The Clean up call: RBI Action against Lending practices
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Open in new tab Recent Updates to HFC Directions: What you need to know
-Chirag Agarwal | chirag@vinodkothari.com
On October 10, 2024, RBI updated the Master Direction – Non-Banking Financial Company – Housing Finance (‘HFC Directions’) applicable to HFCs. The HFC Directions were updated to consolidate various circulars that have been issued since its last update on March 21, 2024. A significant change in this edition is the introduction of a new format for the Most Important Terms and Conditions (MITC) following the rollout of the Key Facts Statement (KFS) vide circular no DOR.STR.REC.13/13.03.00/2024-25 dated April 15, 2024.
In this article, we will be discussing the changes introduced by the October 10th update to the HFC Directions.
Clarification regarding MITC and KFS
Previously, Para 85.8 of the HFC Directions mandated that to facilitate a quick, and better understanding of the terms and conditions of the housing loan, a document containing the ‘Most Important Terms and Conditions’ (MITC) must be furnished to the borrower. However, when the KFS circular was first introduced, there was some ambiguity regarding whether both the MITC and KFS would apply to HFCs. This confusion arose because both disclosures contained overlapping information. However, with the recent updates to the HFC Directions on October 10, 2024, clarity has been provided on this matter. The revised regulations clearly state that “the HFCs shall additionally obtain a document containing the other most important terms and conditions (MITC) of such loan (i.e., other than the details included in KFS)”.
Notably, the MITC has now been renamed as Other Most Important Terms and Conditions (‘OMITC’). The OMITC will no longer include disclosures that are already covered in the KFS. The revised format no longer includes an obligation to disclose details of the loan amount, interest rate, type of interest, details of moratorium, date of reset of interest, installment type, loan tenure, the purpose of the loan, fees and other charges, as well as the details of the grievance redressal mechanisms now exclusively appear in the KFS. Further, other substantive aspects have been retained, i.e., details of the security/collateral for the loan, details of the insurance, conditions for disbursement of the loan, repayment of the loans and interest, procedure to be followed for recovery, the date on which annual outstanding balance sheet will be issued, and details of the customer services.
This updated approach simplifies the compliance process for HFCs by clearly defining where specific information should be disclosed. It reduces redundancy and ensures that borrowers can find critical information in a consolidated format without surfing through repetitive disclosures.
Consolidation of Circulars
The following circulars and notifications have been consolidated under the HFC Directions pursuant to the update:
Conclusion
To summarise, the recent updates to the HFC Directions not only consolidate past circulars but also clarify the relationship between the MITC and KFS. HFCs can now navigate their disclosure requirements more effectively, enhancing transparency and making it easier for consumers to understand the terms of their loan.
Our other resources on the topic are:-
RBI proposes major regulatory restrictions on bank NBFCs and HFCs
– Vinod Kothari, finserv@vinodkothari.com
Banking regulation is slated to get into a group-wide regulatory framework, embroiling group entities of banks. According to a draft of the proposed regulation circulated on 4th October, 2024,[1] (“Draft Proposal”) NBFCs in the bank group, engaged in lending or housing finance shall be treated as Upper Layer entities, and additionally, shall be subject to the restrictions on lending as applicable to banks. The proposed regulations also provide that there shall be no overlap between the business carried by the bank[2], and that by bank group entities, which, literally, would mean that lending and asset finance business cannot be done by banking group companies, and if the bank has a housing finance subsidiary, housing finance can be done only by the housing finance entity.
Once the draft circular, expected to force banks to do a major group rejig, is finalised, banks will have 2 years time to comply with it. The restrictions are proposed to be put by way of amendments to the 2016 Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016[3] (‘Master Directions’).
The following are some of the major proposals:
- Certain activities can be carried only by subsidiaries, and not by banks departmentally
These include activities listed under paragraphs 13, 14(a), 14(b), 15, 16, 17 and 22 in Chapter – III of the Master Directions viz. mutual fund business, insurance business, pension fund management, investment advisory services, portfolio management services and broking services or other such risk-sharing activities that require ring-fencing. While out of the list aforesaid, mutual fund business and Insurance business with risk participation, pension fund management investment advisory services, portfolio management service, broking services for commodity derivatives segment were there in the 2016 Directions as well, the new inclusion seems to be “risk sharing activities that require ring-fencing”. This expression will obviously require explanation. Formation of a limited liability entity is sometimes recommended for the reason of ring-fencing, that is, ensuring that the business liabilities do not go beyond the investment made by the shareholder. Hence, if the activity carried by the bank is something that is in the nature of risk absorption or risk participation, the same can be done only through separate entities.
- No overlap in permitted businesses
The most challenging requirement would be to ensure that in case of multiple regulated entities in the same banking group, only one entity within the group shall be allowed to engage in a specific type of permissible business. There should not be any overlap between loan products extended by the bank and its group entities. Hence, in case the group has an HFC extending housing loans, the same shall not be extended by the banking entity.
- Bank lending restrictions apply to group entities as well
There are numerous restrictions on lending by banks[4], including lending to connected entities, directors’ interested entities, senior officers, etc. To the extent these are not currently applicable to NBFCs and HFCs, these restrictions will now apply to such entities in the banking group.
Further, the Draft Proposal also provides that group entities shall not be deployed for regulatory arbitrage – they cannot do what is not permitted for the bank.
- Bar on investment in Category III AIFs
Banks shall not invest in Cat III AIFs. In case of a bank’s group entities, if the entity is a sponsor of an AIF, it can only hold the minimum investment required as a sponsor [Rs. 1 crore]. Note that earlier in December 2023, the RBI has given a shocker, to curb round tripping of money, prohibiting banks and NBFCs to make investment in such AIFs, which in turn have an investment in borrowers of banks/NBFCs[5]. Further, prior approval from RBI’s Department of Regulations shall be required before investing 20% or more in the equity capital of any financial services company/ Category I or II AIF either individually or collectively by the bank group
- The statutory cap of 30% of investee’s capital to include investments by group companies
It is an important provision of the Banking Regulation Act [Section 19(2)] that restricts a bank from holding more than 30% of the equity capital of an investee. This cap shall now include shares held by group companies as well. In existing practice, NBFCs/lending entities in the group are deployed for holding shares or pledges of more than 30%. In fact, one of the proposed changes speaks about shares held indirectly through “trustee companies” as well, raising a question whether shares held by mutual funds and AIFs will also be aggregated. The answer should be negative, as MF and AIF investments cannot be said to be investments held indirectly by the bank, unless the AIF is majority controlled by the bank.
- Capital management to be group-wide
The banking group shall have a group-wide capital management policy, enumerating risks and providing economic capital. Understandably, ICAAP will also have to be monitored on a group-wide basis.
Our comments
Veteran bankers are not surprised by the RBI’s move, though, with expected losses, changes in LCR requirements and lot more in the offing, this seems too much over too short a time. In fact, when the non-operating financial holding company (NOFHC) model was recommended in 2013 by the Parliamentary Standing Committee on Finance, it was laid there that “(T)he general principle is that no financial services entity held by the NOFHC would be allowed to engage in any activity that a bank is permitted to undertake departmentally”. The idea of ring fencing of diverse activities was inspired by the need for controlling contagion, alleviation of regulatory arbitrage, etc. The RBI’s Internal Committee named P K Mohanty Working Group also made similar recommendations.
The proposed changes are clearly aimed at curbing any possibility of regulatory arbitrage. Currently, most foreign banks in India have non-banking finance companies; several Indian banks also have NBFCs which are quite large in size and do things which the bank does. In some cases, such as lending against shares, given the NBFC lending norms being more liberal, NBFCs are used for loans against shares, particularly for funding equity investments by group holding companies. Further, NBFCs are not subject to the statutory limit of 30% of the investee company’s capital, by way of ownership, pledge or mortgage. This liberty will no longer be available.
As regards housing finance entities forming part of banking groups, unless the RBI provides a carve out, there will be need to do major corporate restructuring. There are large home loan portfolios both within banks, as also in bank group HFCs. The bank will either need to spin off the housing finance business, or to consider stake sale in HFCs to bring them out of the “group company” definition.
In short, once the proposed changes are finally coded, the banking sector in the country is headed for some very far reaching restructuring changes.
[1] https://rbidocs.rbi.org.in/rdocs/Content/PDFs/DRAFTCIRCULAR0410202419AC7BEE698D41F4BF221D39468A9E59.PDF
[2] There is a list of permissible activities that can be undertaken by the bank, laid down in Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 (Updated as on August 10, 2021)
[3] 25MD2605164EDAA7B1E214468EBE2D7CC406CA6648.PDF (rbi.org.in)
[4] Prescribed under Master Circular- Loans and Advances – Statutory and Other Restrictions 95MND246C0F34D0041F6831205AB5D695422.PDF (rbi.org.in)
[5] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0
Other related resources:
Aligning Regulations: Harmonizing the Frameworks for HFCs and NBFCs
Team Finserv (finserv@vinodkothari.com)
Vide notification dated August 12, 2024, RBI has amended certain regulations applicable to Housing Finance Companies, and NBFCs to enure harmonization between HFC Master Directions and SBR Master Directions. These amendments shall be effective from January 01, 2025. The following table contains a snapshot of the changes from all HFCs and NBFCs1:
| Sr. | Particulars | Erstwhile provision | Amended / Harmonised provision |
|---|---|---|---|
| Changes in HFC Master Directions for all HFCs | |||
| 1 | Participation in exchange-traded currency derivatives | HFCs were allowed to participate in currency futures and options however no regulatory guidelines were prescribed for the same. | All HFCs can now participate in currency futures exchanges and Non-deposit HFCs with asset size of ₹1000 crore and above can participate in currency option exchanges, subject to the guidelines issued in the matter by the Foreign Exchange Department of the Reserve Bank and necessary disclosures in the balance sheet in accordance with guidelines issued by SEBI. |
| 3 | Participation in Interest Rate Futures | HFCs were allowed to participate in interest rate futures however no regulatory guidelines were prescribed for the same. | All HFCs can now participate in interest rate futures exchanges as clients and Non-deposit HFCs with asset size of ₹1000 crore and above are permitted to participate in interest rate futures market as trading members, subject to adherence to instructions contained in Rupee Interest Rate Derivatives (Reserve Bank) Directions, 2019 dated June 26, 2019, as amended from time to time. |
| 4 | Credit Default Swaps (CDS) | HFCs were allowed to participate in the CDS market however no regulatory guidelines were prescribed for the same. | HFCs will now be permitted to participate in the CDS market as users only and they may buy credit protection only to hedge their credit risk on corporate bonds they hold. HFCs cannot enter into short positions in CDS contracts. HFCs shall be required to comply with Annex XIV of SBR Directions while participating in CDS market as users. |
| 5 | Issue of co-branded credit cards | HFCs were not allowed to issue co-branded cards under the erstwhile directions. | HFCs are now allowed to issue co-branded credit cards, subject to the instructions prescribed in Master Direction – Credit Card and Debit Card – Issuance and Conduct Directions, 2022, as amended from time to time. |
| 6 | Accounting Year | Every HFC shall prepare its financial statements for the year ending on the 31st day of March. | HFCs must finalize their balance sheets within 3 months from the relevant date. If an HFC wishes to extend this period under the Companies Act, it must first obtain approval from NHB before seeking an extension from the RoC. In cases where NHB and RoC grants extension of time, the HFC shall furnish to NHB a proforma balance sheet(unaudited) as on March 31 of the year and the returns due on the said date. |
| 7 | Periodicity of IS Audit | The Audit Committee must ensure that an Information System Audit of the critical and significant internal systems and processes is conducted at least once in two years to assess operational risks faced by the HFC. | HFCs can now decide the periodicity of IS Audit as per its policy in accordance with IT Governance Directions. However, a continuous auditing approach for critical systems shall be undertaken. |
| 8 | Investment through Alternative Investment Funds for calculation of NOF | No regulatory guidelines were prescribed | To determine the Net Owned Funds (NOF) of a Housing Finance Company (HFC), investments or loans to subsidiaries, group companies, and other HFCs exceeding 10% of owned funds are deducted from the owned funds. Investments made by an HFC in group entities, either directly or indirectly through an AIF (if 50% or more of the AIF’s funds come from the HFC) or an AIF trust (if the HFC is the beneficial owner and 50% of the trust’s funds come from the HFC), shall be treated similarly. |
| 9 | Technical Specifications for all participants of Account Aggregator ecosystem | Regulatory provisions did not exist | HFCs acting either as ‘Financial Information Provider’ or ‘Financial Information User’ are expected to adopt the technical specifications published by ReBIT, as updated from time to time. |
| Changes in SBR Directions for all NBFCs | |||
| 7 | Periodicity of IS Audit | The Audit Committee must ensure that an Information System Audit of the critical and significant internal systems and processes is conducted at least once in two years to assess operational risks faced by the NBFCs. | NBFCs can now decide the periodicity of IS Audit as per its policy in accordance with IT Governance Directions. Further, a continuous auditing approach for critical systems shall be undertaken. |
- The changes specifically for deposit taking HFCs and NBFCs have note been covered ↩︎
HFCs: risk weights for undisbursed home loans rationalised
Vinod Kothari and Anita Baid l finserv@vinodkothari.com
What is the notification on change in Risk Weights (RWs) issued by RBI?
RBI has issued notification dated August 12, 2024 on Review of Risk Weights for Housing Finance Companies (HFCs). Accordingly, with immediate effect, the RWsfor computation of risk weighted assets (RWAs), for capital adequacy purposes, for for undisbursed portion of housing loans/other loans shall be capped at the RWA computed on a notional basis for an equivalent amount of disbursed loan. In other words, the applicable RW shall be lower of (a) RW, applying the credit conversion factor (CCF) on the undisbursed loan, with a 100% RW; and (b) the RW that will be applicable, based on the size and the LTV of the loan, if the undisbursed part were to be disbursed.
Read more →Two days refresher course on NBFC Regulations
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Refer our resources on SBR:
Recovery of debt by HFCs and initiation of SARFAESI action in case of a decided civil suit: Two significant rulings by High Courts
-Shrestha Banerjee & Archisman Bhattacharjee I finserv@vinodkothari.com
Introduction
The High Courts of Madhya Pradesh and Kerala recently rendered two judgments delving into crucial legal inquiries surrounding the recoverability and enforcement of security interests in instances of borrower default via initiation of SARFAESI proceedings by financial institutions.
The Madhya Pradesh High Court’s ruling specifically addresses the recoverability of Housing Finance Companies (HFCs) in relation to the initiation of SARFAESI actions following borrower default. Conversely, the Kerala High Court’s judgement examines the enforcement of security interests through SARFAESI actions, where the same has been initiated without placing consideration on any judgement delivered by the civil courts concerning such recovery.
In this article, we aim to analyse both judgments, shedding light on their implications and legal interpretations.
Read more →Fair Lending: RBI bars several practices
Lenders asked to mend ways immediately
Team Finserv | finserv@vinodkothari.com
Introduction
If fairness lies in the eyes of the beholder, the RBI’s eye is getting increasingly customer-centric. This fiscal year, the RBI has issued circulars aimed at fostering fairness and transparency in lending practices; these come at the backdrop of circulars last year on penal interest, adjustable rates of interest, release of security interests, strengthening customer service by Credit Information Companies and Credit Institutions, and establishing a framework for compensating customers for delayed updation or rectification of credit information. Recently on April 15, 2024, the RBI introduced a circular on Key Facts Statement (KFS) for Loans & Advances, with the goal of enhancing transparency and reducing information asymmetry regarding financial products offered by various regulated entities. This initiative aims to empower borrowers to make well-informed financial decisions.
A new Circular, dated 29th April 2024 Fair Practices Code for Lenders – Charging of Interest comes down on some of the practices related to computation of rates of interest by lenders. . This Circular is all about stopping lenders from doing things that aren’t fair when it comes to charging interest.
Applicability
The Circular applies to a wide range of financial institutions including Banks, Co-operative Banks, NBFCs, and HFCs. It is worth noting that this Circular comes into effect immediately upon its issuance.
| Practices observed | Regulatory stipulation |
| Lenders charge interest from the date of execution of the loan, or the date of sanction, even though disbursement has not taken place as yet | Interest may be charged only from the date of disbursement |
| Interest is charged from a particular date, even though it is clear that the cheque was handed over to the borrower several days after the said date | Interest may be charged from the date when the cheque is handed over to the borrower |
| In some cases, one or more EMIs were received in advance; however, the interest was computed on the loan amount, without considering the advance payment | Interest shall be charged after netting off the advance EMI from the disbursement amount |
Our analysis:
- Loan agreement in place, but disbursement has not happened:
- If the lender has sanctioned a loan, but the disbursement has not happened, can the lender charge a commitment charge for the period upto disbursement?
- In our view, the sanction amounts to a committed lending. Committed lending has liquidity implications for the lender, and also eats up regulatory capital. Therefore, it is quite okay for a lender to start charging commitment charge from the date of sanction till the date of disbursement, provided the same is clear in the KFS/terms of the loan.
- If the disbursement does not happen for a particular period of time, can the lender revoke the sanction?
- Yes, if the same is clear in the terms of the loan
- If the lender has sanctioned a loan, but the disbursement has not happened, can the lender charge a commitment charge for the period upto disbursement?
- Interest to commence from the date of the disbursement:
- What is the meaning of the date of disbursement? The funds actually leaving the bank account of the lender, or the cheque handed over?
- Usually, handing over of a cheque is a common mode of making payments (unless the payments are being made in online mode – see below). Therefore, if there is an evidence of the cheque being handed over, the lender accounts for the disbursement from that date. If the cheque is not encashed, it appears as a reconciliation item. In our view it is okay to relate the date of handing over a cheque to the date of disbursement (assuming the cheque is good for immediate banking; it is not post-dated and subsequently does not bounce).
- The RBI expects lenders to move to online modes of disbursement. What are the online modes of disbursement that are acceptable?
- Disbursement through UPI
- Disbursement to the bank account
- Electronic Clearing System
- Lender cannot transfer to a PPI wallet
- What is the meaning of the date of disbursement? The funds actually leaving the bank account of the lender, or the cheque handed over?
- Advance EMIs to be considered while computing interest:
- Advance EMIs should be captured while computing EMIs. If the EMIs are being collected in “advance” mode, rather than arrears, standard worksheet formulae (PMT) allows for advance EMIs to be considered. There is no further need to net off the advance EMI from the disbursement. For computing amortisation, the interest will be computed on the loan amount, minus the EMI
- Does the advance EMI also have an interest component?
- Yes. EMIs is an equated amount, payable through the term of the loan. Each EMI consists of interest and principal. The only difference is that while computing the EMIs, the disbursement was taken as net of the first EMI. That is to say, there is an interest component in the first EMI, but the interest is on the amount remaining after the first EMI.
Applicability date and scope
- The circular as above is immediately applicable. Does it apply to existing loans too?
- Each of the practices referred to above are treated by the regulator as unfair. It is not as if these were fair all this while and become unfair from a particular date. In fact, the Circular also says that the regulator during supervisory inspections has directed lenders to refund the excess interest if collected. Therefore, in our view, each of the above stipulations are applicable on all loans.
- Is the circular applicable only on “retail loans” as covered by Key Facts Statement (KFS) for Loans & Advances circular, or does it apply to all loans?
- Coming from basic considerations of fairness, in our view, the Circular is applicable to all loans.
Actionables
- REs to check whether the interest is being calculated from the date of actual disbursement rather than from the date of sanction of loan.
- REs to review their modes of disbursal of loans and to use online account transfers in lieu of cheques. In cases where loan is disbursed through cheques, we recommend REs take an acknowledgement when the cheque is handed over to the borrower
- REs to check whether they have received any intimation from RBI regarding the refund of any excess interest charged.
Related articles
Harmonising computation for concentration limits across NBFCs
– Kaushal Shah, finserv@vinodkothari.com
Reserve Bank of India (RBI) has recently announced amendments to the Credit and Investment concentration norms, specifically targeting Base and Middle Layer Non-Banking Financial Companies (NBFCs). The circular, dated January 15, 2024, brings about notable changes aimed at ensuring uniformity and consistency across NBFCs while computing the concentration norms.
What has RBI done?
For Middle Layer NBFCs (NBFC-MLs) :
- In addition to the use of Credit Default Swaps (‘CDS’), RBI has now allowed NBFC MLs to offset the aggregate exposure with the following additional Credit Risk Transfer (CRT) instruments:
- Cash margin/caution money/security deposit held as collateral on behalf of the borrower against the advances for which right to set off is available;
It is pertinent to note that, as per para 84 of the SBR Directions, already requires the NBFC for the purpose of assignment of risk weight to net off the amount of cash margin/ caution money/security deposits held as collateral against the advances out of the total outstanding exposure of the borrower.
- Central Government guaranteed claims which attract 0 per cent risk weight for capital computation;
- State Government guaranteed claims which attract 20 per cent risk weight for capital computation; and
- Guarantees issued under Credit guarantee Schemes of Credit Guarantee Fund Trust for Micro and Small Enterprises, Credit Risk Guarantee Fund Trust for Low Income Housing and individual schemes under National Credit Guarantee Trustee Company Ltd