-Kanakprabha Jethani |Executive
Vinod Kothari Consultants
The RBI has made some crucial amendments to the Large Exposures Framework (LEF) by notification dated June 03, 2019. These changes are intended to align with global practices, such as look through approach for identifying exposures, determination of the group of “connected” counterparties, to name a few.
The LEF, announced by the RBI vide its notification dated December 01, 2016 and amended through notification dated June 03, 2019, is applicable with effect from April 1, 2019. However, the provisions relating to Introduction of economic interdependence criteria in definition of connected counterparties and non-centrally cleared derivatives exposures shall become applicable from April 1, 2020. This framework is likely to widen the scope of the definition of group of connected counterparties on one hand, and narrowing down the same by expanding the scope of exempted counterparties. Further, look-through approach demarcates between direct or indirect exposure of banks in various counterparties.
More about the LEF
A bank may have exposure to various large borrowers, and of group of entities that are related to each other. This exposure in large borrowers, whether singularly or by way of different related entities, results in concentration of bank’s exposure in the same group, thus increasing the credit risk of the bank. There have been examples of large banking failures throughout the world. In the words of the Basel Committee on Banking Supervision-
“Throughout history there have been instances of banks failing due to concentrated exposures to individual counterparties (eg Johnson Matthey Bankers in the United Kingdom in 1984, the Korean banking crisis in the late 1990s). Large exposures regulation has been developed as a tool for limiting the maximum loss a bank could face in the event of a sudden counterparty failure to a level that does not endanger the bank’s solvency.”
To deal with the risk arising out of such concentration, there has to be in place limits on concentration in a single borrower or a borrower group. Accordingly, after considering various frameworks being included in local laws and banking regulations and recommendations of committees such as Basel Committee on Banking Supervision, ‘Supervisory framework for measuring and controlling large exposures’ was issued by the said committee. The same was adopted by the RBI in respect of banks in India.
The Large Exposure Framework (LEF) shall be applied by banks at group level (considering assets and liabilities of borrower and its subsidiaries, joint ventures and associates) as well as at solo level (considering the capital strength and risk profile of borrower only).
Reporting of large exposure: As per the LEF, large exposure shall mean exposure of 10% or more of the eligible capital base of the bank in a single counterparty or a group of counterparties. The same shall be reported to Department of Banking Supervision, Central Office, Reserve Bank of India.
Limit on large exposure: the maximum exposure of a bank in a single counterparty shall not be more than 20% of its eligible capital base at any time. This limit shall be raised to 25% of bank’s eligible capital base in case of a group of counterparties.
Eligible capital base, in this reference shall mean the aggregate of Tier 1 capital as defined in Basel III – Capital Regulation as per the latest balance sheet of the company, infusion of capital under Tier I after the published balance sheet date and profits accrued during the year which are not in deviation of more than 25% from the average profit of four quarters.
The LEF shall be applicable on all scheduled commercial banks in India, with respect to their counterparties only.
The LEF has become applicable with effect from April 1, 2019. The revised guidelines on LEF shall also become applicable from the same date with retrospective effect except for the provisions of economic interdependence and non-centrally cleared derivative exposures.
What sort of borrowers are affected?
The revised guidelines have an impact on the borrowers who used to take advantage of different entities and hide behind the corporate veil to avail funding. The introduction of economic interdependence as a criteria for determining connected counterparties ensures that no same persons, whether promoters or management avail facilities through other entity.
Further, borrowers who operate as special purposes vehicles, securitisation structures or other structures having investments in underlying assets would also be affected as the banks will now look-through the structure to identify the counterparty corresponding the underlying asset.
However, the LEF does not address issues relating to lending to any specific sector or such other exposures.
What happens to affected borrowers?
The borrowers taking advantage of corporate veil will no more be able to avail funds in the covers of veil. The entities having same or related parties in their management shall not be able to avail funds exceeding the exposure limit. This would result in shrinkage of the availability of borrowed funds that would have otherwise been available to the entities. Also, entities operating as aforementioned structures, are likely to face contraction of borrowed fund availability.
The global framework on large exposures called the Supervisory framework for measuring and controlling large exposures became applicable from 1st Jan 2019. The key features of the global framework are as follows:
- Norms for determining scope of counterparties and exemptions thereto.
- Specification of limits of large exposures and reporting requirements.
- The sum of exposure to a single borrower or a group of connected borrowers shall not exceed 25% of bank’s available capital base.
- If a G-SIB (Global systemically Important Banks) shall not exceed exposure limit of 15% of its available capital base in another G-SIB.
- Principles for measurement of value of exposures.
- Techniques for mitigation of credit risk.
- Treatment of sovereign exposures, interbank exposures, exposures on covered bonds collective investment schemes, securitisation vehicles or other structures having underlying assets and in central counterparties been specified.
A bank shall lend within concentration limits prescribed in the LEF. For this purpose, the aggregate of concentration in all the connected counterparties shall be considered. Basically, connected counterparties are those parties which have such a relationship among themselves, either by way of control or interdependence, that failure of one of them would result in failure of the other too. The LEF provides the following criteria for determining the “connected” relationship between counterparties.
- Control- where one of the counterparties has direct or indirect control over the other, ‘Control maybe determined considering the following:
- holding 50% or more of total voting rights
- having significant influence in appointment of managers, supervisors etc.
- significant influence on senior management
- where both the counterparties are controlled by a third party
- Qualitative guidance on determining control as provided in accounting standards.
- Common owners, shareholders, management etc.
- Economic interdependence- where if one of the counterparties is facing problems in funding or repayment, the other party would also be likely to face similar difficulties. Following criteria has to be considered for determining economic interdependence between entities:
- Where 50% or more of gross receipts or expenditures is derived from the counterparty
- Where one counterparty has guaranteed exposure of the other either fully or partly
- Significant part of one counterparty’s output is purchased by the other
- When the counterparties share the source of funds to repay their loans
- When the counterparties rely on same source of funding
Look through approach
In case of investing vehicles such as collective investment vehicles, securitisation SPVs and other cases such as mutual funds, venture capital funds, alternative investment funds, investment in security receipts, real estate investment trusts, infrastructure investment trusts etc., the recognition of exposures will be done on a see-through or look-through approach. The meaning of look-through approach is the underlying exposures will be recognised in constituents of the pool or the fund, rather than the fund.
When banks invest in structures which themselves have exposures to underlying assets, the bank shall determine if it is able to look-through the structure. If the bank is able to look-through and the exposure of bank in each of the underlying asset of the structure is equal to or above 0.25% of its eligible capital base, the bank must identify specific counterparties corresponding to the underlying asset. The exposure of bank in each of such underlying assets shall be added to the bank’s overall exposure in the corresponding counterparty.
Further, if the exposure in each of the underlying assets is less than 0.25% of bank’s eligible capital base, the exposure maybe assigned to the structure itself.
However, if a bank is unable to identify underlying counterparties in a structure:
- bank’s exposure in that structure is 0.25% or more of its eligible capital base, the bank shall assign such exposure in the name of “unknown client”.
- bank’s exposure in that structure is less than 0.25% of its eligible capital base, the exposure shall be assigned to the structure itself.
However, if the exposure of bank in the structure is less than 0.25% of the eligible capital base of the bank, the total exposure maybe assigned to the structure itself, as a distinct counterparty, rather than looking through the structure and assigning it to corresponding counterparties.
Overall impact of the LEF
The primary objective of LEF is to limit the concentration of bank in a single group of borrowers. By specifying criteria for large exposures, determination of “connected” relationship, reporting to RBI, ways to mitigate risk etc. the LEF intends to reduce credit risk of banks caused due to concentration in a single borrower or a group of borrowers.
The application of provisions of LEF will reduce the concentration risk of banks which in turn would result in reduction of credit risk of the bank. It would also result in increased monitoring by the RBI on the lending practices of banks. It is likely to reduce the instances of default in repayments, which have become a routine practice nowadays.