Capital Treatment, Loan Loss Provisioning and Accounting for Default Loss Guarantees

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Vinod Kothari (finserv@vinodkothari.com)

The FinTech sector is booming and is a market disruptor as well as facilitator, based on the report published by Inc42, the estimated market opportunity in India fintech is around $2.1 Tn+ and currently there are 23 FinTech “unicorns” with combined valuation of $74 Bn+ and 34 FinTech “soonicorns” with combined valuation of $12.7Bn+.

The unprecedented growth of the fintech sector has transformed guarantees specifically First Loss Default Guarantees (FLDG) into a commonly employed tool for emerging players like fintechs. They leverage these guarantees to take exposures on loan transactions using low-cost funding from established entities such as large NBFCs and Banks. Fintechs issue guarantees that enable them to garner trust from prominent lenders, facilitating the origination of new loans through their digital platforms. 

One of the crucial concerns in DLG arrangements is navigating the complexities surrounding capital treatment and NPA accounting covering both lenders and guarantors. In this article, we delve into an in-depth exploration of these crucial issues.

Capital Treatment 

We organise this section into the following parts:

  • Capital treatment for the lender availing the guarantee
  • Capital treatment for the guarantor 
  • Expected credit loss treatment for the lender availing the guarantee
  • Expected credit loss treatment for the guarantor
  • Provisioning requirement for the lender availing the guarantee
  • Provisioning requirement for the guarantor

Capital Treatment for Lenders: 

Capital requirement is linked with the credit risk on the exposure: hence, before getting into the regulatory prescription, let us examine what is impact on the credit risk of the lender. For capital rules, a guarantee is regarded as a case of credit risk mitigation, provided the guarantee satisfies several conditions (e.g., it should be explicit, enforceable, guarantor’s financial resources adequate, etc). The lender, on the basis of the guarantee, shifts the risk of the first (or subsequent, as may be the nature of the guarantee) layer of the losses to the guarantor. Thus, there is a substitution of risk from the borrowers in the pool to the guarantor. The remaining exposure remains unprotected – hence, to that extent, there is no credit risk transfer. Therefore, if the risk weight of the guarantor is lesser than the risk weight of the underlying pool, there was a case to expect a reduction in the capital requirements.

The regulatory prescription is as follows: DLG Guidelines states that for the purpose of capital computation, i.e., computation of exposure and application of Credit Risk Mitigation benefits on individual loan assets in the portfolio shall continue to be governed by the extant norms. The “extant norms” for this purpose would be the norms on credit risk mitigation. These norms are applicable in case of banks [see part 7 of the Basel III  Master circular ] However, in case of NBFCs, there is no equivalent.

However, FLDG is expected to be backed by either a cash deposit, or a bank guarantee. If it is backed by cash deposit, cash is to be assigned 0 risk weight. Similarly, if it is backed by a bank guarantee, the risk shifts to the bank, and therefore, a 20% risk weight as applicable to banks may be assigned by the NBFC. Note that the above risk weights are only for the part backed by the guarantee. That is, if there is a 5% FLDG, the 5% of the loan pool will be risk weighted as above, and the remaining 95% will attract the risk weight applicable to the borrower pool.

Capital Treatment for the guarantor 

When we talk about capital treatment, the same would depend on the capital rules applicable to the guarantor entity. If the guarantor entity is an RBI regulated lender, it will be covered by the capital rules. If the guarantor not a regulated lender, it is unlikely to have any capital rules.

We discussed above the nature of a structured default loss guarantee. A structured DLG (first loss, second loss, or subsequent loss) integrates the risk of a pool of loans and then strips the same into multiple tranches. Therefore, it becomes a case of structured risk transfer.

The generic rule in case of any structured risk transfer is that the acquirer of the first loss tranche acquires the risk of the entire pool. Therefore, a first loss default guarantor is required to keep capital on the pool size (and not the size of the guarantee). However, the size of the guarantee is the loss limit of the guarantor – therefore, the capital requirement, computed by applying the risk weight to the pool size, will be limited to the size of the guarantee. We discuss this further below. 

First Loss

If the guarantee is first loss in nature, then, as the principle goes, the RE will have to maintain capital on the entire pool, since, it is exposed to all the risks associated with all loan accounts individually, subject to a ceiling on the the amount of guarantee it has provided. 

For instance, if the guarantor provides a 5% FLDG for a pool of loans aggregating to Rs. 100 crores, and the regulatory capital requirement of the guarantor is 15%, then the capital required to be maintained against such pool is:

Lower of

  • 15% of Rs. 100 crores * 100% (Assuming 100% is the applicable risk weight of such loans)
  • 5% of Rs. 100 crores

= Rs. 5 crores.

As per the RBI FAQs, RE providing DLG shall deduct “the full amount of the DLG which is outstanding” from its capital. The above is in line with the RBI FAQs on the subject.

This prescription should be taken as applicable in case of first loss guarantees.

Further, the apparent question that arises here is in what proportion should the capital be reduced from Tier I and Tier II. In absence of any specifications in this regard in the regulations or the FAQs, it is only logical to deduct the capital from the Tier I and Tier II in their respective ratios. That is, if the Tier I is 10% and Tier II is 5%, then the capital reduction should also happen in the ratio of 2:1.

Second Loss

If the guarantee is second loss in nature, then, the losses will start piling up on the guarantor only once the first loss support is exhausted. Unlike the other case, here, the guarantor is not exposed to all the risks associated with all loan accounts individually. Therefore, the capital will have to be maintained on the amount of guarantee provided instead of the entire pool. 

Using the same example, as used in the earlier case, the capital requirement for the RE will be:

Rs. 100 crores * 5% * 15% = Rs. 0.75 crores.

Of course, this is applicable only where the first loss guarantee is sufficient to absorb losses upto a level sufficient to absorb a certain multiple of “expected losses”. Usually, the multiple should be sufficient so as to render the second loss facility to achieve an investment grade rating.

Expected credit loss for the recipient of the guarantee

Expected credit losses are for the potential for the loan or pool of loans to result in credit losses. If the lender has the benefit of first loss guarantee, the situation is that to the extent of the FLDG, the lender has exposure on the guarantor, and for the remaining pool size, the lender has exposure on the borrowers.

As regards a potential credit loss on the guaranteed amount, the RBI rules require the guarantee to be either fully backed by cash, or backed by a bank guarantee. Hence, the question of any credit loss on the same does not arise.

Hence, the lender will be exposed to losses only on so much of the expected credit losses as exceed the FLDG cover. For instance, if the FLDG is 5%, and the ECL estimated by the lender is 6.8%, the lender may create ECL provision only for 1.8%.

Note that ECL for any pool is a dynamic number – while estimations of the default probabilities and the exposure change over time, there are also changes due to unwinding of the discounting factor applied in computing present value of the ECL. Therefore, ECL estimation is bound to change every reporting period. For that matter, FLDG will remain fixed as 5% of the originated pool, but this number will also be dynamic as the loan pool matures – partly due to amortisation of the pool, and partly due to utilisation of the guarantee. Therefore, on an ongoing basis, the lender may compare the ECL with the percentage of FLDG still available, and create ECL for the differential amount.

Expected credit loss for the guarantor

If the guarantor is covered by ECL requirements, the guarantor needs to estimate the losses likely to be caused to the guarantor. As against the guarantee, the payoff of the guarantor may be (a) fixed guarantee fees (b) right to get a variable fee, usually linked with the excess spreads from the pool. 

Note that ECL computation is required not only for loans, but also for financial guarantees. Therefore, the guarantor will need to compute the expected credit losses from the underlying loans using exactly the same basis as if the loans were on the books of the guarantor. Of course, the maximum ECL will be the limit of the guarantee.

Provisioning for the recipient of the guarantee

In this regard, the RBI has clearly specified that no benefit will be given for provisioning requirements – that is, the regulatory provisioning will continue irrespective of the guarantee.

Provisioning for the guarantor

As regards the guarantor, while a financial guarantee is regarded as a direct credit substitute, however, there are no explicit provisioning requirements. To the extent the guarantee has already been utilised, it will be taken as a loss (even though recovery may happen subsequently, but it will be contingent). 

Accounting

Given that the recoveries are against an outstanding asset, receipts from DLG invocation should not be treated as income. The recoveries made from the accounts, for which the lender has already invoked DLG, in our view,should be recorded as a liability. This is because any recoveries from borrowers after receiving DLG payout would be liable to be remitted back to the DLG provider, and the lender will only hold it in trust. Hence creating a back to back obligation on the RE. It is important to note that, in general, a lender may not relinquish their legal right to recover a loan, even after the loan has been written off. Consequently, the obligation to pass on the recoveries from the borrower may also persist indefinitely. 

To support this perspective, we suggest that the lender establish a timeline in agreement with the DLG provider. This timeline should specify the duration during which any recoveries from loans, for which DLG payouts were made, will be passed on to the DLG provider. After the specified period, the lender will no longer be obligated to transfer such recoveries. Consequently, upon completion of the agreed period, the RE can write off the liability associated with the credit protection payouts received.

Treatment of an NPA account in case the guarantee is invoked.

Through the DLG Guidelines RBI has stated that the NPA classification would be the responsibility of the RE and would be as per the extant asset classification and provisioning norms irrespective of any DLG cover available at the portfolio level [para 7 of the DLG Guidelines]. The amount invoked by the DLG cannot be set off against the underlying individual loans and thus, asset classification and provisioning would not be affected by any DLG cover. However, any future recovery by the RE from the loans on which the DLG cover was invoked and realised can be shared with the DLG provider in terms of their contractual arrangements.

Since the guarantee invoked cannot be set off against the loan, how would the guarantee amount be shown in the books of the RE?

Accounting-wise, if the amount has been recovered, it is set off from the outstanding pool However, there is a departure here between accounting treatment and the NPA/capital requirements, as the RBI expects the NPA recognition to be continued in the books of the lender. 

Similarly, capital requirements will also remain unaffected. However,  it will be wrong to show the amount recovered from the guarantor as a liability as it is not a liability – though there may be an understanding that any recovery from the loans will be paid back to the guarantor. It is also wrong to treat the amount received from the guarantor as income, as the payment consists of both interest and principal.

Invocation of DLG will not affect NPA classification of borrower

It shall be noted that despite the FLDG being invoked against the borrowers outstanding amount, the capital requirements and asset classification remain unaffected. Further, reporting to CIC and NESL pertains to the borrowers performance, and therefore, the invocation of FLDG shall not influence these reporting. Repayment as well as defaults of the borrower should continue to be reported without any impact from FLDG invocation. Therefore, the borrowes account will continue to be classified as NPA and reported accordingly to the CIC and other relevant reporting entities.

Related Articles – 

FAQs on Default Loss Guarantee in Digital Lending

Lend, Recover, Replenish: A guide to revolving lines of credit

Risk Management Function of NBFCs – A Need to Integrate Operational Risk Management & Resilience 

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An examination of the RBI Guidance Note on Operational Risk Management and Resilience

Subhojit Shome & Archisman Bhattacharjee | finserv@vinodkothari.com

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12th Securitisation Summit

The who’s who of structured finance is joining the 12th edition of our flagship event, the Securitisation Summit on May 15, 2024, in Mumbai. Be shoulder-to-shoulder with leading originators, investors, lawyers, rating agencies, consultants, regulators, mediators, market makers, and everyone else who matters.

For details of the event and to book your seat, please visit our Summit page – HERE

Agenda – 12th Securitisation Summit | May 15, 2024

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Relinquishment of source of profit in favour of an RP: also an RPT

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Mahak Agarwal | corplaw@vinodkothari.com

The broad spectrum of the definition of Related Party Transactions (RPTs) under the Listing Regulation, continues to be an error prone area in terms of compliance. A recent SEBI ruling has further strengthens this aspect where the phrase ‘transfer of resources, services or obligations’ has been explained in an extremely new dimension with a commendable insight from the authorities which again shows that the regulators can no more be restricted by the imaginary boundaries placed by the corporates when it comes tightening the loose ends of corporate governance.

This article delves into the basis which the Regulators considered for concluding a mutual understanding and agreement between related parties to be an RPT notwithstanding the  contention of the company. The essential question of law involved in this case was whether the allocation of certain products and geographic areas between RPs constitutes an RPT. The article contains our analysis of SEBI’s order in the matter affirming the said stand.

Read more →

AIFs cannot be used as regulatory arbitrage

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SEBI mandates ongoing due diligence for investors and investments made by AIFs

-Vinita Nair, Senior Partner and Lavanya Tandon, Executive | corplaw@vinodkothari.com

Background

Alternative Investment Funds (‘AIFs’), presently around 1324 registered with SEBI, channels risk capital to enterprises, including unlisted companies, as well as cater to sophisticated investors. One of the major concerns highlighted by SEBI was that while the AIF industry had registered robust growth over the years, a number of instances of AIFs being structured to facilitate circumvention of different financial sector regulations was witnessed, thereby eroding trust in the system.

SEBI had raised following concerns in its Consultation Paper issued in January, 2024:

  1. Evergreening of loans by regulated lenders:

A regulated lender would subscribe to a junior class of units of an AIF, and the AIF in turn would fund the lender’s stressed borrower. The borrower would use these funds to repay the loan given by the regulated lender, without disclosure of any stress. The stressed asset in the books of the regulated lender would in effect be replaced with the investment in the junior class units of an AIF.

  1. Circumvention of FEMA norms:

Some foreign investors set up AIFs with domestic managers/sponsors to invest in sectors prohibited for FDI, or to invest beyond the allowed FDI sectoral limit. Further, foreign investors may set up AIFs to invest foreign money in debt/debt securities where foreign investment is envisaged through the FPI/ECB route.

  1. Circumvention of QIB regulations:

In terms of SEBI (ICDR) Regulations, 2018 all AIFs are designated as QIBs. QIBs are generally perceived as large, regulated, sophisticated and informed institutional investors. Certain AIFs have single or very few investors, at times belonging to same investor group, and avail benefits available to QIBs (for e.g. investing in IPO under QIB quote) which would otherwise not be available to them. It also permits otherwise ineligible entities/ persons to influence the price discovery process in public market in the garb of AIF.

SEBI also recorded 40+ cases wherein the structure of AIF had been abused and used to circumvent extant financial sector regulations. Read our analysis in the article ‘AIFs ail SEBI: Cannot be used for regulatory breach’ dated January 31, 2024.

Last year, SEBI had issued ‘Guidelines with respect to excusing or excluding an investor from an investment of AIF dated April 10, 2023 that empowered an AIF to excuse its investor from participating in a particular investment in the following circumstances:



Figure 1: Circumstances to excuse an investor of AIF

Further, RBI had also barred all regulated entities (REs) with respect to their investments in AIFs, discussed in our article.

Present Amendment

Accordingly, in order to restore the trust and prevent such circumvention in the AIF ecosystem and to facilitate ease of doing business, it was proposed introduce a general obligation in the existing AIF regulations that would require AIFs, managers and their key management personnel (‘KMPs’) to ensure that their operations and investments do not facilitate circumvention of regulations administered by any financial sector regulator.
Subsequent to receipt of public comments on the Consultation Paper, the proposal to mandate due-diligence of investors and each of the investments made by the AIF was approved in the SEBI Board meeting held on March 15, 2024. SEBI notified SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2024 effective from April 25, 2024 amending Reg. 20 of the SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’) dealing with general obligations thereby requiring every a. AIF, b. investment manager of the AIF, c. KMP of the AIF, and d. KMP of the investment manager, to exercise specific due diligence with respect to their investors and investments in order to prevent facilitation of circumvention of such laws as may be specified by SEBI from time to time

Scope of laws covered under the ambit of due diligence

‘Laws’ here include Acts, Rules, Regulations, Guidelines  or  circulars  framed thereunder that are administered by a financial sector regulator, including those administered by SEBI. SEBI shall prescribe a framework under the above-mentioned regulation, by way of issuance of circular, to address circumvention of specifically identified financial sector regulations

As indicated in Annexure A of the SEBI Board meeting agenda the list of identified specific  regulations of financial sector regulations for which specific due-diligence checks shall be  formulated  to  prevent  AIFs facilitating circumvention of the same comprises of following:

Figure 2: List of laws for due–diligence 

Due diligence requirement – one-time or ongoing?

As discussed in the SEBI BM Agenda, the  purpose  of  the  due-diligence  check  is  to  prevent  facilitation  of any circumvention of provisions of financial sector regulators, which cannot be a time specific check. An entity who intends to circumvent can design the structure in such a way that, at a later date post investment, it acquires the units  of  AIFs  post  investment,  such  as  buying  the  units  of  an  existing investor or by acquiring control over the existing investor entity, as per prior arrangement.  Accordingly, it has been indicated that due diligence around investors and investments will be an ongoing one.

Applicability of due diligence – prospective or retrospective?

It was suggested that any proposed due diligence  criteria  should  only  be  applicable  in  relation  to  prospective investments and SEBI should grandfather investments made as on date. Further, it was also discussed that in  case it has been ascertained that the AIF has  facilitated circumvention with respect to the investments already made, the manager may be mandated to report the same to SEBI or the respective financial sector regulator for examination.

Standards for due-diligence

In order to ensure that the due-diligence requirements are not open-ended or subject to  interpretation, the specific implementation standards for verifiable due diligence to be conducted on investors and investments of AIFs will be formulated by the pilot Industry Standards Forum for AIFs, in consultation with SEBI.

Conclusion

The present amendment lays an onerous burden on the AIF, manager and KMP of the AIF and the manager. The obligation of on-going due diligence will result in a compliance burden. It will be worth watching to see the standards for due diligence framed by the industry forum in line with ‘trust, but verify’ principle and ascertain the actionable arising therefrom.

Our other resources:

  1. AIFs ail SEBI: Cannot be used for regulatory breach
  2. RBI bars lenders’ investments in AIFs investing in their borrowers
  3. Some relief in RBI stance on lenders’ round tripping investments in AIFs

Proposals approved in SEBI Board Meeting held on April 30, 2024

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Laveena Gajwani and Garima Chugh | corplaw@vinodkothari.com

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Lend, Recover, Replenish: A guide to revolving lines of credit

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“Chivalry is like a line of credit. You can get plenty of it when you do not need it.”

— Nellie L. McClung

Dayita Kanodia | Finserv@vinodkothari.com

In the realm of financial management, having access to a flexible and readily available source of funds can be a game-changer for individuals and businesses alike. One such financial tool that offers this flexibility is a revolving line of credit. Often misunderstood or overlooked, revolving lines of credit are versatile financial instruments that can provide quick access to funds when needed.

A revolving line of credit is a type of loan arrangement that provides borrowers with access to a predetermined amount of funds, which they can borrow, repay, and borrow again as needed. Unlike traditional term loans, where you receive a lump sum upfront and repay it over a set period with fixed payments, a revolving line of credit offers ongoing access to funds that can be drawn upon at any time, up to the credit limit.

Revolving line of credits has been defined as a committed loan facility allowing a borrower to borrow (up to a limit), repay, and re-borrow loans.These are also known as revolving credit facilities, replenshing loans, revolving loans,  or just revolver. 

How Does it Work?

When one opens a revolving line of credit, there is an approval for a certain credit limit based on factors such as creditworthiness, income, and other financial obligations. Once approved, funds can be accessed from the credit line as needed, either by writing checks, using a debit card, making online transfers, or withdrawing cash, depending on the terms of the agreement.

The line of credit is drawn down as disbursements occur. However, the limit is reinstated to the extent repayment is made by the borrower. Obviously, the borrower is free to repay the whole or a part of the limit anytime, and there is no question of any prepayment charge. 

It is not as though a revolving line of credit will continue to revolve all the time – the lender may set a renewal date, and if the facility is not renewed, the lender may convert it into either an instalment credit, or one payable in one or more tranches at a defined time. During the period the facility remains revolving, the borrower services interest.

It is also important to note that during such time, and for such amount, the facility is not used not used fully, the lender still keeps a commitment to lend alive, which has both liquidity burden as well as regulatory capital charge for the lender. Therefore, it is perfectly okay for a lender to provide for a commitment charge for the unutilised facility amount. 

Features of Revolving Lines of Credit

  • Revolving Nature: Unlike traditional term loans, revolving lines of credit allow borrowers to repeatedly borrow and repay funds without the need to reapply for a new loan each time.
  • Interest on Utilized Amount: Interest is typically charged only on the amount of credit actually used, rather than on the entire credit limit. This can result in lower interest costs for borrowers who do not fully utilize their credit line.
  • Variable Interest Rates: Interest rates on revolving lines of credit may be variable, meaning they can fluctuate over time based on market conditions. This can be advantageous if rates decrease but may pose risks if rates rise.
  • No Fixed Repayment Schedule: Unlike term loans with fixed monthly payments, revolving lines of credit typically have no fixed repayment schedule. Borrowers can repay the borrowed amount on their own timeline, as long as they make at least the minimum required payments.
  • Credit Renewal: As long as the borrower meets the terms and conditions of the credit agreement, revolving lines of credit can be renewed indefinitely, providing ongoing access to funds.

Lines of credit and its types

The US Federal Reserve has distinguished between revolving and non-revolving lines of credit. It says, 

“Revolving credit plans may be unsecured or secured by collateral and allow a consumer to borrow up to a prearranged limit and repay the debt in one or more installments. Credit card loans comprise most of revolving consumer credit measured in the G.19, but other types, such as prearranged overdraft plans, are also included. Nonrevolving credit is closed-end credit extended to consumers that is repaid on a prearranged repayment schedule and may be secured or unsecured. To borrow additional funds, the consumer must enter into an additional contract with the lender.”

Credit can be classified as:

Revolving Credit: A fixed line of credit is determined from where draw down take place. The line of credit then gets reinstated on repayment by the borrower.

Non-Revolving Credit: They provide borrowers with access to funds up to a predetermined credit limit which does not get reinstated on repayments being made. To borrow additional funds, a new contract has to be entered into.

Installment Credit: Installment credit involves borrowing a specific amount of money upfront and repaying it over a set period in equal installments, typically including both principal and interest.

Non-installment Credit: In case of non-installment credit, repayment does not happen in equal installments over a period of time but there is generally a bullet repayment made by the borrower.

Types of revolving lines of credit

Revolving lines of credit come in various types, each tailored to meet specific needs and circumstances:

Personal Revolving Line of Credit: 

This type of credit is designed for individual consumers and can be used for various personal expenses, such as home renovations, unexpected medical bills, or debt consolidation. Personal revolving lines of credit offer flexibility in borrowing and repayment, allowing individuals to access funds as needed.

Working Capital Revolving Line of Credit: 

Businesses often use this type of credit to manage cash flow, finance day-to-day operations, purchase inventory, or cover short-term expenses. Working capital revolving lines of credit provide flexibility for businesses to access funds when needed and repay them as cash flow allows, helping to smooth out fluctuations in revenue and expenses.

Secured and Unsecured Revolving Line of Credit: 

Secured lines of credit require collateral, such as real estate, inventory, or equipment, to secure the credit line. Because the lender has the security of collateral, secured lines of credit typically offer lower interest rates and higher credit limits compared to unsecured lines of credit.

Unsecured lines of credit do not require collateral. Instead, the creditworthiness of the borrower determines the credit limit and terms of the line of credit. Interest rates for unsecured lines of credit may be higher, and credit limits lower, compared to secured lines, but they offer the advantage of not requiring collateral.

Home Equity Line of Credit (HELOC): 

A HELOC is a revolving line of credit that is secured by the equity in a borrower’s home. Homeowners can borrow against the equity in their home up to a certain limit, using the home as collateral. HELOCs often have lower interest rates compared to other forms of credit and may offer tax benefits, but they carry the risk of foreclosure if payments are not made.

Revolving Credit Cards: 

Credit cards are a common form of revolving line of credit. They allow cardholders to make purchases up to a certain credit limit, repay the balance, and then borrow again up to the credit limit. Revolving credit cards typically have variable interest rates and may offer rewards or cashback incentives.

Maintenance of Regulatory Capital

According to para 5.9.3 of the Basel III Master Circular, revolving lines of credit can be considered as retail claims for regulatory capital purposes and included in a regulatory retail portfolio if they meet certain conditions. :

However, it is important to understand that a revolving facitliy has a drawn amount (and therefore, on-balance sheet exposure), and the undrawn amount (which is off balance sheet exposure). 

Para 5.15.2 (iv) of the Basel III Circular states that, 

“Where the non-market related off-balance sheet item is an undrawn or partially undrawn fund-based facility, the amount of undrawn commitment to be included in calculating the off-balance sheet non-market related credit exposures is the maximum unused portion of the commitment that could be drawn during the remaining period to maturity. Any drawn portion of a commitment forms a part of bank’s on-balance sheet credit exposure.”

Accordingly, say there is a credit facility for Rs.100 lakh (which is not unconditionally cancellable) where the drawn portion is Rs. 60 lakh, the undrawn portion of Rs. 40 lakh will attract a Credit Conversion Factor of 20 per cent. 

The credit equivalent amount of Rs. 8 lakh (20% of Rs.40 lakh) will be assigned the appropriate risk weight as applicable to the counterparty/rating to arrive at the risk weighted asset for the undrawn portion. The drawn portion (Rs. 60 lakh) which forms a part of the bank’s on-balance sheet credit exposure will attract a risk weight as applicable to the counterparty/rating.

Liquidity Risk 

According to para 131 of the Basel III: The Liquidity Coverage Ratio and liquidity risk monitoring

tools any contractual loan drawdowns from committed facilities and estimated drawdowns from revocable facilities within the 30-day period should be fully reflected as outflows. 

In case of committed credit facilities to retail and small business customers, banks have to assume a 5% drawdown of the undrawn portion whereas in case of non-financial corporates, drawdown has to be assumed for 10% of the undrawn amount.

Can revolving lines of credit be Transferred or Securitised ?

Transfer of Revolving Lines of Credit:

In case of a revolving line of credit, there is typically an undrawn amount. Accordingly, the transfer can only happen for the amount already drawn. However, in terms of the RBI Master Direction – Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021 (‘TLE Directions’), the requirement of Minimum Holding Period (‘MHP’) needs to be fulfilled. This MHP requirement is of 3 months for loans having tenure of upto 2 years. Therefore, for loans having very short tenure, it may not be possible to fullfill the same. 

Accordingly, although there is no express prohibition from transferring the line of credit exposure, it may not be practical to do so. 

Securitisation of revolving lines of credit:

As per para 6(d) of the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 (‘SSA Directions’) securitisation of revolving credit facilities is not permitted. Accordingly, revolving lines of credit cannot be securitised. 

Obtaining Default Loss Guarantee for Revolving Lines of Credit

Default Loss Guarantee(DLG) can only be obtained for digital loans. Since, revolving credit facilities (say, credit cards) may be offered through digital means it is important to discuss if DLG can be obtained for revolving lines of credit. The RBI FAQs (FAQ No.10) on Default Loss Guarantee (‘DLG FAQs) have prohibited REs from entering into DLG arrangements with respect to revolving lines of credit. 

For other non-digital revolving lines of credit provided, the bar on synthetic securitisation continues to apply and therefore, no default loss guarantee can be obtained. 

Conclusion

In a world where financial needs can arise unexpectedly, having access to a revolving line of credit can be invaluable. However, it’s essential for lenders to understand the regulatory requirements and implications associated with these credit facilities to ensure compliance and mitigate risks effectively.

Related Articles – 

Personal revolving lines of credit by NBFCs: nuances and issues

The Credit Card Business for NBFCs

FAQs on Default Loss Guarantee in Digital Lending