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Interest on interest burden taken over by the Government

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

Introduction

After months of litigation in the Apex Court and a lot of confusion surrounding interest on interest being charged by the lenders on loan accounts whose payments were deferred under the moratorium scheme, the Government has come up with the guidelines in line with the submission made by it to the Hon’ble Supreme Court of India. We have also argued earlier that the government is best placed to provide any relief to borrowers on issues concerning interest on interest.[1] The plight of small borrowers’ has finally been addressed via notification dated October 23, 2020 providing the “Scheme for grant of ex-gratia payment of difference between compound interest and simple interest for six months to borrowers in specified loan accounts (1.3.2020 to 31.8.2020)”.[2] Further, the RBI, via notification dated October 26, 2020, directed all banks, NBFCs, HFCs and All India Financial Institutions take actions as per the provisions of the said scheme. This ex-gratia payment scheme is another COVID-19 related relief and incentive by the Government to bear additional interest on interest on certain small specified loan accounts.

We have tried to cover some of the important aspects of the scheme in form of FAQ’s herein below:

  1. What is the objective of this Scheme?

This is an ex-gratia scheme that is to say, from a sense of moral obligation rather than because of any legal requirement, the Government shall pay the difference between compound interest and simple interest for six months period on specified loan accounts. That is the period commencing from March 01, 2020 to August 31, 2020 (‘Moratorium Period’).

  1. Is the payment of the ex gratia amount under the scheme, an option for lending institutions or has to be complied mandatorily by the lending Institutions?

The payment to the specified loan accounts of eligible borrowers is mandatory under the Scheme. The language of Ex-gratia Scheme clearly provides that the lending institutions shall credit the difference between simple interest and compound interest for a period between 1,03,2020 to 31.08.2020 in specified loan accounts of eligible borrowers.

  1. What is the time period for credit/payment of ex-gratia amount by the lender?

The scheme provides that the exercise of crediting the amount under the scheme shall be completed by respective lending institutions on or before November 05, 2020.

 Therefore the amount under this Ex-gratia scheme has to be credited to the borrower’s account by the lending institutions within the stipulated time.

  1. Which Lending institutions have to pass the benefits to borrowers under this Scheme?

The following list of lenders shall pass benefit to the borrowers under this scheme:

  • Banking Company
  • Public Sector Banks (PSB)
  • Co-operative Bank – Urban Co-operative Banks,or a State Co-operative Bank, or a District Co-operative Bank
  • Regional Rural Bank (RRB)
  • All India Financial Institution
  • Non-Banking Financial Company
  • Non-Banking Finance Company -Micro Finance Institution member of Self Regulatory Organisation (SRO) registered with RBI
  • Housing Finance Company registered with RBI, or National Housing Bank
  1. Are all types of NBFCs covered under the scheme irrespective of the asset size?

The Government intends to pass on the benefit of the Scheme through the lending institutions including all NBFCs involved in lending to the specified category of borrowers irrespective of the asset size of the NBFCs.

  1. Which all classes or categories of loans are eligible under this Scheme?

The loans falling under any of the categories mentioned below are ‘specified loan accounts’ under this Ex-gratia Scheme.

  • MSME loans
  • Education loans
  • Consumer durable loans
  • Credit Card Dues
  • Automobile loans
  • Personal loans to professionals
  • Consumption loans
  • Housing Loans
  1. Which all borrowers are eligible to be benefitted under the Scheme?

The borrowers falling under any or more than one of the specified loan accounts as mentioned above are eligible under Ex-gratia Scheme “Eligible Borrower”. However additional conditions and stipulations need to be complied as laid below:

  • Such borrower should not have, sanctioned limit and the outstanding amount exceeding Rupees 2 (two) crores in aggregate with all the lending institutions as on 29.02.2020. That is the sum of all the borrowings of such a borrower in specified loan accounts and all the other categories of loans should have, both sanctioned limits as well outstanding loan amounts less than 2 crores.
  • Such an eligible category loan account should be standard (less than 90 DPD) as on 29.02.2020.
  • Whether such borrower availed complete moratorium, partial moratorium, or did not avail any moratorium benefit in respect of such eligible category loan account is irrelevant for the purpose of extending benefit under the Ex-gratia Scheme.
  1. Will the eligibility be determined as on the date of this scheme or as on 29.02.2020?

The borrower account must fall in the category of specified loan account as on 29.02.2020. For example, a loan account was classified as an MSME as on 29.02.2020 and later on a subsequent change in definition has moved it out of the category of MSME, the benefit under the scheme shall still be given to the said borrower account, subject to fulfilment of the eligibility conditions.

  1. Does this Ex-gratia Scheme mean that no-interest will be charged by the lending institutions for the period of 01.03.2020 till 31.08.2020 on eligible loan accounts?

No, this Ex-gratia scheme is in the form of waiver of interest on interest in the specified loan account category, irrespective of whether moratorium benefit was extended/availed completely, partially or not availed at all on such loan accounts.

Therefore all the eligible borrowers in specified loan accounts will receive payment under the Scheme from their respective lending institution. The credit amount would be such part of interest which would have been chargeable by the lending institutions on the accrued interest component during the six months deferment period from 29.02.2020 till 31.08.2020. That is the difference between the Compound interest and Simple Interest on the outstanding amount will be payable by the lending institution which shall be reimbursed to them by the Government.

Illustration:

Outstanding loan amount in the specified loan account as on 29.02.2020 was Rs. 1,00,000 (Rupees One Lakh).

Interest Rate as applicable on such a loan account as on 29.02.2020 is taken @ 10% annualised rate, compounded monthly.

Therefore the balance 105.33/- shall be credited to the specified account of the borrower by the lending institution.

  1. What are the rates of interest on which the difference between compound interest and simple interest on the amount outstanding as on 29.02.2020 will be calculated?

The rate of interest would be prevailing as on 29.02.2020, any change thereafter shall not be reckoned for purpose of computation. Additionally penal interest rate or late payment penalty not to be included as contracted rate or WALR.

  1. Will crediting the amount to the account of the borrower mean upfront payment or adjustment with the outstanding liability?

To credit the amount to the account of the borrower the lending institution may either adjust the same with the outstanding balance or pay to the borrower the sum of money.

  1. A borrower loan account has been closed in the books of the lending institution as on 30 April, 2020. However, the borrower was eligible under the scheme as on 29.02.2020. Will the borrower receive any benefit under the Scheme?

Since the eligibility is to be determined as on 29.02.2020, the fact that the loan account has been closed should not deprive the borrower of the benefit under the Scheme.

Illustration

The outstanding amount in a specified loan account as on 29.02.2020 is Rs. 1,00,000 (Rs. One Lakhs Only). The borrower paid the all the dues towards the loan amount by 30 April 2020. The contracted annualised rate compounded monthly as on 29.02.2020 is at 10%.

The ex-gratia payment as under the scheme guidelines should be as follows:

Therefore the borrower shall be entitled to Rs. 6.94 under the ex-gratia scheme.

  1. A borrower satisfies all other conditions but is classified as NPA as on 29.02.2020 and subsequently becomes standard. Will the borrower be eligible under the Scheme?

The subsequent movement of the NPA to standard will not make the account eligible under the scheme. As per the eligibility conditions, the loan account must be classified as standard as on 29.02.2020.

  1. A borrower account was standard as on 29.02.2020 and also satisfies all the other eligibility conditions under the scheme, but as on date is an NPA. Can the benefit still be availed?

Yes, the benefit shall still be given to the borrower based on the fact that the loan account was eligible as on 29.02.2020.

  1. A borrower under a specified loan account is having sanctioned limit of Rs. 2.5 Crores as on 29.02.2020, however its aggregate outstanding borrowing with respect to such loan account as on 29.02.2020 is less than 2 crore, will such borrower be eligible under the Ex-gratia Scheme?

No, the Ex-gratia Scheme clearly specifies that the ‘sanctioned limit’ and ‘outstanding amount’ in respect to loan accounts should not exceed Rs. 2 Crore. Aggregate of all the facilities of lending institutions to such a borrower shall be less than Rs 2 Crore. Borrower’s sanctioned limit and outstanding loan amount, both shall be below Rs. 2 Crores. Please refer to FAQ 7.

  1. A borrower under specified loan account has an aggregate outstanding loan facility as on 29.02.2020 less than Rs. 2 Crores with a lending institution. Additionally it also has a Bank Guarantee in its favour with the same the lending institution. Will such a borrower be eligible under the Ex-gratia Scheme? 

No, the borrower is not eligible for ex-gratia payment. The Ex-gratia Scheme does not seem to differentiate between funded and non-funded facilities with the lending institutions. It specifies ‘aggregate of all facilities with lending institutions’, therefore in our view, funded and non-funded exposures should be taken in account while arriving at Rs. 2 crore limit for the purpose eligibility under the Ex-gratia Scheme.  

  1. Will the eligibility of the borrower in FAQ 16 would be affected, if the bank guarantee would have been availed from some other lending institution, i.e. other than the lending institution with whom loan facility has been availed?

If the bank guarantee has been availed from the lending institution, other than the one with whom borrower has loan facility, still the borrower would not be eligible for ex-gratia payment. 

  1. What will be the ex-gratia payment eligibility of a borrower in any of the below two scenarios?

Scenario 1: The borrower has taken moratorium benefit until the first three months under moratorium scheme, i.e. from 01.03.2020 till 31.05.2020.

Scenario 2: The borrower has taken the moratorium benefit for the last three months of the moratorium scheme, i.e. from 01.06.2020 till 31.08.2020.

Yes, the borrower shall be eligible for ex-gratia payment in both of the scenarios mentioned above. The Ex-gratia scheme is applicable on all the specified loan accounts, whether moratorium benefit is completely availed, or partially availed, or not availed at all.

All the payments made by such a borrower towards its eligible loan account between 01.03.2020 and 31.08.2020 will be ignored. For the purpose of uniformity, the difference between compound interest and simple interest is to be reckoned at an outstanding amount as on 29.02.2020 for a period of six months.

  1. A borrower have not availed the deferment benefit under the moratorium Scheme. Will such a borrower be eligible under the ex-gratia Scheme?  

Yes, the Ex-gratia Scheme clearly specifies that all the eligible loan accounts, whether moratorium benefit is completely availed, or partially availed, or not have been availed at all shall be eligible for ex-gratia payment under the scheme.

All the payments made by such a borrower towards its eligible loan account between 01.03.2020 and 31.08.2020 will be ignored. For the purpose of uniformity, the difference between compound interest and simple interest is to be reckoned at an outstanding amount as on 29.02.2020 for a period of six months.

  1. Will it be right to say that all specified accounts of eligible borrowers are entitled for Ex-gratia payment under the scheme, irrespective of whether payment deferment have been availed or not under the moratorium scheme?

Yes, all the specified loan accounts of eligible borrowers are entitled to ex gratia payment under the Ex-gratia scheme.

  1. A borrower falls under the MSME category as per the new MSME classification. But such borrower has not availed Udyam Registration, will it be eligible under the scheme?

The borrower must be classified as an MSME on 29.02.2020 irrespective of the classification under the new definition. Further, it is recommended that in case the borrower continues to be classified as an MSME, it may submit its proof of Udyam registration to the lending institution.

  1. Is there any requirement for eligible borrowers under specified loan accounts which needs to be fulfilled for the purpose of availing ex-gratia payment benefit?

No, as per the ex-gratia scheme guidelines all lending institutions under the scheme have to credit the difference between compound interest and simple interest in specified loan accounts of the eligible borrowers.

However it is always prudent on part of borrowers and the lending institutions to exchange confirmation about the credit of such payment under the scheme.

  1. Where shall the lending institutions file their reimbursement claims after crediting the ex-gratia amounts in specified accounts of eligible borrowers?

The claims shall be submitted to designated officer (s) /cell   at State Bank of India (SBI). The SBI shall act as a nodal agency of the Central Government for settlement of all the claims of lending institutions.

  1. What are the procedures to be followed by lending institutions for reimbursement of claims processing?

The following timelines and procedures need to be complied by all the lending institutions falling under the scheme.

  • The last date for filing claims of reimbursement of amounts credited to specified loan accounts of eligible borrowers is by December 15, 2020.
  • The reimbursement claim amount should be pre-audited by a statutory auditor of the lending institution. A certificate by such an auditor shall be attached with the claim.
  1. What are the remedies of a borrower, whose lending institution is not extending the payment benefit under the ex-gratia scheme? 

As under the scheme operational guidelines, each lending institution shall put in place a grievance redressal mechanism for eligible borrowers within one week from date of issuance of ex-gratia guidelines i.e. latest by 29.10.2020.

  1. What are the remedies of a lending institution, having grievances concerning the Scheme?

Grievances of lending institutions shall be resolved through designated cell at State Bank of India (SBI) in consultation with the Ministry of Finance, GoI. However in respect to the issues/queries related to interpretation of scheme, the decision of GoI shall be final.

The timeline below summarises the important dates to be abided by lending institutions under the ex-gratia scheme.

 

 

[1] Our write up ‘Moratorium Scheme: Conundrum of Interest on Interest’ dated 16-09-2020, <http://vinodkothari.com/2020/09/moratorium-scheme-conundrum-of-interest-on-interest/>

We have also covered Moratorium Schemes and asset classification in great details; See ‘Moratorium on loans due to Covid 19 disruption’,< http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/ > ; ‘Moratorium 2.0 on term loans and working capital’, < http://vinodkothari.com/2020/05/moratorium-2-0-on-term-loans-and-working-capital/>

[2] Operational guidelines on ex-gratia payment scheme  dated 23-10-2020, <https://financialservices.gov.in/sites/default/files/Scheme%20Letter.pdf>

Other Related Write-ups:

 

 

Modes of Restructuring of Stressed Accounts

Our detailed write-ups on these frameworks may be referred here:

 

RBI refines the role of the Compliance-Man of a Bank

Notifies new provisions relating to Compliance Functions in Banks and lays down Role of CCO.

By:

Shaivi Bhamaria | Associate

Aanchal Kaur Nagpal | Executive

Introduction

The recent debacles in banking/shadow banking sector have led to regulatory concerns, which are reflected in recent moves of the RBI. While development of a robust “compliance culture” has always been a point of emphasis, RBI in its Discussion Paper on “Governance in Commercial Banks in India’[1] [‘Governance Paper’] dated 11th June 2020 has dealt extensively with the essentials of compliance function in banks.  The Governance Paper, while referring to extant norms pertaining to the compliance function in banks, viz. RBI circulars on compliance function issued in 2007[2] [‘2007 circular’] and 2015[3] [‘2015 circular’], placed certain improvement points.

In furtherance of the above, RBI has come up with a circular on ‘Compliance functions in banks and Role of Chief Compliance Officer’ [‘2020 Circular’] dated 11th September, 2020[4], these new guidelines are supplementary to the 2007 and 2015 circulars and have to be read in conformity with the same. However, in case of or any common areas of guidance, the new circular must be followed.  Along with defining the role of the Chief Compliance Officer [‘CCO’], they also introduce additional provisions to be included in the compliance policy of the Bank in an effort to broaden and streamline the processes used in the compliance function.

Generally, in compliance function is seen as being limited to laying down statutory norms, however, the importance of an effective compliance function is not unknown. The same becomes all-the-more paramount in case of banks considering the critical role they play in public interest and in the economy at large. For a robust compliance system in Banks, an independent and efficient compliance function becomes almost indispensable. The effectiveness of such a compliance function is directly attributable to the CCO of the Bank.

Need for the circular

The compliance function in banks is monitored by guidelines specified by the 2007 and 2015 circular. These guidelines are consistent with the report issued by the Basel Committee on Banking Supervision (BCBS Report)[5] in April, 2005.

While these guidelines specify a number of functions to be performed by the CCO, no specific instructions for his appointment have been specified. This led to banks following varied practices according to their own tailor-made standards thus defeating the entire purpose of a CCO. Owing to this, RBI has vide the 2020 circular issued guidelines on the role of a CCO, in order to bring uniformity and to do justice to the appointment of a CCO in a bank.

Background of CCOs

The designation of a CCO was first introduced by RBI in August, 1992 in accordance with the recommendations of the Ghosh Committee on Frauds and Malpractices in Banks. After almost 15 years, RBI introduced elaborate guidelines on compliance function and compliance officer in the form of the 2007 circular which was in line with the BCBS report.

According to the BCBS report:

‘Each bank should have an executive or senior staff member with overall responsibility for co-ordinating the identification and management of the bank’s compliance risk and for supervising the activities of other compliance function staff. This paper uses the title “head of compliance” to describe this position’.

Who is a CCO and how is he different from other compliance officials?

The requirement of an individual overseeing regulatory compliance is not unique to the banking sector. There are various other laws that the provide for the appointment of a compliance officer. However, there is a significant difference in the role which a CCO is expected to play. The domain of CCO is not limited to any particular law or its ancillaries, rather, it is all pervasive. He is not only responsible for heading the compliance function, but also overseeing the entire compliance risk[6] in banks.

Role of a CCO in a Bank:

The predominant role of a CCO is to head the compliance function in a Bank. The 2007 circular lays down the following mandate of a CCO:

  1. overall responsibility for coordinating the identification and management of the bank’s compliance risk and supervising the activities of other compliance function staff.
  2. assisting the top management in managing effectively the compliance risks faced by the bank.
  3. nodal point of contact between the bank and the RBI
  4. approving compliance manuals for various functions in a bank
  5. report findings of investigation of various departments of the bank such as at frequent intervals,
  6. participate in the quarterly informal discussions held with RBI.
  7. putting up a monthly report on the position of compliance risk to the senior management/CEO.
  8. the audit function should keep the Head of compliance informed of audit findings related to compliance.

The 2020 circular adds additional the following responsibilities on the CCO:

  1. Design and maintenance of compliance framework,
  2. Training on regulatory and conduct risks,
  3. Effective communication of compliance expectations

Selection and Appointment of CCO:

The 2007 circular is ambiguous on the qualifications, roles and responsibilities of the CCO. In certain places the CCO was referred to as the Chief Compliance officer and some places where the words compliance officer is used. This led to difficulty in the interpretation of aspects revolving around a CCO. However, the new circular gives a clear picture of the expectation of RBI from banks in respect of a CCO. The same has been listed below:

Basis 2020 circular 2007 circular
Tenure Minimum fixed tenure of not less than 3 years The Compliance Officer should be appointed for a fixed tenure
Eligibility Criteria for appointment as CCO The CCO should be the senior executive of the bank, preferably in the rank of a General Manager or an equivalent position (not below two levels from the CEO). The compliance department should have an executive or senior staff member of the cadre not less than in the rank of DGM or equivalent designated as Group Compliance Officer or Head of Compliance.
Age 55 years No provision
Experience Overall experience of at least 15 years in the banking or financial services, out of which minimum 5 years shall be in the Audit / Finance / Compliance / Legal / Risk Management functions. No provision

 

Skills Good understanding of industry and risk management, knowledge of regulations, legal framework and sensitivity to supervisors’ expectations No provision
Stature The CCO shall have the ability to independently exercise judgement. He should have the freedom and sufficient authority to interact with regulators/supervisors directly and ensure compliance No provision
Additional condition No vigilance case or adverse observation from RBI, shall be pending against the candidate identified for appointment as the CCO. No provision
Selection* 1.      A well-defined selection process to be established

2.      The Board must be required to constitute a selection committee consisting of senior executives

3.      The CCO shall be appointed based on the recommendations of the selection committee.

4.      The selection committee must recommend the names of candidates suitable for the post as per the rank in order of merit.

5.      Board to take final decision in the appointment of the CCO.

No provision
Review of performance appraisal The performance appraisal of the CCO should be reviewed by the Board/ACB No provision
Reporting lines The CCO will have direct reporting lines to the following:

1.      MD & CEO and/or

2.      Board or Audit Committee

No provision
Additional reporting In case the CCO reports to the MD & CEO, the Audit Committee of the Board is required to meet the CCO quarterly on one-to-one basis, without the presence of the senior management including MD & CEO. No provision
Reporting to RBI 1.      Prior intimation is to be given to the RBI in case of appointment, premature transfer/removal of the CCO.

2.      A detailed profile of the candidate along with the fit and proper certification by the MD & CEO of the bank to be submitted along with the intimation, confirming that the person meets the supervisory requirements, and detailed rationale for changes.

No provision
Prohibitions on the CCO 1.      Prohibition on having reporting relationship with business verticals

2.      Prohibition on giving business targets to CCO

3.      Prohibition to become a member of any committee which brings the role of a CCO in conflict with responsibility as member of the committee. Further, the CCO cannot be a member of any committee dealing with purchases / sanctions. In case the CCO is member of such committees, he may play only an advisory role.

No provision

*The Governance paper had proposed that the Risk Management Committee of the Board will be responsible for selection, oversight of performance including performance appraisals and dismissal of a CCO. Further, any premature removal of the CCO will require with prior board approval. [Para 9(6)] However, the 2020 circular goes one step further by requiring a selection committee for selection of a CCO.

Dual Hatting

Prohibition of dual hatting is already applicable on the Chief Risk Officer (‘CRO’) of a bank. The same has also been implemented in case the of a CCO.

Hence, the CCO cannot be given any responsibility which gives rise to any conflict of interest, especially the role relating to business. However, roles where there is no direct conflict of interest for instance, anti-money laundering officer, etc. can be performed by the CCO. In such cases, the principle of proportionality in terms of bank’s size, complexity, risk management strategy and structures should justify such dual role. [para 2.11 of the 2020 circular] 

Role of the Board in the Compliance function

Role of the Board

The bank’s Board of Directors are overall responsible for overseeing the effective management of the bank’s compliance function and compliance risk.

Role of MD & CEO

The MD & CEO is required to ensure the presence of independent compliance function and adherence to the compliance policy of the bank.

Authority:

The CCO and compliance function shall have the authority to communicate with any staff member and have access to all records or files that are necessary to enable him/her to carry out entrusted responsibilities in respect of compliance issues.

Compliance policy and its contents

The 2007 circular required banks to formulate a Compliance Policy, outlining the role and set up of the Compliance Department.

The 2020 circular has laid down additional points that must be covered by the Compliance Policy. In some aspects, the 2020 circular provides further measures to be taken by banks whereas in some aspects, fresh points have been introduced to be covered in the compliance policy, these have been highlighted below:

1. Compliance philosophy: The policy must highlight the compliance philosophy and expectations on compliance culture covering:

  • tone from the top,
  • accountability,
  • incentive structure
  • Effective communication and Challenges thereof

2. Structure of the compliance function: The structure and role of the compliance function and the role of CCO must be laid down in the policy

3. Management of compliance risk: The policy should lay down the processes for identifying, assessing, monitoring, managing and reporting on compliance risk throughout the bank.

The same should adequately reflect the size, complexity and compliance risk profile of the bank, expectations on ensuring compliance to all applicable statutory provisions, rules and regulations, various codes of conducts and the bank’s own internal rules, policies and procedures and must create a disincentive structure for compliance breaches.

4. Focus Areas: The policy should lay special thrust on:

  • building up compliance culture;
  • vetting of the quality of supervisory / regulatory compliance reports to RBI by the top executives, non-executive Chairman / Chairman and ACB of the bank, as the case may be.

5. Review of the policy: The policy should be reviewed at least once a year

Quality assurance of compliance function

Vide the 2020 circular, RBI has introduced the concept of quality assurance of the compliance function Banks are required to develop and maintain a quality assurance and improvement program covering all aspects of the compliance function.

The quality assurance and improvement program should be subject to independent external review at least once in 3 years. Banks must include in their Compliance Policy provisions relating to quality assurance.

Thus, this would ensure that the compliance function of a bank is not just a bunch of mundane and outdated systems but is improved and updated according to the dynamic nature of the regulatory environment of a bank.

Responsibilities of the compliance function

In addition to the role of the compliance function under the compliance process and procedure as laid down in the 2007 the 2020 circular has laid down the below mentioned duties and responsibilities of the compliance function:

  1. To apprise the Board and senior management on regulations, rules and standards and any further developments.
  2. To provide clarification on any compliance related issues.
  3. To conduct assessment of the compliance risk (at least once a year) and to develop a risk-oriented activity plan for compliance assessment. The activity plan should be submitted to the ACB for approval and be made available to the internal audit.
  4. To report promptly to the Board/ Audit Committee/ MD & CEO about any major changes / observations relating to the compliance risk.
  5. To periodically report on compliance failures/breaches to the Board/ACB and circulating to the concerned functional heads.
  6. To monitor and periodically test compliance by performing sufficient and representative compliance testing. The results of the compliance testing should be placed before the Board/Audit Committee/MD & CEO.
  7. To examine sustenance of compliance as an integral part of compliance testing and annual compliance assessment exercise.
  8. To ensure compliance of Supervisory observations made by RBI and/or any other directions in both letter and spirit in a time bound and sustainable manner.

 Actionables by Banks:

Links to related write ups –

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49937

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=3433&Mode=0

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=9598&Mode=0

[4] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11962&Mode=0

[5] https://www.bis.org/publ/bcbs113.pdf

[6]  According to BCBS report, compliance risk is the risk of legal or regulatory sanctions, material financial loss, or loss to reputation a bank may suffer as a result of its failure to comply with laws, regulations, rules, related self-regulatory organization standards, and codes of conduct applicable to its banking activities”

The new PSL Master Direction and its Impact on NBFCs

-Siddharth Goel (finserv@vinodkothari.com)

Introduction

The Reserve Bank of India (RBI) issued Master Directions-Priority Sector Lending (PSL) Targets and Classification on September 4, 2020 (‘Master Directions’).[1] The Master Directions consolidates various circulars and guidelines issued by RBI with respect to PSL.

The changes made in the Master Directions primarily deal with targets and sub-targets for classification of loans as priority sector loans. Further there are some addition of new sectors in Eligible categories, along with increase in lending limit of some of the existing eligible categories for priority sector lending.

Our detailed write-up on the topic can be viewed here.

Changes in priority sector norms do not have a direct impact on the NBFCs, but they have an indirect impact. Banks are allowed to acquire loans under Direct Assignment arrangements or invest in pass through certificates backed by loans which qualify the definition of PSL, in order to meet the prescribed targets. Mostly, the banks acquire these receivables from NBFCs who does the origination of the loans. Additionally, banks also engage in co-lending arrangements with NBFCs to originate PSLs. Therefore, it is worthwhile to examine the impact of these changes on NBFCs.

Co-origination of loans by Banks for lending to Priority Sector

RBI through its vide notification RBI/2018-19/49 dated September 21, 2018 issued guidelines on Co-origination of loans by Commercial Banks and NBFC-ND-SI (“Co-origination Guidelines”).[2] These guidelines excluded Regional Rural Banks (RRBs) and Small Finance Banks (SFBs). Essentially, the banks could claim priority sector status in respect of its share of credit while engaging in the co-origination arrangement with NBFC under the Co-origination Guidelines. Provided, the priority sector assets on the bank’s books should at all times be without recourse to the NBFC.

It is pertinent to note that the PSL Master Directions under its para 25 covers Co-origination of loans by Banks and NBFC-ND-SI. The Master Direction specifically excludes, RRBs SFBs and Urban Co-Operative Banks (UCBs) and Local Area Banks (LABs) under the above para. Moreover, the Master Directions under the said para, specifically stipulates that detailed guidelines in this regard are to be governed as provided under Co-origination Guidelines dated September 21, 2018. Hence there are no changes intended to be introduced vis-a-vis Master Direction, to the co-origination of loans by banks and NBFCs.

PSL- Lending by Banks to NBFCs for On-Lending

In the earlier regime, after the review of Priority sector lending by banks to NBFC for On-Lending notification dated August 13, 2019[3], RBI through its notification dated March 23, 2020,[4] extend the priority sector classification for bank loans to NBFCs for on-lending for the FY 2020-21. Further, existing loans disbursed under the on-lending model continued to be classified under Priority Sector till the date of repayment/maturity. The extension notification also stipulated an overall capping limit for calculating bank’s total priority sector lending as produced herein below;

“3. Bank credit to registered NBFCs (other than MFIs) and HFCs for on-lending will be allowed up to an overall limit of five percent of individual bank’s total priority sector lending. Further, banks shall compute the eligible portfolio under on-lending mechanism by averaging across four quarters, to determine adherence to the prescribed cap.”

Para 22 of the Master Directions governs Bank loans to registered NBFCs (other than MFIs). It is highlighted that there is no change in sub-category for On-lending by NBFC, and limits also remain unchanged. The above para in the Master Direction, clearly stipulates that on-lending will be eligible for classification as priority sector under respective categories which is subject to the following conditions:

(i) Agriculture: On-lending by NBFCs for ‘Term lending’ component under Agriculture will be allowed up to ₹ 10 lakh per borrower.

(ii) Micro & Small enterprises: On-lending by NBFC will be allowed up to ₹ 20 lakh per borrower.

The above dispensation is valid up to March 31, 2021 and will be reviewed thereafter. However, loans disbursed under the on-lending model will continue to be classified under Priority Sector till the date of repayment/maturity. Caping of overall limit of Bank Credit to 5 percent has been prescribed under para 24 of the Master Directions.

Investments by Banks in Securitised Assets & Direct Assignment

Investments by banks in securitised assets or assignment/outright purchase of a pool of assets, representing loans by banks and financial institutions to various categories of priority sector, except ‘others’ category, are eligible for classification under respective categories of priority sector depending on the underlying assets. However, earlier the requirement was that the interest rate charged to the ultimate borrower in securitised assets and in case of transfer of assets through direct assignment, shall be capped at Base Rate of the investing bank plus 8 percent per annum.

Therefore, investments by banks, in securitised assets and purchase of assets originated by NBFCs in eligible sectors had to comply with above capping in order to qualify as eligible for PSL. To encourage MSME lending in smaller areas where cost of intermediation is high for the smaller NBFCs, the UK Sinha committee in its report has proposed the cap at Base Rate of the investing bank plus 12% per annum initially and periodical review thereafter. The intent of the recommendation stood on the grounds that price caps are not applicable to banks when they originate directly through branches.

Accordingly, such capping limit has been relaxed and as per the as per the revised requirement the all-inclusive interest charged to the ultimate borrower by the originating entity should not exceed the External Benchmark Lending Rate (EBLR)/ MCLR of the investing bank plus appropriate spread which will be communicated separately. It is expected that the RBI shall be separately communicating the limits to the banks.

The aforesaid relaxation in the interest rate capping would widen the eligibility of loans originated by the NBFCs for securitisation and direct assignment to banks, for meeting the PSL requirement.

Adjustments for weights in PSL Achievement

To address the regional disparities in flow of credit at the district level, currently districts have been ranked on the basis of per capita credit flow. Higher weight (125%) is assigned to the incremental priority sector credit in districts with low per capita credit flow. Similarly, lower weight (90%) has been assigned to incremental PSL in districts with comparatively higher credit flow. The higher PSL credit (125 %) districts are specified in ANNEX-I A and districts with comparatively low PSL credit (90%) are specified in ANNEX-IB of the Master direction. Districts not mentioned in either of the Annex will be having weightage of 100%. PSL incremental credit shall be applicable from F.Y. 2021-2022 onwards.

Thus, for the purpose of above incentives, banks will get incremental PSL credit, if they invest as following:

  • Investment in securitsed assets/direct assignment/outright purchase, of loans originated by NBFCs from high priority districts. The entire investment in PTCs made by the banks, the proportion which is represented by those as priority districts will be weighted at 125% and low priority districts at 90% and others at 100%.
  • On-lending by Banks to NBFCs, wherein NBFCs are further lending in districts with high priority.
  • Incremental credit incentive will be available to Banks, on proportion of their share of loans, to district with high priority under Co-Origination model.

Impact of new Master Directions on NBFCs

The new Master Direction does not seem to impact legal relationship between banks and NBFCs in respect to co-origination of loans and co-lending materially, since all the regulations are similar to the earlier PSL regime. However, the incentives introduced by way of incremental PSL credit to Banks will channel the credit to districts with low credit penetration. Therefore, banks will be benefitted by dealing with NBFCs having portfolio of loans (eligible for PSL) and presence in districts with lower credit penetration.

Further, change in capping, of investments by Banks in securitised assets and direct assignment/ outright purchase of loans, originated by NBFCs is intended to cover loans originated with higher spreads. Further lending to new sub sectors introduced through Master Direction, would also qualify towards PSL target investments by Banks.

The indicative list of new sub-sectors and sub-sectors with enhanced credit limit is reproduced herein below for ready reference.

Agriculture Lending Including Farm Credit (Allied Activities), lending for Agriculture Infrastructure and Ancillary Activities. ·        Inclusion of loans to farmers for installation of stand-alone Solar Agriculture Pumps and for solarisation of grid connected Agriculture Pumps.

·        Inclusion of loans to farmers for installation of solar power plants on barren/fallow land or in stilt fashion on agriculture land owned by farmer

·        Inclusion of loans up to ₹50 crore to Start-ups, as per definition of Ministry of Commerce and Industry, Govt. of India that are engaged in agriculture and allied services.

·        Inclusion of loans up to ₹2 lakh to individuals solely engaged in Allied activities without any accompanying land holding criteria. This change is in line with recommendation by M.K. Jain Committee7.

·        Inclusion of loans for construction of oil extraction/ processing units for production of bio-fuels, their storage and distribution infrastructure along with loans to entrepreneurs for setting up Compressed Bio Gas (CBG) plants.

·        Laying of Indicative list conveying permissible activities under Food Processing Sector as recommended by Ministry of Food Processing Industries.

·        A credit limit of ₹5 crore per borrowing entity has been specified for Farmers Producers Organisations (FPOs)/Farmers Producers Companies (FPCs) undertaking farming with assured marketing of their produce at a pre-determined price. This inclusion is as per the M.K Jain Committee Recommendations8.

 

Other Finance to MSMEs In line with the series of benefits being extended to MSMEs, loans up to ₹50 crore to Start-ups, as per definition of Ministry of Commerce and Industry, Govt. of India that confirm to the definition of MSME has been included under the PSL catergory. (On the basis of recommendations by UK Sinha Committee, to financially incentivise the startups in India)

 

 

Housing Loans

 

·        Increase in Loans up to ₹ 10 lakh (earlier ₹ 5 lakh) in metropolitan centres and up to ₹6 lakh (earlier 2 ₹ Lakh) in other centres for repairs to damaged dwelling units.

·        Bank loans to governmental agency for construction of dwelling units or for slum clearance and rehabilitation of slum dwellers subject to dwelling units with carpet area of not more than 60 square meters. Under the earlier regime, it was based on cost of dwelling unit which was ₹ 10 lakh per unit.

·        Inclusion of bank loans for affordable housing projects using at least 50% of FAR/FSI (Floor Area Ratio/ Floor Space Index) for dwelling units with carpet area of not more than 60 sq.m.

 

Social Infrastructure

 

Inclusion of loans up to a limit of ₹ 10 crore per borrower for building health care facilities including under ‘Ayushman Bharat’ in Tier II to Tier VI centres. This is in addition to the existing limit of ₹5 crore per borrower for setting up schools, drinking water facilities and sanitation facilities including construction/ refurbishment of household toilets and water improvements at household level, etc.

 

Renewable Energy Increase in loan limit to ₹ 30 Crore for purposes like solar based power generators, biomass-based power generators, wind mills, micro-hydel plants and for non-conventional energy based public utilities etc. This is to boost renewable energy sector, the earlier limit was up to ₹ 15 Crore.

 

 

[1]https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MDPSL803EE903174E4C85AFA14C335A5B0909.PDF

[2] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT49BAA4688D36A64EAF8DB0BFD99C6FC54C.PDF

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11659&Mode=0

[4] https://www.rbi.org.in/scripts/FS_Notification.aspx?Id=11828&fn=2754&Mode=0

 

Our related write-ups

 

 

PSL guidelines reviewed for wider credit penetration

By Siddarth Goel (finserv@vinodkothari.com)

Introduction

The Reserve Bank of India (RBI) issued Master Directions-Priority Sector Lending (PSL) Targets and Classification on September 4, 2020 (‘Master Directions’)[1]. The Master Directions are in the nature of a consolidating piece, of various circulars and guidelines issued by RBI in regard to PSL. The objective of Master Directions is to harmonise instructions guidelines for Commercial Banks[2], Small Finance Banks (“SFB”)[3], Regional Rural Banks (“RRBs”)[4], Urban Co-Operative Banks (“UCBs”)[5] and Local Area Banks (“LABs”) for PSL targets and classification under single universe.

The objective of Master Directions is to consolidate all the concerning circulars to PSL under one master direction. However, certain changes have been introduced under the Master Directions in line with the recommendations of Expert Committee on Micro, Small and Medium Enterprises (Chairman: Shri U.K. Sinha) and the ‘Internal Working Group to Review Agriculture Credit’ (Chairman: Shri M. K. Jain).

This write up endeavors to highlight major changes which has been implemented through the said Master Direction that were not forming part of the erstwhile notifications or guidelines in this regard.

Changes in Targets / Sub-targets Classification for Priority Sector

The targets and sub-targets set under priority sector lending is computed on the percentage basis of Adjusted Net Bank Credit (ANBC)/ Credit Equivalent of Off-Balance Sheet Exposures (CEOBE). The Master Directions, has increased the total priority sector lending target for Urban Co-Operative Banks, which is to be achieved through milestones-based targets in a phased manner. Further there has been increase in targets for advances to weaker sections and Small Farmer Margins (SMF) in the agriculture sector. The table below summarises the changes along with timelines for complying with Targets/Sub-targets for PSL.

Categories Domestic Commercial Banks Small Finance Banks RRB Urban Co-Operative Bank#
Total Priority Sector No change No Change No Change Increased in total priority sector target from 40 % to 75% of ANBC or CEOBE whichever is higher.
Advances to Weaker Sections Target * Increased to 12% of ANBC or CEOBE, whichever is higher.

[earlier target was 10%]

Increased to 12% of ANBC or CEOBE, whichever is higher.

[earlier target was 10%]

No Change Increased to 12% of ANBC or CEOBE, whichever is higher.

[earlier target was 10%] 

Agriculture Target * -No Change Small Marginal Farmers (SMF) target increased to 10% of the 18% of ANBC or CEOBE, whichever is higher.

[earlier it was 8 % of 18%] 

Small Marginal Farmers (SMF) target Increased to 10% of 18% of ANBC or CEOBE, whichever is higher.

[earlier it was 8% of 18%]

No Target
Micro Enterprises No Change No Change No Change No Change

# Target of total priority sector to be achieved in phased manner by Co-operative Banks as below.

Existing Target March 31, 2021 March 31, 2022 March 31, 2023 March 31, 2024
40% 45% 50% 60% 75%

 

* Phased manner for achieving Small Marginal Farmers and Weaker Section Targets as below.

Financial Year SMF Weaker Section Target
2020-2021 8% 10%
2021-2022 9% 11%
2022-2023 9.5% 11.5%
2023-2024 10% 12%

Inclusion of Weights in PSL Achievement

From the UK Sinha committee recommendations,[6] in order to address regional disparities in flow of credit to district levels. Adjusted Priority Sector Lending mechanism has been implemented under the new regime, to incentivise flow of credit to underserved districts. There will be no change in the underlying sectors eligible for PSL, however an additional weightage has been given to lending to the more underserved districts. From financial year 2021-2022 onwards weights would be assigned to incremental priority sector credit as follows:

  • Higher weight (125%) would be assigned to the districts where credit flow is comparatively lower, that is per capita PSL less than ₹ 6,000.
  • Lower weight (90%) would be assigned to the districts where credit flow is comparatively higher, that is per capita PSL is greater than ₹ 25,000.

RRBS, Urban Co-operative Banks and Local Area Banks and Foreign Banks have been kept out for the purpose of calculation of PSL weights, due to their limited presence.

Inclusions in Eligible Categories

Along with the inclusion of fresh categories eligible for finance under priority sector there has been some enhancement in the credit limit of the existing categories as well. Some of the changes are as follows-

Agriculture Lending Including Farm Credit (Allied Activities), lending for Agriculture Infrastructure and Ancillary Activities.
  • Inclusion of loans to farmers for installation of stand-alone Solar Agriculture Pumps and for solarisation of grid connected Agriculture Pumps.
  • Inclusion of loans to farmers for installation of solar power plants on barren/fallow land or in stilt fashion on agriculture land owned by farmer
  • Inclusion of loans up to ₹50 crore to Start-ups, as per definition of Ministry of Commerce and Industry, Govt. of India that are engaged in agriculture and allied services.
  • Inclusion of loans up to ₹2 lakh to individuals solely engaged in Allied activities without any accompanying land holding criteria. This change is in line with recommendation by M.K. Jain Committee[7].
  • Inclusion of loans for construction of oil extraction/ processing units for production of bio-fuels, their storage and distribution infrastructure along with loans to entrepreneurs for setting up Compressed Bio Gas (CBG) plants.
  • Laying of Indicative list conveying permissible activities under Food Processing Sector as recommended by Ministry of Food Processing Industries.
  • A credit limit of ₹5 crore per borrowing entity has been specified for Farmers Producers Organisations (FPOs)/Farmers Producers Companies (FPCs) undertaking farming with assured marketing of their produce at a pre-determined price. This inclusion is as per the M.K Jain Committee Recommendations[8].
Other Finance to MSMEs In line with the series of benefits being extended to MSMEs, loans up to ₹50 crore to Start-ups, as per definition of Ministry of Commerce and Industry, Govt. of India that confirm to the definition of MSME has been included under the PSL catergory. (On the basis of recommendations by UK Sinha Committee, to financially incentivise the startups in India)
Housing Loans

 

  • Increase in Loans up to ₹ 10 lakh (earlier ₹ 5 lakh) in metropolitan centres and up to ₹6 lakh (earlier 2 ₹ Lakh) in other centres for repairs to damaged dwelling units.
  • Bank loans to governmental agency for construction of dwelling units or for slum clearance and rehabilitation of slum dwellers subject to dwelling units with carpet area of not more than 60 square meters. Under the earlier regime, it was based on cost of dwelling unit which was ₹ 10 lakh per unit.
  • Inclusion of bank loans for affordable housing projects using at least 50% of FAR/FSI (Floor Area Ratio/ Floor Space Index) for dwelling units with carpet area of not more than 60 sq.m.
Social Infrastructure

 

Inclusion of loans up to a limit of ₹ 10 crore per borrower for building health care facilities including under ‘Ayushman Bharat’ in Tier II to Tier VI centres. This is in addition to the existing limit of ₹5 crore per borrower for setting up schools, drinking water facilities and sanitation facilities including construction/ refurbishment of household toilets and water improvements at household level, etc.
Renewable Energy Increase in loan limit to ₹ 30 Crore for purposes like solar based power generators, biomass-based power generators, wind mills, micro-hydel plants and for non-conventional energy based public utilities etc. This is to boost renewable energy sector, the earlier limit was up to ₹ 15 Crore.
Others

 

Inclusion of loans for meeting local needs such as construction or repair of house, construction of toilets not exceeding ₹2 lakh provided directly by banks to SHG/JLG for activities other than agriculture or MSME.

Investments by Banks in Securitised Assets & Direct Assignment

Earlier the interest rate charged to the ultimate borrower was capped at Base Rate of the investing bank plus 8 percent per annum. Post UK Sinha Committee recommendation,[9] the all-inclusive interest charged to the ultimate borrower by the originating entity should not exceed the External Benchmark Lending Rate (EBLR)/ MCLR of the investing bank plus appropriate spread which will be communicated separately.

The intent of the recommendation stood on the grounds that price caps are not applicable to banks when they originate directly through branches. Therefore, to encourage MSME lending in smaller areas where cost of intermediation is high by the smaller NBFCs, the committee proposed the cap at Base Rate of the investing bank plus 12% per annum initially and periodical review thereafter.

Conclusion

The Master Direction aids in compilation and provides easy understandability of all the guidelines at one place. The two committee reports recommendations have aided in recognising important sub-sectors of economy which were not covered under earlier regimes. Loans to starts-ups in agriculture and allied activities, loans to healthcare, sanitation along with impetus on renewable energy will not only bolster flow of credit in these sectors but also aimed at improving socio-economic conditions in the country. The introduction of incentive on incremental PSL by ranking of districts on basis of per capita credit flow could be an enabler for the deeper penetration of credit in rural economy. Therefore, the new Master Direction is a welcome move and will help in achieving better channeling of credit in the desired sectors of the economy.

[1] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MDPSL803EE903174E4C85AFA14C335A5B0909.PDF

[2] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/33MD08B3F0CC0F8C4CE6B844B87F7F990FB6.PDF

[3] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=11644&Mode=0

[4] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=11604&Mode=0

[5] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11274&Mode=0

[6] Para 9.24, Report of the Expert Committee on Micro, Small and Medium Enterprises, (UK Sinha Committee) https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=924

[7] Para 1.7.6, Report of the Internal Working Group to Review Agricultural Credit, ( M. K Jain Committee) https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=942#CP28

[8] Para 2.7.5, Report of the Internal Working Group to Review Agricultural Credit, ( M. K Jain Committee) https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=942#CP28

[9] Para 9.24, Report of the Expert Committee on Micro, Small and Medium Enterprises, (UK Sinha Committee) https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=924

RBI lessons ARCs on fairness

A discussion on the fair practice code issued for ARCs

-Sikha Bansal and Kanakprabha Jethani

Introduction

Asset Reconstruction Companies (ARCs) are companies specializing in the business on acquiring non-performing assets and stressed assets of the banks and financial institutions and reconstructing them.

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI) accords the status of ‘financial institutions’ and ‘secured creditor’ to ARCs, such that an ARC acquiring bad loans is also able to exercise same rights and powers as the originator of the loan would have. This is explicitly stated in section 5 of SARFAESI.

Now, as they say, with great power, comes great responsibility; since, the business of ARCs involves frequent dealing with borrowers of loans, they must be guided by principles of fairness in their dealings with borrowers. Earlier, there were no guidelines with respect to fair practices of ARCs. However, after a gap of almost 20 years from the time the law was enacted, the Reserve Bank of India (RBI) through a notification dated 16.07.2020[1], issued a Fair Practices Code (FPC) for ARCs. It is noteworthy that in this span of 20 years, around 28 ARCs have been registered in India[2] and have an AUM of USD 14,583 million[3]. Further, the role and involvement of ARCs have increased multifold with IBC proceedings.

The FPC seeks to ensure fairness as well as transparency in the operations of ARCs, and calls upon the ARCs to put in place board approved FPC, grievance redressal mechanisms, code of conduct for recovery agents, etc. However, what is more important is that the FPC sets out principles for ARCs for sale and purchase of assets, as discussed below.

Acquisition of assets: follow arm’s length principle

While acquiring any asset, an ARC should maintain transparency and follow arms’ length principle and shall ensure there is no discrimination between sellers in the process of acquisition.

Notably, RBI has already prohibited ARCs to have bilateral acquisitions (that is, one to one transactions) from certain connected entities, e.g. sponsor banks/FIs, and group entities[4], irrespective of the consideration involved. However, auction purchases are allowed provided the auction is transparent, is on arms’ length and price is determined by market forces. This essentially entails that the auctions should be widely publicised, be open to all interested parties and be transparent in terms of bids submitted.

Sale of assets: be transparent

ARC should enable the participation of as many prospective buyers they can, so that actual market value can be determined of any asset. For that, the invitation shall be made public. The extant guidelines for conduct of ARCs[5] also require sale of assets through public auction only. Thus, this is just a reiteration of the existing guidelines.

Further, while finalising the terms and condition for sale of underlying assets, the ARCs shall consult the investors of security receipts (SRs).

Besides, a crucial provision in the FPC is the reference to section 29A of the Insolvency and Bankruptcy Code, 2016 (IBC), as discussed below.

The ‘spirit’ of section 29A

FPC mentions that the “spirit” of section 29A of IBC may be followed while dealing with prospective buyers”.

The reference to section 29A, most predictably, comes in the wake of rising involvement of ARCs in insolvency proceedings, either as sole or joint resolution applicants. Section 29A provides a list of persons who shall not be eligible to be a resolution applicant or a buyer of assets in case of a liquidation sale. The intent here seems to bar persons such as undischarged insolvents, wilful defaulters, a person whose accounts are classified as NPA, etc. from buying the assets. One concern with regard to section 29A is possible use of ARCs as devices to camouflage ineligible persons. Therefore, it is a logical and a positive step to add this restriction as a component of FPC for ARCs.

It is relevant to note that courts have held that the disability under section 29A is to be considered even where the sales are made by a secured creditor outside liquidation[6]. Say, what if the secured creditor assigns his rights and interest to an ARC? Will an ARC be debarred from selling the assets to a person hit by section 29A?

The issue has to be examined under two circumstances – first, where the borrower has been under insolvency proceedings of IBC and in case of liquidation, the secured creditor stands out of liquidation proceedings to sell the asset, and second, where there are no preceding IBC proceedings.

Considering the extant precedents surrounding section 29A, it can be contended that the contagion of section 29A might also hamper the freehand of ARCs in selling the assets whether or not the assets have been through IBC proceedings or not. However, one may note that the extant guidelines, on the contrary, permit the defaulting promoters to buy-back the assets from ARCs, provided the settlement is considered beneficial in certain respects[7].

Hence, ARCs would be required to take a balanced view on determining whether the sale is to be made to a prospective buyer or not. Notably, FPC does not impose section 29A, per se, on sales by ARCs, but advises the ARCs to follow the spirit of section 29A. The intent of section 29A has been to ensure that among others, persons responsible for insolvency of the corporate debtor do not participate in the resolution process[8].

Therefore, it may be contended that in case the assets are in or have passed through IBC proceedings, the provisions of section 29A will apply strictly, and in other cases, the ARCs should endeavour to abide by the intent of section 29A. The stance of the regulator may become clearer in due course of time.

Action points for ARCs

The following are actionables on the part of ARCs. We are of the view that, since the notification does not provide for any specific date of applicability, the same shall be immediately applicable. Hence, the FPC, incorporating the following, shall be formulated within reasonable time and may be adopted in the next board meeting.

Particulars Actionables
Measures to prevent harassment by recovery agents ·  Ensure that the staff and recovery agents are adequately trained to deal with customers and to handle their responsibilities with care and sensitivity, particularly in respect of aspects such as hours of calling, privacy of customer information

·  Adoption of code of conduct (as discussed above)

·  Ensure that the recovery agents and the staff of ARCs observe strict customer confidentiality.

·  Ensure that recovery agents do not induce adoption of uncivilized, unlawful and questionable behaviour or recovery process.

Charging of fees Put in place a board approved policy on management fee, expenses and incentives, if any, claimed from trusts under their management.
Outsourcing Put in place an outsourcing policy, approved by the Board, which incorporates, criteria for selection of activities to be outsourced as well as service providers, delegation of authority depending on risks and materiality and systems to monitor and review the operations of these activities/ service providers.
Grievance Redressal ·  Constitute a Grievance Redressal machinery which deals with the issue relating to services provided by the outsourced agency and recovery agents, if any.

·  Mention the name and contact number of designated grievance redressal officer of the ARC in communications with the borrowers.

Conclusion

As regards acquisition and realisation of assets, the extant directions provide for framing of acquisition policies and realisation plans. Further, as discussed, RBI from time to time, had been issuing directives regulating the sales by ARCs. The FPC, incorporating the provisions of section 29A, can be said to be an additional step in the same direction.

Insofar as conduct towards borrowers is concerned, before issue of the FPC for ARCs, there were no separate guidelines. However, this should not imply that ARCs were not required to act as such. As a matter of practice, the conduct of ARCs towards the borrowers should be guided by the behavioural principles and principles of fairness and equity.

The banks/financial institutions are anyway under the directions of RBI[9] to be fair in all respects in dealing with the borrowers. Therefore, it could not be said that an ARC which purchases loans from the banks/financial institutions could have all the powers of a secured lender but not the responsibilities. In the authors’ view, the responsibility to act fairly is tagged along with the right to enforce security. However, the FPC as issued now, concretises the concept of ‘fair practice’ for ARCs, and is a step in the right direction. With the FPC coming into force, practices of ARCs, which were earlier based on the market practice and varied largely, shall be unified.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11937&Mode=0

[2] List of ARCs on the website of the RBI (As in February 2020)

[3] https://www2.deloitte.com/content/dam/Deloitte/in/Documents/tax/in-tax-asset-reconstruction-companies-tax-regulatory-framework-noexp.pdf

[4] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=11749&Mod e=0

[5] https://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9901

[6] NCLAT ruling- https://nclat.nic.in/Useradmin/upload/20572042075dd3e35176572.pdf

[7] See para 5 of the ARC Guidelines

[8] Swiss Ribbons Pvt. Ltd. vs Union Of India (https://indiankanoon.org/doc/17372683/)

[9] Guidelines on Fair Practices for lenders- https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=3315&Mode=0 and;

Fair Practice Code for NBFCs- https://rbidocs.rbi.org.in/rdocs/notification/PDFs/45MD01092016B52D6E12D49F411DB63F67F2344A4E09.PDF

Intricacies of the Draft Framework on Sale of Loans

-Kanakprabha Jethani (kanak@vinodkothari.com)

Background

The draft framework for ‘Sale of Loan Exposures’[1] (‘Draft’) issued by the Reserve Bank of India (RBI) recently provides a detailed framework for sale of all kinds of loan exposures viz. standard, stressed and NPLs. The RBI invited comments and suggestions from the stakeholders on the Draft and has raised a few specific questions for discussion in the Draft.

Presently, there are two separate guidelines, one for sale of standard assets (Direct Assignment guidelines) and one for sale of stressed assets and NPLs (Master Circular on Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances[2])

While we have already prepared a comparative[3] and a detailed analysis[4] for sale of standard loans, we hereby provide an analysis of guidelines relating to sale of stressed assets and NPLs.

Understanding the Existing Framework

The existing framework for sale of loan exposures is posed in bits and pieces. The framework may broadly be understood in the following manner:

For sale of standard loans (this includes assets falling between 0-90 DPD) Guidelines on Transactions Involving Transfer of Assets through Direct Assignment (DA) of Cash Flows and the Underlying Securities- Provided in the Master Directions for NBFCs[5]
For Sale of stressed loans (this includes NPAs, SMA-2 and standard assets under consortium, 75% of which has been classified as NPA by other lenders and 75% of lenders by value agree to the sale to ARCs) ·        Para 6 of Master Circular – Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances

·        Notification issued by the RBI on Prudential Framework for Resolution of Stressed Assets[6]

·        Notification issued by the RBI on Guidelines on Sale of Stressed Assets by Banks[7]

For Sale of NPLs (this includes assets falling in the 90+DPD bucket) ·        Para 7 of Master Circular – Prudential norms on Income Recognition, Asset Classification and Provisioning pertaining to Advances

·        Notification issued by the RBI on Guidelines on Sale of Stressed Assets by Banks

What does the Draft behold?

The Draft proposes a consolidated framework to govern sale of loan exposures and is a combination of certain existing guidelines and some newly introduced ones. Let us delve into key changes introduced in the Draft one by one.

Applicability

Seller

While the existing guidelines were specifically applicable to NBFCs, banks and other financial institutions, the applicability of the Draft is extended to SFBs and All India Financial Institutions (AIFIs) such as NABARD, NHB, SIDBI, EXIM Bank etc.

Purchaser

The existing guidelines were applicable to sale of loans by a financial entity to another. However, this did not prohibit sale of loans to non-financial entities. The only difference was that the rights under SARFAESI and other laws were impacted.

The Draft guidelines specifically state that the sale of sale of loans may be made by the entities mentioned above as sellers to any regulated entity, which is allowed by its statutory or regulatory framework to buy such loans.

Hence, any sale of loans, to entities whose regulatory/statutory framework does not allow such purchase, cannot be done. Further, sale of loan to entities whose regulatory/statutory framework allows such purchase, irrespective of whether such entity is a financial entity or not, shall be governed by the provisions of the Draft.

Nature of Assets

The Draft directions contain separate provisions for sale of standard assets, sale of stressed assets to ARCs and sale of NPAs. Under the existing framework, an asset was said to be standard, till it is classified as NPA i.e. after 90 DPD. The Draft defines stressed assets to include NPAs as well as SMA accounts. Thus, any 0+ DPD account becomes a stressed asset. Due to this, the provisions relating to sale of standard assets, which are broadly in line with the guidelines on DA, shall not apply on assets falling between 1 to 90 DPD.

Since the classification of the asset is strictly based on the number of days past due, it may raise various practical difficulties. For example, if the due date for repayment of a loan installment is January 1, 2020 and there is a grace period of 10 days. The loan is classified as SMA-0 on February 1, 2020 (irrespective of the fact that it is not even 30 days past the grace period) and now, the sale of such loan shall be as per the guidelines for sale of stressed assets.

Recourse against the Transferor/Originator

Under the existing guidelines, the sale to ARCs was allowed on a ‘with’ or ‘without’ recourse basis and sale of NPAs to parties other than ARCs was allowed on a non-recourse basis only. The Draft clearly states that any sale of loans shall be on a ‘without recourse’ basis only. While there will be no impact on sale of standard assets and sale NPAs to parties other than ARCs, the transactions of sale of stressed assets to ARCs shall certainly be affected.

Treatment of loans given for on-lending

The Draft contains specific provisions with respect to the loans that were granted by the originator for on-lending. Para 51 of the Draft states that “Lenders may also purchase stressed assets from other lenders even if such assets had been created out of funds lent by the transferee to the transferor subject to all the conditions specified in these directions.”

Let us take an example to understand this:

A is an NBFC, which has given out a loan amounting to Rs. 100 @ 5% p.a. to B, which is another NBFC. Now B, gives out loans of Rs. 20 each @ 7% p.a. to 5 individuals.

Now, A can purchase these 5 loans from B, when they become stressed i.e. 0+ DPD. Here, it is clearly visible that the risk undertaken by B has no risk at all. The funds for lending have been provided by A. B keeps the assets in its books only till they are standard. As soon as assets turn SMA-0, B will remove them from its books sell them off to A. Additionally, till the time assets were standard, B earned a spread of 2%.

Manner of Transfer

The Draft defines transfer as- “transfer” means a transfer of economic interest in loan exposures in the manner prescribed in these directions, and includes loan participations and transactions in which the loan exposure remains on the books of the transferor even after the said transaction.

Para 9 contradicts the definition, requiring a legal separation of the asset from the books of the transferor. Tis issue has been discussed at length in our write-up titled “Originated to transfer- new RBI regime on loan sales permits risk transfers.[8]

The Draft further specifies that the sale/transfer of loans may be done by way of assignment or novation. Presently, most of such transactions are effected through assignment only. The loan agreement usually contains a clause whereby the borrowers gives consent to the lender to sell the loan to a third party. In case such a clause is not there in the loan agreement, the sale of loan would require consent of all the parties to the agreement, including the borrower.  In this case, the transfer of loans will have to be effected through novation of the agreement.

The Draft simply clarifies that transfer may be done through either of the modes. We do not see any practical implication as such.

Asset Classification

The asset classification criteria has been divided into 2 categories:

  • If the transferee has existing exposure to the same borrower: The asset classification shall be the same as that of the existing exposure in books of the transferee
  • If the transferee does not have an existing exposure to the same borrower: The asset acquired shall be classified as standard and thereafter the classification shall be determined based on the record of recovery

If the existing exposure is not standard in the books, the asset classification of the acquired asset shall also be as per the existing exposure. This seems to be derived from the asset classification practices followed earlier to determine stress in the assets i.e. if the borrower is defaulting in one of the exposures, it is likely to delay/default in repayment of other exposures as well.

However, this shall increase the provisioning requirements for the transferee and thus, may be a demotivating factor for sale of stressed assets.

MHP requirements

The Draft extends MHP requirements to ARCs as well. The business of ARCs includes frequent selling and buying of loans and portfolios. Putting a holding requirement of 12 months may slow down the business.

On the other hand, this may ensure that ARCs put better recovery efforts, before selling the loans to other entities.

Reporting Requirements

The existing guidelines did not lay the responsibility of reporting to CIC on any of the parties. Thus, the same was determines by the agreement between the parties. Usually, in case of sale to ARCs, the reporting is done by the ARCs and in case of sale to banks/FIs, the reporting is done by the originator only (since originator usually acts as a servicer).

The Draft specifically lays the responsibility of reporting on the transferee. Reasonably, the servicer of the loans has entire information of the servicing of the loan, repayment patterns etc. and thus, is the most suitable party to do the reporting. Let us examine a few cases with regard to reporting:

Transferee Servicer Reporting Obligation on Remarks
ARC ARC ARC Since the ARC is servicing the loan, it shall be able to properly report the details to CICs
Bank/FI Originator Bank/FI The Bank/FI will have to obtain the servicing details from the originator and then report the same to CICs
Bank/FI Bank/FI Bank/FI Since the bank/FI is servicing the loan, it shall be able to properly report the details to CICs

Hence, the reporting obligation may be placed on the servicer or may be kept open for the parties to decide.

Realisation

The existing guidelines relating to sale of NPAs required the transferor to work out the NPV of the estimated cash flows associated with the realisable value of the assets net of the cost of realisation. At least 10% of the estimated cash flows should be realized in the first year and at least 5% in each half year thereafter, subject to full recovery within three years.

The above requirement is not there in the Draft, the reason for which is unknown.

The Draft provides that in case of sale to ARCs, if the ARC is not able to redeem the SRs/PTCs by the end of resolution period (obviously due to inadequate servicing of the loans) the liability against the same should be written off as loss.

Takeover of standard assets

The Draft allows all the regulated entities, other than the transferor, to take over the assets from ARCs, once they turn standard on successful implementation of resolution plan. Earlier only ARCs were allowed to buy assets from other ARCs. This is a welcome move as it will enable other financial entities to buy assets from ARCs.

Conclusion

The Draft has come with some interesting proposals and the RBI is yet to receive comments on the same from the industry. The representations from the industry and the response of the RBI on the same will formulate the new regime for securitisation.

 

Our other write-ups may be referred here:

http://vinodkothari.com/2020/06/draft-guidelines-on-securitisation-sale-of-loans-with-respect-to-rmbs-transactions/

http://vinodkothari.com/2020/06/presentation-on-draft-directions-on-securitisation-of-standard-assets/

http://vinodkothari.com/2020/06/presentation-on-draft-directions-on-sale-of-loans/

http://vinodkothari.com/2020/06/inherent-inconsistencies-in-quantitative-conditions-for-capital-relief/

http://vinodkothari.com/2020/06/comparison-of-the-draft-securitisation-framework-with-existing-guidelines-and-committee-recommendations/

http://vinodkothari.com/2020/06/originated-to-transfer-new-rbi-regime-on-loan-sales-permits-risk-transfers/

http://vinodkothari.com/2020/06/new-regime-for-securitisation-and-sale-of-financial-assets/

 

[1] https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=957

[2] https://www.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9908#7

[3] http://vinodkothari.com/2020/06/originated-to-transfer-new-rbi-regime-on-loan-sales-permits-risk-transfers/

[4] http://vinodkothari.com/2020/06/comparison-on-draft-framework-for-sale-of-loans-with-existing-guidelines-and-task-force-recommendations/

[5]https://rbidocs.rbi.org.in/rdocs/notification/PDFs/45MD01092016B52D6E12D49F411DB63F67F2344A4E09.PDF

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

[7] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10588&Mode=0

[8] http://vinodkothari.com/2020/06/originated-to-transfer-new-rbi-regime-on-loan-sales-permits-risk-transfers/

Special Liquidity Scheme – providing short term liquidity relief for NBFCs

Timothy Lopes | Senior Executive

Vinod Kothari Consultants

finserv@vinodkothari.com

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

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

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

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

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

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

Eligible instruments

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

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

Validity of the Scheme

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

Investment by the SPV

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

Rate of Return and collateral

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

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

Conclusion

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

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

Our related write ups may be viewed below –

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

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

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

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

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

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

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

RBI guidelines on governance in commercial banks

Vinita Nair | Senior Partner

Vinod Kothari & Company

vinita@vinodkothari.com