-Financial Services Division (email@example.com)
The Finance Minister has, in the month of May, 2020, announced a slew of measures as a part of the economic stimulus package for self-reliant India. Among various schemes introduced in the package, one was the Emergency Credit Line Guarantee Scheme (ECLGS, ‘Scheme’), which intends to enable the flow of funds to MSMEs. This is the so-called Rs 300000 crore scheme. The scheme was further amended on 4th August 2020 for widening the scope of the said scheme
Under this Scheme the GoI, through a trust, will guarantee loans provided by banks and Financial Institutions (FIs) to Individuals MSMEs and MUDRA borrowers. 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 crisis.
Based on the information provided by the Finance Minister about this Scheme, the press release issued in this regard and the operating guidelines scheme documents issued subsequently, we have prepared the below set of FAQs. There is also a set of FAQs prepared by NCGTC – we have relied upon these as well.
In brief, the Guaranteed Emergency Line of Credit [GECL] is a scheme whereby a lender [referred to as Member Lending Institution or MLI in the Scheme] gives a top-up loan of 20% of the outstanding facility as on 29th February, 2020. This top up facility is entirely guaranteed by NCGTC. NCGTC is a special purpose vehicle formed in 2014 for the purpose of acting as a common trustee company to manage and operate various credit guarantee trust funds.
[Vinod Kothari had earlier recommended a “wrap loan” for restarting economic activity – http://vinodkothari.com/2020/04/loan-products-for-tough-times/. The GECL is very close to the idea of the wrap loan.]
Essentially, the GECL will allow lenders to provide additional funding to business entities and individual businessman. The additional funding will run as a separate parallel facility, along with the main facility. The GECL loan will have its own term, moratorium, EMIs, and may be rate of interest as well. Of course, the GECL will share the security interest with the original facility, and will rank pari passu, with the main facility, both in terms of cashflows as in terms of security interest.
The major questions pertaining to the GECL are going to be about the eligible borrowers to whom GECL may be extended, and the allocation of cashflows and collateral with the main facility. Operationally, issues may also centre round the turnaround time, after disbursement, for getting the guarantee cover, and whether the guarantee cover shall be in batch-processed, or processed loan-by-loan. Similarly, there may be lots of questions about how to encash claims on NCGTC.
Eligible Lenders and eligible borrowers
- What is the nature of GECL?
The GECL shall be an additional working capital term loan (in case of banks and FIs), and additional term loan (in case of NBFCs) provided by the MLIs to Eligible Borrowers. The GECL facility may run upto 20% of the loan outstanding on 29th February, 2020.
The meaning of “working capital term loan” is that the amount borrowed may be used for general business purposes by the borrower.
- Who are the MLIs/eligible lenders under the Scheme?
For the purpose of the Scheme MLIs/eligible lenders include:
- All Scheduled Commercial Banks. Other banks such as RRBs, co-operative banks etc. shall not be eligible lenders.
- Financial Institutions (FIs), defined under section 45-I(c) of the RBI Act, 1934. The term all-India Financial Institutions” now includes Exim Bank, NABARD, SIDBI and NHB, none of which are extending primary loans. Hence, the term “financial institutions” as per sec. 45I (c) of the RBI Act will essentially refer to NBFCs, covered below..
III. Non-Banking Financial Companies (NBFCs), registered with the RBI and which have been in operation for a period of 2 years as on 29th February, 2020.
- What is the meaning of NBFC having been in operation for 2 years? Are we referring to 2 years from the date of incorporation of the Company, or 2 years from the date of getting registration with the RBI as an NBFC, or 2 financial years?
The language of the scheme indicates that the NBFC must be in operation for 2 years (and not financial years) as on 29th February, 2020. Thus, the period of 2 years shall be counted from the starting of operations after getting registration as an NBFC.
Usually, the RBI while granting registration requires the NBFC to start operations within a period of six months of getting registration. It also requires the NBFC to intimate to RBI that it has commenced operations. Logically, the 2 years’ time for starting of operations should be read from the date of commencement of operations
- Does the NBFC have to be a systemically important company? Or any NBFC, whether SI or not, will qualify?
The asset size of the NBFC would not matter. The NBFC must only hold a valid certificate of registration issued by RBI in order to be eligible under the scheme (and in operation for 2 years). Thus, whether SI or not, any NBFC will qualify.
- Is it necessary that the NBFC must be registered with the RBI?
Yes, the eligibility criteria specifically requires the NBFC to be registered.
- Will the following qualify as MLIs?
- HFCs: HFCs fall under the definition of financial institutions provided under the eligibility criteria for lenders. While HFCs essentially grant home loans, HFCs are permitted to have other types of loans within a limit of 50% of their assets. Hence, if the HFC has facilities that qualify for the purpose of the Scheme, an HFC will also qualify as MLI. This is further clarified in the FAQs 44 as well.
- MFIs: MFIs are a class of NBFCs and thus, eligible as MLIs. However, it is to be seen if the nature of loans granted by the MFI will be eligible for the purpose of the Scheme.
- CICs: CICs again are a class of NBFCs and thus, eligible as MLIs. However, they can grant loans to their group companies only.
- Companies giving fin-tech credit to consumers: The nature of the loan will mostly be by way of personal loans or consumer credit. While the lender may qualify, but the facility itself may not.
- Gold loan companies: Mostly, the loan is a personal loan and does not relate to a business purpose. Hence, the loan will not qualify.
- Is it possible for a bank to join as co-lender in case of a loan given by an NBFC? To be more precise, the primary loan is on the books of the NBFC. Now, the NBFC wants to give the GECL facility along with a bank as a co-lender. Is that possible?
In our view, that should certainly be possible. However, in our view, in that case, the rate of interest charged to the borrower should be the blended rate considering the interest rate caps for the bank [9.25%] and the NBFC [14%].
- Who are the eligible borrowers (Eligible Borrower or Borrower)?
The Eligible Borrowers shall be entities/individuals fulfilling each of the following features :
- Nature of the activity/facility: Our understanding is that Scheme is meant only for business loans. Hence, the nature of activity carried by the entity must be a business, and the facility must be for the purpose of the business.
- Scale of business: Business enterprises /MSMEs. The term MSME has a wide definition and we are of the view that it is not necessary for the borrower to be registered for the purpose of MSME Development Act. Please see our detailed resources on the meaning of MSMEs here: http://vinodkothari.com/2020/05/resources-on-msme/.In addition, the word “business enterprises” is also a wide term – see below.
- Existing customer of the MLI: The borrower must be an existing customer of the MLI as on 29th Feb., 2020. That is, there must be an existing facility with the borrower.
- Size of the existing facility: The size of the existing facility, that is, the POS, as on 29th Feb. 2020, should be upto Rs 50 crores.
- Turnover for FY 2019-20: The turnover of the Eligible Borrower, for financial year 2019-20, should be upto Rs 250 crores. In most cases, the financial statements for FY 2019-20 would not have been ready at the time of sanctioning the GECL. In that case, the MLI may proceed ahead based on a borrower’s declaration of turnover.
- GST registration: Wherever GST registration is mandatory, the entity must have GST registration.
- Performance of the loan: As on 29th Feb., 2020, the existing facility must not be more than 59 DPD.
- Further, Business Enterprises / MSMEs/Individuals would include loans covered under Pradhan Mantri Mudra Yojana extended on or before 29.2.2020, and reported on the MUDRA portal. All eligibility conditions including the condition related to Days past due would also apply to PMMY loans.
- Who are eligible Mudra borrowers?
Mudra borrowers are micro-finance units who have availed of loans from Banks/NBFCs/MFIs under the Pradhan Mantri Mudra Yojna (PMMY) scheme.
- Do Eligible Borrowers have to have any particular organisational form, for example, company, firm, proprietorship, etc?
No. There is no particular organisational form for the Eligible Borrower. It may be a company, firm, LLP, proprietorship, etc.
Note that the Scheme initially used the expression: “all Business Enterprises / MSME institution borrower accounts”. From the use of the words “business enterprises” or “institution borrower account”, it was contended that individuals are excluded. In Para 7 of the Operational Guidelines on the website of NCGTC, it mentioned that “Loans provided in individual capacity are not covered under the Scheme”. However, the very same para also permitted a business run as a proprietorship as an eligible case of business enterprise.
Hence, there was a confusion between a business owned/run by an individual, and a loan taken in individual capacity. The latter will presumably mean a loan for personal purposes, such as a home loan, loan against consumer durables, car loan or personal loan. As opposed to 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”.
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.
To ensure clarity, the revised operational guidelines include business loans taken by individuals for their own businesses in the ambit of scheme, Further, individual would be required to fulfil eligibility criteria for the borrower.
- What is the meaning of the term “business enterprise” which is defined as one of the Eligible Borrowers?
The term “ business enterprise” has been used repetitively in the Scheme, and is undefined. In our view, its meaning should be the plain business meaning– enterprises which are engaged in any business activity. The word “business activity” should be taken broadly, so as to give an extensive and purposive interpretation to fulfil the intent of the Scheme. Clearly, the Scheme is intended to encourage small businesses which are the backbone of the economy and which may help create “self reliant” India.
Having said this, it should be clear that the idea of the Scheme is not to give loans for consumer durables, personal use vehicles, consumer loans, personal loans, etc. While taking the benefit of the Scheme, the MLI should bear in mind that the intent of the lending is to spur economic activity. There must be a direct nexus between the granting of the facility and economic/business activity to be carried by the Eligible Borrower.
- One of the Eligible Borrowers is an MSME. Is it necessary that the entity is registered i.e. has a valid Udyog Aadhaar Number, as required under the MSMED Act?
The eligibility criteria for borrowers does not specifically require the MSMEs to be registered under the MSMED Act. Thus, an unregistered MSME may also be an Eligible Borrower under the scheme.
- For the borrowers to give a self-declaration of turnover for FY 2019-20, is there a particular form of declaration?
There is no particular form. However, we suggest something as simple as this:
To whomsoever it may concern
Sub: Declaration of Turnover
I/ We………………………………….. (Name of Authorized Signatory), being ……………………..(Designation) of …………………………………………………. (Legal Name as per PAN) do hereby state that while the financial statements for the FY 2019-20 have not still been prepared or finalised, based on our records, the turnover of the abovementioned entity/unit during the FY 2019-2 will be within the value of Rs 250 crores.
Signed …………. Date:…………………
- One of the important conditions for the Eligible Borrower is that the Borrower must not be an NPA, or SMA 2 borrower. For finding the DPD status of the existing facility, how do we determine the same in the following cases?
- My EMIs are due on 10th of each month. On 10th Feb., 2020, the borrower had two missing EMIs, viz., the one due on 10th Jan. 2020 and the one due on 10th Feb., 2020. Is the Borrower an Eligible Borrower on 29th Feb., 2020?
The manner of counting DPD is – we need to see the oldest of the instalments/ principal/interest due on the reckoning date. Here, the reckoning date is 29th Feb. On that date, the oldest overdue instalment is that of 10th Jan. This is less than 59 DPD. Hence, the borrower is eligible.
- My EMIs are due on the 1st of each month. The borrower has not paid the EMIs due on 1st Jan. and 1st Feb., 2020. Is the Borrower an Eligible Borrower on 29th Feb., 2020?
On the reckoning date, the oldest instalment is that of 1st Jan. 2020. Since the reckoning date is 29th Feb., we will be counting only one two dates – 1st Jan and 29th Feb. The time lag between the two adds to exactly 59 days. The borrower becomes ineligible if the DPD status is more than 59 days. Hence, the borrower is eligible.
- Is the Scheme restrictive as to the nature of the existing facility? Can the GECL be different from the existing facility?
It does not seem relevant that the GECL should be of the same nature/type or purpose as the primary facility. We have earlier mentioned that the purpose of the GECL is to support the business/economic activity of the borrower.
However, there may be issues where the existing facility itself would not have been eligible for the Scheme. For instance, if the existing facility was a car loan to a business entity (say, an MSME), can the GECL be eligible if the same is granted for working capital purposes? Intuitively, this does not seem to be covered by the Scheme. Once again, the intent of the Scheme is to provide “further” or additional funding to a business. Usually, the so-called further or additional funding for a business may come from a lender who had facilitated business activity by the primary facility.
Hence, in our view, the primary as well as the GECL facility should be for business purposes.
- Is there a relevance of the residual tenure of the primary facility? For example, if the primary facility is maturing within the next 6 months, is it okay for the MLI to grant a GECL for 4 years?
There does not seem to be a correlation between the residual term of the primary facility and the tenure of the GECL facility. The GECL seems to be having a term of 4 years, irrespective of the original or residual term of the primary facility.
Of course, the above should be read with our comments above about the primary facility as well as the GECL to be for business purposes.
- A LAP loan was granted to a business entity/Individual. The loan was granted against a self-owned house, but the purpose of the loan was working capital for the retail trade business carried by the borrower. Will this facility be eligible for GECL?
Here, the purpose of the loan, and the nature of collateral supporting the loan, are different, but what matters is the end-use or purpose of the loan. The collateral is a self-occupied house. But that does not change the purpose of the loan, which is admittedly working capital for the retail trade activity.
Hence, in our view, the facility will be eligible for GECL, subject to other conditions being satisfied.
- I have an existing borrower B, who is a single borrower as on 29th Feb 2020. I now want to grant the GECL loan to C, who would avail the loan as a co-borrower with B. Can I lend to B and C as co-borrowers?
It seems that even loans extended to co-obligors or co-applicants also qualify.
We may envisage the following situations:
- The primary facility was granted to B and C. B is an Eligible Borrower. The GECL is now being granted to B and C. This is a good case for GECL funding, provided B remains the primary applicant. In co-applications, the co-borrowers have a joint and several obligations, and the loan documentation may not make a distinction between primary and secondary borrower. However, one needs to see the borrower who has utilised the funding.
- The primary facility was granted to B who is an Eligible Borrower. The GECL is now being granted to B and C. This is a good case for GECL funding if B is the primary applicant. See above for the meaning of “primary” applicant.
- The primary facility was granted to B, who is a director of a company, where C, the company, joined as a co-applicant. C is an Eligible Borrower. The GECL is now being granted to C. This is a good case for GECL funding since the GECL funding is to C and C is an Eligible Borrower.
- When can GECL be sanctioned? Is there a time within which the GECL should be sanctioned?
The Scheme shall remain in operation till 30th November, 2020, or till such time as the maximum amount of loans covered by NCGTC reaches Rs 300000 crores. Accordingly, it can be inferred that the GECL must be sanctioned during the period of the operation of Scheme, that is during the period from May 23, 2020 to 30th November, 2020, or till an amount of Rs. 3 lakh crore is sanctioned under GECL, whichever is earlier.
- How can an MLI keep track of how much is the total amount of facilities guaranteed by NCGTC?
Understandably, there may be mechanisms of either dissemination of the information by NCGTC, or some sort of a pre-approval of a limit by NCGTC.
- Whether the threshold limit of outstanding credit of Rs. 50 crores, will have to be seen across all the lenders, the borrower is currently dealing with, or with one single lender?
The Scheme specifically mentions that the limit of Rs. 50 crores shall be ascertained considering the borrower accounts of the business enterprises/MSMEs with combined outstanding loans across all MLIs. For the purpose of determining whether the combined exposure of all MLIs is Rs 50 crores or not, the willing MLI may seek information about other loans obtained by the borrower.
- For the threshold limit of outstanding credit of Rs. 50 crores, are we capturing only eligible borrowings of the borrower, or all debt obligations?
Logically, all business loans, that is, loans/working capital facilities or other funded facilities availed for business purposes should be aggregated. For instance:
- Unfunded facilities, say, L/Cs or guarantees, do not have to be included.
- Non-business loans, say, car loans, obtained by the entity do not have to be included as the same are not for business purposes.
- What is the meaning of MSME? Is it necessary that the Eligible Borrower should be meeting the definition of MSME as per the Act?
The Scheme uses the term MSME, but nowhere has the Scheme made reference to the definition of MSME under the MSMED Act, 2006. Therefore, it does not seem necessary for the Eligible Borrower to have registration under the MSMED Act. Further, even if the entity in question is not meeting the criteria of MSME under the Act, it may still be satisfying the criteria of “business enterprise” with reference to turnover and borrowing facilities. Hence, the reference to the MSMED Act seems unimportant.
However, for the purpose of ease of reference, we are giving below the meaning of MSME as per the definition of MSMEs provided in the MSMED Act, 2006 (‘Act’):
|Enterprise||Manufacturing sector [Investment in plant and machinery (Rs.)]||Service sector [Investment in equipment (Rs.)]|
|Small||Not exceeding 25 lakhs||Not exceeding 10 lakhs|
|Micro||Exceeding 25 lakhs but does not exceed 5 crores||Exceeding 10 lakhs but does not exceed 2 crores|
|Medium||Exceeding 5 crores but not exceeding 10 crores||Exceeding 2 crores but does not exceed 5 crores|
The above definition has been amended by issue of a notification dated June 1, 2020. As per the amendment such revised definition shall be applicable with effect from July 01, 2020. Accordingly, w.e.f. such date, following shall be the definition of MSMEs:
|Enterprise||Investment in plant and machinery or equipment (in Rs.)||Turnover (in Rs.)|
|Micro||Upto 1 crore||Upto 5 crores|
|Small||Upto 10 crores||Upto 50 crores|
|Medium||Upto 50 crores||Upto 250 crores|
- The existing schemes laid down by the CGTMSE, CGS-I and CGS-II, cover the loans extended to MSE retail traders. Will the retail traders be eligible borrowers for this additional facility?
The Scheme states that a borrower is eligible if the borrower has –
(i) total credit outstanding of Rs. 50 Crore or less as on 29th Feb 2020;
(ii) turnover for 2019-20 was upto Rs. 250 Cr;
(iii) The borrower has a GST registration where mandatory.
Udyog Aadhar Number (UAN) or recognition as MSME is not required under this Scheme.
Hence, even retail traders fulfilling the eligibility criteria above would be eligible under the scheme.
- If the borrower does not have any existing credit facility as on 29th February, 2020, will it still be able to avail fresh facility(ies) under this Scheme?
Looking at the clear language of the Scheme, it seems that existence of an outstanding facility is a prerequisite to avail credit facility under the Scheme. The intent of the Scheme is to provide additional credit facility to existing borrowers.
- I have a borrower to whom I have provided a sanction before 29th February, 2020; however, no disbursement could actually take place within that date. Will such a borrower qualify for the Scheme?
Since the amount of GECL is related to the POS as on 29th Feb., 2020, there is no question of such a borrower qualifying.
- The Scheme seems to refer to the facility as a “working capital term loan” in case of banks/FIs and “additional term loan” in case of NBFCs. Does that mean the MLIs cannot put any end-use restrictions on utilisation of the facility by the Eligible Borrowers?
It is counter-intuitive to think that the MLI cannot put end-use restrictions. Ensuring that the funds lent by the MLI are used for the purpose for which the facility has been extended is an essential prudential safeguard for a lender. It should be clear that the additional facility has been granted for restarting business, following the disruption caused by the COVID crisis. There is no question of the lender permitting the borrower to use the facility for extraneous or irrelevant purposes.
Terms of the GECL Facility
- What are the major terms of the GECL Facility?
The major terms are as follows:
- Amount of the Facility: Up to 20% of the POS as on 29th Feb., 2020. Note that the expression “upto” implies that the MLI/borrower has discretion in determining the actual amount of top up funding, which may go upto 20%.
- Tenure of the Facility: 4 years. See below about whether the parties have a discretion as to tenure.
- Moratorium: 12 months. During the moratorium, both interest and principal will not be payable. Hence, the first payment due under the top up facility will be on the anniversary of the facility.
- Amortisation/repayment term: 36 months.
- Mode of repayment: While the Scheme says that the principal shall be payable in 36 installments, it should not mean 36 equal instalments of principal. The usual EMI, wherein the instalment inclusive of interest is equated, works well in the financial sector. Hence, EMI structure may be adopted. However, if the parties prefer equated repayment of principal, and the interest on declining balances, the same will also be possible. Note that in such case, the principal at the end of 12 months will have the accreted interest component for 12 months’ moratorium period as well.
- Collateral: The Scheme says that no additional collateral shall be asked for the purposes of the GECL. In fact, given the sovereign guarantee, it may appear that no additional collateral is actually required. [However, see comment below on dilution of the collateral as a result of the top-up funding].
- Rate of interest: The rate of interest is capped as follows – In case of banks/ – Base lending rate + 100 bps, subject to cap of 9.25% p.a. In case of NBFCs, 14% p.a.
- Processing/upfront fees: None
- As regards the interest rate, is it possible that the MLI has the benefit under any interest rate subvention scheme as well?
Yes. This scheme may operate in conjunction with any interest rate subvention scheme as well.
- Is the tenure of the GECL facility non-negotiably fixed at 4 years or do the parties have discretion with respect to the same? For example, if the borrower agrees to a term of 3 years, is that possible?
It seems that the Scheme has a non-negotiable tenure of 4 years. Of course, the Scheme document does say the parties may agree to a prepayment option, without any prepayment penalty. However, in view of the purpose of the Scheme, that is, to restart business activity in the post-COVID scenario, it does not seem as if the purpose of the Scheme will be accomplished by a shorter loan tenure.
- Is it possible for MLI to lend more than 20%, but include only 20% for the benefit of the guarantee?
Minus the Scheme, nothing stopped a lender from giving a top-up lending facility on a loan. Therefore, the wrapped portion of the GECL facility is 20% of the loan, but if the lender so wishes to give further loan, there is nothing that should restrain the lender from doing so.
- The Scheme document provides that the collateral for the primary loan shall be shared pari passu with the GECL facility. What does the sharing of the collateral on pari passu basis mean?
Para 11 of the Scheme document says: “…facility granted under GECL shall rank pari passu with the existing credit facilities in terms of cash flows and security”. The concept of pari passu sharing of the security, that is, the collateral, may create substantial difficulties in actual operation, since the terms of repayment of the primary facility and the GECL facility are quite divergent.
To understand the basic meaning of pari passu sharing, assume there is a loan of Rs 100 as on 29th Feb., 2020, and the MLI grants an additional loan of Rs 20 on 1st June, 2020. Assume that the value of the collateral backing the primary loan is Rs 125. As and when the GECL is granted, the value of this collateral will serve the benefit of the primary loan as well as the GECL facility. In that sense, there is a dilution in the value of the security for the primary loan. This, again, is illogical since the primary does not have a sovereign wrap, while the GECL facility has.
What makes the situation even worse is that due to amortizing nature of the primary loan, and the accreting nature of the GECL facility during the moratorium period, the POS of the primary facility will keep going down, while the POS of the GECL facility will keep going up. It may also be common that the primary facility will run down completely in a few months (say 2 years), while the GECL facility is not even half run-down. In such a situation, the benefit of the collateral will serve the GECL loan, in proportion to the amount outstanding of the respective facilities. Obviously, when the primary facility is fully paid down, the collateral serves the benefit of the GECL facility only.
- The Scheme provides that the primary facility and the GECL facility shall rank pari passu, in terms of cash flows. What is the meaning of pari passu sharing of cashflows?
The sharing of cashflows on pari passu basis should mean, if there are unappropriated payments made by the borrower, the payment made by the borrower should be split between the primary facility and the GECL facility on proportionate basis, proportional to the respective amounts falling/fallen due.
For instance, in our example taken in Q 15 above, assume the borrower makes a payment in the month of July 2020. The entire payment will be taken to the credit of the primary loan since the GECL loan is still in moratorium.
Say, in the month of July 2021, an aggregate payment is made by the borrower, but not sufficient to discharge the full obligation under the primary facility and the GECL facility. In this case, the payment made by the borrower will be appropriated, in proportion to the respective due amounts (that is, due for the month or past overdues) for the primary facility and the GECL facility.
- Given the fact that the payments for the GECL are still being collected by the MLI, who also has a running primary facility with the same borrower, is there any obligation on the part of the MLI to properly appropriate the payments received from the borrower between the primary and the GECL facility?
Indeed there is. The difficulty arises because there are two facilities with the borrower, one is naked, and the other one wrapped. The pari passu sharing of cashflows will raise numerous challenges of appropriation. Since the claim is against the sovereign, there may be a CAG audit of the claims settled by the NCGTC.
- The Scheme document says that the charge over the collateral has to be created within 3 months from the date of disbursal. What is the meaning of this?
If the existing loan has a charge securing the loan, and if the same security interest is now serving the benefit of the GECL facility as well, it will be necessary to modify the charge, such that charge now covers the GECL facility as well. As per Companies Act, the time for registration of a modification is thirty days, and there is an additional time of ninety days.
- Say the primary loan is a working capital loan given to a business and has a residual tenure of 24 months. The loan is secured by a mortgage of immovable property. Now, GECL facility is granted, and the same has a tenure of 48 months. After 24 months, when the primary loan is fully discharged, can the borrower claim the release of the collateral, that is, the mortgage?
Not at all. The grant of the GECL facility is a grant of an additional facility, with the same collateral. Therefore, until the GECL loan is fully repaid, there is no question of the borrower getting a release of the collateral.
- Should there be a cross default clause between the primary loan and the GECL loan?
In our view, the collateral is shared by both the facilities on pari passu basis. Hence, there is no need for a cross default clause.
- What are the considerations that should prevail with the borrower/MLI while considering the quantum of the GECL facility?
The fact that the GECL facility is 100% guaranteed by the sovereign may encourage MLIs to consider the GECL facility as risk free, and go aggressively pushing lending to their existing borrowers. However, as we have mentioned above, the pari passu sharing of the collateral results into a dilution of collateral for the primary facility. Hence, MLIs should use the same time-tested principles of lending in case of GECL as well – capacity, collateral, etc.
For the borrower as well, the borrower eventually has to pay back the loan. In case of NBFCs, the loan is not coming cheap – it is coming at a cost of 14%. While for the lender, the risk may be covered by the sovereign guarantee, the risk of credit history impairment for the borrower is still the same.
Hence, we suggest both the parties to take a considered call. For the lender, the consideration should still be the value of the collateral, considering the amount of the top up facility. In essence, the top up facility does not mechanically have to be 20% -the amount may be carefully worked out.
- Does the disbursal of the GECL facility have to be all in cash, or can it be adjusted partly against the borrower’s obligations, say for any existing overdues? Can it be partly given to MLI as a security deposit?
While the disbursal should appropriately be made by the MLI upfront, if the borrower uses the money to settle existing obligations with the MLI, that should be perfectly alright.
- In case the borrower has multiple loan accounts with multiple eligible lenders, how will such borrower avail facility under GECL?
It is clarified that a borrower having multiple loan accounts with multiple lenders can avail GECL. The GECL will have to be availed either through one lender or each of the current lenders in proportion depending upon the agreement between the borrower and the MLI.
Further, In case the borrower wishes to take from any lender an amount more than the proportional 20% of the outstanding credit that the borrower has with that particular lender, a No Objection Certificate (NOC) would be required from the lender whose share of ECLGS loan is proposed to be extended by a specific lender. Further, it would be necessary for the specific lender to agree to provide ECLGS facility on behalf of such of the lenders.
- The Scheme has consistently talked about an opt-out facility for the GECL scheme. What exactly is the meaning of the opt-out facility?
In our understanding, the meaning is, except for those borrowers who opt out of the facility, the lender shall consider the remaining borrowers as opting for the facility. However, there cannot be a case of automatic lending, as a loan, after all, is a mutual obligation of the borrower towards the lender. Hence, there has to be explicit agreement on the part of the borrower with the lender.
Of course, a wise borrower may also want to negotiate a rate of interest with the lender.
- What documentation are we envisaging as between the MLI and the borrower?
At least the following:
- Additional loan facility documentation, whether by a separate agreement, or annexure to the master facility agreement executed already by the borrower.
- Modification of charge.
Income recognition, NPA recognition, risk weighting and ECL computation
- During the period of the moratorium on the GECL facility, will income be recognised?
Of course, yes. In case of lenders following IndAS 109, the income will be recognised at the effective interest rate. In case of others too, there will be accrual of income.
- Once we give a GECL loan, we will have two parallel facilities to the borrower – the primary loan and the GECL loan. Can it be that one of these may become an NPA?
The GECL loan will have a moratorium of 12 months – hence, nothing is payable for the first 12 months. The primary facility may actually be having upto 59 DPD overdues at the very start of the scheme itself. Hence, it is quite possible that the primary facility slips into an NPA status.
As a rule, if a facility granted to a borrower has become an NPA, then all facilities granted to the same borrower will also be characterised as NPAs.
Therefore, despite the 100% sovereign guarantee, the facility may still be treated as an NPA, unless there is any separate dispensation from the RBI.
- If the GECL facility becomes an NPA, whether by virtue of being tainted due to the primary loan or otherwise, does it mean the MLI will have to create a provision?
As regards the GECL facility, any provision is for meeting the anticipated losses/shortfalls on a delinquent loan. As the GECL is fully guaranteed, in our view, there will be no case for creating a provision.
- Will there be any expected credit loss [ECL] for the GECL facility?
In view of the 100% sovereign guarantee, this becomes a case of risk mitigation. In our view, this is not a case for providing for any ECL.
- Will the 40 bps general loss provision for standard assets have to be created for the GECL loans too?
Here again, our view is that the facility is fully sovereign-guaranteed. Hence, there is no question of a prudential build up of a general loss provision as well. The RBI should come out with specific carve out for GECL loans.
- Will capital adequacy have to be created against GECL assets?
The RBI issued a notification on June 22, 2020 stating that since the facilities provided under the Scheme are backed by guarantee from GoI, the same shall be assigned 0% risk weight, in the books of MLIs.
Guarantor and the guarantee
- Who is the guarantor under the Scheme?
The Guaranteed Emergency Credit Line (GECL) or the guarantee under the Scheme shall be extended by National Credit Guarantee Trustee Company Limited (NCGTC, ‘Trust’).
- What is National Credit Guarantee Trustee Company Ltd (NCGTC)?
NCGTC is a trust set up by the Department of Financial Services, Ministry of Finance to act as a common trustee company to manage and operate various credit guarantee trust funds. It is a company incorporated under the Companies Act, 1956.
- What is the role of NCGTC?
The role of NCGTC is to serve as a single umbrella organization which handles multiple guarantee programmes of the GoI covering different cross-sections and segments of the economy like students, micro entrepreneurs, women entrepreneurs, SMEs, skill and vocational training needs, etc.
Presently, NCGTC manages 5 credit guarantee schemes that deal with educational loans, skill development, factoring, micro units etc.
- To what extent will the guarantee be extended?
The guarantee shall cover 100% of the eligible credit facility.
- Whether the guarantee will cover both principal and interest components of the credit facility?
Yes, the Scheme shall cover both the interest as well as the principal amount of the loan.
- What will be the guarantee fee?
The NCGTC shall charge no guarantee fee from the Member Lending Institutions (MLIs) in respect of guarantee extended against the loans extended under the Scheme.
- Are eligible lenders required to be registered with the NCGTC to become MLIs?
Usually, eligible lenders under such schemes are required to enter into an agreement with the trust extending the guarantee, to become their members. In this scheme, the eligible lenders are required to provide an undertaking to the NCGTC, in the prescribed format, in order to become MLIs.
- What is the procedure for obtaining the benefit of guarantee under the Scheme?
The MLI shall, within 90 days from a borrower account under the scheme turning NPA, inform the date on which such account turned NPA. On such intimation, NCGTC shall pay 75% of the guaranteed amount to the MLI i.e. 75% of the default amount.
The rest 25% shall be paid on conclusion of recovery proceedings or when the decree gets time barred, whichever is earlier.
Securitisation, direct assignment and co-lending
- The loan, originated by the NBFC, has been securitised. Is it possible for the NBFC to give a GECL facility based on the POS of the securitised loan?
On the face of it, there is nothing that stops a lender from giving a further facility, in addition to the one that has been securitised. However, in the present case, there will be modification of the existing charge document, whereby the charge will be extended to the top up GECL loan as well. This amounts to a dilution of the security available for the primary loan. In our view, this will require specific consent of the PTC investors, through the trustee.
Note that FAQ 35 by NCGTC seems to be talking about off-balance sheet facility. Many securitisation transactions are actually on the balance sheet. Further, even if the original facility has gone off the balance sheet, the additional funding being given by the originator-servicer will be on-the-balance sheet.
Any interpretation of the guarantee scheme has to serve the purpose for which the scheme was envisaged – which is, clearly, to provide additional liquidity to borrowers affected by the disruption. There can be no suggestion that borrowers whose loans have been securitised will not need additional liquidity. Hence, the Scheme intends to wrap all additional lendings done by the lender, within the limits of 20%.
- The loan, originated by the NBFC, has been assigned to the extent of 90% to a bank. Is it possible for the NBFC to give a GECL facility based on the POS of the partly-assigned loan?
Same reasoning as above. Here again, FAQ 40 by NCGTC is talking about the entity on whose books the loan currently is. NCGTC’s view about the loan being on the books of a lender is seemingly overshadowed by accounting concepts which have drastically changed over time. For example, a loan which has been a matter of a DA transaction is actually partly on the books of the original lender, and partly on the books of the assignee. One cannot expect the assignee to be giving the additional line of credit, as the assignee is, practically speaking, a mere passive investor. The assignee does not have the franchise/relation with the borrower, which the originator has. To contend that the assignee bank should extend the additional facility is actually to deny the facility to the borrower completely, for no fault of the borrower and for no gain for the system. Since it is the original lender who maintains the relation with the borrower, it is original lender only who may extend the facility.
- Is it possible for the NBFC to originate the GECL facility, and securitise/assign the same? Will the assignee have the benefit of the GoI guarantee?
There is nothing in the Scheme for assignment of the benefit of guarantee. Typically, unless the guarantee agreement says to the contrary, the benefit of a security or guarantee is assignable along with the underlying loan. However, the guarantee agreement between NCGTC and the lender will be critical in determining this.
 The scheme earlier required the MSMEs to obtain UAN (i.e. get registered) in order to avail benefit under the same. However the same was recently done away with through a notification issued on February 5, 2020. Link to the notification- https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11803&Mode=0
Our related write-ups may be referred here:
The Reserve Bank of India, on 13th March, 2020, issued a notification 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:
- Things to be done by the Board of Directors (BOD)
- Expected Credit Losses (ECL) and prudential norms
- Dealing with defaults and significant increase in credit risk
- Things to be done by the Audit Committee of the Board (ACB)
- Computation of regulatory capital
- Securitisation accounting and prudential norms
- 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, 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) 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. 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, 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:
- 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.
- 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:
- NBFC classification under IFRS financial statements: http://vinodkothari.com/wp-content/uploads/2018/11/Article-template-VKCPL-3.pdf
- 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/
- 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/
- 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/
- Classification and reclassification of financial instruments under Ind AS: http://vinodkothari.com/2019/01/classification-of-financial-asset-liabilities-under-ind-as/
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:
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:
Vinod Kothari Consultants P Ltd (firstname.lastname@example.org)
The partial credit enhancement (PCE) Scheme of the Government, 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.
The data required for the analysis will be same as data required for securitisation of a static pool.
- 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
Other Related Articles :
- Government Credit enhancement scheme for NBFC Pools: A win-win for all
- 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
- Dissecting the gois partial credit guarantee scheme
Vinod Kothari (email@example.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.
Broadly, the way we envisage the Scheme working is as follows:
- 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.
- 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).
- 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).
- 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.
- 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.
- 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.
- 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.
- 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.
- Now comes the critical question – what will be the coupon rates that the PSB may expect on the pool.
- 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.
- 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.
- 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.
- For the NBFC, the actual cost is the coupon expected by the PSB, plus 25bps paid for the guarantee.
- 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.
Whoever takes the first transaction to market will have to obviously do a lot of educating – PSBs, rating agencies, law firms, SIDBI, and of course, DFS. However, the exercise is worth it, and it may not take 6 months as envisaged for the GoI to reach the target of Rs 1 lakh crores.
Other related articles:
- Dissecting the GOIs partial credit guarantee scheme
Abhirup Ghosh (firstname.lastname@example.org)
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, 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.
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.
The Scheme lays down criteria to check the eligibility of sellers to avail benefits under this Scheme, and the same are follows:
- NBFCs registered with the RBI, except Micro Financial Institutions or Core Investment Companies.
- HFCs registered with the NHB.
- 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%
- The net NPA of the NBFC/HFC must not have exceeded 6% as on 31st March, 2019
- 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.
- 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:
- 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.
- 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.
Pool of assets satisfying the following conditions can be assigned under the Scheme:
- The asset must have been originated on or before 31st March, 2019.
- The asset must be classified as standard in the books of the NBFC/ HFC as on the date of the sale.
- The pool of assets should have a minimum rating of “AA” or equivalent at fair value without the credit guarantee from the Government.
- 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.
- 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.
- The individual asset size in the pool must not exceed Rs. 5 crore.
- The following types of loans are not eligible for assignment for the purposes of this Scheme:
- Revolving credit facilities;
- Assets purchased from other entities; and
- Assets with bullet repayment of both principal and interest
Our observations on the eligibility criteria are as follows:
- 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.
- 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.
- 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
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
- 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.
- 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.
- To-do for the NBFCs/ HFCs – In order to avail the benefits under the Scheme, the following actionables have to be undertaken:
- 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;
- 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.