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Prompt Corrective Action Framework for NBFCs

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– Team Finserv | finserv@vinodkothari.com

RBI Notification dated December 14, 2021 – https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12208&Mode=0

Our recent write-ups around the financial services sector – https://vinodkothari.com/category/financial-services/

FAQs on IPO Financing

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IPO Financing, as the name suggests, is providing finance for the purpose of subscribing to initial public offers done by companies. In case of IPO Financing, the exposure is based on the borrower, and the securities/ shares, if allotted, are taken as collateral for securing the obligations under the loan. The investor will realise the shares so allotted in the IPO and pay-off the loan taken from the Banks/NBFCs.

How does IPO Financing work?

IPO Financing is widely used by High Networth Individuals (HNIs) as a tool to leverage the funds available with an intent to make profits from the IPO allotment price and the price at the time of listing. Typically, the lender would provide a short-term loan to the borrower at a certain interest rate, till the shares are listed. The transaction forces the investor to sell the shares once listed. Out of the proceeds, the lender would retain the repayment of loan and payment of interest plus other charges, as may be levied; and the balance is taken home by the investor as profits.  Hence, the idea is not to “invest” in an IPO and eventually earn investment rewards; rather, the intent usually is to “enter” and “exit” by booking possible gains in the shortest time span.

Recently, the RBI has released Scale Based Regulation (SBR): A Revised Regulatory Framework for NBFCs (SBR) on October 22, 2021. While the SBR provides for broad contours of the revised framework, concrete regulations in the form of ‘Directions’ are awaited from RBI. SBR fixes a ceiling of Rs. 1 crore per borrower in case of IPO financing by any NBFC.

We have tried to figure out the probable questions arising out of the aforesaid proposal and respond to the same in the form of these FAQs. However, these are subject to final directions yet to be issued by RBI in this regard. We shall update this FAQ once there are clear directions in this regard. These FAQs shall be read accordingly.

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Workshop on Effective Regulatory interface: Preparing for and handling RBI’s NBFC inspections

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Registeration for the workshop have been closed. You may register your interest for a repeat workshop here here: https://forms.gle/RmwXa13DjuLBqhMU9

brochure-Training-on-KYC-1-1

Basics of Factoring in India

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– 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 release the working capital required for holding receivables. 

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Sale assailed: NBFC crisis may put Indian securitisation transactions to trial

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-By Vinod Kothari (vinod@vinodkothari.com)

Securitisation is all about bankruptcy remoteness, and the common saying about bankruptcy remoteness is that it works as long as the entities are not in bankruptcy! The fact that any major bankruptcy has put bankruptcy remoteness to challenge is known world-over. In fact, the Global Financial Crisis itself put several never-before questions to legality of securitisation, some of them going into the very basics of insolvency law[1]. There have been spate of rulings in the USA pertaining to transfer of mortgages, disclosures in offer documents, law suits against trustee, etc.

The Indian securitisation market has faced taxation challenges, regulatory changes, etc. However, it has so far been immune from any questions at the very basics of either securitisability of assets, or the structure of securitisation transactions, or issues such as commingling of cashflows, servicer transition, etc. However, sitting at the very doorstep of defaults by some major originators, and facing the spectrum of serious servicer downgrades, the Indian securitisation market clearly faces the risk of being shaken at its basics, in not too distant future.

Before we get into these challenges, it may be useful to note that the Indian securitisation market saw an over-100% growth in FY 2019 with volumes catapulting to INR 1000 billion. In terms of global market statistics, Indian market may now be regarded as 2nd largest in ex-Japan Asia, only after China.

Since the blowing up of the ILFS crisis in the month of September 2018, securitisation has been almost the only way of liquidity for NBFCs. Based on the Budget proposal, the Govt of India launched, in Partial Credit Guarantee Scheme, a scheme for partial sovereign guarantee for AA-rated NBFC pools. That scheme seems to be going very well as a liquidity breather for NBFCs. Excluding the volumes under the partial credit enhancement scheme, securitisation volumes in first half of the year have already crossed INR 1000 billion.

In the midst of these fast rising volumes, the challenges on the horizon seem multiple, and some of them really very very hard. This write up looks at some of these emerging developments.

Sale of assets to securitisation trusts questioned

In an interim order of the Bombay High court in Edelweiss AMC vs Dewan Housing Finance Corporation Limited[2], the Bombay High court has made certain observations that may hit at the very securitisability of receivables.  Based on an issue being raised by the plaintiff, the High Court has directed the company DHFL to provide under affidavit details of all those securitisation transactions where receivables subject to pari passu charge of the debentureholders have been assigned, whether with or without the sanction of the trustee for the debentureholders.

The practice of pari passu floating charge on receivables is quite commonly used for securing issuance of debentures. Usually, the charge of the trustees is on a blanket, unspecific common pool, based on which multiple issuances of debentures are covered. The charge is usually all pervasive, covering all the receivables of the company. In that sense, the charge is what is classically called a “floating charge”.

These are the very receivables that are sold or assigned when a securitisation transaction is done. The issue is, given the floating nature of the charge, a receivable originated automatically becomes subject to the floating charge, and a receivable realised or sold automatically goes out of the purview of the charge. The charge document typically requires a no-objection confirmation of the chargeholder for transactions which are not in ordinary course of business. But for an NBFC or an HFC, a securitisation transaction is a mode of take-out and very much a part of ordinary course of business, as realisation of receivables is.

If the chargeholder’s asset cover is still sufficient, is it open for the chargeholder to refuse to give the no-objection confirmation to another mode of financing? If that was the case, any chargeholder may just bring the business of an NBFC to a grinding halt by refusing to give a no-objection.

The whole concept of a floating charge and its priority in the event of bankruptcy has been subject matter of intensive discussion in several UK rulings[3]. There have been discussions on whether the floating charge concept, a judge-made product of UK courts, can be eliminated altogether from the insolvency law[4].

In India, the so-called security interest on receivables is not really intended to be a security device – it is merely a regulatory compliance with company law rules under which unsecured debentures are treated as “deposits”[5]. The real intent of the so-called debenture trust document is maintenance of an asset cover, which may be expressed as a covenant, even otherwise, in case of an unsecured debenture issuance. The fact is that over the years, the Indian bond issuance market has not been able to come out of the clutches of this practice of secured debenture issuance.

While bond issuance practices surely need re-examination, the burning issue for securitisation transactions is – if the DHFL interim ruling results into some final observations of the court about need for the bond trustee’s NOC for every securitisation transaction, all existing securitisation transactions may also face similar challenges.

Servicer-related downgrades

Rating agencies have recently downgraded two notches from AAA ratings several pass-through certificate transactions of a leading NBFC. The rationale given in the downgrade action, among other things, cites servicer risks, on the ground that the originator has not been able to obtain continuous funding support from banks. While absence of continuing funding support may affect new business by an NBFC, how does it affect servicing capabilities of existing transactions, is a curious question. However, it seems that in addition to the liquidity issue, which is all pervasive, the rating action in the present case may have been inspired by some internal scheme of arrangement proposed by the NBFC in question.

This particular downgrades may, therefore, not have a sectoral relevance. However, what is important is that the downgrades are muddying the transition history of securitisation ratings. From the classic notion that securitisation ratings are not susceptible to originator-ratings, the dependence of securitisation transactions to pure originator entity risks such as internal funding strengths or scheme of arrangement puts a risk which is usually not considered by securitisation investors. In fact, the flight to securitisation and direct assignments after ILFS crisis was based on the general notion that entity risks are escaped by securitisation transactions.

Servicer transitions

The biggest jolt may be a forced servicer transition. In something like RMBS transactions, outsourcing of collection function is still easy, and, in many cases, several activities are indeed outsourced. However, if it comes to more complicated assets requiring country-wide presence, borrower franchise and regular interaction, if servicer transition has to be forced, the transaction will be worse than originator bankruptcy.

Questions on true sale

The market has been leaning substantially on the “direct assignment” route. Most of the direct assignments are seen by the investors are look-alikes and feel-alikes of a loan to the originator, save and except for the true-sale opinion. Investors have been linking their rates of return to their MCLR. Investors have been viewing the excess spread as a virtual credit support, which is actually not allowed as per RBI regulations. Pari-passu sharing of principal and interest is rarely followed by the market transactions.

If the truth of the sale in most of the direct assignment transactions is questioned in cases such as those before the Bombay High court, it will not be surprising to see the court recharacterise the so-called direct assignments as nothing but disguised loans. If that was to happen in one case of a failed NBFC, not only will the investors lose the very bankruptcy-remoteness they were hoping for, the RBI will be chasing the originators for flouting the norms of direct assignment which may have hitherto been ignored by the supervisor. The irony is – supervisors become super stringent in stressful times, which is exactly where supervisor’s understanding is required more than reprimand.

Conclusion

NBFCs are passing through a very strenuous time. Delicate handling of the situation with deep understanding and sense of support is required from all stakeholders. Any abrupt strong action may exacerbate the problem beyond proportion and make it completely out of control. As for securitisation practitioners, it is high time to strengthen practices and realise that the truth of the sale is not in merely getting a true sale opinion.

Other Related Articles:

[1] For example, in a Lehman-related UK litigation called Perpetual Trustees vs BNY Corporate Trustee Services, the typical clause in a synthetic securitisation diverting the benefit of funding from the protection buyer (originator – who is now in bankruptcy) to the investors, was challenged under the anti-deprivation rule of insolvency law. Ultimately, UK Supreme Court ruled in favour of securitisation transactions.

[2] https://www.livelaw.in/pdf_upload/pdf_upload-365465.pdf. Similar observations have been made by the same court in Reliance Nippon Life AMC vs  DHFL.

[3] One of the leading UK rulings is Spectrum Plus Limited, https://www.bailii.org/uk/cases/UKHL/2005/41.html. This ruling reviews whole lot of UK rulings on floating charges and their priorities.

[4] See, for example, R M Goode, The Case for Abolition of the Floating Charge, in Fundamental Concepts of Commercial Law (50 years of Reflection, by Goode)

[5] Or partly, the device may involve creation of a mortgage on a queer inconsequential piece of land to qualify as “mortgage debentures” and therefore, avail of stamp duty relaxation.

The cult of easy borrowing: New age NBFCs ride high on tempting loan offers

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-Rahul Maharshi and Kanakprabha Jethani

(finserv@vinodkothari.com)

 

“यावज्जीवेत्सुखं जीवेत् ऋणं कृत्वा घृतं पिबेत् |

भस्मीभूतस्य देहस्य पुनरागमनं कुतः ||”

The ancient couplet from the Charvak Darshan, in Indian mythology is popularly known as the philosophy of life. There are various interpretations of the above, in general, the meaning of the above couplet gives us a saying that “One should live luxuriously, as long as he is alive, and to attain the same, one may even live on credit and in debt. Because once you are dead and cremated, it is foolish to think about afterlife and rebirth.”

It is seen today that the financial services industry is taking the above couplet too seriously and making the borrowers flooded with opportunities and facilities to burden them with debt in one click. Even the person who is unwilling to enter into a debt trap is somewhat lured by the “instant loan” facilities given by numerous NBFCs these days.

Whilst the Indian economy facing a slowdown and banks in India showing significant falls in their lending volumes, the NBFCs engaged in e-lending are displaying an inverse relation to the trend. The NBFCs have been showing extravagant growth in their lending volumes. On one hand banks are tightening the lending norms considering the current state of the economy, NBFCs seem to be doing reckless lending and reporting exceptionally high lending volumes. The financial market seems to be showing a transition from secured lending to unsecured lending, from corporate finance to personal finance, from paperwork to digitisation. This transition is the reason behind such a drastic shift of lending volumes.

CURRENT STATE OF LENDING TRANSACTIONS

NBFCs are crossing milestones, making new records everyday. A leading NBFC reported disbursal of Rs. 550 crores in 3,50,000 loan transactions and has been consistently disbursing loans over Rs. 80 crores every month[1]. Another NBFC reported an existing customer base of 1.1 million. An app-based lender NBFC has 100 million downloads of its app and has disbursed around Rs. 700 crores in FY 19 with an expectation of increasing the amount of disbursals to Rs. 2,000 crores in FY 20[2].

On the contrary, banks are showing a completely opposite picture. Under the 59-minute loan scheme introduced by the Prime Minister for small entities (having turnover upto Rs. 25 crores) to avail loans of amount upto Rs. 5 crores from banks within an hour, only 50,706 loans were given approval in the FY 19. The growth rates in the banking sector are lowering. The growth in retail loans fell down to 15.7% in April 2019 as compared to 19.1% in April 2018. The growth rate in credit card loans has also shown a decline of 8.8%[3].

UNDERSTANDING THEIR BUSINESS MODEL

NBFCs do unsecured lending of small-ticket size loans, usually personal in nature. The market tends to be more inclined towards obtaining finance from such NBFCs. The basic features of loans provided by NBFCs can be understood through following points:

  • Unsecured: The loans provided by NBFCs doing e-lending are generally unsecure loans. The borrower or the customer is not required to provide any security for obtaining such loans. Thus, even if borrowers have no assets at all, they can still obtain loans.
  • Instant: These NBFCs process the loans within a very short period (‘superfast processing’ as they call it) and the disbursement is made within a period ranging from 5 minutes to 3 days depending on the size of the loan. There is no requirement of long procedures as required to be followed in case of bank loans.
  • Digital: Usually, these NBFCs have an app-based or website based platform through which they provide such loans. The KYC process is also carried out through the app or website itself.
  • High-interest rates: The interest rates on such loans are very high as compared to the interest rates on loans provided by banks. The rates usually range from 15% p.a. to 130% p.a.
  • Small-ticket size: The loan size is generally small ranging from Rs. 500 to Rs, 50,000
  • Short-term loans: The term of loan is also short. Repayment is required on weekly, fortnightly or monthly basis.
  • Credit Score based decisions: The lending decisions made by NBFCS are largely dependent on the credit score of the borrower. A strong network of Credit Information Companies (CICs) stores the credit information of the borrowers and the borrower making default of even a single day would be barred from accessing any other e-lending platform as well. However, for first time borrowers, the only way to check credit standing is their bank statement.
  • Source of funds: NBFCs get their funds from banks as well as bigger size NFCs and Private Equity investors.
  • Purpose: These loans are provided mostly for personal purposes like marriage ceremonies, buying a car, medical issues, travel etc.
  • Innovation: Each of the e-lending platform has a different model. While some involve students in their marketing activities, some have tied-up with sellers and buyers to finance transactions between them and some tying up with different brands to finance their operations.

NBFCs BRUSHING OFF THE REGULATIONS: THEIR OWN SWEET WAYS

The operational structures of such loans are in defiance of many requirements of the RBI Directions. One can see disparity from the RBI Directions in many ways. Following are the areas where most of the NBFCs take their own sweet ways:

  • KYC process: As per the KYC Master Directions an authorised representative of the lender NBFC to physically visit and originally see and verify the KYC details of the borrower. There are further requirements of maintaining the KYC records and carrying out Customer Due Diligence (CDD) which the NBFCs fail (refuse) to comply with in the hurry of their “superfast processing”.
  • Fair Practice Code (FPC): The FPC requires lender NBFCs to display annualised interest rates in all their communications with the borrowers. However, most of the NBFCs show monthly interest rates in the name of their “marketing strategy”.
  • Risk Management: The Directions require the NBFCs to assess the risk before granting loans to borrowers, which is overlooked while providing speedy disbursals.
  • Recovery Process: NBFCs do not even have properly defined recovery process. They are just making rapid disbursals ignorant of whether these loans will be repaid.
  • Risk to personal information: Many NBFCs obtain access to the personal information such as text messages and social media profile of the borrower by way of incorporating clauses in this regard in the detailed terms and conditions of the loan agreement.

RISKS TO THE BORROWERS

The borrowers face several risks under such loan transactions, ranging from personal to financial such as:

  • Many borrowers usually don’t read the entire set of terms and conditions and end up granting the NBFCs access to their personal information. Privacy of the borrower is at stake as information trading is yet another business that the NBFCs may secretly engage into posing a threat to borrowers’ personal information.
  • The lucrative advertising strategies of these NBFCs might make a borrower take loans for purposes which otherwise would not have been a necessity or priority for the borrower. Hence, the borrower tends to borrow without any actual requirement because a demand has been created by the lender NBFCs.
  • The interest rates are very high on such loans. In case the amount of loan is high, the borrower is unable to pay the huge amount of interest and thus has to take another loan to repay the first.
  • The credit score of the borrower may get affected at the slightest delay in repayment, even if the amount of loan is as small as Rs. 500. Thus the credibility of borrower is at a risk of degradation.

THE BUBBLE OF ATTRACTION: PLAYING WITH THE PSYCHOLOGY

Even in existence of such high interest rates, why is a borrower more attracted to loans from NBFCs? The only answer one finds to this is the ease and the fact that they are instant. In an era where everyone wants everything in a jiffy, be it food or health solutions, being attracted to instant loans is a very natural thing.

For example you meet an accident and don’t have money for treatment to be done, take a loan. You are shopping and suddenly realise you forgot your purse, take a loan.

The most crucial thing is that these NBFCs do not monitor the end use of the loan amounts disbursed. So a borrower may specify any purpose for the loan, which he might not actually use the loan for. Moreover, the high interest rates are not noticed by the borrowers as most of the NBFCs show monthly interest rates rather than the yearly rates in their communications on the app or the website.

Many borrowers usually don’t read the entire set of terms and conditions and end up granting these NBFCs access to their personal information. Information trading is yet another business that the NBFCs may secretly engage into posing a threat to borrowers’ information.

The NBFCs are rightly playing the psychology game by becoming a friend in need for the borrowers. No matter how high the interest rates maybe or how risky the transaction maybe, it is a handy help whenever needed.

Furthermore, the advertisements made by these NBFCs are so catchy that they may lure a person who might not really be in need of finance. The catchy phrases like “make your dream wedding come true”, “let the wanderlust in you come alive” create a “need” for the customer to become a borrower. Marriage functions, travel and luxuries things are the Indian way of showing richness and the abovementioned philosophy wraps people in a comfortable blanket of justification to remain under debt-burden.

ALL OUR MONEY INTO THE BLACK HOLE

While lending to businesses results in more capital formation and growth of the economy. Personal lending mostly results in wasteful expenditure. Further, the interest rates being so high, many a times the borrowers obtain another loan to pay the previous loan and gets trapped into the vicious circle of obtaining and repaying loans. The increasing lending volumes are not an indication of overall growth of the economy. Most of the purposes for which such loans are availed are consumption-based and have no value-addition. All the money taken on loan is being used in consumption-based expenditure and not in value-addition activities and thus even after such high lending volumes, the growth of the economy is just disappearing into the black hole.

CONCLUSION

While on one hand, such loans are helping us in need, on the other hand they are luring us to take unnecessary debt burden. The lender NBFCs are under the risk of regulatory action by the regulators since many of them are in non-compliance with regulatory requirements. The borrowers are under the risk of pressing themselves under unnecessary debt burden and huge interest costs. The recovery procedures of these NBFCs are very lenient but due to the high interest costs, the cost of funds is readily recovered by the lender NBFC. Even when banks have tried to provide quick loans under 59-minutes loan scheme, they have failed to do away with the procedural requirements such as document submission and are still regarded as “slow-loans” considering the super-fast loans being provided by NBFCs within 5 minutes.

Though immensely helpful, these loans have a potential to impact the economy in such a manner that it seems to be beneficial while it’s actually not. The borrowers are happily floating in the bubble of “instant loans” which is definitely going to burst in no time.

 

[1] Source: Economic Times

[2] Source: CNBC

[3] Source: Business Standard

Government credit enhancement for NBFC pools: A Guide to Rating agencies

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Vinod Kothari Consultants P Ltd (finserv@vinodkothari.com)

 

The partial credit enhancement (PCE) Scheme of the Government[1], for purchase by public sector banks (PSBs) of NBFC/HFC pools, has been discussed in our earlier write-ups, which can be viewed here and here.

This document briefly puts the potential approach of the rating agencies for rating of the pools for the purpose of qualifying for the Scheme.

Brief nature of the transaction:

  • The transaction may be summarised as transfer of a pool to a PSB, wherein the NBFC retains a subordinated piece, such that the senior piece held by the PSB gets a AA rating. Thus, within the common pool of assets, there is a senior/junior structure, with the NBFC retaining the junior tranche.
  • The transaction is a structured finance transaction, by way of credit-enhanced, bilateral assignment. It is quite similar to a securitisation transaction, minus the presence of SPVs or issuance of any “securities”.
  • The NBFC will continue to be servicer, and will continue to charge servicing fees as agreed.
  • The objective to reach a AA rating of the pool/portion of the pool that is sold to the PSB.
  • Hence, the principles for sizing of credit enhancement, counterparty (servicer) risk, etc. should be the same as in case of securitisation.
  • The coupon rate for the senior tranche may be mutually negotiated. Given the fact that after 2 years, the GoI guarantee will be removed, the parties may agree for a stepped-up rate if the pool continues after 2 years. Obviously, the extent of subordinated share held by the NBFC will have to be increased substantially, to provide increased comfort to the PSB. Excess spread, that is, the excess of actual interest earned over the servicing fees and the coupon may be released to the seller.
  • The payout of the principal/interest to the two tranches (senior and junior), and utilisation of the excess spread, etc. may be worked out so as to meet the rating objective, provide for stepped-up level of enhancement, and yet maintain the economic viability of the transaction.
  • Bankruptcy remoteness is easier in the present case, as pool is sold from the NBFC to the PSB, by way of a non-recourse transfer. Of course, there should be no retention of buyback option, etc., or other factors that vitiate a true sale.
  • Technically, there is no need for a trustee. However, whether the parties need to keep a third party for ensuring surveillance over the transaction, in form of a monitoring agency, may be decided between the parties.

Brief characteristics of the Pool

  • For any meaningful statistical analysis, the pool should be a homogenous pool.
  • Surely, the pool is a static pool.
  • The pool has attained seasoning, as the loans must have been originated by 31st March, 2019.
  • In our view, pools having short maturities (say personal loans, short-term loans, etc.) will not be suitable for the transaction, since the guarantee and the guarantee fee are on annually declining basis.

Data requirement

The data required for the analysis will be same as data required for securitisation of a static pool.

Documentation

  • Between the NBFC and the PSB, there will be standard assignment documentation.
  • Between the Bank and the GoI:
    • Declaration that requirements of Chapter 11 of the GFR have been satisfied.
    • Guarantee documentation as per format given by GOI

[1] http://pib.gov.in/newsite/PrintRelease.aspx?relid=192618

Other Related Articles :

Government Credit enhancement scheme for NBFC Pools: A win-win for all

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Vinod Kothari (vinod@vinodkothari.com)

The so-called partial credit enhancement (PCE) for purchase of NBFC/HFC pools by public sector banks (PSBs) may, if meaningfully implemented, be a win-win for all. The three primary players in the PCE scheme are NBFCs/HFCs (let us collectively called them Originators), the purchasing PSBs, and the Government of India (GoI). The Scheme has the potential to infuse liquidity into NBFCs while at the same time giving them advantage in terms of financing costs, allow PSBs to earn spreads while enjoying the benefit of sovereign guarantee, and allow the GoI to earn a spread of 25 bps virtually carrying no risks at all. This brief write-ups seeks to make this point.

The details of the Scheme with our elaborate questions and answers have been provided elsewhere.

Modus operandi

Broadly, the way we envisage the Scheme working is as follows:

  1. An Originator assimilates a pool of loans, and does tranching/credit enhancements to bring a senior tranche to a level of AA rating. Usually, tranching is associated with securitisation, but there is no reason why tranching cannot be done in case of bilateral transactions such as the one envisaged here. The most common form of tranching is subordination. Other structured finance devices such as turbo amortisation, sequential payment structure, provisions for redirecting the excess spread to pay off the principal on senior tranche, etc., may be deployed as required.
  2. Thus, say, on a pool of Rs 100 crores, the NBFC does so much subordination by way of a junior tranche as to bring the senior tranche to a AA level. The size of subordination may be worked, crudely, by X (usually 3 to 4) multiples of expected losses, or by a proper probability distribution model so as to bring the confidence level of the size of subordination being enough to absorb losses to acceptable AA probability of default. For instance, let us think of this level amounting to 8% (this percentage, needless to say, will depend on the expected losses of respective pools).
  3. Thus, the NBFC sells the pool of Rs 100 crores to PSB, retaining a subordinated 8% share in the same. Bankruptcy remoteness is achieved by true sale of the entire Rs 100 crore pool, with a subordinated share of 8% therein. In bilateral transactions, there is no need to use a trustee; to the extent of the Originator’s subordinated share, the PSB is deemed to be holding the assets in trust for the Originator. Simultaneously, the Originator also retains excess spread over the agreed Coupon Rate with the bank (as discussed below).
  4. Assuming that the fair value (computation of fair value will largely a no-brainer, as the PSB retains principal, and interest only to the extent of its agreed coupon, with the excess spread flowing back to the Originator) comes to the same as the participation of the PSB – 92% or Rs 92 crores, the PSB pays the same to the Originator.
  5. PSB now goes to the GoI and gets the purchase guaranteed by the latter. So, the GoI has guaranteed a purchase of Rs 92 crores, taking a first loss risk of 10% therein, that is, upto Rs 9.20 crores. Notably, for the pool as a whole, the GoI’s share of Rs 9.20 crores becomes a second loss position. However, considering that the GoI is guaranteeing the PSB, the support may technically be called first loss support, with the Originator-level support of Rs 10 crores being separate and independent.
  6. However, it is clear that the sharing of risks between the 3 – the Originator, the GoI and the Bank will be as follows:
  • Losses upto first Rs 8 crores will be taken out of the NBFC’s first loss piece, thereby, implying no risk transfer at all.
  • Losses in excess of Rs 8 crores, but upto a total of Rs 17.20 crores (the GoI guarantee is limited to Rs 9.20 crores), will be taken by GoI.
  • It is only when the loss exceeds Rs 17.20 crores that there is a question of the PSB being hit by losses.
  1. Thus, during the period of the guarantee, the PSB is protected to the extent of 17.2%. Note that first loss piece at the Originator level has been sized up to attain a AA rating. That will mean, higher the risk of the pool, the first loss piece at Originator level will go up to protect the bank.
  2. The PSB, therefore, has dual protection – to the extent of AA rating, from the Originator (or a third party with/without the Originator, as we discuss below), and for the next 10%, from the sovereign.
  3. Now comes the critical question – what will be the coupon rates that the PSB may expect on the pool.
    1. The pool effectively has a sovereign protection. While the protection may seem partial, but it is a tranched protection, and for a AA-rated pool, a 10% thickness of first loss protection is actually far higher than required for the highest degree of safety. What makes the protection even stronger is that the size of the guarantee is fixed at the start of the transaction or start of the financial year, even though the pool continues to amortise, thereby increasing the effective thickness.
    2. Assume risk free rate is R, and the spreads for AAA rated ABS are R +100 bps. Assume that the spreads for AA-rated ABS is R+150 bps.
    3. Given the sovereign protection, the PSB should be able to price the transaction certainly at less than R +100 bps, because sovereign guarantee is certainly safer than AAA. In fact, it should effectively move close to R, but given the other pool risks (prepayment risks, irregular cashflows), one may expect pricing above R.
    4. For the NBFC, the actual cost is the coupon expected by the PSB, plus 25bps paid for the guarantee.
    5. So as long as the coupon rate of the pool for the NBFC is lower than R+75 bps, it is an advantage over a AAA ABS placement. It is to be noted that the NBFC is actually exposing regulatory and economic capital only for the upto-AA risk that it holds.

Win-win for all

If the structure works as above, it is a win-win for all:

  • For the GoI, it is a neat income of 25 bps while virtually taking no real risks. There are 2 strong reasons for this – first, there is a first loss protection by the Originator, to qualify the pool for a AA rating. Secondly, the guarantee is limited only for 2 years. For any pool, first of all, the probability of losses breaching a AA-barrier itself will be close to 1% (meaning, 99% of the cases, the credit support at AA level will be sufficient). This becomes even more emphatic, if we consider the fact that the guarantee will be removed after 2 years. The losses may pile up above the Originator’s protection, but very unlikely that this will happen over 2 years.
  • For the PSB, while getting the benefit of a sovereign guarantee, and therefore, effectively, investing in something which is better than AAA, the PSB may target a spread close to AAA.
  • For the NBFC, it is getting a net advantage in terms of funding cost. Even if the pricing moves close to AAA ABS spreads, the NBFC stands to gain as the regulatory capital eaten up is only what is required for a AA-support.

The overall benefits for the system are immense. There is release of liquidity from the banking system to the economy. Depending on the type of pools Originators will be selling, there may be asset creation in form of home loans, or working capital loans (LAP loans may effectively be that), or loans for transport vehicles. If the GoI objective of buying pools upto Rs 100000 crores gets materialised, as much funding moves from banks to NBFCs, which is obviously already deployed in form of assets. The GoI makes an income of Rs 250 crores for effectively no risk.

In fact, if the GoI gains experience with the Scheme, there may be very good reason for lowering the rating threshold to A level, particularly in case of home loans.

Capital treatment, rating methodologies and other preparations

To make the Scheme really achieve its objectives, there are several preparations that may have to come soon enough:

  • Rating agencies have to develop methodologies for rating this bilateral pool transfer. Effectively, this is nothing but a structured pool transfer, akin to securitisation. Hence, rating methodologies used for securitisation may either be applied as they are, or tweaked to apply to the transfers under the Scheme.
  • Very importantly, the RBI may have to clarify that the AA risk retention by Originators under the Scheme will lead to regulatory capital requirement only upto the risk retained by the NBFC. This should be quite easy for the RBI to do – because there are guidelines for securitisation already, and the Scheme has all features of securitisation, minus the fact that there is no SPV or issuance of “securities” as such.

Conclusion

Whoever takes the first transaction to market will have to obviously do a lot of educating – PSBs, rating agencies, law firms, SIDBI, and of course, DFS. However, the exercise is worth it, and it may not take 6 months as envisaged for the GoI to reach the target of Rs 1 lakh crores.

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