Securitisation of Stressed Assets (SOSTRA)
Team Finserv | finserv@vinodkothari.com
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RBI Updates for NBFCs- A rerun of the regulatory changes introduced during FY 24-25
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Bond Credit Enhancement Framework: Competitive, rational, reasonable
Balancing between Bling & Business: RBI proposes new Gold Lending rules
Unified framework for Non-fund based facilities, by banks and NBFCs
Bond Credit Enhancement Framework: Competitive, rational, reasonable
-Vinod Kothari (vinod@vinodkothari.com)
The RBI’s proposed framework for partial credit enhancement for bonds has significant improvements over the last 2015 version
The RBI released the draft of a new comprehensive framework for non-fund based support, including guarantees, co-acceptances, as well as partial credit enhancement (PCE) for bonds. The PCE framework is proposed to be significantly revamped, over its earlier 2015 version.
Note that PCE for corporate bonds was mentioned in the FM’s Budget 20251, specifically indicating the setting up of a PCE facility under the National Bank for Financing of Infrastructural Development (NaBFID).
A quick snapshot of how PCE works and who all can benefit is illustrated below:
The highlights of the changes under the new PCE framework are:
What is PCE?
Partial Credit Enhancement (PCE) is a risk-mitigating financial tool where a third party provides limited financial backing to improve the creditworthiness of a debt instrument. Provision of wrap or credit support for bonds is quite a common practice globally.
PCE is a contingent liquidity facility – it allows the bond issuer to draw upon the PCE provider to service the bond. For example, if a coupon payment of a bond is due and the issuer has difficulty in servicing the same, the issuer may tap the PCE facility and do the servicing. The amount so tapped becomes the liability of the issuer to the PCE provider, of course, subordinated to the bondholders. In this sense, the PCE facility is a contingent line of credit.
A situation of inability may arise at the time of eventual redemption of the bonds too – at that stage as well, the issuer may draw upon the PCE facility.
Since the credit support is partial and not total, the maximum claim of the bond issuer against the PCE provider is limited to the extent of guarantee – if there is a 20% guarantee, only 20% of the bond size may be drawn by the issuer. If the facility is revolving in nature, this 20% may refer to the maximum amount tapped at any point of time.
Given that bond defaults are quite often triggered by timing and not the eventual failure of the bond issuer, a PCE facility provides a great avenue for avoiding default and consequential downgrade. PCE provides a liquidity window, allowing the issuer to arrange liquidity in the meantime.
Who can be the guarantee provider?
PCE under the earlier framework could have been given by banks. The ambit of guarantee providers has been expanded to include SCBs, AIFIs, NBFCs in Top, Upper and Middle Layers and HFCs. However, in case of NBFCs and HFCs, there are additional conditions as well as limit restrictions.
As may be known, entities such as NABFID have been tasked with promoting bond markets by giving credit support.
Who may be the bond issuers?
The PCE can be extended against bonds issued by corporates /special purpose vehicles (SPVs) for funding all types of projects and to bonds issued by Non-deposit taking NBFCs with asset size of ₹1,000 crore and above registered with RBI (including HFCs).
What are the key features of the bonds?
- REs may offer PCE only in respect of bonds whose pre-enhanced rating is “BBB minus” or better.
- REs shall not invest in corporate bonds which are credit enhanced by other REs. They may, however, provide other need based credit facilities (funded and/ or non-funded) to the corporate/ SPV.
- To be eligible for PCE, corporate bonds shall be rated by a minimum of two external credit rating agencies at all times.
- Further, additional conditions for providing PCE to bonds issued by NBFCs and HFCs:
- The tenor of the bond issued by NBFCs/ HFCs for which PCE is provided shall not be less than three years.
- The proceeds from the bonds backed by PCE from REs shall only be utilized for refinancing the existing debt of the NBFCs/ HFCs. Further, REs shall introduce appropriate mechanisms to monitor and ensure that the end-use condition is met.
What will be the form of PCE?
PCE shall be provided in the form of an irrevocable contingent line of credit (LOC) which will be drawn in case of shortfall in cash flows for servicing the bonds and thereby may improve the credit rating of the bond issue. The contingent facility may, at the discretion of the PCE providing RE, be made available as a revolving facility. Further, PCE cannot be provided by way of guarantee.
What is the difference between a guarantee and an LOC? If a guarantor is called upon to make payments for a beneficiary, the guarantor steps into the shoes of the creditor, and has the same claim against the beneficiary as the original creditor. For example, if a guarantor makes a payment for a bond issuer’s obligations, the guarantor will have the same rights as the bondholders (security, priority, etc). On the contrary, the LOC is simply a line of liquidity, and explicitly, the claims of the LOC provider are subordinated to the claims of the bondholders.
If the bond partly amortises, is the amount of the PCE proportionately reduced? This should not be so. In fact, the PCE facility continues till the amortisation of the bonds in full. It is quite natural to expect that the defaults by a bond issuer may be back-heavy. For example, if there is a 20% PCE, it may have to be used for making the last tranche of redemption of the bonds. Therefore, the liability of the PCE provider will come down only when the outstanding obligation of the bond issuer comes to less than the size of the PCE.
Any limits or restrictions on the quantum of PCE by a single RE?
The existing PCE framework restricts a single entity to providing only 20% of the total 50% PCE limit for a bond issuance. It is now proposed that the sub-limit of 20% be removed, enabling single entity to provide upto 50% PCE support.
Further, the exposure of an RE by way of PCEs to bonds issued by an NBFC/ HFC shall be restricted to one percent of capital funds of the RE, within the extant single/ group borrower exposure limits.
Who can invest in credit-enhanced bonds?
Under the existing framework, only the entities providing PCE were restricted from investing in the bonds they had credit-enhanced. However, the new Draft Directions expand this restriction by prohibiting all REs from investing in bonds that have been credit-enhanced through a PCE, regardless of whether they are the PCE provider. The draft regulations state that the same is with an intent to promote REs enabling wider investor participation.
This is, in fact, a major point that may need the attention of the regulator. A universal bar on all REs from investing in bonds which are wrapped by a PCE is neither desirable, nor optimal. Most bond placements are done by REs, and REs may have to warehouse the bonds. In addition, the treasuries of many REs make opportunistic investments in bonds.
Take, for instance, bonds credit enhanced by NABFID. The whole purpose of NABFID is to permit bonds to be issued by infrastructure sector entities, by which banks who may have extended funding will get an exit. But the treasuries of the very same banks may want to invest in the bonds, once the bonds have the backing of NABFID support. There is no reason why, for the sake of wider participation, investment by regulated entities should be barred. This is particularly at the present stage of India’s bond markets, where the markets are not liquid and mature enough to attract retail participation.
What is the impact on capital computation?
Under the Draft Directions the capital is required to be maintained by the REs providing PCE based on the PCE amount based on applicable risk weight to the pre-enhanced rating of the bond. Under the earlier framework, the capital was computed so as to be equal to the difference between the capital required on bond before credit enhancement and the capital required on bond after credit enhancement. That is, the existing framework ensures that the PCE does not result into a capital release on a system-wide basis. This was not a logical provision, and we at VKC have made this point on various occasions2.
Related Resources –
Webinar on 4 new major regulations on NPL Securitisation, Co-lending, Gold lending and NFB facilities
Balancing between Bling & Business: RBI proposes new Gold Lending rules
– Team Finserv | finserv@vinodkothari.com
Genesis of the change
The RBI on September 30, 2024, flagged several concerns in gold lending practices of financial entities. Further, there were separate guidelines for banks and NBFCs leading to regulatory arbitrage and operational ambiguity. On April 09, 2025, the RBI introduced the Reserve Bank of India (Lending Against Gold Collateral) Directions, 2025 (Draft Directions).
The Draft Directions intend to:
- Harmonise guidelines w.r.t. gold lending across all REs.
- Address previous observations raised by RBI in lending practices and plug any loopholes.
In this write-up, we highlight the major changes for lenders, and particularly for NBFCs (The same are subsequently elaborated in the article).
Read more →Gains on sale of Zombie loans: RBI’s year-end bonus to banks
– Vinod Kothari & Dayita Kanodia (finserv@vinodkothari.com)
“There is no such thing as government money – only taxpayer money.”
— Margaret Thatcher
RBI has introduced a significant amendment to the prudential treatment of Security Receipts (SRs) guaranteed by the Government of India through its latest circular dated March 29, 2025. What this amendment briefly means is, that for sale of bad loans to NARCL, funded by issue of sovereign-backed SRs, the banks may book a gain equal to the sale consideration minus the provisioned value of the bad loans. Interestingly, this treatment will be applied not only to transactions done after the amendment, but to existing SRs held by banks too.
By way of a background, National Asset Reconstruction Company Limited (NARCL), along with its sister body India Debt Resolution Company Ltd. (IDRCL), was created to clean up the legacy stressed assets with an exposure of Rs 500 crore and above in the Indian Banking system. A 2021 cabinet note approved the grant of GOI guarantee for the SRs issued by NARCL for the bad loans it will buy from banks. When banks sell bad loans to NARCL (or, for that matter, to any other ARCs), they put in 15% of their own funds, and for the balance, they issue a paper called SRs. While presumably the bad loans are to be bought at their fair value, given that the chunk of the value is funded by the issue of this paper, one may understand that the fair valuation is quite often an abstraction.
As per para 77 of the TLE Directions, in respect of the stressed loans transferred to the ARC, the transferors are required to carry the investment in their books on an ongoing basis, until its transfer or realization, at lower of the redemption value of SRs arrived based on the NAV as above, and the NBV of the transferred stressed loan at the time of transfer. Hence, there is no gain on sale booked at the time of the sale, even if the sale is at higher than the net book value.
However, the RBI made a specific amendment, targeted at NARCL SRs (as those are the only ones guaranteed by GOI), having the effect of saying that, in view of the GOI guarantee, banks holding the SRs may value them at their face value. As a result, banks may book the entire difference between the sale consideration of the bad loans, and the net-of-provisions value of the loans, as a gain on sale or reversal of the provision. Either way, the credit goes to P&L account.
Key Highlights of the Circular
There are, of course, several caveats to booking this gain on sale. First of all, let everyone understand that the loans have been languising in the books of the banks for several years, and therefore, they would have mostly slipped in the category of “doubtful assets”, requiring steep and progressively scaling-up provisions. Therefore, it is quite likely that the fair value, which may, in turn, be influenced by the likely value in case of a resolution plan or liquidation, or the value of the underlying secured assets, may be substantially higher than the provisioned value.
The circular makes the following crucial changes to the treatment of SRs guaranteed by the sovereign:
- Reversal of Excess Provision: When a loan is transferred to an ARC for a value higher than its Net Book Value (NBV), the excess provision can be reversed to the P&L account. However, this is permitted only if the sale consideration consists solely of (i) cash and (ii) SRs guaranteed by the Government of India.
- Deduction from regulatory capital: Despite allowing provision reversals or gain on sale, the RBI mandates that the non-cash component (SRs) must be deducted from Common Equity Tier 1 (CET 1) capital/Tier 1 Capital. Additionally, no dividends can be paid out of the SRs component, ensuring that banks do not distribute unrealized profits to shareholders. This means that the provision reversal or gain on sale will stay in the bank’s balance sheet as a non-distributable surplus. How long will this credit remain non-distributable? Since the government guarantee is valid only for 5 years, it is incumbent that NARCL will do either a resolution or liquidation of the borrower sooner than this period. Eventually, the SRs may receive cash distribution, either by way of realisation from the bad loans, or by way of the devolvement of the GOI guarantee, or both. Will the non-distributable credit become part of usual distributable profits when the value of the SRs is realised? While the circular does not give clarity on the subsequent treatment of the credit, our understanding says, yes.
- Periodic Valuation Based on NAV: The SRs will be periodically valued based on the Net Asset Value (NAV) declared by the ARC, derived from the recovery ratings of such instruments. Here once again, it is not clear whether the recovery ratings will be disregarding the underlying GOI guarantee. Logically, since the SRs are fully guaranteed, there is no reason for the rating to drop. But if the recovery ratings are done disregarding the guarantee, then the valuation of the SRs is bound to drop in the near future, making the FY 24-25 profit short-lived.
- Final Valuation of SRs: If SRs remain outstanding after the final settlement of the government guarantee or upon the expiry of the guarantee period, they will be valued at a nominal price of ₹1.
- Conversion of SRs: If the SRs are converted into another form of instrument as part of the resolution process, their valuation and provisioning will follow the provisions outlined under the Prudential Framework for Resolution of Stressed Assets dated June 7, 2019.
The Implications of RBI’s Move
The amendment, issued just 2 days to the end of the fiscal year, means a lot to the profit and loss accounts of the banks holding the SRs.
However, on a policy front, it leaves several questions to be answered. The loans were evidently bad to their core. If the loans had any value in the hands of the banks, the banks would have used the several tools in their arsenal to recover them. Not that ARCs were unknown to the banks, or that IBC was far away from them. Therefore, if the banks were tempted to sell them to NARCL, the only reason would have been that the sale consideration, to the extent of 85% in form of paper-against-paper, was attractive. This paper, in the form of the SRs, suddenly means a lot of value in what was all this while not turning into value at all.
Central Government guarantee of Rs.30,600 crore to back Security Receipts issued by NARCL for acquiring stressed loan assets has been approved by the Union Cabinet. NARCL proposes to acquire stressed assets of about Rs. 2 Lakh crore in phases through 15% Cash and 85% in SRs. IDRCL will be engaged for management and value addition once NARCL acquires the assets.
It may be noted that according to the FAQs released by the Ministry of Finance on the subject, such sovereign guarantee will incentivize quicker action on resolving stressed assets thereby helping in better value realization. The FAQs state that this approach will also permit freeing up of personnel in banks to focus on increasing business and credit growth. Further, it will bring about improvement in the bank’s valuation and enhance their ability to raise market capital.
GOI guarantee is essentially tax payer’s money, eventually to fill the gap left in recovering a bad loan. Of course the bad loan is money lent by a bank to a bad borrower. Therefore, indirectly, the cost of this bad lending is transferred to the taxpayers.
It is quite okay for the GOI to recapitalise banks, but is it okay for the RBI or GOI to insert an item on the P/L accounts of banks by converting an imaginary profit into value?
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Bank-NBFC Partnerships for Priority Sector Lending: Impact of New Directions
-Harshita Malik (finserv@vinodkothari.com)
Background
The Reserve Bank of India (RBI) has, after almost five years, updated its Priority Sector Lending (PSL) norms that prescribes the PSL limits for banks. PSL targets ensure an adequate flow of credit from the banking system to sectors of the economy that are crucial for their socio-economic contributions, with a focus on specific segments whose credit needs remain underserved despite being creditworthy.
On March 24, 2025, the RBI issued Master Directions – Reserve Bank of India (Priority Sector Lending – Targets and Classification) Directions, 2025 (‘New Directions’), in supersession of the 2020 Master Directions of Priority Sector Lending (PSL)- Targets and Classification, prescribing higher loan limits for housing and other loans, expanding eligible purposes for PSL classification, removing the interest rate limits caps in case of securitisation and transfer of loan exposures and including an increased list of eligible borrowers under certain categories. While these measures are expected to help banks achieve their overall targets, the limits and restrictions that persist within sub-categories often require banks to adjust underwriting standards to meet PSL requirements. The revised loan limits offer banks flexibility to address these challenges, while also providing room for growth acceleration.
Effective Date
The New Directions shall come into effect on April 1, 2025 and shall supersede the erstwhile directions on the subject, namely, the Reserve Bank of India (Priority Sector Lending – Targets and Classification) Directions dated September 04, 2020 (‘Erstwhile Directions’).
Further, all loans eligible to be categorised as PSL under the Erstwhile Directions (updated as on March 25, 2025) shall continue to be eligible for such categorisation under the New Directions, till their maturity.
Applicability
The New Directions are applicable to all commercial banks, Regional Rural Banks (RRBs), Small Finance Banks (SFBs), Local Area Banks (LABs), and Primary (Urban) Co-operative Banks (UCBs), excluding Salary Earners’ Banks.
Bank-NBFC Partnerships for PSL
Achieving PSL targets has always been an uphill task for banks, especially those without a strong retail branch network. PSL typically involves bite-sized/ small ticket loans to the last mile borrowers that come with borrower proximity, geographical presence, strong operational abilities and tailored recovery strategies, making it less appealing for banks to dive in wholeheartedly.
To add to the predicament, these sectors tend to bear higher risk compared to traditional borrowers, leading to a greater chance of defaults. Delinquencies in the early buckets—0+ and 30+ days past due – increased by approximately 110 basis points (bps) and ~55 bps, respectively, during the first quarter of fiscal 2025 compared to the preceding March quarter1. This indicates a rising rate of defaults in the microfinance sector, making banks naturally reluctant to adopt the “ekala chalo re” model in priority sector lending.
When banks fall short of meeting their PSL targets, they turn to alternative methods to bridge the gap. One notably effective approach has been partnering with Non-Banking Financial Companies (NBFCs), a strategy that has seen increasing acceptance with most of the banks.
Figure 1: Bank-NBFC Partnership for Priority Sector Lending
When we talk about Bank-NBFC partnership, the same can broadly be undertaken in the following four ways:
- Banks lending to NBFCs/HFCs for on-lending to priority sector borrowers;
- securitisation;
- Transfer of Loan Exposure (‘TLE’); and
- Co-lending.
Banks Giving Loans to NBFCs or HFCs for On-lending Under the PSL Category
NBFCs have broader customer coverage across priority sectors, particularly in PSL categories such as agriculture and MSMEs. By channeling funds to NBFCs with defined end-use restrictions and lending terms, banks can achieve indirect exposure to the PSL sector. While the on-book exposure remains on the NBFC, the underlying loans are directed towards the priority sectors thereby enabling banks to benefit by fulfilling their PSL target. Bank loans provided to NBFCs/HFCs for on-lending are further classified into the following three categories:
- Bank loans to MFIs (NBFC-MFIs, Societies, Trusts, etc.)
This category of loans remains unchanged, with the framework detailed as follows:
| Attributes | Particulars of the framework |
| Borrowers | Registered NBFC-MFIs and other MFIs (Societies, Trusts, etc.) that are members of RBI-recognised Self Regulatory Organisation (SRO) for the sector |
| Eligible underlying loan | Loans eligible for categorization as priority sector advances under respective categories viz., Agriculture, MSME, Social Infrastructure and Others |
| Purpose of loan | On-lending to individuals and members of SHGs/JLGs |
| Conditions to be adhered | MFIs to adhere to the conditions prescribed under SBR Master Directions and MFI Master Directions |
| Cap on quantum of loans | Not specified |
| Maximum ticket size of underlying loans | Not specified |
- Bank loans to NBFCs (other than MFIs)
This category of loans remains unchanged; however, it has been clarified that the 5% cap on bank credit to NBFCs for on-lending is calculated based on the bank’s total PSL in the previous financial year. Further, compliance with the cap is to be ensured by averaging the eligible portfolio across four quarters of the current financial year. For instance, if the on-lending proportion for a particular quarter is more than 5% and then due to amortisation of the loan pools the same comes to below 5% in the remaining quarters, the limit shall be seen by averaging the exposure across all quarters in a particular financial year. The updated framework is detailed as follows:
| Attributes | Particulars of the framework |
| Borrowers | Registered NBFCs other than MFIs |
| Eligible underlying loan | Loans eligible for classification as priority sector lending under the respective categories, viz., Agriculture and Micro & Small enterprises |
| Purpose of loan | On-lending to respective categories of priority sector lending, viz., Agriculture and Micro & Small enterprises |
| Conditions to be adhered | Banks to maintain disaggregated data of such loans in the portfolio. |
| Cap on quantum of loans | 5% of individual bank’s total priority sector lending of the previous financial year Banks shall determine adherence to the caps prescribed by averaging the eligible portfolio under on-lending mechanism across four quarters of the current financial year. |
| Maximum ticket size of underlying loans (per borrower) | Agriculture: Upto Rs. 10 lakhs in respect of ‘term lending’ component under this categoryMicro & Small Enterprises: Upto Rs. 20 lakhs |
- Bank loans to HFCs
Under the New Directions, this category of loans has been explicitly designated as part of the ‘Housing’ category with the updated framework detailed as follows:
| Attributes | Particulars of the framework |
| Borrowers | HFCs approved by NHB for refinance. |
| Eligible underlying loan | Loans eligible for classification as priority sector lending under the ’Housing’ category |
| Purpose of loan | On-lending for:Purchase, construction, or reconstruction of individual dwelling units.Slum clearance and rehabilitation of slum dwellers |
| Condition | Banks must maintain borrower-wise details of the underlying loan portfolio |
| Cap on quantum of loans | 5% of individual bank’s total priority sector lending of the previous financial year Banks shall determine adherence to the caps prescribed by averaging the eligible portfolio under on-lending mechanism across four quarters of the current financial year. |
| Maximum ticket size of underlying loans (per borrower) | Aggregate limit of Rs. 20 lakhs |
Securitisation
The New Directions streamline the eligibility criteria by removing interest cap-related provisions. This is a significant change and aligns with the fact that no such lending rates are prescribed by RBI for direct lending exposure by the banks or the NBFCs. Earlier, the RBI had also removed such lending rate restrictions in the case of microfinance loans. The removal of capping would allow originating NBFCs to focus on the other terms of loans and the end use to classify as PSL.
While the removal of the net interest margin cap allows substantial flexibility to the NBFCs, by way of downside, it may also allow NBFCs to charge higher interest rates to ultimate borrowers. The outlined changes might encourage banks to invest more in Securitisation Notes, as they would have fewer restrictions. However, it could also lead to a shift in focus away from the priority sector’s socio-economic objectives, as higher interest rates might deter borrowers from accessing these loans.
Further, the general conditions for investments in Securitisation Notes and explicit exclusion of loans against gold jewellery originated by NBFCs have been retained. The New Directions focus solely on ensuring that underlying loan assets are eligible for priority sector classification before securitisation, without the additional conditions that were there in the Erstwhile Directions.
Now, the investments by banks in ‘Securitisation Notes’ representing loans by banks and financial institutions to various categories of priority sector, except ‘others’ category, are eligible for classification under respective categories of priority sector depending on the underlying assets subject to only the following two conditions:
- Assets are originated by banks and financial institutions and are eligible to be classified as priority sector advances, prior to their securitisation, and the transaction is in compliance with the RBI Guidelines on ‘securitisation of Standard Assets’ as updated from time to time; and
- Loans against gold jewellery originated by NBFCs as underlying, are not eligible for priority sector status.
Transfer of Loan Exposures
The New Directions streamline the eligibility criteria for assignment/outright purchase of asset pools by banks, in the same manner as in the case of ‘investments by banks in Securitisation Notes’.
Now the assignment/outright purchase of the pool of assets by banks representing loans under various priority sector categories, except the ‘others’ category, will be eligible for classification under the respective categories, subject to the following conditions:
- Assets are originated by banks and financial institutions and are eligible to be classified as priority sector advances prior to the purchase and fulfil the RBI guidelines on ‘Transfer of Loan Exposures’;
- Banks shall report the outstanding amount actually disbursed to priority sector borrowers and not the premium embedded amount paid to the seller; and
- Loans against gold jewellery acquired by banks from NBFCs are not eligible for priority sector status.
Co-lending
Banks collaborate with other financial entities through lending partnerships, leveraging their partners’ origination expertise to gain exposure in the PSL segment. These co-lending arrangements involve a structured sharing of risk and reward, with specific lending process functions distributed between the co-lenders. As a result, banks are able to meet their PSL targets proportionate to their share in the loans facilitated under these partnerships.
The New Directions eliminate the temporary allowance for continuing old co-origination arrangements and clarify the eligibility of loans under these arrangements for priority sector classification, limiting it to their repayment or maturity timeline.
Scheduled Commercial Banks can co-lend with registered NBFCs (including HFCs) for priority sector lending, as per the guidelines issued on November 5, 2020. Loans under the earlier co-origination guidelines (September 21, 2018) will remain eligible for priority sector classification until repayment or maturity, whichever is earlier.
Comparison at a glance
| On-lending | Securitisation | TLE | Co-lending | |
| Capping on exposure | 5% of individual bank’s total priority sector lending of the previous financial year | No cap | No cap | No cap |
| Loan size caps | Loan size caps exist on the loan by the NBFC, e.g. Rs. 20 lakhs in case of home loans and Micro & Small enterprises loans, and Rs. 10 lakhs in case of agriculture loans. | The same loan cap that would have applied had the portfolio been originated by the bank for e.g. loans to individuals for educational purposes, including vocational courses, not exceeding Rs.25 lakhs | The same loan cap that would have applied had the portfolio been originated by the bank for e.g. loans to individuals for educational purposes, including vocational courses, not exceeding Rs.25 lakhs | The same loan cap that would have applied had the portfolio been originated by the bank for e.g., loans to individuals for educational purposes, including vocational courses, not exceeding Rs.25 lakhs |
| Credit exposure of the bank | On the borrower i.e. NBFC | On the pool of loans, though credit enhanced by the NBFC | On the pool of loans | On the pool of loans |
| PSL loans originated in the books of | NBFCs (including MFIs and HFCs) | NBFC (originator) | NBFC (transferor) | Banks (to the extent of share in the loan) |
| Additional compliance requirements | – | SSA Directions | TLE Directions | Co-lending Guidelines of 2020 |
Conclusion
The New Directions on PSL provide a significant update to the framework, aiming to enhance the flow of credit to priority sectors while making the process more efficient for banks and financial institutions. By clarifying the eligibility criteria for various mechanisms like bank-NBFC partnerships, securitisation, transfer of loan exposures, and co-lending, these amendments create a more streamlined and transparent approach for meeting PSL targets. The removal of certain provisions, such as interest rate caps and exemptions for MFIs, reflects a shift towards more simplified criteria that ensure compliance while maintaining focus on supporting critical sectors like agriculture, MSMEs, and housing. The clear guidelines on the involvement of NBFCs, HFCs, and other financial entities in PSL activities are expected to strengthen the collaborative efforts between banks and non-banking institutions, ultimately contributing to the economic growth and financial inclusion of underserved communities. As the revisions come into effect from April 1, 2025, banks and other eligible financial institutions must adapt their strategies to leverage these opportunities and fulfill their PSL obligations efficiently.
- https://www.crisilratings.com/en/home/newsroom/press-releases/2024/09/for-mfis-asset-quality-hiccups-to-lift-credit-cost-curb-profitability.html ↩︎
Refer our related resources below:
NBFCs and HFCs get the Ticket to Qualified Buyers Club
-Neha Malu & Dayita Kanodia (finserv@vinodkothari.com)
Under the SARFAESI Act, only qualified buyers can invest in security receipts (SRs). The term “Qualified Buyer” has been defined under section 2(1)(u) of the SARFAESI Act, 2002, to mean a financial institution, insurance company, bank, state financial corporation, state industrial development corporation, trustee or an ARC or any asset management company making investment on behalf of a mutual fund, a foreign institutional investor registered with SEBI, or any category of non-institutional investors as may be specified by the RBI in consultation with SEBI from time to time, or any other body corporate as may be specified by SEBI.
Earlier, in exercise of the power to notify a body corporate as a QIB (now, QB)1 for the purpose of SARFAESI Act, SEBI, vide Notification dated March 31, 20082 notified NBFCs registered under section 45-IA of the RBI Act, 1934, provided the following conditions were fulfilled:
- systemically important non-deposit taking non-banking financial companies (NBFCs) with asset size of one hundred crore rupees and above3; and
- other non-deposit taking NBFCs which have asset size of fifty crore rupees and above and “Capital to Risk – weighted Assets Ratio” (CRAR) of 10% as applicable to non-deposit taking NBFCs as per the last audited balance sheet.
Definition of Qualified Buyers Amended
Now, vide gazette notification dated February 28, 20254, the scope of qualified buyers under the SARFAESI Act has been expanded to explicitly include all NBFCs and HFCs regulated by the RBI. This amendment clarifies and broadens the range of participants who can acquire security receipts from ARCs, thereby enhancing liquidity in the distressed asset market. This notification supersedes the earlier March 31, 2008 notification (discussed above).
However, the allowance for all NBFCs and HFCs to act as qualified buyers comes with the following conditions:
- such non-banking financial companies including housing finance companies shall ensure that the defaulting promoters or their related parties do not directly or indirectly gain access to secured assets through security receipts; and
- such non-banking financial companies including housing finance companies shall comply with such other conditions as the Reserve Bank of India may specify from time to time
Analysis of the conditions specified in the 28th February notification
- The first condition provides that the NBFC or HFC participating as QB shall ensure that (1) the defaulting promoters or (2) their related parties do not, directly or indirectly, regain control over the secured assets through SRs.
The intent behind the condition quite evidently is to prevent defaulting promoters and their related parties from circumventing the resolution process and regaining control over the stressed assets through security receipts.
Now, the pertinent questions in relation to the above stated condition is (a) are as follows:
- Who constitutes a “defaulting promoter” in the context of this condition, and does ineligibility extend indefinitely, or is there a specific timeline after which the promoter may become eligible?
Section 29A(c)5 of the IBC was introduced to prevent defaulting promoters from regaining control over their stressed companies through the resolution process. This aligns with the objective of the February 28, 2025, notification, which seeks to prevent defaulting promoters and their related parties from indirectly reacquiring secured assets via SRs.
Under section 29A(c) of the IBC, a promoter of a corporate debtor classified as an NPA for over a year is ineligible to participate in the resolution process unless the default is cured. The underlying principle is that those responsible for financial distress should not benefit from restructuring their own assets.
Further, as per the RBI Prudential Framework for Resolution of Stressed Assets, 2019, when changing control of a borrowing entity and reclassifying a credit facility as ‘standard,’ it must be established that the acquirer is not disqualified under section 29A of the IBC. Additionally, the ‘new promoter’ must not be linked – whether as a person, entity, subsidiary, or associate, domestically or overseas – to the existing promoter/promoter group.
Therefore, for interpreting the present condition, inference may be drawn from section 29A(c) of the IBC.
As for the timeline for re-eligibility, section 29A(c) provides that a promoter may regain eligibility upon full repayment of all overdue amounts, including interest and charges, before submitting a resolution plan. In the author’s view, a similar approach may be considered for the present condition.
- What constitutes “direct” and “indirect” control in the context of this restriction?
Since the condition ensured at the time of issuance of SRs is required to be fulfilled by the ARC vide para 23.1(ii) of the Master Direction – Reserve Bank of India (Asset Reconstruction Companies) Directions, 2024, it comes to an intriguing question as to how can the NBFC/ HFC grant access to the defaulting promoters. The SR investor is simply one of the investors. Any sale of the loans, if any, will have to be done by the ARC and not the SR holder.
Therefore, it appears that the intent of this requirement, possibly applicable when the NBFC/HFC becomes a major buyer of the SRs, is that it does not have any specific funding or other obligation from the defaulter/ defaulter’s promoters.
- From where will the definition of “related party” be derived?
The term “related party” has been defined in several legal frameworks like Companies Act, 2013, SEBI LODR Regulations (in case of listed companies), Accounting Standards (AS-18, Ind AS 24, as may be applicable) and IBC. This raises the question of which definition should apply in the present context.
In this context, section 2(2) of the SARFAESI Act provides that-
Words and expressions used and not defined in this Act but defined in the Indian Contract Act, 1872 (9 of 1872) or the Transfer of Property Act, 1882 (4 of 1882) or the Companies Act, 1956 (1 of 1956) or the Securities and Exchange Board of India Act, 1992 (15 of 1992) shall have the same meanings respectively assigned to them in those Acts.
Given the above stated provision of the SARFAESI Act, it is reasonable to infer that the definition of “related party” may be derived from the Companies Act, 2013.
- The second condition mandates compliance with any additional requirements that RBI may prescribe from time to time. This provision grants the RBI flexibility to introduce further safeguards or operational guidelines as necessary, ensuring that the participation of NBFCs and HFCs remains in line with evolving regulatory and market considerations.
Conclusion
In essence, the February 28, 2025, amendment marks a significant step in expanding the pool of qualified buyers to include all NBFCs and HFCs regulated by the RBI, thereby enhancing liquidity and participation in the security receipt market. However, the accompanying conditions ensure that increased participation does not lead to the compromise of regulatory objectives. Thus, while the amendment strengthens the investor base and improves liquidity in SRs market, it also introduces necessary safeguards to prevent potential misuse by entities with prior exposure to defaulting borrowers.
Related Resources:
- SARFAESI Act for NBFCs – Frequently Asked Questions
- ARC rights to use SARFAESI for debts assigned by non-SARFAESI entities
- The SARFAESI Act originally used the term Qualified Institutional Buyer (QIB), which was subsequently amended in 2016 and replaced with Qualified Buyer (QB). ↩︎
- https://www.sebi.gov.in/acts/qibnotification.pdf ↩︎
- In 2015, the threshold for classification of an NBFC as systemically important was increased from Rs. 100 Cr to Rs. 500 Cr but there was no consequent notification to modify the earlier notification in line with the changes in the regulatory framework for NBFCs. Even under the Scale-Based Regulation (SBR) framework, while references to Systemically Important NBFCs were replaced, the absence of an updated notification led to the continued reliance on the earlier definition. Consequently, to maintain regulatory continuity and consistency in the treatment of NBFCs, NBFCs with an asset size of ₹500 crore or more should have qualified as QBs. ↩︎
- https://egazette.gov.in/%28S%28j1ssisiqkc1nzfdmqesgfw5u%29%29/ViewPDF.aspx ↩︎
- Read more about the ineligibility criteria u/s 29A in our earlier article titled “INELIGIBILITY CRITERIA U/S 29A OF IBC: A NET TOO WIDE?” available at: https://vinodkothari.com/wp-content/uploads/2019/06/Ineligibility-Criteria-under-sec.-29A-of-IBC.pdf ↩︎
Partial Credit Enhancement: A Catalyst for Boosting Infrastructure Bond Issuances?
-Abhirup Ghosh (abhirup@vinodkothari.com)
What is partial credit enhancement?
Partial Credit Enhancement (PCE) is a risk-mitigating financial tool where a third party provides limited financial backing to improve the creditworthiness of a debt instrument. It ensures that investors are partially protected against default risk, making it easier for issuers to raise funds at better terms.
The key features of a PCE are as follows:
- Parties involved: A typical PCE structure would involve at least three parties:
- Issuer: A company or an entity that wants to raise funds by issuing debt instruments;
- PCE Provider or Credit Enhancer: A third party (usually a government agency or a financial institution with strong credibility) that provides the credit enhancement
- Investor(s): The one who invests in the debt instruments.
- Multiple forms: Can be structured in various forms, like guarantee, subordinated line of credit, investment in subordinated tranche, cash collateral etc.
- Limited coverage: Unlike full credit enhancement, PCE covers only a portion of the potential losses in case of default. The extent of coverage is pre-fixed and does not extend once the same is exhausted.
- Improved Credit Rating: PCE lowers the perceived credit risk, leading to an improved bond rating by credit rating agencies. A higher credit rating results in lower interest rates, benefiting the issuer.
Why has this become so important all of a sudden?
The concept of PCE has been in India for quite some time now, and is commonly used in securitisation transactions. However, the Finance Minister’s announcement during Union Budget 2025 about setting up of a PCE facility under the National Bank for Financing Infrastructure Development (NaBFID) has brought this into the limelight.
How does it help issuance of bonds by an infrastructure entity?
Infrastructure development is the backbone of economic growth, but funding large-scale projects such as highways, railways, power plants, and airports requires substantial capital. Infrastructure projects often face challenges in raising funds due to their long gestation periods, high risks, and lower credit ratings. PCE serves as an effective financial tool to improve the creditworthiness of infrastructure bonds, making them more attractive to investors. By providing a partial guarantee or security, PCE helps reduce the cost of borrowing and widens investor participation, ultimately facilitating infrastructure financing.
Challenges in Infrastructure Bond Issuances
Infrastructure bond issuances face several obstacles that make fundraising difficult. One of the primary challenges is low credit ratings. Infrastructure projects, especially those in their early stages, often receive sub-investment-grade ratings (such as BBB or lower), making them unattractive to investors. Additionally, these projects are subject to high perceived risks, including revenue uncertainty, regulatory hurdles, construction delays, and cost overruns. Since many infrastructure projects rely on user charges, such as tolls or metro fares, their cash flow projections can be unpredictable.
Another major issue is the long maturity period of infrastructure bonds. Most investors prefer short- to medium-term investments, whereas infrastructure bonds typically have tenures of 10 to 30 years. This mismatch reduces the appetite for such bonds in the market. Lastly, lack of institutional investor participation further limits the success of infrastructure bond issuances, as pension funds, insurance companies, and mutual funds prefer highly rated bonds with stable returns.
Enhancing Credit Ratings and Investor Confidence
One of the most significant ways PCE helps infrastructure bond issuances is by improving their credit ratings. When a bank or financial institution provides partial credit enhancement in the form of a guarantee or reserve fund, it reduces the default risk associated with the bond. This leads to a higher credit rating, making the bond more attractive to investors. For example, an infrastructure company with a BBB-rated bond issuance may improve its rating to A with a 20% PCE support, or AA with a 50% PCE support thereby increasing demand from investors. A higher rating not only boosts investor confidence but also expands the pool of potential buyers, including institutional investors such as pension funds and insurance companies.
Reducing Cost of Borrowing
By improving the credit rating of infrastructure bonds, PCE directly leads to a reduction in interest costs. Bonds with higher ratings attract lower interest rates, which helps infrastructure companies secure financing at more affordable terms. For instance, without PCE, a BBB-rated bond may require 12%, whereas a bond upgraded to an AA rating with PCE support may only require 9%. This reduction in interest rates can result in significant savings over the life of the bond. Lower borrowing costs also make infrastructure projects more financially viable, ensuring their timely execution and long-term sustainability.
Attracting Institutional Investors
Institutional investors, such as mutual funds, pension funds, and insurance companies, typically have strict investment guidelines that restrict them from investing in low-rated securities. Since many of these investors require bonds to be rated AA or higher, infrastructure bonds often struggle to meet these requirements. PCE helps bridge this gap by enhancing the credit rating, making infrastructure bonds eligible for investment by these large institutional players. This leads to greater liquidity and stability in the corporate bond market, ensuring a steady flow of capital to infrastructure projects.
Why is issuance of bonds helpful/ important for the infrastructure entity?
PCE contributes to the overall development of the corporate bond market by encouraging more issuers to raise funds through bonds rather than relying solely on bank loans. Traditionally, infrastructure financing in India has been dependent on banks, which exposes them to high asset-liability mismatches due to the long tenure of infrastructure projects. By facilitating infrastructure bond issuances, PCE helps shift the burden away from banks and towards a broader investor base. This not only diversifies funding sources but also enhances financial stability in the banking sector.
As per a CII report (2022), the infrastructure financing gap is estimated at over 5% of GDP. Approx. 80% of the investment in infrastructure space is by government agencies (80%), and the remaining 20% comes from private developers.
As per the National Infrastructure Pipelines, the total investment target was set at INR 111 trillion (USD 1.34 trillion) for the period between FY 20 and FY 25; and only 6-8% (INR 6.66-8.88) of the such targets were expected to be met by bond issuances. Reliance on bond markets is planned to the extent of 6% to 8% (INR 6.66 – 8.88 trillion). As per the said estimates, the average annual issuances should have been INR 1.480 trillion. However, between FY18 and FY22, the issuance of infrastructure bonds has been at INR 5.37 trillion, that is, an average of INR 1.07 trillion per annum, that is a shortfall of ~30% compared to the target.
Furthermore, the issuances have been highly concentrated in the top 5 PSUs. The charts below show the annual bond issuances between FY 18 – FY 22, and share of issuance by top 5 PSUs and others:
Source: CRISIL
The market is dominated by highly rated issuers. In general approx. 75% of bond issuers are rated AAA, and more than 90% of the issuances are by AA and above rated entities. The reason for this dominance by highly rated issuers is the fact that for practical purposes, the most acceptable rating in the infra bonds space is AA, as long term investors like insurance companies, pension funds etc. are by regulation required to invest in AA or above rated papers.
PCE support from a credible source will help a lot of infrastructure operators, who are stopped at the gate, with ratings in the range of A, with easy access to the market.
Existing scheme for PCE – why has it not found takers
The existing scheme for PCE was notified by the RBI in 2015. In a nutshell, the scheme provides for the following:
Form of PCE: To be structured as a non-funded, irrevocable contingent line of credit. This facility can be drawn upon in the event of cash flow shortfalls affecting bond servicing.
Limitations: The total PCE extended by a single bank cannot exceed 20% of the bond’s total size; however, overall, the PCE provided by all banks, in aggregate, cannot exceed 50% of the bond’s total size.
Further, PCE can be provided only to bonds which have a pre-enhanced rating of BBB- or above.
Capital Requirements: The bank providing PCE does not hold capital based only on its PCE amount. Instead, it calculates the capital based on the difference between:
- The capital required before credit enhancement.
- The capital required after credit enhancement.
The objective is to ensure that the PCE provider should absorb the risks that it covers in the entire transaction. Illustrating with an example:
Assume that the total bond size is Rs. 100 crores for which PCE to the extent of Rs. 20 crore is provided by a bank. The pre-enhanced rating of the bond is BBB which gets enhanced to AA with the PCE. In this scenario:
- At the pre-enhanced rating of BBB (100% risk weight), the capital requirement on the total bond size (Rs.100 crores) is Rs.9.00 crores.
- The capital requirement for the bond (Rs.100 crores) at the enhanced rating (AA, i.e., 30% risk weight)) would be Rs.2.70 crores.
- As such, the PCE provider will be required to hold the difference in capital i.e., Rs.6.30 crores (Rs.9.00 crores – Rs.2.70 crores).
As can be seen, the capital has to be maintained on the total bond issuance, and not just the exposure. Ironically, this capital has to be maintained until the outstanding principal of bonds falls below the extent of PCE provided. Usually, the bonds are amortising in nature – that is, the actual exposure of the guarantor continues to come down. Given, however, that default in bonds may be back-ended, the capital has still to be maintained till the redemption of the bonds. This requires the PCE provider to maintain huge regulatory capital for a significantly long period of time; which also gets reflected in the ultimate cost to the beneficiary, therefore, making it unviable.
How to make it work?
The FM’s announcement though comes with a lot of promise, as it shows a positive intent. But to make things work, there are quite a few things that should be put into place:
- Specific applicability: Currently, the PCE framework applies only to banks. For NaBFID to commence its PCE operations, it would be ideal to receive explicit approval from the RBI, even if the requirement is minor or procedural in nature.
- Limitations: Currently, the RBI’s PCE framework restricts a single entity to providing only 20% of the total 50% PCE limit for a bond issuance. It is recommended that a single institution, such as NaBFID, be allowed to provide the entire PCE, which would enhance flexibility. The existing framework is not particularly attractive for banks in India. In the infrastructure finance sector, a 20% PCE contribution from a single entity may not be sufficient to secure a strong rating from credit rating agencies. Removing this 20% sub-limit would grant NaBFID greater flexibility while also reducing the time required to identify multiple institutions to fulfill the remaining PCE. Additionally, this change would lead to a reduction in operational expenses associated with coordinating multiple PCE providers.
- Capital treatment: The current setting of capital requirement makes the transactions very costly. There has to be an alternative way of achieving the objective. Setting the capital requirement as a fixed proportion of the outstanding bond value may not be appropriate, as defaults can occur at any stage. A more effective approach would be to apply the capital treatment for structured credit risk transfer under the Basel III framework, that is SEC ERBA. Under Basel III, capital requirements are not linked to the total bond issuance size but are instead based on the rating of the tranche and the extent of exposure undertaken. This method ensures that capital is aligned with the actual risk exposure, rather than a fixed percentage of the bond size. Additionally, it accounts for the possibility of defaults occurring later in the bond’s lifecycle, providing a more efficient risk management framework.
- Credit risk transfer: The PCE framework should specifically allow credit risk transfer by the PCE provider – this will help the PCE provider reduce its exposures, and consequently, extent of capital to be maintained on the PCE provided. This will help in reducing the cost of the PCE support as well.
