Posts

New regime for securitisation and sale of financial assets

Team, Vinod Kothari Consultants

finserv@vinodkothari.com

On Monday, 8th June, 2020, the RBI released, for public comments, two separate draft guidelines, one for securitisation of standard assets, and the other for sale of loans. Once implemented, these guidelines will replace the existing regulatory framework that has stood ground, in case of securitisation for the last 14 years, and 8 years in case of direct assignment. We have separately dealt with the Draft Directions on Securitisation of Standard Assets in a write up titled “Originated to transfer- new RBI regime on loan sales permits risk transfers

Read more

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. The scheme was further amended on 4th August 2020 for widening the scope of the said scheme

Under this Scheme the GoI, through a trust, will guarantee loans provided by banks and Financial Institutions (FIs) to Individuals MSMEs and MUDRA borrowers. The Scheme aims to extend additional funding of Rs. 3 lakh crores to eligible borrowers in order to help them through the liquidity crunch faced by them due to the crisis.

Based on the information provided by the Finance Minister about this Scheme, the press release issued in this regard and the operating guidelines scheme documents issued subsequently, we have prepared the below set of FAQs. There is also a set of FAQs prepared by NCGTC – we have relied upon these as well.

In brief, the Guaranteed Emergency Line of Credit [GECL] is a scheme whereby a lender [referred to as Member Lending Institution or MLI in the Scheme] gives a top-up loan of 20% of the outstanding facility as on 29th February, 2020. This top up facility is entirely guaranteed by NCGTC. NCGTC is a special purpose vehicle formed in 2014 for the purpose of acting as a common trustee company to manage and operate various credit guarantee trust funds.

[Vinod Kothari had earlier recommended a “wrap loan” for restarting economic activity – http://vinodkothari.com/2020/04/loan-products-for-tough-times/. The GECL is very close to the idea of the wrap loan.]

Essentially, the GECL will allow lenders to provide additional funding to business entities and individual businessman. The additional funding will run as a separate parallel facility, along with the main facility. The GECL loan will have its own term, moratorium, EMIs, and may be rate of interest as well. Of course, the GECL will share the security interest with the original facility, and will rank pari passu, with the main facility, both in terms of cashflows as in terms of security interest.

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

Eligible Lenders and eligible borrowers

  1. What is the nature of GECL?

The GECL shall be an additional working capital term loan (in case of banks and FIs), and additional term loan (in case of NBFCs) provided by the MLIs to Eligible Borrowers. The GECL facility may run upto 20% of the loan outstanding on 29th February, 2020.

The meaning of “working capital term loan” is that the amount borrowed may be used for general business purposes by the borrower.

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

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

  1.  All Scheduled Commercial Banks. Other banks such as RRBs, co-operative banks etc. shall not be eligible lenders.
  2.  Financial Institutions (FIs), defined under section 45-I(c) of the RBI Act, 1934. The term all-India Financial Institutions” now includes Exim Bank, NABARD, SIDBI and NHB, none of which are extending primary loans. Hence, the term “financial institutions” as per sec. 45I (c) of the RBI Act will essentially refer to NBFCs, covered below..

III.    Non-Banking Financial Companies (NBFCs), registered with the RBI and which have been in operation for a period of 2 years as on 29th February, 2020.

  1. What is the meaning of NBFC having been in operation for 2 years? Are we referring to 2 years from the date of incorporation of the Company, or 2 years from the date of getting registration with the RBI as an NBFC, or 2 financial years?

The language of the scheme indicates that the NBFC must be in operation for 2 years (and not financial years) as on 29th February, 2020. Thus, the period of 2 years shall be counted from the starting of operations after getting registration as an NBFC.

Usually, the RBI while granting registration requires the NBFC to start operations within a period of six months of getting registration. It also requires the NBFC to intimate to RBI that it has commenced operations. Logically, the 2 years’ time for starting of operations should be read from the date of commencement of operations

  1. Does the NBFC have to be a systemically important company? Or any NBFC, whether SI or not, will qualify?

The asset size of the NBFC would not matter. The NBFC must only hold a valid certificate of registration issued by RBI in order to be eligible under the scheme (and in operation for 2 years). Thus, whether SI or not, any NBFC will qualify.

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

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

  1. Will the following qualify as MLIs?
  • HFCs: HFCs fall under the definition of financial institutions provided under the eligibility criteria for lenders. While HFCs essentially grant home loans, HFCs are permitted to have other types of loans within a limit of 50% of their assets. Hence, if the HFC has facilities that qualify for the purpose of the Scheme, an HFC will also qualify as MLI. This is further clarified in the FAQs 44 as well.
  • MFIs: MFIs are a class of NBFCs and thus, eligible as MLIs. However, it is to be seen if the nature of loans granted by the MFI will be eligible for the purpose of the Scheme.
  • CICs: CICs again are a class of NBFCs and thus, eligible as MLIs. However, they can grant loans to their group companies only.
  • Companies giving fin-tech credit to consumers: The nature of the loan will mostly be by way of personal loans or consumer credit. While the lender may qualify, but the facility itself may not.
  • Gold loan companies: Mostly, the loan is a personal loan and does not relate to a business purpose. Hence, the loan will not qualify.
  1. Is it possible for a bank to join as co-lender in case of a loan given by an NBFC? To be more precise, the primary loan is on the books of the NBFC. Now, the NBFC wants to give the GECL facility along with a bank as a co-lender. Is that possible?

In our view, that should certainly be possible. However, in our view, in that case, the rate of interest charged to the borrower should be the blended rate considering the interest rate caps for the bank [9.25%] and the NBFC [14%].

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

The Eligible Borrowers shall be entities/individuals fulfilling each of the following features :

  • Nature of the activity/facility: Our understanding is that Scheme is meant only for business loans. Hence, the nature of activity carried by the entity must be a business, and the facility must be for the purpose of the business.
  • Scale of business: Business enterprises /MSMEs. The term MSME has a wide definition and we are of the view that it is not necessary for the borrower to be registered for the purpose of MSME Development Act. Please see our detailed resources on the meaning of MSMEs here: http://vinodkothari.com/2020/05/resources-on-msme/.In addition, the word “business enterprises” is also a wide term – see below.
  • Existing customer of the MLI: The borrower must be an existing customer of the MLI as on 29th Feb., 2020. That is, there must be an existing facility with the borrower.
  • Size of the existing facility: The size of the existing facility, that is, the POS, as on 29th Feb. 2020, should be upto Rs 50 crores.
  • Turnover for FY 2019-20: The turnover of the Eligible Borrower, for financial year 2019-20, should be upto Rs 250 crores. In most cases, the financial statements for FY 2019-20 would not have been ready at the time of sanctioning the GECL. In that case, the MLI may proceed ahead based on a borrower’s declaration of turnover.
  • GST registration: Wherever GST registration is mandatory, the entity must have GST registration.
  • Performance of the loan: As on 29th Feb., 2020, the existing facility must not be more than 59 DPD.
  • Further, Business Enterprises / MSMEs/Individuals would include loans covered under Pradhan Mantri Mudra Yojana extended on or before 29.2.2020, and reported on the MUDRA portal. All eligibility conditions including the condition related to Days past due would also apply to PMMY loans.
  1. Who are eligible Mudra borrowers?

Mudra borrowers are micro-finance units who have availed of loans from Banks/NBFCs/MFIs under the Pradhan Mantri Mudra Yojna (PMMY) scheme.

  1. Do Eligible Borrowers have to have any particular organisational form, for example, company, firm, proprietorship, etc?

No. There is no particular organisational form for the Eligible Borrower. It may be a company, firm, LLP, proprietorship, etc.

Note that the Scheme initially used the expression: “all Business Enterprises / MSME institution borrower accounts”. From the use of the words “business enterprises” or “institution borrower account”, it was contended that individuals are excluded. In Para 7 of the Operational Guidelines on the website of NCGTC, it mentioned that “Loans provided in individual capacity are not covered under the Scheme”. However, the very same para also permitted a business run as a proprietorship as an eligible case of business enterprise.

Hence, there was a confusion between a business owned/run by an individual, and a loan taken in individual capacity. The latter will presumably mean a loan for personal purposes, such as a home loan, loan against consumer durables, car loan or personal loan. As opposed to that, a loan taken by a business, even though owned by an individual and not having a distinctive name than the individual himself, cannot be regarded as a “loan provided in individual capacity”.

For instance, many SRTOs, local area retail shops etc are run in the name of the proprietor. There is no reason to disregard or disqualify such businesses. It is purpose and usage of the loan for business purposes that matters.

To ensure clarity, the revised operational guidelines include business loans taken by individuals for their own businesses in the ambit of scheme, Further, individual would be required to fulfil eligibility criteria for the borrower.

  1. What is the meaning of the term “business enterprise” which is defined as one of the Eligible Borrowers?

The term “ business enterprise” has been used repetitively in the Scheme, and is undefined. In our view, its meaning should be the plain business meaning– enterprises which are engaged in any business activity. The word “business activity” should be taken broadly, so as to give an extensive and purposive interpretation to fulfil the intent of the Scheme. Clearly, the Scheme is intended to encourage small businesses which are the backbone of the economy and which may help create “self reliant” India.

Having said this, it should be clear that the idea of the Scheme is not to give loans for consumer durables, personal use vehicles, consumer loans, personal loans, etc. While taking the benefit of the Scheme, the MLI should bear in mind that the intent of the lending is to spur economic activity. There must be a direct nexus between the granting of the facility and economic/business activity to be carried by the Eligible Borrower.

  1. One of the Eligible Borrowers is an MSME. Is it necessary that the entity is registered i.e. has a valid Udyog Aadhaar Number, as required under the MSMED Act?

The eligibility criteria for borrowers does not specifically require the MSMEs to be registered under the MSMED Act. Thus, an unregistered MSME may also be an Eligible Borrower under the scheme.

  1. For the borrowers to give a self-declaration of turnover for FY 2019-20, is there a particular form of declaration?

There is no particular form. However, we suggest something as simple as this:

To whomsoever it may concern

Sub: Declaration of Turnover

I/ We………………………………….. (Name of Authorized Signatory), being ……………………..(Designation) of …………………………………………………. (Legal Name as per PAN) do hereby state that while the financial statements for the FY 2019-20 have not still been prepared or finalised, based on our records, the turnover of the abovementioned entity/unit during the FY 2019-2 will be within the value of Rs 250 crores.

 

Signed ………….            Date:…………………

  1. One of the important conditions for the Eligible Borrower is that the Borrower must not be an NPA, or SMA 2 borrower. For finding the DPD status of the existing facility, how do we determine the same in the following cases?
  • My EMIs are due on 10th of each month. On 10th Feb., 2020, the borrower had two missing EMIs, viz., the one due on 10th Jan. 2020 and the one due on 10th Feb., 2020. Is the Borrower an Eligible Borrower on 29th Feb., 2020?

The manner of counting DPD is – we need to see the oldest of the instalments/ principal/interest due on the reckoning date. Here, the reckoning date is 29th Feb. On that date, the oldest overdue instalment is that of 10th Jan. This is less than 59 DPD. Hence, the borrower is eligible.

  • My EMIs are due on the 1st of each month. The borrower has not paid the EMIs due on 1st Jan. and 1st Feb., 2020. Is the Borrower an Eligible Borrower on 29th Feb., 2020?

On the reckoning date, the oldest instalment is that of 1st Jan. 2020. Since the reckoning date is 29th Feb., we will be counting only one two dates – 1st Jan and 29th Feb. The time lag between the two adds to exactly 59 days. The borrower becomes ineligible if the DPD status is more than 59 days. Hence, the borrower is eligible.

  1. Is the Scheme restrictive as to the nature of the existing facility? Can the GECL be different from the existing facility?

It does not seem relevant that the GECL should be of the same nature/type or purpose as the primary facility. We have earlier mentioned that the purpose of the GECL is to support the business/economic activity of the borrower.

However, there may be issues where the existing facility itself would not have been eligible for the Scheme. For instance, if the existing facility was a car loan to a business entity (say, an MSME), can the GECL  be eligible if the same is granted for working capital purposes? Intuitively, this does not seem to be covered by the Scheme. Once again, the intent of the Scheme is to provide “further” or additional funding to a business. Usually, the so-called further or additional funding for a business may come from a lender who had facilitated business activity by the primary facility.

Hence, in our view, the primary as well as the GECL facility should be for business purposes.

  1. Is there a relevance of the residual tenure of the primary facility? For example, if the primary facility is maturing within the next 6 months, is it okay for the MLI to grant a GECL for 4 years?

There does not seem to be a correlation between the residual term of the primary facility and the tenure of the GECL facility. The GECL seems to be having a term of 4 years, irrespective of the original or residual term of the primary facility.

Of course, the above should be read with our comments above about the primary facility as well as the GECL to be for business purposes.

  1. A LAP loan was granted to a business entity/Individual.  The loan was granted against a self-owned house, but the purpose of the loan was working capital for the retail trade business carried by the borrower. Will this facility be eligible for GECL?

Here, the purpose of the loan, and the nature of collateral supporting the loan, are different, but what matters is the end-use or purpose of the loan. The collateral is a self-occupied house. But that does not change the  purpose of the loan, which is admittedly working capital for the retail trade activity.

Hence, in our view, the facility will be eligible for GECL, subject to other conditions being satisfied.

  1. I have an existing borrower B, who is a single borrower as on 29th Feb 2020. I now want to grant the GECL loan to C, who would avail the loan as a co-borrower with B. Can I lend to B and C as co-borrowers?

It seems that even loans extended to co-obligors or co-applicants also qualify.

We may envisage the following situations:

  • The primary facility was granted to B and C. B is an Eligible Borrower. The GECL is now being granted to B and C. This is a good case for GECL funding, provided B remains the primary applicant. In co-applications, the co-borrowers have a joint and several obligations, and the loan documentation may not make a distinction between primary and secondary borrower. However, one needs to see the borrower who has utilised the funding.
  • The primary facility was granted to B who is an Eligible Borrower. The GECL is now being granted to B and C. This is a good case for GECL funding if B is the primary applicant. See above for the meaning of “primary” applicant.
  • The primary facility was granted to B, who is a director of a company, where C, the company, joined as a co-applicant. C is an Eligible Borrower. The GECL is now being granted to C. This is a good case for GECL funding since the GECL funding is to C and C is an Eligible Borrower.
  1. When can GECL be sanctioned? Is there a time within which the GECL should be sanctioned?

The Scheme shall remain in operation till 30th November, 2020, or till such time as the maximum amount of loans covered by NCGTC reaches Rs 300000 crores. Accordingly, it can be inferred that the GECL must be sanctioned during the period of the operation of Scheme, that is during the period from May 23, 2020 to 30th November, 2020, or till an amount of Rs. 3 lakh crore is sanctioned under GECL, whichever is earlier.

  1. How can an MLI keep track of how much is the total amount of facilities guaranteed by NCGTC?

Understandably, there may be mechanisms of either dissemination of the information by NCGTC, or some sort of a pre-approval of a limit by NCGTC.

  1. Whether the threshold limit of outstanding credit of Rs. 50 crores, will have to be seen across all the lenders, the borrower is currently dealing with, or with one single lender?

The Scheme specifically mentions that the limit of Rs. 50 crores shall be ascertained considering the borrower accounts of the business enterprises/MSMEs with combined outstanding loans across all MLIs. For the purpose of determining whether the combined exposure of all MLIs is Rs 50 crores or not, the willing MLI may seek information about other loans obtained by the borrower.

  1. For the threshold limit of outstanding credit of Rs. 50 crores, are we capturing only eligible borrowings of the borrower, or all debt obligations?

Logically, all business loans, that is, loans/working capital facilities or other funded facilities availed for business purposes should be aggregated. For instance:

  • Unfunded facilities, say, L/Cs or guarantees, do not have to be included.
  • Non-business loans, say, car loans, obtained by the entity do not have to be included as the same are not for business purposes.
  1. What is the meaning of MSME? Is it necessary that the Eligible Borrower should be meeting the definition of MSME as per the Act?

The Scheme uses the term MSME, but nowhere has the Scheme made reference to the definition of MSME under the MSMED Act, 2006. Therefore, it does not seem necessary for the Eligible Borrower to have registration under the MSMED Act. Further, even if the entity in question is not meeting the criteria        of MSME under the Act, it may still be satisfying the criteria of “business enterprise” with reference to turnover and borrowing facilities. Hence, the reference to the MSMED Act seems unimportant.

However, for the purpose of ease of reference, we are giving below the meaning of MSME as per the definition of MSMEs provided in the MSMED Act, 2006 (‘Act’):

Enterprise Manufacturing sector [Investment in plant and machinery (Rs.)] Service sector [Investment in equipment (Rs.)]
Small Not exceeding 25 lakhs Not exceeding 10 lakhs
Micro Exceeding 25 lakhs but does not exceed 5 crores Exceeding 10 lakhs but does not exceed 2 crores
Medium Exceeding 5 crores but not exceeding 10 crores Exceeding 2 crores but does not exceed 5 crores

 

The above definition has been amended by issue of a notification dated June 1, 2020. As per the amendment such revised definition shall be applicable with effect from July 01, 2020. Accordingly, w.e.f. such date, following shall be the definition of MSMEs:

Enterprise Investment in plant and machinery or equipment (in Rs.) Turnover (in Rs.)
Micro Upto 1 crore Upto 5 crores
Small Upto 10 crores Upto 50 crores
Medium Upto 50 crores Upto 250 crores
  1. The existing schemes laid down by the CGTMSE, CGS-I and CGS-II, cover the loans extended to MSE retail traders. Will the retail traders be eligible borrowers for this additional facility?

The Scheme states that a borrower is eligible if the borrower has –

(i) total credit outstanding of Rs. 50 Crore or less as on 29th Feb 2020;

(ii) turnover for 2019-20 was upto Rs. 250 Cr;

(iii) The borrower has a GST registration where mandatory.

Udyog Aadhar Number (UAN) or recognition as MSME is not required under this Scheme.

Hence, even retail traders fulfilling the eligibility criteria above would be eligible under the scheme.

  1. If the borrower does not have any existing credit facility as on 29th February, 2020, will it still be able to avail fresh facility(ies) under this Scheme?

Looking at the clear language of the Scheme, it seems that existence of an outstanding facility is a prerequisite to avail credit facility under the Scheme. The intent of the Scheme is to provide additional credit facility to existing borrowers.

  1. I have a borrower to whom I have provided a sanction before 29th February, 2020; however, no disbursement could actually take place within that date. Will such a borrower qualify for the Scheme?

Since the amount of GECL is related to the POS as on 29th Feb., 2020, there is no question of such a borrower qualifying.

  1. The Scheme seems to refer to the facility as a “working capital term loan” in case of banks/FIs and “additional term loan” in case of NBFCs. Does that mean the MLIs cannot put any end-use restrictions on utilisation of the facility by the Eligible Borrowers?

It is counter-intuitive to think that the MLI cannot put end-use restrictions. Ensuring that the funds lent by the MLI are used for the purpose for which the facility has been extended is an essential prudential safeguard for a lender. It should be clear that the additional facility has been granted for restarting business, following the disruption caused by the COVID crisis. There is no question of the lender permitting the borrower to use the facility for extraneous or irrelevant purposes.

Terms of the GECL Facility

  1. What are the major terms of the GECL Facility?

The major terms are as follows:

  • Amount of the Facility: Up to 20% of the POS as on 29th Feb., 2020. Note that the expression “upto” implies that the MLI/borrower has discretion in determining the actual amount of top up funding, which may go upto 20%.
  • Tenure of the Facility: 4 years. See below about whether the parties have a discretion as to tenure.
  • Moratorium: 12 months. During the moratorium, both interest and principal will not be payable. Hence, the first payment due under the top up facility will be on the anniversary of the facility.
  • Amortisation/repayment term: 36 months.
  • Mode of repayment: While the Scheme says that the principal shall be payable in 36 installments, it should not mean 36 equal instalments of principal. The usual EMI, wherein the instalment inclusive of interest is equated, works well in the financial sector. Hence, EMI structure may be adopted. However, if the parties prefer equated repayment of principal, and the interest on declining balances, the same will also be possible. Note that in such case, the principal at the end of 12 months will have the accreted interest component for 12 months’ moratorium period as well.
  • Collateral: The Scheme says that no additional collateral shall be asked for the purposes of the GECL. In fact, given the sovereign guarantee, it may appear that no additional collateral is actually required. [However, see comment below on dilution of the collateral as a result of the top-up funding].
  • Rate of interest: The rate of interest is capped as follows – In case of banks/ – Base lending rate + 100 bps, subject to cap of 9.25% p.a. In case of NBFCs, 14% p.a.
  • Processing/upfront fees: None
  1. As regards the interest rate, is it possible that the MLI has the benefit under any interest rate subvention scheme as well?

Yes. This scheme may operate in conjunction with any interest rate subvention scheme as well.

  1. Is the tenure of the GECL facility non-negotiably fixed at 4 years or do the parties have discretion with respect to the same? For example, if the borrower agrees to a term of 3 years, is that possible?

It seems that the Scheme has a non-negotiable tenure of 4 years. Of course, the Scheme document does say the parties may agree to a prepayment option, without any prepayment penalty. However, in view of the purpose of the Scheme, that is, to restart business activity in the post-COVID scenario, it does not seem as if the purpose of the Scheme will be accomplished by a shorter loan tenure.

  1. Is it possible for MLI to lend more than 20%, but include only 20% for the benefit of the guarantee?

Minus the Scheme, nothing stopped a lender from giving a top-up lending facility on a loan. Therefore, the wrapped portion of the GECL facility is 20% of the loan, but if the lender so wishes to give further loan, there is nothing that should restrain the lender from doing so.

  1. The Scheme document provides that the collateral for the primary loan shall be shared pari passu with the GECL facility. What does the sharing of the collateral on pari passu basis mean?

Para 11 of the Scheme document says: “…facility granted under GECL shall rank pari passu with the existing credit facilities in terms of cash flows and security”. The concept of pari passu sharing of the security, that is, the collateral, may create substantial difficulties in actual operation, since the terms of repayment of the primary facility and the GECL facility are quite divergent.

To understand the basic meaning of pari passu sharing, assume there is a loan of Rs 100 as on 29th Feb., 2020, and the MLI grants an additional loan of Rs 20 on 1st June, 2020. Assume that the value of the collateral backing the primary loan is Rs 125. As and when the GECL is granted, the value of this collateral will serve the benefit of the primary loan as well as the GECL facility. In that sense, there is a dilution in the value of the security for the primary loan. This, again, is illogical since the primary does not have a sovereign wrap, while the GECL facility has.

What makes the situation even worse is that due to amortizing nature of the primary loan, and the accreting nature of the GECL facility during the moratorium period, the POS of the primary facility will keep going down, while the POS of the GECL facility will keep going up. It may also be common that the primary facility will run down completely in a few months (say 2 years), while the GECL facility is not even half run-down. In such a situation, the benefit of the collateral will serve the GECL loan, in proportion to the amount outstanding of the respective facilities. Obviously, when the primary facility is fully paid down, the collateral serves the benefit of the GECL facility only.

  1. The Scheme provides that the primary facility and the GECL facility shall rank pari passu, in terms of cash flows. What is the meaning of pari passu sharing of cashflows?

The sharing of cashflows on pari passu basis should mean, if there are unappropriated payments made by the borrower, the payment made by the borrower should be split between the primary facility and the GECL facility on proportionate basis, proportional to the respective amounts falling/fallen due.

For instance, in our example taken in Q 15 above, assume the borrower makes a payment in the month of July 2020. The entire payment will be taken to the credit of the primary loan since the GECL loan is still in moratorium.

Say, in the month of July 2021, an aggregate payment is made by the borrower, but not sufficient to discharge the full obligation under the primary facility and the GECL facility. In this case, the payment made by the borrower will be appropriated, in proportion to the respective due amounts (that is, due for the month or past overdues) for the primary facility and the GECL facility.

  1. Given the fact that the payments for the GECL are still being collected by the MLI, who also has a running primary facility with the same borrower, is there any obligation on the part of the MLI to properly appropriate the payments received from the borrower between the primary and the GECL facility?

Indeed there is. The difficulty arises because there are two facilities with the borrower, one is naked, and the other one wrapped. The pari passu sharing of cashflows will raise numerous challenges of appropriation. Since the claim is against the sovereign, there may be a CAG audit of the claims settled by the NCGTC.

  1. The Scheme document says that the charge over the collateral has to be created within 3 months from the date of disbursal. What is the meaning of this?

If the existing loan has a charge securing the loan, and if the same security interest is now serving the benefit of the GECL facility as well, it will be necessary to modify the charge, such that charge now covers the GECL facility as well. As per Companies Act, the time for registration of a modification is thirty days, and there is an additional time of ninety days.

  1. Say the primary loan is a working capital loan given to a business and has a residual tenure of 24 months. The loan is secured by a mortgage of immovable property. Now, GECL facility is granted, and the same has a tenure of 48 months. After 24 months, when the primary loan is fully discharged, can the borrower claim the release of the collateral, that is, the mortgage?

Not at all. The grant of the GECL facility is a grant of an additional facility, with the same collateral. Therefore, until the GECL loan is fully repaid, there is no question of the borrower getting a release of the collateral.

  1. Should there be a cross default clause between the primary loan and the GECL loan?

In our view, the collateral is shared by both the facilities on pari passu basis. Hence, there is no need for a cross default clause.

  1. What are the considerations that should prevail with the borrower/MLI while considering the quantum of the GECL facility?

The fact that the GECL facility is 100% guaranteed by the sovereign may encourage MLIs to consider the GECL facility as risk free, and go aggressively pushing lending to their existing borrowers. However, as we have mentioned above, the pari passu sharing of the collateral results into a dilution of collateral for the primary facility. Hence, MLIs should use the same time-tested principles of lending in case of GECL as well – capacity, collateral, etc.

For the borrower as well, the borrower eventually has to pay back the loan. In case of NBFCs, the loan is not coming cheap – it is coming at a cost of 14%. While for the lender, the risk may be covered by the sovereign guarantee, the risk of credit history impairment for the borrower is still the same.

Hence, we suggest both the parties to take a considered call. For the lender, the consideration should still be the value of the collateral, considering the amount of the top up facility. In essence, the top up facility does not mechanically have to be 20% -the amount may be carefully worked out.

  1. Does the disbursal of the GECL facility have to be all in cash, or can it be adjusted partly against the borrower’s obligations, say for any existing overdues? Can it be partly given to MLI as a security deposit?

While the disbursal should appropriately be made by the MLI upfront, if the borrower uses the money to settle existing obligations with the MLI, that should be perfectly alright.

  1. In case the borrower has multiple loan accounts with multiple eligible lenders, how will such borrower avail facility under GECL?
    It is clarified that a borrower having multiple loan accounts with multiple lenders can avail GECL. The GECL will have to be availed either through one lender or each of the current lenders in proportion depending upon the agreement between the borrower and the MLI.

Further, In case the borrower wishes to take from any lender an amount more than the proportional 20% of the outstanding credit that the borrower has with that particular lender, a No Objection Certificate (NOC) would be required from the lender whose share of ECLGS loan is proposed to be extended by a specific lender. Further, it would be necessary for the specific lender to agree to provide ECLGS facility on behalf of such of the lenders.

Lender-Borrower documentation

  1. The Scheme has consistently talked about an opt-out facility for the GECL scheme. What exactly is the meaning of the opt-out facility?

In our understanding, the meaning is, except for those borrowers who opt out of the facility, the lender shall consider the remaining borrowers as opting for the facility. However, there cannot be a case of automatic lending, as a loan, after all, is a mutual obligation of the borrower towards the lender. Hence, there has to be explicit agreement on the part of the borrower with the lender.

Of course, a wise borrower may also want to negotiate a rate of interest with the lender.

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

At least the following:

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

Income recognition, NPA recognition, risk weighting and ECL computation

  1. During the period of the moratorium on the GECL facility, will income be recognised?

Of course, yes. In case of lenders following IndAS 109, the income will be recognised at the effective interest rate. In case of others too, there will be accrual of income.

  1. Once we give a GECL loan, we will have two parallel facilities to the borrower – the primary loan and the GECL loan. Can it be that one of these may become an NPA?

The GECL loan will have a moratorium of 12 months – hence, nothing is payable for the first 12 months. The primary facility may actually be having upto 59 DPD overdues at the very start of the scheme itself. Hence, it is quite possible that the primary facility slips into an NPA status.

As a rule, if a facility granted to a borrower has become an NPA, then all facilities granted to the same borrower will also be characterised as NPAs.

Therefore, despite the 100% sovereign guarantee, the facility may still be treated as an NPA, unless there is any separate dispensation from the RBI.

  1. If the GECL facility becomes an NPA, whether by virtue of being tainted due to the primary loan or otherwise, does it mean the MLI will have to create a provision?

As regards the GECL facility, any provision is for meeting the anticipated losses/shortfalls on a delinquent loan. As the GECL is fully guaranteed, in our view, there will be no case for creating a provision.

  1. Will there be any expected credit loss [ECL] for the GECL facility?

In view of the 100% sovereign guarantee, this becomes a case of risk mitigation. In our view, this is not a case for providing for any ECL.

  1. Will the 40 bps general loss provision for standard assets have to be created for the GECL loans too?

Here again, our view is that the facility is fully sovereign-guaranteed. Hence, there is no question of a prudential build up of a general loss provision as well. The RBI should come out with specific carve out for GECL loans.

  1. Will capital adequacy have to be created against GECL assets?

The RBI issued a notification on June 22, 2020 stating that since the facilities provided under the Scheme are backed by guarantee from GoI, the same shall be assigned 0% risk weight, in the books of MLIs.

Guarantor and the guarantee

  1. Who is the guarantor under the Scheme?

The Guaranteed Emergency Credit Line (GECL) or the guarantee under the Scheme shall be extended by National Credit Guarantee Trustee Company Limited (NCGTC, ‘Trust’).

  1. What is National Credit Guarantee Trustee Company Ltd (NCGTC)?

NCGTC is a trust set up by the Department of Financial Services, Ministry of Finance to act as a common trustee company to manage and operate various credit guarantee trust funds. It is a company incorporated under the Companies Act, 1956.

  1. What is the role of NCGTC?

The role of NCGTC is to serve as a single umbrella organization which handles multiple guarantee programmes of the GoI covering different cross-sections and segments of the economy like students, micro entrepreneurs, women entrepreneurs, SMEs, skill and vocational training needs, etc.

Presently, NCGTC manages 5 credit guarantee schemes that deal with educational loans, skill development, factoring, micro units etc.

  1. To what extent will the guarantee be extended?

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

  1. Whether the guarantee will cover both principal and interest components of the credit facility?

Yes, the Scheme shall cover both the interest as well as the principal amount of the loan.

  1. What will be the guarantee fee?

The NCGTC shall charge no guarantee fee from the Member Lending Institutions (MLIs) in respect of guarantee extended against the loans extended under the Scheme.

  1. Are eligible lenders required to be registered with the NCGTC to become MLIs?

Usually, eligible lenders under such schemes are required to enter into an agreement with the trust extending the guarantee, to become their members. In this scheme, the eligible lenders are required to provide an undertaking to the NCGTC, in the prescribed format, in order to become MLIs.

  1. What is the procedure for obtaining the benefit of guarantee under the Scheme?

The MLI shall, within 90 days from a borrower account under the scheme turning NPA,  inform the date on which such account turned NPA. On such intimation, NCGTC shall pay 75% of the guaranteed amount to the MLI i.e. 75% of the default amount.

The rest 25% shall be paid on conclusion of recovery proceedings or when the decree gets time barred, whichever is earlier.

Securitisation, direct assignment and co-lending

  1. The loan, originated by the NBFC, has been securitised. Is it possible for the NBFC to give a GECL facility based on the POS of the securitised loan?

On the face of it, there is nothing that stops a lender from giving a further facility, in addition to the one that has been securitised. However, in the present case, there will be modification of the existing charge document, whereby the charge will be extended to the top up GECL loan as well. This amounts to a dilution of the security available for the primary loan. In our view, this will require specific consent of the PTC investors, through the trustee.

Note that FAQ 35 by NCGTC seems to be talking about off-balance sheet facility. Many securitisation transactions are actually on the balance sheet. Further,  even if the original facility has gone off the balance sheet, the additional funding being given by the originator-servicer will be on-the-balance sheet.

Any interpretation of the guarantee scheme has to serve the purpose for which the scheme was envisaged – which is, clearly, to provide additional liquidity to borrowers affected by the disruption. There can be no suggestion that borrowers whose loans have been securitised will not need additional liquidity. Hence, the Scheme intends to wrap all additional lendings done by the lender, within the limits of 20%.

  1. The loan, originated by the NBFC, has been assigned to the extent of 90% to a bank. Is it possible for the NBFC to give a GECL facility based on the POS of the partly-assigned loan?

Same reasoning as above. Here again, FAQ 40 by NCGTC is talking about the entity on whose books the loan currently is. NCGTC’s view about the loan being on the books of a lender is seemingly overshadowed by accounting concepts which have drastically changed over time. For example, a loan which has been a matter of a DA transaction is actually partly on the books of the original lender, and partly on the books of the assignee. One cannot expect the assignee to be giving the additional line of credit, as the assignee is, practically speaking, a mere passive investor. The assignee does not have the franchise/relation with the borrower, which the originator has. To contend that the assignee bank should extend the additional facility is actually to deny the facility to the borrower completely, for no fault of the borrower and for no gain for the system. Since it is the original lender who maintains the relation with the borrower, it is original lender only who may extend the facility.

  1. Is it possible for the NBFC to originate the GECL facility, and securitise/assign the same? Will the assignee have the benefit of the GoI guarantee?

There is nothing in the Scheme for assignment of the benefit of guarantee. Typically, unless the guarantee agreement says to the contrary, the benefit of a security or guarantee is assignable along with the underlying loan. However, the guarantee agreement between NCGTC and the lender will be critical in determining this.

 

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

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

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

[4] The scheme earlier required the MSMEs to obtain UAN (i.e. get registered) in order to avail benefit under the same. However the same was recently done away with through a notification issued on February 5, 2020. Link to the notification- https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11803&Mode=0

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

 

Our related write-ups may be referred here:

 

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/

To access various web-lectures, webinars and other useful resources useful for the Corporate and Financial sector, visit and subscribe to our Youtube channel: https://www.youtube.com/channel/UCgzB-ZviIMcuA_1uv6jATbg

[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