The Reserve Bank of India yesterday released a fresh set of draft guidelines governing securitisation and assignment transactions. While the draft was released by the Department of Banking Operations and addressed to banks, it is expected that a similar draft will be issued for NBFCs as well.
The draft guidelines are comprehensive and cover various aspects of a securitisation including minimum holding period (MHP), minimum retention or risk (MRR), accounting treatment, true sale, credit enhancement requirements and due diligence by the purchaser. Further, the RBI seeks to cover assignment transactions under the ambit of its regulations.
Securitisation and assignment transactions have emerged as preferred financing routes for NBFCs in the last few years. On the whole, banks have been net buyers, acquiring largely priority sector portfolios from NBFCs. Given the stringent first loss requirements imposed by the RBI in the 2006 guidelines (marked off against Tier I and Tier II Capital, fixed till maturity of the transaction), banks issuers have been rare.
At the same time, securitisation has emerged as a viable route for non-traditional originators to access the capital markets. Microfinance institutions (MFIs) have raised substantial funds through this route, with the first rated assignment in 2004 and the first rated securitisation in 2009. In October 2010, the microfinance sector faced headwinds after the Andhra Pradesh government issued an ordinance curtailing microfinance activities. Post the ordinance, securitisation has emerged as the largest source of financing for MFIs, with an estimated INR 15 billion raised via this route1.
We will attempt to highlight the key changes / inclusions in the draft guidelines and potential implications on issuances
- Minimum Holding Period (MHP)
MHP for loans is distinguished on two parameters: a) frequency of repayment schedule (quarterly or more frequent) and b) tenor of loan (less or greater than 24 months). While the logic behind including the former is understandable and a good move, it is unclear why the RBI has split the market on a 24 month tenor basis. It would be significantly better from a regulatory perspective to assess MHP requirements based on the average life of the underlying loans. This would prevent the possibility of having a 6 month MHP on a loan with weekly repayments and tenor of 12 months.
Imposing a high MHP will, in effect, prevent securitisation of lower tenor loans completely. Potentially, this could disincentivise originators from providing lower tenor loans due to lack of financing, thus increasing balance sheet risk.
- Minimum Retention of Risk (MRR)
The guidelines also advise a MRR of 5%. This is a welcome inclusion and in line with global practices. The concept of a dynamic cash collateral and reduction of the MRR through the transaction tenor is a good step that should bring bank originators back into the market. Further, this will force rating agencies to model and monitor asset behavior more closely. It would be better, in our view, if the RBI allowed market forces to determine the frequency / amount of release of credit enhancement, rather than stipulate time / amount of release – given the variation in performance of different asset classes.
The draft guidelines also permit originators to invest into the equity tranche of a securitisation, unlike the existing regulation that allows originators to invest only into senior securities issued by an SPV.
- Accounting of Profits
The guidelines allow originators to recognise the cash profit on a limited basis on premium structure deals. Such profits is to be termed as “Cash Profit on Loan Transfer Transactions Pending Recognition” and maintained on a transaction basis. This divergence from regular accounting standards will encourage corporates to move away from amortisation to straight line basis. In a financial year, any loss on account of Mark to Market and write off will be adjusted in this account and net effect will be transferred to profit and loss account
The RBI has finally stepped in to fill the regulatory vaccum that existed with respect to bilateral assignment of assets. Bilateral assignment is now governed by guidelines similar to that of securitisation. One major difference however, is that “external” credit enhancement by the originator is banned under the assignment route. The offered justification is that subscribers to this route are sophisticated, institutional investors who should be able to assess the risk involved and take a decision on the exposure. Disallowing credit enhancement will only increase investor discomfort in this route and prevent such transactions from taking place. The sophisticated market forces that exist under the assignment route should be able to determine the need for cash collateral.
- Purchaser due diligence
The guidelines place a greater onus on the buyer with respect to due diligence. Purchasers must carry out verification on at least 5% of the obligors. Such verification cannot be delegated to a specialized firm. The guidelines also require rigorous credit monitoring and identification of non-performing borrowers 90 days after the loans are due. Banks are required to collect information regarding default rates, prepayment rates, loans in foreclosure, collateral type and occupancy, and frequency distribution of credit scores or other measures of credit worthiness across underlying exposures, industry and geographical diversification.
It is essential that buyers are aware of the assets that they are investing in and the above requirements will ensure that quality of due diligence improves.
Last year, securitisation volumes fell by 29%. This was largely believed to be a fall-out of the draft guidelines released in April 2010. The revised draft guidelines are significantly more comprehensive and include features that could completely transform the market. However, the draft guidelines are also too prescriptve. This could stifle a sector that has just begun to find its feet in the Indian market. A nuanced regulatory policy that recognizes the varied and dynamic nature of the market and encourages financial innovation is necessary.
1 – IFMR Capital estimates