New regime for securitisation and sale of financial assets

Team, Vinod Kothari Consultants

finserv@vinodkothari.com

On Monday, 8^th 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”

The decision to revisit the regulatory framework for securitisation and sale of loans was announced as part of the Statement on Developmental and Regulatory Policies issued along with the First Bimonthly Monetary Policy for the year 2019-20 on April 4, 2019. Subsequently, in May, 2019 the RBI appointed two separate working groups, one under the Chairmanship of Dr. Harsh Vardhan, and one under the chairmanship of Mr. T. N. Manoharan, respectively for review of the regulatory frameworks for securitisation and sale of loans. The two working groups submitted their reports, respectively on 05th September, 2019 and 03rd September, 2019 .

The present proposals, awaited for nine months,  are largely based on the recommendations of the two working groups.^[1]

Regulatory framework for securitisation and direct assignments is presently contained in two sets of common guidelines – viz., guidelines of 2006 and 2012 – both are now being separated, as per recommendations of the Harsh Vardhan Committee, into two separate Directions. Also, the earlier regulatory regime had two similarly-worded guidelines, one set applicable to banks and another set applicable to NBFCs. In case of HFCs, which were, till recently, under the regulatory ambit of NHB, there were no specific guidelines, but it was a commonplace practice to follow the RBI guidelines as in case of NBFCs. All of these are now being clubbed together into a common set of Directions, applicable to banks, financial institutions and HFCs.

Securitisation

The draft Reserve Bank of India (Securitisation of Standard Assets) Directions, 2020 [SSA Directions] will apply to banks, small finance banks, term finance institutions (NABARD, EXIM Bank, NHB, and SIDBI), NBFCs, and HFCs. Their applicability to the so-called term finance institutions, including SIDBI or NHB, seems a little out of place,  as these institutions themselves are engaged in providing securitisation platforms. For example, NHB itself has provided a securitisation platform for residential mortgage backed securities (RMBS). SIDBI provides synthetic credit support by providing credit enhancements to loan and loan pools of MSME loans.

What all will be eligible to be securitised?

Like the present guidelines, the proposed guidelines also allow securitisation of all types of loans except for the following:

1. Revolving credit facilities;
2. Loans having bullet repayment of both principal and interest; and
3. Securitisation exposures

Exception has been granted to agricultural loans having bullet repayment of both principal and interest with tenor upto 24 months, and also to trade receivables discounted payable on maturity with tenor upto 12 months. These facilities shall be eligible for securitisation where a borrower (in case of agricultural loans) /a drawee of the bill (in case of trade receivables) has fully repaid the entire amount of last two loans/receivables (one loan, in case of agricultural loans with maturity extending beyond one year) within 90 days of the due date.

However, in an important change, it will now be possible for an originator to securitise even those loans which have been purchased/acquired from others, provided the same have been held by the originator for at least 12 months. Present guidelines completely prohibit securitisation of purchased exposures.

Note that the types of assets that will remain ineligible for securitisation also remain the same: synthetic exposures, re-securitisation, and securitisation of revolving credit facilities.

Minimum holding period (MHP) rules

In case of loans  other than residential mortgage loans or home loans, the MHP requirement remains the same – 6 months for loans between 2-5 years original maturity, and 12 months for loans with 5 years maturity or longer.

However, in case of residential mortgage loans, there is a significant change – the MHP Has been reduced to 6 months, or 6 instalments, whichever is later. This change was strongly being advocated, since there is a substantial seasoning that anyways happens as home loans are typically disbursed in tranches. Note that there is an important provision in the proposed Directions that the MHP will start running only when the loan is fully disbursed, or, in case of a loan for acquisition of an asset, the asset has been acquired.

MRR requirements

In case of minimum risk retention (MRR) requirements, as in case of MHP requirements, relaxation has been given in case of RMBS transactions. The existing MRR as in case of non-mortgage transactions remains the same, that is, for loans with tenor upto 24 months – 5% and for loans with more than 24 months tenor – 10%.

However, in case of RMBS transactions, the MRR has been reduced to 5% irrespective of the tenure. Earlier, effectively, the MRR transactions for home loans was invariably 10%, as the tenure of home loans was seldom less than 5 years.

The industry advocacy has been strongly for reducing the MRR for home loans,as the default rates in home loans are much lower. In fact, the stakeholders have consistently advocated the MRR requirement should be done away with in case of “qualifying residential mortgage loans”, as has been done by regulators in the USA.

Importantly, the Directions clarify that the MRR is a percentage of the unamortised principal – so, it is not that the MRR remains fixed in absolute terms.

Revolving structures

There have been doubts as to whether transactions with revolving or replenishing structures are allowed in India. The Directions set all doubts to rest – by having elaborate provisions for replenishing structures. In fact, the Directions come with a revolving period, and an amortization period, and also provide for illustrative early amortization triggers.

Notably revolving or replenishing structures are particularly useful for short-tenure loans such as microfinance loans, consumer loans, pay-day loans, etc.

Listing requirements

A new stance of the Directions is the requirement that forces listing of residential mortgage backed securities with underlying exposures of Rs. 500 crores or more. However, listing of RMBS transactions with underlying exposures of less than Rs. 500 crores and other securitisation transactions have been made optional.

Note that listing of securitised tranches is covered by SEBI’s (Issue and Listing of Securitised Debt Instruments)  Regulations, 2008. Listing was not very common in the past, but recently, with mutual funds having been required to invest only in listed securities, listing of securitised debt instruments has also been increasing.

It is important to note that the SDI Regulations of SEBI may require tweaking, as certain parts of these Regulations, particularly those dealing with corporate governance etc. are inappropriate for securitisation.

Directions contain accounting requirements

Several years after proper securitisation accounting standards have been implemented, the Directions possibly still carry the hangover from the 2006/2012 Guidelines, and have written the accounting rules for securitisation, importantly, the rules pertaining to recognition of profits. It is  important to note that all of this is now clearly defined by IndAS 109 and therefore, there was no reason for the RBI to state these rules.

In any case, these rules conflict with the accounting rules, and therefore, ought to be deleted.

STC rules

Global regulators have implemented rules for STC securitisation. The concept of STC securitisation was first introduced by European regulators as Simple Transparent and standardised (STS) framework and subsequently made a part of Basel III securitisation framework as well.

The idea of global regulators is to distinguish between what is simple, transparent and comparable, from the ones which are exotic, complex or structured. the former are more akin to bonds – and therefore, these have the twin advantages of structural robustness with credit enhancements and bankruptcy remoteness, as also the simplicity of corporate bonds. Hence, STC securitisations have been promoted by laying down lower risk weights.

In India too, RBI is introducing an STC framework, with lower risk weights for Standardised approach as well as External Ratings Based Approach (ERBA) similar to the lower weights prescribed under Basel norms.

Further, homogeneity of a pool which lacked clarity in the earlier guidelines, is now incorporated into the STC framework proposed by RBI. The test for homogeneity is the same as that of Basel III Framework.

The detailed requirements for STC securitisations are given in Annex 1. These are akin to the STC rules of Basel securitisation framework. Note that we have given a detailed guidance on the STC rules of Basel securitisation framework –

http://vinodkothari.com/2020/01/basel-iii-requirements-for-simple-transparent-and-comparable-stc-securitisation/

See-through approach

The Directions propose a see-through approach for monitoring of the credit of the securitisation exposures. Though the Present Guidelines also talks about credit monitoring, however, not as elaborately as proposed in the Directions.

The Directions states the investors should consider the underlying exposures as a the counter-party instead of the SPE. In fact, the securitisation exposures of the lenders should be subject to the RBI’s Large Exposures Framework issued on 3rd June, 2019. It seems the see-through approach must be adopted even while applying the provisions of the Large Exposure Framework.

The Lenders are allowed to initiate necessary actions based on ongoing monitoring and in a timely manner, performance information on the underlying exposures.

Mezzanine tranches will become the rule for capital relief

In a major recast of the capital rules, there are two separate conditions based on which the capital relief, that is, exclusion of securitised assets from risk weighted assets of the originator – will be computed.

The two separate scenarios are – one where there is a mezzanine tranche, and one where there is no mezzanine tranche.

If there is a mezzanine tranche, the originator should not be holding more than 50% of the mezzanine tranches. Of course, the MRR rules require that the first loss or equity tranche will be retained by the originator. Thus, the maximum holding of the originator for the capital relief will be:

• 100% of the first loss tranche, or
• Maximum 50% of the mezzanine tranche

this condition will not be difficult to comply with, because, mostly, if there are mezzanine tranches, the originator will be holding the first loss tranche only.

However, if the transaction does not have at least 3 tranches (that is, there is no mezzanine tranche), the originator should not be holding more than 20% of the “exposure value” of the first loss positions. If the intent of this is to limit the originator’s position only to 20% of the first loss tranche, this is absolutely impractical. However, if the intent is to relate the “exposure value” to the total of the asset pool, then, what is being implied is that the first loss tranche shall not be more than 20% of the total pool, which is mostly easy to satisfy.

There is another rule which defines what the thickness of the first loss tranche should be. This requirement states that the minimum first loss tranche should be the product of (a) exposure (b) weighted maturity in years and (c) the average slippage ratio over the last one year.

The slippage ratio is a term often used by banks in India to mean the ratio of standard assets slipping to substandard category. So, if, say 2% of the performing loans in the past 1 year have slipped into NPA category, and the weighted average life of the loans in the pool is, say, 2.5 years (say, based on average maturity of loans to be 5 years), the minimum first loss tranche should be [2% * 2.5%] = 5% of the pool value.

NBFCs also eligible to use ratings-based risk weights for securitisation tranches

While Basel’s ratings-based risk weights were applicable to banks, the same were not available to NBFCs.

Currently, the draft Directions propose the following:

• For Banks: the Banks will have an option of choosing between either Securitisation – External Ratings Based Approach (SEC-ERBA) or Securitisation Standardised Approach (SEC-SA) for risk weight of exposures.
• For NBFC (including HFCs): the draft Directions currently propose that the NBFCs should follow SEC-ERBA for risk weighting.

Also, the risk weights for securitisation tranches largely emulate the Basel securitisation framework and range from as low as 15% risk weight, to 1250% (which is the same as full deduction from capital). As against the Basel securitisation framework for the so-called ratings-based approach, there are risk weight points for almost each rating notch, all the way upto CCC rating.

However, by way of an incentive, if the securitisation transaction abides by the STC rules, it will be eligible for lower risk weights – as low as 10%.

Applicability to existing securitisation transactions

Chapters VI and VII are intended to apply to existing securitisation transactions too. These parts, respectively, deal with capital requirements and disclosures.

The capital requirements require the Investors/ Lenders to maintain capital on all securitisation transactions, even on the ones arising due to provision of credit mitigants. Further, as discussed earlier, even NBFCs will have to provide risk weights under SEC-ERBA method; with the extension of these requirements on existing transactions as well, NBFCs will have to change the way they have been providing capital on securitisation exposures.

The capital requirements also deal with derecognition of assets for the purpose of capital relief. As already discussed, the derecognition criteria laid down in the Directions spells out the requirement of mezzanine tranches to avail capital relief or retention of not more than 20% exposure in first loss tranches by the Originator.

The disclosure requirements relate to disclosures in the Servicer/ Trustee/ Investor’s Report and Notes to Accounts of the Originator. The intention of disclosing information in the Servicer’s Report is to make material information available for prospective investors.

The Originators are required to disclose the outstanding amount of loans securitised by them, held by the SPEs and the amount of exposure retained by the Originator.

Servicing to be on arms’ length terms

This is an area where stakeholders may have to mend their ways. Currently, the servicing of securitised assets is carried out by the Originator itself, and a moderate fee is charged for such servicing. Either an ad hoc fee is charged for the servicing or as a percentage on the actual collections.

The draft Directions, in paras 60 and 61, state the servicing function should be on an arm’s length basis. The servicer should not have any obligation to pay the cash flows in case of shortfall in collection. If the servicer plugs in the shortfall, then it will be deemed to have extended a liquidity facility and risk weighting should be done accordingly.

Note that arms’ length servicing fees will cause major GST losses, since the SPV that avails of the servicing by the originator/servicer will not be able to pass on GST credit to the investors.

Read our related write ups here –

1. Originated to transfer- new RBI regime on loan sales permits risk transfers;
2. Comparison of the Draft Securitisation Framework with existing guidelines and committee recommendations;
3. Comparison of the Draft Framework for sale of loans with existing guidelines and task force recommendations;
4. Inherent inconsistencies in quantitative conditions for capital relief;
5. Presentation on Draft Directions on Securitisation of Standard Assets;
6. Presentation on Draft Directions Sale of Loans;
7. YouTube video of the webinar held on June 12, 2020.

^[1] Indian Securitisation Foundation did a stakeholders’ meeting in Mumbai on 10th July, 2019 and thereafter, made a presentation with the Harsh Vardhan Working Group. Several of our recommendations have been reacted positively by the Working Group. For a write up on the recommendations of Harsh Vardhan Committee and recommendations made by us on behalf of ISF, see our report here – http://indiansecuritisation.com/product1/21570707129.pdf