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Draft Framework For Secularization Of Standard Assets And It's Implications

Securitization is a process in which certain types of assets are pooled together so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities.[1]

A large number of financial institutions use securitisation to transfer the credit risk of the assets that originate from their balance sheets to those of other financial institutions, such as banks, insurance companies, and hedge funds for a variety of reasons. Some of them being that it was often proved that raising money through securitisation were cheaper and they were less then less costly for banks to hold because financial regulators had different standards for them than for the assets that underpinned them.

Securitization follows a ‘originate and distribute’ approach, under which there are many economic benefits too like spreading out credit exposures, which in turn reduce risk concentration and systematic vulnerability.

In order to understand securitisation, it is important to understand the process behind it. First, a company with loans or other income-producing assets—the originator—identifies the assets it wants to remove from its balance sheet and pools them into what is called the reference portfolio. Then, it sells this asset pool to an issuer, such as a special purpose vehicle (SPV)—an entity set up, usually by a financial institution, specifically to purchase the assets and realize their off-balance-sheet treatment for legal and accounting purposes.

In the second step, the issuer finances the acquisition of the pooled assets by issuing tradable, interest-bearing securities that are sold to capital market investors. The investors receive fixed or floating rate payments from a trustee account funded by the cash flows generated by the reference portfolio.

In majority cases, , the originator services the loans in the portfolio, collects payments from the original borrowers, and passes them on—less a servicing fee—directly to the SPV or the trustee. To sum up, securitisation is an alternative and diversified source of finance based on the transfer of credit risk (and possibly also interest rate and currency risk) from issuers to investors.

Securitisation in India[2] is regulated and governed by the Reserve Bank of India (RBI) under the provisions of the 2006 and 2012 Guidelines on Securitisation of Standard Assets (RBI Guidelines) for standard assets and by the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act) for stressed financial assets, when undertaken by banks, financial institutions and non-banking financial companies. (NBFCs)

The Securities and Exchange Board of India (SEBI) is the market regulator for listed securitised debt instruments. The SEBI (Public Offer and Listing of Securitised Debt Instruments) Regulations 2008 (as amended) apply in this regard.

The securitisation has been defined under both- the RBI guidelines and the SARFAESI Act. However, both these regulators see securitisation as a ‘ring-fenced and bankruptcy-remote true sale of financial assets (or a pool of such assets)’ for immediate cash payment. Under the true sale mechanism, the assets move from the balance sheet of the originator to the balance sheet of a special purpose vehicle (SPV) or asset reconstruction company, and are pooled, sub-divided, repackaged as tradable securities backed by such pooled assets and sold to investors either as pass through certificates (PTCs) or security receipts (SRs), which represent claims on incoming cash flows from such pooled assets.

Banks and financial institutions in India also often enter into direct assignments of non-stressed financial assets under the provisions of the RBI Guidelines. Such direct assignment structures would not involve an SPV, the pooling of assets or the issuance of PTCs, and are often preferred in the Indian market by banks and financial institutions when selling down to other banks or financial institutions.

The main reasons for doing for doing securitizations are:[3]

Meeting regulatory requirements. All banks must have mandatory minimum exposure levels to sectors identified as priority sectors. Often, banks which are unable to meet these targets buy out assets from those who have such assets in excess or are not required to hold them.

Portfolio diversification. Investment in stratified securities, catering to the risk appetite of multiple investor classes, can improve liquidity and risk management. It offers investors an opportunity to increase their returns by diversifying into non-traditional asset classes and hedging the market volatility, while at the same time expanding the financial market.
Cost of financing. As the originator has already invested time and effort on risk analysis at the time of lending, securitisation allows the purchaser to take comfort from this analysis, thereby reducing the total cost of financing.

Liquidity constraints. In the last two years, there has been a significant increase in transactions where the seller, facing liquidity challenges, is constrained to sell financial assets in the form of loans and receivables. Often these are in the form of securitisations.

Off-balance sheet financing. Originators can securities assets from their balance sheets, thereby increasing the pool of available capital that can be used for investment. In addition, since securitisation normally requires less capital to support it than traditional on-balance sheet funding, it enhances return on capital.

Reduces credit exposure to a specific type of asset. If a particular class of lending forms a larger proportion of the balance sheet as a whole, then securitisation can offload some of the assets (of a particular class) from the balance sheet.

Makes non-tradable assets tradable. This, along with the promotion of a regular market for securitised paper, enhances liquidity in a variety of previously illiquid financial assets.
Spreads the ownership of risk. Pooling and distributing financial assets provides greater ability to diversify risk and provides investors with more choice as to how much risk to hold in their portfolios. Such diversified risk to a wide base of investors ensures that the risk inherent in financial transactions is diffused.

On June 8, 2020, The Reserve Bank of India disclosed its draft frameworks for securitisation of standard assets[4] and sale of loan exposures[5] in an effort to create a strong and robust securitisation market in India. With the introduction of the new framework, the RBI has decided to create a regulatory scheme which not only allows development of a strong and robust liquid secondary market in securitized assets, but also follows the international standards, most importantly the Basel III[6] and IFRS[7] guidelines. One of the major recommendations[8] of the two committees set up by the RBI was that direct assignment transactions were understood to be in the nature of a ‘loan sale’, and securitisation of standard assets and sale of loan exposures should be regulated separately, furthering their operational clarity. This resulted into the bifurcation of guidelines for ‘Sale of Loan Exposures’ from the Securitization Guidelines.

Draft Securitization Framework

Under the Draft Securitization Framework[9], ‘securitisation’ has been defined as:
‘the set of transactions or scheme wherein credit risk associated with eligible exposures is tranched and where payments in the set of transactions or scheme depend upon the performance of the specified underlying exposures as opposed to being derived from an obligation of the originator and the subordination of tranches determines the distribution of losses during the life of the set of transactions or scheme; Provided that the pool may contain one or more exposures eligible to be securitized;’

Earlier, securitisation was defined as the sale of performing assets to a bankruptcy remote special purpose vehicle (‘SPV’), in return for an immediate cash payment. However, the framework has inculcated the concept of ‘tranching’ in its very definition [guideline 5(u)], which was missing in the earlier guideline.

Tranching
[10] is the process of dividing the credit portfolio in segments. Tranching is essential for providing a structure and rating to any pool of exposures, and leads to a greater understanding of the credit risks by the lender and the investors. Non-tranched portfolios have a risk of containing bad debts, and may lead to defaults on a major part of the exposures pool. Making tranching of credit risks, a necessary condition for sale of securities, is a measure that has been followed all over the world. By inculcating this, the RBI has made the much required amendment that has been long overdue.

One of the shortcomings of the 2012 guidelines[11] was the absence of provision which permitted securitisation of single assets. The reason for its preclusion was primarily that it did not involve risk redistribution and credit trenching. The new draft encapsulates within itself this provision too. RBI too, on the precondition that the either the principle or interest be paid in installments, authorized that bullet payment loans can be securitized.

This development will also enable the longer tenure loans to be securitized either in part or in whole. Among other benefits, this will enhance the ability to generate rated securities and benefit the investors to diversify their portfolios even in case of single asset loans. This alteration will also enable the eligible investors avail the credit tranched securities after the single loans lettered on the books of banks or NBFC are securitized. This also provides that without the express approval of the borrower, the existing lender will have to bear the burden of obligations pertaining to such loans.

The Draft Securitisation Framework has introduced Simple, Transparent and Comparable (STC) securitizations[12]. A traditional securitisation, which additionally satisfies the criteria set out in Annexure 1[3], will fall within the scope of the STC framework. Clauses 112, 113, 114,127 and 128 give a blow-by-blow account of STC- compliant securitizations which may be subject to alternative capital treatment.

A traditional securitisation has been defined as a structure in which two or more stratifies risk positions or tranches are serviced by using cash flow from an underlying pool of exposures. Instead of being reasoned from the originator’s obligation, payment to the investors will depend upon the specified underlying exposures, which depict varied strata of credit risks. For all traditional securitisation transactions which abide by the STC framework, the draft offers a lower risk weight. This is likely to benefit the banks to a great extent.

RBI has specifically allowed replenishment structures [13]wherein the replenishment period has to be identified upfront and following the end of such period, the structure reverts to an amortisation one.

Replenishment has been defined as the ‘process of using cash flows from securitised assets to acquire more eligible assets, which will continue for a pre-announced replenishment period, following which the securitisation structure reverts to an amortizing one’. Securitisation, which features a replenishment period, is required to have provisions for appropriate early amortisation events and / or triggers for termination of the replenishment period.

Introducing replenishment structures will help package shorter tenor loan deals and ensure better return to investors.

The draft framework has expanded the definition of stressed exposures to include both non-performing assets and special mention accounts[14]. Also, the deregulation of the price discovery process will enable faster and more efficient pricing of exposures – especially when coupled with a wider range of eligible investors – as articulated earlier.

Enhanced Viability of Stressed Asset Takeover Structures[15]: More importantly, the proposed framework will allow investors in stressed assets to classify the exposure as standard, although subject to any other exposure to the same entity on the investor’s books not being sub-standard on the date of the acquisition of the asset.

This could significantly lower capital charge and provisioning requirements for the acquirer/investor of the stressed assets. Given that most stressed assets are restructured as well – often including a complete management overhaul, the rationalisation of the capital charge and provisions could make such assets more attractive to prospective acquirers.

Residential mortgage backed securities (RMBS)[16] can be elucidated as “the securities issued by the special purpose entity against underlying exposures that are all residential mortgages”. The RBI, following the exhortations of the Development of Housing Finance Securitisation Market, has provided certain relaxations in relation to the RMBS.

According to the said framework, the minimum holding period for RMBS could be six months or six installments (whichever is later). The MRR has been limited to 5% of the book value of the loans that have been securitized. If the value of exposure for an underlying an RMBS crosses INR 500 crore mark, the listing of the security has to be statutorily done.

This emendation will directly benefit HFCs and NBFCs by accrediting them with the required exposure to RMBS to package such portfolios in order to issue securities of different credit tranches and list them. Risk adverse investors can be issued with senior tranches while the subscribers of such instruments can be issued with junior tranches. These will help the market in three-fold ways:
  • It will provide the much-needed liquidity to HFCs
  • With due course of time, it will deepen the RMBS market
  • It will ensure that the products are available to wider spectrum of investors

The Draft Securitisation Framework provides for conditions required to be met by lenders for maintenance of capital. Such conditions will come into immediate effect and will apply to existing securitisation exposures as well.

Conditions required to be met for de-recognition of the transferred asset by the originator include:

  • Significant credit risk associated with the underlying exposures of the securities issued by the special purpose entity (SPE) being transferred to third parties. Significant credit risk will be treated as transferred if:
    1. There are at least three tranches, risk weighted exposure amounts of the mezzanine securitisation positions held by the originator do not exceed 50% of the risk weighted exposure amounts of all mezzanine securitisation positions existing in this securitisation; and
    2. In cases where there are no mezzanine securitisation positions, the originator does not hold more than 20% of the exposure values of securitisation positions that are first loss positions;
  • The transferred exposures are legally isolated from the originator and are put beyond the reach of the originator or its creditors;
  • The securities issued by the SPE are not obligations of the originator;
  • Securitisation does not contain clauses that require the originator to replenish or replace the underlying exposures to improve the credit quality of the pool, in the event of deterioration in the underlying credit quality.

While the Draft Securitisation Framework now permits assets purchased from other entities to be securitised, resecuritisation exposures, synthetic securitisation and securitisation with revolving credit facilities as underlying continue to be prohibited. Pooling of purchased loans along with existing portfolios will increase the rating of certain kinds of pools.

Transactions involving revolving credit facilities, loans with bullet repayments of both principal and interest and securitisation exposures continue to be exempt from the applicability of the Draft Securitisation Framework.

Conclusion
Considering that the country is in midst of a pandemic, the present framework is a welcome change. It will have a major role to play as the market revives from the Corona crisis. The framework aims to standardize the practice of securitisation, leading to a efficient and strong securities market in India.

It is an amalgamation of a long series of steps undertaken by the RBI to foster the securities sector, and to promote securitisation as a well-developed mechanism in the financial sector. It also clears the air around the permissibility of certain structures that remained uncertain before this.

The RBI, with this, has strived towards securitising certain loans which were not available before. This will not only help achieve a more investment friendly market, but also a more diverse one, which would in turn increase the liquidity and will tackle bad loans in various financial institutions. The increase in liquidity and minimizing the risk of bad loans particularly would provide the much-required boost in the revival of market in a post-Covid-era.

The new introductions are additionally the RBI's bid to account for a more transparent plan which will additionally bring down the odds of somebody getting hoodwinked in the market chain. All things considered, constructing a more robust national securitisation regime will help manage and diversify risks, which would give the economy a genuinely necessary stability as we enter the post-Covid period.

End-Notes:
  1. https://www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf
  2. https://www.azbpartners.com/bank/india-securitisation-2020/?utm_source=Mondaq&utm_medium=syndication&utm_campaign=LinkedIn-integration
  3. https://uk.practicallaw.thomsonreuters.com/3-522-6865?transitionType=Default&contextData=(sc.Default)&firstPage=true
  4. https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=958#CH6
  5. https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=957
  6. https://www.bis.org/publ/bcbs189.pdf
  7. https://www.ifrs.org/issued-standards/list-of-standards/
  8. https://rbidocs.rbi.org.in/rdocs/content/pdfs/Brief08062020.pdf
  9. https://rbidocs.rbi.org.in/rdocs/content/pdfs/Brief08062020.pdf
  10. https://www.accaglobal.com/gb/en/student/exam-support-resources/professional-exams-study-resources/p4/technical-articles/toxic-assets.html
  11. https://rbidocs.rbi.org.in/rdocs/notification/PDFs/C170RG21082012.pdf
  12. https://corporate.cyrilamarchandblogs.com/2020/06/a-new-regime-for-securitisation/#more-3861
  13. https://taxguru.in/rbi/draft-securitisation-framework-revised-scheme-advanced-era.html
  14. https://www.thehindubusinessline.com/opinion/editorial/boosting-securitisation/article31862936.ece
  15. https://www.moneylife.in/article/rbis-draft-framework-on-sale-of-loan-exposures-could-deepen-loan-markets-ind-ra/60775.html
  16. https://www.moneylife.in/article/rbis-draft-framework-on-sale-of-loan-exposures-could-deepen-loan-markets-ind-ra/60775.html

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