Banking & Finance units in IFSC- A regulatory overview

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– Siddarth Goel (finserv@vinodkothari.com)

Introduction- IFSCs

The stage of development of financial markets infrastructure in a country, amongst many other things, is a mirror of sound legal regulations, corporate governance, judicial certainty, and debtor protection regime within the country. The inflow of global capital is quintessential for financial markets development and allocation of adequate capital resources in growth sectors. In a move to make India a hub for global capital flow, Gujarat International Finance Tech-City (GIFT) has been established as a globally benchmarked International Financial Service Centre (GIFT-IFSC). GIFT-IFSC is India’s first dominant gateway for global capital flows in and out of the country.  The GIFT IFSC supports a gamut of financial services inter alia, banking, insurance, asset management, and other financial market activities. Prior to dealing with the regulatory framework governing financial units established in GIFT-IFSC, it is important to understand the broad function of an IFSC.

IFSCs are the Offshore Financial Centers (OFCs) that cater to customers outside their own jurisdiction. IMF defines OFCs as any financial center where the offshore activity takes place. However, this does not limit financial institutions in OFCs from undertaking domestic transactions. Therefore practical definition propounded by IMF is;

“OFC is a center where the bulk of financial sector activity is offshore on both sides of the balance sheet, (that is the counterparties of the majority of financial institutions liabilities and assets are non-residents), where the transactions are initiated elsewhere, and where the majority of the institutions involved are controlled by non-residents.”

Units set up in GIFT-IFSC can broadly be categorised on the basis of business activity intended to being undertaken by the entity.

 

This write-up covers regulations governing banking and financial services undertaken by Banking Units and Finance Companies set up in IFSC. The first part touches upon the benefits of setting up a unit in IFSC. The second part covers Banking Units and permitted financial activities. The third part covers Financial Companies in IFSC along with permissible activities and capital requirements. The fourth part covers financial service transactions to and fro between a financial unit based in IFSC and domestic tariff area (DTA). The last part deals with the applicable  KYC/PMLA compliances and the currency of transactions with units based in IFSC.

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RBI means to halt second wave of borrower defaults: Announces ResFra 2.0

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The RBI Governor on May 05, 2021[1] announced a series of measures for improving credit delivery, ensuring that there is sufficient liquidity with the masses, and State Governments have sufficient resources in their effort to deal with the pandemic. The measures include an upto Rs 50000 crore “Covid Loan Book” which qualifies for repo at the rate of 4%, and priority sector tag, additional liquidity for small finance banks, overdrafts to state governments, and, version 2.0 of the Resolution Frameworks originally announced on 6th August, 2020[2]. Subsequently, on the same day, the RBI came out with two separate notifications, Notification no 31 dealing with individuals and small businesses, and Notification no 32 dealing with MSMEs.

An injury is particularly hurting when the body is already weak and rejuvenating. The second wave of the Pandemic, besides the ferocity it carries, comes at a time when the economy had just started inching towards normalcy. The second wave has particularly been seen over the last 2 months, and therefore, financial institutions are just beginning to see the aftermath.

In this scenario, the announcement by the RBI governor was a much needed surprise relief. The measures under the aforesaid notifications shall be contingent on the lenders satisfying themselves that the same is necessitated on account of the economic fallout from Covid-19.

The following timelines depicts the relevant circulars issued by RBI, from time to time in this context:

In this write up we are focusing on the Resolution Framework 2.0, which is permitting a restructuring of loans to individuals, small businesses and MSMEs.

Restructuring for individuals, small businesses and MSMEs

ResFra 2.0 consists of two separate notifications, one dealing with MSMEs, and one dealing with individuals and small businesses which are not registered as MSMEs. While every MSME is, by definition, a small business, the rationale for having a separate framework altogether for MSMEs could not be clear – in fact, in several respects, it seems that the one for MSMEs is more restrictive than the one for “small businesses”. It seems that the RBI has kept to the tradition of having a separate framework for MSMEs, though the present framework does not seem to be resulting into an advantage for either the lender or the borrower, over the framework applicable to small businesses. Further, if one compares the earlier frameworks for MSME restructuring, ResFra 2.0 does not rank at par.

We accordingly discuss the two separately:

ResFra 2.0 for individuals and small businesses:

Notably, this Framework, coming from Notification no 31, is applicable only for individuals and “small businesses”. The expression “small business” would exclude MSMEs as defined in  Gazette Notification S.O. 2119 (E) dated June 26, 2020.[3]

For both the categories, there are 3 types of restructuring – we call them First time restructuring, Convergence Restructuring, and Working Capital reassessment.

(a) First time restructuring

Eligible borrowers:

There are 3 categories of of eligible facilities, given in Para 5 of the Notification:

  • Individuals, who have availed personal loans. See below for the meaning of “personal loans”. Conspicuously, the limit on the exposure size of Rs 25 crores is not visible here. This means, in case of personal loans, as long as fits into the definition, there is no limit to the aggregate exposure.
  • Individuals who have availed loans and advances for business purposes, and in respect of whom the aggregate exposure of lending institutions is not more than Rs 25 crores as on 31st March, 2021. The very same individual may have availed personal loans as well, and a question may arise whether the aggregate exposure will include that by way of personal loans. Our answer is in affirmative.
  • Small businesses, including those engaged in wholesale or retail trade, not classified as MSMEs as on 31st March, 2021, and on whom the aggregate exposure of lending institutions is within Rs 25 crores.

What are Personal Loans to Individuals

Under the ResFra 2.0 reference of personal loans to individuals is to be taken from XBRL Returns – Harmonization of Banking Statistics- dated Jan 04, 2018.  

Personal loans would include the following:

  • Consumer Credit- Consumer credit refers to the loans given to individuals; (i) loans for consumer durables, (ii) credit card receivables, (iii) auto loans (other than loans for commercial use), (iv) personal loans secured by gold, gold jewellery, immovable property, fixed deposits (including FCNR(B)), shares and bonds, etc., (other than for business / commercial purposes), (v) personal loans to professionals (excluding loans for business purposes), and (vi) loans given for other consumptions purposes (e.g., social ceremonies, etc.).
  • Education Loan
  • Loans for creation/ enhancement of immovable assets (e.g., housing, etc.), and
  • Loans for investment in financial assets (shares, debentures, etc.).

For further discussion on meaning of “personal loans”, see FAQ 5A in our write up on the earlier resolution framework

Additional eligibility conditions:

  1. The ineligible businesses as were listed in clauses (a) to (e) of Para 2 of Annexure to ResFra 1.0 will remain ineligible here too. These are as follows:
    1. MSME borrowers whose aggregate exposure to lending institutions collectively, is ₹25 crore or less as on March 1, 2020.
    2. Farm credit as listed in Paragraph 6.1 of Master Direction FIDD.CO.Plan.1/04.09.01/2016-17 dated July 7, 2016 (as updated) or other relevant instructions as applicable to specific category of lending institutions.
    3. Loans to Primary Agricultural Credit Societies (PACS), Farmers’ Service Societies (FSS) and Large-sized Adivasi Multi-Purpose Societies (LAMPS) for on-lending to agriculture.
    4. Exposures of lending institutions to financial service providers.
    5. Exposures of lending institutions to Central and State Governments; Local Government bodies (eg. Municipal Corporations); and, body corporates established by an Act of Parliament or State Legislature.
  2. The borrower should not have availed of restructuring as per ResFra 1.0
  3. The credit exposure to the borrower should be standard as on 31st March, 2021. The standard classification, obviously, is lender-specific. That is, while the credit exposure by different lending institutions is being aggregated, the standard classification is as per the books of the specific lender considering restructuring.

“Small business” or MSME: Dilemma whether Borrowers will fall under Notification No 31 or Notification No 32

There would be certain categories of borrower, who may be satisfying the definition of being classified as MSME, but have neither obtained the Udyam Registration nor do they intend to obtain such registration. These borrowers may not have GST registration or exemption from GST registration.

The RBI has come with two separate notifications – one applicable to individuals and small businesses, and the other specifically applicable to MSMEs, with conditions as above. We have discussed above that this demarcation between “small businesses” and MSMEs will only breed confusion, and was unwarranted. However, the predicament for a lender will be – can a lender choose either of the two Notifications?

It seems clear that Notification no 31 specifically excludes borrowers with MSME registration (as was the case of 6th August 2020 notification). It is also clear that the precondition for falling under Notification no 32 is that the borrower must have MSME registration, or must have Udyam registration before implementation. If the borrower, otherwise eligible to be classified as MSME, does not avail of Udyam registration, can it be the idea of the RBI to deny him the benefit of restructuring?

In our view, the intent of the Governor’s 5th May dispensation was to allow more money to flow or stay with smaller borrowers, because that is where the brunt of the pandemic is the maximum. MSMEs are admittedly conferred several benefits by scheme of various enactments and policy measures. The idea cannot be to deny the benefit of restructuring to MSMEs not strictly falling within the terms of Notification no 32, even as small businesses are specifically eligible for restructuring under Notification no 31, without any such conditions.

That brings us to a question – can a lender allow the borrower the option of coming under Notification no 31 or 32? We have tabulated below the differences between Notification 31 restructuring and Notification 32 restructuring. However, given the mutually exclusive nature of the two, it does not seem logical that the borrower is to be allowed the option. However, the borrower may, of course, choose not to have Udyam registration, and therefore, come under Notification 31.

Resulting questions are – if the lender has treated the borrowers as MSMEs for the purpose of priority sector lending guidelines, or CGTMSE scheme, or for other benefits, is the lender precluded from putting the borrower under Notification 31? In our view, Notification 32 comes with its own set of clear conditions. An MSME is also a small business. If the MSME does not meet all the conditions of Notification 32, but meets those of Notification 31, it would be contrary to the intent of the Governor’s pronouncement to deny such an entity the benefit of either of the Notifications.

Qualitative considerations in restructuring:

The restructuring under the Framework is intended to be a redressal of the difficulties faced by the borrower by the Pandemic, more specifically, the second wave. Thus, an en masse  restructuring, or restructuring without any due diligence on the impact of the pandemic on the cashflows of the borrower is not warranted. Appropriately, the restructuring policy [see below] should set out the basis for identification of borrowers to whom the restructuring facility will be granted. There is a reference in Para 8 to standardised product-level templates; however, it should be clear that the decision to restructure is neither agnostic to the borrower’s income, assets and cashflows, nor is it mechanical. The reference to templates may be standardisation of the parameters, so as to arrive at fast decision-making on restructuring.

Where there are various lenders, it is quite likely that some lenders approve the borrower for restructuring while other lender(s) do not. This is perfectly acceptable – see para 9 of the Notification.

Procedure and Time limit for invocation:

Invocation of restructuring happens when a request made by either the borrower or the lender, for the purpose of restructuring, is accepted by the other. Para 8 provides: “The resolution process under this window shall be treated as invoked when the lending institution and the borrower agree to proceed with the efforts towards finalising a resolution plan to be implemented in respect of such borrower”. In essence, it is mutual agreement between the lender and the borrower to proceed for a resolution plan. Invocation does not imply that the contours of the resolution plan itself are finalised.

Thus, if the borrower proposes restructuring, and the lender agrees to consider the proposal, or vice versa, the invocation would have been triggered. If the request comes from the borrower, obviously, it is not a mere non-speaking intent of restructuring; the borrower provides some justification as to why his case should be considered for restructuring.

If the borrower puts up an application for restructuring, the lender should consider the same within 30 days. Invocation shall be deemed done only when the lender, on consideration of the application, agrees to approach for restructuring.

Given the prevailing situation, where most of the states are under lockdown, it may not be practically possible to ensure physical meeting with the borrowers or obtain their physical signatures on the restructured terms. In our view, the invocation atleast could be done electronically, via text message or email, provided a proper written trail is maintained. Further since there is sufficient time for implementation, proper execution of the relevant supplementary agreements and revised repayment schedules can be ensured.

The invocation must have been done by Sept., 30, 2021.

Process and Time limit for implementation:

Since restructuring is modification of the loan facility, it will require either a supplementary agreement or a fresh set of documentation. There may be modifications as to security  etc – depending thereon, the same also shall be documented.

Implementation shall be deemed complete when all the following conditions are satisfied:

    1. all related documentation, including execution of necessary agreements between lending institutions and borrower and collaterals provided, if any, are completed by the lenders concerned in consonance with the resolution plan being implemented;
    2. the changes in the terms of conditions of the loans get duly reflected in the books of the lending institutions; and,
    3. borrower is not in default with the lending institution as per the revised terms.

Further, implementation must be done within 90 days from the date of invocation. The lenders will have an incentive for early implementation, as the asset classification may be treated as standard only upon implementation.

What all may restructuring include?

Restructuring may include rescheduling of payments, conversion of any interest accrued or to be accrued into another credit facility, revisions in working capital sanctions, granting of moratorium etc. based on an assessment of income streams of the borrower. Para 11 says that restructuring shall not include “compromise settlement”. A question may be, whether a reduction of rate of interest, grant of a rebate, or a partial waiver, will also be a case of “compromise settlement” not permitted under restructuring framework? In our view, compromise settlement should be agreeing to a substantial sacrifice by the lender, mostly resulting into waiver of outstanding principal.

Restructuring should not result into moratorium beyond 2 years or extension of the residual tenure of the loan by more than 2 years.

What if the restructuring is not compliant with the conditions of the Notification?

Such restructuring will be deemed to be restructuring within the meaning of 7th June, 2019 framework, and will be treated as such.

Asset classification, Provisioning and write back of the provision:

The Eligible Borrower accounts restructured under ResFra 2.0, the standard classification of the assets can be retained. However, whereby the Eligible Borrower account has slipped into NPA classification between the date of invocation and implementation of resolution plan, such account can be upgraded to standard classification as on date of implementation of resolution plan.

There is no relaxation provided to borrowers who have slipped into NPA between the period from March 31, 2021 to the date of invocation. Hence, such loan accounts, which have become NPA from 1st April to the invocation date, irrespective of being restructured in compliance with the provisions of the Notifications will continue to be classified as NPA.  Note that this position is different in case of MSMEs coming under Notification 32, wherein the borrowers who have slipped into NPA between the period from March 31, 2021, till the date of invocation shall be upgraded to standard.

Provisioning- The provisions to be maintained on such restructured account  by lending institutions shall be higher of the two below:

  • Provisions maintained with respect to such Eligible Borrower prior to implementation of resolution plan as per the applicable IRAC norms
  • 10 % of the renegotiated debt exposure after implementation of resolution plan (‘Residual Debt’)

Write back of provisions- 50% of the provision may be written back upon the borrower paying at least 20% of the Residual Debt without slipping into NPA and remaining half may be reversed upon payment of additional 10% of Residual Debt.

However, in cases (other than personal loans) the provisions shall not be written back before one year from date of commencement of first payment of interest or principal (whichever is later) on credit facility with the longest period of moratorium.

Disclosure 

The RBI has required quarterly disclosure of resolution plans approved under this Framework in a format, viz. Format X, annexed to the Notification. It appears that this will have to be part of the quarterly disclosures to the public for those lending institutions which prepare and publish quarterly financial statements.

Additionally, the credit reporting, to credit information companies, of borrowers whose accounts are restructuring under this facility shall carry a specific mention – “restructured due to COVID19” status. The intent seems that the restructuring shall not tarnish the credit history of the borrower.

Granting of new facilities pending implementation

The Eligible Borrowers in respect to whom the Resolution Plan has been invoked, the lending institutions can grant interim finance by way of additional credit facility to such borrowers. The additional credit facility shall be classified as standard, irrespective of the underlying actual performance by the borrower with regard to such additional credit facility.

However, where the resolution plan is not implemented within 90 days from the date of invocation, the additional credit facility shall be classified worse of the two below:

  • Actual performance of the borrower under interim additional credit facility
  • Performance of the borrower under the original loan account

Immediate actionables for lenders

Lending institutions to frame board approval policies not later than 4 weeks from the date of ResFra 2.0 circular date, i.e. latest by 04 June 2021.

The policy should have following broad coverage:

  • Eligible Borrowers to whom resolution under ResFra 2.0 is to be extended
  • Due diligence and considerations to be followed for resolution of stress accounts
  • Policies with respect to viable resolution plans of Eligible Borrowers
  • Resolution under ResFra 2.0 is provided to borrowers having stress on account of COVID-19
  • Grievance redressal mechanism for borrowers requesting resolution or undergoing resolution under ResFra 2.0
  • The policy should be published on the lending institutions’ website

Board-approved policy

  • Why when?

The framework requires formulation of a Board-approved policy pertaining to implementation of viable resolution plans for eligible borrowers under this framework, ensuring that the resolution under this facility is provided only to the borrowers having stress on account of Covid-19. The policy has to be adopted at the earliest, but not later than four weeks from the date of the Notification, that is, by 4th June, 2021.

The policy shall be published on the website of the Company.

  • Contents of the Policy

The major contents of the policy should include the following:

  1. Eligible borrowers
    1. Manner of determining that the total exposure is within the permissible limits
    2. Manner of determining whether the borrower is eligible for restructuring, manner of assessing the impact of the pandemic on the borrower’s cashflows, nature of evidence to be provided by the borrower, etc.
  2. Invocation of the RP
    1. Procedure of initiation of the RP
    2. Applications for RP
  • Conditions precedent for invocation of RP
  1. Time limit for sanctioning the RP- To be confirmed within 30 days from the date of receipt of application
  2. Invocation to be done before 30th September, 2021
  3. To be implemented with 90 days from the date of invocation
  1. Manner of restructuring – This should deal with the variety of modifications which can be explored between the parties, including but not limited to rescheduling of payments, conversion of any interest accrued or to be accrued into another credit facility, revisions in working capital sanctions, granting of moratorium etc. The policy should have requisite flexibility. The authority matrix for permitting/rejecting restructuring applications should be laid down.
  2. Asset Classification of the restructured accounts
  3. Provisioning norms
    1. Provisioning at the rate of 10% of the residual debt
    2. Circumstances of reversal of provisions
      1. For personal loans
      2. For small business loans
  • Likely impact on the ECL of the entity, where applicable
  1. Grievance redressal: This should include the hierarchy of at least 2 levels of complaint redressal. The complaint may, for example, relate to refusal to restructure, or a restructuring which is burdensome.
  2. Disclosure requirements: This should broadly follow the regulations.

(b) Convergence restructuring:

This covers those borrowers who have availed restructuring under ResFra 1.0. Such borrowers will be eligible if the original restructuring either did not grant a moratorium, or the moratorium  granted was less than 2 years, or the elongation of the residual term, was less than 2 years.

Eligible borrowers

Who have already availed the restructuring benefit under ResFra 1.0. Therefore, by presumption, the borrower should have been eligible under ResFra 1.0. Additionally, the eligibility criteria in Para 5 of the Notifications, discussed above in case of Frist time Restructuring, shall also apply.

Conditions of eligibility:

Apart from the moratorium/term extension being within 2 years, there does not seem to be any other conditions. For example, a condition that the borrower should have been paying as per restructured terms is not specified.

In such cases, what sort of restructuring can be offered? Restructuring to borrowers affected by a systemic stress is typically moratorium or extension of term. That is why the RBI makes reference to the same. However, so far it is unclear whether restructuring by way of reduction of rate of interest, waiver of any extras such as penalty or overdue interest, or a waiver of any amounts payable, can be granted. One will have to wait for the fineprint of the regulations to comment on that.

Incoation of Resolution Process

The borrower shall by way of application request the lending institution for invocation of resolution process under ResFra 2.0. The decision on application of such borrower shall be communicated in writing within 30 days of receipt of application.

For meaning of invocation and implementation, please see discussion above, under the First time restructuring.

(c) Restructuring by review of working capital facilities

In respect of individuals who have availed advances for business, or small businesses (other than MSMEs), lending institutions are also being permitted as a one-time measure, to review the working capital sanctioned limits, based on a reassessment of the working capital cycle, margins, etc.

It appears that this facility is available only in case of working capital facilities, as lenders have been permitted to “review” working capital sanctioned limits. Possibly, lenders will enhance working capital sanctioned limits, such that irregularities may be corrected, and the increased time for accounts receivables and inventory build-up may be granted to borrowers.

This facility shall be available to individuals who have availed business loans, and small businesses.

A pertinent question would be – if the original facility was not a working capital facility, can a lender grant a working capital facility and treat the same as a case of restructuring of the original facility? In our view, the intent does not seem to be such.

ResFra 2.0 for MSMEs:

Conditions of eligibility for MSME Restructuring:

  1. Not availed of restructuring under any of the earlier restructuring frameworks. This would include the earlier issued Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances circulars, dated August 6, 2020, February 11, 2020 and January 1, 2019 (‘MSME Restructuring Circulars’).
  2. The borrower should be classified as a micro, small or medium enterprise as on March 31, 2021 in terms of the Gazette Notification S.O. 2119 (E) dated June 26, 2020.
    1. If the borrower is not registered in the Udyam Registration portal, such registration shall be required to be completed before the date of implementation of the restructuring plan for the plan to be treated as implemented.
  3. The  borrower should be standard as on March 31, 2021. In case of term loans or similar facilities, this would mean the account must not be more than 89 DPD. In case of working capital facilities, this would mean any of the credit facilities has not become a non-performing asset.
  4. The borrower should be GST-registered on the date of implementation of the restructuring. However, this condition will not apply to MSMEs that are exempt from GST-registration. This shall be determined on the basis of exemption limit obtaining as on March 31, 2021.
  5. The “aggregate exposure” of the borrower should be upto Rs 25 crore, including non-fund based facilities, from all lending institutions to the borrower as on March 31, 2021.

Time limit for invocation:

The restructuring of the borrower account is invoked by September 30, 2021.

The restructuring shall be treated as invoked when the lending institution and the borrower agree to proceed with implementation of a restructuring plan.

Time limit for implementation:

    1. An MSME borrower intending to avail the restructuring benefit shall be required to make an application to the lender.
    2. The decisions on applications received by the lending institutions from their customers for invoking restructuring shall be communicated in writing to the applicant within 30 days of receipt of such applications.
    3. The restructuring has to be implemented within 90 days after invocation.

Does implementation necessarily have to be done by all lenders, if there are multiple lenders? The decision to invoke the restructuring under this facility shall be taken by each lending institution having exposure to a borrower independent of invocation decisions taken by other lending institutions, if any, having exposure to the same borrower.

What all may the restructuring entail?

Restructuring can be done in any of the following manners or a combination of

any of these, as may be feasible, considering the status of the borrower and the loan account:

  • Rescheduling of payments;
  • Conversion of any interest accrued, or to be accrued, into a separate credit facility;
  • Granting moratorium (with immediate effect upon implementation of the RP), based on an assessment of income streams of the borrower, subject to a maximum of two years;
  • Extension of tenure, subject to a maximum of two year and accordingly restructuring of repayment instalments;
  • Granting additional credit facilities;
  • Conversion of a portion of the debt into equity or other marketable, non-convertible debt securities issued by the Borrower, subject to the relevant RBI guidelines and other applicable laws;
  • Any other measures or modification in the existing terms of the loan, as the lender may deem appropriate, considering the financial situation of the borrower and the feasibility of restructuring.

Any additional provision requirement?

Upon implementation of the restructuring plan, the lending institutions shall keep provision of 10 percent of the residual debt of the borrower.

This is different from the earlier MSME Restructuring Guidelines wherein the requirement was to create an additional provision of 5% over and above the provision already held.

Further, the asset shall retain its standard status and the 10% provision shall be a ‘provision specific to the asset’ created considering the risk involved in the asset after restructuring. The accounts which may have slipped into NPA category between April 1, 2021 and date of implementation may be upgraded as ‘standard asset’, as on the date of implementation of the restructuring plan.

Can restructuring be offered selectively by the lender? Does the lender have discretion to offer restructuring selectively to borrowers, or to impose any additional conditions?

In our view, restructuring is a free choice of the lender and the borrower. The regulator permits restructuring, while not treating the facility as an NPA. However, neither can the regulator nor can the borrower force the lender to agree to restructuring. The lender has to take a call on the extent to which the borrower’s cash flows are affected by the pandemic. The lender is also free to add further conditions.

Upgradation to standard status

Discuss here

Can MSME accounts already restructured under the MSME Restructuring Circulars avail any further benefit?

Lenders have an option to review and reassess, before September 30, 2020, the working capital sanctioned limits and / or drawing power based on a reassessment of the working capital cycle, reduction of margins, etc. without the same being treated as restructuring.

The reassessed sanctioned limit / drawing power shall be subject to review by the lending institution at least on a half yearly basis and the renewal / reassessment at least on an annual basis. The annual renewal/reassessment shall be expected to suitably modulate the limits as per the then-prevailing business conditions.

 What are the immediate actionables?

There is a requirement for adopting a board approved policy within one month from the date of notification, that is by June 5, 2021. In our view, since this may be an extension of the MSME Restructuring Circulars, the existing policy may be suitably modified to include the new provisions. In other words, there is no need to proliferate policies – the existing policy may be suitably amended to permit both the types of restructuring covered by the 5th May Notifications.

What kind of disclosures are required to be made for the MSME accounts restructured?

In compliance with the earlier MSME Restructuring Circulars, Lender shall make appropriate disclosures in their financial statements, under ‘Notes on Accounts’, relating to the MSME accounts restructured under these instructions as per the following format:

No. of accounts restructured Amount (₹ in million)

Comparison of the provisions in the two Notifications:

Point of distinction Individuals and Small Business MSMEs
Eligibility ●       Individual borrowers

●       Individuals who have borrowed for business purposes with an aggregate exposure, including non-fund based facilities, of all lending institutions to the borrower does not exceed ₹25 crore as on March 31, 2021.

●       Small businesses, not being MSMEs, with an aggregate exposure, including non-fund based facilities, of all lending institutions to the borrower does not exceed ₹25 crore as on March 31, 2021.

●       Should be standard as on March 31, 2021

 

 ●       MSMEs with an aggregate exposure, including non-fund based facilities, of all lending institutions to the borrower does not exceed ₹25 crore as on March 31, 2021.

●       Should be standard as on March 31, 2021
Provisioning 10% of the residual debt 10% of the residual debt
Provision reversal For other than personal loans –

50% can be reversed once 20% of the residual debt is repaid

Rest 50% can be reversed once an additional 10% of the residual debt is repaid

 

Additional point for loans other than personal loans – the reversal cannot happen before the expiry of 1 year from date of first payment of interest  or principal (whichever is later) with the longest moratorium period.

 Nothing has been mentioned in this regard.
Asset classification Standard assets to be retained as standard

 

Accounts which have slipped into NPA category between the invocation date and the date of implementation shall be upgraded

 Standard assets to be retained as standard

 

Accounts which have slipped into NPA category between 1st April and the date of implementation shall be upgraded
Maximum period of moratorium 2 years 2 years
Board approved policy Required Required
Restructuring of the working capital facility Allows review of sanctioned limits based on a reassessment of the working capital cycle, reduction of margins, etc. without the same being treated as restructuring Allows review of sanctioned limits based on a reassessment of the working capital cycle, reduction of margins, etc. without the same being treated as restructuring
Restructuring of accounts, already restructured under the earlier framework Only extension of moratorium is allowed, provided that the aggregate period of moratorium should not exceed 2 years Not allowed
Disclosure Fresh disclosure requirements have been introduced in the circular The present circular does not provide for fresh requirements, however, the disclosure requirements under the earlier circulars shall continue

Restructuring for Direct assignment and PTC customers

Several lenders, mostly NBFCs, would have done securitisation of their receivables, or sold the same under direct assignment transactions. Question will arise, whether such receivables may be restructured too.

We have earlier discussed restructuring in case of direct assignment and securitisation – see here. We have also discussed the implication of moratorium in case of securitisation and direct assignment.

Our earlier discussion on restructuring will be applicable in case restructuring of securitised and assigned loans too.

Conclusion

At the time when the country is gasping for oxygen, whether RBI’s measures will ease the situation? The answer must be optimistic. These measures, besides their own tangible impact, are also symbolic – they indicate that the policy-makers’ attention is now seriously on resolving the after-effects of the pandemic.

[1] https://rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1108

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11941&Mode=0 and https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11942&Mode=0

[3] We have substantially rich resources dealing with MSME financing -see here: http://vinodkothari.com/2020/05/resources-on-msme/

Strengthening Corporate Governance Norms in Banks – An after dose to a wounded governance system

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Aanchal kaur Nagpal | finserv@vinodkothari.com

Introduction

A witness of serious lapses, over the past, in the banking system of India has brought the adequacy of the entire governance framework of banks into question. Banks have a huge fiduciary responsibility thereby casting a higher need of accountability. Failure or weakness in governance of a bank severely affects its risk profile, financial stability and depositors’ interest resulting in systemic and systematic risks in the entire financial sector as well as the economy as a whole.

In response to the aftermath created by bank failures like PNB and Yes bank, RBI released a Discussion Paper on ‘Governance in Commercial Banks in India’ on 11th June, 2020 (‘Discussion Paper’)[1]. The objective of the Discussion Paper was to align the current regulatory framework with global best practices while being mindful of the context of domestic financial system. Various proposals were made to fill in the cracks of the age-old and derelict governance regime of the banking sector.

Based on the feedback received from market participants, RBI has reviewed and released a Circular on ‘Corporate Governance in Banks – Appointment of Directors and Constitution of Committees of the Board’ on 26th April, 2021[2] (‘Circular’). The Circular consists of instructions by RBI on certain aspects covered in the Discussion Paper viz. chair and meetings of the board, composition of certain committees of the board, age, tenure and remuneration of directors, and appointment of the whole-time directors (‘WTDs’). A Master Direction on Governance will be issued in due course.

Effective Date

These guidelines will be effective from the date of issue of this circular i.e. 26th April, 2021. However, in order to enable smooth transition to these requirements, RBI has permitted banks to comply with the same latest by 1st October, 2021. Further, there are certain specific transitioning relaxations, as discussed later in this article.

Applicability of the Circular

Supplementary nature of the Circular  

The Circular does not have an overriding effect and will be read along with other governing statutes. It shall supplement the existing law in place and not withstand anything contrary contained in the any notifications, directions, regulations, guidelines, instructions, etc., issued by RBI before the Circular. Therefore, the most stringent provision will prevail.

The following guidelines have been brought by the Circular –

Chairperson and Meetings of the Board

Chairperson –

As per the Circular, the Chairperson of the Board shall be an independent director. Section 10B of the Banking Regulation Act, 1949 gives banks, an option to either appoint a whole time or a part-time chairman subject provided that in case of a part-time chairman, the following conditions are satisfied –

  1. A managing director (‘MD’) is appointed for management of the affairs of the bank
  2. Prior approval of RBI is obtained

The Circular provides a transitioning relaxation if the Chairperson of the Board is not an independent director as on the date of issue of the Circular, such Chairperson will be allowed to complete the current term as already approved by RBI.

As per market practice, most of the banks have independent directors as Chairpersons. However, in case of non-independent Chairpersons, Banks will be required to appoint an independent director to the office of the Chairperson while also complying with conditions under section 10B of the BR Act (since the Circular is only supplemental to existing provisions).

Further, in the absence of the Chairperson, the meetings of the board shall be chaired by an independent director.

Meetings of the Board

The quorum for the board meetings shall be:

  1. 1/3rd of the total strength of the board or
  2. three directors, whichever is higher

Further, at least half of the directors attending the meetings of the board shall be independent directors.

While the intent is to pose independence in Board deliberations, this also implies that banks will be required to have a majority of independent directors on their Board as well, at all times, considering if Board Meetings have full attendance. The Circular therefore is nudging banks towards a Board with an independent majority.

Committees of the Board

The guidelines provide for a stringent framework related to the composition and functioning of the Board Committees.

 

  Audit committee (‘AC’) Risk Management Committee (‘RMC’) Nomination and Remuneration Committee (‘NRC’)
Composition  Only NEDs

 

 Majority NEDs Only NEDs

 
Minimum 2/3rd of the directors shall be IDs

 

 Minimum 1/2 of the directors shall be IDs Minimum 1/2 of the directors shall be IDs
Chairperson Independent Director

 

 Independent Director Independent Director
Restrictions on Chairperson Cannot chair any other committee of the Board Cannot chair the Board and/or any Committee of the Board

 

 Cannot chair the Board
Qualification of Members All members should have the ability to understand all financial statements as well as the notes/ reports attached thereto and

 

At least 1 member shall have requisite professional expertise/ qualification in financial accounting or financial management

 

 At least 1 member shall have professional expertise/ qualification in risk management No specific provision
Meetings One meeting in every quarter One meeting in every quarter

 

 As and when required
Quorum 3 members  of which at least 2/3rd will be IDs 3 members  of which at least 1/2 are IDs 3 members of which at least 1/2 are IDs of which one shall be a member of the RMC.

 

 

RBI has retained majority of the provisions as proposed in the Discussion Paper. However, the requirement of holding at least 6 meetings in a year and not more than 60 days to elapse between 2 meetings has been relaxed to 4 meetings for the RMC and AC, while the NRC is permitted to meet as and when required. Such modification prevents the Company from being excessively burdened and statutorily mandated to hold meetings.

Remunerations of NEDs

As per the Circular, banks may pay remuneration to NEDs by way of sitting fees, expenses related to attending meetings of the Board and Committees, and compensation in the form of a fixed remuneration. However, the existing guidelines on ‘Compensation of NEDs of Private Sector Banks’[3] dated 1st June, 2015 permit profit related commission to NEDs, except Part-time Chairman, subject to the bank making profits. The ambiguity that arises here is whether banks will be permitted to pay fixed remuneration as well as profit-based commission or only fixed compensation to its NEDs. A clarification with respect to the same is yet sought.

Payment of fixed compensation to NEDs seems like a move in similar lines to SEBI’s proposal to grant stock options to IDs instead of profit linked commission[4]. However, if banks are only allowed to pay fixed remuneration, payment in the form of ESOPs as per SEBI guidelines, would not be permitted. Further, the earlier circular permits profit-linked commission, if banks have profit. Permitting a fixed remuneration would enable banks to pay remuneration to its NEDs during losses as well, as has been recently allowed by MCA[5].

Further, the Circular sets a limit of INR 20 lakhs on the fixed compensation payable to an NED. The existing guidelines also provide for a limit of INR 10 lakhs on compensation paid as profit-linked commission to an NED. This leads to another question whether a bank is permitted to pay a maximum of INR 30 lakhs (where INR 20 lakhs shall be fixed component and INR 10 lakhs will be profit-linked) or INR 20 lakhs is an all-inclusive limit.

Since the Circular does not have any repealing effect, it creates various ambiguities as mentioned above. Clarifications are sought for the same from RBI.

Age and tenure of NEDs

The upper age limit for all NEDs, including the Chairperson, will be 75 years post which no person can continue as an NED. The total tenure of an NED, continuously or otherwise, on the board of a bank, shall not exceed 8 years and such NED will be eligible for re-appointment after a cooling period of 3 years. This means that even if an NED’s appointment is staggered and results into a total of 8 years irrespective of any gaps in the tenure, a cooling period of 3 years will be required before his/her reappointment once he/she completes 8 years as an NED.

However, such cooling period will not preclude him/her from being appointed as a director in another bank subject to meeting the requirements.

Tenure of MD & CEO and WTDs

The Circular also puts a limit to the tenure of MD&CEO and WTDs which was indicative of the need to separate ownership from management while also building a culture of sound governance and professional management in banks.

A person can act as an MD and CEO or a WTD only for a period of 15 years, subject to statutory approvals required from time to time. The person will be eligible for re-appointment as MD&CEO or WTD in the same bank, if considered necessary and desirable by the Board, after a cooling off period of 3 years, subject to meeting other conditions. During this three-year cooling period, the person will not be allowed to be appointed or associated with the bank or its group entities in any capacity, either directly or indirectly.

Further, an MD&CEO or WTD who is also a promoter/ major shareholder, cannot hold such posts for more than 12 years. However, in extraordinary circumstances, at the sole discretion of RBI such directors may be allowed to continue up to 15 years.

It is to be noted that RBI has permitted banks with MD&CEOs or WTDs who have already completed 12/15 years, on the date these instructions come to effect, to complete their current term as already approved by RBI.

Conclusion

The growing size and complexity of the Indian financial system underscores the significance of strengthening corporate governance standards in regulated entities. After the financial sector took huge blows due to failed governance systems in various banks, it was seen imperative to strengthen the governance culture in banks. However, there are certain aspects that still require clarity.

 

[1] https://www.rbi.org.in/Scripts/PublicationsView.aspx?id=19613

[2] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=12078&Mode=0

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=9749&Mode=0

FAQs: Appointment of Statutory Auditors

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-Financial Services Divison (finserv@vinodkothari.com)

The Reserve Bank of India has issued Guidelines for Appointment of Statutory Central Auditors (SCAs)/Statutory Auditors (SAs) of Commercial Banks (excluding RRBs), UCBs and NBFCs (including HFCs) under Section 30(1A) of the Banking Regulation Act, 1949, Section 10(1) of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980 and Section 41(1) of SBI Act, 1955; and under provisions of Chapter IIIB of RBI Act, 1934 for NBFCs, on 27th April 2021 (“Guidelines”).

The Guidelines intend to supersede the existing circulars/notification on appointment of statutory auditors by Banks and NBFC. The Guidelines provide necessary instructions for appointment of SCAs/SAs, the number of auditors, their eligibility criteria, tenure and rotation as well as norms for ensuring the independence of auditors.

We have tried to figure out the probable questions arising out of these Guidelines and respond to the same in the form of these FAQs.

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FAQs on refund of interest on interest

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-Financial Services Division (finserv@vinodkothari.com)

The Supreme Court of India (‘SC’ or ‘Court’) had given its judgment in the matter of Small Scale Industrial Manufacturers Association vs UOI & Ors. and other connected matters on March 23, 2021. The said order of SC put an end to an almost ten months-long legal scuffle that started with the plea for a complete waiver of interest but edged towards waiver of interest on interest, that is, compound interest, charged by lenders during Covid moratorium.  While there is no clear sense of direction as to who shall bear the burden of interest on interest for the period commencing from 01 March 2020 till 31 August 2020. The Indian Bank’s Association (IBA) has made representation to the government to take on the burden of additional interest, as directed under the Supreme Court judgment. While there is currently no official response from the Government’s side in this regard, at least in the public domain in respect to who shall bear the interest on interest as directed by SC. Nevertheless, while the decision/official response from the Government is awaited, the RBI issued a circular dated April 07, 2021, directing lending institutions to abide by SC judgment.[1] Meanwhile, the IBA in consultation with banks, NBFCs, FICCI, ICAI, and other stakeholders have adopted a guideline with a uniform methodology for a refund of interest on interest/compound interest/penal interest.

We have earlier covered the ex-gratia scheme in detail in our FAQs titled ‘Compound interest burden taken over by the Central Government: Lenders required to pass on benefit to borrowers’ – Vinod Kothari Consultants>

In this write-up, we have aimed to briefly cover some of the salient aspects of the RBI circular in light of SC judgment and advisory issued by IBA.

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Payment and Settlement Systems: A Primer

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– Siddarth Goel (finserv@vinodkothari.com)

Introduction

A payment denotes the performance or discharge of an obligation to pay, which may or may not involve money transfer. Payment is therefore a financial obligation in whatever parties have agreed constituting a payment. A payment and settlement system could be understood as a payments market infrastructure that facilitates the flow of funds in satisfaction of a financial obligation. The need for a payment system is an integral part of commerce. From the use of a payment system in an e-commerce purchase, a debit or credit card fund transfer, stock or share purchase. The payment obligation can also be settled without the presence of any financial intermediary (peer-to-peer). The payment transaction need not always be settled in money, it could be settled in security, commodity, or any other obligation as may be decided by payment system participants.

One of the earlier known payment mechanisms was the barter system. With the evolution of civilisation, the world moved to a system supported by tokens and coins that are still prevalent and are widely used as the mode of payment. The payment mechanism supported by physical currency notes or coins is simple, as it offers peer-to-peer, real-time settlement of obligation between the parties, by way of physical transfer of note or coin from one party to another.

In contemporary electronic payment systems, the manner of flow of funds from one payment system participant to another is central to the security, transparency, and stability of the payment system and financial system as a whole. The RBI’s main objective is to maintain public confidence in payment and settlement systems, while the other function being to upgrade and introduce safe and efficient modes of payment systems. The RBI is also the banker to all scheduled banks and maintains bank accounts on their behalf.  All the scheduled commercial banks have access to a central payment system operated by RBI. Thereby banks have access to liquidity funding line with RBI which have been discussed later in this chapter.

Electronic payments usually involve the transfer of funds via money in bank deposits. While securities settlement system involves trade in financial instruments namely; bonds, equities, and derivatives. The implementation of sound and efficient payment and securities settlement systems is essential for financial markets and the economy. The payment system provides money as a means of exchange, as central banks are in control of supplying money to the economy which cannot be achieved without public confidence in the systems used to transfer money. It is essential to maintain stability of the financial systems, as default under very large value transfers create the possibilities of failure that could cause broader systemic risk to other financial market participants. There is a presence of negative externality that can emanate from a failure of a key participant in the payment system.[1]

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Understanding regulatory intricacies of Payment Aggregator business

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-Siddarth Goel (finserv@vinodkothari.com)

Abstract

The penetration of electronic retail payments has witnessed a steep surge in the overall payment volumes during the latter half of the last decade. One of the reasons accorded to this sharp rise in electronic payments is the exponential growth in online merchant acquisition space. An online merchant is involved in marketing and selling its goods and/or services through a web-based platform. The front-end transaction might seem like a simple buying-selling transaction of goods or services between a buyer (customer) and a seller (merchant). However, the essence of this buying-selling transaction lies in the payment mode or methodology of making/accepting payments adopted between the customer and the merchant. One of the most common ways of payment acceptance is that the merchant establishes its own payment integration mechanism with a bank such that customers are enabled to make payments through different payment instruments. In such cases, the banks are providing payment aggregator services, but the market is limited usually to the large merchants only. Alternatively, merchants can rely upon third-party service providers (intermediary) that facilitate payment collection from customers on behalf of the merchant and thereafter remittance services to the merchant at the subsequent stage – this is regarded as a payment aggregation business.

The first guidelines issued by the RBI governing the merchant and payment intermediary relationship was in the year 2009[1]. Over the years, the retail payment ecosystem has transformed and these intermediaries, participating in collection and remittance of payments have acquired the market-used terminology ‘Payment Aggregators’. In order to regulate the operations of such payment intermediaries, the RBI had issued detailed Guidelines on Regulation of Payment Aggregators and Payment Gateways, on March 17, 2020. (‘PA Guidelines’)

The payment aggregator business has become a forthcoming model in the online retail payments ecosystem. During an online retail payment by a customer, at the time of checkout vis-à-vis a payment aggregator, there are multiple parties involved. The contractual parties in one single payment transaction are buyer, payment aggregator, payment gateway, merchant’s bank, customer’s bank, and such other parties, depending on the payment mechanism in place. The rights and obligations amongst these parties are determined ex-ante, owing to the sensitivity of the payment transaction. Further, the participants forming part of the payment system chain are regulated owing to their systemic interconnectedness along with an element of consumer protection.

This write-up aims to discuss the intricacies of the regulatory framework under PA Guidelines adopted by the RBI to govern payment aggregators and payment gateways operating in India. The first part herein attempts to depict growth in electronic payments in India along with the turnover data by volumes of the basis of payment instruments used. The second part establishes a contrast between payment aggregator and payment gateway and gives a broad overview of a payment transaction flow vis-à-vis payment aggregator. The third part highlights the provisions of the PA Guidelines and establishes the underlying internationally accepted best principles forming the basis of the regulation. The principles are imperative to understand the scope of regulation under PA Guidelines and the contractual relationship between parties forming part of the payment chain.

Market Dynamics

The RBI in its report stated that the leverage of technology through the use of mobile/internet electronic retail payment space constituted around 61% share in terms of volume and around 75% in share in terms of value during FY 19-20.[2] The innovative payment instruments in the retail payment space, have led to this surge in electronic payments. Out of all the payment instruments, the UPI is the most innovative payment instrument and is the spine for growth in electronic payments systems in India. Chart 1 below compares some of the prominent payment instruments in terms of their volumes and overall compounded annual growth rate (CAGR) over the period of three years.

The payment system data alone does not show the complete picture. In conformity with the rise in electronic payment volumes, as per the Government estimates the overall online retail market is set to cross the $ 200 bn figure by 2026 from $ 30 bn in 2019, at an expected CAGR of 30 %.[4] India ranks No. 2 in the Global Retail Development Index (GRDI) in 2019. It would not be wrong to say, the penetration of electronic payments could be due to the presence of more innovative products, or the growth of online retail has led to this surge in electronic payments.

What are Payment Aggregators and Payment Gateways?

The terms Payment Aggregator (‘PA’) and Payment Gateways (‘PG’) are at times used interchangeably, but there are differences on the basis of the function being performed. Payment Aggregator performs merchant on-boarding process and receives/collects funds from the customers on behalf of the merchant in an escrow account. While the payment gateways are the entities that provide technology infrastructure to route and/or facilitate the processing of online payment transactions. There is no actual handling of funds by the payment gateway, unlike payment aggregators. The payment aggregator is a front-end service, while the payment gateway is the back-end technology support. These front-end and back-end services are not mutually exclusive, as some payment aggregators offer both. But in cases where the payment aggregator engages a third-party service provider, the payment gateways are the ‘outsourcing partners’ of payment aggregators. Thereby such payments are subject to RBI’s outsourcing guidelines.

PA Transaction Flow

One of the most sought-after electronic payments in the online buying-selling marketplace is the payment systems supported by PAs. The PAs are payment intermediaries that facilitate e-commerce sites and merchants in accepting various payment instruments from their customers. A payment instrument is nothing but a means through which a payment order or an instruction is sent by a payer, instructing to pay the payee (payee’s bank). The familiar payment instruments through which a payment aggregator accepts payment orders could be credit cards, debit cards/PPIs, UPI, wallets, etc.

Payment aggregators are intermediaries that act as a bridge between the payer (customer) and the payee (merchant). The PAs enable a customer to pay directly to the merchant’s bank through various payment instruments. The process flow of each payment transaction between a customer and the merchant is dependent on the instrument used for making such payment order. Figure 1 below depicts the payment transaction flow of an end-to-end non-bank PA model, by way of Unified Payment Interface (UPI) as a payment instrument.

In an end-to-end model, the PA uses the clearing and settlement network of its partner bank. The clearing and settlement of the transaction are dependent on the payment instrument being used. The UPI is the product of the National Payments Corporation of India (NPCI), therefore the payment system established by NPCI is also quintessential in the transaction. The NPCI provides a clearing and settlement facility to the partner bank and payer’s bank through the deferred settlement process. Clearing of a payment order is transaction authorisation i.e., fund verification in the customer’s bank account with the payer’s bank. The customer/payer bank debits the customer’s account instantaneously, and PA’s bank transfers the funds to the PA’s account after receiving authorisation from NPCI. The PA intimates the merchant on receipt of payment and the merchant ships the goods to the customer. The inter-bank settlement (payer’s bank and PA’s partner bank) happens at a later stage via deferred net-settlement basis facility provided by the NPCI.

The first leg of the payment transaction is settled between the customer and PA once the PA receives the confirmation as to the availability of funds in the customer’s bank account. The partner bank of PA transfers the funds by debiting the account of PA maintained with it. The PA holds the exposure from its partner bank, and the merchant holds the exposure from the PA. This explains the logic of PA Guidelines, stressing on PAs to put in place an escrow mechanism and maintenance of ‘Core Portion’ with escrow bank. It is to safeguard the interest of the merchants onboarded by the PA. Nevertheless, in the second leg of the transaction, the merchant has its right to receive funds against the PA as per the pre-defined settlement cycle.

Regulatory approach towards PAs and PGs

The international standards and best practices on regulating Financial Market Infrastructure (FMI) are set out in CPSS-IOSCO principles of FMI (PFMI).[5] A Financial Market Infrastructure (FMI) is a multilateral system among participating institutions, including the operator of the system. The consumer protection aspects emerging from the payment aggregation business model, are regulated by these principles. Based on CPSS-IOSCO principles of (PFMI), the RBI has described designated FMIs, and released a policy document on regulation and supervision of FMIs in India under its regulation on FMIs in 2013.[6] The PFMI stipulates public policy objectives, scope, and key risks in financial market infrastructures such as systemic risk, legal risk, credit risk, general business risks, and operational risk. The Important Retail Payment Systems (IRPS) are identified on the basis of the respective share of the participants in the payment landscape.  The RBI has further sub-categorised retail payments FMIs into Other Retail Payment Systems (ORPS). The IRPS are subjected to 12 PFMI while the ORPS have to comply with 7 PFMIs. The PAs and PGs fall into the category of ORPS, regulatory principles governing them are classified as follows:

These principles of regulation are neither exclusive nor can said to be having a clear distinction amongst them, rather they are integrated and interconnected with one another. The next part discusses the broad intention of the principles above and the supporting regulatory clauses in PA Guidelines covering the same.

Legal Basis and Governance framework

The legal basis principle lays the foundation for relevant parties, to define the rights and obligations of the financial market institutions, their participants, and other relevant parties such as customers, custodians, settlement banks, and service providers. Clause 3 of PA Guidelines provides that authorisation criteria are based primarily on the role of the intermediary in the handling of funds. PA shall be a company incorporated in India under the Companies Act, 1956 / 2013, and the Memorandum of Association (MoA) of the applicant entity must cover the proposed activity of operating as a PA forms the legal basis. Henceforth, it is quintessential that agreements between PA, merchants, acquiring banks (PA’s Partners Bank), and all other stakeholders to the payment chain, clearly delineate the roles and responsibilities of the parties involved. The agreement should define the rights and obligations of the parties involved, (especially the nodal/escrow agreement between partner bank and payment aggregator). Additionally, the agreements between the merchant and payment aggregator as discussed later herein are fundamental to payment aggregator business. The PA’s business rests on clear articulation of the legal basis of the activities being performed by the payment aggregator with respect to other participants in the payment system, such as a merchant, escrow banks, in a clear and understandable way.

Comprehensive Management of Risk

The framework for the comprehensive management of risks provides for integrated and comprehensive view of risks. Therefore, this principle broadly entails comprehensive risk policies, procedures/controls, and participants to have robust information and control systems. Another connecting aspect of this principle is operational risk, arising from internal processes, information systems and disruption caused due to IT systems failure. Thus there is a need for payment aggregator to have robust systems, policies to identify, monitor and manage operational risks. Further to ensure efficiency and effectiveness, the principle entails to maintain appropriate standards of safety and security while meeting the requirements of participants involved in the payment chain. Efficiency is resources required by such payment system participants (PAs/PGs herein) to perform its functions. The efficiency includes designs to meet needs of participants with respect to choice of clearing and settlement transactions and establishing mechanisms to review efficiency and effectiveness. The operational risk are comprehensively covered under Annex 2 (Baseline Technology-related Recommendation) of the PA Guidelines. The Annex 2, inter alia includes, security standards, cyber security audit reports security controls during merchant on-boarding. These recommendations and compliances under the PA Guidelines stipulates standard norms and compliances for managing operational risk, that an entity is exposed to while performing functions linked to financial markets.

KYC and Merchant On-boarding Process

An important aspect of payment aggregator business covers merchant on-boarding policies and anti-money laundering (AML) and counter-terrorist financing (CFT) compliance. The BIS-CPSS principles do not govern within its ambits certain aspects like AML/CFT, customer data privacy. However, this has a direct impact on the businesses of the merchants, and customer protection. Additionally, other areas of regulation being data privacy, promotion of competition policy, and specific types of investor and consumer protections, can also play important roles while designing the payment aggregator business model. Nevertheless, the PA Guidelines provide for PAs to undertake KYC / AML / CFT compliance issued by RBI, as per the “Master Direction – Know Your Customer (KYC) Directions” and compliance with provisions of PML Act and Rules. The archetypal procedure of document verification while customer on-boarding process could include:

  • PA’s to have Board approved policy for merchant on-boarding process that shall, inter-alia, provide for collection of incorporation certificates, constitutional document (MoA/AoA), PAN and financial statements, tax returns and other KYC documents from the merchant.
  • PA’s should take background and antecedent checks of the merchants, to ensure that such merchants do not have any malafide intention of duping customers, do not sell fake/counterfeit/prohibited products, etc.

PAs shall ensure that the merchant’s site shall not save customer’s sensitive personal data, like card data and such related data. Agreement with merchant shall have provision for security/privacy of customer data.

Settlement and Escrow

The other critical facet of PA business is the settlement cycle of the PA with the merchants and the escrow mechanism of the PA with its partner bank. Para 8 of PA Guidelines provide for non-bank PAs to have an escrow mechanism with a scheduled bank and also to have settlement finality. Before understanding the settlement finality, it is important to understand the relevance of such escrow mechanisms in the payment aggregator business.

Escrow Account

Surely there is a bankruptcy risk faced by the merchants owing to the default by the PA service provider. This default risk arises post completion of the first leg of the payment transaction. That is, after the receipt of funds by the PA from the customer into its bank account. There is an ultimate risk of default by PA till the time there is final settlement of amount with the merchant. Hence, there is a requirement to maintain the amount collected by PA in an escrow account with any scheduled commercial bank. All the amounts received from customers in partner bank’s account, are to be remitted to escrow account on the same day or within one day, from the date amount is debited from the customer’s account (Tp+0/Tp+1). Here Tp is the date on which funds are debited from the customer’s bank account.  At end of the day, the amount in escrow of the PA shall not be less than the amount already collected from customer as per date of debit/charge to the customer’s account and/ or the amount due to the merchant. The same rules shall apply to the non-bank entities where wallets are used as a payment instrument.[7] This essentially means that PA entities should remit the funds from the PPIs and wallets service provider within same day or within one day in their respective escrow accounts. The escrow banks have obligation to ensure that payments are made only to eligible merchants / purposes and not to allow loans on such escrow amounts. This ensures ring fencing of funds collected by the PAs, and act as a deterrent for PAs from syphoning/diverting the funds collected on behalf of merchants. The escrow agreement function is essentially to provide bankruptcy remoteness to the funds collected by PA’s on behalf of merchants.

Settlement Finality

Settlement finality is the end-goal of every payment transaction. Settlement in general terms, is a discharge of an obligation with reference of the underlying obligation (whatever parties agrees to pay, in PA business it is usually INR). The first leg of the transaction involves collection of funds by the PA from the customer’s bank (originating bank) to the PA escrow account. Settlement of the payment transaction between the PA and merchant, is the second leg of the same payment transaction and commences once funds are received in escrow account set up by the PA (second leg of the transaction).

Settlement finality is the final settlement of payment instruction, i.e. from the customer via PA to the merchant. Final settlement is where a transfer is irrevocable and unconditional. It is a legally defined moment, hence there shall be clear rules and procedures defining the point of settlement between the merchant and PA.

For the second leg of the transaction, the PA Guidelines provide for different settlement cycles:

  1. Payment Aggregator is responsible for the delivery of goods/service– The settlement cycle with the merchant shall not be later than one day from the date of intimation to PA of shipment of goods by the merchant.
  2. Merchant is responsible for delivery– The settlement cycle shall not be later than 1 day from the date of confirmation by the merchant to PA about delivery of goods to the customer.
  3. Keeping the amount by the PA till the expiry of refund period– The settlement cycle shall not be later than 1 day from the date of expiry of the refund period.

These settlement cycles are mutually exclusive and the PA business models and settlement structure cycle with the merchants could be developed by PAs on the basis of market dynamics in online selling space. Since the end-transaction between merchant and PA is settled on a contractually determined date, there is a deferred settlement, between PA and the merchant.  Owing to the rules and nature of the relationship (deferred settlement) is the primary differentiator from the merchants proving the Delivery vs. Payment (DvP) settlement process for goods and services.

Market Concerns

Banks operating as PAs do not need any authorisation, as they are already part of the the payment eco-system, and are also heavily regulated by RBI. However, owing to the sensitivity of payment business and consumer protection aspect non-bank PA’s have to seek RBI’s authorisation. This explains the logic of minimum net-worth requirement, and separation of payment aggregator business from e-commerce business, i.e. ring-fencing of assets, in cases where e-commerce players are also performing PA function. Non-bank entities are the ones that are involved in retail payment services and whose main business is not related to taking deposits from the public and using these deposits to make loans (See. Fn. 7 above).

However, one could always question the prudence of the short timelines given by the regulator to existing as well as new payment intermediaries in achieving the required capital limits for PA business. There might be a trade-off between innovations that fintech could bring to the table in PA space over the stringent absolute capital requirements. While for the completely new non-bank entity the higher capital requirement (irrespective of the size of business operations of PA entity) might itself pose a challenge. Whereas, for the other non-bank entities with existing business activities such as NBFCs, e-commerce platforms, and others, achieving ring-fencing of assets in itself would be cumbersome and could be in confrontation with the regulatory intention. It is unclear whether financial institutions carrying financial activities as defined under section 45 of the RBI Act, would be permitted by the regulator to carry out payment aggregator activities. However, in doing so, certain additional measures could be applicable to such financial entities.

Conclusion

The payment aggregator business models in India are typically based on front-end services, i.e. the non-bank entitles are aggressively entering into retail payment businesses by way of providing direct services to merchants. The ability of non-bank entitles to penetrate into merchant onboarding processes, has far overreaching growth potential than merchant on-boarding processes of traditional banks. While the market is at the developmental stage, nevertheless there has to be a clear definitive ex-ante system in place that shall provide certainty to the payment transactions. The CPSS-IOSCO, governing principles for FMIs lays down a good principle-based governing framework for lawyers/regulators and system participants to understand the regulatory landscape and objective behind the regulation of payment systems. PA Guidelines establishes a clear, definitive framework of rights between the participants in the payment system, and relies strongly on board policies and contractual arrangements amongst payment aggregators and other participants. Therefore, adequate care is necessitated while drafting escrow agreements, merchant-on boarding policies, and customer grievance redressal policies to abide by the global best practices and meet the objective of underlying regulation. In hindsight, it will be discovered only in time to come whether the one-size-fits-all approach in terms of capital requirement would prove to be beneficial for the overall growth of PA business or will cause a detrimental effect to the business space itself.

 

[1] RBI, Directions for opening and operation of Accounts and settlement of payments for electronic payment transactions involving intermediaries, November 24, 2009. https://www.rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=5379

[2] Payment Systems in India – Booklet (rbi.org.in)

[3] https://m.rbi.org.in/Scripts/AnnualReportPublications.aspx?Id=1293

[4] https://www.investindia.gov.in/sector/retail-e-commerce

[5] The Bank for International Settlements (BIS), Committee on Payment and Settlement Systems (CPSS) and International Organisation of Securities Commissions (IOSCO) published 24 principles for financial market infrastructures and  and responsibilities of central banks, market regulators and other authorities. April 2012 <https://www.bis.org/cpmi/publ/d101a.pdf>

[6]Regulation and Supervision of Financial Market Infrastructures, June 26, 2013 https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=2705

[7] CPMI defines non-banks as “any entity involved in the provision of retail payment services whose main business is not related to taking deposits from the public and using these deposits to make loans”  See, CPMI, ‘Non-banks in retail Payments’, September 2014, available at <https://www.bis.org/cpmi/publ/d118.pdf>

 

Our other related articles:

Overview of Regulatory Framework of Payment and Settlement Systems in India by Anita Baid – Vinod Kothari Consultants

RBI to regulate operation of payment intermediaries – Vinod Kothari Consultants

Major recommendations of the Committee on Payment Systems on Payment and Settlement System Bill, 2018 – Vinod Kothari Consultants

No compound interest during moratorium: RBI directs lenders pursuant to SC order

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Anita Baid | Vice President, Financial Services (anita@vinodkothari.com)

Overview

The Supreme Court of India (‘SC’ or ‘Court’) had given its judgement in the matter of Small Scale Industrial Manufacturers Association vs UOI & Ors. and other connected matters on March 23, 2021. The said order of SC put an end to an almost ten months-long legal scuffle that started with the plea for complete waiver of interest, but edged towards waiver of interest on interest, that is, compound interest, charged by lenders during Covid moratorium. From the miseries suffered by people due to the pandemic, to the economic strangulation of trade and activity – the unfinished battle with the pandemic continues. Nevertheless, the SC realised the economic limitation of any Government, even in a welfare state. The SC acknowledged that the economic and fiscal regulatory measures are fields where judges should encroach upon very warily as judges are not experts in these matters. What is best for the economy, and in what manner and to what extent the financial reliefs/ packages be formulated, offered and implemented is ultimately to be decided by the Government and RBI on the aid and advice of the experts.

Compound interest continues to elude judicial acceptance – there are several rulings against compound interest pertaining to arbitral awards, and a lot more for civil awards. In the present ruling as well, observations of the Apex court seem to be indicating that compound interest is penal in nature. This may be surprising to a person of finance, as in the financial world, compound interest is ubiquitous and unquestionable.

In the concluding part of the judgment while dismissing all the petitions, the Court lifted the interim relief granted earlier, pertaining to the NPA status of the borrowers. However, the last tranche of relief in the judgement came for the large borrowers that had loans outstanding/ sanctioned as on February 29, 2020 greater than Rs. 2 crores, and other borrowers who were not eligible to avail compound interest relief as per the Scheme for grant of ex-gratia payment of difference between compound interest and simple interest for six months to borrowers in specified loan accounts (1.3.2020 to 31.8.2020) dated October 23, 2020 (“Ex-Gratia Scheme”). The Court did not find any basis for the limit of Rs 2 crores while granting relief of interest-on-interest (under ex-gratia scheme) to the borrowers. Thus, the Court directed that there shall not be any charge of interest on interest/ penal interest for the period during moratorium for any borrower, irrespective of the quantum of loan, or the category of the borrowers.  The lenders should give credit/ adjustment in the next instalment of the loan account or in case the account has been closed, return any amount already recovered, to the concerned borrowers.

Given that the timelines for filing claims under the ex-gratia scheme have expired, it was expected that the Government would be releasing extended/ updated operational guidelines in this regard for adjustment/ refund of the interest on interest charged by the lenders from the borrowers. Further, it seemed that the said directions of the Court would be applicable only to the loan accounts that were eligible and have availed moratorium under the COVID 19 package.

However, as a consequence of the aforesaid ruling, the Reserve Bank of India (‘RBI’) has issued a circular on April 7, 2021 (‘RBI Circular’) instructing the financial institutions to take steps for refund/ adjustment of the interest on interest. While the SC order clearly pertains to the Ex-Gratia Scheme of MoF, the RBI does not talk anywhere about the burden being passed to the GoI.

The RBI Circular is applicable on all lending institutions, that is to say, (a) Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks), (b) Primary (Urban) Co-operative Banks/State Co-operative Banks/ District Central, Co-operative Banks, (c) All All-India Financial Institutions, (d) Non-Banking Financial Companies (including Housing Finance Companies).

Interest on Interest

More than 20 writ petitions were filed with the Supreme Court and the relief sought by them can broadly be classified in four parts – waiver of compound interest/ interest on interest during the moratorium period; waiver of total interest during the moratorium period; extension of moratorium period; and that the economic packages/ reliefs should sector specific. Our write on the issue can be read here.

The contention of the petitioners was that even charging interest on interest/compound interest can be said to be in the form of penal interest. Further, it was argued that the penal interest can be charged only in case of wilful default.  In view of the effect of pandemic due to Covid­19 and even otherwise, there was a deferment of payment of loan during the moratorium period as per RBI circulars, hence, it cannot be said that there is any wilful default which warrants interest on interest/penal interest/compound interest. The appeal was that there should not be any interest on interest/penal interest/compound interest charged for and during the moratorium period.

The Central Government and RBI had already provided the following reliefs to mitigate the burden of debt servicing brought about by disruptions on account of Covid­19 pandemic:

The nature of moratorium was to provide a temporary standstill on payment of both, principal and interest thereby providing relief to the borrowers in two ways, namely, the   account   does   not become NPA despite nonpayment of dues; and since there was no reporting to the Credit Information Companies, the moratorium did not adversely impact the credit history of the borrowers.

It is important to understand the concept of “moratorium”- the word “moratorium” is categorically defined by the RBI, while issuing various circulars. The relevant circulars of RBI show that “moratorium” was never intended to be “waiver of interest”, but “deferment of interest”. In other words, if a borrower takes the moratorium benefit, his liability to make payment of contractual interest (both normal interest and interest on interest) gets deferred for a period of three months and subsequently three months thereafter. After a very careful and major consideration of several fiscal and financial criteria, it’s inevitable effects and keeping the uncertainty of the existing situation in mind, the payment of interest and interest on interest was merely deferred and was never waived.

Further, it is to be noticed that while the standstill applicable to bank loans results in the bank not getting its funds back during the period of moratorium, the bank continues to incur cost on bank’s deposits and borrowings. Since a moratorium offers certain advantages to borrowers, there are costs associated with obtaining the benefit of a moratorium and placing the burden of the same on lenders might just shift the burden on the financial sector of the country. If the lenders were to bear this burden, it would necessarily wipe out a substantial and a major part of their net worth, rendering most of the banks unviable and raising a very serious question over their very survival. Even on the occurrence of other calamities like cyclone, earthquake, drought or flood,  lenders do not waive interest but provide necessary relief packages to the borrowers. A waiver   can only be granted by the Government out of the exchequer. It cannot come out of a system from banks, where credit is created out of the depositor’s funds alone. Any waiver will create a shortfall and a mismatch between the Bank’s assets and liabilities.

Considering the same, the Government had granted the relief of waiver of compound interest during the moratorium period, limited to the most vulnerable categories of borrowers, that is, MSME loans and personal loans up to Rs. 2 crores. Our write up on the same can be viewed here.

However, the SC felt that there is no justification to restrict the relief of not charging interest on interest with respect to the loans up to Rs. 2 crores only and that too restricted to certain categories. Accordingly, the SC had directed that directed that there shall not be any charge of interest on interest/compound interest/penal interest for the period during the moratorium and any amount already recovered under the same head, namely, interest on interest/penal interest/compound interest shall be refunded to the concerned borrowers and to be given credit/adjusted in the next instalment of the loan account.

The ruling however, did not clarify as to who shall bear the burden of the waiver of such interest on interest. Further, the RBI Circular seems to place the burden on the lenders and not wait for the Government to come up with a relief scheme or extend the existing ex-gratia scheme.

RBI Circular

Coverage of Lenders

All lending institutions are covered under the ambit of the RBI Circular. The coverage includes all HFCs and NBFCs, irrespective of the asset size. Clearly, non-banking non-financial entities, or unincorporated bodies are not covered by the Circular.

Coverage of Borrowers

The borrowers eligible as per March 27 Circular (COVID-19 – Regulatory Package) were those who have availed term loans (including agricultural term loans, retail and crop loans) and working capital financing in the form of cash credit/ overdraft. Certain categories of borrowers were ineligible under the March 27 Circular such as those which were not standard assets as on 1st March 2020. Hence, loans already classified as NPA  continued with further asset classification deterioration during the moratorium period in case of non-payment.

The question that arises is whether the benefit under the RBI Circular is limited to any particular type of facility? The benefit of the RBI Circular is to be provided to all borrowers, including those who had availed of working capital facilities during the moratorium period. Further, the benefit is irrespective of the amount sanctioned or outstanding and irrespective of whether moratorium had been fully or partially availed, or not availed. However, this should include only those loans that were originally eligible to claim the moratorium but did not claim it or claimed partially or fully.

Thus, all corporate borrowers, including NBFCs who may have borrowed from banks, are apparently eligible for the relief.

Another crucial aspect is whether the benefit is applicable to facilities which have been repaid, prepaid during the moratorium period? If so, upto what date? The benefit must be provided to all eligible loans existing at the time of moratorium but has been repaid as on date.

Coverage of facilities

Both term loans as well as working capital facilities are covered. Facilities which are not in the nature of loans do not seem to be covered.  Further, facilities for which the Covid moratorium was not applicable also do not seem to be covered. Examples are: unfunded facilities, loans against shares, invoice financing, factoring, financial leases, etc. In addition, borrowing by way of capital market instruments such as bonds, debentures, CP, etc are not covered by the RBI Circular.

Questions will also arise as to whether lenders will be liable to provide the relief in case of those loans which are securitised, assigned under DA transactions or transacted under co-lending arrangement? We have covered these questions in our detailed FAQs on the moratorium 1.0  and 2.0.

Since the moratorium benefit was to be extended only to such installments that were falling due during the said moratorium period. Hence, only those borrowers were eligible for availing moratorium who were standard as on February 29, 2020 and whose installments fell due during the moratorium period. Accordingly, there can be the following situations:

 

Burden of interest on interest

The SC order was with reference to the Central Govt decision vide Ex-Gratia Scheme. Among other things, the petitioners had challenged that there was no basis for limiting the amount of eligible facilities to Rs 2 crores, or limiting the facility only to categories of borrowers specified in the Ex-Gratia Scheme. As per the GoI decision, the benefit was to be granted by lending institutions to the borrowers, and correspondingly, there was a provision for making a claim against SBI, acting as the banker for the GoI.

The SC order is an order upon the UoI. Neither were individual banks/NBFCs parties to the writ petition, nor does it seem logical that the order of the Court may require parties to refund or adjust interest which they charged as per their lending contracts. The UoI may be required to extend a benefit by way of Covid relief, but it does not seem logical that the burden may be imposed on each of the lending institutions, who, incidentally, did not even have the chance to take part in the proceedings before the apex court.

Hence, it seems that the impact of the SC order is only to extend the benefit of the Ex-Gratia Scheme to all borrowers, but the mechanics of the original circular, viz., lending institutions to file a counterclaim against the UoI through SBI, should apply here too.

Accounting disclosure for FY 20-21

The RBI Circular talks about a disclosure for the adjustment or refund to be reflected in the financial statements for FY 20-21.

In terms of accounting standards, the question whether the liability for refund or adjustment of the compound interest is a liability or a provision will be answered with reference to Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets. Since the RBI Circular may be seen as creating a liability as on 31st March, 2021, the lending institution may simply adjust the differential amount [that is, compound interest – simple interest on the Base Amount] into the ongoing account of the customer. If such a liability has been booked, there is no question of any provision.

The computation of the differential amount will have to be done for each borrower. Hence, any form of macro computation does not seem feasible. Therefore, there will not be much of a difference between a provision and a liability.

Accounting for the refund in FY 20-21 by the borrowers

If the lending institution makes a provision, can the borrower book a receivable by crediting interest paid or provided? The answer seems affirmative.

Mechanism of extending the benefit

Methodology for calculation is to be provided by IBA. In this regard, representation has been made to the Government to bear the burden.

Base amount: If the mode of computation as provided in the RBI Circular is to be followed [IBA’s methodology will be awaited], then the computation will be based on the amount outstanding as on 1st March 2020.

Computation: On the Base amount, the differential amount will be CI- SI.

If the facility has been fully repaid during the moratorium period, the Differential Amount will run upto the date of the repayment.

Actionables

A board approved policy is to be put in place immediately. In this regard, the concern is whether the lenders can modify existing moratorium policy or adopt a new policy altogether? In our opinion, the existing policy itself may be amended to give effect to the RBI Circular or alternatively a new policy may be adopted.

Also, there is no timeline prescribed as to by when are these actionables required. However, since there are certain disclosure requirements in the financials for the FY 2020-21, the policy must be in place before the financials are approved by the Board of the respective lenders.

The lender may await the instructions to be issued by the Government and the methodology to be prescribed by IBA. Logically, the same method as was provided under the Ex-Gratia Scheme should be applicable. Accordingly, lenders may create provisions for the refund of the excess interest charged and whether corresponding receivable will be shown would depend on whether the same is granted by the Government.

Asset Classification

The RBI moratorium notifications freezed the delinquency status of the loan accounts, which availed moratorium benefit under the scheme. It essentially meant that asset classification standstill was imposed for accounts where the benefit of moratorium was extended. A counter obligation on Credit Information Companies (CIC) was also imposed to ensure credit history of the borrowers is not impacted negatively, which are availing benefits under the scheme.

Various writ petitions were filed with the SC seeking an extended relief in terms of relaxation in reporting the NPA status to the credit bureaus. Hence, while hearing the petition of Gajendra Sharma Vs Union of India & Anr. and other writ petitions, the SC granted stay on NPA classification in its order dated September 03, 2020. The said order stated that:

“In view of the above, the accounts which were not declared NPA till 31.08.2020 shall not be declared NPA till further orders.”

The intent of granting such a stay was to provide interim relief to the borrowers who have been adversely affected by the pandemic, by not classifying and reporting their accounts as NA and thereby impacting their credit score.

In its latest judgment, the SC has directed that the interim relief granted earlier not to declare the accounts of respective borrowers as NPA stands vacated. We have also covered the same in our write up.

As a consequence of the SC order, the RBI Circular has clarified the asset classification as follows:

This would mean that after September 1, 2020 though there was a freeze on NPA classification, the same cannot be construed as a freeze on DPD counting. The DPD counting has to be in continuation from the due date of the EMI. The accounts classified as standard, but in default of more than 90 DPD may now be classified NPA, since the freeze on NPA classification is lifted by the SC and directed by the RBI as well.