RBI eases norms on loans and advances to directors and its related entities

Payal Agarwal, Executive, Vinod Kothari & Company ( payal@vinodkothari.com )

RBI has recently, vide its notification dated 23rd July, 2021 (hereinafter called the “Amendment Notification”), revised the regulatory restrictions on loans and advances given by banks to directors of other banks and the related entities. The Amendment Notification has brought changes under the Master Circular – Loans and Advances – Statutory and Other Restrictions (hereinafter called “Master Circular”). The Amendment Notification provides for increased limits in the loans and advances permissible to be given by banks to certain parties, thereby allowing the banks to take more prudent decisions in lending.

Statutory restrictions

Section 20 of the Banking Regulation Act, 1949 (hereinafter called the “BR Act”) puts complete prohibition on banks from entering into any commitment for granting of loan to or on behalf of any of its directors and specified other parties in which the director is interested. The Master Circular is in furtherance of the same and specifies restrictions and prohibitions as below –

 

*since the same does not fall within the meaning of loans and advances for this Master Circular

Loans and advances without prior approval of Board

The Master Circular further specifies some persons/ entities that can be given loans and advances upto a specified limit without the approval of Board, subject to disclosures in the Board’s Report of the bank.  The Amendment Notification has enhanced the limits for some classes of persons specified.

Serial No. Category of person Existing limits specified under Master Circular Enhanced limits under Amendment Notification
1 Directors of other banks Upto Rs. 25 lacs Upto Rs.  5 crores for personal loans

(Please note that the enhancement is only in respect of personal loans and not otherwise)

2 Firm in which directors of other banks interested as partner/ guarantor Upto Rs. 25 lacs No change
3 Companies in which directors of other banks hold substantial interest/ is a director/ guarantor Upto Rs. 25 lacs No change
4 Relative(other than spouse) and minor/ dependent children of Chairman/ MD or other directors Upto Rs. 25 lacs Upto Rs. 5 crores
5 Relative(other than spouse) and minor/ dependent children of Chairman/ MD or other directors of other banks Upto Rs. 25 lacs Upto Rs. 5 crores
6 Firm in which such relatives (as specified in 4 or 5 above) are partners/ guarantors Upto Rs. 25 lacs Upto Rs. 5 crores
7 Companies in which relatives (as specified in 4 or 5 above) are interested as director or guarantor or holds substantial interest if he/she is a major shareholder Upto Rs. 25 lacs Upto Rs. 5 crores

Need for such changes

The Master Circular was released on 1st July, 2015, which is more than 5 years from now. Considering the inflation over time, the limits have become kind of vague and ambiguous and required to be revisited. Moreover, the population all over the world is facing hard times due to the Covid-19 outbreak. At this point of time, such relaxation can be looked upon as the need of the hour.

Impact of the phrase ‘Substantial interest’ vs ‘Major shareholder’

The Master Circular uses the term “substantial interest” to generally regulate in the context of lending to companies in which a director is substantially interested.

The relevant places where the term has been used are as below –

Completely prohibited Allowed with conditions
Section 20(1) of the BR Act – for companies in which directors are substantially interested Para 2.2.1.2. of Master Circular – for companies in which directors of other banks are substantially interested – upto  a limit of Rs. 25 lacs without prior approval of Board

 

Para 2.1.2.2. of Master Circular – for companies in which directors are substantially interested Para 2.2.1.4. of Master Circular – for the companies in which the relatives of directors of any bank are substantially interestedupto Rs. 25 lacs without prior approval of Board After amendment, the para stands modified as – for the companies in which the relatives of directors of any bank are major shareholdersupto Rs. 5 crores without prior approval of Board

While the Amendment Notification itself provides for the meaning of “major shareholder”, the meaning of “substantial interest” for the purposes of the Master Circular has to be taken from Section 5(ne) of the BR Act which reads as follows –

  • in relation to a company, means the holding of a beneficial interest by an individual or his spouse or minor child, whether singly or taken together, in the shares thereof, the amount paid up on which exceeds five lakhs of rupees or ten percent of the paid-up capital of the company, whichever is less;
  • in relation to a firm, means the beneficial interest held therein by an individual or his spouse or minor child, whether singly or taken together, which represents more than ten per cent of the total capital subscribed by all the partners of the said firm;

The above definition provides for a maximum limit of shareholding as Rs. 5 lacs, exceeding which a company falls into the list of a company in which director is substantially interested. The net effect is that a lot of companies fall into the radar of this provision and therefore, ineligible to take loans or advances from banks.

However, the Amendment Notification provides an explanation to the meaning of “major shareholder” as –

“The term “major shareholder” shall mean a person holding 10% or more of the paid-up share capital or five crore rupees in paid-up shares, whichever is less.”

This eases the strict limits because of which several companies may fall outside the periphery of the aforesaid restriction. Having observed the meaning of both the terms it is clear that while ‘substantial interest’ lays down strict limits and therefore, covers several companies under the prohibition list, the term ‘major shareholder’ eases the limit and makes several companies eligible to receive loans and advances from the bank subject to requisite approvals thereby setting a more realistic criteria.

The BR Act was enacted about half a century ago when the amount of Rs. 5 lacs would have been substantial, but not at the present length of time. Keeping this in mind, while RBI has substituted the requirement of “substantial interest” to “major shareholder” in one of the clauses, the other clauses and the principal Act are still required to comply with the “substantial interest” criteria, thereby, keeping a lot of companies into the ambit of restricted/ prohibited class of companies in the matter of loans and advances from banks.

Other petty amendments

Deeming interest of relative –

The Amendment Notification has the effect of inserting a new proviso to the extant Master Circular which specifies as below –

“Provided that a relative of a director shall also be deemed to be interested in a company, being the subsidiary or holding company, if he/she is a major shareholder or is in control of the respective holding or subsidiary company.”

This has the effect of including both holding and subsidiary company as well within the meaning of company by providing that a major shareholder of holding company is deemed to be interested in subsidiary company and vice versa.

Explanations to new terms –

The Amendment Notification allows the banks to lend upto Rs. 5 crores to directors of other banks provided the same is taken as personal loans. The meaning of “personal loans” has to be taken from the RBI circular on harmonisation of banking statistics which provides the meaning of personal loans as below –

Personal loans refers to loans given to individuals and consist of (a) consumer credit, (b) education loan, (c) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), and (d) loans given for investment in financial assets (shares, debentures, etc.).

Other terms used in the Amendment Notification such as “major shareholder” and “control” has also been defined. The meaning of “major shareholder” has already been discussed in the earlier part of this article. The meaning of “control” has been aligned with that under the Companies Act, 2013.

Concluding remarks

Overall, the Amendment Circular is a welcoming move by the financial market regulator. However, as pointed out in this article, several monetary limits under the BR Act have become completely incohesive and therefore, needs revision in the light of the current situation.

 

Covered Bonds in India: creating a desi version of a European dish

Abhirup Ghosh | abhirup@vinodkothari.com

It is not uncommon to have Indianised version of global dishes when introduced in India, and we are very good in creating fusion food. We have a paneer pizza, and we have a Chinese bhel. As covered bonds, the European financial instrument with over 250 years of history were introduced in India, its look and taste may be quite different from how it is in European market, but that is how we introduce things in India.

It is also interesting to note that regulatory attempts to introduce covered bonds in India did not quite succeed – the National Housing Bank constituted Working Group on Securitisation and Covered Bonds in the Indian Housing Finance Sector, suggested some structures that could work in the Indian market[1]  and thereafter, the SEBI COBOSAC also had a separate agenda item on covered bonds. Several multilateral bodies have also put their reports on covered bonds[2].

However, the market did not wait for regulators’ intervention, and in the peak of the liquidity crisis of the NBFCs, covered bonds got uncovered – first slowly, and now, there seems to be a blizzard of covered bond issuances. Of course, there is no legislative bankruptcy remoteness for these covered bonds.

There are two types of covered bonds, first, the legislative covered bonds, and second, the contractual covered bonds. While the former enjoys a legislative support that makes the instrument bankruptcy remote, the latter achieves bankruptcy remoteness through contractual features.

To give a brief understanding of the instrument, a standard covered bond issuance would reflect the following:

  1. On balance sheet – In case of covered bonds, both the cover pool and the liability towards the investor remains on the balance sheet of the issuer. The investor has a recourse on the issuer. However, the cover pool remains ring fenced, and is protected even if the issuer faces bankruptcy.
  2. Dual recourse – The investor shall have two recourses – first, on the issuer, and second, on the cover pool.
  3. Dynamic or static pool – The cover pool may be dynamic or static, depending on the structure.
  4. Prepayment risk – Since, the primary exposure is on the issuer, any prepayment risk is absorbed by the issuer.
  5. Rating arbitrage – Covered bonds ratings are usually higher than the rating of the issuer. Internationally, covered bonds enjoy upto a maximum of 6-notch better rating than the rating of the issuer.

Therefore, covered bond is a half-way house, and lies mid-way between a secured corporate bond and the securitized paper. The table below gives comparison of the three instruments:

  Covered bonds Securitization Corporate Bonds
Purpose Essentially, to raise liquidity Liquidity, off balance sheet, risk management,

Monetization of excess profits, etc.

To raise liquidity
Risk transfer The borrower continues to absorb default risk as well as prepayment risk of the pool The originator does not absorb default risk above the credit support agreed; prepayment risk is usually transferred entirely to investors. The borrower continues to absorb default risk as well as prepayment risk of the pool
Legal structure A direct and unconditional obligation of the issuer, backed by creation of security interest. Assets may or may not be parked with a distinct entity; bankruptcy remoteness is achieved either due to specific law or by common law principles True sale of assets to a distinct entity; bankruptcy remoteness is achieved by isolation of assets A direct and unconditional obligation of the issuer, backed by creation of security interest. No bankruptcy remoteness is achieved.
Type of pool of assets Mostly dynamic. Borrower is allowed to manage the pool as long as the required “covers” are ensured. From a common pool of cover assets, there may be multiple issuances. Mostly static. Except in case of master trusts, the investors make investment in an identifiable pool of assets. Generally, from a single pool of assets, there is only issuance. Dynamic.
Maturity matching From out of a dynamic pool, securities may be issued over a period of time Typically, securities are matched with the cashflows from the pool. When the static pool is paid off, the securities are redeemed. From out of a dynamic pool, securities may be issued over a period of time.
Payment of interest and principal to investors Interest and principal are paid from the general cashflows of the issuer Interest and principal are paid from the asset pool Interest and principal are paid from the general cashflows of the issuer.
Prepayment risk In view of the managed nature of the pool, prepayment of loans does not affect investors Prepayment of underlying loans is passed on to investors; hence investors take prepayment risk Prepayment risk of the pool does not affect the investors, as the same is absorbed by the issuer.
Nature of credit enhancement The cover, that is, excess of the cover assets over the outstanding funding. Different forms of credit enhancement are used, such as excess spread, subordination, over-collateralization, etc. No credit enhancement. Usually, the cover is 100% of the pool principal and interest payable.
Classes of securities Usually, a single class of bonds are issued Most transactions come up with different classes of securities, with different risk and returns Single class of bonds are issued.
Independence of the ratings from the rating of the issuer Theoretically, the securities are those of the issuer, but in view of bankruptcy-proofing and the value of “cover assets”, usually AAA ratings are given AAA ratings are given usually to senior-most classes, based on adequacy of credit enhancement from the lower classes. There is no question of independent rating.
Off balance sheet treatment Not off the balance sheet Usually off the balance sheet Not applicable.
Capital relief Under standardized approaches, will be treated as on-balance sheet retail portfolio, appropriately risk weighted. Calls for regulatory capital Calls for regulatory capital only upto the retained risks of the seller Not applicable

 

This article would briefly talk about the issuance of Covered bonds world-wide and in India, and what are the distinctive features of the issuances in India.

Global volume of Covered Bonds

Since most volumes for covered bonds came from Europe, there has been a decline due to supply side issues. This is evident from the latest data on Euro-Denominated Covered bonds Volume. The performance in FY 2020 and FY 2021 has been subdued mainly due to COVID-19. Though, the volumes suffered significantly in the Q3 and Q4 of FY 20, but returned to moderate levels by the beginning of FY 2021.

The figure below shows Euro-Denominated Covered bond Issuances until Q2 2021.

Source: Dealogic[3]

Countries like Denmark, Germany, Sweden continues to be dominant markets for covered bond issuances. The countries in the Asia-Pacific region like Japan, Singapore, and Australia continues to report moderate level of activities. In North America, Canada represents all the whole of the issuance, with no issuances in the USA.

The tables below would show the trend of issuances in different jurisdictions in 2019 (latest available data):

Source: ECBC Factbook 2020[4]

Covered Bonds in India

In India, the struggle to introduce covered bonds started way back in 2012, when the National Housing Bank formed a working group[5] to promote RMBS and covered bonds in the Indian housing finance market. Though the outcome of the working group resulted in some securitisation activity, however, nothing was seen on covered bonds.[6]

Some leading financial institutions attempted to issue covered bonds in the Indian market, but they failed. Lastly, FY 2019 witnessed the first instance of covered bonds, which was backed by vehicle loans.

In India, issuance of covered bonds witnessed a sharp growth in FY 2021, as the numbers increased to INR 22 Bn, as against INR 4 Bn in FY 2020. Even though the volume of issuances grew, the number of issuers failed to touch the two-digit mark. The issuances in FY 2021 came from 9 issuers, whereas, the issuances in FY 2020 were from only 2 issuers. Interestingly, all were non-banking financial companies, which is a stark contrast to the situation outside India.

The figure below shows the growth trajectory of covered bonds in India:

Source: ICRA, VKC Analysis

The growth in the FY 2021 was catapulted by the improved acceptance in Indian market in the second half of the year, given the uncertainty on the collections due to the pandemic, and the additional recourse on the issuer that the instrument offers, when compared to a traditional securitisation transaction.

Almost 75% of the issuances were done by issuers have ‘A’ rating, the following could be the reasons for such:

  1. Enhanced credit rating – In the scale of credit ratings, ‘A’ stands just above the investment grade rating of ‘BBB’. Therefore, it signifies adequate degree of safety. With an earmarked cover pool, with certain degree of credit enhancements and, covered bonds issued by these entities fetched a much better credit rating, going up to AA or even AAA.
  2. AUM – FY 2021 was a year of low level of originations due to the pandemic. As a result, most of the financial sector entities stayed away from sell downs, which is evident from the low of level of activity in the securitisation market, as they did not want their AUM to drop significantly. In covered bonds, the cover pool stays on the books, hence, allowing the issuer to maintain the AUM.
  3. Better coupon rate – Improved credit ratings mean better rates. It was noticed that the covered bonds were issued 50 bps – 125 bps cheaper than normal secured bonds.

The Indian covered bonds market is however, significantly different from other jurisdictions. Traditionally, covered bonds are meant to be long term papers, however, in India, these are short to medium term papers. Traditionally covered bonds are backed by residential mortgage loans, however, in India the receivables mostly non-mortgages, gold loans and vehicle loans being the most popular asset classes.

In terms of investors too, the Indian market has shown differences. Globally, long term investors like pension funds and insurance companies are the most popular investor classes, however, in India, so far only Family Wealth Offices and High Net-worth Individuals have invested in covered bonds so far.

Another distinct feature of the Indian market is that a significant share of issuances carry market linked features, that is, the coupon rate varies with the market conditions and the issuers’ ability to meet the security cover requirements.

But the most important to note here is that unlike any other jurisdiction, covered bonds don’t have a legislative support in India. In Europe, the hotspot for covered bonds, most of the countries have legislations declaring covered bonds as a bankruptcy-remote instruments. In India, however, the bankruptcy-remoteness is achieved through product engineering by doing a legal sale of the cover pool to a separate trust, yet retaining the economic control in the hands of the issuer until happening of some pre-decided trigger events, and not with the help of any legislative support. In some cases, the legal sale is done upfront too.

Considering the importance and market acceptability of the instrument, rating agencies in India have laid down detailed rating methodologies for covered bonds[7].

Conclusion

Covered Bonds issued in India will not match most of the features of a traditional covered bond issued in Europe, however, the fact that finally the investors community in India has started recognizing it as an investment opportunity is very encouraging.

The real economics of covered bonds will come to the fore only when the market grows with different classes of investors, like the mutual funds, pension funds, insurance companies etc. in the demand side, which seems a bit far-fetched for now.

 

 

[1] A working group was constituted by the National Housing Bank to promote RMBS and Covered Bonds, the report of the working group can be viewed here: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf

[2] In 2014-15, the Asian Development Bank appointed Vinod Kothari Consultants to conduct a Study on Covered Bonds and Alternate Financing Instruments for the Indian Housing Finance Segment

[3] https://www.icmagroup.org/resources/market-data/Market-Data-Dealogic/#14

[4] https://hypo.org/app/uploads/sites/3/2020/10/ECBC-Fact-Book-2020.pdf

[5] A working group was constituted by the National Housing Bank to promote RMBS and Covered Bonds, the report of the working group can be viewed here: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf

[6] Vinod Kothari Consultants has been a strong advocate for a legal recognition of Covered Bonds in India. They were involved in the initiatives taken by the NHB to recognize Covered Bonds as a bankruptcy remote instrument in India.

[7] The rating methodology adopted by ICRA Ratings can be viewed here: https://www.icra.in/Rating/ShowMethodologyReport/?id=709

The rating methodology adopted by CRISIL can be viewed here: https://www.crisil.com/mnt/winshare/Ratings/SectorMethodology/MethodologyDocs/criteria/crisils%20criteria%20for%20rating%20covered%20bonds.pdf

Our Video on Covered Bonds can be viewed here <https://www.youtube.com/watch?v=XyoPcuzbys4>

Some resources on Covered Bonds can be accessed here –

Introduction to Covered Bonds by Vinod Kothari: http://vinodkothari.com/2015/01/introduction-to-covered-bonds-by-vinod-kothari/

The Name is Bond. Covered Bond. By Vinod Kothari: http://www.vinodkothari.com/wp-content/uploads/covered-bonds-article-by-vinod-kothari.pdf

NHB’s Working Paper on Covered Bonds: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf

 

 

Leveling the playing field for all Microfinance Lenders

RBI proposes uniform regulatory framework for the Microfinance Sectorfinserv@vinodkothari.com )

The microfinance sector, in India, has proved to be fundamental for promoting financial inclusion by extending credit to low-income groups that are traditionally not catered to by lending institutions. The essential features of microfinance loans are that they are of small amounts, with short tenures, extended without collateral and the frequency of loan repayments is greater than that for traditional commercial loans. These loans are generally taken for income-generating activities, although they are also provided for consumption, housing and other purposes. There exist various market players in the microfinance industry viz. scheduled commercial banks, small finance banks, co-operative banks, various NBFCs extending microfinance loans and NBFCs-MFIs.

The microfinance industry has reached 6 crores of live borrowers base the end of the calendar year of 2020. Book size of the microfinance industry as on 31st December is 228,818 crore[1]. The sector grew by 16% from December 2019 to December 2020 (based on outstanding loan portfolio size) and has witnessed phenomenal growth over the last two decades.

Source- SIDBI Microfinance Pulse Report, April 2021

Source- SIDBI Microfinance Pulse Report, April 2021

While banks are leading by contributing 42% towards total portfolio outstanding and 39% towards active loans, NBFC-MFIs are the second highest contributors in the microfinance sector. When compared to the total portfolio size of all microfinance lenders, NBFC-MFIs only contribute to a little over 30% of the total size. However, the framework regulating microfinance has been made applicable solely to NBFC-MFIs (‘NBFC-MFI Regulations’ as provided under the respective Master Directions) while the other lenders that hold a lion’s share of the sector are not subjected to similar regulatory conditions/ restrictions. These include cap on multiple lending, ceiling on maximum lending amount, various customer protection measures etc. Absence of regulatory control has led to various problems such as multiple lending by borrowers resulting in overindebtedness, increased defaults, coercive recovery methods by lenders at the prejudice of borrowers etc.

As a solution to the same, RBI has issued a consultative paper on regulation of microfinance on June 14, 2021[2] (‘Consultation Paper’) with an intention to harmonise the regulatory frameworks for various regulated lenders (‘RE’s) in the microfinance space while also proposing a slew of changes to the existing norms for NBFC-MFIs and NBFCs.

RBI has invited comments, suggestions and feedback on the proposed regulation by July 31, 2021 from all stakeholders. The proposed norms intend to have uniform regulations applicable to microfinance loans provided by all entities regulated by the RBI and are aimed at protecting the microfinance borrowers from over-indebtedness as well as enabling competitive forces to bring down the interest rates by empowering the borrowers to make an informed decision. The key proposals of the Consultative Document have been discussed herein below in this article:

Regulations for all Microfinance Loans

MFIs encompass a host of financial institutions engaged in advancing loans to low-income groups. However, except NBFC-MFIs, none of the other entities are regulated by microfinance-specific regulations.

Resultantly, RBI has proposed to introduce a common regulatory framework for all microfinance lending institutions, irrespective of their form. The intent behind the same is to ensure that all lenders under the microfinance sector are subject to the same rules. This would not only protect borrower interest but also ensure that all lenders are operating on a level playing field thereby passing the benefit of competition to the ultimate borrower. Further, considering the total indebtedness of borrowers vis-a-vis their repayment capacity seems more fitting rather than indebtedness only from NBFC-MFIs.

Common definition of ‘Microfinance’ for all REs

RBI has proposed to revise the definition of ‘microfinance loans’ and in order to avoid over-indebtedness and multiple lending, the same is proposed to be applied uniformly to all entities regulated by the RBI (REs) and operating in the microfinance sector.

 

Annual Household Income Threshold

Common definition of microfinance borrowers

Under extant regulations for NBFC-MFIs, a microfinance borrower is identified by annual household income not exceeding ₹1,25,000 for rural and ₹2,00,000 for urban and semi-urban areas. In order to ensure a common definition, the said criteria for classification is proposed to be extended to all regulated entities (REs).

RBI has proposed to base the threshold on the income of the entire household rather than that of an individual, similar to the existing guidelines for NBFC-MFIs. The reason being that income in such households is usually assumed to be pooled.

For this purpose, ‘household’ shall mean a group of persons normally living together and taking food from a common kitchen. Even though the determination of the actual composition of a household shall be left to the judgment of the head of the household, more emphasis has been advised to be placed on ‘normally living together’ than on ‘ordinarily taking food from a common kitchen’. Note that a household differs from a family. Households include persons who ordinarily live together and therefore may include persons who are not related by blood, marriage or adoption but living together, while a family may comprise persons who are living apart from the household.

Methodology for assessment of household income

Assessment of household income in a predominant cash-based economy might pose certain difficulties. However, applying a uniform methodology may not be appropriate for such assessment, especially of low-income households, since the practice may differ based on the different types of borrowers and lenders. The same should be left at the discretion of the lender in the form of a policy. However, broad parameters/ factors may be provided. These can include deriving income from expenditure patterns, assessment of the borrower’s occupation and the ordinary remuneration flowing thereof, assessment of cash flows etc.

Criteria dropped from the existing definition –

  1. Absolute cap on the permissible amount of loan to be extended, is no longer relevant due to linking of loan to income in terms of debt-income ratio and therefore has been removed;
  2. Minimum tenure requirement is also to be be removed since longer tenures for larger loans will not be appropriate (since the absolute cap for amount of loans has been removed);
  • The existing NBFC-MFI regulations require at least 50% of the total amount of loans extended by NBFC-MFIs to be given for income generation. This means part (i.e. maximum of 50 per cent) of the aggregate amount of loans may be extended for other purposes such as housing repairs, education, medical and other emergencies. However, aggregate amount of loans given to a borrower for income generation should constitute at least 50 per cent of the total loans from the NBFC-MF. It has been realised that while microfinance loans should ideally be used for income-generating activities, placing too much emphasis on the same may lead to borrowers availing informal and more expensive modes of lending for their other financial needs. Therefore, the said requirement not being conducive, has been proposed to be removed;
  1. Restriction on lending by two NBFC-MFIs to be dropped due to overall restriction in terms of debt-income ratio (discussed below).

Maximum Permissible level of indebtedness in terms of debt-income ratio

One of the major risks in microlending has been the issue of overborrowing, with nearly 35% of the borrowers having access to two or more lenders.(source PWC report)

It is proposed to link the loan amount to household income in terms of debt-income ratio.  The payment of interest and repayment of principal for all outstanding loans of the household at any point of time is proposed to be capped at 50% of the household income i.e. total indebtedness of any borrower will not increase 50% of his/her total income. This has been proposed keeping in mind various factors such as –

  • Low savings therefore taking into account that half of their income should be available to meet their other expenses necessary for survival
  • Possibility of repayment towards other forms of informal lending from friends and family
  • Likely inflation of income to avail higher loans.

However, individual REs will be permitted to adopt a conservative threshold as per their own assessments and Board approved policy. Since, the level of indebtedness for a particular borrower is proposed to be regulated, the current stipulation that limits lending by not more than two NBFC-MFIs to the same borrower will no longer be required.

Grandfathering of existing facilities

The aforesaid threshold shall become effective from the date of introduction of the proposed regulations. However, existing loans to the households which are not complying with the limit of 50% of the household income, shall be allowed to mature. Although, in such cases, no new loans will be provided to such households till the limit is complied with.

Collateral-free loans

Microfinance borrowers belong to the low income group and generally do have the available assets to be provided as collateral for availing financial facilities. The assets possessed by them are usually those that are essential for their survival and losing them in case of a default will be detrimental to their existence. Therefore, it has been proposed that to extend the collateral free nature of microfinance loans, as applicable to NBFC-MFIs, to all REs.

Prepayment Penalty

In case of NBFC-MFIs, the borrowers are allowed prepayment without charging any penalty. It has now been proposed that microfinance borrowers of all REs shall be provided with the right of prepayment without attracting penalty.

Repayment Schedule

As per the extant regulations, microfinance borrowers of NBFC-MFIs are permitted to repay weekly, fortnightly or monthly instalments as per their choice. With a view to keep the repayment pattern at the discretion of the borrowers that will suit their repayment capacity and/or preference, all REs will be required to provide repayment periodicity to such borrowers as per a Board approved policy.

Minimum NOF for NBFC-MFIs

RBI had issued a Discussion Paper on ‘Revised Regulatory Framework for NBFCs – A Scale-Based Approach’ on January 22, 2021 proposing to revise the minimum net owned fund (NOF) limit for all NBFCs including NBFC-MFIs, from ₹2 crore to ₹20 crore.

At present, NBFC-MFIs are required to have a minimum NOF of ₹5 crore (₹2 crore for NBFC-MFIs registered in the North Eastern Region). RBI has sought the view of stakeholders whether the proposed minimum NOF of ₹20 crore for NBFCs under scale-based regulations is appropriate for NBFC-MFIs or not.

The evolution of regulatory framework for NBFCs may recall, the NOF requirement for NBFCs was Rs 25 lacs in 1990s. Then, it was increased to Rs 2 crores, Rs. 5 crores in case of NBFC-MFIs. The regulator is now proposing to increase the same to Rs 20 crores – a 10 fold increase. The underlying rationale is to have a stronger entry barrier, and to ensure that NBFCs have the initial capital for investing in technology, manpower and establishment. However, such a sharp hike in entry point requirement will keep smaller NBFCs out of the fray. Smaller NBFCs, especially NBFC-MFIs, have been doing a useful job in financial inclusion and having a stricter entrance will only prove to demotivate the sector.  You may read further on the scalar based approach framework by RBI in our article here.

Revised Definition of ‘microfinance’ for ‘not for profit’ Companies

Section 8 companies engaged in micro-finance and not accepting public deposits, are exempt from obtaining registration under section 45IA of the RBI Act, 1934 as well as from complying with sections 45-IB (Maintenance of percentage of assets) and 45-IC (Reserve Fund).

The exemption is applicable to all not-for-profit NBFC-MFIs that meet the above criteria irrespective of their size.  However, it has been proposed to bring Section 8 companies above a certain threshold in terms of balance sheet size (say, asset size of ₹100 crore and above) under the regulatory ambit of the RBI. This is because Section 8 companies are dependent on public funds including borrowings from banks and other financial institutions for their funding needs and any risk of failure in these companies will have a resultant impact on the financial sector.

Further, not-for profit MFIs operate in an almost similar manner to that of for-profit MFIs but the latter enjoys exemptions from various requirements. The mandatory requirement for registration will ensure that not-for-profit MFIs with considerably large asset size, are effectively regulated.

The revised criteria for exemption is proposed to be as under:

‘Exemption from Sections 45-IA, 45-IB and 45-IC of the RBI Act, 1934 shall be available to a micro finance company which is

  1. engaged in micro financing activities i.e. providing collateral-free loans to households with annual household income of ₹1,25,000 and ₹2,00,000 for rural and urban/semi urban areas respectively, provided the payment of interest and repayment of principal for all outstanding loans of the household at any point of time does not exceed 50 per cent of the household income;
  2. registered under Section 8 of the Companies Act, 2013;
  3. not accepting public deposits; and
  4. having asset size of less than ₹100’

Review of Specific Regulations for NBFC-MFIs

Qualifying Asset Criteria

In order to be classified as a ‘qualifying asset’, a loan is required to satisfy the following criteria:

  1. Loan which is disbursed to a borrower with household annual income not exceeding ₹1,25,000 and ₹2,00,000 for rural and urban/semi-urban households respectively;
  2. Loan amount does not exceed ₹75,000 in the first cycle and ₹1,25,000 in subsequent cycles;
  • Total indebtedness of the borrower does not exceed ₹1,25,000 (excluding loan for education and medical expenses);
  1. Minimum tenure of 24 months for loan amount exceeding ₹30,000;
  2. Collateral free loans without any prepayment penalty;
  3. Minimum 50 per cent of aggregate amount of loans for income generation activities;
  • Flexibility of repayment periodicity (weekly, fortnightly or monthly) at borrower’s choice.

The following changes have been proposed –

  1. The household income limits have been retained under the revised definition of microfinance loans and made applicable to all REs
  2. Absolute cap is no longer relevant due to linking of loan to income in terms of debt-income ratio
  • Minimum tenure requirement to be removed since longer tenures for larger loans will not be appropriate (since the absolute cap for amount of loans has been removed)
  1. Collateral free loans and absence of prepayment penalty have been retained in the revised definition.
  2. The existing NBFC-MFI regulations require at least 50% of the total amount of loans extended by NBFC-MFIs to be given for income generation. This means part (i.e. maximum of 50 per cent) of the aggregate amount of loans may be extended for other purposes such as housing repairs, education, medical and other emergencies. However, aggregate amount of loans given to a borrower for income generation should constitute at least 50 per cent of the total loans from the NBFC-MF. It has been realised that while microfinance loans should ideally be used for income-generating activities, placing too much emphasis on the same may lead to borrowers availing informal and more expensive modes of lending for their other financial needs. Therefore, the said requirement not being conducive, has been proposed to be removed.

Limit of lending by two NBFC-MFIs

Owing to an overall restriction based on debt-income ratio of 50% for all REs, the restriction of lending by only two NBFC-MFIs to a borrower will be withdrawn.

Pricing of Credit by NBFC-MFIs

Given the vulnerable nature of the borrowers of microfinance loans, the NBFC-MFI regulations imposed an interest cap to prevent exorbitant interest rates charged to such borrowers.

The interest rate cap prescribes multiple ceilings rather than a single one. Accordingly, NBFC-MFIs have been permitted to charge interest with a maximum margin cap of 10% and 12% over and above the cost of funds, depending on the size of loan portfolio (₹100 crore threshold) or 2.75 times of the average base rate of five largest commercial banks, whichever is lower.

The latter criterion provides a linkage with the prevailing interest rate in the economy and ensures that higher borrowing costs for NBFC-MFIs with riskier business models are not transmitted to the end borrowers. Further, NBFC-MFIs are not permitted to levy any other charge except for a processing fee (capped at 1% of the loan amount) and actual cost of insurance to ensure that interest rate ceilings are not bypassed by NBFC-MFIs through other hidden charges.

However, the regulatory ceiling on interest rate is applicable only to NBFC-MFIs. Nearly 70% of the microfinance sector, comprising banks and small finance banks, is deregulated in terms of pricing. It has also been observed that an unintended consequence of creating a regulatory prescribed benchmark for the rest of the entities operating in the microfinance segment. Lenders, such as banks, though having a lower cost of funds, still charge a higher interest rate. This has led to borrowers being deprived of benefits of economies of scale and competition in the microfinance market.

The provision of such interest rate ceilings was suitable in an environment where NBFC-MFIs were the primary lenders. However, currently, as discussed, NBFC-MFIs contribute to only 30%. Proposing a fixed benchmark for interest rate in the microfinance industry may not be appropriate considering the differences in the cost of funds, financial or otherwise, among different types of entities.

Based on the above rationale, it has been proposed to remove such interest rate ceiling limits and align the interest rate model for NBFC-MFIs with that of regular NBFCs.  NBFC-MFIs will now be permitted to adopt interest rates based on a Board approved policy while adhering to fair practice code to ensure disclosure and transparency. However, necessary regulation must also be put in place to avoid charging usurious interest rates. The intention is to enable the market mechanism to reduce the lending rates for the entire microfinance sector.

Fair Practice Norms

The above relaxation from interest rate ceiling, comes with its own set of fair practice norms to ensure transparency and protecting interests of borrowers.

  1. Disclosure of information on pricing

To allow borrowers to make an informed decision, REs will mandatorily be required to disclose pricing information by way of a standardised and simplified disclosure format (specified under table III of the Consultation Paper). Such information will enable borrowers to compare interest rates as well as other fees associated with a microfinance loan in a more readable and understandable manner. The pricing related fact sheet shall be provided to every prospective borrower before on-boarding.

  1. Board Policy for determining charges including interest rate

Boards of all REs will be required to frame suitable internal principles and procedures for determining interest rates and other charges to arrive at an all-inclusive usurious interest rate.

  1. Display of interest rates

All REs will be required to display the minimum, maximum and average interest rates charged by them on microfinance loans. The manner of display is still to be prescribed.

  1. Scrutiny by RBI

The above information will also be incorporated in returns submitted to RBI and shall be subjected to the supervisory scrutiny.

[1] Source- SIDBI Microfinance Pulse Report, April 2021

[2] https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=51725

Basics of Factoring in India

Megha Mittal, Associate ( mittal@vinodkothari.com )
Factoring as an age-old concept has stood the test of time as it enabled businesses to resolve the cash flow issues, rendered liquidity, facilitated uninterrupted services and cushioned businesses against the lag in the billing cycles. Also the merit of the product lies in the simplicity of the concept which is well understood and accepted. 
The principles of factoring work broadly on the seller selling the receivables of a debtor to a specialised financial intermediary called a factor. The sale of the receivables happens at a discount and transfers the ownership of the receivables to the factor who shall on purchase of receivables, collect the dues from the debtor instead of the seller doing so, enabling the seller to receive upfront funds from the factor. This allows companies to cash in on their sales without having to wait for payments to come in from customers in due course. With the purchase of the receivables the factor enters the shoes of the seller and takes on the liability under the contract.

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List of Disclosures Requirements Applicable to NBFCs

 

Srl No Particular Clause Reference Remarks
List of Disclosure in Annual Report – As per RBI Direction
1 NBFCs shall disclose in their annual reports the details of the auctions conducted during the financial year including the number of loan accounts, outstanding amounts, value fetched and whether any of its sister concerns participated in the auction. Para 27(4) (d)-Loans against security of single product – gold jewellery Applicable for Gold loan business
2
Non-deposit taking NBFC with asset size of ₹ 500 crore and above issuing PDI, shall make suitable disclosures in their Annual Report about : Annex XVII
(i) Amount of funds raised through PDI during the year and outstanding at the close of the financial year;
(ii) Percentage of the amount of PDI of the amount of its Tier I Capital;
(iii) Mention the financial year in which interest on PDI has not been paid in accordance with clause 1(viii) above.
Terms and Conditions Applicable to Perpetual Debt Instruments (PDI) for Being Eligible for Inclusion in Tier I capital Applicable for NBFCs issuing PDIs
2A Details of all material transactions with related parties shall be disclosed in the annual report along with policy on dealing with Annual Report Para 4.3 – Annex IV, Master Directions
2B (i) Remunerarion of Directors (Para 4.5)
(ii) a Management Discussion and Analysis report
Para 4.3 – Annex IV, Master Directions
Disclosure in Financial Statements- as per RBI Direction
3
Disclosure in the balance sheet
The provision towards standard assets need not be netted from gross advances but shall be shown separately as ‘Contingent Provisions against Standard Assets’ in the balance sheet. Master Directions Para 14
Every applicable NBFCshall separately disclose in its balance sheet the provisions made as per these Directions without netting them from the income or against the value of assets.

The provisions shall be distinctly indicated under separate heads of account as under:-
(i) provisions for bad and doubtful debts; and
(ii) provisions for depreciation in investments.

Master Direction Para 17 (1) and (2)
In addition to the above every applicable NBFCshall disclose the following particulars in its Balance Sheet:
(i) Capital to Risk Assets Ratio (CRAR);
(ii) Exposure to real estate sector, both direct and indirect; and
(iii) Maturity pattern of assets and liabilities.
Master Direction Para 17 (5)
4 Indicative List of Balance Sheet Disclosure for non-deposit taking NBFCs with Asset Size ₹500 Crore and Above and Deposit Taking NBFCs (hereinafter called as Applicable NBFCs) Annex XIV Please refer Annex XIV
5
Disclosures to be made by the Originator in Notes to Annual Accounts Guidelines on Securitisation Transactions
The Notes to Annual Accounts of the originating NBFCs shall indicate the outstanding amount of securitised assets as per books of the SPVs sponsored by the NBFC and total amount of exposures retained by the NBFC as on the date of balance sheet to comply with the MRR. These figures shall be based on the information duly certified by the SPV’s auditors obtained by the originating NBFC from the SPV. These disclosures shall be made in the format given in Appendix 2.
6
LRM Framework
An NBFC shall publicly disclose information (Appendix I) on a quarterly basis on the official website of the company and in the annual financial statement as notes to account that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position. Guidelines on Liquidity Risk Management Please refer Appendix I
7
LCR Disclosure Standards
NBFCs in their annual financial statements under Notes to Accounts, starting with the financial year ending March 31, 2021, shall disclose information on LCR for all the four quarters of the relevant financial year. The disclosure format is given in the Appendix I. Data must be presented as simple averages of monthly observations over the previous quarter (i.e., the average is calculated over a period of 90 days). However, with effect from the financial year ending March 31, 2022, the simple average shall be calculated on daily observations.
NBFCs should provide sufficient qualitative discussion (in their annual financial statements under Notes to Accounts) around the LCR to facilitate understanding of the results and data provided. Please refer Appendix I (Part B)
8
Schedule to the balance sheet Master Direction Clause 19
Every applicable NBFC shall append to its balance sheet prescribed under the Companies Act, 2013, the particulars in the schedule as set out in Annex IV.
9
Participation in Currency Options Master Direction Clause 83
Disclosures shall be made in the balance sheet regarding transactions undertaken, in accordance with the guidelines issued by SEBI.
10
Participation in Currency Futures Master Direction Clause 94
Disclosures shall be made in the balance sheet relating to transactions undertaken in the currency futures market, in accordance with the guidelines issued by SEBI.
11
Disclosure for Restructured Accounts Master Direction Annex VII
With effect from the financial year ending March 2014 NBFCs shall disclose in their published annual Balance Sheets, under “Notes on Accounts”, information relating to number and amount of advances restructured, and the amount of diminution in the fair value of the restructured advances as per the format given in Appendix – 4
12 Disclosures relating to fraud in terms of the notification issued by Reserve Bank of India
14
Moratorium Circular
The lending institutions shall suitably disclose the following in the ‘Notes to Accounts’ while preparing their financial statements for the half year ending September 30, 2020 as well as the financial years 2019-20 and 2020-2021:

(i) Respective amounts in SMA/overdue categories, where the moratorium/deferment was extended, in terms of paragraph 2 and 3;

(ii) Respective amount where asset classification benefits is extended.

(iii) Provisions made during the Q4FY2020 and Q1FY2021 in terms of paragraph 5;

(iv) Provisions adjusted during the respective accounting periods against slippages and the residual provisions in terms of paragraph 6.

Para 10 COVID19 Regulatory Package – Asset Classification and Provisioning
15
Disclosure under sector – Restructuring of Advances, Circular
NBFCs shall make appropriate disclosures in their financial statements, under ‘Notes on Accounts’, relating to the MSME accounts restructured under these instructions as per the following format:

No. of accounts restructured Amount (₹ in million)

Micro, Small and Medium Enterprises (MSME) sector – Restructuring of Advances
16
Lending institutions publishing quarterly statements shall, at the minimum, make disclosures as per the format prescribed in Format-A Para 52 of Resolution Framework for COVID-19-related Stress In the financial statements for the quarters ending March 31, 2021, June 30, 2021 and September 30, 2021
16A (i) registration/ licence/ authorisation, by whatever name called, obtained from other financial sector regulators;
(ii) ratings assigned by credit rating agencies and migration of ratings during the year;
(iii) penalties, if any, levied by any regulator;
(iv) information namely, area, country of operation and joint venture partners with regard to joint ventures and overseas subsidiaries and
(v) Asset-Liability profile, extent of financing of parent company products, NPAs and movement of NPAs, details of all off-balance sheet exposures, structured products issued by them as also securitization/ assignment transactions and other disclosures
Para 73 – Master Directions (Ref. Annexure XIV)
Other Disclosure
17 Report on-line to stock exchanges on a quarterly basis, information on the shares pledged against LAS, in their favour, by borrowers for availing loans 22 of Master Directions In format as given in Annex V for Master Direction.
18 Quarterly statement to RBI on change of directors, and a certificate from the Managing Director of the applicable NBFC that fit and proper criteria in selection of the directors has been followed 72 of Master Direction The statement must be sent 15 days of the close of the respective quarter. The statement for the quarter ending March 31, shall be certified by the auditors
19 On a quarterly basis, NBFCs shall report “total exposure” in all cases where they have assumed exposures against borrowers in excess of the normal single / group exposure limits due to the credit protections obtained by them through CDS, guarantees or any other permitted instruments of credit risk transfer Para 8 of Guidelines for Credit Default Swaps – NBFCs as users
Website Disclosure
20
Public disclosure
An NBFC shall publicly disclose information (Appendix I) on a quarterly basis on the official website of the company that enables market participants to make an informed judgment about the soundness of its liquidity risk management framework and liquidity position. Guidelines on Liquidity Risk Management Please refer Appendix I
21 NBFCs are required to disclose information on their LCR every quarter Para 6 LCR Framework To be made on website
Additional Disclosures w.r.t. COVID-19
22 Lending institutions publishing quarterly financial statements shall, at the minimum, shall make disclosures in their financial statements for the quarters ending September 30, 2021 and December 31, 2021. The resolution plans implemented in terms of Part A of this framework should also be included in the continuous disclosures required as per Format-B prescribed in the Resolution Framework – 1.0. As per format prescribed in Format-X
23 The number of borrower accounts where modifications were sanctioned and implemented in terms of Clause 22 above, and the aggregate exposure of the lending institution to such borrowers may also be disclosed on a quarterly basis,
24 The credit reporting by the lending institutions in respect of borrowers where the resolution plan is implemented under Part A of this window shall reflect the “restructured due to COVID-19” status of the account

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

Aanchal kaur Nagpal | finserv@vinodkothari.com

Introduction

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

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

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

Effective Date

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

Applicability of the Circular

Supplementary nature of the Circular  

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

The following guidelines have been brought by the Circular –

Chairperson and Meetings of the Board

Chairperson –

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

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

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

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

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

Meetings of the Board

The quorum for the board meetings shall be:

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

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

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

Committees of the Board

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

 

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

 

Majority NEDs Only NEDs

 

Minimum 2/3rd of the directors shall be IDs

 

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

 

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

 

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

 

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

 

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

 

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

 

 

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

Remunerations of NEDs

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

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

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

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

Age and tenure of NEDs

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

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

Tenure of MD & CEO and WTDs

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

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

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

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

Conclusion

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

 

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

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

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

FAQs on refund of interest on interest

-Financial Services Division (finserv@vinodkothari.com)

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

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

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

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Payment and Settlement Systems: A Primer

– Siddarth Goel (finserv@vinodkothari.com)

Introduction

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

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

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

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

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Understanding regulatory intricacies of Payment Aggregator business

-Siddarth Goel (finserv@vinodkothari.com)

Abstract

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

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

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

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

Market Dynamics

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

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

What are Payment Aggregators and Payment Gateways?

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

PA Transaction Flow

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

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

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

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

Regulatory approach towards PAs and PGs

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

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

Legal Basis and Governance framework

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

Comprehensive Management of Risk

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

KYC and Merchant On-boarding Process

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

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

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

Settlement and Escrow

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

Escrow Account

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

Settlement Finality

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

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

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

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

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

Market Concerns

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

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

Conclusion

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

 

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

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

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

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

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

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

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

 

Our other related articles:

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

RBI to regulate operation of payment intermediaries – Vinod Kothari Consultants

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

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

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

Overview

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

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

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

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

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

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

Interest on Interest

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

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

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

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

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

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

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

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

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

RBI Circular

Coverage of Lenders

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

Coverage of Borrowers

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

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

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

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

Coverage of facilities

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

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

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

 

Burden of interest on interest

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

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

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

Accounting disclosure for FY 20-21

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

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

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

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

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

Mechanism of extending the benefit

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

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

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

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

Actionables

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

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

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

Asset Classification

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

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

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

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

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

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

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