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Guaranteed Emergency Line of Credit: Understanding and FAQs

-Financial Services Division (finserv@vinodkothari.com)

The Finance Minister has, in the month of May, 2020, announced a slew of measures as a part of the economic stimulus package for self-reliant India. Among various schemes introduced in the package, one was the Emergency Credit Line Guarantee Scheme (ECLGS, ‘Scheme’), which intends to enable the flow of funds to MSMEs. This is the so-called Rs 300000 crore scheme.

Under this Scheme the GoI, through a trust, will guarantee loans provided by banks and Financial Institutions (FIs) to 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 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. The additional funding will run as a separate parallel facility, along with the main facility. The GECL loan will have its own term, moratorium, EMIs, and may be rate of interest as well. Of course, the GECL will share the security interest with the original facility, and will rank pari passu, with the main facility, both in terms of cashflows as in terms of security interest.

The major questions pertaining to the GECL are going to be about the eligible borrowers to whom GECL may be extended, and the allocation of cashflows and collateral with the main facility. Operationally, issues may also centre round the turnaround time, after disbursement, for getting the guarantee cover, and whether the guarantee cover shall be in batch-processed, or processed loan-by-loan. Similarly, there may be lots of questions about how to encash claims on NCGTC. Read more

RBI grants additional 3 months to FPIs under Voluntary Retention Route

Shaifali Sharma | Vinod Kothari and Company

corplaw@vinodkothari.com

In March, 2019, the RBI with an objective to attract long-term and stable FPI investments into debt markets in India introduced a scheme called the ‘Voluntary Retention Route’ (VRR)[1]. Investments through this route are in addition to the FPI General Investment limits, provided FPIs voluntarily commit to retain a minimum of 75% of its allocated investments (called the Committed Portfolio Size or CPS) for a minimum period of 3 years (retention period).However, such 75% of CPS shall be invested within 3 months from the date of allotment of investment limits. Recognizing the disruption posed by the COVID-19 pandemic, RBI vide circular dated May 22, 2020[2], has granted additional 3-months relaxation to FPIs for making the required investments. The circular further addresses the questions as to which all FPIs are covered under this relaxation and how the retention period will be determined.

This article intends to discuss the features of the VRR scheme and the implications of RBI’s circular in brief.

What is ‘Voluntary Retention Route’?

RBI, to motivate long term investments in Indian debt markets, launched a new channel of investment for FPIs on March 01, 2019[3] (subsequently the scheme was amended on May 24, 2019[4]), free from the macro-prudential and other regulatory norms applicable to FPI investment in debt markets and providing operational flexibility to manage investments by FPIs. Under this route, FPIs voluntarily commit to retain a required minimum percentage of their investments for a period of at least 3 years.

The VRR scheme was further amended on January 23, 2020[5], widening its scope and provides certain relaxations to FPIs.

Key features of the VRR Scheme:

  1. The FPI is required to retain a minimum of 75% of its Committed Portfolio Size for a minimum period of 3 years.
  2. The allotment of the investment amount would be through tap or auctions. FPIs (including its related FPIs) shall be allotted an investment limit maximum upto 50% of the amount offered for each allotment, in case there is a demand for more than 100% of amount offered.
  3. FPIs may, at their discretion, transfer their investments made under the General Investment Limit, if any, to the VRR scheme.
  4. FPIs may apply for investment limits online to Clearing Corporation of India Ltd. (CCIL) through their respective custodians.
  5. Investment under this route shall be capped at Rs. 1,50,000/- crores (erstwhile 75,000 crores) or higher, which shall be allocated among the following types of securities, as may be decided by the RBI from time to time.
    1. ‘VRR-Corp’: Voluntary Retention Route for FPI investment in Corporate Debt Instruments.
    2. ‘VRR-Govt’: Voluntary Retention Route for FPI investment in Government Securities.
    3. ‘VRR-Combined’: Voluntary Retention Route for FPI investment in instruments eligible under both VRR-Govt and VRR-Corp.
  6. Relaxation from (a) minimum residual maturity requirement, (b) Concentration limit, (c) Single/Group investor-wise limits in corporate bonds as stipulated in RBI Circular dated June 15, 2018[6] where exposure limit of not more than 20% of corporate bond portfolio to a single corporate (including entities related to the corporate) have been dispensed with. However, limit on investments by any FPI, including investments by related FPIs, shall not exceed 50% of any issue of a corporate bond except for investments by Multilateral Financial Institutions and investments by FPIs in Exempted Securities.
  7. FPIs shall open one or more separate Special Non-Resident Rupee (SNRR) account for investment through the Route. All fund flows relating to investment through the VRR shall reflect in such account(s).

What are the eligible instruments for investments?

  1. Any Government Securities i.e., Central Government dated Securities (G-Secs), Treasury Bills (T-bills) as well as State Development Loans (SDLs);
  2. Any instrument listed under Schedule 1 to Foreign Exchange Management (Debt Instruments) Regulations, 2019 other than those specified at 1A(a) and 1A(d) of that schedule; However, pursuant to the recent amendments, investments in Exchange Traded Funds investing only in debt instruments is permitted.
  3. Repo transactions, and reverse repo transactions.

What are the options available to FPIs on the expiry of retention period?

Option 1

 

Continue investments for an additional identical retention period
 

 

 

Option 2

 

Liquidate its portfolio and exit; or

 

Shift its investments to the ‘General Investment Limit’, subject to availability of limit under the same; or

 

Hold its investments until its date of maturity or until it is sold, whichever is earlier.

Any FPI wishing to exit its investments, fully or partly, prior to the end of the retention period may do so by selling their investments to another FPI or FPIs.

3-months investment deadline extended in view of COVID-19 disruption

As discussed above, once the allotment of the investment limit has been made, the successful allottees shall invest at least 75% of their CPS within 3 months from the date of allotment. While announcing various measures to ease the financial stress caused by the COVID-19 pandemic, RBI Governor acknowledged the fact that VRR scheme has evinced strong investor participation, with investments exceeding 90% of the limits allotted under the scheme.

Considering the difficulties in investing 75% of allotted limits, it has been decided that an additional 3 months will be allowed to FPIs to fulfill this requirement.

Which all FPIs shall be considered eligible to claim the relaxation?

FPIs that have been allotted investment limits, between January 24, 2020 (the date of reopening of allotment of investment limits) and April 30, 2020 are eligible to claim the relaxation of additional 3 months.

When does the retention period commence? What will be the implication of extension on retention period?

The retention period of 3 years commence from the date of allotment of investment limit and not from date of investments by FPIs. However, post above relaxation granted, the retention period shall be determined as follows:

FPIS

 

RETENTION PERIOD
*Unqualified FPIs Retention period commence from the date of allotment of investment limit

 

**Qualified FPIs opting relaxation

 

 

Retention period commence from the date that the FPI invests 75% of CPS
Qualified FPIs not opting relaxation

 

Retention period commence from the date of allotment of investment limit

*Unqualified FPIs – whose investments limits are not allotted b/w 24.01.2020 and 30.04.2020

**Qualified FPIs to relaxation – whose investments limits not allotted b/w 24.01.2020 and 30.04.2020 

What will be the consequences if the required investment is not made within extended period of 3 months?

Since no separate penal provisions are prescribed under the circular, in terms of VRR Scheme, any violation by FPIs shall be subjected to regulatory action as determined by SEBI. FPIs are permitted, with the approval of the custodian, to regularize minor violations immediately upon notice, and in any case, within 5 working days of the violation. Custodians shall report all non-minor violations as well as minor violations that have not been regularised to SEBI

Concluding Remarks

The COVID-19 disruption has adversely impacted the Indian markets where investors are dealing with the market volatility. Given this, FPIs are pulling out their investments from the Indian markets (both equity and debt). Thus, relaxing investments rules of VRR Scheme during such financial distress, will help the foreign investors manage their investments appropriately.

You may also read our write ups on following topics:

Relaxations to FPIs ahead of Budget, 2020, click here

Recommendations to further liberalise FPI Regulations, click here

RBI removes cap on investment in corporate bonds by FPIs, click here

SEBI brings in liberalised framework for Foreign Portfolio Investors, click here 

For more write ups, kindly visit our website at: http://vinodkothari.com/category/corporate-laws/

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[1]https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11561&Mode=0

[2]https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11896&Mode=0

[3]https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11492&Mode=0

[4]https://www.rbi.org.in/Scripts/BS_CircularIndexDisplay.aspx?Id=11561

[5]https://rbidocs.rbi.org.in/rdocs/notification/PDFs/APDIR19FABE1903188142B9B669952C85D3DCEE.PDF

[6] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT199035211F142484DEBA657412BFCB17999.PDF

Regulator’s move to repair the NBFC sector

-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

Special Liquidity Facility for Mutual Funds

By Anita Baid (finserv@vinodkothari.com)

[Posted on April 27, 2020 and updated on April 30, 2020]

The Reserve Bank of India (RBI) has been vigilantly taking necessary measures and steps to mitigate the economic impact of Covid-19 and preserve financial stability. The capital market of our country has also been exposed to the disruption. The liquidity strains on mutual funds (MFs) has intensified for the high-risk debt MF segment due to redemption or closure of some debt MFs. This was witnessed when Franklin Templeton Mutual Fund[1] announced the winding up of six yield-oriented, managed credit funds in India, effective April 23, citing severe market dislocation and illiquidity caused by the coronavirus. Sensing the need of the hour and in order to ease the liquidity pressures on MFs, RBI has announced a special liquidity facility for Mutual Funds (SLF-MF)[2] of Rs. 50,000 crore.

Under the SLF-MF, the RBI shall conduct repo operations of 90 days tenor at the fixed repo rate. The SLF-MF is on-tap and open-ended, wherein banks shall submit their bids to avail funding on any day from Monday to Friday (excluding holidays) between 9 AM and 12.00 Noon. The scheme shall be open from April 27, 2020 till May 11, 2020 or up to utilization of the allocated amount, whichever is earlier. An LAF Repo issue will be created every day for the amount remaining under the scheme after deducting the cumulative amount availed up to the previous day from the sanctioned amount of Rs. 50,000 crores. The bidding process, settlement and reversal of SLF-MF repo would be similar to the existing system being followed in case of LAF/MSF. Further, the RBI will further review the timeline and amount, depending upon market conditions.

As per the press release, the RBI will provide funds to banks at lower rates and banks can avail funds for exclusively meeting the liquidity requirements of mutual funds in the following ways:

  • extending loans, and
  • undertaking outright purchase of and/or repos against the collateral of investment grade corporate bonds, commercial papers (CPs), debentures and certificates of Deposit (CDs) held by MFs.

Accordingly, the funds availed by banks from the RBI at the repo window will be used to extend loans to MFs, buy outright investment grade corporate bonds or CPs or CDs from them or extend the funds against collateral through a repo.

The RBI has further vide its notification dated April 30, 2020, extended the regulatory benefits under the SLF-MF scheme to all banks, irrespective of whether they avail funding from the RBI or deploy their own resources under the scheme. Banks meeting the liquidity requirements of MFs by any of the aforesaid methods, shall be eligible to claim all the regulatory benefits available under SLF-MF scheme without the need to avail back to back funding from the RBI under the SLF-MF.

It is important to note that in terms of regulation 44(2) of the SEBI (Mutual Funds) Regulations, 1996[3], a MF shall not borrow except to meet temporary liquidity needs of the MFs for the purpose of repurchase, redemption of units or payment of interest or dividend to the unit holders and, further, the mutual fund shall not borrow more than 20% of the net asset of the scheme and for a duration not exceeding six months.

As per the aforesaid SEBI regulations, MFs should normally meet their repurchase/redemption commitments from their own resources and resort to borrowing only to meet temporary liquidity needs. Therefore, under the SLF-MF scheme as well banks will have to be judicious in granting loans and advances to MFs only to meet their temporary liquidity needs for the purpose of repurchase/redemption of units within the ceiling of 20% of the net asset of the scheme and for a period not exceeding 6 months. While banks will decide the tenor of lending to /repo with MFs, the minimum tenor of repo with RBI will be for a period of three months.

Similar to the incentives given to the banks in case of LTRO schemes, the following shall be available for banks extending funding under the SLF-MF-

  1. the liquidity support availed under the SLF-MF would be eligible to be classified as held to maturity (HTM) even in excess of 25% of total investment permitted
  2. Exposures under this facility will not be reckoned under the Large Exposure Framework (LEF)
  3. The face value of securities acquired under the SLF-MF and kept in the HTM category will not be reckoned for computation of adjusted non-food bank credit (ANBC) for the purpose of determining priority sector targets/sub-targets
  4. Support extended to MFs under the SLF-MF shall be exempted from banks’ capital market exposure limits.

The RBI’s move is much needed to ease the liquidity stress on the MF industry. However, as has been seen in the TLRTO 2.0 auctions, banks are taking a cautious approach before using this facility provided by RBI. However, it is expected that this will ensure easing of liquidity and also boost investor sentiment.

 

[1] With assets worth more than Rs 86,000 crore as of the end of March, Franklin Templeton is the ninth largest mutual fund in the country

[2] https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=49728

[3] Last updated on March 6, 2020- https://www.sebi.gov.in/legal/regulations/mar-2020/securities-and-exchange-board-of-india-mutual-funds-regulations-1996-last-amended-on-march-06-2020-_41350.html

Loan products for tough times

-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

-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:

 

The Great Lockdown: Standstill on asset classification

– RBI Governor’s Statement settles an unwarranted confusion

Timothy Lopes, Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

Background

In the wake of the disruption caused by the global pandemic, now pitted against the Great Depression of 1930s and hence called The Great Lockdown[1], several countries have taken measures to try and provide stimulus packages to mitigate the impact of COVID-19[2]. Several countries, including India, provided or permitted financial institutions to grant ‘moratorium’, ‘loan modification’ or ‘forbearance’ on scheduled payments of their loan obligations being impacted by the financial hardship caused by the pandemic.

The RBI had announced the COVID-19 Regulatory Package[3] on 27th March, 2020. This package permitted banks and other financial institutions to grant moratorium up to 3 months beginning from 1st March, 2020. We have covered this elaborately in form of FAQs.[4]

However, there was ambiguity on the ageing provisions during the period of moratorium. That is to say,  if an account had a default on 29th February, 2020, whether the said account would continue to age in terms of days past due (DPD) as being in default even during the period of moratorium. Our view was strongly that a moratorium on current payment obligation, while at the same time expecting the borrower to continue to service past obligations, was completely illogical. Such a view also came from a judicial proceeding in the case of Anant Raj Limited Vs. Yes Bank Limited dated April 6, 2020[5]

However, the RBI seems to have had a view, stated in a mail addressed to the IBA,  that the moratorium did not affect past obligations of the customer. Hence, if the account was in default as on 1st March, the DPD will continue to increase if the payments are not cleared during the moratorium period.

Read more

Would the doses of TLTRO really nurse the financial sector?

-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/