Personal revolving lines of credit by NBFCs: nuances and issues

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By Kanakprabha Jethani | Executive

Vinod Kothari Consultants P. Ltd.

(kanak@vinodkothari.com)

Personal loans by NBFCs are mostly extended as revolving lines of credit. Most of these facilities are originated by use of online apps. The lender will be quite keen, if there were no regulatory obstacles, to provide this line of credit by way of a credit card, or virtual credit card. However, there are regulatory barriers to NBFCs issuing credit cards. Therefore, NBFCs end up giving revolving lines of credit. However, the lurking issue is – if a credit card is also an instance of a revolving line of credit, is revolving line of credit an alternative to a card or virtual card, and if so, are there regulatory issues in NBFCs giving personal revolving lines of credit?

The issue is not whether the credit is personal, or for business purposes, for instance, a working capital line of credit. There is a general notion that NBFCs cannot extend working capital lines of credit, while they may give working capital loans.

It is important to examine this issue at length – as is done in this article.

Revolving line of credit: explained

A revolving line of credit is a mode of lending wherein the lender agrees to lend an amount equal to or less than a pre-determined credit limit, as approved for the borrower. The parameters for fixing the limit may be the credit appraisal of the borrower, or, as in case of working capital, the asset liability gap. The borrower may continue to use the line of credit – he may keep repaying, in which case the drawn amount comes down, and then he may re-draw, when the drawn amount goes up. The credit limit gets restored on repayment being made by the borrower. Such line of credit maybe secured or unsecured, depending on the agreement between lender and the borrower. The line of credit is essentially governed by the agreement between the parties. The term “revolving” does not imply that the line of credit is not subject to a review, or repayment. Each line of credit has a review period. If the lender decides not to revolve the line of credit, then the line of credit becomes a term loan, and has to be paid down as per the terms of agreement between the lender and the borrower.

For certain types of facilities, a revolving line of credit is aptly suitable. While, in case of businesses, working capital is best financed by a line of credit, in case of personal finance also, the ability to draw based on a line of credit extends the finances of the borrower, and allows him the flexibility to tap into the funding when needed, and pay it off when not needed. There is, of course, a standing commitment on the part of the lender to provide the facility amount the amount of the limit, for which lenders may charge a continuing commitment charge.

A line of credit implies a commitment to disburse. To the extent of the amount already disbursed, there is a funded facility. To the extent of the limit sanctioned but not yet availed, there is an unfunded commitment to disburse. Undisbursed or partly disbursed loans are common in case of term loans as well – for example, a home loan may take a substantial time to get disbursed.

Similarities between a credit card and revolving line of credit

A credit card is a payment card which the borrower may use for making payments at point of sale. The lender makes payment on behalf of the borrower and then recovers the same from the borrower. A detailed explanation of features of credit cards maybe referred to in one of our write-ups[1].

A revolving line of credit shares some of its features with a credit card, due to which they are seen as equivalents. The similarities between both the modes are as follows:

  • Borrowers can take the disbursement as and when needed.
  • The lender, in both cases, always reserves the right to reduce the credit limit.
  • The lender has to maintain optimum amount of working capital to meet the disbursement demands of the borrowers.
  • The credit limit is restored on repayment being made.

Disparity between credit card and revolving line of credit

Based on usual practice of the market, the following are the key points:

  • Security: A revolving line of credit maybe secured or unsecured, whereas, a credit card is always unsecured.
  • End-use restrictions: There are no restrictions on end use of funds in case of a credit card. However, in a line of credit, the end use is restricted by mentioning the purpose for availing the loan in the loan agreement. Of course, the purpose may be generic – for example, personal use or general business use.
  • Restriction w.r.t. withdrawal of fund: A revolving line of credit does not require a purchase to be made in order to get the funds disbursed. It allows money to be transferred into bank account for any reason without requiring an actual transaction. Whereas, in case of a credit card, payments can be made at Point of Sale (PoS) only and thus, it requires an actual transaction for the disbursement to be made..
  • Interest Period: In case of credit card, if repayment is made within a specified term, no interest is usually charged. However, after the specified period, a high rate of interest is charged. While on the other hand, in case of a revolving line of credit, the interest is calculated from the day of disbursement being made at a comparatively lower rate.
  • Credit Limit: As a market practice, revolving line of credit maybe availed for business purposes or personal purposes and thus, has higher credit limits as compared to a credit card which is generally used for personal purposes only.
  • Manner of Repayment: In case of credit card, funds once availed have to be repaid within a specified period of time, in lump sum. On the other hand, when credit is availed from a revolving line of credit, the same is repaid by the borrower in instalments.
  • Risks: Credit cards come with the risk of theft, misuse etc. However, the same maybe done away with, in case of virtual credit cards.

The fundamental difference

The abovementioned differences are, in essence, surficial. They are based on practices of the market, which may easily be reshaped suiting the needs of the parties. What is the key difference between a card, virtual card and a revolving line of credit? ​

A logical difference that one finds is that while in case of a credit card, the borrower uses it to make payments to third parties, in case of a revolving line of credit, the disbursements are made to the account of the borrower from where the borrower may use it for the required purpose. A credit card is an instrument: it can be used to settle payments, and therefore, becomes a part of the payment and settlement system. A straight line of credit may be tapped by the borrower. After tapping the line, the borrower may use it for making payments and settlements. But the line of credit itself is not an instrument of settling payments.

Therefore, fundamentally, while a revolving line of credit is a promise by lender to the borrower, a credit card is a promise by the lender to the world at large. A lender in case of a line of credit is obliged to make disbursement to the borrower, and only the borrower has a recourse against the lender. However, in case of issue of credit cards, the issuer or the lender is obliged to make payments to any authorized merchant who supplies goods and services against the card.

Understanding Promise to the World at Large

A credit card is a mode of payment. It is a part of the payments and settlement system. Usually, when a customer swipes the credit card at merchant point of sales (POS), the issuer’s liability to make payment to the customer comes into existence. The cardholder is absolved from the liability to the merchant and becomes liable to the issuer.

Settlements in case of a credit card may be understood as follows:

Settlement 1: Merchant and issuer

Settlement 2: Issuer and cardholder

In settlement 1, the time of settlement depends on the specifics of the card network, that is to say, the issuer shall make payment for the goods after a few days, based on the settlement cycle. In effect, at the time of sale, the merchant has not received any payment but has given the goods to the customer based on the strength of credit given by the credit card issuer.

What if the revolving line of credit gives an option to the customer at the merchant POS? Would that amount to a promise to the world at large?

The answer to this question lies in the nitty-gritty of the structure. How would the payment be made to the merchant? Would it result in creation of a relationship between the lender and the merchant?

Lets us assume a revolving line of credit with an option to use the disbursement at merchant POS. Note here that it is the option to use the ‘disbursement’- hence, the settlement takes place as follows:

Settlement 1: Lender disburses loan to the customer’s account/wallet

Settlement 2: Customer makes payment to the merchant

There is no creation of a relationship between the card issuer and the merchant. Post-disbursement, the customer will be liable to repay to the lender.

The thin line of difference between the two concepts lies in the manner of creation of relationships between the parties. The same is highlighted from the above discussion.

The burning question- Can NBFCs extend a revolving line of credit?

Logical answer

The distinction between a revolving line of credit and credit card has already been highlighted above. Further, it is also quite evident from the above discussion that a credit card has wider risks than that of a revolving line of credit. In case of a revolving line of credit, the failure on the part of the lender to disburse the sanctioned amount impacts the borrower. However, if a card issuer defaults, it may affect all those merchants who might have used the card to supply goods and services. There may be a contagion impact, and therefore, the failure of a card issuer has systemic implications. Thus, capital adequacy, solvency and liquidity are far greater issues for a card issuer, than in case of a plain lender against revolving line of credit.

The above discussion leads one to conclude that there are no specific concerns in case of granting of a revolving line of credit. The only concern may be the exposure on account of the sanctioned but undisbursed amount, for which off-balance sheet credit conversion factors exist.

Regulatory support

The above logic may further be supported by the provisions of the Prudential Framework for Resolution of Stressed Assets[2], wherein the Reserve Bank of India (RBI) has recognized the practice of extending revolving line of credit by NBFCs. Following is the relevant extract from the said framework which is applicable on Scheduled Commercial Banks (excluding RRBs), All India Term Financial Institutions, Small Finance Banks, Deposit taking NBFCs and Systemically Important NBFCs (‘NBFC-SI’):

In the case of revolving credit facilities like cash credit, the SMA sub-categories will be as follows:

SMA Sub-categories Basis for classification – Outstanding balance remains continuously in excess of the sanctioned limit or drawing power, whichever is lower, for a period of:
SMA-1 31-60 days
SMA-2 61-90 days

So, firstly there are no express restrictions on extending revolving line of credit and secondly, the RBI recognizes such credit in its frameworks. Therefore, it is safe to take this recognition as a provenance to allowability of extending revolving line of credit by NBFCs.

Further, the provisions relating to restructuring of accounts of borrowers by NBFCs as per the Master Directions also recognize extension of revolving cash credit. It recognizes that roll-over of short-term loans based on actual requirement of borrower and not as a concession considering the credit weakness of the borrower, shall not be considered as restructuring of accounts. For-this purpose, short-term loans shall not include properly assessed regular Working Capital Loans like revolving Cash Credit or Working Capital Demand Loans. The relevant extract is as follows:

“In the cases of roll-over of short-term loans, where proper pre-sanction assessment has been made, and the roll-over is allowed based on the actual requirement of the borrower and no concession has been provided due to credit weakness of the borrower, then these shall not be considered as restructured accounts.

**

Further, Short Term Loans for the purpose of this provision do not include properly assessed regular Working Capital Loans like revolving Cash Credit or Working Capital Demand Loans.”

Concerns on maintenance of capital

In case of line of credit, the disbursements are to be made as and when the borrower requires, therefore, the NBFC should maintain adequate capital and liquidity to meet such abrupt demands. The RBI Master Directions take care of the solvency concerns of the NBFCs extending revolving line of credit. Liquidity standards, internally set by the NBFC under the ALM process, also contain safeguards by taking the undisbursed amount of committed facilities as “required funding”.

The Master Directions for NBFC-SI[3] requires the NBFC-SIs to maintain a Capital to Risk Assets Ratio (CRAR) of 15%. It provides the detailed methodology of how the risk-weighting of assets is to be done to meet the CRAR requirement.

Following is the extract from the said methodology:

Instrument Credit Conversion Factor
Other commitments (e.g., formal standby facilities and credit lines) with an original maturity of:

 

up to one year

over one year

  

 

 

20

50
Similar commitments that are unconditionally cancellable at any time by the applicable NBFC without prior notice or that effectively provide for automatic cancellation due to deterioration in a borrower’s credit worthiness  

 

0

 

Thus, depending on the terms of the revolving line of credit, a credit conversion factor will be multiplied to the total amount of obligation and the capital will be maintained accordingly.

Further, the Master Directions for Non-Systemically Important NBFCs (NBFC-NSIs)[4] require the NBFC-NSIs to maintain a leverage ratio of 7. Leverage Ratio shall mean Total outside Liabilities/ Owned Funds.

The definition of Total Outside Liabilities can be derived from Master Directions for Core Investments Companies (CICs)[5] which is as follows:

“outside liabilities” means total liabilities as appearing on the liabilities side of the balance sheet excluding ‘paid up capital’ and ‘reserves and surplus’, instruments compulsorily convertible into equity shares within a period not exceeding 10 years from the date of issue but including all forms of debt and obligations having the characteristics of debt, whether created by issue of hybrid instruments or otherwise, and value of guarantees issued, whether appearing on the balance sheet or not.”

Due to the leverage restriction, NBFC-NSIs shall also automatically be restricted from lending more than its capacity.

Nuts and bolts to the structure of revolving line of credit

From the above discussion, it is clear that NBFCs may extend revolving line of credit. However, from the prudence perspective, following are certain essentials that must be kept in mind by the NBFCs while extending a revolving line of credit:

  • It is advisable for the lender to retain the right to unconditionally cancel the commitment of revolving line of credit. In such case, the credit conversion factor for such exposure shall be “0”.
  • The terms of the line of credit must provide for review and reset as the lender may deem fit.
  • The lender must ensure that it maintains liquidity to meet abrupt calls for disbursement by the borrower.
  • In case the tenure of revolving line of credit is pre-determined, the credit conversion factor shall accordingly be taken as 20 or 50.

Conclusion

Though there are similarities between features of a credit card and a revolving line of credit, but the differences are not skin-deep. Further, it may also be argued that the RBI Master Directions recognize NBFCs extending line of credit, by providing expressly for prudential framework for SMA classification for revolving line of credit.

 

[1] https://vinodkothari.com/2018/07/credit-cards-and-emi-cards-from-an-nbfc-viewpoint/

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

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

[4] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/MD44NSIND2E910DD1FBBB471D8CB2E6F4F424F8FF.PDF

[5] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/39MD440D125D51C2451295A5CA7D45EF09B9.PDF

SEBI’s Framework for listing of Commercial Papers

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Munmi Phukon | Principal Manager, Vinod Kothari & Company

corplaw@vinodkothari.com

Introduction

SEBI on 22nd October, 2019 came out with a Circular to provide for the Framework for listing of Commercial Papers (CPs). The Circular is based on the recommendations of the Corporate Bonds & Securitization Advisory Committee (CoBoSAC) chaired by Shri H. R. Khan which was set up for making recommendations to SEBI on developing the market for corporate bonds and securitized debt instruments.

CPs are currently traded in OTC market though settled through the clearing corporations. Evidently, listing of CPs for trading in stock exchanges will enhance the investor participation which will in turn help the issuers to cope up with their short term fund requirements. SEBI’s current move in laying down the Framework is to ensure investor protection keeping in mind a prospective broader market for CPs. The Circular is mostly concerned about making elaborate disclosures at the time of submitting the application for listing and also some disclosures on a continuous basis post listing of the CPs.

As evident from the content of the Circular, some of the disclosure requirements proposed at the time of application for listing of the CPs are same as provided in the format of Letter of Offer as provided in the Operational Guidelines on CPs[1] (Operational Guidelines) prescribed by the Fixed Income Money Market and Derivatives Association of India (FIMMDA). However, there are certain additional requirements which are discussed in this article.

Disclosure requirements at the time of application for listing

Annexure I of the Circular provides for the disclosure requirements which the issuers are required to make at the time of submitting the application and the content of the same is quite elaborative which covers almost every aspect of an issuer. The broad segments of disclosures are as below:

General details of issuer
Under this heading, details such as, name, CIN, PAN, line of business group affiliation will be given. The issuer will also be required to give name of the managing director, CEO, CFO or president as chief executives. The disclosures are same as provided in the Operational Guidelines.

Details of directors
Details of current set of directors including inter alia their list of directorships and the details of any change in directors in the last 3 financial years and the current year shall be required to be disclosed.  Currently, the Operational Guidelines do not require these details.

Details of auditors
Details of current auditor and any change in directors in the last 3 financial years and the current year shall be required to be disclosed. Currently, the Operational Guidelines do not require these details.

Details of security holders
Under this category, the disclosure shall be made for top 10 equity shareholders, top 10 debt security holders and top 10 CP holders. However, the date of determination of the same has not been provided. Currently, the Operational Guidelines do not require these details.

Details of borrowings as at the end of latest quarter before filing of the application
Details of borrowings are divided into 3 parts-

a.      Details of debt securities and CPs. The Operational Guidelines require the details of CPs issued during last 15 months and also of the outstanding balance as on the date of offer letter.

b.      Details of other facilities such as secured/ unsecured loan facilities/bank fund based facilities, borrowings other than above, if any, including hybrid debt like foreign currency convertible bonds (FCCB), optionally convertible debentures / preference shares from banks or financial institutions or financial creditors. The details related to outstanding debt instruments and bank fund based facilities are same as provided in the Operational Guidelines however, it was silent on the hybrid instruments.

c.      Details of corporate guarantee or letter of comfort along with name of the counterparty on behalf of whom it has been issued, contingent liability including debt service reserve account (DSRA) guarantees/ any put option etc. Operational Guidelines do not require these details currently.

Information related to the concerned issue

The content is more or less similar to the details required to be provided in the Letter of Offer as provided in the Operational Guidelines. The additional requirements are as follows:

d.     Details of credit rating letter issued should not be older than one month on the date of opening of the issue and

e.      Copy of the executed guarantee.

Financial information
The stock exchanges shall be provided with the following financial information-

a.      Audited / Limited review of half yearly consolidated financial statements, if available;

b.      Financial statements along with auditor qualifications, if any, for last 3 years along with latest available financial results;

c.      Latest available quarterly financial results prepared under Regulation 33, if applicable;

d.     Latest audited financials not older than six months from the date of application. However, companies already complying with the Listing Regulations may submit unaudited financials with limited review.

The Operational Guidelines currently require the financial summary only of last 3 FYs to be provided in the letter of offer.

Material information
The following shall be disclosed-

a.      Details of all default/s and/or delay in payments of interest and principal of CPs, (including technical delay), debt securities, term loans, external commercial borrowings and other financial indebtedness including corporate guarantee issued in the past 5 financial years including in the current financial year.

b.      Ongoing and/or outstanding material litigation and regulatory strictures, if any.

c.      Any material event/ development having implications on the financials/credit quality including any material regulatory proceedings against the issuer/ promoters, tax litigations resulting in material liabilities, corporate restructuring event which may affect the issue or the investor’s decision to invest / continue to invest in the CP.

The disclosures in point (a) and (c) above are not required to be disclosed in the letter of offer as per Operational Guidelines.

Asset Liability Management (ALM) disclosures for NBFCs and HFCs

The Circular specifically provides for some additional disclosures for NBFCs and HFCs which are currently not required to be provided in the letter of offer prescribed by FIMMDA:

a.      NBFCs shall make disclosures as specified for NBFCs in SEBI Circular nos. CIR/IMD/DF/ 12 /2014[2], dated June 17, 2014 and CIR/IMD/DF/ 6 /2015, dated September 15, 2015. Further, “Total assets under management”, under the aforesaid Circular dated September 15, 2015 shall also include details of off balance sheet assets.

b.      HFCs shall make disclosures as specified for NBFCs in the said SEBI Circular no. CIR/IMD/DF/ 6 /2015, dated September 15, 2015, with appropriate modifications viz. retail housing loan, loan against property, wholesale loan – developer and others.

In terms of the SEBI Circular dated June 17, 2014, NBFCs are required to disclose the details with regards to the lending done by them, out of the issue proceeds of previous public issues, including details regarding the following:

a.      Lending policy;

b.      Classification of loans/advances given to associates, entities /person relating to Board, Senior Management, Promoters, Others, etc.;

c.      Classification of loans/advances given to according to type of loans, sectors, maturity profile, denomination, geographical classification of borrowers, etc.;

d.      Aggregated exposure to the top 20 borrowers with respect to the concentration of advances, exposures to be disclosed in the manner as prescribed by RBI in its guidelines on Corporate Governance for NBFCs, from time to time;

e.      Details of loans, overdue and classified as non-performing in accordance with RBI guidelines.

The Circular dated September 15, 2015 provides for the following additional disclosures:

a.      In case any of the borrower(s) of the NBFCs form part of the “Group” as defined by RBI, then appropriate disclosures shall be made as regards the name of the borrower, Amount of Advances /exposures to such borrower and Percentage of Exposure;

b.      A portfolio summary with regards to industries/ sectors to which borrowings have been made by NBFCs;

c.      Quantum and percentage of secured vis-à-vis unsecured borrowings made by NBFCs;

d.      Any change in promoter’s holdings in NBFCs during the last financial year beyond a particular threshold (RBI has prescribed such a threshold level at 26% at present).

Continuous disclosures after listing of CPs

Annexure II of the Circular provides for the disclosure requirements which shall be observed on a continuous basis. The details of such disclosures are broadly as below:

a.      Submission of financial results

i.          For issuers which are required to follow Chapter IV of SEBI LODR Regulations i.e. whose specified securities are listed, the financial results shall be in the format as prepared and submitted under Regulation 33. The issuers will also be required to disclose along with the financial results the additional line items as required under Regulation 52(4). This shall also apply to an issuer which is required to prepare financial results for the purpose of consolidated financial results in terms of Regulation 33;

·      The line items as provided under Regulation 52(4) are as below:

o  credit rating and change in credit rating (if any);

o  asset cover available, in case of non- convertible debt securities;

o  debt-equity ratio;

o  previous due date for the payment of interest/ dividend for non-convertible redeemable preference shares/ repayment of principal of non-convertible preference shares /non- convertible debt securities and whether the same has been paid or not; and,

o  next due date for the payment of interest/ dividend of non-convertible preference shares /principal along with the amount of interest/ dividend of non-convertible preference shares payable and the redemption amount;

o  debt service coverage ratio;

o  interest service coverage ratio;

o  outstanding redeemable preference shares (quantity and value);

o  capital redemption reserve/debenture redemption reserve;

o  net worth;

o  net profit after tax;

o  earnings per share:

 ii.          For issuers which are required to comply with provisions of Chapter V of the Regulations only i.e. whose NCDs/ NCPSs are only listed, the financial results shall be prepared and submitted as per regulation 52; and

iii.          Issuers who only have outstanding listed CPs shall prepare and submit financial results in terms of Regulation 52.

 

b.      Disclosure of material events

The issuers shall disclose the following details to the stock exchange(s) as soon as possible but not later than 24 hours from the occurrence of event (or) information:

i.          Details such as expected default/ delay/ default in timely fulfilment of its payment obligations for any of the debt instrument;

ii.          Any action that shall affect adversely, fulfilment of its payment obligations in respect of CPs;

iii.          Any revision in the credit rating;

iv.          A certificate confirming fulfilment of its payment obligations, within 2 days of payment becoming due.

c.      ALM Statements for issuers who are NBFCs/HFCs

NBFCs and HFCs will be required to simultaneously submit to the stock exchanges the latest ALM statements as and when they submit the same to respective regulator(s) viz RBI/NHB, as applicable.

d.     CEO/ CFO Certification

A certificate from the CEO/CFO shall be submitted by the issuers to the recognized stock exchange(s) on quarterly basis certifying that CP proceeds are used for disclosed purposes, and adherence to other listing conditions.

Conclusion

As mentioned above, the disclosure requirements as provided in the Circular are meant for assisting the investors in taking an informed decision. Since the requirements are new, it is expected that apart from the stock exchanges, FIMMDA/ RBI will also come out with the revised Operational Guidelines/ Directions in order to bring more clarity on this aspect.

 

 

 

 

 

 

 

 

 

 

 

[1] http://www.fimmda.org/modules/content/?p=1033
[2] https://www.sebi.gov.in/sebi_data/attachdocs/1403065620622.pdf

Resurrecting the Dead- A discussion around schemes of arrangement in liquidation

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-Sikha Bansal

(resolution@vinodkothari.com)

In India, the provisions for schemes of compromises/arrangements have formed a part of the Indian Companies Act, 1913 and then the successors – the Companies Act, 1956/2013 following the English law.

After Sick Industrial Companies (Special Provisions) Act, 1985 (‘SICA’) was enacted, it was not possible to invoke the provisions relating to the schemes of compromise/arrangement for companies under BIFR[1].  However, the Insolvency and Bankruptcy Code, 2016 (‘Code’) made amendments[2] in section 230 of the Companies Act, 2013 so as to include a liquidator appointed under the Code as eligible to propose a scheme under that section.  Later, the Insolvency and Bankruptcy Board of India (Liquidation Process) Regulations, 2016 (‘Regulations’) were amended[3] to facilitate schemes under section 230 of the Companies Act, 2013. Given that the company gets a fair chance of resolution under the Code before being pushed to liquidation, the window for completion of scheme has been provided only for the initial duration of 90 days from the liquidation order. Read more →

Proposed Group Insolvency Framework in India

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[A brief discussion on the Report of the Working Group on Group Insolvency]

– Priya Udita

(resolution@vinodkothari.com)

 

With group structures holding prominence in business landscape of India, there has been a need to frame a holistic group insolvency framework. There are cases where the stakeholders may maximise their interests and the possibility of revival of companies may be higher, if companies in a group are resolved together. However, the Insolvency and Bankruptcy Code, 2016 (‘IBC’) does not envisage a framework to either synchronise insolvency proceedings of different companies in a group or to resolve their insolvencies together. Recently, the need was realised in the insolvency resolution of some corporate debtors such as Videocon, Era Infrastructure, Lanco, Educomp, Amtek, Adel, Jaypee and Aircel, where special issues arose from their interconnection with other group companies. In some of these cases, the Adjudicating Authority under the Code as well as the Supreme Court, have passed orders to partially ameliorate such issues. This highlighted the need to examine the desirability and feasibility of having a group insolvency framework. Read more →

SEBI disallows investment by Mutual Funds in unlisted debt instruments

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Read more →

Partial credit enhancement scheme gets off to a flying start

/0 Comments/in , , /by

Abhirup Ghosh

abhirup@vinodkothari.com

The Government of India, with an intent to infuse liquidity in the financial sector, in the Union Budget, 2019, proposed to provide partial credit guarantee for sale of high quality assets of good NBFCs/ HFCs to public sector banks. Subsequently, on 10th August 2019, the FinMin launched the scheme[1].

Initially, there were various ambiguities in the scheme, however, later on, the same were clarified by the Government and the Reserve Bank of India. The start had to be slow and it took almost a month to figure things out and keep the systems in place, meanwhile an industry forum was also organised by the Indian Securitisation Foundation and Edelweiss Group to deliberate on the various issues surrounding the matter. However, close to the end of the second quarter, the product gained traction and reported volume of close Rs. 17,000 crores have already been done, with another Rs. 15,000 crores worth deals in the pipeline.

This has come as a relief for all the financial sector entities, as the banks are now keen to look at NBFC assets, considering that – a) the pool of loans are of good quality[2], b) additionally, the GOI will provide a first loss guarantee on the pool of assets. AA rating is itself treated as a good rating and with an additional sovereign guarantee over that, the transaction technically becomes risk free in the hands of the purchasing bank.

As per market sources, majority of the transactions are being priced in the range of 9%-10%.  Considering the level of stress the financial sector is going through, the transactions are being priced decently.

Some ambiguities still linger on

Though the transactions are being processed seamlessly, however, some ambiguities with respect to accounting treatment of the transaction are still worrying the financial institutions. The transaction being a mix of securitisation and direct assignment transaction throws new challenges. One of the key issues in case of any direct assignment/ securitisation transaction is whether the transaction would result in de-recognition of financial assets from the books of the originator. The de-recognition principles are laid down in Para 3.2 of Ind AS 109. These principles allow an entity to remove financial assets from its books either based on substantial transfer of risks and rewards, or based on a surrender of control. If the risks and rewards are substantially retained, de-recognition is denied. While the conditions of assessing whether there has been a substantial transfer of risks and rewards are subjective, there is substantial amount of global guidance on the subject.

Since Indian securitisation transactions involve credit enhancements normally to the extent of AAA-ratings, and sweep all residual excess spread, most of the securitisation transactions as currently done fail to transfer risks and rewards in the pool of assets, and consequently, do not lead to de-recognition of financial assets. However, in case of direct assignment transactions, the transfer of assets presumably leads to pari passu transfer of risks and rewards in the assets. Therefore, the same leads to de-recognition of assets transferred by the originator to the buyer.

In case of transfers under this Scheme, the assets must be rated as high as AA, which is impossible to achieve unless there is a tranching of pool done. This signifies that the first loss support to the pool would come from the originator or from a third party. There is certainly a strong element of risk retention by the originator. Correspondingly, the excess spread is also retained by the originator. However, whether the same would be regarded as “substantially all the risks and rewards” in the pool is still questionable. The very need for a sovereign guarantee signifies that there is a left over risk which requires to be covered by the Government guarantee..

Therefore, the transaction seems to be splitting the overall risks of the pool into 3 pieces – partially, retention by the originator, partially going to the GoI, and the remaining or super-senior part, going to the bank. It may be noted that if there is a significant transfer of risks, then it may not be separately necessary to establish a transfer of rewards as well, as risks and rewards are concomitant.

This, however, is subject to interpretation and there is a strong likelihood of different opinions in this regard. One shall have to wait for the finalisation of quarterly accounts of the major financial institutions to understand the direction in which the industry is inclined to.

The other ambiguity that continues is regarding the guarantee commission. On the apparent reading of the scheme, it seems that guarantee commission to be paid to the GOI, has to paid annually, however, another school of thought believes that the guarantee commission will have to be paid only once during the lifetime of the transaction. A clarification in this regard from the GOI will be very helpful.

Impact on other structured finance transactions

Interestingly, this scheme has, so far, not hampered the otherwise booming securitisation industry. The first half of the FY 2020 has reported recorded approximately Rs 1 lakh crores worth transactions, which is 48% year on year growth.

[1] http://pib.gov.in/newsite/PrintRelease.aspx?relid=192618

[2] As per the Scheme, the pool should be highly rated. It should be rated at least AA even before the government guarantee.