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Guaranteed Emergency Line of Credit: Understanding and FAQs

/23 Comments/in , , /by

-Financial Services Division (finserv@vinodkothari.com)

-Updated as on June 08, 2021

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 second charge, 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.

On account of nationwide disruption due to COVID-19 pandemic second wave, the Government has further enlarged the scope of the Emergency Credit Line Guarantee Scheme (ECLGS) via updated ECLGS operation guidelines dated June 07, 2021(‘ECLGS 4.0’). Additionally, FAQs pertaining to scheme operational guidelines were also updated via notification dated June 07, 2021. 

The following chart depicts the various parts of ECLGS as per updated operational guidelines on June 07, 2021. 

Eligible Lenders and eligible borrowers

  1. What is the nature of GECL (ECLGS 1.0)?

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.

1A. What are the key differences between ECLGS 1.0, ECLGS 2.0, ECLGS, 3.0 and ECLGS 4.0?

Refer to the comparative table at the end of the FAQs.

  1. Who are the MLIs/eligible lenders under the Scheme?

For the purpose of the Scheme MLIs/eligible lenders include:

  1.  All Scheduled Commercial Banks. Other banks such as RRBs, co-operative banks etc. shall not be eligible lenders.
  2.  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.

  1. 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

  1. 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.

  1. Is it necessary that the NBFC must be registered with the RBI?

Yes, the eligibility criteria specifically requires the NBFC to be registered.

  1. 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.
  1. 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%].

  1. Who are the eligible borrowers (Eligible Borrower or Borrower) under ECLGS 1.0?

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.

8A. Can the beneficiary under one scheme avail benefits under other schemes?

The guaranteed extended credit line (GECL) is borrower-specific and sector-specific relief. The additional credit line under ECLGS 1.0 and ECLGS 2.0 are mutually exclusive. Whereas, in cases where an additional credit line has been extended under ECLGS 1.0 and the borrower is also covered ECLGS 3.0, such accounts are eligible for additional funding up to 40% of the outstanding amount as on Feb 29. 2020. The additional funding up to 2 crores under ELGS 4.0 is allowed to all the eligible borrowers under ECLGS 4.0, irrespective of whether the funding has been availed under ECLGS 1.0, ECLGS 2.0, ECLGS 3.0.  

  1. 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.

  1. 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.

  1. 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.

  1. 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.

  1. 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:…………………

Note: The turnover applicability under ECLGS 1.0 has been removed. 

  1. One of the important conditions under ECLGS 1.0, ECLGS 2.0 and ECLGS 3.0 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.

  1. 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.

  1. 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 (ECLGS 1.0) 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.

  1. 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 (ECLGS 1.0)?

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 (ECLGS1.0), subject to other conditions being satisfied.

  1. 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.
  1. When can GECL be sanctioned? Is there a time within which the GECL should be sanctioned? –Updated as on June 08, 2021

The GECL under ECLGS 1.0, ELCGS, 2.0, ECLGS 3.0, and ECLGS 4.0 shall be sanctioned latest by Spetember 30, 2021 or till an amount of Rs. 3 lakh crore is sanctioned under GECL, whichever is earlier.

19A. Is there a sunset clause for the guarantees to be extended under the ECLGS schemes?

For fund-based (ECLGS 1.0, ECLGS 2.0, ECLGS 3.0, and ECLGS 4.0) and non-fund-based (ECLGS 2.0 and ECLGS 4.0) as may be applicable, facilities under all the Schemes to be sanctioned latest by September 30, 2021.

While the disbursement or utilisation (as the case may be) of such sanctioned additional credit facility shall be done latest by December 31, 2021.   

  1. 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.

  1. Whether the threshold limit of outstanding credit of Rs. 50 crores under ECLGS 1.0, 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.

  1. For ECLGS 1.0 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.
  1. 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
  1. 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; (Turnover limit omitted by way of updated operational guidelines) 

(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.

  1. 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.

25 A. What if the borrower satisfies the conditions with respect to DPDs on the respective cut-off dates under various ECLGS schemes, but subsequently is downgraded to NPA – will the borrower still be eligible for additional finance under the schemes?

The borrower account otherwise eligible under the scheme should not be an NPA as on the date of sanction / disbursement.

  1. 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.

  1. 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

  1. What are the major terms of the GECL Facility (ECLGS 1.o)?

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
  1. 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.

  1. 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.

  1. 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.

  1. 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?- Updated -The collateral under ECLGS scheme will rank second in terms of collateral and cashflows to the primary credit facility. 

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 ECLGS scheme initially provided for parri-passu charge over collateral, but by way of subsequent amendment, the anomaly discussed above was removed by the  Government. Therefore, in the example above, there will be no dilution in the value of the security for the primary loan. Since the proceeds from the collateral will be used, firstly to recover dues of the primary loan facility, and secondly the remaining amount from realisation of collateral (if any) will be used to satisfy loan under GECL Facility.

  1. 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 cashflow? Updated -The cashflows under ECLGS scheme will rank second to the primary credit facility. 

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.

Refer to updated FAQ 32.

  1. 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.

  1. 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.

  1. 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 (ECLGS 1.0) 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.

  1. 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.

  1. 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.

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.

  1. 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.

  1. 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.

Lender-Borrower documentation

  1. 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.

  1. What documentation are we envisaging as between the MLI and the borrower?

At least the following:

  1. Additional loan facility documentation, whether by a separate agreement, or annexure to the master facility agreement executed already by the borrower.
  2. Modification of charge.

Income recognition, NPA recognition, risk weighting and ECL computation

  1. 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.

  1. 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.

  1. 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.

  1. 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.

  1. 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.

  1. 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

  1. 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’).

  1. 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.

  1. 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.

  1. To what extent will the guarantee be extended?

The guarantee shall cover 100% of the eligible credit facility.

  1. 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.

  1. 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.

  1. 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.

  1. 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

  1. 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%.

  1. 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.

  1. 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.

60. Can a borrower who availed facility under ECLGS 1.0, restructure the same, and to what extent?

Borrowers who have availed assistance under ECLGS 1.0 and are eligible for restructuring as per RBI guidelines of May 05, 2021, are permitted to avail of the same. However, the restructuring can involve granting of moratorium on payments, and granting of additional assistance upto 10% of the POS as on 29.02.2020 or 40% of the POS as on 29.02.2020 if borrower satisfies the conditions under ECLGS 3.0. In case, a moratorium is granted, the restructured repayment tenure can be extended upto 5 years, i.e, period upto 24 months during which only interest shall be payable and the principal instalments shall be payable thereafter in 36 monthly instalments. 

61. Can the borrowers whose existing ECLGS facilities have been restructured become eligible for additional facilities under any of the ECLGS schemes?

In case the borrower has availed funding under ECLGS 1.0, the loan can be restructured and borrower can avail either of the following

1. ECLGS 3.0- 40% (incremental only), provided the borrower is an eligible borrower under ECLGS 3.0

OR

2. 10% additional facility

The borrower accounts covered under the RBI’s resolution framework would be eligible for additional assistance of 10% or additional assistance under ECLGS 3.0, but not both

 

62. Can the borrowers who have availed additional finance from the lender as a part of the RBI’s restructuring framework also avail additional finance under the ECLGS framework?

The borrower will have the following options

  1. ECLGS 1.0- 20%
  2. ECLGS 3.0- 40% 

The only difference between the additional funding under the RBI framework and the ECLGS Scheme would be that the former is not guaranteed whereas the latter is 100% guaranteed.

63. Can the borrowers who have availed the restructuring facility for other loans avail the ECLGS facility post restructuring?

In case the borrower has not availed additional facilities under any of the ECLGS schemes previously, and gets its existing facilities restructured, it will have the option of availing additional facilities under any of the ECLGS schemes, subject to the fulfillment of the conditions provided thereunder. 

 

64. To what extent can moratorium be granted (on the loans extended under the ECLGS scheme?

 

Scheme Total repayment period including moratorium Moratorium period on principal repayment
ECLGS 1.0 4 years * 1 year
ECLGS 2.0 5 years 1 year
ECLGS 3.0 6 years 2 year
ECLGS 4.0  5 years 6 months

 

The aforementioned indicates the maximum period of moratorium, the lenders shall have the discretion to provide shorter moratorium periods as well. Further, it is important to note that during the moratorium period, the interest will have to be serviced by the borrower – therefore, unlike the moratorium period under the COVID 19 relief package provided by the RBI which provided for complete moratorium on EMI payments, this will not be a complete moratorium, and at least the interest will have to be serviced during this period. 

* Provided there is no restructuring under Restructuring Framework 2.0. 

65. What is the tenure and moratorium period allowed for non-fund based facilities?

Under ECLGS 2.0 and 4.0, no tenor has been prescribed for non-fund based facility, but the guarantee cover on the non-fund based facility shall expire on completion of 5 years from the date of first disbursement/first utilization under fund based or non-fund based facility.

66. A borrower has availed 20% additional credit line under ECLGS 1.0. What incremental funding can be availed by such borrower if it qualifies as an eligible borrower under ECLGS 3.0?

The borrower who has availed 20% GECL under ECLGS 1.0, and the same borrower is also eligible under ECLGS 3.0, in such a case the borrower shall only be eligible for incremental funding amount. Incremental funding amount can be calculated as follows:

Let POS as on Feb 29 be Rs. 200

1. Eligible funding under ECLGS 3.0 (40% of POS as on Feb 29, 2020) = Rs. 80
2. Funding availed under ECLGS 1.0 (20% of POS as on Feb 29, 2020) = Rs. 40
3. Eligible incremental funding: 1-2  = Rs. 40

67. Will there be a provisioning requirement for additional 10% funding extended to loans under ECLGS 1.0, as part of RBI 05 May 2021 Restructuring Framework 2.0?  

The initial top up GECL facility was zero rated (notification on June 22, 2020), therefore additional finance extended by the lender as part of restructuring of GECL under RBI Restructuring Framework 2.0 shall also be risk free. Hence there is no provisioning requirement for such additional 10% finance extended to GECL loan under Restructuring Framework 2.0.   

Comparative table of ECLGS schemes :

  ECLGS 1.0 ECLGS 2.0 ECLGS 3.0 ECLGS 4.0
Nature of support Opt Out (Pre approved)- Extended Credit Guarantee Line upto 20% of Outstanding loan as on 29.02.2020 Opt In Extended Credit Guarantee Line (fund based or non-fund based) upto 20% of Outstanding loan as on 29.02.2020 Opt In Extended Credit Guarantee line (fund based) upto 40% of Outstanding loan as on 29.02.2020 Opt In Extended Credit line for assistance upto 2 crores.
Fund based support or non-fund based support
  • Fund based support by MLI 
  • Fund based and Non-Fund based support by MLI 
  • Fund based Support 
  • Fund based and Non fund based support
Extent of additional finance permitted 
  • upto 20% of Outstanding loan as on 29.02.2020
  • upto 20% of Outstanding loan as on 29.02.2020
  • Outstanding loans not more than Rs. 500 crore as on Feb 29, 2020 [Rs. 500 Crore limit removed by ECLGS 4.0, current limit 200 crore or 40% of outstanding loan whichever is lower]
  • Upto 2 crores (funded and non-funded)
Eligible borrowers Business Enterprises / MSMEs/individuals who have availed loan for business purposes

  • Outstanding loans upto 50 crores as on Feb 29, 2020
  • Accounts less than 60 DPD as on Feb 29, 2020
 26 key sectors identified by Kamath committee report and healthcare sector

  • Outstanding loans more than 50 crores but less than 500 crores as on Feb 29, 2020
  • Accounts less than 60 DPD as on Feb 29, 2020
 Hospitality, Travel & Tourism, Leisure & Sporting sectors, scheduled and non-scheduled airlines, chartered 

flight operators, air ambulances and airports

  • Outstanding loans not more than Rs. 500 crore as on Feb 29, 2020 [Rs. 500 Crore limit removed by ECLGS 4.0, current limit 200 crore or 40% of outstanding loan whichever is lower]
  • Accounts less than 60 DPD as on Feb 29, 2020 
 Existing Hospitals/nursing 

homes/clinics/medical colleges / units engaged in manufacturing of liquid oxygen, 

oxygen cylinders etc 

  • Outstanding credit facility with an MLI as on March 31, 2021
  • Less than 90 DPD on March 31, 2021 
Eligible lenders
  • Banks,  AIFI NBFCs/HFCs (operation for 2 years as on 29th Feb, 2020) 
  • Banks,  AIFI NBFCs/HFCs (operation for 2 years as on 29th Feb, 2020) 
  • Banks,  AIFI NBFCs/HFCs (operation for 2 years as on 29th Feb, 2020)
  • Banks,  AIFI NBFCs/HFCs (operation for 2 years as on 29th Feb, 2020)
Interest rate on facilities (Max cap)
  • Banks 9.25%
  • NBFCs: 14% 
  • Banks 9.25%
  • NBFCs: 14% 
  • Banks 9.25%
  • NBFCs: 14% 
 7.5% 
Tenor of facilities
  • 4 years 
  • 5 years
  • 6 years
  • Fund based: 5 years from date of disbursal
  • Non Fund Based: 5 years from date of utilisation (last date of utilisation Dec 31, 2021) 
Moratorium on repayment of facilities
  • 1 year on principal payment 
  • 1 year on principal payment 
  • 2 years moratorium on principal payment
  • 6 months for fund based portion on interest and principal
Principal repayment tenor in case moratorium has to be granted 
  • 36 months after moratorium 
  • 48 months after moratorium
  • 48 months after moratorium
  • 54 months after moratorium  
Whether eligible for restructuring
  • Yes
  • No
  • No 
  • No 
Security
  • No additional security
  • However, second charge will be created on collateral obtained under existing facilities, if any

No security for  Rs.25 lakh (outstanding as on
February 29, 2020 plus loan sanctioned under GECL
  • No additional security 
  • However, second charge will be created on collateral obtained under existing facilities, if any

No security for  Rs.25 lakh (outstanding as on
February 29, 2020 plus loan sanctioned under GECL
  • No additional security
  • However, second charge will be created on collateral obtained under existing facilities, if any  

No security for  Rs.25 lakh (outstanding as on
February 29, 2020 plus loan sanctioned under GECL
  • No additional security
  • However, second charge will be created on collateral obtained under existing facilities, if any

No security for  Rs.25 lakh (outstanding as on February 29, 2020 plus loan sanctioned under GECL  
Guarantee fee
  • No guarantee fee 
  • No guarantee fee
  • No guarantee fee
  • No guarantee fee

 

[1] https://pib.gov.in/PressReleasePage.aspx?PRID=1625306

[2] http://www.dcmsme.gov.in/publications/circulars/cate-12-6.pdf

[3] https://udyogaadhaar.gov.in/Web/doc/Activities_NIC_CodesNotAllowed.PDF

[4] 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

[5] https://www.cgtmse.in/files/CGS-I.pdf

 

Our related write-ups may be referred here:

Resources on MSME financing

 

Regulatory framework for NBFC-SI

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Regulator’s move to repair the NBFC sector

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-Mridula Tripathi

(finserv@vinodkothari.com)

The evolving impact on people’s health has casted a threat on their livelihoods, the businesses in which they work, the wider economy, and therefore the financial system. The outbreak of this pandemic is nothing like the crisis faced by the economies in the year 2007-08 and imperils the stability of the financial system. The market conditions have forced traders to take aggressive steps exposing the system to great volatility thereby resulting in crashing asset values. Combating the pandemic and safeguarding the economy, the financial sectors across the globe have witnessed numerous reforms to hammer the aftermaths of the global crisis. Read more →

Loan products for tough times

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-Vinod Kothari (vinod@vinodkothari.com)

Economic recoveries in the past have always happened by increasing the supply of credit for productive activities. This is a lesson that one may learn from a history of past recessions and crises, and the efforts made by policymakers towards recovery. [See Appendix]

The above proposition becomes more emphatic where the disruption is not merely economic – it is widespread and has affected common life, as well as working of firms and entities. There will be major effort, expense and investment required for restarting economic activity. Does moratorium merely help?  Moratorium possibly helps avoiding defaults and insolvencies, but does not help in giving the push to economic activity which is badly needed. Entities will need infusion of additional finance at this stage.

The usual way governments and policy-makers do this is by releasing liquidity in the banking system. However, there are situations where the banking system fails to be an efficient transmission device for release of credit, for reasons such as stress of bad loans in the banking system, lack of efficient decision-making, etc.

In such situations, governments and central banks may have to do direct intervention in the market. Governments and central banks don’t do lending – however, they create institutions which promote lending by either banks or quasi-banks. This may be done in two ways – one, by infusion of money directly, and two, by ways of sovereign guarantee, so as to do credit risk transfer to the sovereign. The former method has the limit of availability of resources – governments have budgetary limitations, and increased public debt may turn counter-productive in the long-run. However, credit risk transfer can be an excellent device. Credit risk transfer also seems to be creating, synthetically, the same exposure as in case of direct lending by the sovereign; however, there are major differences. First, the sovereign does not have to go for immediate borrowings. Second and more important, the perceived risk transfer, where credit risk is shifted to the sovereign, may not actually hit in terms of credit losses, if the recovery efforts by way of the credit infusion actually bear fruit.

The write-up below suggests a product that may be supported by the sovereign in form of partial credit risk guarantee.

Genesis of the loan product

For the sake of convenience, let us call this product a “wrap loan”. Wrap-around mortgage loans is a practice prevalent in the US mortgage market, but our “wrap loan” is different. It is a form of top-up loan, which does not disturb the existing loan terms or EMI, and simply wraps the existing loan into a larger loan amount.

Let us assume the following example of, say, a loan against a truck or a similar asset:

Original Loan amount 1000000
Rate of interest 12%
Tenure 60 Months
EMIs ₹ 22,244.45
Number of months the loan has already run 24 Months
Number of remaining months of original loan term 36 Months
Principal outstanding (POS) on the date of wrap loan ₹ 6,69,724.82

For the sake of convenience, we have not considered any moratorium on the loan[1]. The customer has been more or less regular in making payments. As on date, he has paid 24 EMIs, and is left with 36. Now, to counter the impact of the disruption, the lender considers an additional loan of Rs 50000/-. Surely, for assessing the size of the wrapper loan, the lender will have to consider several things – the LTV ratio based on the increased exposure and the present depreciated value of the asset, the financial needs of the borrowers to restart his business, etc.

With the additional infusion of Rs 50000, the outstanding exposure now becomes Rs 719725/-. We assume that the lender targets a slightly higher interest for the wrapper part of the loan of Rs 50000, say 14%. The justification for the higher interest can be that this component is unsecured. However, we do not want the existing EMI, viz., Rs 22244/- to be changed. That is important, because if the EMIs were to go up, there will be increasing pressure on the revenues of the borrower, and the whole purpose of the wrap loan will be frustrated.

Therefore, we now work the increased loan tenure, keeping the EMIs the same, for recovering the increased principal exposure. The revised position is as follows:

POS on the date of wrap loan ₹ 6,69,724.82
Additional loan amount 50000
Interest on the additional loan 14%
Blended interest rate 12.139%
Revised loan tenure 39.39 months
total maturity in months (rounded up) 40 months
Number of whole months                        39 months
Fractional payment for the last month ₹ 8,664.67

Note that the blended rate is the weighted average, with interest at the originally-agreed rate of 12% on the existing POS, and 14% on the additional amount of lending. The revised tenure comes to 39.39 months, or 40 months. There will be full payment for 39 months, and a fractional payment in the last month.

Thus, by continuing his payment obligation for 3-4 more months, the borrower can get Rs. 50000/- cash, which he can use to restart his business operations.

The multiplier impact that this additional infusion of cash may have in his business may be substantial.

Partial Sovereign Guarantee for the Wrapper Loan

Now, we bring the key element of the structure. The lender, say a bank or NBFC, will generally be reluctant to take the additional exposure of Rs 50000, though on a performing loan. However, this may be encourage by the sovereign by giving a guarantee for the add-on loan.

The guarantee may come with minimal actual risk exposure to the sovereign, if the structure is devised as follows:

  • The sovereign’s portion of the total loan exposure, Rs 719725, is only Rs 50000, which is less than 10%. A safe limit of 10% of the size of the existing exposure may be kept, so that lenders do not aggressively push top-up loans.
  • Now, the sovereign’s portion, which is only Rs 50000/- (and in any case, limited to 10%), may either be a pari-passu share in the total loan, or may be structured as a senior share.
  • If it is a pari-passu share, the question of the liability for losses actually coming to the sovereign will arise at the same time as the lender. However, if the share of the sovereign is a senior share, then the sovereign will get to share losses only if the recoveries from the loan are less than Rs 50000.

The whole structure may be made more practical by moving from a single loan to a pool of loans. The sovereign guarantee may be extended to a pool of similar loans, with a prescription of a minimum number, maximum concentration per loan, and other diversity parameters. The moment we move from a single loan to a pool of loans, the sharing of losses between the sovereign and the originator will now be on a pool-wide basis. Even if the originator takes a first loss share of, say, 10%, and the sovereign’s share comes thereafter, the chances of the guarantee hitting the sovereign will be very remote.

And of course, the sovereign may also charge a reasonable guarantee fee for the mezzanine guarantee.

Since the wrapper loan is guaranteed by the sovereign, the lender may hope to get risk weight appropriate for a sovereign risk. Additional incentives may be given to make this lending more efficient.

Appendix

Economic recovery from a crisis and the role of increased credit supply: Some global experiences

  1. Measures by FRB during following the Global Financial Crisis:

‘The first set of tools, which are closely tied to the central bank’s traditional role as the lender of last resort, involve the provision of short-term liquidity to banks and other depository institutions and other financial institutions. A second set of tools involved the provision of liquidity directly to borrowers and investors in key credit markets. As a third set of instruments, the Federal Reserve expanded its traditional tool of open market operations to support the functioning of credit markets, put downward pressure on longer-term interest rates, and help to make broader financial conditions more accommodative through the purchase of longer-term securities for the Federal Reserve’s portfolio.’[2]

  1. Liquidity shocks may cause reverse disruption in the financial chain:

‘During a financial crisis, such “liquidity shock chains” can operate in reverse. Firms that face tightening financing constraints as a result of bank credit contraction may withdraw credit from their customers. Thus, they pass the liquidity shock up the supply chain; that is, their customers might cut the credit to their customers, and so on…..Thus, the supply chains might propagate the liquidity shocks and exacerbate the impact of the financial crisis.’[3]

  1. Measures taken during Global Financial Crisis – US Fed publication – From Credit Crunches to Financial Crises:

Therefore, many of the policy remedies proposed to alleviate credit crunches were, in fact, used during the early stages of the 2008 financial crisis to mitigate potential credit availability problems. These remedies included capital infusions into troubled banks, the provision of liquidity facilities by the Federal Reserve, and, in the initial stress test, a primary focus on raising bank capital rather than allowing banks to shrink assets to maintain, or regain, required capital ratios.[4]

  1. Observations of Banca Italia on the 2008 Crisis

‘First, the effect of credit supply on value added is not detectable in the years before the great recession, indicating that credit supply is more relevant during an economic downturn. Second, the reduction in credit supply also explains the decline in employment even if the estimated effect is lower than that on value added. As a result, we can also detect a significant impact on labor productivity, while there is no effect on exports and on firm demographics. Third, the role of credit supply does vary across firms’ size, economic sectors, degree of financial dependence and, consequently, across geographical areas. Specifically, the impact is concentrated among small firms and among those operating in the manufacturing and service sectors. The impact is also stronger in the provinces that depend more heavily on external finance’[5]

 

[1] In fact, the wrap loan could have been an effective alternative to the moratorium

[2] https://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm

[3] http://siteresources.worldbank.org/INTRANETTRADE/Resources/TradeFinancech01.pdf

[4] https://www.bostonfed.org/-/media/Documents/Workingpapers/PDF/economic/cpp1505.pdf

[5] https://www.bancaditalia.it/pubblicazioni/temi-discussione/2016/2016-1057/en_tema_1057.pdf

 

Our other content relating to COVID-19 disruption may be referred here: http://vinodkothari.com/covid-19-incorporated-responses/

Our FAQs on moratorium may be referred here: http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

Guidance on money laundering and terrorist financing risk assessment

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-Financial Services Division (finserv@vinodkothari.com)

Background

The Reserve Bank of India (RBI) introduced an amendment[1] to Master Direction – Know Your Customer (KYC) Direction, 2016 (‘KYC Directions’)[2] requiring Regulated Entities (REs) to carry out money laundering (ML) and terrorist financing (TF) risk assessment exercises periodically. This requirement shall be applicable with immediate effect and the first assessment has to be carried out by June 30, 2020.

Carrying out ML and TF risk assessment is a very subjective matter and there is no thumb rule to be followed for the same. There is no uniformity on procedures of risk assessment, however, they may be guided by a set of broad principles. The following write-up intends to explore guidance principles enumerated by international bodies and suggest principles to be followed by financial institutions in India, specifically NBFCs, for carrying out risk assessment exercise.

Origin of the concept

The concept of ML and TF risk assessment arises from the recommendations of Financial Action Task Force (FATF). FATF has also provided detailed guidance on TF Risk Assessment[3]. Due to the inter-linkage between ML and TF, the guidelines also serve the purpose of guiding ML risk assessment. TF risk is defined as-

“A TF risk can be seen as a function of three factors: threat, vulnerability and consequence. It involves the risk that funds or other assets intended for a terrorist or terrorist organisation are being raised, moved, stored or used in or through a jurisdiction, in the form of legitimate or illegitimate funds or other assets.”

Global practices for ML/TF risk assessment

Based on FATF recommendations, many jurisdictions have prepared and published risk assessment procedures. India is yet to come up with the same.

For example, the National risk assessment of money laundering and terrorist financing[4] is the guidance published by the UK government. It provides sector specific guidance for risk assessment. The sector specific guidance is further granulated keeping in view the specific threats to certain parts of the sector.

The guidance provided by the Republic of Serbia[5] is a generalised one providing broad guidance to all sectors for risk assessment.

In Germany, financial institutions are classified on the basis of potential risk of ML/TF identified by them (considering the factors such as location, scope of business, product structure, customers’ profile and distribution structure) and the intensity of supervision by regulator is based on such risk categorisation.

Risk assessment process by NBFC

The risk assessment of a financial sector entity such as an NBFC, need not be complex, but should be commensurate with the nature and size of its business. For smaller or less complex NBFCs where the customers fall into similar categories and/or where the range of products and services are very limited, a simple risk assessment might suffice. Conversely, where the loan products and services are more complex, where there are multiple subsidiaries or branches offering a wide variety of products, and/or their customer base is more diverse, a more sophisticated risk assessment process will be required.

Based on the guiding principles provided by the FATF and specific guidance issued by FATF for banking and financial sector[6], the process of risk assessment by NBFCs may be divided into following stages:

Stage 1: Collection of information

The risk assessment shall begin with collecting of information on a wide range of variables including information on the general criminal environment, TF and terrorism threats, TF vulnerabilities of specific sectors and products, and the jurisdiction’s general AML capacity

The information may be collected externally or internally. In India, Directorate of Enforcement is the body which deals with ML and TF matters and has collection of information and list of terrorists. Further, the information may also be obtained from Central Bureau of Investigation.

Stage 2: Threat identification

Based on the information collected, jurisdiction and sector specific threats should be identified. Threat identification should be based on the risks identified on the national level, however, shall not be limited to the same. It should also be commensurate to the size and nature of business of the entity.

For individual NBFCs, it should take into account the level of inherent risk including the nature and complexity of their loan products and services, their size, business model, corporate governance arrangements, financial and accounting information, delivery channels, customer profiles, geographic location and countries of operation. The NBFC should also look at the controls in place, including the quality of the risk management policy, the functioning of the internal oversight functions etc.

Stage 3: Assessment of ML/TF vulnerabilities

This stage involves determination of the how the identified threats will impact the entity. The information obtained should be analysed in order to assess the probability of risks occurring. Based on the assessment, ML/TF risks should be classified as low, medium and high impact risks.

While assessing the risks, following factors should be considered:

  • The nature, scale, diversity and complexity of their business;
  • Target markets;
  • The number of customers already identified as high risk;
  • The jurisdictions the entity is exposed to, either through its own activities or the activities of customers, especially jurisdictions with relatively higher levels of corruption or organised crime, and/or deficient AML/CFT controls and listed by RBI or FATF;
  • The distribution channels, including the extent to which the entity deals directly with the customer or relies third parties to conduct CDD;
  • The internal audit and regulatory findings;
  • The volume and size of its transaction.

The NBFCs should complement this information with information obtained from relevant internal and external sources, such as operational/business heads and lists issued by inter-governmental international organisations, national governments and regulators.

The risk assessment should be approved by senior management and form the basis for the development of policies and procedures to mitigate ML/TF risk, reflecting the risk appetite of the NBFC and stating the risk level deemed acceptable. It should be reviewed and updated on a regular basis. Policies, procedures, measures and controls to mitigate the ML/TF risks should be consistent with the risk assessment.

Stage 4: Analysis of ML/TF threats and vulnerabilities

Once potential TF threats and vulnerabilities are identified, the next step is to consider how these interact to form risks. This could include a consideration of how identified domestic or foreign TF threats may take advantage of identified vulnerabilities. The analysis should also include assessment of likely consequences.

Stage 5: Risk Mitigation

Post the analysis of threats and vulnerabilities, the NBFC must develop and implement policies and procedures to mitigate the ML/TF risks they have identified through their individual risk assessment. Customer due diligence (CDD) processes should be designed to understand who their customers are by requiring them to gather information on what they do and why they require financial services. The initial stages of the CDD process should be designed to help NBFCs to assess the ML/TF risk associated with a proposed business relationship, determine the level of CDD to be applied and deter persons from establishing a business relationship to conduct illicit activity.

Focus on CDD procedure

While entering into a relationship with the customer, carrying out Customer Due Diligence (CDD) is the initial step. It is during the CDD process that the identity of a customer is verified and risk based assessment of the customer is done. While assessing credit risks, financial entities should also assess ML/TF risks. The CDD procedures and policies should suitably include checkpoints with respect to ML and TF.

The risk classification of the customer, as discussed above, should also be done based on the CDD carried out. The CDD procedure, apart from verifying the identity of the customer, should also go a few steps further to understand the nature of business or activity of the customer. Measures should be taken to prevent the misuse of legal persons for money laundering or terrorist financing.

In case of medium or high risk customers, or unusual transactions, the entities should also carry out transaction due diligence to identify source and application of funds, beneficiary of the transaction, purpose etc.

NBFCs should document and state clearly the criteria and parameters used for customer segmentation and for the allocation of a risk level for each of the clusters of customers. Criteria applied to decide the frequency and intensity of the monitoring of different customer segments should also be transparent. Further, the NBFC must maintain records on transactions and information obtained through the CDD measures. The CDD information and the transaction records should be made available to competent authorities upon appropriate authority.

Some examples of enhanced and simplified due diligence measures are as follows:

Enhanced Due Diligence (EDD)

  • obtaining additional identifying information from a wider variety or more robust sources and using the information to inform the individual customer risk assessment
  • carrying out additional searches (e.g., verifiable adverse media searches) to inform the individual customer risk assessment
  • commissioning an intelligence report on the customer or beneficial owner to understand better the risk that the customer or beneficial owner may be involved in criminal activity
  • verifying the source of funds or wealth involved in the business relationship to be satisfied that they do not constitute the proceeds from crime
  • seeking additional information from the customer about the purpose and intended nature of the business relationship

Simplified Due Diligence (SDD)

  • obtaining less information (e.g., not requiring information on the address or the occupation of the potential client), and/or seeking less robust verification, of the customer’s identity and the purpose and intended nature of the business relationship
  • postponing the verification of the customer’s identity
Ongoing CDD and Monitoring

Ongoing monitoring means the scrutiny of transactions to determine whether the transactions are consistent with the NBFC’s knowledge of the customer and the nature and purpose of the loan product and the business relationship.

Monitoring also involves identifying changes to the customer profile (for example, their behaviour, use of products and the amount of money involved), and keeping it up to date, which may require the application of new, or additional, CDD measures. Monitoring transactions is an essential component in identifying transactions that are potentially suspicious. Monitoring should be carried out on a continuous basis or triggered by specific transactions. It could also be used to compare a customer’s activity with that of a peer group. Further, the extent and depth of monitoring must be adjusted in line with the NBFC’s risk assessment and individual customer risk profiles

Reporting

The NBFCs should have the ability to flag unusual movement of funds or transactions for further analysis. Further, it should have appropriate case management systems so that such funds or transactions are scrutinised in a timely manner and a determination made as to whether the funds or transaction are suspicious. Funds or transactions that are suspicious should be reported promptly to the FIU and in the manner specified by the authorities. There must be adequate processes to escalate suspicions and, ultimately, report to the FI.

Internal Controls

Adequate internal controls are a prerequisite for the effective implementation of policies and processes to mitigate ML/TF risk. Internal controls include appropriate governance arrangements where responsibility for AML/CFT is clearly allocated and there are controls to test the overall effectiveness of the NBFC’s policies and processes to identify, assess and monitor risk. It is important that responsibility for the consistency and effectiveness of AML/CFT controls be clearly allocated to an individual of sufficient seniority within the NBFC to signal the importance of ML/TF risk management and compliance, and that ML/TF issues are brought to senior management’s attention.

Recruitment and Training

NBFCs should check that personnel they employ have integrity and are adequately skilled and possess the knowledge and expertise necessary to carry out their function, in particular where staff are responsible for implementing AML/CFT controls. The senior management who is responsible for implementation of a risk-based approach should understand the degree of discretion an NBFC has in assessing and mitigating its ML/TF risks. In particular, it must be ensured that the employees and staff have been trained to assess the quality of a NBFC’s ML/TF risk assessments and to consider the adequacy, proportionality and effectiveness of the NBFC’s AML policies, procedures and internal controls in light of this risk assessment. Adequate training would allow them to form sound judgments about the adequacy and proportionality of the AML controls.

Stage 6: Follow-up and maintaining up-to-date risk assessment

Once assessed, the impact of the risk shall be recorded and measures to mitigate the same should be provided for. The information that forms basis of the risk assessment process should be timely updated and the entire risk assessment procedure should be carried out in case of major change in the information.

The compliance officer of the NBFC should have the necessary independence, authority, seniority, resources and expertise to carry out these functions effectively, including the ability to access all relevant internal information. Additionally, there should be an independent audit function carried out to test the AML/CFT programme with a view to establishing the effectiveness of the overall AML/CFT policies and processes and the quality of NBFC’s risk management across its operations, departments, branches and subsidiaries, both domestically and, where relevant, abroad.

 

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11873&Mode=0

[2] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11566

[3] https://www.fatf-gafi.org/media/fatf/documents/reports/Terrorist-Financing-Risk-Assessment-Guidance.pdf

[4] https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/655198/National_risk_assessment_of_money_laundering_and_terrorist_financing_2017_pdf_web.pdf

[5] https://www.nbs.rs/internet/english/55/55_7/55_7_4/procena_rizika_spn_e.pdf

[6] http://www.fatf-gafi.org/media/fatf/documents/reports/Risk-Based-Approach-Banking-Sector.pdf

 

Our other write-ups on NBFCs may be viewed here: http://vinodkothari.com/nbfcs/

Write-rps relating to KYC and Anti-money laundering may also be referred:

Revised Guidelines on KYC & Anti-Money Laundering Measures for HFCs

Torrid time for NBFCs as FIU-IND lays down ‘High Risk’ classification

 

Would the doses of TLTRO really nurse the financial sector?

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-Kanakprabha Jethani | Executive

Vinod Kothari Consultants P. Ltd

(kanak@vinodkothari.com)

Background

In response to the liquidity crisis caused by the covid-19 pandemic, the Reserve Bank of India (RBI) through a Press Release Dated April 03, 2020[1] announced its third Targeted Long Term Repo Operation (TLTRO). This issue is a part of a plan of the RBI to inject funds of Rs. 1 lakh crores in the Indian economy. Under the said plan, two tranches of LTROs of Rs. 25 thousand crores each have already been undertaken in the months of February[2] and March[3] respectively. This move is expected to restore liquidity in the financial market, that too at relatively cheaper rates.

The following write-up intends to provide an understanding of what TLTRO is, how it is supposed to enhance liquidity and provide relief, who can derive benefits out of it and what will be its impact. This article further views TLTROs from NBFCs’ glasses to see if they, being financial institutions, which more outreach than banks, avail benefit from this operation.

Meaning

LTRO is basically a tool to provide funds to banks. The funds can be obtained for a tenure ranging from 1 year to 3 years, at an interest rate equal to one day repo. Government securities with matching or higher tenure, would serve as a collateral. Usually, the interest rate of one day repo is lower than that of other short term loans. Thus, banks can avail cheaper finance from the RBI.

Banks will have to invest the amount borrowed under TLTROs in fresh acquisition of securities from primary or secondary market (Specified Securities) and the same shall not be used with respect to existing investments of the bank.

In the current LTRO, the RBI has directed that atleast 50% of the funds availed by the bank have to be invested in investment grade corporate bonds, commercial papers and debentures in the secondary market and not more than 50% in the primary market.

Why were the existing measures not enough?

Ever since the IL&FS crisis broke the liquidity supply chain in the economy, the RBI has been consistently putting efforts to bring back the liquidity in the financial system. For almost a year, the RBI kept cutting the repo rate, hoping the cut in repo rates increases banks’ lending power and at the same time reduces the interest rate charged by them from the customers. Despite huge cuts in repo rates, the desired results were not visible because the cut in repo rates enhanced banks’ coincide power by a nominal amount only.

Another reason for failure of repo rate cuts, as a strategy to reduce lending rates, was that repo rate is one of the factors determining the lending rate. However, it is not all. Reduction in repo rates did affect the lending rate, but the effect was overpowered by other factors (such as increased cost of funds from third party sources) and thus, the banks’ lending rates did not reduce actually.

Further, various facilities have been introduced by the RBI to enhance liquidity in the system through Liquidity Adjustment Facility (LAF) which includes repo agreements, reverse repo agreements, Marginal Standing Facility (MSF), term repos etc.

  • Under LAF, banks can either avail funds (through a repurchase agreement, overnight or term repos) or extend loans to the RBI (through reverse repo agreements). Other than providing funds in the time of need, it also allows the banks to safe-keep excess funds with the RBI for short term and earn interest on the same.
  • Under MSF (which is a new window under LAF), banks are allowed to draw overnight funds from the RBI against collateral in the form of government securities. The rate is usually 100 bps above the repo rate. The amount of borrowing is limited to 1% of Net demand and Term Liabilities (NDTL).
  • In case of term repos, funds can be availed for 1 to 13 days, at a variable rate, which is usually higher than the repo rate. Further, the funds that can be withdrawn under such facility shall be limited to 0.75% of NDTL of the bank.

Although these measures do introduce liquidity to the financial system, they do not provide banks with ‘durable liquidity’ to provide a seamless asset-liability match, based on maturity. On the other hand, having funds in hand for a year to 3 years definitely is a measure to make the maturity based assets and liabilities agree. Thus, giving banks the confidence to lend further to the market.

Bits and pieces to be taken care of

The TLTRO transactions shall be undertaken in line with the operating guidelines issued by the RBI through a circular on Long Term Repo Operations (LTROs)[4]. A few points to be taken care of are as follows:

  • The RBI conducts auctions (through e-Kuber platform) for extending such facility. Banks have to bid for obtaining funds from such facility. The minimum bid is to be of Rs. 1 crore and the allotment shall be in multiples of Rs. 1 crore.
  • The investment in Specified Securities is to be mandatorily made within 30 days of availment of funds. In case the bank fails to deploy funds availed under TLTRO within 30 days, an incremental interest of repo rate plus 200 basis points shall be chargeable, in addition to normal interest, for the period the funds remain un-deployed.
  • The banks will have to maintain the amount of specified securities in its Hold-to-Maturity (HTM) portfolio till the maturity of TLTRO i.e. such securities cannot be sold by banks until the term of TLTRO expires. Further, in case bank intends to hold the Specified Securities after the term of TLTRO expires, the same shall be allowed to be held in banks’ HTM portfolio.

Impact

The TLTRO operation of the RBI is expected to bring about a relief to the financial sector. The LTRO auctions conducted recently received bids amounting to several times the auction amount. Thus, a clear case of extreme demand for funds by banks can be seen. Although, the recent auctions are yet to reap their fruits, the major benefits that may arise from this operation are as follows:

  • The liquidity in the banking system will get increased. Resultantly, the banks’ lending power would increase. Thus, injecting liquidity into the entire economy.
  • Since, the marginal cost of funds of the banks will be based on one-day repo transactions’ rate, the same shall be lower as compared to other funding options of similar maturity. A reduced cost of funds for the banks will compel banks to lend at lower rates. Thus, making the short-term lending cheaper.

The picture from NBFCs’ glasses

Barely out of the IL&FS storm, the shadow bankers had not even adjusted their sails and were hit by another crisis caused by the covid-19 disruption. While the RBI is introducing measures for these lenders to cope with the crisis such as moratorium on repayment instalments[5], stay on asset reclassification based on the moratorium provided etc. The liquidity concerns of NBFCs remain untouched by these measures.

Word has it, the TLTRO is expected to restore liquidity in the financial system. Only banks can bid under LTRO auctions and avail funds from the RBI. This being said, let us look at how an NBFC would fetch liquidity from this.

Banks would use the funds availed under TLTRO transactions to invest in Specified Securities of various entities. Let us assume a bank avails funds of Rs. 1 crore under LTRO. Out of the funds availed, the bank decides to invest 50% in Specified Securities of companies in non-financial sector and 50% in entities in financial sector. Assuming that the entire 50% portion is invested in Specified Securities of 20 NBFCs equally. Each NBFC gets 2.5% of the funding availed by the Bank.

In the primary market

For the purchase of Specified Securities through primary market, the question of prime importance is whether it is feasible for an NBFC to come up with a fresh issue in the current scenario of lockdown. It is not feasible for an NBFC to plan an issue, obtain a credit rating, and get done with all other formalities within a period of 30 days. Thus, the option of fresh issue would generally be ruled out. Primary issues in pipeline may get banks as their investors. However, existence of such issues in pipeline are very low at present.

If an NBFC decides to go for private placement and gets it done within a span of say around a week, it can succeed in getting fresh liquidity for its operations. However, looking at the bigger picture, the restriction of investing only in investment grade securities bars the banks from investing in NBFCs which have lower rating i.e. usually the smaller NBFCs (more in number though). So the benefit of the scheme gets limited to a small number of NBFCs only. Thus, the motive of making liquidity reach the masses gets squashed.

In the secondary market

Above was just a hypothetical example to demonstrate that only a fraction of funds given out under LTRO would actually be used to bring back liquidity to the stagnant NBFC sector. It is important to note here that the liquidity is being brought back through purchase of securities from the secondary market, which does not result in introduction of any additional money to the NBFCs for their operations.

The liquidity enhancement in secondary market would also be limited to Specified Securities of investment grade. Thus, as already discussed, only the bigger size NBFCs would get the benefit of liquidity restoration.

Conclusion

The TLTRO is a measure introduced by the RBI to enhance liquidity in the system. Although it provides banks with liquidity, the restrictions on the use of availed funds bar the banks to further pass on the liquidity benefit. As for NBFCs, the benefit is limited to making the securities of the NBFCs liquid and the introduction of fresh liquidity to the NBFC is likely to be minimal.

Further, the benefit is also likely to be limited to bigger NBFCs, destroying the motive of making liquidity reach to the masses. A few enhancements to the existing LTRO scheme, such as directing the banks to ensure that the investment is not concentrated in a few destinations or prescribing concentration norms might result in expanding liquidity reach to some extent and would create a chain of supply of funds that would reach the masses through the outreach of such financial institutions.

News Update:

The RBI Governor in his statement on April 17, 2020[6], addressed the problem of narrow outreach of liquidity injected through TLTRO and announced that the upcoming TLTRO (TLTRO 2.0) would come with a specification that the proceeds are to be invested in investment grade bonds, commercial paper, and non-convertible debentures of NBFCs only, with at least 50 per cent of the total amount availed going to small and mid-sized NBFCs and MFIs. This is likely to ensure that a major portion of the investments go to the small and mid-sized NBFCs, thus expanding the liquidity outreach.

 

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49628

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

[3] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49583

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

[5] Our detailed FAQs on moratorium on loans due to Covid-19 disruption may be referred here: http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

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

 

Our write-up on stay on asset classification due to covid-19 may be referred here: http://vinodkothari.com/2020/04/the-great-lockdown-standstill-on-asset-classification/

Our other write-ups on NBFCs may be referred here: http://vinodkothari.com/nbfcs/

Moving to contactless lending, in a contact-less world

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-Kanakprabha Jethani (kanak@vinodkothari.com)

Background

With the COVID-19 disruption taking a toll on the world, almost two billion people – close to a third of the world’s population being  restricted to their homes, businesses being locked-down and work-from home becoming a need of the hour; “contactless” business is what the world is looking forward to. The new business jargon “contactless” means that the entire transaction is being done digitally, without requiring any of the parties to the transaction interact physically. While it is not possible to completely digitise all business sectors, however, complete digitisation of certain financial services is well achievable.

With continuous innovations being brought up, financial market has already witnessed a shift from transactions involving huge amount of paper-work to paperless transactions. The next steps are headed towards contactless transactions.

The following write-up intends to provide an introduction to how financial market got digitised, what were the by-products of digitisation, impact of digitisation on financial markets, specifically FinTech lending segment and the way forward.

Journey of digitisation

Digitisation is preparing financial market for the future, where every transaction will be contactless. Financial entities and service providers have already taken steps to facilitate the entire transaction without any physical intervention. Needless to say, the benefits of digitisation to the financial market are evident in the form of cost-efficiency, time-saving, expanded outreach and innovation to name a few.

Before delving into how financial entities are turning contactless, let us understand the past and present of the financial entities. The process of digitisation leads to conversion of anything and everything into information i.e. digital signals. The entire process has been a long journey, having its roots way back in 1995, when the Internet was first operated in India followed by the first use of the mobile phones in 2002 and then in 2009 the first smartphones came into being used. It is each of these stages that has evolved into this all-pervasive concept called digitisation.

Milestones in process of digitisation

The process of digitization has seen various phases. The financial market, specifically, the NBFCs have gone through various phases before completely guzzling down digitization. The journey of NBFCs from over the table executions to providing completely contactless services has been shown in the figure below:

From physical to paperless to contactless: the basic difference

Before analysing the impact of digitisation on the financial market, it is important to understand the concept of ‘paperless’ and ‘contactless’ transactions. In layman terms, paperless transactions are those which do not involve execution of any physical documents but physical interaction of the parties for purposes such as identity verification is required. The documents are executed online via electronic or digital signature or through by way of click wrap agreements.

In case of contactless transactions, the documents are executed online and identity verification is also carried out through processes such as video based identification and verification. There is no physical interaction between parties involved in the transaction.

The following table analyses the impact of digitisation on financial transactions by demarcating the steps in a lending process through physical, paperless and contactless modes:

 

Stages Physical process Paperless process Contactless process
Sourcing the customer The officer of NBFC interacts with prospective applicants The website, app or platform (‘Platform’) reaches out to the public to attract customers or the AI based system may target just the prospective customers Same as paperless process
Understanding needs of the customer The authorised representative speaks to the prospects to understand their financial needs The Platform provides the prospects with information relating to various products or the AI system may track and identify the needs Same as paperless process
Suggesting a financial product Based on the needs the officer suggests a suitable product Based on the analysis of customer data, the system suggests suitable product Same as paperless process
Customer on-boarding Customer on-boarding is done upon issue of sanction letter The basic details of customer are obtained for on-boarding on the Platform Same as paperless process
Customer identification The customer details and documents are identified by the officer during initial meetings Customer Identification is done by matching the details provided by customer with the physical copy of documents Digital processes such as Video KYC are used carry out customer identification
Customer due-diligence Background check of customer is done based on the available information and that obtained from the customer and credit information bureaus Information from Credit Information Agencies, social profiles of customer, tracking of communications and other AI methods etc. are used to carry out due diligence Same as paperless process
Customer acceptance On signing of formal agreement By clicking acceptance buttons such as ‘I agree’ on the Platform or execution through digital/electronic signature Same as paperless process
Extending the loan The loan amount is deposited in the customer’s bank account The loan amount is credited to the wallet, bank account or prepaid cards etc., as the case may be Same as paperless process
Servicing the loan The authorised representatives ensures that the loan is serviced Recovery efforts are made through nudges on Platform. Physical interaction is the last resort Same as paperless process. However, physical interaction for recovery may not be desirable.
Customer data maintenance After the relationship is ended, physical files are maintained Cloud-based information systems are the common practice Same as paperless process

The manifold repercussions

The outcome of digitisation of the financial markets in India, was a land of opportunities for those operating in financial market, it has also wiped off those who couldn’t keep pace with technological growth. Survival, in financial market, is driven by the ability to cope with rapid technological advancements. The impact of digitisation on financial market, specifically lending related services, can be analysed in the following phases:

Payments coming to online platforms

With mobile density in India reaching to 88.90% in 2019[1], the adoption of digital payments have accelerated in India, showing a rapid growth at a CAGR of 42% in value of digital payments. The value of digital payments to GDP rose to 862% in the FY 2018-19.

Simultaneously, of the total payments made up to Nov 2018, in India, the value of cash payments stood at a mere 19%. The shift from cash payments to digital payments has opened new avenues for financial service providers.

Need for service providers

With everything coming online, and the demand for digital money rising, the need for service providers has also taken birth. Services for transitioning to digital business models and then for operating them are a basic need for FinTech entities and thus, there is a need for various kinds of service providers at different stages.

Deliberate and automatic generation of demand

When payments system came online, financial service providers looked for newer ways of expanding their business. But the market was already operating in its own comfortable state. To disrupt this market and bring in something new, the FinTech service providers introduced the idea of easy credit to the market. When the market got attracted to this idea, digital lending products were introduced. With time, add-ons such as backing by guarantee, indemnity, FLDG etc. were also introduced to these products.

Consequent to digital commercialization, the need for payment service providers also generated automatically and thus, leading to the demand for digital payment products.

Opportunities for service providers

With digitization of non-banking financial activities, many players have found a place for themselves in financial markets and around. While the NBFCs went digital, the advent of digitization also became the entry gate to other service providers such as:

Platform service providers:

In order to enable NBFCs to provide financial services digitally, platform service providers floated digital platforms wherein all the functions relating to a financial transaction, ranging from sourcing of the customer, obtaining KYC information, collating credit information to servicing of the customer etc.

Software as a Service (SaaS) providers:

Such service providers operate on a business model that offers software solutions over the internet, charging their customers based on the usage of the software. Many of the FinTech based NBFCs have turned to such software providers for operating their business on digital platforms. Such service providers also provide specific software for credit score analysis, loan process automation and fraud detection etc.

Payment service providers:

For facilitating transactions in digital mode, it is important that the flow of money is also digitized. Due to this, the demand for payment services such as payments through cards, UPI, e-cash, wallets, digital cash etc. has risen. This demand has created a new segment of service providers in the financial sector.

NBFCs usually enter into partnerships with platform service providers or purchase software from SaaS providers to digitize their business.

Heads-up from the regulator

The recent years have witnessed unimaginable developments in the FinTech sector. Innovations introduced in the recent times have given birth to newer models of business in India. The ability to undertake paperless and contactless transactions has urged NBFCs to achieve Pan India presence. The government has been keen in bringing about a digital revolution in the country and has been coming up with incentives in forms of various schemes for those who shift their business to digital platforms. Regulators have constantly been involved in recognising digital terminology and concepts legally.

In Indian context, innovation has moved forward hand-in-hand with regulation[2]. The Reserve Bank of India, being the regulator of financial market, has been a key enabler of the digital revolution. The RBI, in its endeavor to support digital transactions has introduced many reforms, the key pillars amongst which are – e-KYC (Know Your Customer), e-Signature, Unified Payment Interface (UPI), Electronic NACH facility and Central KYC Registry.

The regulators have also introduced the concept of Regulatory Sandbox[3] to provide innovative business models an opportunity to operate in real market situations without complying with the regulatory norms in order to establish viability of their innovation.

While these initiatives and providing legal recognition to electronic documents did bring in an era of paperless[4] financial transactions, the banking and non-banking segment of the market still involved physical interaction of the parties to a transaction for the purpose of identity verification. Even the digital KYC process specified by the regulator was also a physical process in disguise[5].

In January 2020, the RBI gave recognition to video KYC, transforming the paperless transactions to complete contactless space[6].

Further, the RBI is also considering a separate regime for regulation of FinTech entities, which would be based on risk-based regulation, ranging from “Disclosure” to “Light-Touch Regulation & Supervision” to a “Tight Regulation and Full-Fledged Supervision”.[7]

Way forward

2019 has seen major revolutions in the FinTech space. Automation of lending process, Video KYC, voice based verification for payments, identity verification using biometrics, social profiling (as a factor of credit check) etc. have been innovations that has entirely transformed the way NBFCs work.

With technological developments becoming a regular thing, the FinTech space is yet to see the best of its innovations. A few innovations that may bring a roundabout change in the FinTech space are in-line and will soon be operable. Some of these are:

  • AI-Driven Predictive Financing, which has the ability to find target customers, keep track on their activities and identify the accurate time for offering the product to the customer.
  • Enabling recognition of Indian languages in the voice recognition feature of verification.
  • Introduction of blockchain based KYC, making KYC data available on a permission based-decentralised platform. This would be a more secure version of data repository with end-to-end encryption of KYC information.
  • Introduction of Chatbots and Robo-advisors for interacting with customers, advising suitable financial products, on-boarding, servicing etc. Robots with vernacular capabilities to deal with rural and semi-urban India would also be a reality soon.

Conclusion

Digital business models have received whole-hearted acceptance from the financial market. Digitisation has also opened gates for different service providers to aid the financial market entities. Technology companies are engaged in constantly developing better tools to support such businesses and at the same time the regulators are providing legal recognition to technology and making contactless transactions an all-round success. This is just the foundation and the financial market is yet to see oodles of innovation.

 

 

[1] https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=19417

[2] https://www.bis.org/publ/bppdf/bispap106.htm

[3] Our write on Regulatory Sandboxes can be referred here- http://vinodkothari.com/2019/04/safe-in-sandbox-india-provides-cocoon-to-fintech-start-ups/

[4] Paperless here means paperless digital financial transactions

[5] Our write-up on digital KYC process may be read here- http://vinodkothari.com/2019/08/introduction-of-digital-kyc/

[6]Our write-up on amendments to KYC Directions may be read here: http://vinodkothari.com/2020/01/kyc-goes-live-rbi-promotes-seamless-real-time-secured-audiovisual-interaction-with-customers/

[7] https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/WGFR68AA1890D7334D8F8F72CC2399A27F4A.PDF

 

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

/3 Comments/in , , , , /by

-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

EASE OF RECOVERY FOR NBFCS?

/1 Comment/in , , , /by

–  Ministry of Finance relaxes the criteria for NBFCs to be eligible for enforcing security interest under SARFAESI

-Richa Saraf (richa@vinodkothari.com)

 

The Ministry of Finance has, vide notification[1] dated 24.02.2020 (“Notification”), specified that non- banking financial companies (NBFCs), having assets worth Rs. 100 crore and above, shall be entitled for enforcement of security interest in secured debts of Rs. 50 lakhs and above, as financial institutions for the purposes of the said Act.

BACKGROUND:

RBI has, in its Financial Stability Report (FSR)[2], reported that the gross NPA ratio of the NBFC sector has increased from 6.1% as at end-March 2019 to 6.3% as at end September 2019, and has projected a further increase in NPAs till September 2020. The FSR further states that as at end September 2019, the CRAR of the NBFC sector stood at 19.5% (which is lower than 20% as at end-March 2019).

To ensure quicker recovery of dues and maintenance of liquidity, the Finance Minister had, in the Budget Speech, announced that the limit for NBFCs to be eligible for debt recovery under the SARFAESI is proposed to be reduced from Rs. 500 crores to asset size of Rs. 100 crores or loan size from existing Rs. 1 crore to Rs. 50 lakhs[3]. The Notification has been brought as a fall out of the Budget.

Our budget booklet can be accessed from the link below:

http://vinodkothari.com/wp-content/uploads/2020/02/Budget-Booklet-2020.pdf

ELIGIBILITY FOR INITIATING ACTION UNDER SARFAESI

To determine the test for eligible NBFCs, it is first pertinent to understand the terms used in the Notification.

The Notification provides that NBFCs shall be entitled for enforcement of security interest in “secured debts”. Now, the term “secured debt” has been defined under Section 2(ze) of SARFAESI to mean a debt which is secured by any security interest, and “debt” has been defined under Section 2(ha) as follows:

(ha) “debt” shall have the meaning assigned to it in clause (g) of section 2 of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (51 of 1993) and includes-

(i) unpaid portion of the purchase price of any tangible asset given on hire or financial lease or conditional sale or under any other contract;

(ii) any right, title or interest on any intangible asset or licence or assignment of such intangible asset, which secures the obligation to pay any unpaid portion of the purchase price of such intangible asset or an obligation incurred or credit otherwise extended to enable any borrower to acquire the intangible asset or obtain licence of such asset.

Further, Section 2(g) of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, provides that the term “debt” means “any liability (inclusive of interest) which is claimed as due from any person by a bank or a financial institution or by a consortium of banks or financial institutions during the course of any business activity undertaken by the bank or the financial institution or the consortium under any law for the time being in force, in cash or otherwise, whether secured or unsecured, or assigned, or whether payable under a decree or order of any civil court or any arbitration award or otherwise or under a mortgage and subsisting on, and legally recoverable on, the date of the application and includes any liability towards debt securities which remains unpaid in full or part after notice of ninety days served upon the borrower by the debenture trustee or any other authority in whose favour security interest is created for the benefit of holders of debt securities.”

Therefore, NBFCs having asset size of Rs. 100 crores and above as per their last audited balance sheet will have the right to proceed under SARFAESI if:

  • The debt (including principal and interest) amounts to Rs. 50 lakhs or more; and
  • The debt is secured by way of security interest[4].

EFFECT OF NOTIFICATION:

An article of Economic Times[5] dated 07.02.2020 states that:

“Not many non-bank lenders are expected to use the SARFAESI Act provisions to recover debt despite the Union budget making this route accessible to more such lenders due to time-consuming administrative hurdles as well as high loan ticket limit.”

As one may understand, SARFAESI is one of the many recourses available to the NBFCs, and with the commencement of the Insolvency and Bankruptcy Code, the NBFCs are either arriving at a compromise with the debtors or expecting recovery through insolvency/ liquidation proceedings of the debtor. The primary reasons are as follows:

  • SARFAESI provisions will apply only when there is a security interest;
  • NBFCs usually provide small ticket loans to a large number of borrowers, but even though their aggregate exposure, on which borrowers have defaulted, is substantially high, they will not able to find recourse under SARFAESI;
  • For using the SARFAESI option, the lender will have to wait for 90 days’ time for the debt to turn NPA. Then there is a mandatory 60 days’ notice before any repossession action and a mandatory 30 days’ time before sale. Also, the debtor may file an appeal before Debt Recovery Tribunal, and the lengthy court procedures further delay the recovery.

While the notification seems to include a larger chunk of NBFCs under SARFAESI, a significant question that arises here is whether NBFCs will actually utilise the SARFAESI route for recovery?

 

[1] http://egazette.nic.in/WriteReadData/2020/216392.pdf

[2] https://m.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=952

[3] https://www.indiabudget.gov.in/doc/Budget_Speech.pdf

[4] Section 2(zf) “security interest” means right, title or interest of any kind, other than those specified in section 31, upon property created in favour of any secured creditor and includes-

(i) any mortgage, charge, hypothecation, assignment or any right, title or interest of any kind, on tangible asset, retained by the secured creditor as an owner of the property, given on hire or financial lease or conditional sale or under any other contract which secures the obligation to pay any unpaid portion of the purchase price of the asset or an obligation incurred or credit provided to enable the borrower to acquire the tangible asset; or

(ii) such right, title or interest in any intangible asset or assignment or licence of such intangible asset which secures the obligation to pay any unpaid portion of the purchase price of the intangible asset or the obligation incurred or any credit provided to enable the borrower to acquire the intangible asset or licence of intangible asset.

[5] https://economictimes.indiatimes.com/industry/banking/finance/banking/not-many-nbfcs-may-use-sarfaesi-act-to-recover-loan/articleshow/74012648.cms