Indicative List of Policies for NBFCs (Base and Middle layer)

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Team Finserv | finserv@vinodkothari.com

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Trade Receivables Financing: Tale of 3 Modalities

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Dayita Kanodia | Finserv@vinodkothari.com

Trade receivables form an important part of working capital, and given the increasing trend toward the provision of buyers’ credit, occupying an ever-increasing part thereof. Traditionally, it is funded by usual modes of working capital funding. However, businesses have been searching for alternative modes of receivables financing. 

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Interest Imbalance: Will the disproportionate interest Split in Loan Transfers be liable to withholding tax?

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ITAT Ruling Clarifies Taxation on Disproportionate Interest share in Loan Transfers

– Dayita Kanodia | Finserv@vinodkothari.com

Direct Assignment of a loan or transfer of loan exposures refers to the process where financial institutions, such as banks, purchase a pool of loans or assets from other entities, typically NBFCs, without the involvement of a third-party intermediary. In this arrangement, the buying institution directly acquires the ownership of the loans or assets and the associated rights, including the right to receive future payments from the borrowers. This method allows the selling NBFC to offload its loans, thereby freeing up capital, while the purchasing institution gains the opportunity to enhance its loan portfolio and earn interest income from the acquired loans. This Direct Assignment is essentially what is popularly known as the transfer of loan exposure.

The RBI issued the transfer of loan exposures directions in 2021 regulating all transactions among regulated entities involving transfer of loan exposures.

Interest sharing and servicing after the transfer

Pursuant to a transfer of loan, it is not necessary that the future interest income arising from the loans would be shared in the same proportion as that of the transfer. For instance, if an NBFC assigns 90% of the loan portfolio to a bank, there is no mandate that all interest income received in the future would be shared in the same proportion of 90:10. Generally, the borrower is not made aware of the transfer and therefore it is important that the NBFC continues to service the loan. In such cases it is only fair that the NBFC gets a higher proportion of interest. Accordingly, it is quite common in direct assignment transactions to have a disproportionate interest share. 

The question which now arises is whether this excess interest income retained by the NBFC would be taxable under the provisions of the income tax act. 

ITAT Ruling and taxation on disproportionate interest share in loan transfers

A recent ITAT ruling of May 7, 2024 clarifies the taxation treatment for disproportionate interest share in case of loan transfers. In this case, NBFC assigned 90% of the loan portfolio to a bank via the direct assignment route. However, the bank was not receiving the entire interest on the 90% loan assigned but was only entitled to a fixed percentage of share while the NBFC retained the excess interest. Accordingly, the revenue department was of the view that the assessee was responsible to deduct TDS on the excess interest allowed to be retained by the NBFC under section 194A of the Income Tax Act. 

The revenue department further raised the question on deduction of TDS under SEction 194J and 194H of the Income Tax Act. 

Interest Retained not a result of money borrowed or debt incurred by the transferee

For the deciding the fate of the NBFC under section 194A of the Income Tax Act, the following was observed by the ITAT:

  1. For TDS to be deducted under section 194A of the Income Tax Act, the crucial aspect to be satisfied was whether the part interest allowed to be retained by the originating NBFC by the bank is payment in the nature of interest to the NBFC for any money borrowed or debt incurred by the bank.
  1. It was acknowledged that the 90% of the loan portfolio was assigned to the bank and consequently any default among the assigned loans would result in loss to the bank. 
  1. Any amount collected from the borrowers was initially getting deposited in an escrow account and was subsequently distributed between the NBFC and the bank in accordance with the agreement entered into by the entities. 
  1. It could not be shown that the interest allowed to be retained with the NBFC was a result of any money borrowed or debt incurred by the bank from the NBFC. 
  2. Accordingly, the assessee was under no obligation to deduct TDS on the excess interest retained by the NBFC under section 194A. 

Interest retained not in the nature of fees for any professional / technical services rendered by the transferor

The next issue which was adjudicated in the case was whether the interest allowed to be retained with the NBFC was a consideration for rendering professional / technical services by the transferor NBFC to the transferee bank. 

As per section 194J of the Act, any person, not being an individual or HUF, who is responsible for paying to a resident any sum, inter alia, by way of fees for professional services or fees for technical services shall at the time of credit of such sum to the account of payee deduct tax at source.

For this purpose the ITAT observed the following:

  1. The NBFC and the Bank entered into a tripartite service agreement pursuant to which the originating NBFC was appointed as servicer for the loans. The NBFC was therefore responsible for managing, collecting and receiving payment of the receivable and depositing the same in the ‘Collection and Payout Account’ to enable the distribution of the payout therefrom and providing certain other services.
  1. As per the service agreement, a one time service fee of Rs.1 Lakh was agreed to be payable by the bank to the NBFC as consideration for the services rendered.
  1. The ITAT brushed aside the contention of the revenue department that service fee of Rs 1L was inadequate and the excess interest allowed to be retained by the NBFC should in fact be considered as fee for rendering the services by the transferor NBFC. 
  1. There was a separate tripartite Deed of Assignment of receivables entered into by the parties according to which the bank paid the entire principal amount equivalent to 90% of the entire pool to the NBFC upfront. However, it was observed that the transfer being an independent commercial transaction cannot be on a cost to cost basis without there being any markup.
  1. Accordingly, the bank opted to pay the consideration for the loans assigned partially by way of an upfront payment equivalent to the principal amount of the loan assigned to it and partly by agreeing to earn a lower rate of interest on its portion of assigned loans and allowing the NBFC to retain the part interest received from the borrower.
  1. Therefore the liability under section 194J of the Income Tax Act was only for the service fee of Rs.1 L and cannot be extended to the excess interest share retained by the NBFC.
  1. Accordingly, the assessee was under no obligation to deduct TDS on the excess interest share retained by the NBFC under section 194J of the Income Tax Act. 

Interest retained not in the nature of commission / brokerage

The last issue in this case to be decided before the ITAT was whether the retained interest would fall in the category of commission or brokerage and was liable to TDS under section 194H of the Income Tax Act. 

As per section 194H of the Act, any person, not being an individual or HUF, who is responsible for paying to a resident, any income by way of commission or brokerage, shall at the time of credit of such income to the account of the payee deduct tax.

For determining the tax treatment under this section, the ITAT observed the following:

  1. It could not be said that the loans originated by the NBFC were on behalf of the bank.
  1. For the services rendered by the NBFC, it was observed that the same was pursuant to a separate service agreement which provides for payment of separate service fees in lieu of such services.
  1. Accordingly, it cannot be contended that the transferor NBFC was acting as an agent of the transferee bank.
  1. Accordingly, the liability to deduct TDS on the excess interest retained by the NBFC under section 194H of the Income Tax Act does not arise. 

Concluding Remarks 

In conclusion, the recent ITAT ruling has provided significant clarity on the taxation treatment of disproportionate interest shares in loan transfers, particularly in the context of Direct Assignment transactions. 

In this case, the ITAT emphasized that the interest retained by the NBFC was not a result of any money borrowed or debt incurred by the bank. Additionally, it was clarified that the interest retained did not constitute fees for professional or technical services rendered by the transferor NBFC, nor did it fall within the ambit of commission or brokerage.

As the financial landscape continues to evolve, such judicial pronouncements play a crucial role in fostering transparency, compliance, and fairness in taxation.

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

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Vinod Kothari (finserv@vinodkothari.com)

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

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

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

Capital Treatment 

We organise this section into the following parts:

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

Capital Treatment for Lenders: 

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

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

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

Capital Treatment for the guarantor 

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

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

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

First Loss

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

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

Lower of

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

= Rs. 5 crores.

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

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

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

Second Loss

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

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

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

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

Expected credit loss for the recipient of the guarantee

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

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

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

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

Expected credit loss for the guarantor

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

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

Provisioning for the recipient of the guarantee

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

Provisioning for the guarantor

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

Accounting

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

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

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

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

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

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

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

Invocation of DLG will not affect NPA classification of borrower

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

Related Articles – 

FAQs on Default Loss Guarantee in Digital Lending

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

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

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

Subhojit Shome & Archisman Bhattacharjee | finserv@vinodkothari.com

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12th Securitisation Summit

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

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Fair Lending: RBI bars several practices

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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 observedRegulatory 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 yetInterest 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 dateInterest 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 paymentInterest 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
  • 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
  • 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

  1. The Key to Loan Transparency : RBI frames KFS norms for all retail and MSME loans
  2. FAQs on Digital Lending Regulations 
  3. FAQs on Penal Charges in Loan Accounts 
  4. RBI streamlines floating rate reset for EMI-based personal loans

Allow borrowers to make free choice: RBI draft rules for digital loan aggregators

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Manisha Ghosh l manisha.ghosh@vinodkothari.com

In a move aimed at fostering transparency and consumer-centric practices in digital lending, the Reserve Bank of India (RBI) issued draft guidelines for digital loan aggregators on 26th April, 2024  titled ‘Digital Lending – Transparency in Aggregation of Loan Products from Multiple Lenders’. Comments are due on the same.  This regulatory framework underscores the importance of empowering borrowers with complete information during the credit process to make an informed decision.

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Webinar on KFS & APR – New Rules by RBI on Retail & MSME Lending

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-Vinod Kothari and Anita Baid | finserv@vinodkothari.com

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Our related resources on the topic:

  1. The Key to Loan Transparency : RBI frames KFS norms for all retail and MSME loans
  2. Transparency in lending: RBI Mandates KFS for Retail and MSME Loans
  3. RBI Regulations on Digital Lending

The Key to Loan Transparency : RBI frames KFS norms for all retail and MSME loans

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All-inclusive APR disclosure; third-party payments also included; no lender-induced changes during the validity period of KFS

-Team Finserv | finserv@vinodkothari.com

(Updated as on May 1, 2024)

The RBI vide its Statement on Developmental and Regulatory Policies dated February 08, 2024 announced its decision to mandate Regulated Entities (REs) to provide Key Fact Statement (KFS) for retail and Micro, Small & Medium Enterprise (MSME) loans.

Following the aforesaid, RBI issued a notification dated April 15, 2024 (Circular) to “harmonise” the instructions in this regard for all REs.

Since the intent of the RBI is to harmonise similar requirements, the KFS Circular overrides similar extant requirements in case of lending by banks to individuals, and digital lending.

Contents

Meaning and Intent
Scope and Applicability
Contents of KFS
Meaning of Retail Lending
Meaning of MSME Lending
Validity period and Cooling off period
Annualised Percentage Rate
Other Requirements

Meaning and Intent

1. What is KFS?

  • A crisp, clear and key information about loan terms. KFS typically includes details such as the all-in-cost of the loan, interest rates, fees, repayment terms, and any associated risks.
  • Because KFS is standardised, it enables borrowers to make comparison with terms offered by other lenders.
  • Plus, it is at-a-glance view, enabling the borrower to avoid the legalese. Allows loans terms to be compared in a simple, transparent and comparable (STC) manner.

2. How will KFS help transparency?

The intent is to have simple transparent, and comparable (STC) terms of the loan communicated to the customer upfront. The standardised format provides is simple and concise and has all the necessary details of the loan – annual percentage rate, fees, recovery mechanism, and associated risks in a straightforward format.

3. Has the format of KFS and other disclosures been prescribed?

Yes, the format for KFS has been prescribed in Annex A of the Circular. Further, formats for computation of APR and amortization schedule to be given to the borrower has also been prescribed in Annex B and C of the Circular respectively.

Scope and applicability

4. Which all entities are covered by the new requirement?

The following entities will be covered under the scope of the Circular –

  • All Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks, excluding Payments Banks)
  • All Primary (Urban) Co-operative Banks, State Co-operative Banks and Central Co-operative Banks
  • All Non-Banking Financial Companies (including Housing Finance Companies)

5. In what kind of loans will KFS be mandatorily applicable?

  1. Loans by scheduled commercial banks to individual borrowers. Para 2 (b) of the erstwhile regulations Display of information by banks stands repealed.
  2. Digital lending by any regulated entity. Para 5.1 and 5.2 of the Guidelines on Digital Lending stands repealed. For meaning of digital lending, see our write up.
  3. Microfinance loans whether by MFIs or other entities. Para 6.3, 6.4 and 6.5 of the RBI (Regulatory Framework for Microfinance Loans) Directions, 2022  stands repealed: For the meaning of microfinance loan, see our write up.
  4. Retail Lending by all Regulated Entities (REs). For the meaning of retail lending see Q 20
  5. Lending to MSMEs loans by all REs: For meaning of MSME loans see Q 22.

Coverage of the Circular

6. Will the KFS norms be applicable on Housing Loans as well?

In case of housing loans extended by HFCs, sharing of most important terms and conditions (MITC) are applicable (Para 85.8 read with Annex XII of the HFC Master Directions). MITC is akin to KFS, however, the format of KFS is more focused on interest rate and other charges as well as a few qualitative terms of the loan, whereas MITC provides several other relevant details.

The Circular is addressed to HFCs as well. Further, meaning of “retail lending” (see below) includes home loans as well. In the absence of any other clarification, we would advise lenders to prepare MITC as well as KFS in case of home loans.

6A. Whether the Circular has to be complied with in case any loan is advanced to MSMEs?

The Circular is applicable in case of all retail and MSME term loan products extended by all REs. However, in our view if the RE doesn’t distinguish between MSME and other categories of borrowers for the same loan product, then there is no requirement to provide KFS only to MSME borrowers. In this case, the lender should also not avail the benefit of any guarantee scheme provided in case of MSME lending. 

The Circular in our view only seems to apply in case the RE has a separate MSME loan product.

7. What happens to the existing circulars on Digital Lending and Microfinance Lending?

The existing provisions for KFS and APR in the Digital Lending Guidelines, MFI Directions and Display of Information by Banks circular shall stand repealed.

8. When does the new requirement become applicable?

The Circular is applicable with effect from October 1, 2024 to all new retail and MSME term loans sanctioned. Further, digital loans, MFI loans and bank finance extended to individuals post the said applicability date would also require to be aligned with the new requirement.

It would, therefore, appear that extant requirements continue to apply from now until 30th September.

It would actually be better for lenders to transition into the new requirement before 1st October, at least on a parallel basis – this will serve as a dry run upto the new requirement from 1st October.

9. In case of banks, what is the applicability of this Circular?

The KFS Circular applies to banks for (a) all loans to individuals, as covered by Display of information by banks; (b) any loans to MSMEs; (c) any microfinance loans; (d) any digital loans.

10. Whether loans under digital lending need to comply with the Circular or will they continue to follow extant guidelines?

The Circular applies to digital loans as well. In fact, it repeals Para 5.1 and 5.2 of the digital lending guidelines dealing with APR and KFS provisions. However, until October 1, 2024, the existing guidelines may continue to be followed.

11. In case of co-lending transactions, is the compliance on the originating co-lender or the funding co-lender?

While specific details of co-lending arrangements are required to be shared with the borrower; the borrower interface is typically done by the originating co-lender. Hence, the originating co-lender should be making the requisite disclosures. Funding co-lenders may ensure that the originating co-lender is making the requisite disclosures.

Contents of KFS

12. What are the contents/format of KFS?

  • Unique Proposal Number : this would be specific to the RE and shall be provided to each borrower for each loan offered
  • Type of loan offered:  for example, home loan, auto loan, personal loan, etc
    Sanctioned Loan Amount: If the sanctioned amount is available for drawdown in tranches or in phases, the same may be specified. Similarly, if the sanctioned amount not drawn within a particular date will remain committed, etc. may be specified.
  • Disbursal Schedule: Often, disbursement may be linked with acquisition of an asset, or progressive construction (say, in case of home loans). The same may be specified here.
  • Loan Term: Digital lenders sometimes offer choice of tenure, and different interest rates for different tenures. The idea of KFS is to provide for maximum comparability – hence, arcane structures or optionalities should be minimised.
  • Type of Installments (Monthly/half-yearly/early)
  • Number of Equated Periodic Instalments (EPIs)
  • Amount of EPI
  • Period after which the EPI will commence post-sanction: For example, 30 days after disbursement. in case a moratorium is provided, the same should be specified.
  • Type of interest rate (fixed/floating/hybrid)
  • In case of floating rate loans following are to be disclosed – Reference Benchmark, Benchmark rate, Percentage of spread, Final rate charged to the borrower, Reset periodicity of benchmark and spread rate, impact of change in reference benchmark,
  • Following fees/charges are to be disclosed –
    • Payable to the RE
    • Payable to third party through RE: See further guidance on this below
  • Annual Percentage Rate :
    • This is the IRR (note this is not XIRR or effective rate of return after compounding to a year) taking care of all the items of costs included in the APR.
  • Contingent Charges such as penal charges, foreclosure charges, charges for switching loan from floating to fixed or vice-versa, etc.: These charges are not collected upfront or are not mandatorily imposed on the borrower; these are contingent on happening of certain events, say default. The rates of these charges shall be disclosed. However, shall not be a part of APR, and accordingly, these charges do not have to be converted into an annualised rate.
  • Qualitative information
    • Clause of loan agreement relating to engagement of recovery agents
    • Clause of loan agreement which details grievance redressal mechanism
    • Phone number and email id of the nodal grievance redressal officer
    • Whether the loan is, or in future maybe, subject to transfer to other REs or securitisation
    • Details relating to co-lending – Name of co-lenders and blended rate of interest
    • In case of digital loans – Cooling-off period, details of LSP acting as recovery agent

13. KFS is intended to be a “standardised format”. What is the significance of the format being standardised? Does the lender have the discretion to add/delete fields?

The Circular prescribes for a “standardised format” for KFS. The intent behind this standardisation is to enhance transparency and to facilitate the  comparability of the loan terms offered by different lenders. The RBI refers to the KFS as a “standardised format”. Therefore, in our view, the comparability of the KFS will be compromised if it was loaded with new details or subjectivities not envisaged in the standard format.

14.Can the lender, for instance, add clauses like “this is not a sanction letter; the grant of the loan is eventually subject to sanction by the lender’s internal credit committee”, or similar conditionalities?

It is important to note that the format of the KFS is standardised. Therefore, the KFS is expected to remain limited to the fields given in the standardised format. However, the KFS may be an annexure to a sanction letter – see below.

15. Is the present practice of issuing sanction letter redundant? Can a lender issue a sanction letter in addition to KFS?

The KFS is a summarised version of the terms of the loan. However, the grant of the loan itself may have several conditions, typically comprised in the sanction letter. The RBI’s Fair Practices Code refers to a sanction letter – NBFCs shall convey in writing to the borrower in the vernacular language as understood by the borrower by means of sanction letter or otherwise, the amount of loan sanctioned along with the terms and conditions including annualised rate of interest

Hence, first, the sanction letter does not become redundant. Secondly, if there are conditionalities or compliances relating to the loan, the same may be contained in the sanction letter. For example, the borrower may be required to complete some conditions precedent. There are normally several conditions subsequently, commonly called “post-disbursement conditions”. Each of these may be contained in the sanction letter.

15A. The charges mentioned in KFS are an amount X. The KFS also says this amount can be varied by the company. Can the variation of this amount in future be done without the borrower’s consent?

Charges mentioned in KFS may relate to charges payable at the time of the taking the loan, charges over the term of the loan, and may include contingent charges too. Para 8 of the Circular also says that whatever is not disclosed cannot be charged without the explicit of the borrower.

Therefore, 

(a) there is no question of charging something that is not a part of the KFS, without the borrowers’ explicit consent. 

(b) as for amounts already disclosed, while the company would have reserved the right to vary, however, in our view, these charges cannot be varied as this would disrupt the comparability and standardisation of the KFS. 

15B. The KFS circular applies from 1st October 2024 – can the company impose charges not already a part of the loan agreement and make them applicable before 1st October?

Since the KFS circular is coming with the perspective of fairness in practices, and given the fact that the prospective applicability date is merely to allow companies time to adhere to and transition to the new paradigm, the move as proposed will be seen as a way to take undue advantage of the applicability date.

16. Does the issuance of a KFS amount to a binding commitment on the part of the lender to lend?

The language of Explanation below clause 5 of the KFS Circular may give such an impression. It says: “Validity period refers to the period available to the borrower, after being provided the KFS by the RE, to agree to the terms of the loan. The RE shall be bound by the terms of the loan indicated in the KFS, if agreed to by the borrower during the validity period.”

However, in our view, the KFS is only the terms of the loan. The binding force of the KFS during the “validity period” is only on the terms, and not on the grant of the loan itself. If the conditions precedent for availing the loan have been satisfied, the lender will be bound by the terms as contained in the KFS; however, the grant of the loan itself is based on conditions precedent may still form part of the sanction letter.

17. Is it permissible for REs to include additional terms in the KFS alongside those outlined in the standardized format?

The purpose of requiring a standardized KFS for borrowers is to guarantee consistency in loan terms across different lenders, enabling borrowers to make fair comparisons. Therefore, we believe that REs should avoid subjectivity and strictly follow the standardized format outlined in the notification.

18. Can REs charge fees/charges not mentioned in the KFS?

The answer to this is positive as REs can charge fees/charges not mentioned in  the KFS with the explicit consent of the borrower.

19. What are Equated Periodic Installments and how are they computed?

Equated Periodic Installment (EPI) refers to a fixed amount comprising both principal and interest repayments that a borrower must pay at regular intervals over a predetermined number of periods to repay a loan fully. These payments ensure the gradual amortization of the loan. When these installments are made on a monthly basis, they are commonly known as Equated Monthly Instalments (EMIs).

Meaning of Retail Lending

20. What is the meaning of retail loans?

  1. The Circular does not provide a specific definition for “Retail Lending”. Instead, it refers to the Master Direction on Interest Rate on Advances (2016) for terms not defined within the Circular. Further, the Master Direction though does not define the term “Retail Lending”, paragraph 7 uses the following language: retail loans (housing, auto, etc.). This gives the impression that the word “retail loans” is used in contradistinction to wholesale lending. In typical banking parlance, lending to companies or businesses is termed as wholesale lending, and retail lending typically refers to loans to individuals.
  1. There is a study on Retail Credit Portfolios of SCBs under Retail Credit Trends – A Snapshot which considered that retail credit refers to all loans given to the individual customers/ households for various purposes.
  2. Further, an RBI article on Dynamics of Credit Growth in the Retail Segment: Risk and Stability Concerns that analyses retail credit flows and asset quality dynamics therein across the supervised entities provides that personal or retail loans are used interchangeably in this study, and they refer to loans given to individuals for housing, loans against property, purchase of vehicles, consumer durables, loans against gold jewellery, personal loans, educational loans, credit cards, etc.
  3. While RBI regulations do not provide a specific definition for “Retail Lending”, it is evident from the intent of the circular that the Circular is to lend transparency and comparability to loan terms, particularly when addressed to a borrower who is not savvy enough to understand nuanced terms. The primary aim is to ensure that information provided to borrowers is Simple, Transparent, and Comparable (STC). Therefore, a broader interpretation of the term “retail loans” may be warranted to align with this overarching objective.
  4. Hence, retail loans may include all types of loans to individuals, including the following –
  • Vehicles/Auto loans
  • Educational loans
  • Home Loans
  • Loan against shares
  • Loan against property
  • Loan against fixed deposit, etc.

Further, it may be noted that credit card receivables, though extended to individuals, are excluded from the purview of the Circular.

21. Give some examples of loans which are not retail lending?

Some examples of loans not considered as retail lending are –

  • Business loans
  • Lines of credit – as the circular specifically refers to term loans
  • Loans to corporates (other than MSMEs)
  • Dealer financing (other than individuals)
  • Builder Finance (other than individuals)

Meaning of MSME Lending

22. What is lending to MSMEs?

Loans to entities satisfying the following conditions and holding Udyam registration as MSMEs:

 Investment in Plant & Machinery or EquipmentTurnover
Micro EnterpriseUpto 1 croreUpto 5 crore
Small EnterpriseUpto 10 croreUpto 50 crore
Medium EnterpriseUpto 50 crore Upto 250 crore

23. Are all loans to MSMEs covered under the scope of the Circular?

The Circular explicitly states its applicability solely to “MSME Term Loans”. Therefore, we understand that working capital loans or lines of credit extended by REs to MSMEs fall outside the scope of the Circular.

Validity period and Cooling off period

24. What is a Validity Period?

The validity period refers to the timeframe within which the borrower, upon receiving the KFS from the RE, can agree to the loan terms. In case the borrower accepts the terms outlined in the KFS during this validity period, the RE is bound by these terms as indicated in the statement.

25. How long should the Validity Period be?

In terms of the notification, the KFS must possess a validity period of a minimum of three working days for loans with a tenor of seven days or more, and one working day for loans with a tenor of less than seven days.

26. What if the customer does not accept the terms during the validity period?

The RE is only bound by the terms mentioned in the KFS if the same is accepted by the borrower during the validity period. Accordingly, if the borrower fails to accept the KFS terms during the validity period, the RE reserves the right to change the terms after the end of such period.

27. Where will the validity period be disclosed?

Going by the standardised format for KFS provided by RBI, there is no requirement to mention the validity period in the KFS. However, to ensure that the borrower is aware of the same, the validity period can be mentioned in the covering note or sanction letter.

28. What will be considered a Working Day?

Working days would mean Monday to Friday of the week excluding public holidays.

29. What is the difference between the validity period and cooling off period in case of digital loans?

Validity PeriodCooling off Period
Applicable for digital as well as physical loans.Applicable only for digital loans.
Pre-disbursement phasePost-disbursement phase
Provided to the borrower to accept the terms of the loan as indicated in the KFSProvided to the borrower for exiting digital loans without any pre-payment penalty in case a borrower decides not to continue with the loan.
The RE is bound by the terms of the loan if accepted by the borrower during the validity period.Grants the borrower the right to repay the principal and the proportionate APR during this period.

30. Is it necessary to provide a validity period to borrowers before approving top-up loans, even if the terms of the top-up loan are identical to those of the existing loan?

Yes, the notification is applicable from October 01, 2024. Accordingly, after this date, KFS should be provided for all top-up loans. Subsequently, following this date, KFS should be furnished for all top-up loans. As a result, borrowers must also be provided with a validity period to accept the terms of the top-up loan.

Annualised Percentage Rate

31. What is APR?

Annual Percentage Rate (APR) is the annual cost of credit to the borrower that includes interest rate and all other charges associated with the loan.

32. What are the components of APR?

The following are the components of APR –

  • Rate of interest charged from the borrower
  • Fees/charges payable to RE
  • Fees/charges payable to third party routed through RE

Excluding

  • Contingent fees/charges

33. Are charges recovered on behalf of third party also a part of the lender’s APR?

Yes, the charges that borrowers pay to the RE, which are passed on to third-party service providers based on actual expenses, like insurance or legal charges, will also be included in the calculation of APR. See the discussion below.

 33A. What is the meaning of the expression “service providers”? Can statutory charges such as stamp duty etc also be a part of APR?

The Circular uses the following language: “Charges recovered from the borrowers by the REs on behalf of third-party service providers on actual basis, such as insurance charges, legal charges etc., shall also form part of the APR and shall be disclosed separately.” In our view, the expression “service providers” has been used consciously, to refer to some entities providing services either in relation to the loan, or the subject matter of the loan. 

Stamp duty is a statutory charge and is in the nature of a tax/duty payable to the statutory authorities. It cannot be contended that the state is providing any specific service either in relation to the loan or the subject matter of the loan. Hence, in our view, it is only the charges payable in respect of services, recovered by the lender, which should be forming part of the APR.

34. Should charges not directly linked/integrated with the loan, also form part of the APR? Will the answer remain the same even if such charges are deducted from the disbursement amount ?

As regards the inclusion of charges within APR, the essential basis should be the definition of APR, defining it as “the annual cost of credit to the borrower which includes interest rate and all other charges associated with the credit facility”. Therefore, a lender providing a credit facility imposes charges, in addition to interest, by whatever name called, including for third party services which are related to the credit facility or the subject matter of the credit facility, should be forming part of the APR. This will, of course, not include contingent charges such as delinquency penalties, repossession charges, etc.

The charges imposed by lenders may, illustratively, be as follows:

  1. Processing fees;
  2. Documentation charges; 
  3. On-boarding charges;
  4. Technical and verification charges;
  5. Documents handling charges

The charges for third-party services, which are typically related to the loan or the subject matter of the loan may be as follows:

  • Insurance charges for the asset/product being funded for the lender, or personal insurance for the borrower (typically assigned to the lender), or credit insurance
  • Valuation charges for the subject matter of the loan
  • Legal charges etc

The mode of collection of these charges does not matter – that is, these may be charged separately, or may be deducted from the disbursement.

35 .Whether statutory dues would form part of APR?

See answer above.

36. If, for instance, the borrower is required to place a security deposit/cash collateral, which is free of interest, is the impact of the same also captured in the APR?

While the placing of the security deposit may impact the overall cost of the borrower, but in our view, it is inappropriate to incorporate this cashflow as a part of the loan cashflows.This is because in our view the positive and negative cash flows arising out of the loan payments and security deposit, respectively, should not be co-mingled.

37. In case of loans for vehicles, it is common practice to require the borrower to make a down payment to the supplier. Is the same also captured in the APR?

The APR is computed on the loan amount; down payment is not a part of the loan.

37A In which all cases insurance charges paid to the third party will form a part of the APR ?

We take some illustrative situations below:

  • Condition in loan agreement – borrower to insure the asset at borrowers cost; premium paid by borrower to insurance co – Will not form a part of the APR, as payment not collected by the lender
  • Event of default includes failure to insure; in which case, lender will pay and claim the money from the borrower – Will not form a part of the APR, because it is a contingent payment
  • Paid by borrower to insurance co, but with a loan from lender. – Will not form a part of the APR, as the payment is made by the borrower
  • Lender makes payment of insurance premium:
    • First year’s payment made immediately by the borrower; rest of the years are loaded on EMIs – will form a part of the APR, since the payments are being made by the lender.

37B If cash flows are not at uniform period of time, how will the APR be calculated?

If cash flows are not at uniform periods of time, lenders generally use the XIRR method to calculate interest. Note that IRR formula fails to capture non-equidistant cashflows. However, XIRR is annually compounded rate. It may be converted into a monthly rate by using “nominal” formula, or de-compounding from a year to a month, and then multiplying the result by 12.  It should be noted that XIRR is generally greater than APR.

37C In case of a demand loan, will the APR be computed based on the sanctioned amount or on the disbursed amount?

For demand loans, the APR should be calculated based on the sanctioned amount. This reflects the potential maximum cost of credit to the borrower if the borrower chooses to utilize the entire sanctioned amount.

38. Lenders quite often get payouts or subvention from third parties, say vendor, OEM, insurance companies, etc., which supplement the returns of the lender. Are these also disclosed as a part of the APR?

In our view, there is no reason to include payouts by third parties, that is, other than the borrower, as a part of the borrower’s cost of credit.

Having said this, if there are discounts/subventions being given by a vendor, the lender should make a fair disclosure of the discount, showing the same as a deduction from his cost of interest.

Graphical illustration summarising APR

Other Requirements

39. What are the disclosure requirements?

Following additional disclosures are to be made by the REs along with KFS –

  • Computation sheet of APR
  • Amortisation schedule of the loan over the loan tenor
  • KFS shall also be part of the loan agreement
  • Validity Period of KFS

40. What are the other requirements as per the Circular?

As per the Circular REs are obligated to do the following –

  • Contents of KFS shall be explained to the borrower
  • Acknowledgement shall be obtained from the borrower that he/she has undestook the contents of KFS

41. In case of digital loans how will RE be able to explain the contents of KFS to the borrower?

For digital loans, REs may have the option to exhibit a pre-recorded video within their application or present a document that elucidates the contents of the KFS.

42. What will be the impact of this circular in existing loans?

REs will not be required to issue KFS in existing loans. However, compliance with this circular will be required for any new loan or top-up loan provided to existing customers.

43. Para 7 of the Circular provides that charges recovered from the borrowers by the REs on behalf of third-party service providers on actual basis shall also form part of the APR and has to be disclosed separately. So does this imply that any amount over and above the actuals will not form a part of APR?

In case the RE is collecting charges that are over and above the actuals, the same is int he form of charges levied by the RE itself and by default should always be included in the APR computation. However, in case of collection of charges on actuals on behalf third-party service provider, the RE shall be required to provide receipt and related documents will have to be provided to the borrower, within a reasonable time.

44. The KFS also needs to disclose the phone number and email id of the grievance redressal officer. So, will it be sufficient compliance with the regulations if a generic email id of the grievance redressal cell is provided ?

As per the KFS format provided, a generic email id and phone number can be provided by the RE in the KFS subject to the customer complaints being redressed within one working day.

45. The KFS must reveal whether the loan is currently or potentially subject to transfer to another RE entity or securitization. Therefore, if an RE fails to disclose this information while providing the KFS to the borrower, does it mean the RE is barred from transferring or securitizing the loan?

In case, the RE has revealed its intention to not transfer/securitise the loan but subsequently after disbursal intends to transfer/securitise the loan, it has to obtain the borrowers approval.

46. The Circular has prescribed that if the charges/fee payable cannot be determined prior to sanction, an upper ceiling may be prescribed by the RE. How will this upper ceiling be determined by the RE ?

The upper ceiling should be mentioned by the REs considering the maximum amount of charges that can be levied.

47. The Circular also extends to all HFCs. Henceforth, do HFCs solely need to furnish the KFS, or is there still an obligation to supply the MITC to borrowers as per the HFC directions?

The HFC directions require MITC to be provided to all borrowers for home loans. Additionally, the relevant provision of the HFC directions that mandates MITC provision has not been repealed. Therefore, until further regulatory clarity is provided on the subject, HFCs are obligated to furnish both MITC and KFS to borrowers.

48. What are the actionables for REs?

The immediate actionables for an  RE shall be as follows:

  1. RE to determine the applicability of the Circular based on the loan products offered by the RE
  2. Systems need to be capacitated to make an all-inclusive computation of APR. Note that this APR computation may be different from the Effective Interest Rate as used for accounting purposes  – for example, third-party payments on actuals are not considered as a part of the loan cashflows in IndAS 109. Nor will this be relevant for amortisation of the loan for accounting purposes – if third party payments are not reported as income.
  3. The Board is to consider and take note of the Circular in the upcoming board meeting
  4. To formulate a plan for implementation of the Circular by October 1, 2024, in terms of the following:
  1. The loan journey (physical or digital, as the case may) be shall be reviewed to ensure the implementation of the requirements under the circular.
  2. The draft of KFS to be considered and adopted for sharing with the customers
  3. System changes for APR computation to be implemented in the systems
  4. The implementation of the validity period in the systems and as a part of the loan process

49. Is there a requirement to issue a new KFS at the time part pre-payment or restructuring?

In the case of pre-payment of loan, pre-payment charges, if any should be disclosed to the borrower in the KFS under contingent charges which do not form a part of the APR. Subsequently, if there is pre-payment or part pre-payment by the borrower there is no need to issue new KFS, APR or repayment schedule since the pre-payment happens at the option of the borrower. 

The intention of the Circular is to promote standardisation and comparability of loan terms. In the case of restructuring, the terms pursuant to such restructuring are borrower specific and therefore not comparable. Accordingly, we do not see a need to again provide a new KFS.

The KFS has to be provided again at the time of levy of additional charges not mentioned in the original KFS.

Our other resources on the topic are:-

  1. Transparency in lending: RBI Mandates KFS for Retail and MSME Loans
  2. RBI Regulations on Digital Lending

Watch our Webinar on the topic here:

Some relief in RBI stance on lenders’ round tripping investments in AIFs

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– Team Finserv | finserv@vinodkothari.com

The Reserve Bank of India on 19th December 2023 issued a notification[1] imposing a bar on all regulated entities[2] (REs) with respect to their investments in AIFs. We had covered the same in our earlier write-up. The Circular has already created some bloodshed as several banks took a hit in their Q3 results. Though late, yet welcome, the RBI has now come with some relief by a March 27 2023 circular.  The following Highlights are based on the original circular, as amended by the March 27th circular :-

What has the RBI done?

  • Prohibited all regulated entities (REs), including banks, cooperative banks, NBFCs and All India Financial Institutions from making investments in Alternative Investment funds (AIFs), if the AIF has made any investment in a “debtor company”, other than by way of equity shares of the debtor company. Hence, if the AIF has made investment by way of bonds, structured capital instruments, etc., issued by a debtor company, the bar as above will apply.
  • Debtor company means a company in which the RE currently has or previously had a loan or investment exposure anytime during the preceding 12 months
  • The bar applies immediately, that is, effective 19th Dec 2023. No further investments to be made.
  • If investments already exist, the RE shall exit within 30 days, that is, by 18th Jan., 2024. Hindsight clearly shows that for most regulated entities, there was no way to cause exit, as AIF investments are evidently illiquid. Hence, most regulated entities took a hit on their P/L.
  • Further, if an RE has made an investment in an AIF, and the AIF invests in a debtor company, the RE shall make an exit within 30 days.
  • Investment by REs in the subordinated units of any AIF scheme with a ‘priority distribution model’ subject to full deduction from RE’s capital funds. See further discussion on priority distribution model below.

What was the intent?

  • Since several REs have affiliated AIFs, routing the money through AIFs to borrowers might have led to ever greening. That is, the AIF would invest the money into a debtor company, and consequently, the debtor company would keep its account as a performing asset. In essence, the AIF was acting as a stopover in the process of round tripping of the money back to a debtor company, from where it will be used to pay off the lender.

What will be the impact of the Circular?

  • Most of the larger REs have affiliated AIFs. Flow of funds to them from the RE would stop completely.
  • The sweep of the circular is wide and non-discriminatory. Not only affiliated AIFs, but any AIF in general will be dried of funding from REs. While the bar is only for those AIFs which have invested in “debtor companies”, it will be practically tough for REs to avoid overlapping investments. Given the severe implications of a breach, compliance-sensitive REs will avoid investing in AIFs.
  • There is an immediate disinvestment pressure on AIFs, as there may be overlapped investments. AIFs’ assets are mostly illiquid – ensuring exit to RE investors may be tough. In many cases, there are lock-in restrictions as well.
  • Not only has the RBI expressed concerns, SEBI also issued a consultation paper for enhancement of trust in the AIF ecosystem, citing use of AIFs for regulatory arbitrage. See our write up on the SEBI proposals.

Direct or indirect investments:

  • As the Circular is driven by concerns of round-tripping, widening the circuit by creating more stop-overs does not help. For example, if a lender invests in an AIF, which invests in an intermediate entity, which in turn invests in a debtor entity, the trail of the money is clear. Likewise, the lender may be making an indirect investment in an AIF.
  • However, where there is no round-tripping of the money to a “debtor company”, there should be no concern. For example, if a lender makes a loan to an entity, where an AIF of the group has also made investments, there is no flow of money from the lender to the AIF, for the purpose of the downstream investment by the AIF into the debtor company.

Investments through mutual funds and FOFs exempt:

  • The 27th March circular exempts instances where investments are made by lenders into mutual funds or FoFs, and those in turn have some exposure in either an AIF or in a debtor entity.

Priority distribution model or structured AIFs

  • In addition to the concerns on downstream investments by AIFs in debtor companies, the RBI also had concerns on the so-called structured AIFs or AIFs with a distribution waterfall. Whether AIFs can at all have a priority distribution waterfall is currently under SEBI examination and SEBI has stopped AIFs from using structured distribution schemes (by way of accepting fresh commitment or making investment in a new investee company) . However, several existing schemes have such models.
  • If a lender makes an investment in the subordinated units of a structured AIF scheme such investments will get deducted from the regulatory capital of the lender. The March 27 circular now clarifies that the deduction will be equally from Tier 1 and Tier 2 capital. Further, it also clarifies that the subordinated exposures in the AIF schemes could be in the form of subordinated exposures, including investment in the nature of sponsor units.

Concern areas

  • Ideally, the bar should have been limited to affiliated AIFs. Affiliated AIFs could have been defined appropriately – for example, a related party, or where the investment manager, or sponsor is a related party of the RE. Extending the bar to all AIFs is quite far from the intent of the circular – which is, admittedly, to curb evergreening. It is difficult to see how unrelated AIFs can be used by an RE to evergreen, as investment decisions of these AIFs are not exercised by the investors.
  • Ideally, the bar should have been limited only to Cat 1 and Cat 2 AIFs. Cat 3 AIFs, widely known as hedge funds, typically play in equity long/short strategies, or do other leveraged trades. REs find such investment a useful way to diversify their funds into hedge funds. Hedge fund investments are common by institutional investors all over the world; an outright curb on these investments by REs is, once again, beyond the stated intent. Notably, given the wide range of investments that Cat 3 AIFs make, avoiding an overlap with the RE’s borrowers will be quite impractical.
  • Practical implementation of this circular, if at all a RE invests in an AIF, will be quite tough. AIFs will have to share their potential investment list, which will be against any investment manager’s choice. Assuming there is an overlapped investment, the RE will have to exit within 30 days, which will create liquidity issues for AIFs, in addition to challenging the lock-in restrictions.
  • Most of the regulated entities took a provision in the 3rd quarter. The 27th March circular of the RBI gives some relief by saying that the provision will be required only to the extent of the downstream investment in a debtor entity.

In our view, there is a need to review the regulatory mechanism for AIFs, as currently, AIFs are being used as instruments of regulatory arbitrage.

[1] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0

[2] Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks), Primary (Urban) Co-operative Banks/State Co-operative Banks/ Central Co-operative Banks, All-India Financial Institutions, Non-Banking Financial Companies (including Housing Finance Companies)

Other articles related to the topic:

  1. Trust, but verify: AIFs cannot be used as regulatory arbitrage (updated on October 9, 2024)
  2. FAQs on Specific Due Diligence of investors & investments of AIF
  3. RBI bars lenders’ investments in AIFs investing in their borrowers
  4. AIFs ail SEBI: Cannot be used for regulatory breach
  5. SEBI’s standard approach, standardising valuation for AIFs
  6. Comparison between non-deposit accepting NBFC – Investment and Credit Company (NBFC-ND-ICC), Core Investment Company (CIC) and an Alternative Investment Fund (AIF)
  7. Snippet on credit of existing & issue of new units of AIFs in demat form
  8. SEBI amends framework for Large Value Funds