Stressed for reform: RBI proposes stressed assets securitisation and loss provisioning
– Team Finserv (finserv@vinodkothari.com)
Rating agency Standard and Poor’s recently noted that at least 60 percent of the world’s economies are either into recession already or heading towards the same. The same report notes that 29 of the 33 countries covered by the study have disorderly inflation above the targets set by the respective central banks[1]. OECD’s interim report of September, 2022 says that despite a boost in activity as COVID-19 infections drop worldwide, global growth is projected to remain subdued in the second half of 2022, before slowing further in 2023 to an annual growth of just 2.2%. This is accompanied by inflationary pressures in most countries[2]. India is one of the two countries projected to have a growth rate of more than 6%.
The RBI’s monetary policy, September, 2022, as expected, has announced an interest rate hike of 50 bps in the policy rates.
While this was expected, the RBI has also proposed at least 2 significant measures to prepare the financial sector for the stressful period into which the financial sector is clearly entering. One pertains to securitisation of stressed assets, and the other, moving from regulatory provisions to expected credit losses, in line with global accounting standards.
Securitisation of stressed assets
Currently, the regulatory framework for securitisation of assets permits only “standard” assets to be securitised. For quite some time now, the RBI has been discussing potential approaches to securitisation of non-performing assets.[3] Securitisation of non-performing assets was also discussed in the 10th Securitisation Summit organised by VKCPL.[4]
Global securitisation regulations do not contain a regulatory bar on securitisation of NPLs. A securitisation of standard assets qualifies for STS treatment; however, there is no outright bar on securitisation of what does not qualify to be standard.
Securitisation of non-performing loans can relate to either (a) corporate loan exposures; or (b) retail loan exposures.
As for corporate loan exposures, the same requires specialised workout and management skills. India has the ARC model for dealing with corporate NPLs; different countries have, at different times, used different approaches to handling centralised solutions to NPL crises. For instance, at the time of the Asian financial crisis, with domestic structured finance markets (especially for stressed loans) underdeveloped, certain Asian companies turned to more developed overseas securities markets, like the US, to sell their non-performing loan portfolios. This included KAMCO (Korea 2011) – KAMCO issued securities in the domestic market that were backed by guarantees from third-party banks(especially state banks with lower NPL levels) and also tapped the foreign markets by setting up overseas SPVs and supported by dedicated marketing campaigns. In certain other Asian countries, securitisation bonds were issued only domestically primarily due to the absence of currency risk hedging markets like in the case of Malaysia’s AMC, Danaharta.[5] In more recent times, certain jurisdictions across Europe (like Italy – GACS[6] and Greece-HERCULES[7]) have launched sovereign guarantee schemes to support the securitisation of NPLs. These schemes were launched around the time the European banks were facing high rates of NPL accumulations.
Given the special servicing skills required in case of corporate NPLs, securitisation of such assets may not be appropriate, and may be the current ARC mechanism may continue to handle such assets.
However, when it comes to retail NPLs, it is important to understand that quite often, what is regulatorily classified as NPL, is actually not completely sticky. A borrower reaches the regulatory NPL zone, and is not able to clear his dues completely, and therefore, stays as “non performing”. However, the borrower continues to make regular payments. Such loans are commonly called “re-performing loans” (RPLs).
In the US, where Federal Government sponsored Agencies play a significant role in the RMBS market, one can find the concept of managing re-performing loans that caters to the possibility that loans in the MBS pools may become distressed. An example of this structure is the “Fannie Mae – Single-Family Reperforming Loan (RPL) Securitization”.[8] When loans are securitised, they are placed in an MBS trust guaranteed by the Agency (Fannie Mae) with the Agency supplementing amounts received by the trust to ensure timely payment of principal and interest to the MBS investor in cases of delinquency in the underlying loan pool. If a loan becomes 24 months delinquent, or in the case of certain other pre-specified exceptions including permanent hardship, the Agency removes the loan from the trust and holds it in its retained portfolio as a distressed asset. To support borrowers in need of assistance, a mortgage loan modification, instead of enforcing foreclosure, might be made available to the borrowers experiencing permanent or long-term hardship and can no longer afford to make regular monthly mortgage payments. Loan servicers evaluate the most appropriate workout program for the borrower based on the type of hardship, duration of delinquency, and the borrower’s intention to remain in the property. In case the workout program is effective and the loan starts reperforming they are added to the mortgage pool and become eligible for securitisation into a new MBS.
As per the press release, the RBI is expected to come up with a Discussion Paper on securitisation of stressed loans for the Indian market. The exact approach to be used by the RBI will be known based on its DP.
Loan provisioning based on expected credit losses
India’s financial sector has, for long, been working on regulatory provisions for NPLs. However, banks world over go by the financial accounting standards. The standards require impairment of financial assets based on 3 categories. The provisions to be maintained are required to reflect the expected losses as estimated by the Company. Accordingly, the provisions are referred to as Expected Credit Losses (ECL).
The asset classification and provisioning under ECL works as follows:
| Classification | Criteria | Provisioning requirement |
| Stage 1 | No reason to believe that there has been significant increase in credit risk (SICR) since initial recognition | 12-months expected losses |
| Stage 2 | SICR has occurred | Lifetime expected losses |
| Stage 3 | Credit Impaired | Reduction in value of asset to absorb expected losses |
The ECL requirements are currently applicable and implemented by NBFCs preparing their financial statements as per Ind AS. Regulatory requirements under the NBFC regulation acts as a prudential floor. Similar requirements may also be introduced for banks, though they may not be required to prepare their financials as per Ind AS.
As per the general experience of NBFCs, it shall be pertinent to note that the regulatory requirements are usually much less than the expected losses. Going by the same analogy, banks complying with the existing regulations, as applicable, would be substantially underestimating their provisions. Introduction of ECL model for banks shall help to bring out the true picture of the banks financial health and sufficiency of profits to absorb losses.
It is expected that the RBI will soon come up with a Discussion Paper on this that would detail the approach of the RBI.
[1] https://www.spglobal.com/_assets/documents/ratings/research/101567037.pdf
[2] OECD (2022), OECD Economic Outlook, Interim Report September 2022: Paying the Price of War, OECD Publishing, Paris, https://doi.org/10.1787/ae8c39ec-en
[3] https://vinodkothari.com/2022/04/securitisation-of-non-performing-loans/
[4] https://vinodkothari.com/2022/08/key-takeaways-conference-on-secondary-markets-in-distressed-loans/
[5] FSI Insights on policy implementation No 3 – Resolution of non- performing loans – policy options; Financial Stability Institute (BIS, 2017) – https://www.bis.org/fsi/publ/insights3.pdf
[6] Refer GACS Tool in the Italian Non-performing Loan Space, KPMG – https://assets.kpmg/content/dam/kpmg/it/pdf/2019/07/GACS-crediti-deteriorati.pdf
[7] Refer – Overview of the Hercules Scheme, KPMG – https://assets.kpmg/content/dam/kpmg/gr/pdf/2019/12/NPEs_securitization_HERCULES.pdf
[8] Details of the Program can be accessed here – https://capitalmarkets.fanniemae.com/media/20951/display
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