed NBFCs and banks to restructure their advances to MSMEs, classified as ‘standard’, without any asset classification downgrade and the same was extended further on 11th February 2020.[2]

Through the notification dated August 6, 2020[3], the RBI has again extended the timeline for restructuring till March 31, 2021.

Further, the notification dated August 6, 2020 provides that the accounts which may have slipped into NPA category between March 2, 2020 and date of implementation i.e. from August 6, 2020 to March 31, 2021, may be upgraded as ‘standard asset’, as on the date of implementation of the restructuring plan.

For accounts restructured under these guidelines, the lenders are required to maintain an additional provision of 5% over and above the provision already held by them with respect to standard assets. Though, the extension notification does not specifically provide such provisioning requirements for NBFCs, however, reading in consonance with the January 2019 notification, it can be said that the requirement is for both banks and NBFCs.

The extension of relaxation would chiefly benefit the MSME borrowers who are having sound businesses as well as repayment capabilities however, are unable to meet their obligations post 1st March 2020, due to widespread disruption caused by the pandemic. The move would ensure that MSMEs that are having a viable business standing are not hit by negative classification just because of short term volatilities.

Advances against Gold Ornaments and Jewellery

The existing RBI guidelines[4] require that for the loan granted by banks against the security of gold jewelry i.e. gold loans a Loan-to-Value (LTV) Ratio of maximum upto 75% has to be maintained. Through notification dated August 6, 2020[5], LTV requirement has been relaxed temporarily. Accordingly, banks may now lend up to 90% of the amount of gold jewellery pledged until March 31, 2021.

Banks may, while sanctioning new loans, grant relatively more amount of loan. Further, using the advantage of extended LTV, banks may also consider providing top-up loans to the existing borrowers, on existing security of gold jewellery.

After March 31, 2021, the LTV requirement shall be restored back to 75%. While the notification mentions that fresh loans granted after such date shall have an LTV of 75%, it is silent about the treatment of existing loans. Clarification in this regard is expected from the RBI.

In the absence of any clarification, the loans given before March 31, 2021 shall also be bound by the LTV of 75% after such date. Accordingly, the banks should either structure the loan in such a manner that the LTV comes down to 75% after receiving repayments up to March 31, 2021 or the banks may have to call back a certain portion of loan so as to meet the LTV requirement after such date.

It may also be noted that despite the high amount of market penetration of NBFCs in gold loan sector[6], no such relaxation has been provided to NBFCs.

Priority Sector Lending by Banks

The RBI has revised the existing guidelines on priority sector lending (PSL) by banks[7]. While the detailed PSL guidelines are yet to be released, following are a few major changes that will be introduced:

  • Start-ups would be a new sector to come under the ambit of priority sectors
  • The limits for renewable energy, including solar power and compressed bio-gas plants, small and marginal farmers and weaker sections are proposed to be increased.
  • An incentive-based system shall be introduced, which shall address the regional disparities in the flow of priority sector credit. Under this system, higher weight will be assigned for incremental priority sector credit in the identified districts where credit flow is comparatively lower and vice versa.

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11445&Mode=0

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11808&Mode=0

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11942&Mode=0

[4] https://www.rbi.org.in/Scripts/BS_CircularIndexDisplay.aspx?Id=9124 and https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=8701&Mode=0

[5] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11944&Mode=0

[6] https://assets.kpmg/content/dam/kpmg/in/pdf/2020/01/return-of-gold-financiers-in-organised-lending-market.pdf

[7] https://m.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=10497

Resolution Framework for Covid-19-related stress

Other related write-ups:

 

 

ECLGS scope expanded to cover business loan by individuals

-Financial Services Division (finserv@vinodkothari.com)

 The Finance Minister had announced several measures to provide stimulus to economy for providing a momentum after impact caused by Covid-19 and also to take further the mission of self-reliant India. Among various schemes introduced in the package, one was the Emergency Credit Line Guarantee Scheme (‘Scheme’), which intends to enable the flow of funds to MSMEs by providing additional loans to MSME’s covered by 100% government guarantee.

Under this Scheme, the Government of India, through a National Credit Guarantee Trust (NCGTC), will provide 100% guarantee on loans provided by banks and Financial Institutions (FIs) to MSMEs and MUDRA borrowers under the said scheme. The Scheme aims to extend additional funding of Rs. 3 lakh crores to eligible borrowers in order to help them through the liquidity crunch faced by them due to the Covid-19 crisis.

In order to ensure the full utilisation of the 100% government guarantee loans in times of such financial downturns, the scheme has been updated on July 4, 2020[1] to widen the scope and significant changes in the limits has been notified. It is evident form the amendments under revised operational guidelines that it is aimed at providing deeper benefit to the society, by expanding the borrower base to include individuals who have availed loan for business purposes under the scheme.

This article discusses the changes and its impacts in detail.

Key changes under the new ECLGS

Eligible Borrower

The erstwhile operational guidelines only allowed Business Enterprises/MSME to borrow under the scheme which were having already existing loan facility with the member lending institution (MLI). The major change under the revised guideline is the extension of the scheme to the individuals who have existing loan facility with MLI. Such application of credit facility by an individual under the scheme shall be supported by Management Certificate to the effect that they have availed such loan facility for their own business purposes.

We had earlier also held the view that a loan taken by a business, even though owned by an individual and not having a distinctive name than the individual himself, cannot be regarded as a “loan provided in individual capacity”. And hence, must be covered under the ambit of the scheme.

For instance, many SRTOs, local area retail shops etc are run in the name of the proprietor. There is no reason to disregard or disqualify such businesses. It is purpose and usage of the loan for business purposes that matters.

The scheme now specifically includes individuals who have availed loans for business purpose, this would help business who are not incorporated or the owner had availed facility in its own name. This would also benefit professionals like Doctors, CA/CS/CMA, who have availed loans for scaling up their service businesses.

Increase in total outstanding loan limit for eligible borrowers

Under the previous operational guideline the total outstanding loan limit of an eligible borrower from all the MLI was caped at INR 25 crores which has now been increased up to INR 50 crores as on February 29, 2020. As the ceiling for maximum amount of loan is increased the maximum amount of guaranteed loan that can be issued under the guideline have increased from INR 5 crores to INR 10 crores.

Increase in turnover limit for eligible borrowers

The turnover limit of eligible borrowers has been increased from INR 100 Crores to INR 250 crores. This means eligible borrowers which were earlier having annual turnover inclusive of all taxes/GST more than INR 100 crores are now eligible under the new operational guidelines. Provided there annual turnover is less than INR 250 crores for financial year 2019-20.

Smaller companies were already covered under the scheme and so the aforesaid amendment would include larger companies as well.

Option to MLI providing ECLGS facility on behalf of other lenders

The erstwhile operational guideline provided for a borrower who wishes to take from any lender more than 20% of outstanding credit that the borrower had with specific lender, a NOC would be required from all the other lenders.

Revised operational guidelines has served as a clarification that NOC to be required in such cases only from the lender whose share of ECLGS loan is proposed to be extended by a specific lender. However, it would be necessary for the specific lender to agree to provide ECLGS facility on behalf of such of the lenders.

Conclusion

As per the news report, more than half of the amount of guarantee approved under the scheme remains unrealised till date. Hence, the increase in ambit of scheme would be beneficial to reach out to the businesses in the name of individuals as well. Further, it would help the larger businesses to avail funding, in these times when all businesses are facing liquidity issues.

 

[1] https://www.eclgs.com/documents/Operational_Guidelines_ECLGS_Updated_as_on_August_04_2020.pdf

 

Our FAQs on ECLGS:

 

SEBI extends deadline for June quarter results amid COVID-19

Companies to manage the dual requirement of holding board meetings and submission of financial results

Shaifali Sharma
Vinod Kothari & Company
corplaw@vinodkothari.com

In the wake of the continuing impact of COVID-19 pandemic, SEBI vide circular[1] dated June 24, 2020, granted relaxation to listed entities and extended the timeline for submission of financial results for quarter / half year / financial year ended March 31, 2020 to July 31, 2020.

Since, now the first quarter of the FY 2020-21 has come to an end, companies are expected to finalize, approve and submit their financials to the respective stock exchange(s) within 45 days from the quarter ended June 30, 2020 as per Regulation 33 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘Listing Regulations’) i.e. on or before August 14, 2020.

Considering the shortened time gap of 14 days between the two due dates stated above i.e. July 31 and August 14, SEBI vide its circular[2] dated July 29, 2020, has extended the deadline to submit financial results for the first quarter from August 14 to September 15, 2020 thereby allowing additional 32 days to the listed companies which will in turn provide extra time to companies and its auditors working on reporting the quarterly financial results.

It is pertinent to note here that the board of directors, as per Regulation 17(2) of the Listing Regulations, must meet at least four times a year, with a maximum time gap of 120 days between any two meetings. In this regard, the SEBI vide circular[3] date June 26, 2020 had exempted the listed entities from observing the stipulated time gap between two board meetings for the meetings held/proposed to be held between the period December 01, 2019 and July 31, 2020.

Considering no further extension has been granted by SEBI yet, the board meeting for approving the financial results should be scheduled keeping in mind the maximum time gap of 120 days prescribed under the Listing Regulations. For example, if we take a case of a listed company which held its last board meeting on May 02, 2020, the next board meeting shall be scheduled on or before August 31, 2020  instead of the extended due date of September 14, 2020.

As regards for unlisted companies, the maximum time gap for conducting board meetings had been relaxed vide MCA circular[4] dated March 24, 2020 to 180 days from present 120 days for the first two quarters of FY 2020-2021.

[1] https://www.sebi.gov.in/legal/circulars/jun-2020/further-extension-of-time-for-submission-of-financial-results-for-the-quarter-half-year-financial-year-ending-31st-march-2020-due-to-the-continuing-impact-of-the-covid-19-pandemic_46924.html

[2] https://www.sebi.gov.in/legal/regulations/jun-2009/securities-and-exchange-board-of-india-delisting-of-equity-shares-regulations-2009-last-amended-on-april-17-2020-_34625.html

[3] https://www.sebi.gov.in/legal/circulars/jun-2020/relaxation-of-time-gap-between-two-board-audit-committee-meetings-of-listed-entities-owing-to-the-covid-19-pandemic_46945.html

[4] http://www.mca.gov.in/Ministry/pdf/Circular_25032020.pdf


Other reading materials on the similar topic:

  1. ‘COVID-19 – Incorporated Responses | Regulatory measures in view of COVID-19’ can be viewed here
  2. ‘Resources on virtual AGMs’ can be viewed here
  3. Our other articles on various topics can be read at: http://vinodkothari.com/

Email id for further queries: corplaw@vinodkotahri.com

Our website: www.vinodkothari.com

Our YouTube Channel: https://www.youtube.com/channel/UCgzB-ZviIMcuA_1uv6jATbg

Special Liquidity Scheme – providing short term liquidity relief for NBFCs

Timothy Lopes | Senior Executive

Vinod Kothari Consultants

finserv@vinodkothari.com

In light of the disruption caused by the pandemic, the Government of India announced a Rs. 20 lakh crores economic stimulus package. The first of the several reforms were announced on 13th May, 2020 which announced the Emergency Credit Line, the partial credit guarantee scheme 2.0 (PCG 2.0), TLTRO 2.0 and much more.

The PCG 2.0 scheme permitted banks to purchase CPs and bonds issued by NBFCs/MFIs/HFCs. These purchases were then guaranteed by the Government of India up to 20% of the first loss. For more details of the scheme see our write up here.

The announcement also proposed launching a Rs. 30,000 crores “Special Liquidity Scheme” for NBFCs/HFCs including MFIs. The Cabinet approved this scheme on 20th May, 2020[1].

On 1st July, 2020, RBI has released the details of the Special Liquidity Scheme[2]. The scheme is intended to avoid potential systemic risk to the financial sector. The scheme seems to be a short term relief for NBFCs acting as a bail-out package for near term maturity debt instruments. The scheme is intended to supplement the existing measures already introduced by the Government.

The scheme will provide liquidity to eligible NBFCs defined in the notification which is similar to the eligibility criteria specified under the PCG 2.0 scheme. The Government will implement the scheme through SBICAP which is a subsidiary of SBI. SBICAP has set up a SPV called SLS Trust to manage the operations. More details about the trust can be found on the website of SBICAP[3].

Under the scheme, the SPV will purchase the short-term papers from eligible NBFCs/HFCs.  RBI will provide liquidity to the Trust depending on actual purchases by the Trust. The utilisation of proceeds from the scheme will be only towards the sole purpose of extinguishing existing liabilities.

Eligible instruments

Instruments eligible for the scheme are relatively short term. The scheme specifies that CPs and NCDs with a residual maturity of not more than three months (90 days) and rated as investment grade will be eligible instruments. These dates, however, may be extended by Government of India. The SPV would invest in securities either from the primary market or secondary market subject to the conditions mentioned in the Scheme.

The actual investment decisions will be taken by the Investment Committee of the SPV.

Validity of the Scheme

The scheme is available only up to 30th September, 2020 as the SPV will cease to make purchases thereafter and would recover all the dues by 31st December, 2021 or any other date subsequently modified.

Investment by the SPV

The SPV set up under the scheme comprises of an investment committee. The investment committee will decide the amount to be invested in a particular NBFC/HFC. The FAQs available on the website of SBICAPs specifies that the Trust shall invest not more than Rs. 2000 crores on any one NBFC/HFC subject to them meeting conditions specified in the scheme. The Trust may have allocation up to 30% to NBFCs/HFCs with asset size of Rs. 1000 crores or less.

Rate of Return and collateral

Rate of Return (RoR) and other specifics under the scheme will likely be based on mutual negotiation between the NBFCs and the trust. According to the FAQs, the yield on securities invested by SPV shall be decided by the Investment Committee subject to the provisions of the scheme.

The Trust may also require an appropriate level of collateral from the NBFCs/ HFCs as specified under the FAQs.

Conclusion

The scheme is a welcome move likely to provide sufficient liquidity to the NBFC sector for the near term and act as a bail-out package for their short term liabilities.

The press release dated 20th May, 2020, approving the Special Liquidity Scheme states that “Unlike the Partial Credit Guarantee Scheme which involves multiple bilateral deals between various public sector banks and NBFCs, requires NBFCs to liquidate their current asset portfolio and involves flow of funds from public sector banks, the proposed scheme would be a one-stop arrangement between the SPV and the NBFCs without having to liquidate their current asset portfolio. The scheme would also act as an enabler for the NBFC to get investment grade or better rating for bonds issued. The scheme is likely to be easier to operate and also augment the flow of funds from the non-bank sector.”

Our related write ups may be viewed below –

http://vinodkothari.com/2020/05/pcg-scheme-2-0-for-nbfc-pooled-assets-bonds-and-commercial-paper/

http://vinodkothari.com/2020/05/guaranteed-emergency-line-of-credit-understanding-and-faqs/

http://vinodkothari.com/2020/05/self-dependent-india-measures-concerning-the-financial-sector/

http://vinodkothari.com/2020/04/would-the-doses-of-tltro-really-nurse-the-financial-sector/

[1] https://pib.gov.in/PressReleasePage.aspx?PRID=1625310

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11925&Mode=0

[3] https://www.sbicaps.com/index.php/sls-trust/

Covered bonds and the COVID disruption

-Vinod Kothari

finserv@vinodkothari.com

Last year, the European Covered Bonds Council celebrated 250th anniversary of covered bonds[1]. That year also marked a substantial increase in global volumes of covered bonds issuance, which had been flat for the past few years. However, no one, joining the 250 years’ celebration, would have the COVID disruption in mind

With a history of more than 250 years now, covered bonds would have withstood various calamities and disruptions, both economic and natural, over the years. Covered bonds have not seen defaults over all these years. Will they be able to sustain the COVID disruption as well, given the fact that the major countries where they have been used extensively, have all suffered COVID casualties or infections, in varying degrees? In addition to the challenging credit environment, covered bonds will also be put to another question – does this device of refinancing mortgages in Europe hold the answer to sustaining continuous funding of home loans, thereby mitigating the impact of the crisis?

While, over the years, the instrument has been talked about (and less practiced) in lots of jurisdictions over the world, EU countries are still the bastion for covered bonds. About 82% of the world’s Euro 2.50 trillion dollar outstanding covered bonds are issued by EU entities.

European banks’ dependence on covered bond funding

European banks have a substantial dependence on covered bonds. Germany, where covered bonds have widely been regarded as a “fixture of German banking”, account for nearly 32% of the total capital market funding. In some countries, albeit with smaller bank balance sheets, the number goes up to as high as 78 – 81% [See Graph].

Figure 1  source: https://www.spglobal.com/_media/documents/spglobalratings_spglobalratings-coveredbondsprimer_jun_20_2019.pdf

If covered bonds were to prove resilient to the crisis, the investors’ confidence in these bonds, which have so had several regulatory privileges such as lower risk weights, will stand justified. On the other hand, if the bonds were to prove as brittle as some of their issuing banks, the claim to 250 years of unblemished vintage will be put to question.

Robustness of covered bonds

Covered bonds have a dual recourse feature – the issuer, and the underlying pool, in that order. Covered bonds are generally issued by mortgage-lending banks in Europe. Therefore, a default of covered bonds may occur only the issuing banks face the risk of default. Even if that were to happen, the extent of over-collateralisation in the cover pool may be sufficient to hold the bondholders safe. The recourse that the bondholders have against the loan pool is further strengthened by inherent support in a mortgage loan in form of the LTV ratio.

After the Global Financial Crisis and the introduction of Basel III norms, the capital of EU banks has generally strengthened. Data published by European Central Bank shows that European banks have a common equity tier 1 [CET 1] ratio of about 14.78%, as against the regulatory minimum of 4.5%. Therefore, the issuer banks seem to be poised to withstand pressure on the performance.

Past instances of default

Robustness of covered bonds is not the only factor which has kept them standing over all these years – another very important factor is sovereign support. European sovereigns have been sensitive to the important of covered bonds as crucial to maintain the flow of funds to the housing sector, and hence, they have tried to save covered bonds from defaulting.

In the period 1997 to 2019, out of covered bonds, there have been 33 instances of default by covered bond issuers, in various other on-balance sheet liabilities. However, these issues did not default on their covered bonds[2].

There are several regulatory incentives for covered bonds. Central banks permit self-issued covered bonds to be used as collateral for repo facilities. ECB also permits covered bonds as a part of its purchase program. In addition, there are preferential risk weights for capital requirements.

Rating downgrades in covered bonds correlate with sovereign downgrades

Rating agency Moody’s reports [16th April, 2020 report][3] that the potential for rating downgrades for covered bonds was strongly correlated with the ratings of sovereigns. “for countries with Aaa country ceilings, the average 12-month downgrade rate between 1997 and 2019 was 6.5% for covered bonds and 15.5% for covered bond issuers. However, in countries with lower country

ceilings, representing lower sovereign credit quality, the average 12-month downgrade rate increased to 24% for covered bonds and 25% for covered bond issuers”.

Rating agency Fitch also had a similar observation – stating that the rating downgrades for covered bonds were mostly related to sovereign downgrades, as in case of Greece and Italy.

Risk of downgrades in covered bonds

Risk of downgrades in covered bonds arises mainly from 2 reasons: weakening health of issuer banks, and quality of the underlying mortgage pools. Mortgage pools face the risks of reducing property prices, strain on urban incomes and increase in unemployment levels, etc. Over-collateralisation levels remain a strength, but unlike in case of MBS, covered bonds lean primarily on the health of the issuer banks. As long as the bank in question has adequate capital, the chances that it will continue to perform on covered bonds remain strong.

At the loan level, LTV ratios are also sufficiently resilient. Moody’s report suggests that in several jurisdictions, the LTV ratios for European covered bonds are less than 60%.

Additionally, in several European jurisdictions, the regulatory requirement stipulate non-performing loans either to be replaced by performing loans, or not to be considered for the purpose of collateral pool.

Unused notches of rating upliftment

A covered bond rating may rise by several notches, because of a combination of factors, including issuer resolution framework, jurisdictional support, and collateral support[4]. Either because of the strength of the pool, or because of the legislation support, or because of both. However, in any case the issuer’s credit rating is already strong, say, AAA, the notching up that could potentially have come has not been used at all. This is what is referred to as “unused notches”.

In order to assess the ability of covered bonds to withstand the pressure on the issuer bank’s rating will be the extent of unused notches of rating upliftment. In a report dated 25th March, 2020[5], rating agency S&P gave data about unused notches of rating upliftment of covered bonds in several jurisdictions. These ranged between 1 to 6 in many countries, thus pointing to the ability of the covered bond issuances to withstand rating pressures.

Conclusion

We are at the cusp of the disruption in global economies caused by the COVID pandemic. Any assessment of the impact of the crisis on capital market instruments may verge on being speculative. However, current signals are that the 250 years of history of performance does not face the risk of a collapse.

Links to our other resources on covered bonds –

http://vinodkothari.com/wp-content/uploads/Introduction-to-Covered-Bonds-by-Vinod-Kothari.pdf

vinodkothari.com/wp-content/uploads/covered-bonds-article-by-vinod-kothari.pdf

[1] 29th August, 1769, Frederick the Great of Prussia signed an order permitting the issuance of a landowners’ cooperative.  It was in 1770 that the first German pfandbrief was issued. Going by this, the 250th anniversary should actually be this year.

[2] See Moody’s report here: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_1117861

[3] https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_1221857

[4] Rating agency Standard and Poor’s, for example, considers at least 2 notches for resolution framework, three notches for jurisdictional support, and four notches for collateral support.

[5] https://www.spglobal.com/ratings/en/research/articles/200325-global-covered-bonds-assessing-the-credit-effects-of-covid-19-11402802

Leasing: The way forward in the post COVID-19 world

Timothy Lopes, Senior Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

The leasing market has always proven to be strong and growing in emerging as well as developed markets through all stages of an economic cycle. According to a US country survey report by White Clarke Group, the US equipment finance industry at the end of 2018 was roughly US$ 900 billion. This was expected to grow at around 3.9% during 2019.

COVID-19 has disrupted businesses and entities as much as it has affected personal lives. As businesses learn to live the new normal, there have to be lot of realization for acquisition of capital assets in time to come. Businesses will arguably find it much easier to connect their payment obligations to their own revenues, so as to have minimum stress and maximum focus on operations.

Demand for capital equipment, vehicles, software, etc. would have slowed down owing to covid disruption. This lower demand results from lower cash in hand to fund any outright equipment purchases. Going forward too, post the COVID-19 scenario, “buying” equipment, etc. would not be a feasible option.

Leasing on the other hand, has in the past proven to be a strong financing alternative even at times of a depression. During the great depression back in the 1930’s, companies that resorted to leasing out equipment and software performed rather well in stress scenarios. To take an example of IBM Corporation, which then derived well over half of its income from leasing, and of United Shoe Machinery Corporation, which distributed virtually all its machine products through leases while the US GDP took a major hit during the 1930-1935 period.

Figure – Leasing during the great depression (1930)

Source: Lease Financing and Hire Purchase, Fourth Edition 1996 by Vinod Kothari

 

Source: Bureau of Economic Affairs, US Department of Commerce

Under leasing plans, since the buyer does not have to put in any capital investment, he may be able to acquire equipment even during a period of depression. Thus, leasing serves to maintain the growth of a manufacturer’s sales during depressionary climate.[1]

Post COVID-19 scenario – Could leasing be the way forward?

Presently, the global economy has entered into recession which may be comparable to the situation back in the 1930s. It is unlikely that companies would be looking to purchase assets during the post COVID-19 scenario owing to several stress factors.

Thus, leasing equipment/ software/ vehicles, etc. should be the way to go during the depression scenario. Leasing allows one to structure the payments in such a way that the cashflows arising from the asset/ equipment will itself service the rentals associated with the asset/ equipment, which is the likely factor to increase the propensity to finance through leasing.

Properly structured, lease transactions have the potential to turn assets into services – enabling users to get to use assets without having to lock capital therein. It is our belief that leasing provides the way for users of capital equipment to acquire assets, keeping their businesses asset-light.

Further, according to a survey done on the impact of COVID-19 on lease financing by Equipment Leasing & Finance Foundation (ELFF), over the next four months, none of the respondents expect more access to capital to fund equipment acquisitions, while some of the survey respondents believe demand for leases and loans to fund capital expenditures (capex) will increase over the next four months.

The Monthly Confidence Index (MCI) for the Equipment Finance Industry, for the month of May, 2020 was at 25.8%, up from 22.3% in April, 2020.

Further, another report by ELFF suggests that capital investment will suffer due to the pandemic. Leasing, however, would enable the buyer to acquire an asset while not having to put in any capital investment.

Global leasing trends

Leasing volumes have seen strong growth across geographies over the 2002-2018 period. This is reflected by the volumes in major regions reported by the White Clarke Group: Global Leasing Report 2020 shown below –

Conclusion

Leasing would be a feasible solution in the upcoming recovery period. The cashflows generated from the asset on lease would service the rentals on the asset, thereby having the asset finance itself, considering that no one would be willing to put in any major capital investment in the times to come.

In India, the penetration of leasing has been fraction of a percentage, compared to global levels, where average penetration has been upwards of 20% consistently. Several factors, including tax disparities, have been responsible.

With innovation as the working tool, solutions may be designed to provide customers with effective asset acquisition solutions.

See our resources on leasing here –

http://vinodkothari.com/leasehome/

[1] Source – Lease Financing and Hire Purchase, Fourth Edition 1996 by Vinod Kothari