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Bridging the gap between Ind AS 109 and the regulatory framework for NBFCs

-Abhirup Ghosh

(abhirup@vinodkothari.com)

The Reserve Bank of India, on 13th March, 2020, issued a notification[1] providing guidance on implementation of Indian Accounting Standards by non-banking financial companies. This guidance comes after almost 2 years from the date of commencement of first phase of implementation of Ind AS for NBFCs.

The intention behind this Notification is to ensure consistency in certain areas like – asset classification, provisioning, regulatory capital treatment etc. The idea of the Notification is not to provide detailed guidelines on Ind AS implementation. For areas which the Notification has not dealt with, notified accounting standards, application guidance, educational material and other clarifications issued by the ICAI should be referred to.

The Notification is addressed to all non-banking financial companies and asset reconstruction companies. Since, housing finance companies are now governed by RBI and primarily a class of NBFCs, this Notification should also apply to them. But for the purpose of this write-up we wish to restrict our scope to NBFCs, which includes HFCs, only.

The Notification becomes applicable for preparation of financial statements from the financial year 2019-20 onwards, therefore, it seems the actions to be taken under the Notification will have to be undertaken before 31st March, 2020, so far as possible.

In this article we wish to discuss the outcome the Notification along with our comments on each issue. This article consists of the following segments:

  1. Things to be done by the Board of Directors (BOD)
  2. Expected Credit Losses (ECL) and prudential norms
  3. Dealing with defaults and significant increase in credit risk
  4. Things to be done by the Audit Committee of the Board (ACB)
  5. Computation of regulatory capital
  6. Securitisation accounting and prudential norms
  7. Matters which skipped attention

1.   Things to be done by the BOD

The Notification starts with a sweeping statement that the responsibility of preparing and ensuring fair presentation of the financial statements lies with the BOD of the company. In addition to this sweeping statement, the Notification also demands the BOD to lay down some crucial policies which will be essential for the implementation of Ind AS among NBFCs and they are: a) Policy for determining business model of the company; and b) Policy on Expected Credit Losses.

(A) Board approved policy on business models: The Company should have a Board approved policy, which should articulate and document the business models and portfolios of the Company. This is an extremely policy as the entire classification of financial assets, depends on the business model of the NBFC. Some key areas which, we think, the Policy should entail are:

There are primarily three business models that Ind AS recognises for subsequent measurement of financial assets:

(a) hold financial assets in order to collect contractual cash flows;

(b) hold financial assets in order to collect contractual cash flows and also to sell financial assets; and

(c) hold financial assets for the purpose of selling them.

The assessment of the business model should not be done at instrument-by-instrument level, but can be done at a higher level of aggregation. But at the same time, the aggregation should be not be done at an entity-level because there could be multiple business models in a company.

Further, with respect the first model, the Ind AS states that the business model of the company can still be to hold the financial assets in order to collect contractual cash flows even if some of the assets are sold are expected to be sold in future. For instance, the business model of the company shall remain unaffected due to the following transactions of sale:

(a) Sale of financial assets due to increase in credit risk, irrespective of the frequency or value of such sale;

(b) Sale of cash flows are made close to the maturity and where the proceeds from the sale approximate the collection of the remaining contractual cash flows; and

(c) Sale of financial assets due to other reasons, namely, to avoid credit concentration, if such sales are insignificant in value (individually or in aggregate) or infrequent.

For the third situation, what constitutes to insignificant or infrequent has not been discussed in the Ind AS. However, reference can be drawn from the Report of the Working Group of RBI on implementation of Ind AS by banks[2], which proposes that there could be a rebuttable presumption that where there are more than 5% of sale, by value, within a specified time period, of the total amortised cost of financial assets held in a particular business model, such a business model may be considered inconsistent with the objective to hold financial assets in order to collect contractual cash flow.

However, we are not inclined to take the same as prescriptive. Business model of an entity is still a question hinging on several relevant factors, primarily the profit recognition, internal reporting of profits, pursuit of securitization/direct assignment strategy, etc. Of course, the volume may be a persuasive factor.

The Notification also requires that the companies should also have a policy on sale of assets held under amortised cost method, and such policy should be disclosed in the financial statements.

(B) Board approved policy on ECL methodology: the Notification requires the companies to lay down Board approved sound methodologies for computation of Expected Credit Losses. For this purpose, the RBI has advised the companies to use the Guidance on Credit Risk and Accounting for Expected Credit Losses issued by Basel Committee on Banking Supervision (BCBS)[3] for reference.

The methodologies laid down should commensurate with the size, complexity and risks specific to the NBFC. The parameters and assumptions for risk assessment should be well documented along with sensitivity of various parameters and assumptions on the ECL output.

Therefore, as per our understanding, the policy on ECL should contain the following –

(a) The assumptions and parameters for risk assessment – which should basically talk about the probabilities of defaults in different situations. Here it is important to note that the assumptions could vary for the different products that the reporting entity offers to its customers. For instance, if a company offers LAP and auto loans at the same time, it cannot apply same set of assumptions for both these products.

Further, the policy should also lay down indicators of significant increase in credit risk, impairment etc. This would allow the reporting entity in determining classifying its assets into Stage 1, Stage 2 and Stage 3.

(b) Backtesting of assumptions – the second aspect of this policy should deal with backtesting of the assumptions. The policy should provide for mechanism of backtesting of assumption on historical data so as to examine the accuracy of the assumptions.

(c) Sensitivity analysis – Another important aspect of this policy is sensitivity analysis. The policy should provide for mechanism of sensitivity analysis, which would predict the outcome based on variations in the assumptions. This will help in identifying how dependant the output is on a particular input.

Further, the Notification states that any change in the ECL model must be well documented along with justifications, and should be approved by the Board. Here it is important to note that there could two types of variations – first, variation in inputs, and second, variation in the model. As per our understanding, only the latter should be placed before the BOD for its approval.

Further, any change in the assumptions or parameters or the ECL model for the purpose of profit smothering shall seriously be frowned upon by the RBI, as it has clearly expressed its opinion against such practices.

2.   Expected Credit Losses (ECL) and prudential norms

The RBI has clarified that whatever be the ECL output, the same should be subject to a regulatory floor which in this case would be the provisions required to be created as the IRAC norms. Let us understand the situation better:

The companies will have to compute two types of provisions or loss estimations going forward – first, the ECL as per Ind AS 109 and its internal ECL model and second, provisions as per the RBI regulations, which has to be computed in parallel, and at asset level.

The difference between the two will have to be dealt with in the following manner:

(A) Impairment Reserve: Where the ECL computed as per the ECL methodology is lower than the provisions computed as per the IRAC norms, then the difference between the two should be transferred to a separate “Impairment Reserve”. This transfer will not be a charge against profit, instead, the Notification states that the difference should be appropriated against the profit or loss after taxes.

Interestingly, no withdrawals against this Impairment Reserve is allowed without RBI’s approval. Ideally, any loss on a financial asset should be first adjusted from the provision created for that particular account.

Further, the continuity of this Impairment Reserve shall be reviewed by the RBI going forward.

A large number of NBFCs have already presented their first financial statements as per Ind AS for the year ended 31st March, 2019. There were two types of practices which were followed with respect to provisioning and loss estimations. First, where the NBFCs charged only the ECL output against its profits and disregarded the regulatory provisioning requirements. Second, where the NBFCs computed provisions as per regulatory requirements as well as ECL and charged the higher amount between the two against the profits.

The questions that arise here are:

(a) For the first situation, should the NBFCs appropriate a higher amount in the current year, so as to compensate for the amount not transferred in the previous year?

(b) For the second situation, should the NBFCs reverse the difference amount, if any, already charged against profit during the current year and appropriate the same against profit or loss?

The answer for both the questions is negative. The provisions of the Notification shall have to be implemented for the preparation of financial statements from the financial year 2019-20 onwards, hence, we don’t see the need for adjustments for what has already been done in the previous year’s financial statements.

(B) Disclosure: The difference between the two will have to be disclosed in the annual financial statements of the company, format of which has been provided in the Notification[4]. Going by the format, the loss allowances created on Stage 1, Stage 2 and Stage 3 cases will have to be shown separately, similarly, the provisions computed on those shall also have to be shown separately.

While Stage 1 and Stage 2 cases have been classified as standard assets in the format, Stage 3 cases cover sub-standard, doubtful and loss assets.

Loss estimations on loan commitments, guarantees etc. which are covered under Ind AS but does not require provisioning under the RBI Directions should also be presented.

3.     Dealing with defaults and significant increase in credit risk

Estimation of expected losses in financial assets as per Ind AS depends primarily on credit risk assessment and identifying situations for impairment. Considering the importance of issue, the RBI has voiced its opinion on identification of “defaults” and “significant increase in credit risk”.

(A)Defaults: The next issue which has been dealt with in the Notification is the meaning of defaults. Currently, there seems to be a departure between the Ind AS and the regulatory definition of “defaults”. While the former allows the company to declare an account as default based on its internal credit risk assessments, the latter requires that all cases with delay of more than 90 days should be treated as default. The RBI expects the accounting classification to be guided by the regulatory definition of “defaults”.

 If a company decides not to impair an account even after a 90 days delay, then the same should be approved by the Audit Committee.

This view is also in line with the definition of “default” proposed by the BASEL framework for IRB framework, which is:

“A default is considered to have occurred with regard to a particular obligor when one or more of the following events has taken place.

 (a) It is determined that the obligor is unlikely to pay its debt obligations (principal, interest, or fees) in full;

 (b) A credit loss event associated with any obligation of the obligor, such as a charge-off, specific provision, or distressed restructuring involving the forgiveness or postponement of principal, interest, or fees;

 (c) The obligor is past due more than 90 days on any credit obligation; or

 (d) The obligor has filed for bankruptcy or similar protection from creditors.”

Further, the number of cases of defaults and the total amount outstanding and overdue should be disclosed in the notes to the financial statements. As per the current regulatory framework, NBFCs have to present the details of sub-standard, doubtful and loss assets in its financial statements. Hence, this disclosure requirement is not new, only the sub-classification of NPAs have now been taken off.

(B) Dealing with significant increase in credit risk: Assessment of credit risk plays an important role in ECL computation under Ind AS 109. Just to recapitulate, credit risk assessments can be lead to three possible situations – first, where there is no significant increase in credit risk, second, where there is significant increase in credit risk, but no default, and third, where there is a default. These three outcomes are known as Stage 1, Stage 2 and Stage 3 cases respectively.

 In case an account is under Stage 1, the loss estimation has to be done based on probabilities of default during next 12 months after the reporting date. However, if an account is under Stage 2 or Stage 3, the loss estimation has to be done based on lifetime probabilities of default.

Technically, both Stage 1 and Stage 2 cases would fall under the definition of standard assets for the purpose of RBI Directions, however, from accounting purposes, these two stages would attract different loss estimation techniques. Hence, the RBI has also voiced its opinion on the methodology of credit risk assessment for Stage 2 cases.

The Notification acknowledges the presence of a rebuttable presumption of significant increase in credit risk of an account, should there be a delay of 30 days or more. However, this presumption is rebuttable if the reporting entity has reasonable and supportable information that demonstrates that the credit risk has not increased significantly since initial recognition, despite a delay of more than 30 days. In a reporting entity opts to rebut the presumption and assume there is no increase in credit risk, then the reasons for such should be properly documented and the same should be placed before the Audit Committee.

However, the Notification also states that under no circumstances the Stage 2 classification be deferred beyond 60 days overdue.

4.   Things to be done by the ACB

The Notification lays down responsibilities for the ACB and they are:

(A) Approval of any subsequent modification in the ECL model: In order to be doubly sure about that any subsequent change made to the ECL model is not frivolous, the same has to be placed before the Audit Committee for their approval. If approved, the rationale and basis of such approval should be properly documented by the company.

(B) Reviewing cases of delays and defaults: As may have been noted above, the following matters will have to be routed through the ACB:

(a) Where the reporting entity decides not to impair an account, even if there is delay in payment of more than 90 days.

(b) Where as per the risk assessment of the reporting entity, with respect to an account involving a delay of more than 30 days, it rebuts that there is no significant increase in credit risk.

In both the cases, if the ACB approves the assumptions made by the management, the approval along with the rationale and justification should be properly documented.

5.   Computation of Regulatory Capital

The Notification provides a bunch of clarifications with respect to calculation of “owned funds”, “net owned funds”, and “regulatory capital”, each of which has been discussed here onwards:

(A) Impact of unrealised gains or losses arising on fair valuation of financial instruments: The concept of fair valuation of financial instruments is one of the highlights of IFRS or Ind AS. Ind AS 109 requires fair valuation of all financial instruments. The obvious question that arises is how these gains or losses on fair valuation will be treated for the purpose of capital computation. RBI’s answer to this question is pretty straight and simple – none of these of gains will be considered for the purpose of regulatory capital computation, however, the losses, if any, should be considered. This view seems to be inspired from the principle of conservatism.

 Here it is important to note that the Notification talks about all unrealised gains arising out of fair valuation of financial assets. Unrealised gain could arise in two situations – first, when the assets are measured on fair value through other comprehensive income (FVOCI), and second, when the assets are measured on fair value through profit or loss (FVTPL).

In case of assets which are fair valued through profit or loss, the gains or losses once booked are taken to the statement of profit or loss. Once taken to the statement of profit or loss, these gains or losses lose their individuality. Further, these gains or losses are not shown separately in the Balance Sheet and are blended with accumulated profits or losses of the company. Monitoring the unrealised gains from individual assets would mean maintenance of parallel accounts, which could have several administrative implications.

Further, when these assets are finally sold and gain is realised, only the difference between the fair value and value of disposal is booked in the profit and loss account. It is to be noted here that the gain on sale of assets shown in the profit and loss account in the year of sale is not exactly the actual gain realised from the financial asset because a part of it has been already booked during previous financial years as unrealised gains. If we were to interpret that by “unrealised gains” RBI meant unrealised gains arising due to FVTPL as well, the apparent question that would arise here is – whether the part which was earlier disregarded for the purpose of regulatory capital will now be treated as a part of capital?

Needless to say, extending the scope of “unrealised gains” to mean unrealised gains from FVTPL can create several ambiguities. However, the Notification, as it stands, does not contain answers for these.

In addition to the above, the Notification states the following in this regard:

  • Even unrealised gains arising on transition to Ind AS will have to be disregarded.
  • For the purpose of computation of Tier I capital, for investments in NBFCs and group companies, the entities must reduce the lower of cost of acquisition or their fair value, since, unrealised gains are anyway deducted from owned funds.
  • For any other category of investments, unrealised gains may be reduced from the value of asset for the purpose of risk-weighting.
  • Netting off of gains and losses from one category of assets is allowed, however, netting off is not allowed among different classes of assets.
  • Fair value gains on revaluation of property, plant and equipment arising from fair valuation on the date of transition, shall be treated as a part of Tier II capital, subject to a discount of 55%.
  • Any unrealised gains or losses recognised in equity due to (a) own credit risk and (b) cash flow hedge reserve shall be derecognised while determining owned funds.

(B) Treatment of ECL: The Notification allows only Stage 1 ECL, that is, 12 months ECL, to be included as a part of Tier II capital as general provisions and loss reserves. Lifetime ECL shall not be reckoned as a part of Tier II capital.

6.   Securitisation accounting and prudential norms

All securitisation transactions undergo a strict test of de-recognition under Ind AS 109. The conditions for de-recognition are such that most of the structures, prevalent in India, fail to qualify for de-recognition due to credit enhancements. Consequently, the transaction does not go off the books.

The RBI has clarified that the cases of securitisation that does not go off the books, will be allowed capital relief from regulatory point of view. That is, the assets will be assigned 0% risk weight, provided the credit enhancement provided for the transaction is knocked off the Tier I (50%) and Tier II (remaining 50%).

There are structures where the level of credit enhancement required is as high as 20-25%, the question here is – should the entire credit support be knocked off from the capital? The answer to this lies in the RBI’s Securitisation Guidelines from 2006[5], which states that the knocking off of credit support should be capped at the amount of capital that the bank would have been required to hold for the full value of the assets, had they not been securitised, that is 15%.

For securitisation transactions which qualify for complete de-recognition, we are assuming the existing practice shall be followed.

But apart from the above two, there can also be cases, where partial de-recognition can be achieved – fate of such transactions is unclear. However, as per our understanding, to the extent of retained risk, by way of credit enhancement, there should be a knock off from the capital. For anything retained by the originator, risk weighting should be done.

Matters which skipped attention

There are however, certain areas, which we think RBI has missed considering and they are:

  1. Booking of gain in case of de-recognition of assets: As per the RBI Directions on Securitisation, any gain on sale of assets should be spread over a period of time, on the other hand, the Ind AS requires upfront recognition of gain on sale of assets. The gap between the two should been bridged through this Notification.
  2. Consideration of OCI as a part of Regulatory Capital: As per Basel III framework, other comprehensive income forms part of Common Equity Tier I [read our article here], however, this Notification states all unrealised gains should be disregarded. This, therefore, is an area of conflict between the Basel framework and the RBI’s stand on this issue.

 

Read our articles on the topic:

  1. NBFC classification under IFRS financial statements: http://vinodkothari.com/wp-content/uploads/2018/11/Article-template-VKCPL-3.pdf
  2. Ind AS vs Qualifying Criteria for NBFCs-Accounting requirements resulting in regulatory mismatch?: http://vinodkothari.com/2019/07/ind-as-vs-qualifying-criteria-for-nbfcs/
  3. Should OCI be included as a part of Tier I capital for financial institutions?: http://vinodkothari.com/2019/03/should-oci-be-included-as-a-part-of-tier-i-capital-for-financial-institutions/
  4. Servicing Asset and Servicing Liability: A new by-product of securitization under Ind AS 109: http://vinodkothari.com/2019/01/servicing-asset-and-servicing-liability/
  5. Classification and reclassification of financial instruments under Ind AS: http://vinodkothari.com/2019/01/classification-of-financial-asset-liabilities-under-ind-as/

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11818&Mode=0#F2

[2] https://rbidocs.rbi.org.in/rdocs/Content/PDFs/FAS93F78EF58DB84295B9E11E21A91500B8.PDF

[3] https://www.bis.org/bcbs/publ/d350.pdf

[4] https://rbidocs.rbi.org.in/rdocs/content/pdfs/NOTI170APP130320.pdf

[5] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=2723

Partial Credit Guarantee Scheme

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

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

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

 

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

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

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

 

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

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

Brief nature of the transaction:

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

Brief characteristics of the Pool

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

Data requirement

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

Documentation

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

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

Other Related Articles :

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

Vinod Kothari (vinod@vinodkothari.com)

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

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

Modus operandi

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

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

Win-win for all

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

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

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

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

Capital treatment, rating methodologies and other preparations

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

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

Conclusion

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


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

Abhirup Ghosh  (abhirup@vinodkothari.com)

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

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

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

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

Applicability:

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

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

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

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

Eligible sellers:

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

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

Some observations on the eligibility criteria are:

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

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

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

Eligible assets

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

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

Our observations on the eligibility criteria are as follows:

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

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

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

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

Invocation of guarantee and guarantee commission

Guarantee commission

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

Invocation of guarantee

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

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

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

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

Other features of the Scheme

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

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

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