Cash in Hand, But Still a Loss? 

RBI mails to NBFCs to disregard DLG in expected loss computation

– Vinod Kothari & Dayita Kanodia (finserv@vinodkothari.com)

Background

RBI has recently been directing NBFCs to compute ECL without factoring in the impact of DLGs obtained¹. This stance appears to stem from the regulator’s perception that fintech-issued guarantees carry inherent risk and may expose NBFCs to potential losses.

As per Ind AS 109, Expected Credit Loss (ECL) model is used for the recognition and measurement of impairment on financial assets. ECL is a forward-looking approach that requires entities to recognize credit losses based on expectations of future defaults.

The Default Loss guarantee Guidelines (‘DLG Guidelines’) allow LSPs, (both regulated and unregulated) to provide DLG to the extent of 5% of the portfolio amount to the lender. The DLG Guidelines specify the forms in which such DLG can be obtained. 

In terms of para 22 of the DL Guidelines, 

“RE can accept DLG only in one or more of the following forms:

1. Cash deposited with the RE;
2. Fixed Deposit maintained with a Scheduled Commercial Bank with a lien marked in favour of the RE;
3. Bank Guarantee in favour of the RE”

Accordingly, DLGs can only be obtained in fully funded forms thus eliminating any question of incurring credit loss on such guarantee. 

RBI Directive to NBFCs

RBI has directed NBFCs to maintain ECL without giving effect to the DLGs obtained in accordance with the DLG Guidelines. In this respect, the following should be taken into consideration:

• A regulatory prescription, without a regulatory backing, and in fact, going against the regulation:
  • There is a well-laid process for the RBI coming with a regulation, and in fact, now, the RBI has decided to come up with a consultation process, impact assessment etc before coming with a regulation. 
  • Dictating a certain treatment with respect to ECL is nothing short of a regulation – if this sort of generic requirements keep coming from the supervisors, then the very dividing line between supervision and regulation is lost.
• Let accounting standards prevail; auditors and accountants know what ECL to provide:
  • Annex II of the SBR Directions provides that NBFCs shall follow applicable accounting standards. The ECL provisioning, known as impairment loss, comes from para 5.5.13 of Ind AS 109. The detailed requirements of how ECL is to be estimated has been laid in that standard.
  • Admittedly, whether and how much ECL write down is required, and whether such ECL estimation does or does not give effect to a fully-funded guarantee, is a matter for the accountants and auditors to deal with. We find little reason for the regulator to step into what is clearly an accounting standard domain.
• If there is a funded guarantee, how can losses met by such guarantee be disregarded?
  • As per DLG guidelines, the guarantee has to be either fully funded, or fully backed by bank guarantee. It is true that even if a credit loss is backed by a guarantee, it is merely shifting of the exposure – from the borrower to the guarantor. But in this case, the guarantee is equivalent to cash. If the lender has a cash collateral to back up the guarantee, there is no reason to not give the benefit of the same in ECL estimation.
  • For example, if for a certain loan pool, the ECL estimation is 3.8%, and the lender has a guarantee of 5% backed by fixed deposits lien-marked to the lender, will the lender have any expected loss? The answer is negative. If the ECL estimation was, say, 6.8% and the guarantee is 5%, clearly the lender’s ECL will be 1.8%. Thus, there is no reason to disregard the funded guarantee while estimating ECL.
• If a company cannot incur loss to the extent of the guarantee, and it still creates an impairment loss, it is actually creating a reserve and not a provision, and therefore, compromising its true and fair view:
  • The RBI expects lenders to disregard the guarantee and create ECL as if the guarantee did not exist. This will be like creating a loss where the losses actually cannot hit the lender. Therefore, the ECL becomes a reserve, and given that the entity is hitting the P/L with a loss that will not hit the lender, the entity is compromising its true and fair view.
• The RBI has reasons to have no trust on the fintechs for the guarantee they give, but it is fully funded.

In light of this, the RBI’s emails sent to various lenders are objectionable, and such emails create a precedent of creating a regulation without going through the regulatory process.

Accordingly, in our view, NBFCs should be allowed to follow their applicable accounting standards while computing the ECL provisions.

Our resources:

1. FAQs on Default Loss Guarantee in Digital Lending
2. Capital Treatment, Loan Loss Provisioning and Accounting for Default Loss Guarantees

1.  https://economictimes.indiatimes.com/industry/banking/finance/rbi-tightens-default-loss-guarantee-rule-nbfcs-to-exclude-cover-on-fintech-sourced-loans/articleshow/121420936.cms?from=mdr
   ↩︎