Managing Credit Risk—An Overview
KEY TAKEAWAYS FROM THE CHAPTER
- Understand the concept of credit risk.
- Know how credit risk arises.
- Learn about credit risk mitigation techniques, such as securitization, covered bonds and credit derivatives.
- Understand the Basel Committee’s role in credit risk management.
- Gain knowledge about the prudential norms for asset classification, income recognition and provisioning.
Banks grant credit to produce profits. In the process, they also assume and accept risks. In evaluating risk, banks should assess the likely downside scenarios and their possible impact on the borrowers and their debt servicing capacity.
Two types of losses are possible in respect of any borrower or borrower class—expected losses (EL) and unexpected losses (UL). EL can be budgeted for, and provisions held to offset their adverse effects on the bank’s balance sheet. EL could arise from the risks in the industry in which the borrower operates, the business risks associated with the borrower firm, its track record of payments and future potential to generate cash flows. UL, being unpredictable, have to be cushioned by holding adequate capital. In this chapter, we will concentrate on the process by which banks identify and provide for EL.1
Banks can utilize the structure of the borrowers’ transactions, collateral and guarantees to mitigate identified and inherent risks, but none of these can substitute for comprehensive assessment of borrowers’ repayment capacity or compensate for inadequate information or monitoring. Any action of credit enforcement (recalling the advances made or instituting foreclosure proceedings, including legal proceedings) may only serve to erode the already thin profit margins on the transactions.
Expected Versus Unexpected Loss
Although credit losses are typically dependent on time and economic conditions, it is theoretically possible to arrive at a statistically measured long run average loss level. Assume, for example, that based on historical performance, a bank expects around 1 per cent of its loans to default every year, with an average recovery rate of 50 per cent. In that case, the bank’s EL for a credit portfolio of ₹1,000 crores is ₹5 crores (i.e., ₹1,000 crores 3 1 per cent 3 50 per cent). EL is, therefore, seen to be based on three parameters:
- The likelihood that default will take place over a specified time horizon (probability of default or PD).2
- The amount owed by the counter party at the moment of default (exposure at default or EAD).
- The fraction of the exposure and net of any recoveries, which will be lost following a default event (loss given default or LGD).3
Since PD is normally specified on a 1 year basis, the product of these three factors is the 1 year EL.
EL can be aggregated at the level of individual loans or the entire credit portfolio. It is also both customer- and facility-specific, since two different loans to the same customer can have very different ELs due to differences in EAD and/or LGD.
It is important to note that EL (and credit quality) does not by itself constitute risk—if losses turned out as expected, they represent the anticipated ‘cost’ of being in business. In any case, their impact is being factored into loan pricing4 and provisions. Credit risk, in fact, emerges from adverse variations in the actual loss levels, which give rise to the so-called UL. As described in a later chapter, the need for bank capital arises from the need to cushion against UL or loss volatility. Statistically, UL is simply the standard deviation of EL as shown in Figure 8.1.5
FIGURE 8.1 EXPECTED AND UNEXPECTED LOSSES
Defining Credit Risk6
Credit risk is most simply defined as the probability that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms.
The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organization. The goal of credit risk management should be maximizing a bank’s risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters.
- The risk in individual credits or transactions (discussed extensively in the foregoing chapters).
- The credit risk inherent in the entire portfolio.
- The relationships between credit risk and other risks.
FIGURE 8.2 ELEMENTS OF CREDIT RISK7
We will discuss these aspects in the ensuing paragraphs and in the next chapter.
Credit Risk of the Portfolio From our earlier discussions, it would be evident that managing the credit portfolio of a bank involves a higher level of risk-reward decisions than managing a portfolio of market investments. This is due to the fact that there is limited upside risk and unlimited downside risk in bank lending (in contrast to market investments, which hold limited downside risk, but unlimited upside risk).
For example, when a bank makes a ‘good’ loan that is repaid in full on the due date, what the bank has received are only the interest payments and principal repayments due to it. The bank cannot demand a share of the substantial cash flows that the business has managed to generate with the help of bank funds. On the other hand, if the business fails, the bank’s earnings take a direct hit—the bank suffers along with the borrower. The bank could price ‘risky’ borrowers higher to compensate for the risk of failure.8 But market dynamics would limit the extent of the risk premium that the bank can charge.
Often, a bank develops expertise in financing a particular activity or industry and increases its credit exposure to this sector to leverage its capabilities. If this sector collapses, for some force majeure reason, it drags the bank’s fortunes down with it.
Thus, it is evident that a bank could be vulnerable to two factors—one, it may not be able to price its loan to compensate fully for the risk and two, its concentration in a specific industry or economic activity could render the bank susceptible to risks inherent in that industry.
It follows that the loan policy of a bank should be able to structure policies and procedures that ensure that credit exposures to various sectors and regions are adequately diversified to maximise the return on the loan portfolio of the bank. Such a task is too daunting for individual banks’ portfolio managers and requires the intervention of the central banks of the countries. In most countries, central banks propose optimal ‘exposure norms’ for various industries and activities from time to time. Such exposure norms not only pre-empt banks intending to invest excessively in similar firms, but also try to balance the risk-reward relationship for banks in the country.
The Relationship Between Credit and Other Risks While loans are the largest source of credit risk and exposure to credit risk continues to be a leading source of problems, there are other sources of credit risk throughout the activities of a bank, in the banking and trading books and on and off its balance sheet. For example, a bank could face credit (or counter party default) risk in various financial instruments other than loans, such as in: (a) acceptances, (b) inter-bank transactions, (c) trade financing, (d) foreign exchange transactions, (e) financial futures, swaps, bonds, equities, options, and (f) in the extension of commitments and guarantees and the settlement of transactions.9
International guidelines and standards for Credit Risk management – The Basel Committee on Banking Supervision (BCBS)
The BCBS and its key role in financial regulation have been described in detail in the chapter titled “Capital – Risk, Regulation and Adequacy”.
Annexure I presents a summary of the sound practices, standards and guidelines related to credit risk management published by the BCBS. Three such documents are noteworthy, which are:
- Principles for the Management of credit risk, published in September 2000, (http://www.bis.org/publ/bcbs75.pdf), establishes sound practices to specifically address key areas in credit risk management.
- Supervisory framework for measuring and controlling large exposures , published in April 2014, (http://www.bis.org/publ/bcbs283.pdf), sets standards to complement the risk based capital norms (which is described in detail in the chapter titled “Capital – Risk, Regulation and Adequacy”.
- The Guidelines for Prudential treatment of problem assets – definitions of non performing assets and forbearance, published in April 2017, (http://www.bis.org/bcbs/publ/d403.pdf) has developed guidelines for the definitions and operative features for two important terms – “non-performing exposures” and “forbearance”.
The above three documents are intended to contribute to increased stability of the financial system, especially after the experiences of the global financial crisis of 2007-08.
Classifying ‘Impaired’ Loans
International accounting practices set forth standards for estimating the impairment of a loan for general financial reporting purposes. Regulators are expected to follow these standards ‘to the letter’ for determining the provisions and allowances for loan losses. According to these standards, a loan is ‘impaired’ when, based on current information and events, it is probable that the creditor will be unable to collect all amounts (interest and principal) due in line with the terms of the loan agreement. Such assets are also called ‘criticized’ assets.
Typically, the impaired assets are categorized as follows:
- Special mentioned loans: These loans are assessed as ‘inherently weak’. The credit risks may be minor, but may involve ‘unwarranted risk’. Such credits contain weaknesses, such as an inadequate loan agreement or poor condition of or control over collateral or deficient loan documentation or evidence of imprudent lending practices. Adverse market conditions in future may unfavourably impact the operations or the financials of the borrower firm, but may not endanger liquidation of assets held as security. The special mentioned loans carry more than normal risks which, had they been present when the credit was appraised, would have led to rejection of the credit request.
- Sub-standard assets: These assets are seen to have well-defined weaknesses that may jeopardize liquidation of the debt, since they are not fully protected by the borrower’s financial condition or the collateral given as security. The bank is likely to sustain a loss if the defects are not corrected.
- Doubtful assets: These assets contain all the weaknesses of a sub-standard asset and, additionally, recovery of the debt in full is quite remote. Auditors may insist on a write down of the asset through a charge to loan loss reserves or a write off of a portion of the asset or they may call for additional capital allocation. Any portion of the balance outstanding in the loan, which is uncovered by the market value of the collateral, may be identified as uncollectible and written off.
- Loss assets: All identified losses have to be charged off. Uncollectible loans with such little value that their continuance as bankable assets is not warranted are generally charged off. Losses are expensed in the same period in which they are written off.
- Partially charged off loans: Though credit exposures contain weaknesses that render them uncollectible in full, some portion of the outstanding loan could be collected if the collateral is marketable and in good condition. Hence, the secured portion is not written off, while the unsecured portion of the loan is charged off.
- Income accrual on impaired loans is discontinued from the time they are classified.
Annexure I summarises the key guidelines from Basel Committee in defining non performing assets and forbearance. Select international practices in classifying impaired loans is shown in Table 8.1.
TABLE 8.1 CLASSIFYING IMPAIRED LOANS- PRACTICES IN SELECT COUNTRIES
Loan Workouts and Going to Court for Recovery
The workout function has been discussed in detail in the previous chapter. In the case of a restructured loan, the ability of the borrower to repay the loan on modified terms is focused upon. The loan will be classified under the ‘impaired’ category if, even after restructuring, there arise weaknesses that tend to jeopardize repayment on the modified terms.
In some developed countries like the US, regulatory rules do not require that banks restructuring a loan grant excessive concessions to the borrower during the period of restructuring.10
If all other forms of renegotiation between the bank and the borrower fail, the bank approaches the court to enforce recovery of dues. In some cases, ‘Debtor-in-Possession’ (DIP) financing is also done while the suit against the borrower is pending at the court. DIP financing is considered attractive by banks where such provision exists, since it is done only under the order of the court, which is empowered to give a priority position on the bankruptcy estate to the lender. Some alternatives for DIP financing include receivables backed credit, factoring and loans against equipment or inventory. The DIP loan is repaid from the following sources:
- cash flows from operations,
- liquidation of the collateral,
- the firm turns viable and the new lender refinances the DIP loan, and
- the DIP loan is taken over by a new DIP lender.
Credit Risk Models
Ever since Markowitz developed his pioneering Portfolio Analysis Model in 1950, quantitative models of portfolio management have been widely used in financial analysis, especially in analysis of equity portfolios. Over the last few decades, equity analysts have been successfully using portfolio management models to quantify default risks in a portfolio of assets. The objective of these methods is to maximize the portfolio’s returns while reining in risk within acceptable levels.11 This maximization involves balancing of risks and returns within a portfolio, asset by asset and group of assets by group of assets.12
However, similar models are not widely used for debt portfolios because of the greater analytical and empirical difficulties involved.
- Debt defaults can happen all of a sudden and once they happen, the risk can increase very quickly.
- We have seen the risk premium associated with the borrower or borrower class is inbuilt into the loan pricing. If the borrower risk has been misjudged, the loan would not be priced appropriately, implying further erosion in the bank’s already thin margins on lending.
- It is also pertinent to remember here that the lenders—the banks—themselves are highly leveraged entities. History is replete with instances where lenders have been destroyed by the combination of financial and default risks.
The truth is that ‘risk’ cannot be wished away, insured away, hedged away or structured away. Risk can merely be allocated or transferred, but ultimately the risk has to be borne by somebody. Hence, lenders try to diversify their credit risks, for they know that they cannot do business if they eliminate risks altogether. How can lenders diversify their risk? By avoiding ‘concentration’ of credit.
The Basel Committee13 has identified ‘credit concentrations’ as the single most important cause of major credit problems. Credit concentrations are viewed as any exposure where the potential losses are large relative to the bank’s capital, its total assets or where adequate measures exist and the bank’s overall risk level. Concentrations of credit and, hence, risk can occur when the bank’s portfolio contains a high level of direct or indirect credit to: (a) a single borrower, (b) a group of associated borrowers, (c) a specific industry or economic activity, (d) a geographic region, (e) a specific country or a group of inter-related countries, (f) a type of credit facility, or (g) a specific type of security. Sometimes, concentrations can also arise from credits with similar maturities or from inter-linkages within the portfolio. Annexure I gives a synopsis of Basel Committee’s standards in relation to credit concentration risk.
Relatively large losses14 may reflect not only large exposures, but also the potential for unusually high percentage losses given default.
Credit concentrations can further be grouped into two broad categories.15
- Conventional credit concentrations would include concentrations of credits to single borrowers or counter parties, a group of connected counter parties and sectors or industries, such as commercial real estate and oil and gas.
- Concentrations based on common or co-related risk factors reflect subtler or more situation-specific factors and often can only be uncovered through analysis, such as correlations between market and credit risks and their correlation with liquidity risk. Such interplay of risks can produce substantial losses.
Why do banks permit concentrations in their credit portfolios? The Basel Committee cites the following reasons:16 ‘First, in developing their business strategy, most banks face an inherent trade-off between choosing to specialize in a few key areas with the goal of achieving a market leadership position and diversifying their income streams, especially when they are engaged in some volatile market segments. This trade-off has been exacerbated by intensified competition among banks and non-banks alike for traditional banking activities, such as providing credit to investment grade corporations. Concentrations appear most frequently to arise because banks identify ‘hot’ and rapidly growing industries and use overly optimistic assumptions about an industry’s future prospects, especially asset appreciation and the potential to earn above-average fees and/or spreads. Banks seem most susceptible to overlooking the dangers in such situations when they are focused on asset growth or market share’.
Until recently, such ‘concentrations’ could be measured only after the credit exposures had been created. Of late, finance literature has produced a variety of models that attempt to measure default risk.
While most of the methodologies are seen to work adequately in practice, research indicates that some issues are still not tackled by the models in respect of bank lending such as predicting macro-economic cycles and industry shocks (systematic or exogenous default risk) and hedging strategies.
MEASURING CREDIT RISK—INTRODUCTION TO SOME POPULAR CREDIT RISK MODELS
A Basic Model
A simple method of estimating credit risk is to assess the impact of non-performing asset (NPA) write offs on the bank’s profits. This can be achieved through dividing the ‘profit before taxes’ (PBT) by the NPAs. Here, PBT is more relevant since losses written-off typically enjoy tax shields.
Accordingly, this simple measure of credit risk can be presented in the following forms:
- (PAT/[1 – t])/TA
Interpretation of the result
If the above measure yields a result of say, 0.7, it simply means that if 70 per cent of the NPAs turn into ‘loss assets’ and are written off, the bank’s PBT would be eroded completely. For this reason, the resultant proportion is also called the ‘margin of safety’.
TEASE THE CONCEPT
Which is safer for the bank—the above measure being lower or higher?
Modeling Credit Risk
Financial institutions have traditionally attempted to minimize the incidence of credit risk primarily through a loan-by-loan analysis. The foundations of a more analytical framework began in the early 1960s when the first ‘credit scoring’ models were built to assist credit decisions for consumer loans. The lending institutions initially classified debtors/counter parties on default potential based only on an ordinal ranking. By the mid-1980s, particularly with the introduction of RAROC as a performance measure, many financial institutions began calibrating each credit score to a particular PD17 to estimate expected losses (EL) and ultimately economic capital.
Techniques to calculate PD can be divided into two broad categories.
- Empirical: These models use historical default rates associated with each ‘score’ to identify the characteristics of defaulting counter parties. Traditionally, such models used discriminant analysis (such as Z scores), but more recently logit or probit regressions are being used to define the score ‘S’18
- Market-based (also known as structural or reduced-form) models: These models use counter party market data (e.g., bond or credit default swap (CDS) spreads and volatility of equity market value) to infer the likelihood of default.
Several commercial credit value-at-risk models have been developed in the last 10–15 years (e.g., Credit Metrics, KMV and Credit Risk+) that use credit risk inputs (credit data, market data, obligor data and issue/facility data) to derive a loss distribution, by assuming that correlations across borrowers arise due to common dependence on a set of ‘systematic risk factors’ (typically, variables representing the state of the economy). Sophisticated banks generally use these models for active portfolio-level credit management (particularly, for large corporate loans) by identifying risk concentrations and opportunities for diversification through debt instruments and credit derivatives.
Table 8.2 classifies popular models according to the approach adopted by them.
TABLE 8.219 INDUSTRY-SPONSORED CREDIT VALUE-AT-RISK (VaR) MODELS
Table 8.3 compares these approaches on various parameters.
TABLE 8.320 COMPARIS ON OF CREDIT RISK MODELS ON VARIOUS PARAMETERS
In addition, several academic models have been developed, which can be categorized into two. The models in the first category adopt an exogenous default-trigger value of assets. In contrast, the models in the second category derive the decision to default endogenously, as part of the borrower’s internal problems and are, therefore, a function of borrower characteristics.21
A description of the approaches to credit risk measurement and the popular models can be found in the next chapter.
CREDIT RISK TRANSfERS—SECURITIZATION, LOAN SALES, COVERED BONDS AND CREDIT DERIVATIVES
Hedging reduces portfolio risk by offsetting one risk against another. Diversification reduces risk because risks are uncorrelated. How portfolio hedges are structured will vary according to the bank’s goals on hedging credit risk.
Till even about a decade ago, banks had to expand their loan portfolios for growing their business and keep these assets in their books till they were completely liquidated. In the present scenario, banks still grow their business by expanding loan assets, but these assets are sold off to other agencies or of floaded in the secondary loan market. In this manner, banks get risky loans off their books. Such loan sales provide liquidity to the selling banks and also represent a valuable portfolio management tool, which minimizes risk through diversification.
Some prominent forms of loan sales include the following.
- Syndication: We have seen this as a form of credit in Chapter 5. The manner in which syndication is conducted spreads the credit risk in the transaction among the banks in the syndicate. Let us assume a borrower wants a loan of ₹10,000 crores for a large project. If Bank X is nominated as the lead bank for the syndication, X will negotiate the documents with the borrower and solicit a group of banks to share the credit exposure. X will generally hold the maximum exposure, though this is not mandatory. Bank X claims a fee for its efforts in syndication.
- Novation: In the above example, Bank X assigns its rights to one or more buyer banks. These buyer banks then become original signatories to the loan agreement. Thus, the borrower would have contracted with Bank X for the ₹10,000 crores loan. Post novation, Bank X would hold, say, ₹2,000 crores of credit exposure to the borrower and the three buyer banks, say A, B and C, would hold the remaining ₹8,000 crores share among themselves in a mutually agreed proportion. Unlike syndication, A, B and C would enter into separate loan agreements with the borrower.
- Participation: In this case, Bank X transfers to other participating banks A, B and C the right to receive pro rata payments from the borrower. Typically, the seller of the participation—Bank X—will have to consult A, B and C before agreeing to changes in the terms of the loan (principal, interest, repayment terms, guarantees, collaterals, interest rate, fees and other covenants).
This is one of the most popular and prominent forms of loan sale. The critical factor is finding a homogeneous pool of loan assets that generate a predictable stream of future cash flows.
Simply stated, securitization involves the transfer of assets and other credit exposures from the ‘originator’ (the bank) through pooling and re-packaging by a special purpose vehicle (SPV) into securities that can be sold to investors. It involves legally isolating the underlying exposures from the originating bank. A ‘true sale’ or ‘traditional securitization’ happens where the assets are actually transferred from the originator’s balance-sheet to the issuer of the securities. For instance, a bank makes auto loans and sells these loans to a SPE or SPV that structures these assets into a homogeneous asset pool. The SPE retains the loan as collateral, sells the pool to investors and pays the bank for the loans bought from it with the proceeds from the sale of securities.
At the end of the tenure of the securitization, the residual assets are passed on to the investors. If the asset quality deteriorates, the investors have to bear the loss. The investors receive variable coupon payments depending upon the risk they decide to bear. The investors who are ready to take the first loss get the maximum spread. The originator, in this fashion, has passed on the risk associated with the assets to the investor.
Figure 8.3 depicts a typical securitization process.
Securitization can be seen as the method of turning un-tradable and illiquid assets into various types of securities, which can then be sold to different investors with different risk appetites. These different types of securities with different inherent risks are known as the ‘tranches’. Technically, securitization is defined as a transaction involving one or more underlying credit exposures from which tranches that reflect different degrees of credit risk are created. Credit exposures may include loans, commitments and receivables. It may take the form of a security or of an unfunded credit derivative (to be explained later). The payments to investors depend upon the performance of specified underlying credit exposures. The salient features of securitization are outlined in Annexure II of this chapter.
The securities sold to investors are called ‘asset-backed securities’ (ABS), since they are backed by the homogeneous pool of underlying assets. Originators of ABS usually want to sell loans ‘without recourse’.22 Hence, investors usually safeguard their interests through three mechanisms—(a) over collateralization, (b) senior/subordinated structures, and (3) credit enhancement.
- ‘Over collateralization’, as the nomenclature implies, involves structuring a collateral pool to ensure cash flow in excess of the amount required to pay the principal and interest on the securities.
FIGURE 8.3 A TYPICAL SECURITIZATION PROCESS
- In the ‘senior/subordinated structures’, the issuer of securities sells two categories of certificates—senior and junior—both secured by the same collateral pool. The senior certificates are usually taken by investors, while the originator itself may purchase the junior certificates. The cash flows from the collateral are first allocated to make payments to senior holders and the residual cash flows are allocated to junior holders. In other words, the actual losses should not exceed the promised payments to subordinated certificate holders. Therefore, the larger the component of junior holders, the greater the protection for senior investors.
- ‘Credit enhancements’, such as letters of credit are used to cover losses in the collateral. A bank other than the originating bank issues the letter of credit, generally covering a certain proportion of the loss on the pool (comparable to historical losses plus a margin) for a fee.
Thus, securitization is seen to benefit banks by providing liquidity to banks’ loan portfolios and mitigating credit risk by removing assets from banks’ books. Other spin offs include a possible lowering of interest rate risk and profitability enhancement through better asset turnover and fee-based income.
Box 8.1 provides an overview of collateralized debt obligations (CDOs) and compares them with securitization.
BOX 8.1 WHAT ARE CDOs/CBOs/CLOs?
These are the fastest growing segment of the securitization market. Banks resort to securitization with the following predominant motives-sourcing cheaper funds, attaining higher regulatory capital, better asset—liability management and reduced NPAs or under-performing assets.
Where the originating bank transfers a pool of loans, the bonds that emerge are called ‘collateralized loan obligations’ (CLOs). Where the bank transfers a portfolio of bonds and securitizes the same, the resulting securitized bonds are termed ‘collateralized bond obligations’ (CBOs). A generic name given to both these is ‘CDOs’. Some banks even securitize their equity investments—calling them ‘collateralized investment obligations’ (CIOs).
Difference between securitization and CDO structures
Though the essential nature of the structures are similar, securitization in its generic form and issuing CBO/CLO at the instance of banks, differ in respect of the following.
- For typical securitizations the primary objective is liquidity, while in the case of CBO/CLOs, the objectives could be capital relief, risk transfer, arbitraging profits or balance sheet optimization.
- While securitizations of, say, mortgage portfolios or auto loan portfolios could have thousands of obligors, CDO pools typically have only 100–200 loans.
- The loans/bonds are mostly heterogeneous in CDOs, whereas the securitized assets are typically homogeneous pools. The originator of CDOs might try to bunch together uncorrelated loans to provide the benefits of a diversified portfolio.
- Most CDO structures use a tranched and multi-layered structure with a substantial amount of residual interest retained by the originator.
- Generally, CDO issues will use a reinvestment period and an amortization period. Some tranches might have a ‘soft bullet’ repayment (a bullet repayment that is not guaranteed by any third party).
- Arbitraging is a common practice in the CDO market, where larger banks buy out loans from smaller ones and securitize them, earning arbitrage revenues in the process. There is a class of CDOs called arbitrage CDOs where the originating bank buys loans/bonds from the market and securitizes the same for gaining an advantage on the rates. Since the motive of such securitizations is arbitraging, such CDOs are called arbitrage CLOs/CBOs. To distinguish these from the ones where a bank securitizes its own receivables, the latter are sometimes referred to as ‘balance sheet CLOs/CBOs’.
Yet another upcoming variety of CLOs is ‘synthetic CLOs’. Here the originating bank merely securitizes the credit risk23 and retains the loans on its balance sheet. Synthetic CLOs repackage the underlying loans into cash flows that suit the needs of the investors and are not dependant on the repayment structure of the underlying loans.
To summarize, CDOs could fall into two basic categories: balance sheet CDOs and arbitrage CDOs. In the case of balance sheet CDOs, loans are actually transferred from the balance sheet of the originator and therefore impact the originating bank’s balance sheet. In the case of arbitrage CDOs, the originator merely ‘buys’ loans or bonds or asset-backed securities from the market, pools and securitizes them as a repackaged entity. The prime objective of balance sheet CDOs is to reduce risk and regulatory capital, while the purpose of arbitrage CDOs is to make profits from arbitrage.
Balance sheet CDOs could be further classified into cash flow CDOs and synthetic CDOs based on the nature of their assets.
In the case of ‘cash flow CDOs’, the assets are acquired for cash. The originating bank transfers a portfolio of loans into an SPV. ‘Master trust’ structures are commonly employed in CDOs to enable the bank to keep transferring loans into the pool on a regular basis without having to do complex documentation for every transfer. In view of the varied repayment structure of commercial loans, cash flow CDOs typically repay through bullet repayments and, hence, have a reinvestment period, during which the cash flows from repayments are reinvested.
However, a synthetic CDO primarily acquires ‘synthetic’ assets by selling ‘protection’24 rather than buying assets for cash. Hence, the funding requirement for a synthetic CDO is much lower than that for a cash flow CDO. The amount of cash raised is limited only to the extent of expected and unexpected losses (EL and UL) in the portfolio of synthetic assets, such that the highest of the cash liabilities can get an investment grade rating. Once the senior most cash liability obtains investment grade rating, the synthetic CDO does not raise more cash—it merely raises a synthetic ‘liability’ by buying protection from a super-senior swap provider. A typical structure in a synthetic CDO is illustrated in Figure 8.4. Clearly, the three different ‘tranches’ have different risk characteristics.
FIGURE 8.4 TYPICAL STRUCTURE OF A SYNTHETIC CDO
TEASE THE CONCEPT
Why would banks be tempted to sell only their best assets under the securitization process?
Let us now sum up the alternatives discussed so far in respect of a bank that has to deal with credit risk in its loan portfolio.
- It can continue to hold the loans, assess the EL periodically, take preventive or remedial measures to reduce the risk of loss or make a provision on the EL and allocate capital for UL.
- It can diversify its loan portfolio with several small loans to different counter parties, so that a few expected defaults may not lead to earnings volatility.
- It can negotiate a loan sale for the whole or part of the loan amount and incur the costs associated with the loan sale.
In resorting to the first alternative—(a) the bank runs the risk of earnings erosion if the provisions are substantial in value. It is not always easy to diversify the portfolio as in alternative; (b) since the bank’s operations, driven by its own internal skills and external competition, may not be able to balance the portfolio as optimally as it would like to. Further, a highly diversified portfolio is no complete hedge against borrower defaults and could lead to high transaction costs. Beyond diversification, banks look to sell off or securitize the loans as in the alternative; and (c) and this approach is seen to work well for standardized payment schedules and homogeneous credit risk characteristics. Commercial and industrial loans exhibit varied credit risk characteristics and can be sold or securitized through the CDO route as described above. In many cases, the banks themselves may not want the loans or more specifically, the ‘borrowers’ off their balance sheets and may merely want to hedge against the credit risk inherent in the loan transaction.
Asset Reconstruction Companies (ARC)
Asset Reconstruction Companies function as the Special Purpose Vehicles designed to hold the pools of securitized assets. Globally, countries have successfully implemented different models of ARCs to resolve the build up of non performing assets. Successful transfer of stressed assets to ARCs has resulted from creating a supportive regulatory environment. ARCs function like Asset Management companies transferring the acquired assets to one or more trusts (at the price at which the financial assets were acquired from the originator). Then, the trusts issue security receipts (SRs) to qualified institutional buyers (QIBs) and the ARCs receive management fees from the trusts. Any profit between the acquired price and the realized price is shared between the beneficiary of the trusts (banks/FIs) and ARCs.
The process is shown in Figure 8.5
FIGURE 8.5 ARC PROCESS
The trust acquires NPAs from banks/FIs by forming different trusts for the financial assets taken over. NPA are acquired from banks/FIs at fair value based on assessment of realisable amount and time to resolution. The maximum life of the trust may be prescribed by regulations. The trust is set up as a pass through entity (PTC) for Income tax purposes.
- Accordingly, the trusts issues securities (SR) to the investors which are usually QIBs or the seller bank itself. Therefore in case the seller bank is itself buying the SR in the Trusts, its status changes from lender of the loan to that of investor in the SR. SR represents undivided right, title and interest in the trust fund. After acquiring the NPA, the trust becomes the legal owner and the security holders its immediate beneficiaries. The Securitisation Act prescribes that an ARC has to make a minimum of 5% investment in the trust.
- The Trust redeems the investment to the SR holders out of the money realised from the borrowers. The ARC facilitates the whole working.
The NPAs acquired are held in an asset specific or portfolio trust scheme. In the portfolio approach, due to the small size of the aggregate debt the ARC makes a portfolio of the loan assets from different banks and FIs. Whereas when the size of the aggregate debt of a bank/FI is large, the trust takes an asset specific approach.
ARCs have several advantages. They help banks to focus on their core business by taking over the responsibility of resolving stressed assets. ARCs help in enabling industry to acquire expertise in loan-resolution arrangements and develop secondary markets for stressed assets. ARCs benefit the overall economy by trying to restore the operational efficiency of financially unviable assets after their acquisition by unlocking their true potential value or disposing them off, so that funds blocked in these assets could be released and invested in more productive sectors in the economy.
Covered bonds are not a new concept. They have been around for over 200 years, with a striking ‘zero’ default record! They have historically been associated with Germany—Pfandbriefe and Denmark–realkreditobligatione
Covered bonds are a hybrid between asset-backed securities/mortgage backed securities and normal secured corporate bonds, and serve as an instrument of refinancing, primarily used by mortgage lenders. Unlike secured corporate bonds which provide recourse against the issuer, covered bonds provide a bankruptcy-protected recourse against the assets of the issuer (Collateral Pool) too. Unlike mortgage backed securities which merely provide recourse against the Collateral Pool, covered bonds provide an additional recourse against the issuer too.
Covered bonds can therefore be defined as fixed income instruments that are unconditional obligations of the issuer, but containing an additional recourse against assets of a specified ‘cover pool’, the rights over which are protected, either by legislation or by using special legal devices, such that investors in the covered bonds have bankruptcy-protected claim against such cover pool.
Covered bonds are essentially used to raise liquidity through a bond issue, backed by a pool of assets. They combine the features of securitization and corporate bonds (debt instruments, more about which can be found in later chapters).
FIGURE 8.5 AT THE TIME OF ISSUING A COVERED BOND
FIGURE 8.6 FLOW OF CASH PAYMENTS IN A STRUCTURED COVERED BOND
It can be understood from the diagrammatic representations that the covered bond, like a securitized asset, is backed by a pool of identifiable assets usually with a level of over collateralization. But there are many points of difference that add up to making covered bonds a viable alternative to securitization.
Traditionally, covered bonds have been used in mortgage refinancing. However, unlike in traditional Mortgage backed securities (MBS), where the pool of underlying mortgages is static, the pool underlying covered bonds is a dynamic pool. Hence the generic structure of covered bonds resembles secured bonds.
Unlike securitization, which does not depend on the rating of the issuer, covered bonds do depend on ratings, but have additional advantage of ‘ring fenced’, high quality assets to back the pool. The quality of underlying asset pool in covered bonds is laid down by specific legislation or common law of the country.
Covered bonds are shown on the balance sheet of the originator, who is therefore subject to default risk and prepayment risk of bondholders. Contrast this with securitization, where the default risk of the assets (and the prepayment risk) is passed on to the investors, and the assets are taken off the originator’s balance sheet.
How do originators/issuers benefit from covered bonds?
- Originators are able to get higher leverage. The rationale for this is that mortgage lending, where covered bonds are the most prevalent, is low risk, low return business, where cash flows are recovered over a long period in time. Hence, for mortgage lenders to get a higher return on their equity, higher leverage is the preferred tool. This fact has been recognized by regulators too. Higher leverage also implies that originators have to constantly seek additional sources of funds. Covered bonds provide one such additional source of funds. The leverage that a covered bond issue can command is directly linked to the quality of underlying assets and the extent of over collateralization. Hence, originators will be able to raise funds only to the extent of the economic capital that the pool requires. (The concept of ‘economic capital’ is discussed in detail in the chapter ‘Capital—risk, regulation and adequacy’)
- Originators can get better ratings for the covered bond issue than their own ratings. This is due to the fact that the ‘cover pool’ of assets that will form the security for the covered bonds would be high quality assets, whose quality would either be stipulated by law or stated in specific legislations.
- Lower cost to originator as a direct result of better ratings.
- Originators can achieve better asset liability matches (asset liability matching is discussed in the chapter ‘Bank risk management’). In a covered bond program there may be asset liability mismatches. The underlying asset is a long term mortgage asset (with a maturity typically greater than 10 years), while covered bonds may be issued with short term or medium term maturities. This would mean that the normal asset amortization alone may be insufficient to pay the bonds on time. While evaluating the asset-liability mismatches, there are two risks that are taken into consideration: (a) asset risk; and (b) cash flow risk. These are dealt with while structuring of the transaction. Thereafter, reliance is placed on the debt service capacity of the issuer. Over and above these, the issuer may need liquidity facility provider to meet the covered bond maturities. The less the magnitude of the asset liability mismatch, the higher the rating for the bonds.
- Originators’ exposure to the capital market yields better reputation. Further the accountability to the capital market brings in better governance, discipline and best practices to the originator.
How do covered bonds benefit the borrowers/investors?
If covered bonds are able to bring down the cost of mortgage refinancing, the same would eventually translate into lower mortgage lending costs. In addition, covered bonds result into standardization of mortgage lending procedures and underwriting norms—all of which make pricing of mortgages far more transparent.
How do covered bonds benefit the economy?
Integration of capital markets with mortgage markets is an important step in the economic development of a country. Securitization is an extreme form of transforming illiquid assets into tradable securities in the capital market. However, post the 2007 crisis, the securitization model was seen as creating problems of moral hazard and adverse selection. As a device of capital market funding, covered bonds are mid-way between securitization and straight corporate bonds, since they combine the benefits of both.
One of the biggest advantages of covered bonds in future will be the liquidity requirements under Basel III (Please see chapter ‘Capital—risk, regulation and adequacy’). Basel III proposes to impose a Liquidity Coverage Ratio requirement for banks according to which banks are to maintain at least 30 days’ cash flows in ‘highly liquid assets’. Covered bonds of a certain rating would qualify as liquid assets for this requirement.
About 32 countries have already passed laws in respect of covered bonds. The National Housing bank (NHB) of India is actively considering introducing covered bonds in the country’s residential mortgage market. A working group submitted its report on the subject in October 2012. A draft National Housing Bank Covered Bonds Regulations, 2012, has also been proposed in the report.
Comparing Securitization and Covered Bonds
Table 8.4 compares securitization and covered bonds on various parameters
TABLE 8.4 COVERED BONDS VS SECURITIZATION
Box 8.2 provides an overview of the legislation governing covered bonds in select countries.
BOX 8.2 LEGISLATION ON COVERED BONDS – SELECT COUNTRIES
Legislation on covered bonds—select countries
A wide range of assets including residential assets as well as commercial assets qualify as eligible assets. Also, the Cover Pool may be comprised of ancillary assets and substitute assets. A loan will not qualify as eligible asset if it is delinquent for more than 60 consecutive days. The Bill stipulates minimum over-collateralization requirements to be established.
In Singapore, the Monetary Authority of Singapore came up with Proposed Consultation Paper on Covered Bonds Issuance by Banks incorporated in Singapore in March, 2012. According to the proposal, Covered Bond holders will have dual recourse against the issuing bank as well as the Cover pool. Further, the aggregate value of assets in the cover pool is to be capped at 2 per cent of the value of the total assets of the bank. Only residential mortgage loans and the derivatives held for the purpose of hedging risks arising from issuing covered bonds are proposed as eligible constituents of the Cover Pool. A minimum over-collateralization of 103 per cent and a LTV (Loan to Value Ratio) of 80 per cent have also been proposed.
The Regulated Covered Bonds Regulations 2008 (amended periodically) constitute the regulatory framework for Covered Bonds in the United Kingdom (UK). The Asset Pool should consist of eligible property (e.g., loans to registered social landlord, loans to a project company for specified projects, etc. or any interest in eligible assets specified in any one of the classes: public sector assets, residential mortgage assets and commercial mortgage assets) which shall be situated in particular areas only.
The European covered bond council (ECBC) has stipulated criteria that issuers will have to satisfy, and the ‘covered bond label convention’—as the legislation will be called—is likely to be passed.
Due to the difficulties experienced by bankers with alternative methods of dealing with credit risk, another alternative has emerged: ‘credit derivatives’—a more specialized way to insure against credit-related losses.
Credit derivatives are an effective means of protecting against credit risk. They come in many shapes and sizes, but all serve the same purpose. Simply stated, a credit derivative is a security with a pay-off linked to a credit related event, such as borrower default, credit rating downgrades or a structural change in a security containing credit risk.
There are different types of credit derivatives, but we will take a brief look in this section at the commonly used derivatives. Some analysts classify credit derivatives into two categories in terms of how they are valued or priced, namely ‘replication’ products and ‘default’ products. Replication products, as the name suggests, replicate the money market transactions, such as credit spread options, while default products, such as credit default swaps (CDS) are priced on the basis of the PD of the asset whose risk is being transferred, the exposure at risk and the expected recovery rate. Another common classification is on the basis of performance—‘protection like’ products (e.g., credit default options and CDS) and ‘exchange like’ products (e.g., total return swaps).
In credit derivatives, there is a party (or a bank) trying to transfer credit risk, called protection buyer and there is a counter party (another bank) trying to acquire credit risk, called protection seller. Over time, the credit derivatives market has become a trading market. Trades in credit derivatives are taken to be proxies for trades in actual loans or bonds of the reference entity and the borrower. For example, a bank willing to acquire exposure in a particular borrower would sell protection with reference to the borrower, while a bank wanting to hedge the risk of lending to the same borrower will buy protection.
Credit derivatives are typically unfunded—the protection seller is not required to put in any money upfront. The protection buyer generally pays a periodic premium. However, the credit derivative may be funded in some cases. For example, the protection buyer may require the protection seller to pre-pay the entire notional value of the contract upfront (as in the case of a ‘credit-linked note’ (CLN) discussed later in this section).
As is typical of derivatives, a credit derivative does not require either of the parties—the protection seller or protection buyer—to actually hold the reference asset (the credit that is being hedged). Thus, a bank may buy protection for an exposure it has taken or has not taken, irrespective of the amount or term of the actual exposure. It, therefore, follows that the amount of compensation claimed under a credit derivative may not be related to the actual losses suffered by the protection buyer.
When a credit event (as specified in the contract between the protection buyer and seller) takes place, there are two ways of settlement—cash and physical. In a cash settlement, the reference asset will be valued and the difference between its par and fair value will be paid by the protection seller. In the case of physical settlement, the protection seller would acquire the defaulted asset for its full par.
Box 8.3 provides an insight into the evolution of credit derivatives.
BOX 8.3 EVOLUTION OF CREDIT DERIVATIVES25
In March 1993, Global Finance carried a feature on J. P. Morgan, Merrill Lynch and Bankers Trust, which were already then marketing some form of credit derivatives. This article also prophesied, quite rightly, that credit derivatives could, within a few years, rival the USD 40 trillion market for interest rate swaps.
In November 1993, Investment Dealers Digest carried an article titled ‘Derivatives Pros Snubbed on Latest Exotic Product’ which claimed that a number of private credit derivative deals had been seen in the market but it was doubted if they were ever completed. The article also said that Standard and Poor’s had refused to rate credit derivative products and this refusal may put a permanent damper on the fledgling market. One commentator quoted in the article said: ‘It (credit derivatives) is like Russian roulette. It doesn’t make a difference if there’s only one bullet: If you get it you die’.
Almost 3 years later, Euromoney reported (March 1996 ‘Credit Derivatives Get Cracking’) that a lot of credit derivatives deals were already happening. The article was optimistic: ‘The potential of credit derivatives is immense. There are hundreds of possible applications: for commercial banks which want to change the risk profile of their loan books, for investment banks managing huge bond and derivatives portfolios, for manufacturing companies over-exposed to a single customer, for equity investors in project finance deals with unacceptable sovereign risk, for institutional investors that have unusual risk appetites (or just want to speculate) and even for employees worried about the safety of their deferred remuneration. The potential uses are so widespread that some market participants argue that credit derivatives could eventually outstrip all other derivative products in size and importance’.
Some significant milestones in the development of credit derivatives have been as follows:
- 1992: Credit derivatives emerge. ISDA26 first uses the term ‘credit derivatives’ to describe a new exotic type of over-the-counter contract.
- 1993: KMV introduces the first version of its Portfolio Manager model, the first credit portfolio model.
- 1994: Credit derivatives market begins to evolve. There are doubts expressed by some.
- September 1996: The first CLO of UK’s National Westminster Bank.
- April 1997: J P Morgan launches Credit Metrics.
- October 1997: Credit Suisse launches CreditRisk+
- December 1997: The first synthetic securitization, JP Morgan’s BISTRO deal.
- July 1999: Credit derivative definitions issued by ISDA.
Why Do Banks Use Credit Derivatives?
- They are an easy and cost-effective means to hedge portfolio risk.
- They permit substantial flexibility and hence increase the portfolio efficiency. For instance, the bank may have made a loan with 5-year maturity, but may be concerned with the risk over the next 2-year period only. The credit derivative permits the bank to allocate this risk to another party. The bank also effectively creates a 2-year security with many of the pricing characteristics of the 5-year loan. There are thus endless possibilities to create and structure flexible credit derivatives.
- They can be used to hedge against interest rate risks.
- Credit derivatives are often more efficient than loan sales since some investors who are unwilling to participate in the loan sales market are more willing to acquire credit derivatives.
- The bank transferring its credit risk may not want its actions to be visible to its borrowers and competitors and hence may want to use credit derivatives.
- Loan sales call for substantial information sharing among participants and the bank is likely to incur higher administrative costs and more obligations.
The popular credit risk transfer instruments can be summarized in Figure 8.7.
FIGURE 8.7 CATEGORIZATION OF CREDIT RISK TRANSFER INSTRUMENTS
Some Basic Credit Derivative Structures
There are many kinds of credit derivatives and to enumerate and describe them would be beyond the scope of this book. Further, most credit derivatives, like other derivatives, can be ‘structured’ to meet the specific requirements of the protection buyers and sellers.
However, we briefly describe some popular types of credit derivatives as follows:
- Loan portfolio swap27: Banks swap loan portfolios to diversify their credit exposures to a particular industry or activity. For instance, if Bank X has more real estate loans in its portfolio and Bank Y has more loans to technology firms, X and Y can agree to swap payments received on a basket of each bank’s loan exposures.
- Total return swap: This is one of the most popular credit derivative instruments. The steps involved in the swap are as follows:
- Bank A has made 5-year loan to firm XYZ. The bank would like to hedge its credit risk on the loan. Bank A is called the ‘beneficiary’ or the ‘protection buyer’.
- In terms of the swap agreement, Bank A agrees to pay Bank B, who is called the ‘guarantor’ or ‘protection seller’, the ‘total return’ on the ‘reference asset’, in this case, the loan to XYZ. The ‘total return’ comprises of all contractual payments on the loan, plus any appreciation in the market value of the reference asset.
- The swap arrangement is completed when Bank B agrees to pay a particular rate (which would include a ‘spread’ and an allowance for loan value depreciation) to Bank A. This rate is generally fixed based on a reference rate such as the London Inter Bank Offered Rate (LIBOR). Now, in effect, Bank B has a ‘synthetic’ ownership of the reference asset, since it has agreed to bear the risks and rewards of such ownership over the swap period. Bank B, therefore, assumes the credit risk and receives a ‘risk premium’ for doing so. The greater the credit risk, the higher the risk premium.
- On the date of a specified payment or when the derivative matures or on the happening of a specified event, such as default, the contract terminates. Any depreciation or appreciation in the amortized value of the reference asset (the loan to XYZ) is arrived at as the difference between the notional principal amount of the reference asset and the dealer price.
- If the dealer price is less than the notional principal amount on the date of contract termination, Bank B must pay the difference to Bank A, absorbing any loss due to the decline in credit quality of the reference asset.
To sum up, the protection buyer makes payments based on the total returns from the reference asset—the loan to XYZ—as seen in Figure 8.8.
FIGURE 8.8 TOTAL RETURN SWAP
The total returns include contractual payments on the loan plus appreciation of the loan value. In return, the protection seller makes regular contracted payments, fixed or floating, which include a spread over funding costs plus the depreciation value (the ‘protection’). Both parties make payments based on the same notional amount. The protection seller gets the advantage of returns without holding the asset on its balance sheet. The protection buyer can negotiate credit protection without having to liquidate the underlying asset. In floating rate contracts, not only is interest rate risk hedged, but also the risk of deterioration of credit quality (which can occur even where there is no default).
Some advantages of the TR swap are as follows:
- Since the asset is never transferred, the bank seeking protection can diversify its credit risk without the need to divulge confidential information on the borrower.
- The features of this type of credit protection are seen to have lower administration costs, as compared to loan liquidation.
- Banks with high funding levels can take advantage of other banks’ lower cost balance sheets through such TR swaps. This facilitates diversification of the user’s asset portfolio as well.
- The maturity of a TR Swap does not have to match the maturity of the underlying asset. Therefore, the protection seller in a swap with maturity less than that of the underlying asset may benefit from the ‘positive carry’ associated with being able to roll forward short-term synthetic financing of a longer-term investment. The protection buyer (TR payer) may benefit from being able to purchase protection for a limited period without having to liquidate the asset permanently. At the maturity of a TR Swap whose term is less than that of the reference asset, the protection seller has the option to reinvest in that asset (by continuing to own it) or to sell it at the market price.
- Other applications of TR Swaps include making new asset classes accessible to investors for whom administrative complexity or lending group restrictions imposed by borrowers have traditionally presented barriers to entry. Recently, insurance companies and levered fund managers have made use of TR Swaps to access bank loan markets.
- Credit default swap (CDS): The CDS provides protection against specific credit-related events and, hence, bears more resemblance to a financial bank guarantee or a standby letter of credit, than to a ‘swap’. Under this agreement, the protection buyer (Bank A in our earlier example) pays the protection seller (Bank B) only a fixed periodic amount over the life of the agreement.
Figure 8.9 illustrates the mechanics of a CDS. The following chapter provides an overview of the mechanics of pricing and trading in the CDS.
The steps in which a basic CDS proceeds are as follows:
- Bank A agrees to pay a fee to Bank B for being guarantor or protection seller. The fee amounts to a specified number of basis points on the value of the reference asset (the loan made by Bank A).
- Bank B agrees to pay a pre-determined, market value based amount (usually a percentage of the value of the reference asset) in the event of credit default. The ‘event of default’ is rigorously defined in the contract—it could take the form of verifiable events such as bankruptcy, payment default or can amount to a specific amount of loss sustained by the protection seeker due to the credit (‘materiality threshold’). Bank B is not required to make any payment unless there is a default within the period of the swap.
- The amount to be paid by Bank B, post-default, will be defined in the contract. This amount usually represents the difference between the reference asset’s initial principal and the actual market value of the defaulted reference asset. The amount is settled through the ‘cash settlement’ mechanism.28
To lower the cost of protection in a credit swap, contingent credit swaps are employed. Contingent credit swaps are hybrid credit derivatives which, in addition to the occurrence of a credit event, require an additional trigger. Such a trigger could typically be tied to the occurrence of a credit event with respect to another reference asset or a material movement in equity prices, commodity prices or interest rates. The credit protection provided by a contingent credit swap, being weaker, is cheaper than that provided under a regular credit swap.
- Credit risk options: These options provide the protection buyer a valuable hedge against interest rate risk, primarily arising out of a downgrade in a borrower’s credit rating. Consider this example. When Bank A entered into a loan agreement with firm XYZ, the firm had an investment grade rating and the loan price was fixed accordingly on floating terms. However, in a year’s time, firm XYZ witnessed a slide in its credit rating, due to various factors. This implies that Bank A will have to raise the risk premium and run the risk of default by XYZ or retain the contracted rate and take on higher risk. The third option available to Bank A is to enter into a contract with Bank B, the protection seller. Bank B writes a simple European option with a fixed maturity, agreeing to compensate Bank A for the decline in credit quality due to the lower credit rating of XYZ.
Credit options can also be put or call options on the price of either a floating rate note bond or loan. In this case, the credit put (or call) option grants the option buyer the right, but not the obligation, to sell to (or buy from) the option seller a specified floating rate reference asset at a pre-specified price (the ‘strike price’). Settlement may be on a cash or physical basis.
The other settlement method is for the protection buyer to make physical delivery of a portfolio of specified deliverable obligations in return for payment of their face amount. Deliverable obligations may be the reference obligation or one of a broad class of obligations meeting certain specifications, such as any senior unsecured claim against the reference entity.
- Credit intermediation swap: In a credit intermediation swap, one creditworthy bank serves as an intermediary between two smaller banks to alleviate credit concerns in the swap transaction. For example, let us assume two small regional banks are keen on entering into a swap contract with each other. Both of them do not have much market presence or credibility and are not convinced of each other’s capability of honouring the respective commitments under the swap. The two small banks, therefore, invite a large prime bank with national/international presence to guarantee the swap. The two smaller banks can either pay to the large bank at floating rate and receive fixed rate in return or pay at fixed rate and receive floating rate. The difference between the rates received and paid forms the income for the large bank for accepting the credit risk of the two smaller banks.
- Dynamic credit swap: An important innovation in credit derivatives is the dynamic credit swap. The protection buyer pays a fixed fee, either up front or periodically, which once set does not vary with the size of the protection provided. The protection buyer will only incur default losses if the swap counter party and the protection seller fail. This dual credit effect means that the credit quality of the protection buyer’s position is at a level better than the quality of either of its individual counter parties. Also, assuming uncorrelated counter parties, the probability of a joint default is small.
Foreign currency denominated exposure may also be hedged using a dynamic credit swap where a creditor is owed an amount denominated in a foreign currency. This is analogous to the credit exposure in a cross-currency swap.
- Credit spread derivatives: Credit spread is the difference between the interest rates of risk-free government securities and risky debt29 in the market. Let us assume that interest rates move consistently with the market. That is, a one per cent change in government securities rate leads to a similar change in the debt market. If this is so, any difference between the two rates could be attributed to credit risk for the risky debt. Derivatives written on this spread are credit spread options/forwards/swaps.
For example, a ‘credit spread call’ is a call option on credit spreads. If the spread increases, the value of the call increases and pays off if the credit spread at maturity exceeds the strike price of the call option.
The ‘asset swap package’ consists of a credit-risky instrument (with any payment characteristics) and a corresponding derivative contract. The contract exchanges the cash flows of the credit-risky instrument for a floating rate cash flow stream.30 Credit options may be American, European or multi-European. Their structure may transfer default risk or credit spread risk or both.
Credit options have found favour with investors and banks for the following reasons:
- Institutional investors see credit options as a means of increasing yields, especially when credit spreads are thin and they find themselves underinvested. These investors prefer to bear the risk of owning (in a put option) or losing (in a call option) an asset at a predetermined price in future and collect current income commensurate with the risk taken.
- Banks, with their highly leveraged balance sheets, prefer credit options since they are off-balance sheet. Further, the credit options and credit swaps are structured to trigger payments upon the happening of a specific event, which help in mitigating credit exposure risk.
- Such options are also attractive for portfolios that are forced to sell deteriorating assets. Options are structured to reduce the risk of forced sales at distressed prices and consequently enable the portfolio manager to own assets of marginal credit quality at lower risk. Where the cost of such protection is less than the benefit in terms of increased yield from weaker credits, a distinct improvement in portfolio risk-adjusted returns can be achieved.
- Borrowers also find options useful for locking in future borrowing costs without impacting their balance sheets. Prior to the advent of credit derivatives, borrowers had to issue debt immediately, even if they had no requirement for the entire amount of debt all at once. The unutilized debt could be invested in other liquid assets, till the requirement for funds came up. This had the adverse effect of inflating the current balance sheet and exposing the issuer to reinvestment risk and often, negative carry.31 Today, issuers can enter into credit options on their own name and lock in future borrowing costs with certainty.
- Credit linked notes (CLN): This is a funded credit derivative where the protection buyer requires the protection seller to make upfront payments. In return, the protection buyer issues a note called ‘CLN’. The CLN is largely similar to any other bond or note. The simplest form of a CLN is represented by a standard note with an embedded CDS. These are typically issued by a trust or SPE. The steps in issuing CLNs are as follows:
- The bank seeking to issue CLNs (Bank A) sets up an SPE, in the form of a ‘trust’. The CLNs are intended to protect Bank A in the event the borrower firm XYZ is unable to repay its debt to the bank.
- Investors or other banks (say, Bank B) buy into these trusts and receive a CLN for a fixed period, say, 3 years.
- The trust offers a steady stream of fixed payments to Bank B over the 3-year period. These payments constitute interest plus a risk premium. The total return on the notes is linked to the market value of the underlying pool of debt securities.
- Bank A invests the funds received from Bank B in relatively risk-free securities, including highly rated corporate bonds.
- If, during the 3-year period of the CLN, firm XYZ keeps up regular payments to Bank A, it returns the investment made by Bank B.
- If firm XYZ defaults in payment, Bank A compensates its possible loss by liquidating the risk-free security investments. Bank B receives firm XYZ’s debt, which could have turned unsecured or worthless.
Issuers find CLNs attractive, because the ‘risk’ attached to a particular borrower is hedged and, therefore, the immediate need for more regulatory capital is avoided. The investing banks find CLNs attractive, because they are able to find a pool of leveraged securities, which could give them good income.
CLNs are used in several ways in practice. Four typical situations32 are presented as follows:
- Bank A has credit exposure to a firm S in a specific industry/sector. Institution C, an institutional investor, cannot, by policy or regulation, gain direct exposure to the industry that S is in, but is interested in reaping the benefits of such exposure. C therefore enters into a CLN contract with Bank A, by which A sells a note to C with underlying exposure equal to the face value of the reference asset S. In return, A receives from C, at the beginning of the contract, the face value of S in cash. In compensation, A pays to C a predetermined interest and some credit risk premium. In case of a credit event experienced by S during the contract period, A pays C the recovery proceeds of S. If the recovery value of S is less than what C paid for the asset, C suffers a loss. In case there is no credit event during the contract period, Bank A pays back to institution C the entire principal.
- The situation above is also applicable to any investor who wants to sell protection to Bank A through a CDS, but is unable to or does not want to access the credit derivatives market.
- Another common way to use a CLN is in buying protection. Bank A in the example above, the originator of the reference asset S, could buy protection from Bank B through a CLN, where A gets the value of the reference asset upfront (and pays interest and premium to the protection seller B). In a second case, Bank B could have sold protection through a CDS to A. Bank B now wants to guard itself against counter party risk, hence initiates a CLN contract with institution C or another Bank D. If the reference asset defaults, Bank A gets compensated as in example (a) above and Bank B makes the contingent payment on the default swap, which has already been compensated by the CLN. Thus, the CLN functions like insurance in both cases.
- Special purpose entities (SPEs) or trusts set up in the context of the CLN (as shown in Figure 8.10) are prevalently used in the case of synthetic CDOs (to be discussed in the next chapter).
- Credit linked deposits/credit linked certificates of deposit: Credit linked deposits (CLDs) are structured deposits with embedded default swaps. Conceptually, they can be thought of as deposits along with a default swap that the investor sells to the deposit taker. The default contingency can be based on a variety of underlying assets, including a specific corporate loan or security, a portfolio of loans or securities or sovereign debt instruments or even a portfolio of contracts which give rise to credit exposure. If necessary, the structure can include an interest rate or foreign exchange swap to create cash flows required by investors. In effect, the depositor is selling protection on the reference obligation and earning a premium in the form of a yield spread over plain deposits. If a credit event occurs during the tenure of the CLD, the deposit is paid and the investor would get the deliverable obligation instead of the deposit amount. Figure 8.11 shows the structure of a simple CLD.
- Repackaged notes: Repackaging involves placing securities and derivatives in a SPV which then issues customized notes that are backed by the instruments placed. The difference between repackaged notes and CLDs is that while CLDs are default swaps embedded in deposits/notes, repackaged notes are issued against collateral—which typically would include cash collateral (bonds/loans/cash) and derivative contracts. Another feature of repackaged notes is that any issue by the SPV has recourse only to the collateral of that issue (Figure 8.12).
FIGURE 8.10 THE STRUCTURE OF A CLNSource: The J.P. Morgan Guide to Credit Derivatives, 25.Source: RBI, ‘Draft Guidelines for Introduction of Credit Derivatives in India’, Figure 4 (26 March 2003): 9.
FIGURE 8.12 TRANSACTIONS UNDER A REPACKAGED NOTESource: RBI, ‘Draft Guidelines for Introduction of Credit Derivatives in India’, Figure 5 (26 March 2003): 10.
- Basket default swap: A credit derivative may be with reference to a single reference asset or a portfolio of reference assets. Accordingly, it is termed a single credit derivative or a portfolio credit derivative. In a portfolio derivative, the protection seller is exposed to the risk of one or more components of the portfolio (to the extent of the notional value of the transaction).
A variant of a portfolio trade is a basket default swap. In this type of swap, there would be a bunch of assets, usually homogeneous. Let us assume that the swap is for the first to default in the basket. The protection seller sells protection on the whole basket, but once there is one default in the basket, the transaction is settled and closed. If the assets in the basket are uncorrelated, this allows the protection seller to leverage himself—his losses are limited to only one default but he actually takes exposure on all the names in the basket. And for the protection buyer, assuming the probability of the second default in a basket is quite low, he actually buys protection for the entire basket but paying a price which is much lower than the sum of individual prices in the basket.
Likewise, there might be a second-to-default or nth to default basket swaps. Box 8.4 sets out the operational requirements for credit derivatives as envisaged by the Basel Committee on Banking Supervision.33
BOX 8.4 OPERATIONAL REQUIREMENTS FOR CREDIT DERIVATIVES
- The credit events specified by the contracting parties must at a minimum include:
- a failure to pay the amounts due according to reference asset specified in the contract,
- a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals,
- a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates and
- a change in the ranking in the priority of payment of any obligation, causing the subordination of such obligation.
- Contracts allowing for cash settlement are recognized for capital purposes provided a robust valuation process is in place in order to estimate loss reliably. Further, there must be a clearly specified period for obtaining post-credit-event valuations of the reference asset, typically not more than 30 days.
- The credit protection must be legally enforceable in all relevant jurisdictions.
- Default events must be triggered by any material event, e.g., failure to make payment over a certain period or filing for bankruptcy or protection from creditors.
- The grace period in the credit derivative contract must not be longer than the grace period agreed upon under the loan agreement.
- The protection purchaser must have the right/ability to transfer the underlying exposure to protection provider, if required for settlement.
- The identity of the parties responsible for determining whether a credit event has occurred must be clearly defined. This determination must not be the sole responsibility of the protection seller. The protection buyer must have the right/ability to inform the protection provider of the occurrence of a credit event.
- Where there is an asset mismatch34 between the exposure and the reference asset, then:
- the reference and underlying assets must be issued by the same obligor (i.e., the same legal entity) and
- the reference asset must rank pari passu or more junior than the underlying asset and legally effective cross-reference clauses (e.g., cross-default or cross-acceleration clauses) must apply.
- Where a bank buying credit protection through a total return swap records the net payments received on the swap as net income, but does not record offsetting deterioration in the value of the asset that is protected (either through reductions in fair value or by an addition to reserves) the credit protection will not be recognized.
- CLN issued by the bank will be treated as cash collateralized transactions.
- Credit protection given by the following will be recognized.
- Sovereign entities, PSEs and banks with a lower risk weight than the obligor.
- Corporates (including insurance companies) including parental guarantees rated A or better.
TREATMENT Of CREDIT RISK IN INDIA—SOME IMPORTANT EXPOSURE NORMS, PRUDENTIAL NORMS fOR ASSET CLASSIfICATION, INCOME RECOGNITION AND PROVISIONING
Some Important Exposure Norms35
In the earlier section, we have learnt that central banks try to limit credit risk concentration in their banking system by limiting exposure to certain sectors or activities.
Exposure is defined as including credit exposure (funded and non-funded credit limits) and investment exposure (including underwriting and similar commitments) as well as certain types of investments in companies. Exposure is taken to be the higher of sanctioned limits or outstanding advances. In the case of term loans that have been fully drawn up to the sanctioned limit, the outstanding will be considered the ‘exposure’.
Computing the credit exposure of derivative products (most of these would be denoted as ‘contingent liabilities’ on banks’ balance sheets) such as interest rate and foreign exchange derivative transactions, and gold, will have to be done using the ‘Current exposure method’. Netting of mark to market (MTM) values arising on these transactions is not permitted by RBI. Therefore, the gross positive MTM value of such contracts should be considered both for exposure and capital adequacy calculations (Capital adequacy is discussed in detail in the chapter ‘Capital- risk, regulation and adequacy’). In simple terms, the credit exposure equivalent of an off balance sheet transaction using the current exposure method is equal to Current credit exposure + future potential credit exposure of the contracts supporting the off balance sheet transactions.
‘Current credit exposure’ is the sum of positive MTM values of the contracts. It is therefore obvious that these values require periodical recalculation.
‘Potential future credit exposure’ is determined by multiplying the notional principal amount of each of these contracts( irrespective of whether the contract has a zero, positive or negative mark-to-market value) by the relevant add-on factor indicated in the quoted circular (page 5) according to the nature and residual maturity of the instrument.
Credit exposure comprises of the following:
- All types of funded and non-funded credit limits.
- Facilities extended by way of equipment leasing, hire purchase finance and factoring services. Under ‘credit exposure’, detailed guidelines are issued for industry/sector exposures, capital markets, financing equity and investment in shares including Initial Public Offerings and various other activities.
Investment exposure comprises of the following:
- Investments in shares and debentures of companies.
- Investment in PSU bonds.
- Investments in commercial papers (CPs).
- The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, provides, among others, sale of financial assets by banks/FIs to securitization companies (SCs)/reconstruction companies (RCs). Banks’/FIs’ investments in debentures/bonds/security receipts/pass-through certificates (PTCs) issued by a securitization company (SC)/reconstruction company (RC) as compensation consequent upon sale of financial assets will constitute exposure on the SC/RC. In view of the extraordinary nature of event, banks/FIs will be allowed, in the initial years, to exceed prudential exposure ceiling on a case-to-case basis.
- Investments made in bonds/debentures of companies guaranteed by public financial institutions as given in the cited circular. Guarantees issued by the Public Financial Institutions (PFI) to corporate bonds are also treated as ‘exposure’ to the PFI.
The concept of ‘group’ and the identification of borrowers belonging to a specific ‘group’ are to be based on the perception of the bank. The guiding principles should however be commonality of management and effective control. The RBI has specifically warned banks against splits in ‘groups’ being engineered to circumvent the exposure norms.
The salient features of the ‘exposure norms’ proposed by the RBI are given as follows:
- The exposure ceiling limits applicable from 1 April 2002, computed based on the capital funds in India36 would be 15 per cent of capital funds (tier 1 + tier 2) in case of single borrower and 40 per cent in the case of a borrower group. However, in case of specified oil companies, the exposure limit to a single borrower can be 25 per cent of capital funds.
- Credit exposure to a borrower group can exceed the exposure norm of 40 per cent of the bank’s capital funds by an additional 10 per cent (up to 50 per cent), if the additional credit exposure is to infrastructure projects. Similarly, exposure to a single borrower may exceed the norm of 15 per cent by 5 per cent (up to 20 per cent) if the additional credit exposure is to the infrastructure sector. (Definition of Infrastructure lending is provided in RBI Master Circular titled “Loans and Advances - Statutory and other Obligations, dated July 1, 2015).
- In addition to the above exposures, banks may enhance exposure to a borrower up to a further 5 per cent of capital funds in exceptional circumstances, with the approval of their Board of Directors.
- The exposures should be disclosed in the banks’ financial statements under ‘Notes on Accounts’.
- Exposures to NBFC and NBFC-AFC are capped at 10 per cent and 15 per cent respectively. However, relaxation may be considered if the NBFC uses the funds for lending to infrastructure sector.
- Exemptions to the above exposure norms can be made in the case of (a) rehabilitation of sick/weak industrial units, (b) Food credit (allocated directly by the RBI), (c) advances fully guaranteed by the Government of India, (d) banks’ exposure to the National Bank for Agriculture and Rural Development (NABARD), and (e) advances granted against the security of the banks’ own term deposits, on which the banks hold specific lien.
- Exposure norms for specific sectors have also been outlined by the RBI in the cited circular, which can be accessed at www.rbi.org.in.
Large Exposures Framework (LEF)
In addition to the Exposure Norms, credit concentration risk is being addressed through the Large Exposures Framework of the RBI, published in December 2016 (https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT16764BDC7CFD0614DBEA69F25E238919000.PDF).
The framework is closely aligned to the standards proposed by the Basel Committee in Supervisory framework for measuring and controlling large exposures, published in April 2014, (http://www.bis.org/publ/bcbs283.pdf). The salient features of this framework are given in Annexure I.
Under the LEF, the sum of all exposure values of a bank (measured as specified in paragraphs 7, 8, 9 and 10 of the framework) to a counterparty or a group of connected counterparties (as defined in paragraph 6 of the framework) is defined as a ‘Large Exposure(LE)’, if it is equal to or above 10 percent of the bank’s eligible capital base (i.e., Tier 1 capital as specified in Basel III).
The following exposures would also be reported to RBI:
- All other exposures, measured as specified in paragraphs 7, 8, 9 and 10 of the framework without the effect of credit risk mitigation (CRM), with values equal to or above 10 percent of the bank’s eligible capital base.
- All the exempted exposures (except intraday inter-bank exposures) with values equal to or above 10 percent of the bank’s eligible capital base.
- The 20 largest exposures included in the scope of application, irrespective of the values of these exposures relative to the bank’s eligible capital base.
The framework limits the sum of all the exposure values of a bank to a single counterparty to 20 percent of the bank’s available eligible capital base at all times. In exceptional cases, Board of banks may allow an additional 5 percent exposure of the bank’s available eligible capital base. For a group of connected counterparties (as defined in paragraph 6 of the Framework), the sum of all the exposure values of a bank must not be higher than 25 percent of the bank’s available eligible capital base at all times. The ‘eligible capital base’ is the effective amount of Tier 1 capital, as required by Basel III regulations in India.
Exposure ceilings are applicable for certain categories of counterparties. For example, Banks’ exposures to a single NBFC will be restricted to 15 percent of their eligible capital base, and 25% to a group of connected NBFCs. The limit applied to a Global-Systemically Important Bank’s (G-SIB) exposure to another G-SIB is set at 15 percent of the eligible capital base. The limit applies to G-SIBs as identified by the Basel Committee and published annually by the Financial Stability Board.
The implementation of the framework will have to be completed by April 1, 2019.
Prudential Norms for Asset Classification, Income Recognition and Provisioning37
To correspond with the classification of loans discussed in Section I, RBI instructs all banks in India to classify assets under specific categories. ‘Non-performing’ assets (NPAs) are the broad equivalent of ‘impaired’ assets discussed in Section I. The RBI has provided detailed guidelines for asset classification, the salient features of which are presented below.
What are NPAs? An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank. An NPA is a loan or an advance where
- Interest and/or installment of principal remain ‘overdue’38 for a period of more than 90 days in respect of a term loan.
- The account remains ‘out of order’39 in respect of an overdraft/cash credit (OD/CC).
- The bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted.
- A loan granted for short duration crops will be treated as NPA, if the installment of principal or interest thereon remains overdue for two crop seasons.
- A loan granted for long duration crops will be treated as NPA, if the installment of principal or interest thereon remains overdue for one crop season.
- The amount of liquidity facility40 remains outstanding for more than 90 days, in respect of a securitization transaction (undertaken in terms of guidelines on securitization dated 1 February 2006.)
- Derivative contracts, whose overdue receivables represent positive mark to market value, remain unpaid for 90 days from the due date for payment.
Additionally, banks should, classify an account as NPA only if the interest charged during any quarter is not serviced fully within 90 days from the end of the quarter.
Income Recognition—Policy The policy for income recognition has to be objective and based on the record of recovery. In line with international best practices, income from NPAs is not to be recognized on accrual basis but is booked as income only when it is actually received. Therefore, banks should not charge and take to income account interest on any NPA,41 including government guaranteed (advance).
Reversal of Income If any advance, including bills purchased and discounted becomes an ‘NPA’ as at close of any year, the unrealized interest accrued and credited to income account in the past periods should be reversed. This will apply to government guaranteed accounts also. Similarly, uncollected fees, commission and other income that have accrued in the NPAs during past periods should be reversed.
Leased Assets The unrealized finance charge component of finance income42 on the leased asset, accrued and credited to income account before the asset became non-performing, should be reversed or provided for in the current accounting period.
Appropriation of Recovery in NPAs Interest realized on NPAs may be taken to income account provided the credits in the accounts towards interest are not out of fresh/additional credit facilities sanctioned to the borrower.
Categories of NPAs Banks in India are required to classify NPAs into the following three categories based on (a) the period for which the asset has remained non-performing and (b) the realizability of the dues.
- Sub-standard assets
- Doubtful assets
- Loss assets
Sub-standard assets: With effect from 31 March 2005, a sub-standard asset would be one, which has remained NPA for a period less than or equal to 12 months. The following features are exhibited by sub-standard assets: the current net worth of the borrower/guarantor or the current market value of the security charged is not enough to ensure recovery of the dues to the banks in full and the asset has well-defined credit weaknesses that jeopardize the liquidation of the debt and are characterized by the distinct possibility that the banks will sustain some loss, if deficiencies are not corrected.
Doubtful assets: With effect from 31 March 2005, an asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12 months.
A loan classified as doubtful has all the weaknesses inherent in assets that were classified as sub-standard, with the added characteristic that the weaknesses make collection or liquidation in full—on the basis of currently known facts, conditions and values—highly questionable and improbable.
Loss assets: A loss asset is one which is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted—although there may be some salvage or recovery value. Also, these assets would have been identified as ‘loss assets’ by the bank or internal or external auditors or the RBI inspection, but the amount would not have been written off wholly.
Treatment of some special situations is outlined in Box 8.5. The list is illustrative.
BOX 8.5 HOW DO WE TREAT THE FOLLOWING UNDER THE ASSET CLASSIFICATION NORMS?
Some assets display operational deficiencies such as inadequate drawing power; non-submission of stock statements, non-renewal of limits on due date or excess drawings over the limit. When should banks classify accounts exhibiting these characteristics as NPAs?
- When the outstanding in the account is based on stock statements more than 3 months old.
- If such irregular drawings are permitted in the account for 90 days continuously, even though the firm is functioning or the borrower’s financial health is satisfactory.
- When an account enjoying regular or ad hoc credit limits has not been reviewed/renewed within 180 days from the due date/date of ad hoc sanction.
In such cases, if arrears of interest and principal are paid by the borrower subsequently, the account may be upgraded to ‘standard’43 category.
Accounts regularized near about the balance sheet date
Where a solitary or a few credits are recorded just before the balance sheet date in a borrowal account and the account exhibits inherent credit weaknesses based on the current available data, it should be classified an NPA.
Asset classification to be borrower-wise and not facility-wise
Even if one credit facility among many such credit facilities granted to a borrower is to be treated as NPA, the entire borrowing account has to be classified as NPA.
Advances under consortium arrangements
Asset classification of accounts under consortium should be based on the record of recovery of the individual member banks and other aspects having a bearing on the recoverability of the advances.
Accounts where there is erosion in the value of security/frauds committed by borrowers
In such cases of serious credit impairment, it will not be prudent to put these accounts through various stages of asset classification and the asset should be straightaway classified as a doubtful or loss asset as appropriate.
- Erosion in the value of security can be reckoned as significant when the realizable value of the security is less than 50 per cent of the value assessed by the bank or accepted by the RBI at the time of last inspection. Such NPAs may be straightaway classified under doubtful category and provisioning should be made as applicable to doubtful assets.
- If the realizable value of the security, as assessed by the bank/the RBI is less than 10 per cent of the outstanding in the borrowal account, the existence of security should be ignored and the asset should be straightaway classified as a loss asset. It may be either written off or fully provided for by the bank.
Advances against term deposits, National Savings Certificates (NSCs), Kisan Vikas Patra (KVP)/Indira Vikas Patra (IVP) Advances against term deposits, NSCs eligible for surrender; IVPs, KVPs and life policies need not be treated as NPAs. However, advances against gold ornaments, government securities and all other securities are not covered by this exemption.
Loans with moratorium for payment of interest
- In cases where the loan agreement incorporates a moratorium for payment of interest, such interest becomes ‘due’ only after completion of the moratorium or gestation period. Therefore, interest does not become overdue and hence is not termed an NPA during the moratorium period. However, the advance becomes overdue if interest remains uncollected after the specified due date.
- In the case of housing loan or similar advances granted to staff members where interest is payable after recovery of principal, interest need not be considered as overdue from the first quarter onwards. Such loans/advances should be classified as an NPA only when there is a default in repayment of principal installment or payment of interest on the specified due dates.
Agricultural advances (some salient features)
- A loan granted for short duration crops (with crop season less than 1 year) will be treated as an NPA, if the installment of principal or interest thereon remains overdue for two crop seasons.
- A loan granted for long duration crops (those with crop season longer than 1 year) will be treated as an NPA, if the installment of principal or interest thereon remains overdue for one crop season (period up to harvesting of the crop).
- Where natural calamities impair the repaying capacity of agricultural borrowers, banks may decide on appropriate relief measures—conversion of the short-term production loan into a term loan; or rescheduling repayment or sanctioning a fresh short-term loan (subject to RBI directives).
- In such cases of conversion or re-schedulement, the term loan as well as fresh short-term loan may be treated as current dues and need not be classified as NPA.
Overdue credit facilities backed by central government guarantee may be treated as an NPA only if the government repudiates its guarantee when invoked. However, in respect of state government guaranteed exposures, with effect from the year ending 31 March 2006, state government-guaranteed advances and investments in state government guaranteed securities would attract asset classification and provisioning norms if interest and/or principal or any other amount due to the bank remains overdue for more than 90 days.
Adequate provisions have to be made for impaired loans or ‘NPA’, classified as given in the foregoing paragraphs. Taking into account the time lag between an account becoming doubtful of recovery, its recognition as an impaired loan, the realization of the security charged to the bank and the likely erosion over time in the value of this security, banks should classify impaired loans into ‘sub-standard’, ‘doubtful’ and ‘loss’ assets and make provisions against these.
Loss assets should be written off or 100 per cent provided for.
- Provision of 100 per cent to the extent the advance is not covered by the realizable value of the security (to which the bank has a valid recourse).
- That portion of the advances covered by realizable value of the security will be provided for at rates ranging from 25 per cent to 100 per cent on the following basis:
|Period for which the advance has remained in ‘doubtful’ category||Provision requirement (per cent) (for the secured portion)|
|Up to 1 year||25|
|1 to 3 years||40|
|More than 3 years||100|
Sub-standard Assets A general provision of 15 per cent on total outstanding should be made (without making any allowance for ECGC guarantee cover and securities available). The ‘unsecured exposures’ identified as ‘sub-standard’ would attract additional provision of 10 per cent thus constituting 25 per cent on the outstanding balance. However, where banks have proposed additional safeguards such as escrow accounts for debt service in the case of lending to infrastructure projects, provisions on infrastructure loans classified as ‘sub standard’ will be at 20 per cent (and not 25 per cent applicable to other loans). The precondition for lower provisioning would be that banks have put in place an appropriate mechanism to escrow the cash flows and also hold a clear and valid legal claim on these cash flows.
What is an ‘Unsecured’ Exposure? RBI defines an ‘unsecured’ exposure as one where the realisable value of the security, as assessed by the bank/approved valuers/Reserve Bank’s inspecting officers, is not more than 10 percent, of the outstanding exposure. ‘Exposure’ shall include all funded and non-funded exposures (including underwriting and similar commitments). ‘Security’ will mean tangible security properly discharged to the bank and will not include intangible securities like guarantees (including State government guarantees), comfort letters etc.
Standard Assets Under the existing norms, banks should make a general provision of a minimum of 0.25 per cent—1 per cent on standard assets on global loan portfolio basis. Within this framework, standard assets in specific sectors would attract lower or higher provisions. For example, provisions on loans to agriculture and SME sectors would be at 0.25 per cent. (For more details, the RBI’s ongoing instructions in this regard would be a good source. It may be noted that by revising the standard asset provisioning upward or downward, RBI, in effect, signals to banks on the risk involved in financing the relevant sectors). Advances to commercial real estate sector would attract a provision of 1 per cent, indicating that standard assets in this sector have higher risk, due to market volatility.
However, these provisions need not be included for arriving at net NPAs and will be presented as ‘Contingent Provisions against Standard Assets’ under ‘Other Liabilities and Provisions—Others’ in Schedule 5 of the balance sheet.
Floating Provisions44 Internal policies approved by the Banks’ Board would determine the level of floating provisions. Such provisions will have to be separately held for ‘advances’ and ‘investments’ and would be used only under ‘extraordinary circumstances’, as dictated in the policy and after approval from RBI.
To facilitate banks’ Boards to evolve suitable policies in this regard, RBI has clarified that the ‘extra-ordinary circumstances’ refer to losses which do not arise in the normal course of business, and are exceptional and nonrecurring in nature. According to RBI, these extra-ordinary circumstances could broadly fall under three categories viz. General, Market and Credit. Under general category, there can be situations where bank faces unexpected loss due to events such as civil unrest or collapse of currency in a country. Natural calamities and pandemics may also be included in the general category. Market category would include events such as a general melt down in the markets, which affects the entire financial system. Among the credit category, only exceptional credit losses would be considered as an extra-ordinary circumstance. For instance, expenses and other charges incurred by banks due to implementation of the Agricultural debt waiver and debt relief scheme, 2008, (announced by the Central Government, which exempted many farmers from repaying loans) would have to be set off against floating provisions.
Disclosures on floating provisions would be found in the ‘notes on accounts’ to the balance sheet as (a) opening balance in the floating provisions account, (b) the quantum of floating provisions made in the accounting year, (c) purpose and amount of draw down made during the accounting year, and (d) closing balance in the floating provisions account.
Banks can also make additional provisions over and above the provisioning rate mentioned for NPAs with Board approval, where the excess provisioning is deemed appropriate. However, the policy has to be clearly spelt out and show consistency over the years.
“Accelerated “ provisions
In some cases, banks do not report the SMA status of borrowers to CRILC, or deliberately conceal the actual status of the account, or evergreen the account. Such borrowers’ accounts will be brought under accelerated provisioning (apart from other penal action by RBI).
There are also instances where, after having agreed to the restructuring decision by the JLF, one of the lenders backtracks or delays or refuses to implement the restructuring package.
Such lenders will be asked to follow accelerated provisioning.
More such instances inviting accelerating provisioning are described in RBI Master Circular on Prudential Norms for Asset Classification, Income Recognition and Provisioning, dated July 1, 2015, under para 31.
Such penal measures would impact the bank’s profitability as well as public image.
The current provisioning requirement and the revised accelerated provisioning in respect of such non performing accounts are shown below:
Writing-Off NPAs Provisions made for NPAs are not eligible for tax deductions. However, tax benefits can be claimed for writing off advances.
Illustration 8.1 demonstrates the impact of provisioning and write-off on banks’ profits.
Profit before provisions for Bank Y is ₹500 crores. If the tax rate is 30 per cent, what will be the impact of the following actions on Bank Y’s: (a) profits, and (b) capital base?
- Make a provision of ₹250 crores for NPAs.
- Provide ₹200 crores for NPAs and write-off the remaining ₹50 crores.
Option 1. Provide ₹250 crores for NPAs.
|Profit before provision||₹500 crores|
|Less provision for NPAs||₹250 crores|
|Less tax at 30 per cent||₹150 crores (since provision for NPAs is not tax deductible, tax calculated at 30 per cent of ₹500 crores.)|
* NBV = Book value LESS provisions held.
|Profit after tax||₹100 crores|
Option 2: Provide ₹200 crores for NPAs and write off ₹50 crores.
|Profit before provision||₹500 crores|
|Less provision for NPAs||₹200 crores|
|Less write-off||₹50 crores|
|Less tax @ 30 per cent||₹135 crores (since write-offs are tax deductible, tax to be calculated on PBT + provisions = ₹450 crores)|
|Profit after tax||₹115 crores|
Option 2 yields more profits after tax and hence would augment the capital base more than Option 1.
Calculation of NPA levels for reporting to RBI—see Box 8.6
BOX 8.6 CALCULATING NPA LEVELS – THE REPORTING FORMAT
|Sl. No.||Description||(To be reported in ₹ crore up to two decimals)
|3||Gross Advances ** (1 + 2)|
|4||Gross NPAs as per cent of Gross advances (2/3)|
(i) Provisions held in the case of NPA Accounts as per asset classification (including additional Provisions for NPAs at higher than prescribed rates).
(ii) DICGC / ECGC claims received and held pending adjustment
(iii) Part payment received and kept in Suspense Account or any other similar account
(iv) Balance in Sundries Account (Interest Capitalization - Restructured Accounts), in respect of NPA Accounts
(v) Floating Provisions***
(vi) Provisions in lieu of diminution in the fair value of restructured accounts classified as NPAs
(vii) Provisions in lieu of diminution in the fair value of restructured accounts classified as standard assets
|6||Net Advances [3 – 5(i + ii + iii + iv + v + vi + vii)]|
|7||Net NPAs [2 – 5(i + ii + iii + iv + v + vi)]|
|8||Net NPAs as per cent of Net advances (7/6)|
* Principal dues of NPAs plus Funded Interest Term Loan (FITL) where the corresponding contra credit is parked in Sundries Account (Interest Capitalization - Restructured Accounts), in respect of NPA Accounts.
** For the purpose of this Statement, ‘Gross Advances’ mean all outstanding loans and advances including advances for which refinance has been received but excluding rediscounted bills, and advances written off at Head Office level (Technical write off).
*** Floating Provisions would be deducted while calculating Net NPAs, to the extent, banks have exercised this option, over utilizing it towards Tier II capital.
The Provisioning Coverage Ratio (PCR)
The PCR is calculated as the ratio of Provisions (specific + floating) to Gross NPAs. The Gross NPA position for calculation of the ratio is the position as on September 30, 2010. The PCR indicates the funds available with a bank to cover loan losses. RBI stipulates that banks in India should hold a PCR of not less than 70 per cent.
The rationale for the PCR is that banks should build provisioning and capital buffers in good times, that is, when profits are healthy, so that the buffer can be used to absorb losses in a downturn. The buffer is called a ‘countercyclical provisioning buffer’ and has to be held till international norms in this respect are finalized.
TREATMENT Of CREDIT RISK IN INDIA—SECURITIZATION AND CREDIT DERIVATIVES
With effect from 23 April 2003, ‘The Securitization Companies and Reconstruction Companies (SC/RC) (Reserve Bank) Guidelines and Directions, 2003’ are operational in India. These guidelines and directions apply to SC/RC registered with the Reserve Bank of India under Section 3 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.
- Incorporation of SPVs, namely, securitization company and reconstruction company.
- Securitization of financial assets.
- Funding of securitization.
- Asset reconstruction.
- Enforcing security interest,i.e., taking over the assets given as security for the loan.
- Establishment of a central registry for regulating and registering securitization transactions: One objective of the Securitization Act is to provide for the enforcement of security interest, that is, taking possession of the assets given as security for the loan. Section 13 of the Securitization Act contains elaborate provisions for a lender (referred to as ‘secured creditor’) to take possession of the security given by the borrower.
- Offences and penalties.
- Boiler-plate provisions.
- Dilution of provisions of the SICA.45
- Banks can sell the following financial assets to the securitization company.
- An NPA, including a non-performing bond/debenture.
- A ‘Standard Asset’46 where
- the asset is under consortium/multiple banking arrangements
- at least 75 per cent by value of the asset is classified as NPA in the books of other banks/FIs and
- at least 75 per cent (by value) of the banks/FIs who are under the consortium/multiple banking arrangements agree to the sale of the asset to SC/RC.
- An asset reported as SMA-2 by the bank to CRILC (for details of these terms please refer to previous chapter).
The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SRFAESI Act) allows acquisition of financial assets by SC/RC from any bank/FI on mutually agreed terms and conditions. The salient features of the Act relevant to banks and those relating to securitization and reconstruction companies are described in various notifications of the RBI.47
The RBI published its Final Guidelines on securitization in May, 2012. The 2012 guidelines (https://rbidocs.rbi.org.in/rdocs/notification/PDFs/FIGUSE070512.pdf) contained important provisions that dealt with “Pass through certificates “(PTCs), Direct Assignment (DA), and also mentioned those securitization measures that were not permitted.
The guidelines comprehensively deal with securitization of a pool of “homogeneous assets” which share similar risk attributes and are “performing loans”. Non performing assets (NPA) securitization is addressed by a separate set of guidelines. The guidelines are not applicable to single loans, revolving credit facilities, assets purchased from other institutions, and loans that specify bullet repayment of principal and interest.
The requirement of a Minimum Holding Period (MHP) and Minimum Retention Requirement (MRR) is one of the highlights of the guidelines. MHP requires that originators have to hold the assets for a minimum period before securitizing them. MHP varies with the original maturity of the loan and its repayment frequency. The intent is to ensure that the bank does not originate and sell loans immediately, but retains the loans on the bank’s books to demonstrate repayment performance.
MRR is intended to ensure that originators continue to hold a stake in the securitized assets so as to protect investors’ interests. The first loss support should come from the originator and the equity tranche must be held by the originator at least upto MRR. The MRR will not remain constant over the term of the transaction, and will be amortised over the period.
Total investment by the originator in the securities issued cannot exceed 20% of the total securitized instruments issued.
The importance of securitization in dealing with credit risk and also creating a secondary market for illiquid loans on banks’ balance sheets has been recognised by other regulatory bodies such as the Securities Exchange Board of India (SEBI – the capital market regulator – www.sebi.gov.in), and the National Housing Bank (NHB – a wholly owned subsidiary of RBI, to regulate, supervise and provide financial support to housing finance companies –www.nhb.org.in).
The SEBI regulations can be accessed at http://www.sebi.gov.in/legal/regulations/may-2008/sebi-public-offer-and-listing-of-securitised-debt-instruments-regulations-2008-last-amended-on-march-6-2017-_34627.html.
The SEBI regulations deal with making a public offer or listing of the securitized debt instruments.
Residential Mortgage Based Securitization (RMBS) is regulated by the NHB, which played a key role in enabling securitization transactions gain popularity in the market within the existing regulatory framework.
One of the unique moves by the RBI is removing the distinction that the market currently enjoys between bilateral or direct assignments and securitizations, and laying down separate standards for securitization and direct assignments
The salient features of the guidelines on securitization and direct assignment are as given in RBI Master circular “Prudential norms on Income recognition, Asset classification and provisioning” dated July 1, 2015, have been summarized below
Salient Features of the Current Operational Guidelines on Securitization
- When a financial asset is sold by one bank to the SC/RC, it should have the effect of taking the asset off the selling bank’s books, ‘without recourse’ to the selling bank. This means that the entire credit risk is also transferred to the SC/RC.
- The Board of the selling bank should lay down policies and guidelines in respect of the following aspects of the asset sale, such as, identification of assets to be sold, the procedure for selling the identified assets, realisticvaluation of the identified assets and delegation of powers for deciding on selling the identified asset.
- After the sale of the identified asset to the SC/RC, the selling bank should not assume any operational, legal or other types of risks relating to the sold asset.
- Banks can decide to accept or reject the purchase price for the identified asset offered by the SC/RC. In the case of multiple banking arrangements/consortium lending, if 75 per cent of the banks in the arrangement decide to accept the offer, the remaining banks would be obligated to accept the offer as well. However, transfer of the asset cannot be made to the SC/RC at a ‘contingent’ price, since this would imply that in the event of a shortfall in realization by the SC/RC, the banks would have to bear a part of the shortfall.
- Banks can receive cash or bonds or debentures as sale consideration for the assets sold to the SC/RC. In case the sale consideration is by bonds/debentures, the selling bank would show these bonds/debentures as ‘investments’ in its books. Similarly, banks’ investments in security receipts, Pass through Certificates (PTC) or other bonds/debentures issued by an SC/RC would be shown under ‘investments’ in the banks’ books.
- If a bank sells an asset to the SC/RC at a price less than the Net Book Value (NBV—defined as book value less provisions held), the shortfall should be debited to the Income statement of the same year. If, on the other hand, the asset is sold for a value higher than the NBV, the excess provision will be kept aside to meet any shortfall or loss arising out of sale by the bank of other assets to SC/RC.
- A bank can invest in the security receipts or pass through certificates issued by the SC/RC arising out of sale of its own assets to the SC/RC. The sale will then be valued in the bank’s books as the lower of the redemption value of the security receipts/PTC, or the NBV of the asset sold.
- The securities issued by the SC/RC should contain the following features:
- The securities must be for a term of less than six years
- The securities must carry a rate of interest higher than the prevailing bank rate + 150 basis point
- The securities must be secured by a legally created charge on the assets being transferred/sold
- The securities must be repaid in full or in part if the underlying asset is sold by the SC/RC before maturity
- The commitment of the SC/RC to redeem the securities must be unconditional (not linked to realization of asset value)
- If the investor in the security receipts transfers ownership to a third party, the SC/RC should be kept informed
- The instruments (debentures/bonds) received by banks as sale consideration for financial assets sold to SC/RC, or those instruments issued by SC/RC in which banks have invested, will both be treated as ‘non SLR securities’. Hence the valuation and other norms will be applicable to these instruments as for non SLR securities. (We will be studying the valuation of non SLR securities in the chapter on ‘Market risk’)
- All securitization transactions have to be disclosed in the ‘Notes on Accounts’ in banks’ balance sheets.
- SC/RC can also act as agents for recovery for a fee, in the case of those assets that banks do not want to sell, but merely recover the outstanding advances. When the SC/RC acts as recovery agent, the assets under recovery will continue to be held in the banks’ books. The amounts recovered will be credited to the banks’ loan account, and therefore, appropriate provision for these assets will also be held by the banks themselves.
Sale of Assets by Banks not Involving SC/RC
Salient Features of Direct Assignment Guidelines of RBI
In Figure 8.7 presented in Section III of this chapter, we see a category of credit risk transfer instruments labelled ‘other instruments’, examples of which are loan sales or asset swaps.
Banks can sell off their loans/financial assets, especially their non performing assets, without involving a securitization process or an SC/RC, to other banks willing to buy the same, when an active secondary market for loans exists in the economy. In effect, loans and non performing assets are now being treated as liquid securities that can be valued and traded in the inter bank market.
RBI has issued guidelines to banks for sale and purchase of financial assets from one another. The players involved in the direct sale and purchase of loans in the secondary loan market would be banks, financial institutions and the non banking finance companies (NBFCs).
The eligible asset would be a financial asset, including assets under multiple or consortium banking arrangements, and would be a non performing advance or investment in the books of the selling bank The salient features of the guidelines on direct sale and purchase of non performing financial assets are given below.
- The bank intending to sell or purchase non performing financial assets direct from other financial institutions should have a Board approved policy in place. The policy should specify how to identify the assets to be purchased or sold, the procedure for such purchase or sale, valuation process for the assets based on estimated future cash flows from repayments and recovery prospects, decision making powers at each level of the bank, and the related accounting policies. The Board should also ensure that the bank has adequately skilled personnel, systems and procedures for risk mitigation are present to make the sale or purchase deals, so that the bank adds value to its financial health.
- For the purpose of selling non performing assets in the secondary market, the NPA should have remained as NPA in the books of the selling bank for at least two years. The bank that purchases the NPA (or NPFA–non performing financial asset) should hold the asset in its books for at least 15 months before selling it to other banks. The asset cannot be however sold back to the bank from which it was purchased.
- Banks selling non performing assets should compute the net present value (NPV) of the estimated cash flows associated with the realizable value of the securities available to support the asset, net of cost of realization. The estimated cash flows are typically expected to flow in within a three year period, with at least 10 per cent of the cash flow being realized in the first year, followed by 5 per cent in each of the following half years, with full recovery being achieved in three years. The net present value thus computed would be the floor of the sale price.
- The purchase or sale of non performing assets should be ‘without recourse’. This implies that the entire credit risk associated with the non performing assets should be transferred to the purchasing bank. For the selling bank, the asset should be taken off its books, with no residual liability or risk. This effectively means that credit enhancements or liquidity facilities (as in the case of securitization) would not be a part of these transactions. Banks are free to accept or reject offers based on the price being quoted for the asset. However, a sale to another bank cannot be made at a ‘contingent’ price, where, in the event of shortfall in realization by the purchasing bank, the selling bank would have to bear a portion of the shortfall.
- The sale of assets should be made only on ‘cash’ basis—the entire sale consideration should be received upfront and the asset be taken off the selling bank’s books.
- Selling or purchasing homogeneous pools of retail NPAs can be done on a portfolio basis, provided each of the NPAs in the pool has remained non performing for at least two years in the books of the selling bank. For the purchasing bank, the pool would be treated as a single asset.
- Though the assets being sold are non performing, the purchasing bank can classify them as ‘standard’ assets in its books for a period of 90 days from the purchase date. After this period, the classification of the asset will depend on the record of recovery in the books of the purchasing bank in accordance with the cash flows estimates while purchasing the asset. For example, any restructuring or rescheduling of the repayment schedule or the estimated cash flow of the non performing asset by the purchasing bank would render the account to be classified as non performing.
- Once a non performing financial asset is sold, the asset will be removed from the selling bank’s books. If the sale is at a price below the Net Book Value (NBV= book value less provisions held), the shortfall should be debited to the Income statement of that year. If the sales is for a value higher than the NBV, the excess provision will be retained and used to meet the shortfall or loss on account of sale of other non performing assets.
- Once the asset is included in the books of the purchasing bank, provision has to be made on the purchased asset appropriate to its asset classification status. The ‘exposure’ norms discussed earlier would be applicable to the addition of the non performing asset to the purchasing bank’s portfolio.
- Sale and purchase of non performing financial assets will have to be disclosed in the Notes on Accounts to the banks’ balance sheets.
All securitization transactions and reconstruction of financial assets and those relating to mortgage by deposit of title deeds to secure any loan or advances granted by banks and financial institutions, as defined under the SARFAESI Act, are to be registered in the Central Registry of Securitisation Asset Reconstruction and Security Interest of India (CERSAI).
Comparison of Guidelines—Securitization vs Direct Assignment
- Both require assignment of the assets to be sold, and both constitute true sale.
- Both ensure bankruptcy remoteness.
- Both can have multiple investors.
- Minimum Holding Period (MHP) is applicable to both.
- Both exhibit bankruptcy remoteness, though in slightly different ways.
- Investors are exposed to the underlying financial assets and their risks in both.
- Both are treated as off balance sheet transactions, subject to certain conditions.
The points where the operational guidelines are different are as follows:
- Securitization requires a special purpose vehicle to be created, while direct assignment does not need one.
- While multiple investors can participate in both, in the case of direct assignment, the multiple investors should also be the joint owners.
- In the case of securitization, investors purchase securities issued by the SPV, while in the case of direct assignment, investors purchase the underlying pool of assets.
- An important point of distinction is that credit enhancements are possible in securitization, while no credit enhancement is possible in a direct assignment.
- The securities are rated in their respective tranches in the case of securitization, while in direct assignment the investor buys a pool of loans, which may or may not be rated.
- Upfront cash payment is mandatory in direct assignment, while it is optional in securitization.
- Since the investors deal with purchase of financial assets in the case of direct assignment, due diligence has to be carried out by the investors themselves; in the case of securitization, the investors do not have recourse to the originator, and hence have to evaluate the cash flows from the securities issued by the SPV.
- Securitization guidelines stipulate a cap of 20 per cent on the extent of investment; there are no such restrictions in the case of direct assignment.
- In the investors’ books, the accounting would be done as for securities under securitization; but would be shown as ‘loans’ under direct assignment.
- Due to the above point, Mark to Market (MTM) requirements are applicable for securities issued under a securitization; MTM is not relevant for direct assignment.
- Under direct assignment capital is freed for the selling bank; while under securitization, the originating bank can be asked to give first loss support, in which case, regulatory capital has to be maintained.
- The pricing of loans in direct assignment can be negotiated and fixed between the purchasing and selling banks; in the case of securitization, the pricing of the securities depend on their rating.
- There are certain unresolved tax related issues in the case of securitization; there are no tax issues in the case of direct assignment since assets are directly bought and sold by banks.
It is evident from the above, that both securitization and direct assignment have benefits and disadvantages to investors and originators. However, direct assignments seem easier to operationalize.
Strengthening the securitization framework in India
During 2016, several measures were taken to strengthen the framework for resolving insolvency of borrowers and the resultant impact on banks’ financial health, and improving recovery of loans. Some of the important steps taken are:
- The Insolvency and Bankruptcy Code in respect of corporate entities, partnership firms and individuals (http://www.indiacode.nic.in/acts-in-pdf/2016/201631.pdf).
- Amendments to the SARFAESI Act 2002, and Amendments to the Recovery of Debts Due to Banks and Financial Institutions (RDDBFI) Act 1993 through passing of the Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Bill, 2016 (http://financialservices.gov.in/Banking/LAWS.pdf).
- On May 5, 2017, the Central government amended the Banking Regulation Act, 1949, through the Banking Regulation (amendment) Ordinance, 2017.
The above measures, taken together, have provided banks and the RBI with more powers to deal with stressed borrowers.
- The Insolvency and Bankruptcy Code, 2016 – Salient features
- The Objective Section of the Act states thus: “An Act to consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a timebound manner for maximisation of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders including alteration in the order of priority of payment of Government dues and to establish an Insolvency and Bankruptcy Board of India, and for matters connected therewith or incidental thereto.”
- The key players in resolving Insolvency would be as shown in Figure 8.13
FIGURE 8.13 KEY PLAYERS IN RESOLVING INSOLVENCY
- The process is depicted in Figure 8.14.
FIGURE 8.14 THE CORPORATE INSOLVENCY RESOLUTION AND LIQUIDATION PROCESS
- Some key aspects of the code are summarised below:
- Shifts from a Debtor in possession (DIP) to Creditor in Control (CIC) model.
- Establishes an Insolvency and Bankruptcy Board as an independent body for the administration and governance of the Insolvency and Bankruptcy Law.
- Consolidates all existing insolvency related laws.
- Amends multiple legislations including the Companies Act.
- Has overriding effect on all other laws relating to insolvency and Bankruptcy.
- Resolves insolvencies within strict timelines.
- Proposes moratorium or calm period.
- Introduces Insolvency Professionals with defined roles and powers.
- Introduces Information Utilities as a depository of credit and financial information.
- Defines order of priority in distribution of liquidated assets – the waterfall mechanism. A notable feature is that government dues have been made junior to other creditors.
- Amendments to the SARFAESI Act 2002, and Amendments to the Recovery of Debts Due to Banks and Financial Institutions (RDDBFI) Act 1993 through passing of the Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Bill, 2016- Salient features.
Some of the important measures, listed below, will be enabled and facilitated by the new Bankruptcy and Insolvency Law. It can be seen that many of the measures are in alignment with the Law.
Amendments to the SARFAESI Act, 2002 are intended to improve recovery and augment ease of doing business in the ways listed below.
- Registration of creation, modification and satisfaction of security interest by all secured creditors and provision for integration of registration systems under different laws relating to property rights with the Central Registry to create a central database of security interests on property rights.
- Enabling non-institutional investors to invest in security receipts.
- Bringing hire purchase, financial lease and conditional sale under its ambit.
- Strengthening the regulation of asset reconstruction companies (ARCs) by the Reserve Bank, including powers to audit, inspect, change directors, issue directions for regulation of management fee and impose penalties.
- Making debenture trustees at par with secured creditors.
- Specifying the timeline for taking possession of secured assets; and
- According priority to secured creditors in repayment of debts over all other debts.
Amendments to the RDDBFI Act, 1993 are intended to reduce stressed assets in the banking system. Some of the important measures are listed below.
- Expeditious adjudication of recovery applications and empowering the central government to provide uniform procedural rules for conducting proceedings in Debt Recovery Tribunals (DRTs) and Debt Recovery Appellate Tribunals (DRATs);
- Instituting electronic filing of recovery applications, documents and written statements; issuing summons by the tribunals in electronic forms; and display of interim and final orders of DRTs and DRATs on their websites; and
- According priority to secured creditors in repayment of debts over all other claimants including claims of the central government, state government or local authorities.
The Bill has also amended the Indian Stamp Act, 1899 to exempt assignment of loans in favour of ARCs from stamp duty; and the Depositories Act, 1996 to facilitate the transfer of shares held in pledge or on conversion of debt into shares in favour of banks and financial institutions.
The amendments are aimed at faster recovery and resolution of bad debts by banks and financial institutions and making it easier for asset reconstruction companies (ARCs) to function. Along with the new bankruptcy law, the amendments will put in place an enabling infrastructure to effectively deal with non-performing assets in the Indian banking system.
- The Banking Regulation (amendment) Ordinance, 2017- salient features
The Government notified the Banking Regulations Amendment Ordinance to accelerate resolution of the pile up of non-performing assets (NPAs). For this purpose, two sections, 35AA and 35AB have been inserted in the Banking Regulation Act, 1949, under section 35A.
The three key measures contained in the ordinance are given below:
- The government has authorised the RBI to issue directions to banks to initiate insolvency proceedings against defaulters under the bankruptcy code. “Default” has the same meaning as in the Bankruptcy Code.
- RBI on its own accord can issue directions to banks for resolution of stressed assets.
- RBI may form committees with members it can choose to appoint to advise banks on resolution of stressed assets.
Further, banks can initiate loan recovery proceedings once default has happened as described in the Bankruptcy Law, even if a borrower account has not been classified as “non performing” (see the earlier section on Prudential norms for Asset Classification). This implies that banks need not wait for 90 days after default in payment of interest or principal amount to initiate loan recovery processes. The Bankruptcy law states that if a payment is missed by a borrower, it is termed as ‘default’ with immediate effect.
The RBI Action Plan for implementing the Ordinance was issued on May 22, 2017. This document can be accessed at https://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/PR31388E3F78A130A9405F9891AC490EB2834B.PDF.
Asset Reconstruction companies in India
There are at present 19 securitization companies in India, owned by public sector banks, private sector banks and private or corporate groups. They are as follows:
|S. No||Name of company||Major Sponsors (owners)|
|1||Asset Reconstruction Company (India) Ltd, (ARCIL) (www.arcil.co.in)||SBI, IDBI, ICICI, PNB|
|2||Assets care & Reconstruction Enterprise Ltd(Formerly Assets Care Enterprise Ltd.) (ACRE) (www.acreindia.com)||IFCI, PNB, Tourism Finance, Bank of Baroda, LIC, UBI|
|3||ASREC (India) Ltd, (www.asrecindia.co.in)||Allahabad Bank, Bank of India, Andhra Bank, Indian Bank, LIC, Deutsche Bank|
|4||Pegasus Assets Reconstruction Pvt. Ltd. (www.pegasus-arc.com)||Bhimjyani Family, Rakesh Jhunjhunwala, L Sanghvi + Family|
|5||Alchemist Asset Reconstruction Company Limited (Formerly Dhir & Dhir Asset Reconstruction & Securitisation Company Ltd.) (www.alchemistarc.com)||Alok Dhir, Sanjiv Gupta, Shivashish Chatterjee, L P Dhir|
|6||International Asset Reconstruction Company Pvt. Ltd. (www.iarc.co.in)||HDFC Bank Ltd, Tata Capital Ltd, City Union Bank, Arun Duggal, ICICI, Standard Bank, FMO|
|7||Reliance Asset Reconstruction Company Ltd. (www.rarcl.com)||Reliance Capital, Corporation Bank, Indian Bank, GIC, Dacecroft Ltd, Blue Ridge|
|8||Pridhvi Asset Reconstruction and Securitisation Company Ltd. (www.paras.org.in)||Dr Divi + Family, M S R Prasad + Family, M Rajya Lakhsmi, PNB|
|9||Phoenix ARC Pvt Ltd. (www.phoenixarc.co.in)||Kotak Mahindra Prime, Kotak Mahindra Investments, others|
|10||Invent Assets Securitisation & Reconstruction Private Limited||Not available|
|11||JM Financial Asset Reconstruction Company Limited (www.jmfinancial.in)||JM Financial, Narotam Sekhsaria, Indian Overseas Bank, Valiant Mauritius|
|12||India SME Asset Reconstruction Company Limited (ISARC) (www.isarc.in)||SIDBI, SIDBI Venture, Bank of Baroda, United Bank of India, and 15 others comprising of banks, state financial corporations, insurance companies|
|13||Edelweiss Asset Reconstruction Company Limited||Edelweiss Capital, Reeta Kuhad, Vineet Kashyap, Alok Tandon, Aakanksha Management, Apian Finance|
|14||UV Asset Reconstruction Company Limited (www.uvarcl.com)||Shilpi Sharma, PJ Vincent, Central Bank of India, B B Choudhary|
|15||Meliora Asset Reconstruction company Limited (www.melioraarc.com)||Sisir Kumar, K Ravi Kumar, P Rama Krishna Rao, Venkat Kanteti, P Siva Kumara|
|16||Omkara Assets Reconstruction Private Limited (www.omkaraarc.com)||Dr A Sakthivel, S K Vignesh|
|17||Prudent ARC Ltd *||K E Venugopal, A K Sureka, Pradeep goel, Anuj Jain, Nitin Gambhir, Alok Kumar|
|18||MAXIMUS ARC Limited *||S R Gaddde, Y Prameela Rani, N Devineni, I K Alluri, H R Nandipati, B Potru , M R R Ganti, S R K Grandhi|
|19||CFM Asset Reconstruction Private Limited *||D P Nair, A K Bhanushali, S C Bhargava, S Vasudeva, D M Mangalore, J S George, A C Mahajan|
*Do not have their own websites, information accessed from www.zaubacorp.com.
How do ARCs work?48
There are two methods under which NPAs are sold to ARCs: 1) Cash Route and 2) Auction Route. Under the auction route, Security Receipts are issued by ARC to the Bank.
1. Cash Route: Auction of NPA Portfolio is conducted and price determined mutually. ARC pays the amount upfront to the Bank.
2. Security Receipts (SR): ARCs generally make a portion of the payment upfront and for the balance SR is issued either to the Bank / Investors. As and when the NPA is recovered, ARC distributes the same to the Bank/investors against redemption of SRs held by them.
The ARC forms different trusts for the financial assets to be acquired from banks / FIs. NPA are acquired from banks/FIs at fair value based on assessment of realisable amount and time to resolution. The maximum life of the trust is five years in accordance with regulations. The trust is set up as a “pass through” entity for tax purposes and it issues Pass Through Certificates (PTC).
- The trusts issue securities in the form of Security Receipts (SR) to the investors who are typically Qualified Institutional Buyers (QIB) or the seller bank itself. Therefore in case the seller bank is itself buying the SR in a Trust, its status changes from lender of the loan to that of investor in the SR, which represents undivided right, title and interest in the trust fund.
- After acquiring the NPA, the Trust becomes the legal owner and the security holders its immediate beneficiaries.
- The Trust redeems the investment to the SR holders out of the money realise from the borrowers. The ARC facilitates the process.
- The NPAs acquired are held in an asset specific or portfolio trust. In the portfolio approach, when the size of the aggregate debt is small, the ARC makes a portfolio of the loan assets from different banks and FIs. For a large aggregate debt of a bank/FI, an asset specific trust is created.
Some commonly used accounting and financial terminologies in respect of ARC (not an exhaustive list)
|Terminology / Income|
|Upside Income||Surplus generated over the acquisition cost of the NPA. For example, if the ARC keeps 20% of the upside income, it implies it distributes the remaining surplus to SR holders. Thus, the ARC benefits in two ways – it gets its share of upside income as ARC (management incentive in upside), and also as SR holder (income from investment). Income is recognised only on realization.|
|Interest from funded expenses||When the trust is set up, the ARC funds the initial expenses such as rating fees and due diligence. Interest is charged by the ARC to the trust for these expenses.|
|Interest on SR||Some tranches guarantee minimum yield to the investors. This interest is shown on accrual basis where recovery is certain.|
|Management fees||ARC charges the trust for managing the asset. It is fixed as a percentage of assets under management (could be in the range of 0.5% to 1%). The assets under management are valued by an independent agency.|
|Advisory fees||ARC has the expertise to advise companies on restructuring of debt. A fee is charged for the advice.|
|Terminology – expenses|
|Acquisition expenses||Expenses related to legal, registration, stamp duty, valuation, Registrar of Companies (ROC), valuation, due diligence are some of the key acquisition expenses. They are accounted for as and when they are incurred.|
|Valuation fees||All trusts are valued every quarter by an independent agency, on the basis of which the trusts are rated. Payments made to the agency fall under this head.|
|SR investment write off||Provided for in the Income statement, where amount receivable from trust remains unrealized over one year, and is considered doubtful of recovery. The provision takes into account the net asset value and rating of the SR.|
|Custodian fees||The SR are kept with a custodian such as National Securities Depository Ltd (NSDL), for a fee.|
|Provision for contingency reserve||ARC appropriates a specific percentage of outstanding SR to a contingency reserve over and above the SR investment write off mentioned above.|
ILLUSTRATION 8.2 GIVES AN EXAMPLE OF TRANSACTIONS INVOLVED IN AN ASSET SALE BY A BANK TO ARC
Bank makes asset sale to ARC – how do the numbers look?
Security for the loan is Rs 700 crore.
On March 31, 2017, the bank sells the loan to ARC.
Accrued interest (which the bank cannot charge to the NPA) assumed at Rs 500 crore.
ARC agrees to buy at Rs 650 crore and pays cash upfront.
The loan asset was NPA for more than 3 years. Hence provision that Bank should have made is 100% (Please see ‘Provisioning norms’ in earlier section).
Bank should have written off Rs 800 crore. Instead it sold the loan to ARC for Rs 650 crore.
The bank’s financial statements will show the following impact.
- Non interest income – Rs 650 core.
- NPA outstanding decreases by Rs 800 crore.
- No write off for Rs 800 crore. Hence profits increase.
- Potential cash flow loss for the bank is Rs 800 + Rs 500 crore = Rs 1300 crore. After sale at Rs 650 crore to ARC, bank has potential cash flow loss of Rs 650 crore. Further, securities are valued at Rs 700 crore. If the bank had liquidated securities, the potential loss would have been Rs 600 crore.
The ARCs were conceptualized as an important mechanism for resolving distressed assets in India. The scheme was initially popular with banks selling large amounts of loans to ARCs, who would in turn issue Security receipts to investors. However, in the last few years banks have not been using the services of ARCs. One of the primary reasons is the absence of uniform valuation norms acceptable to both banks and ARCs. Another reason is the poor performance of ARCs in resolving stressed loans.
The ceiling on foreign investment in ARCs has been raised to 100% in the Union Budget 2016-17. In April 2017, RBI raised the minimum stipulated Net Owned Funds (NOF) of ARCs to Rs 100 crore (against the current stipulation of Rs 2 crore). All the measures (discussed in the previous and this chapter) – such the SDR, S4A and the Insolvency Code - are expected to strengthen ARCs in their role of resolution of stressed assets. Foreign Distressed Asset funds have also begun showing interest in investing in ARCs in India.
Securitization—The Indian Experience
Securitization is not new to India. It has been used since 1992. In the early years, originators directly sold consumer loan pools to buyers and also acted as servicers to collect the periodic loan and interest payments. The late 1990s saw the emergence of liquid and transferable securities backed by the pool receivables—Pass Through Certification (PTCs as they are commonly known).
The Indian securitization market is dominated by the following asset classes:
- Asset Backed Securitizations (ABS) continued to remain the major asset class in FY 2013, dominated by commercial vehicles including two and three wheeler loans, car loans, micro-finance loans, SME loans, gold loans and others. Microfinance loans increased their share substantially during the FY 2013.
- Residential mortgage-backed securities (RMBS).
- Single loan CLO and loan sell offs (LSO).
It is noteworthy that there has been no default in any of the transactions.
In India, issuers have typically been private sector banks, foreign banks and non-banking financial companies with the underlying assets being mostly retail and corporate loans. Public sector banks are yet to enter securitization in a big way.
The Indian securitization market exhibits some unique characteristics, a few of which are listed as follows:
- Credit enhancements to senior notes are usually provided through a cash reserve or guarantee by a highly rated institution.
- Most investments in securitized instruments are held till maturity.
- PTCs are not tradable securities. Since, the secondary market for securitized instruments is almost non-existent, almost all issues are privately placed.
- The predominant investors in securitized instruments are mutual funds, insurance companies and some private sector banks.
- In many countries where a robust market for securitization exists, ratings of securitized instruments are based on timely payment of interest. However, in India ratings are based on timely payment of principal as well as interest.
Figure 8.15 traces the growth of the securitization market over the years, mentioning specific landmark deals.
FIGURE 8.15 TRACING SECURITIZATION GROWTH—LANDMARK DEALS
In recent times, one of the major drivers for securitisation in India has been PSL (Priority Sector Lending) targets of the banks. Banks are required by RBI to have prescribed minimum exposure in identified sectors like agriculture, MSME (micro small and medium enterprises), export, education, housing, social infrastructure, renewable energy and others as notified by the central bank. The shortfall in PSL targets of banks can be met by purchasing portfolios from other banks and financial institutions.49
Major asset classes being securitized in India are shown in Figure 8.16
FIGURE 8.16 MAJOR ASSET CLASSES IN INDIAN SECURITIZATION MARKET
India’s Securitization market in 201650
India’s securitization market grew by 45% to about Rs 25000 crore in 2016, in contrast to the deceleration witnessed over the last three years. ICRA (a credit rating agency, which along with other rating agencies, is described in Chapter 5, Annexure II), in its latest study on the Indian Securitization market, has recorded that ABS transactions grew by number (39%) and volume (51%). However, RMBS declined to insignificant amounts.
Charts 8.1 and 8.2 show the trends in the various asset classes of securitization. It can be seen that Commercial Vehicles (CV) and microfinance loans have been the most popular asset classes for securitization.
CHART 8.1 AND 8.2 GROWTH TRENDS IN VARIOUS ASSET CLASSES OF SECURITIZATION
Table 8.5 shows the trend in securitization issuances over the last few years. The LSO market, it can be seen, has become practically extinct since 2012.
TABLE 8.5 TREND IN SECURITIZATION ISSUANCES (INCLUDING RATED BILATERAL ASSIGNMENTS) – BY VALUE, IN RS. CRORE
Direct Assignment(DA), where a pool of loan receivables is assigned directly to the investor with no intermediate institution or special purpose vehicle is also popular in India. In such cases, there is no issuance of a tradeable instrument. ICRA estimates that the volume of the bilateral retail loan pool assignments/ Direct Assignment (D. A.) transactions grew by 56% to around Rs. 42,000 crore in 2016. Thus, ICRA estimates the total retail loan sell-down volume (including assignment and securitisation) to be around Rs. 67,000 crore in 2016, which signifies a 52% increase from 2015.
Chart 8.3 shows the trend in direct assignments.
The ICRA report states that Public Sector Banks have been the key acquirers of retail pools under the D.A. route, as they see it as a convenient way of achieving balance sheet growth as well as for meeting Priority Sector Lending (PSL) Targets.
Outlook for the securitization market
ICRA expects the outlook for securitisation market activity to be positive in 2017, given the renewed interest in securitization transactions and widening of the investor base in the securitisation market with the exemption of income at distribution from distribution tax.
Moody’s Investors Service says51 that India’s introduction of three significant regulatory changes during 2016-17 will have transformative implications for its securitization market. The three measures are:
- A new tax regime that will lift post-tax investment returns from securitization trusts. Under new rules effective 1 June 2016, investors can claim a tax deduction against income from investments in PTCs issued by securitization trusts, and adjust for expenses incurred in relation to securitization income. The new tax treatment will boost the post-tax returns of investments in PTCs.
- Changes in regard to foreign portfolio investors (FPIs) that will encourage foreign investment and changes to deal structures. FPIs were allowed by RBI to invest in Indian PTCs from May 2016. The changes would encourage foreign investment and changes to the structure of Indian securitization deals that would align them with global practices. and
- A new bankruptcy code that will reinforce creditors’ rights. Under the code passed by India’s Parliament in May 2016, creditors’ rights are expected to be strengthened in resolution of distressed assets. The new code also provides greater clarity on the insolvency process, such that for securitization transactions, which rely on legal structuring. Accordingly, the impact of an originator default can be better assessed.
Credit Derivatives in India52
After protracted deliberations and several draft guidelines since 2005 on the introduction of Credit Default Swaps(CDS) in India, RBI finally released guidelines on Credit Default Swaps in corporate bonds in November 2011. Revisions to the guideline were made in January 2013. RBI Master Circular on ‘Basel III Capital Regulations’ dated July 1, 2013, provides prudential guidelines on CDS.
RBI guidelines specify the participants and the processes for using CDS in corporate bonds. The participants can be of the following categories. An RBI regulated entity should be a participant at least on one side of the transaction.
- Users: The users are typically protection buyers. They can buy credit protection (buy CDS contracts) only to hedge the underlying credit risk on corporate bonds. They cannot hold credit protection without hedging the underlying asset. They cannot sell protection (hold short positions in CDS contracts). They can exit their CDS ‘bought’ contract by unwinding it with the original counter party, or by assigning it in favour of the buyer of the underlying bonds. The ‘User’ categories named by RBI comprise of Commercial Banks, Primary Dealers, NBFCs, Mutual Funds, Insurance Companies, Housing Finance Companies, Provident Funds, Listed Corporates, All India Financial Institutions namely, Export Import Bank of India (EXIM), National Bank for Agriculture and Rural Development (NABARD), National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI), Foreign Institutional Investors (FIIs) and any other institution specifically permitted by the Reserve Bank
- Market makers: RBI permits certain entities to quote—both buy and/or sell—CDS spreads. (The following chapter gives more details on the fixing of CDS spreads). These entities, who would be permitted to buy protection without having the underlying bonds include Commercial Banks, stand alone Primary Dealers (PDs), Non-Banking Financial Companies (NBFCs) having sound financials and good track record in providing credit facilities and any other institution specifically permitted by the Reserve Bank. In addition, Insurance companies and Mutual Funds would be permitted as market-makers subject to their having strong financials and risk management capabilities as prescribed and permitted by their respective regulators, IRDA and SEBI53. The eligibility norms for market makers are detailed in the quoted RBI guidelines, and the list of market makers can be accessed from the RBI website.
Eligible Underlying Assets for CDS—Deliverable Obligations or Reference Assets
- Rated corporate bonds—both listed and unlisted.
- Unrated corporate bonds in the case of SPVs set up by infrastructure companies (the rationale for setting up SPVs to hold infrastructure assets in the case of Public Private Partnerships – PPP-in the infrastructure sector has been outlined in the Chapter ‘Uses of bank funds—the lending function’).
- Money market securities (securities with original maturity up to one year) such as Commercial Paper, Certificates of Deposit, Non-convertible debentures.
- Reference assets should be in dematerialized form only.
Other Requirements to be Fulfilled
- The users (except FIIs) and the market makers should be resident entities.
- The contract should clearly define the identity of parties responsible for determining whether a credit event has occurred.
- The reference asset and the deliverable obligation should be to a resident and denominated in Indian Rupees.
- The CDS contract should be denominated and settled in Indian Rupees.
- Asset backed securities, mortgage backed securities, convertible bonds and bonds with call or put options (Please refer to Chapter ‘Bank risk management’ for details on options) cannot form the reference assets/deliverable obligations.
- Interest receivable cannot form the underlying asset for CDS.
- The CDS contract should represent a direct claim on the protection seller. The contract should be irrevocable—there must be no clause in the contract that allows the protection seller to unilaterally cancel the contract, unless the protection buyer defaults under the terms of the contract.
- The CDS contract should not have any clause that may prevent the protection seller from making the credit event payment on time—after occurrence of the credit event and completion of necessary formalities in terms of the contract.
- The protection seller can have no recourse to the protection buyer for credit-event losses.
- Dealing in any structured financial product with CDS as one of the components is not permitted.
- Dealing in a derivative product where the CDS itself is an underlying asset is not permitted.
Credit Events and Settlement
The credit events specified in the CDS contract typically cover Bankruptcy, Failure to pay, Repudiation/moratorium, Obligation acceleration, Obligation default, Restructuring approved under Board for Industrial and Financial Reconstruction (BIFR) and Corporate Debt Restructuring (CDR) mechanism and corporate bond restructuring. The contracting parties to a CDS may include all or any of the approved credit events. Further, the definition of various credit events should be clearly defined in the bilateral Master Agreement prepared by FIMMDA.
A Determination Committee (DC), formed by the market participant (of which at 25 per cent will be drawn from the ‘users’) and FIMMDA, will be based in India and will deliberate and resolve CDS related issues such as Credit Events, CDS Auctions, Succession Events, Substitute Reference Obligations, etc. The decisions of the Committee would be binding on CDS market participants.
The settlement method, to be determined and documented in the CDS agreement, can be one of the following—physical, cash or auction. (More on these settlement methods can be found in the following chapter ‘Credit risk—Advanced topics’). Where the CDS transaction involves ‘users, physical settlement is mandatory. Where the CDS transaction involves market makers, any of the above three methods can be used. As their names suggest,
- ‘Physical’ settlement would require the protection buyers to transfer any of the deliverable obligations against the receipt of the full notional or face value of the reference asset;
- ‘Cash’ settlement would require the protection seller to pay the protection buyer an amount equivalent to the loss resulting from the credit event of the reference asset;
- ‘Auction’ settlement would require the intervention of the Determination committee, and would be decided on a case to case basis.
The RBI guidelines also mention other aspects such as accounting, pricing of CDS (FIMMDA would publish a daily CDS curve), and prudential norms for risk exposures and capital adequacy of market participants.
Would the Guidelines Energize the Credit Risk Transfer Market in India?
It is noteworthy that after the guidelines came into force, only 3 CDS transactions have happened upto end 2012.
The first two transactions involved IDBI Bank and ICICI Bank in December 2011. IDBI Bank underwrote two CDS deals of ₹5 crore each in respect of Rural Electrification Corporation (REC) and Indian Railways finance corporation (IRFC) bonds held by ICICI Bank. Both deals were for one year. The details of the third deal were not available.
The lukewarm response to the much awaited CDS guidelines has been attributed to the following factors:
- CDS is restricted to the Indian corporate bond market, which is shallow and illiquid.
- The corporate bond market today is dominated by AAA rated bonds, with few takers for lower rated bonds. The highest rated bonds do not require protection against default
- The guidelines are perceived as too restrictive. Speculation, an essential ingredient of a liquid market, is not permitted.
- Most of the bonds are being held to maturity. (Please refer to the chapter ‘Market risk’ for an explanation of ‘held to maturity’). Hence they are not available for trading or marking to market. Derivative transactions are required only where the securities are actively traded
- Other players such as Mutual funds or Insurance companies cannot be market makers under the present guidelines. This has further restricted the market
- An acceptable operational framework for all participants is still not present. The market in its present form is dominated by banks. A heterogeneous market is necessary for CDS to grow
- Globally, most CDS trades are for a tenure of over 3 years. In a short term instrument such as Commercial Paper, which RBI has permitted as an underlying asset, the probability of default is perceived to be low, and it may be costly to hedge through CDS.
- Since India does not have an active or deep corporate bond market, it is difficult to develop a CDS market only for corporate bonds.
- Two types of losses are possible in respect of any borrower or borrower class—expected and unexpected losses or EL and UL. EL can be budgeted for and provisions held to offset their adverse effects on the bank’s balance sheet. UL, being unpredictable, have to be cushioned by holding adequate capital.
- Credit risk is most simply defined as the probability that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms.
- A bank needs to manage (a) the risk in individual credits or transactions, (b) the credit risk inherent in the entire portfolio and (c) the relationships between credit risk and other risks.
- Although specific credit risk management practices may differ among banks depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program will address these four areas. (a) Establishing an appropriate credit risk environment, (b) operating under a sound credit granting process, (c) maintaining an appropriate credit administration, measurement and monitoring process and (d) ensuring adequate controls over credit risk. These practices should also be applied in conjunction with sound practices related to the assessment of asset quality, the adequacy of provisions and reserves and the disclosure of credit risk.
- International accounting practices set forth standards for estimating the impairment of a loan for general financial reporting purposes. Regulators are expected to follow these standards ‘to the letter’ for determining the provisions and allowances for loan losses. According to these standards, a loan is ‘impaired’ when, based on current information and events, it is probable that the creditor will be unable to collect all amounts (interest and principal) due in line with the terms of the loan agreement. Such assets are also called ‘criticized’ or ‘non-performing’ (in India) assets.
- Assessment of credit risk for individual borrowers and for a loan portfolio is an important task, for which various models are available, ranging from simple ones to banks’ internal models to industry-sponsored models.
- Loan sales provide liquidity to the selling banks and also represent a valuable portfolio management tool, which minimizes risk through diversification. Some prominent forms of loan sales include (a) syndication, (b) novation, (c) participation and (d) securitization.
- Covered bonds are a hybrid between asset-backed securities/mortgage backed securities and normal secured corporate bonds, and serve as an instrument of refinancing, primarily used by mortgage lenders. Unlike secured corporate bonds which provide recourse against the issuer, covered bonds provide a bankruptcy-protected recourse against the assets of the issuer (Collateral Pool) too. Unlike mortgage backed securities which merely provide recourse against the Collateral Pool, covered bonds provide an additional recourse against the issuer too.
- A credit derivative is a security with a pay-off linked to a credit-related event, such as borrower default, credit rating downgrades or a structural change in a security containing credit risk. In credit derivatives, there is a party (or a bank) trying to transfer credit risk, called a protection buyer and there is a counter party (another bank) trying to acquire credit risk, called a protection seller.
- Credit derivatives are typically unfunded. The protection buyer generally pays a periodic premium. However, the credit derivative may be funded in some cases. Some popular forms of credit derivatives include (a) loan default swaps, (b) total return swaps, (c) CDS, (d) credit risk options, (e) credit intermediation swaps, (f) dynamic credit swaps, (g) credit spread derivatives, (h) CLNs, (i) CLDs, (j) repackaged notes and (k) basket default swaps.
- For Indian banks, the RBI has provided detailed guidelines for ‘exposure norms’ to avoid credit concentration and for asset classification, income recognition and provisioning for credit risk. Assets are classified into (a) standard, (b) sub-standard, (c) doubtful and (d) loss, and provisions are made accordingly.
TEST OUR UNDERSTANDING
- Rapid fire questions
Answer ‘True’ or ‘False’
- Expected losses can be budgeted for.
- Expected losses are another name for credit risk.
- Income accrual on impaired loans is continued even after they are classified.
- Risk cannot be allocated or transferred.
- Concentration risk is an important form of credit risk.
- Syndication is a type of loan sale.
- In traditional securitization loan assets are not transferred from the originator’s balance sheet.
- Originators of asset backed securities usually sell loans without recourse.
- Covered bonds are a hybrid between asset backed securities and mortgage backed securities.
- A Total return swap is a form of credit derivative.
Check your score in Rapid fire questions
- Fill in the blanks with appropriate words and expressions.
- Expected losses reflect ————— risk of banking.
- Volatility in Expected Losses reflect ————— risk in Banking.
- Unexpected losses are statistically measured as the ————— ————— of Expected losses.
- In credit derivatives, the party transferring credit risk is known as the Protection —————.
- In credit derivatives, the party acquiring the credit risk is known as the Protection —————.
- A credit derivative where the protection seller need not put in money upfront is known as an ————— Credit derivative.
- An example of a funded credit derivative is the —————.
- The two alternate ways of settlement in a credit derivative transaction are ————— and —————.
- In India, if a financial institution sells off loans to another institution without the intermediation of an Asset Reconstruction Company, it is called —————.
- In India, non performing assets are put into three categories, namely, —————, —————, and ————— assets.
- Expand the following abbreviations in the context of the Indian financial system
- Test your concepts and application
- How do the following help in credit risk mitigation?
- Loan covenants
- Credit scoring/risk rating system
- Credit risk models
- Why do banks move loans off their balance sheets? What are the motivations for and risks involved in offbalance sheet transactions of banks?
- Can each of the following types of loans be easily securitized? Give reasons.
- Agricultural loans
- Credit card loans
- Loans to professionals
- Home loans
- Vehicle loans
- Loans for capital expenditure
- J bank has written off some loss assets. Which of the following is true?
- Its total assets and total liabilities decrease by that amount.
- Its total liabilities and capital decrease by that amount.
- Its total assets, total liabilities and capital decrease by that amount.
- Its total assets and capital decrease by that amount.
- Its total liabilities and capital increase by that amount.
- Rank the following according to the degree of credit risk (highest credit risk = 1, lowest credit risk = 4)
- Advances against hypothecation of inventory and receivables
- Advances against pledge of inventory
- Advances against gold
- Underwriting commitments
- The following data relate to K Bank.
- Margin of safety 0.75
- Return on assets (ROA) 9 per cent
- Total assets ₹2,000 crores
- Tax rate 40 per cent
What is the level of NPAs of K Bank?
- S Bank’s profits before provisioning for NPAs is at ₹300 crores. The bank has total assets of ₹7,000 crores and its NPAs form 6 per cent of total assets. Which of the following actions should the bank take in that year to maximize its return to shareholders? (Assume tax rate of 40 per cent).
- Make a provision of 50 per cent of NPAs
- Write off 25 per cent of NPAs
- What do we mean by the term ‘securitization is non-recourse’? Who bears the risk in non-recourse lending?
- What is the role of the ‘SPV’ in securitization?
- How is ‘securitization’ of receivables different from ‘factoring’ of receivables?
- The following table represents the balance sheet of Bank A before securitizing some of its assets. Can you fill in the balance sheet format alongside that indicates the balance sheet position after securitization? Assume that the pool of securitized assets have been sold at par. (₹ in crores).
Before Securitization After Securitization Liabilities Assets Liabilities Assets Equity 5 Cash 10 Other Liabilities 105 Assets for Securitization 80 Other assets 20 Total 110 Total 110 Total 110 Total 110
- How is a Credit Default Swap different from an insurance contract?
- How do the following help in credit risk mitigation?
TOPICS FOR FURTHER DISCUSSION
- What factors would bankers consider before deciding to use credit derivatives? Can you evolve a checklist?
- Why do you think SPEs are used for issuing ABS? Why do the banks, which originate these assets, not issue these securities themselves?
- How has the ISDA standardized credit derivative transactions?
- Study the corporate debt restructuring scheme of the Reserve Bank of India. Would banks prefer to use this mechanism to restructure potentially viable corporate bodies or would they prefer to securitize loans that need restructuring?
- What should be the enabling factors for covered bonds to be successful in India?
- What are the risks that RBI perceives in introducing CDS for bank loans in India?
- Harvard Business School, An Overview of Credit Derivatives, rev. (12 March 1999), Harvard Business School Publishing.
- JP Morgan and Risk Metrics Group, The J P Morgan Guide to Credit Derivatives. Risk Publications, U. S.
BASEL COMMITTEE DOCUMENTS ON CREDIT RISK MANAGEMENT
(Source: ‘Principles for the Management of Credit Risk,’ Basel Committee on Banking Supervision, pp. 3–4 September, 2000 accessed at www.bis.org)
Establishing an Appropriate Credit Risk Environment
- Principle 1: The board of directors should have responsibility for approving and periodically (at least annually) reviewing the credit risk strategy and significant credit risk policies of the bank. The strategy should reflect the bank’s tolerance for risk and the level of profitability the bank expects to achieve for incurring various credit risks.
- Principle 2: Senior management should have the responsibility for implementing the credit risk strategy approved by the board of directors and for developing policies and procedures for identifying, measuring, monitoring and controlling credit risk. Such policies and procedures should address credit risk in all of the bank’s activities and at both the individual credit and portfolio levels.
- Principle 3: Banks should identify and manage credit risk inherent in all products and activities. Banks should ensure that the risks of products and activities new to them are subject to adequate risk management procedures and controls before being introduced or undertaken and approved in advance by the board of directors or its appropriate committee.
Operating Under a Sound Credit-Granting Process
- Principle 4: Banks must operate within sound and well-defined credit-granting criteria. These criteria should include a clear indication of the bank’s target market and a thorough understanding of the borrower or counter party, as well as the purpose and structure of the credit and its source of repayment.
- Principle 5: Banks should establish overall credit limits at the level of individual borrowers and counter parties and groups of connected counter parties that aggregate in a comparable and meaningful manner of different types of exposures, both in the banking and trading book and on- and off-balance sheet.
- Principle 6: Banks should have a clearly established process in place for approving new credits as well as the amendment, renewal and re-financing of existing credits.
- Principle 7: All extensions of credit must be made on an arm’s length basis. In particular, credits to related companies and individuals must be authorized on an exception basis, monitored with particular care and other appropriate steps taken to control or mitigate the risks of non-arm’s length lending.
Maintaining an Appropriate Credit Administration, Measurement and Monitoring Process
- Principle 8: Banks should have in place a system for the ongoing administration of their various credit risk-bearing portfolios.
- Principle 9: Banks must have in place a system for monitoring the condition of individual credits, including determining the adequacy of provisions and reserves.
- Principle 10: Banks are encouraged to develop and utilise an internal risk rating system in managing credit risk. The rating system should be consistent with the nature, size and complexity of a bank’s activities.
- Principle 11: Banks must have information systems and analytical techniques that enable management to measure the credit risk inherent in all on- and off-balance sheet activities. The management information system should provide adequate information on the composition of the credit portfolio, including identification of any concentrations of risk.
- Principle 12: Banks must have in place a system for monitoring the overall composition and quality of the credit portfolio.
- Principle 13: Banks should take into consideration potential future changes in economic conditions when assessing individual credits and their credit portfolios and should assess their credit risk exposures under stressful conditions.
Ensuring Adequate Controls over Credit Risk
- Principle 14: Banks must establish a system of independent and ongoing assessment of the bank’s credit risk management processes and the results of such reviews should be communicated directly to the board of directors and senior management.
- Principle 15: Banks must ensure that the credit-granting function is being properly managed and that credit exposures are within levels consistent with prudential standards and internal limits. Banks should establish and enforce internal controls and other practices to ensure that exceptions to policies, procedures and limits are reported in a timely manner to the appropriate level of management for action.
- Principle 16: Banks must have a system in place for early remedial action on deteriorating credits, managing problem credits and similar workout situations.
The Role of Supervisors
- Principle 17: Supervisors should require that banks have an effective system in place to identify, measure, monitor and control credit risk as part of an overall approach to risk management. Supervisors should conduct an independent evaluation of a bank’s strategies, policies, procedures and practices related to the granting of credit and the ongoing management of the portfolio. Supervisors should consider setting prudential limits to restrict bank exposures to single borrowers or groups of connected counter parties.
The Basle Committee has also published in 2011 and 2012, documents in respect of counter party credit risk, which can be accessed at www.bis.org
BASEL COMMITTEE – SUPERVISORY FRAMEWORK FOR MEASURING AND CONTROLLING LARGE EXPOSURES – SALIENT FEATURES54
This document sets out a framework for mitigating and managing ‘credit concentration risk’, which has been identified as an important cause for major credit problems. The RBI guidelines for large exposures, outlined earlier in this chapter, is based on this document.
In the words of the Committee, “Large exposures regulation has been developed as a tool for limiting the maximum loss a bank could face in the event of a sudden counterparty failure to a level that does not endanger the bank’s solvency.”
The important features of this framework are shown below:
- This framework is intended to complement the capital adequacy standards that we will be studying in a subsequent chapter. Hence, the framework is closely aligned to the risk based capital framework that goes by the common name, Basel norms.
- Credit concentration risk can arise due to a host of factors. However, this framework has restricted its scope to losses incurred due to default of a single borrower/counterparty or a group of connected borrowers/counterparties.
- Under the standards set out in the guidelines by the Basel Committee, banks must report to the supervisor the exposure values before and after application of the credit risk mitigation (CRM) techniques (discussed in this and the next chapter). The CRM techniques have been specified in the Basel committee document.
- Banks must report to the supervisor:
- all exposures equal to or above 10% of the bank’s eligible capital (ie meeting the definition of a large exposure);
- all other exposures without the effect of credit risk mitigation being taken into account equal to or above 10% of the bank’s eligible capital;
- all the exempted exposures with values equal to or above 10% of the bank’s eligible capital;
- their largest 20 exposures to counterparties, irrespective of the values of these exposures relative to the bank’s eligible capital base.
- The sum of all the exposure values of a bank to a single counterparty or to a group of connected counterparties must not be higher than 25% of the bank’s available eligible capital base.
- In some cases, a bank may have exposures to a group of counterparties with specific relationships or dependencies such that, were one of the counterparties to fail, all of the counterparties would very likely fail. A group of this sort, referred to in this framework as a group of “connected counterparties”, must be treated as a single counterparty. In this case, the sum of the bank’s exposures to all the individual entities included within a group of connected counterparties is subject to the large exposure limit and to the regulatory reporting requirements as specified above. (A more rigorous description of ‘connected counterparties’ has been given in the document).
- “Exposures” are specified and their measurement and valuation described in Sections III and IV of the document. Section IV also deals with specific types of exposures, such as sovereign, inter bank, covered bonds, securitisation and similar structures.
- Global Systemically Important Banks (G-SIBs), the large exposure limit applied to a G-SIB’s exposure to another G-SIB is set at 15% of the eligible capital base (Tier 1). The limit applies to G-SIBs as identified by the Basel Committee and published annually by the Financial Stability Board (FSB) of the Basel committee. This document can be accessed at, Global systemically important banks: updated assessment methodology and the higher loss absorbency requirement, July 2013, available at https://www.bis.org/publ/bcbs255.pdf.
- All aspects of the large exposures framework must be implemented in full by 1 January 2019.
BASEL COMMITTEE – GUIDELINES – PRUDENTIAL TREATMENT OF PROBLEM ASSETS-DEFINITIONS OF NON PERFORMING EXPOSURES AND FORBEARANCE55
Earlier in this chapter, we have seen how RBI monitors credit quality of loans made by banks in India, by classifying them into ‘performing’ and ‘non performing’ loans. The various categories of asset classification, provisioning and income recognition norms have been briefly described in Section IV.
In response to the financial crisis of 2007-08, Basel Committee formed a dedicated task force to analyse central bank practices in various countries regarding asset categorisation schemes – the system that requires loans to be grouped based on their credit quality – and to assess the consequences of any differences in practices. The survey analysed the regulatory frameworks and supervisory practices across 28 countries and their central banks.
Based on the results of the survey, the Basel Committee developed guidelines for the definitions for two important terms in credit risk management – ‘non performing exposures’ and ‘forbearance’. These definitions were built on commonalities in the existing definitions of many countries. The guidelines have been formulated to help harmonize the quantitative and qualitative criteria used for credit categorisation used by various countries and their central banks.
The common definitions of asset classification would help in the following ways:
- Supervisory / central bank asset quality monitoring.
- Banks’ internal credit categorization systems for credit risk management.
- Pillar 3 disclosure on asset quality (this will be discussed in the chapter titled “Capital – Risk, Regulation and Adequacy).
- Data dissemination for asset quality indicators in a uniform manner.
- Serve as a reference point for other related working groups of the Basel Committee.
Interestingly, the document uses “categorisation” to denote ‘asset/ credit classification’ in order to avoid confusion with the concept of ‘classification’ as used in terminologies such as “classified loans” or “adversely classified” loans used in some countries as a supervisory tool and in the accounting framework. In Section I, we have also mentioned terminologies such as ‘impaired’ or ‘special mentioned’ loans. Essentially, all these terminologies are used with the singular objective of segregating loans and assets that have become difficult to recover, thus posing a credit risk to lending banks.
The Basel Committee clearly states that harmonising the various definitions of credit risk or impairment is not intended to replace the accounting concept of impairment or the regulatory concept of default. However, consistency in applying these concepts can provide supervisors and the global community a better understanding of asset quality and improve the comparability of credit risk information reported and disclosed by banks.
Points to be noted in the harmonised definitions are given below:
Non performing exposures
- Scope: The definition will be applied to on-balance sheet loans, debt securities and other amounts due (eg interest and fees) that a bank includes in its banking book (which consists of long term assets created by the bank other than for trading) for the purpose of computing its capital requirements under the June 2006 International convergence of capital measurement and capital standards (“Basel II”), regardless of their measurement basis under the accounting standards. The definition will also be applied to off-balance sheet items (eg loan commitments and financial guarantees). Exposures that a bank includes in its trading book (which consists of assets created for short term holding or trading purposes) under Basel II, or that are treated as derivatives, are not within the scope of the definition of non-performing exposures.
- Harmonised recognition criteria: A uniform 90 days past due criterion is applied to all types of exposures within the scope, including those secured by real estate and public sector exposures. The 90 days past due criterion is supplemented by considerations for analysing a counterparty’s unlikeliness to pay, for which the definition emphasises the importance of financial analysis.
- Role of collateralisation: Collateralisation plays no direct role in the categorisation of nonperforming exposures. Any recourse to collateral securities by the bank shall not be considered in this judgment. Collateral may, however, influence a borrower’s economic incentive to pay and, therefore, has an indirect impact on the assessment of a borrower’s unlikeliness to pay.
- Upgrading to performing: The definition identifies specific criteria that needs to be met to upgrade a nonperforming exposure to performing status, especially regarding the amounts in arrears and the borrower/ counterparty’s degree of solvency.
- Concept of forbearance: Forbearance is a concession granted to a counterparty for reasons of financial difficulty that would not be otherwise considered by the lender. Forbearance recognition is not limited to measures that give rise to an economic loss for the lender.
- Examples of financial difficulty and concessions: the definition includes a list of examples intended to help banks understand what these two concepts cover, and help them differentiate forbearance from commercial renegotiation not resulting from financial difficulty. Concessions can include refinancing of exposures.
- Categorisation of forborne exposures: Forborne exposures can be included within the performing or non-performing category. The appropriate categorisation depends on: (i) the status of the exposure at the time when forbearance is granted; and (ii) the counterparty’s payment history or creditworthiness after the extension of forbearance.
- Discontinuation of the forbearance categorisation: a forborne exposure can cease being categorised as such when both an objective criterion (a probation period for which a minimum duration is set) and a solvency criterion are met.
It can be inferred from the above definition that ‘forbearance’ is similar to the concept of ‘restructuring’ discussed in the previous chapter.
The Basel Committee also cautions in cases where there could be an overlapping of the two concepts – ‘non performing assets’ and ‘forbearance’ – and banks use forbearance practices to avoid categorizing loans as non performing. Similarly, granting forbearance to a non performing asset will not automatically upgrade it to a performing asset.
Some noteworthy features of the definition are given below:
- Non-performing exposures should always be categorised for the whole exposure, including when non-performance relates to only a part of the exposure, for instance, unpaid interest. For off balance sheet exposures, such as loan commitments or financial guarantees, the whole exposure is the entire uncancellable nominal amount.
- The following exposures are considered as non-performing:
- all exposures that are “defaulted” under the Basel II framework and subsequent amendments:
- According to paragraph 452 of the Basel II framework, (www.bis.org), a default is considered to have occurred with regard to a particular borrower when either or both of two following events have taken place.
- The bank considered that the borrower is unlikely to pay credit obligations and the bank has to recover by selling the securities held, and/or,
- The borrower’s credit obligations, including overdrafts, are overdue for more than 90 days.
- All impaired exposures, where there is a downward adjustment to their valuation due to deterioration of their creditworthiness according to the applicable accounting framework.
- All other exposures that are not defaulted or impaired but are more than 90 days overdue, or where there is evidence that repayment of principal and interest is unlikely without the bank realising the collateral securities, regardless of the number of days the exposure is overdue.
- all exposures that are “defaulted” under the Basel II framework and subsequent amendments:
- Forborne exposures should be identified as non-performing when they meet the specific criteria provided for in this definition.
The document pictorially depicts the interconnectedness between forbearance and non performing assets on page 15 of the quoted Basel document, and is shown in Figure 8.17.
FIGURE 8.17 BASIC STEPS IN SECURITIZATION
The document also records the different practices adopted by various countries, and their implications.
SALIENT FEATURES OF SECURITIZATION
The concept is not new. ‘Securitization’, broadly defined, is simply the conversion of a typically illiquid ‘financial relationship’ into a tradable and liquid transaction. For example, trade debt on a firm’s balance sheet is illiquid and signifies among others, the relationship between the firm and its suppliers. The debt is converted into a liquid transaction (instrument) in the market when it is issued as Commercial Paper (CP). The issue of ‘equity shares’ as a tradable instrument signifying ownership of a firm, is another example.
In today’s capital markets, however, ‘securitization’ is synonymous with ABS—where illiquid assets (loans) on a firm’s balance sheet are transformed into traded instruments by pooling the firm’s interest in future cash flows from the assets, transferring these claims to another specially created entity that would use the future cash flows to pay off investors over time. Thus, securitization has enabled movement of assets from the less efficient debt markets to the more efficient capital markets, resulting in lower funding costs.
However, there is a key difference between an ABS and a typical capital market security. To the investor, the capital market security signals exposure to the issuer’s business, whereas the ABS is no more than exposure to a pool of assets and has no connection with the business risks of the originator.56
The Key Players in ABS
The asset originator: Typically, this would be a bank which transfers a pool of loan assets to the securitization entity. However, it may continue to service the assets—for instance, if a pool of retail loans have been securitized, the bank may continue to collect the payments from the borrowers and pass it on to the securitization vehicle.
The issuer or the SPE: The securitization vehicle is created as a special purpose entity. It is created for the limited purpose of acquiring the underlying assets, issuing securities and other related activities.
Rating agencies: They are responsible for rating the multiple ‘tranches’ with different risk profiles, to help investors choose securities in keeping with their risk appetite.
Trustee: The trustee holds the securitization cash flows in separate accounts, and alerts investors and rating agencies in events of default or covenant breaches.
The underwriter: The primary responsibility of structuring the securitization—pricing and marketing the multiple tranches so that the issue is attractive to various classes of potential investors—rests with the underwriter.
The administrator: There is an important role for administrators in the CDO and Asset Backed Commercial Paper (ABCP) products. They actively manage, trade and monitor the respective loan pools.
The servicer: Typically, the servicer is also the asset originator and hence would be responsible for day to day portfolio administration, including collecting and temporarily reinvesting asset cash flows, where required.
Credit enhancement provider: In order to make the issue more attractive to investors and provide the tranches with better credit ratings, credit enhancement providers extend support.
Liquidity facility provider: Typically, liquidity support is provided to adjust for short-term lags between expected cash inflows from the underlying assets and the payment obligations under the securitization structure. Such liquidity access could be provided by financial institutions in the form of a commitment to lend or a commitment to purchase assets.
Figure 8.18 depicts the basic steps in a typical securitization deal
FIGURE 8.18 BASIC STEPS IN SECURITIZATION
The Cash Flows and Economics in Securitization
- Assume that this pool is being transferred at par value to an SPV—i.e., the outstanding principal amount of the loans in the pool, ₹100 crores.
- The SPV would also have to receive interest on the principal. This interest rate would be the weighted average interest rate of the loans in the pool. Let us assume the interest at 10 per cent per year.
- Now the SPV has to pay for the asset pool it holds. It does so by issuing securities. These securities will be rated (by credit rating agencies) depending on the cash flows that the asset pool is capable of generating.
- These cash flows will be used to repay the investors who have bought the securities issued by the SPV. It has to be noted here that Bank A will not have any claim on the cash flows (except to receive them and pass them on to the SPV), nor will the investors have any claim over Bank A’s assets in case of a shortfall in cash flows (except to the extent of credit support Bank A would be providing, where agreed upon).
- The securities are then structured into multiple tranches—typically, senior, mezzanine and junior (with hybrid classifications such as sub senior or sub junior) or any other nomenclature to convey differentiated priority of cash flows to investors in the pool. In our pool with ₹100 crores of Bank A’s assets, let us assume that the description of the tranches are as follows: senior 290 per cent, mezzanine 27 per cent and junior 23 per cent. This implies that if losses occur in the asset pool, the junior tranche will absorb the first 3 per cent. If losses exceed 3 per cent, the mezzanine tranche will absorb up to 10 per cent (3 per cent + 7 per cent). Only if losses in the asset pool exceed 10 per cent, will the cash flows to the senior investors be impaired. This 10 per cent (in this case) cushion against losses will enable the senior tranche to be highly rated by the rating agencies, the mezzanine tranche would get a lower rating, and many times, the most junior tranche may be unrated, since the risk of loss is very high. Typically, the unrated tranche is retained by the originating Bank A.
- Understandably, since the risk of each tranche differs, the return would also be different. The senior tranche, which is perceived to be safe, would earn the lowest, while the junior tranche, perceived to be highly risky, would earn the highest yield. In other words, the cost of issue of the tranches to the SPV would depend on the risk of each tranche. Let us assume that the weighted average cost to the SPV is 8 per cent.
- The SPV is only a conduit (in other words, a bank-ruptcy remote vehicle) and, therefore, requires an entity to carry out the functions of collecting the cash flow streams from the original borrowers in the asset pool and servicing the investors. Many times, these functions are taken on by Bank A itself, for a fee or servicing the investors can be done by a separate servicing firm. Let us assume that the fee for servicing is 70 bps per annum (that is, .07 per cent).
- Recollect that the weighted average interest that the pool earned when it was transferred to the SPV was 10 per cent. We have seen now that the pool pays an average interest + fee of 8 + .07 = 8.07 per cent. The difference between the two rates, 1.93 per cent, is called the ‘excess spread’. This ‘residual interest’ may be retained by the originator, Bank A or sold to willing investors.
- Hence, at the end of the securitization transaction, Bank A has got the following cash flows: (a) upfront cash flow of ₹100 crores or ₹97 crores in case the junior tranche bearing the first loss of ₹3 crores has been retained by the Bank (in both cases, the transaction takes the assets off its balance sheet and provides liquidity) and (b) the residual interest, representing the excess cash after paying investors.
- For the investors, especially in the more senior tranches, the transaction has assured periodic cash flows.
Some commonly used measures and metrics in securitization:57
- Originator: The bank or finance company that has originated the pool of receivables.
- Pool principal: The sum of principal outstanding for all loans present in the pool at the time of securitization.
- Pool cash flows: The sum of principal and interest outstanding for all loans present in the pool at the time of securitization.
- Future payouts: The total obligation towards the PTC holders or the acquirer at the time of securitization.
- Structure: Structure of a transaction can either be at par or at a premium, depending on whether the pool principal is sold at par or at a premium to investors. In case of transactions with Interest Only (IO) strips, or Deferred Purchase Consideration (DPC), it is suitably mentioned. Also mentioned is any other structural feature present in the transaction, for example par with turbo amortization etc.
- Asset class: The asset(s) that back the securitized receivables.
- Pool duration: The weighted average balance maturity of cash flows in months. Pool cash flows are taken as weights for the purpose of calculating the average. In MBS transactions, principal amounts are used as weights.
- Weighted Average Seasoning (WAS): Indicates the weighted average seasoning (in months) of the pool at the time of securitization.
- Weighted Average Loan to Value (WAL): The weighted average Loan to Value (LTV) ratio of the pool at the time of securitization.
- Weighted Average Yield (WAY): The pool yield at the time of securitization.
- Average yield: The current pool yield, calculated as the Internal Rate of Return (IRR) of the pool cash flows.
- Overdue composition: Indicates the proportion of cash flows pertaining to current contracts, one-month overdue contracts and soon at the time of securitization.
- Weighted Average Residual Maturity (WAM): The weighted average balance maturity of PTC/Acquirer payouts in months. Monthly payouts to PTC holders/acquirer are taken as weights for the purpose of calculating the average.
- Deferred Purchase Consideration (DPC) as percentage of pool cash flows: The deferred purchase consideration (DPC) is carved out of the interest portion of the pool available after servicing interest on the PTCs/acquirer’s principal balance. It is expressed as a percentage of total pool cash flows.
- Credit collateral as percentage of pool cash flows: The credit collateral stipulated at the time of securitization/outstanding as on date as a percentage of future pool cash flows. In case of Mortgage Backed Securities (MBS) transactions, the credit collateral is expressed as a percentage of pool principal.
- First loss as percentage of pool cash flows: The first loss credit facility stipulated at the time of securitization as a percentage of total pool cash flows. In case of Mortgage Backed Securities (MBS) transactions, the first loss credit facility is expressed as a percentage of pool principal.
- Second loss as percentage of pool cash flows: The second loss credit facility stipulated at the time of securitization as a percentage of total pool cash flows. In case of Mortgage Backed Securities (MBS) transactions, the second loss credit facility is expressed as a percentage of pool principal.
- Liquidity facility as percentage of pool cash flows: Indicates the liquidity support available to the transaction, expressed as a percentage of pool cash flows. Some transactions also have an advance payment mechanism, wherein monthly payouts are funded by the liquidity facility, which will be reflected in a high level of utilization of liquidity facility. In case of Mortgage Backed Securities(MBS) transactions, the liquidity facility is expressed as a percentage of pool principal.
- Excess Interest Spread (EIS) as percentage of pool cash flows: The embedded cushion available in a transaction on account of the differential between the pool yield and pass-through rate. This is only available in par structures and is expressed as a percentage of the pool cash flows. However, in a few structures, this cushion is diluted as the spread is utilized to make certain payouts like charge-offs, servicing fees, fees to liquidity provider etc. In such cases the actual cushion available to investors due to EIS may be lower than the amount stated herein. In case of Mortgage Backed Securities (MBS) transactions, the EIS is expressed as a percentage of pool principal.
More such terms and measures can be accessed in the CRISIL document mentioned above.
KINGFISHER AIRLINES – A HIGH PROFILE NPA58
In May 2014, United Bank of India declared Kingfisher Airlines, and Vijay Mallya, its key promoter, as ‘wilful defaulters’. Its share, in the total exposure of over Rs 7000 crore to Kingfisher Airlines of 17 banks, was just over Rs 400 crore. State Bank of India (SBI), the largest lender to the company, soon followed suit. Its notice in August 2014 alleged diversion of funds by Kingfisher Airlines to UB Group of companies and other firms. Soon more banks joined and declared the Kingfisher Airlines borrowing account a wilful defaulter and Non Performing Asset (NPA).
Table 8.6 shows the exposure of various banks to Kingfisher Airlines.
Known as the “liquor baron” of India, Vijay Mallya, a well known industrialist, and a Member of Parliament in India’s Rajya Sabha, launched Kingfisher Airlines in May 2005.
In 2002, Mallya had completed the acquisition of Shaw Wallace, one of the oldest liquor manufacturers in India, for Rs 1300 crore. He followed it up with a deal with the British beer maker, Scottish and Newcastle, which had bought a 37.5 % stake in Mallya’s United Breweries Ltd for Rs 940 crore.
TABLE 8.6 WHAT KINGFISHER AIRLINES OWED TO BANKS IN 2014
It was a time when many Indian business houses were getting into infrastructure projects, riding on easy liquidity and buoyant economic growth. The airlines sector too was opening up to private players.
Mallya positioned Kingfisher as a premium, world class airline. He personally hired his airhostesses and Yana Gupta, a Bollywood actor, performed in a video demonstrating safety instructions to passengers flying with the airline. In 2006, Kingfisher Airlines approached the Mumbai based IDBI Bank, seeking funds to acquire aircraft.
The credit committee of IDBI Bank was not convinced about financing a fledgling airline in a highly competitive and capital intensive industry. Moreover, before becoming a commercial bank, IDBI was a development financial institution, where it had faced problems with the credit extended to Mallya’s acquisition of Mangalore Chemicals and Fertilisers. The credit committee declined the proposal.
However, in 2009, in a volte face, IDBI Bank financed Kingfisher Airlines to the extent of Rs 900 crore. This move has come to hurt some top executives of the bank, who have been apprehended by the Central bureau of Investigation (CBI) in early 2017.
What went wrong with Kingfisher Airlines?
The airline industry, though competitive, was reeling under high operating costs. At the time Kingfisher Airlines started operating, crude oil prices were ruling high, which formed about half the operating cost burden. The high service standards set by the company also contributed to increasing operating costs.
In an ambitious plan to accelerate flying to international destinations, Kingfisher Airlines acquired a languishing Air Deccan in 2007. The group’s flagship and holding company, United Breweries Ltd, paid Rs 550 crore to buy a 26% stake in Air Deccan, which was then positioned as a low cost carrier.
Soon, Kingfisher Airlines catapulted to the second largest airline in India in terms of the number of passengers it carried. The Deccan acquisition had enabled the growing company to fulfil the criteria for flying to international destinations. In September 2008, just three years after it came into being, Kingfisher Airlines launched its Bengaluru- London flight.
Growth came at a heavy cost. Oil prices increased steeply between 2005 and 2010, and the company’s operating expenses soared, as did its losses. Its debt burden increased to Rs 934 crore at the end of March 2008, and its losses stood at Rs 188 crore. Just a year later, the debt had swelled to Rs 5665 crore, and the losses to Rs 1605 crore.
Chart 8.4 depicts the company’s worsening financials.
CHART 8.4 KINGFISHER’S FINANCIAL DECLINE
Kingfisher as NPA
In 20019-10, the debt burden had further increased to Rs 7000 crore. In November 2010, banks decided to restructure Kingfisher’s debt. Accordingly, the group of lenders led by State Bank of India (SBI) converted Rs 1355 crore of debt into equity at a 61.6% premium to the market price of Kingfisher Airlines stock at that time. The banks also extended the repayment period for loans to nine years with a two year moratorium at reduced interest rates, and also sanctioned fresh loans for the company to continue operations.
The loans to Kingfisher Airlines were backed by the following securities:
- The Kingfisher brand was valued at Rs 4100 crore, which was pledged to bankers.
- Personal guarantee of Mallya for Rs 248.97 crore.
- United Breweries Holdings Ltd corporate guarantee of Rs 1601.43 crore.
- Pooled collateral security of Rs 5238.59 crore, which included Kingfisher House, Mumbai, Kingfisher villa, Goa, helicopters, and other equipment such as computers, office equipment, furniture and fixtures, and an aircraft.
Kingfisher Airlines was grounded in 2012. The company owed employees their salaries and Provident Fund amounts that had not been deposited with the government. In 2013, the company’s flying permits were withdrawn.
In March 2013, the company’s accumulated losses soared to Rs 16023 crore, signifying a negative net worth of Rs 12919 crore.
Service tax of Rs 115 crore was in arrears of payment, and the authorities seized eight helicopters and aircraft of the company, including an Airbus. These assets were to be auctioned later to recover dues. Income tax of about Rs 372 crore deducted from employees had not been deposited with the government. In 2015, Mumbai International Airport Ltd (MIAL), sold Mallya’s personal aircraft for Rs 22 crore to recover airport dues.
Revival plan – also gone awry
Mallya was hopeful of a turnaround, and submitted revival plans to DGCA (Director General of Civil Aviation) and the bankers.
One of his plans was to sell a major stake in United Spirits Ltd, a company promoted by his father, through the holding company, United Breweries Holding Ltd (UBHL). Accordingly, he decided to sell a stake of Rs 5000 crore to British alcoholic beverages giant Diageo Plc. In July 2013, around Rs 2400 crore was sold to Diageo. But in December the same year, the group of banks struck the deal down by approaching Karnataka High Court, on the plea that the sale of UBHL stake in USL to Diageo was contrary to agreements between Kingfisher Airlines and its creditors, where UBHL is a guarantor.
At the end of March 2016, the total amount to be paid to employees of Kingfisher Airlines employees amounted to Rs 3000 crore. The total amount owed to banks crossed Rs 9000 crore.
Mallya had been asked by the Board of United Spirits Ltd to quit his position in the company. He was also asked to resign as Chairman of United Breweries Ltd.
In 2016, Mallya left India for the UK. The Indian government sought his extradition for trying him under various cases pending with Indian courts.
QUESTIONS ON THE CASE
- Why did Mallya, a seasoned businessman, promote Kingfisher Airlines?
- When other private airlines are still staying afloat, in spite of losses along the way, why did Kingfisher Airlines fail?
- In retrospect, what are the things that Mallya should have done differently?
- Is the Kingfisher airline NPA a creation of the bankers, the company, or the government?
- What are the lessons to be learnt by banks from the Kingfisher airlines experience?
- The need for banks to hold capital as a cushion against ‘UL’ will be dealt with in detail in the Chapter ‘Capital—Risk, Regulation and Adequacy’.
- Note that the Z score described in the previous chapter attempts to measure the probability of default typically over a 1 year horizon.
- Also defined simply as the value of the loan outstanding less the market (realizable) value of collateral held by the bank.
- See Chapter on ‘The Lending Function’ for more on loan pricing.
- Constantinos Stephanouand Juan Carlos Mendoza, ‘Credit Risk Measurement under Basel II: An Overview and Implementation Issues for Developing Countries’,World Bank Policy Research Working Paper 3556, Fig. 1 (2005): 7
- Basel Committee on Banking Supervision, Principles for the Management of Credit Risk (September 2000): 1.
- The grouping is as proposed by Peter Crosbie in ‘Modeling Default Risk’, published by KMV Corporation, Document no 999-0000-031, Revision 2.1.0 (1999):1–2.
- See chapter on ‘The Lending Function’ for more on loan pricing.
- A further particular instance of credit risk relates to the process of settling financial transactions. If one side of a transaction is settled but the other fails, a loss may be incurred that is equal to the principal amount of the transaction. Even if one party is simply late in settling, then the other party may incur a loss relating to missed investment opportunities. ‘Settlement risk’ (i.e., the risk that the completion or settlement of a financial transaction will fail to take place as expected) thus includes elements of liquidity, market, operational and reputation risk as well as credit risk. The level of risk is determined by the particular arrangements for settlement. Factors in such arrangements that have a bearing on credit risk include: the timing of the exchange of value, payment/settlement finality and the role of intermediaries and clearing houses.
- We have seen in the previous chapter that in India, restructuring invariably involves ‘sacrifices’ on the part of banks.
- Basically, the model works like this. Assume a lower return-to-risk asset is swapped for a higher return-to-risk asset. This improves the return of the overall portfolio with no addition to risk. The process of an asset being swapped out of a portfolio implies that the concentration of risk in the portfolio is being reduced, i.e., risk is being ‘diversified’. The reverse applies when an asset is swapped into the portfolio. Thus, the returns to risk increases for the low return asset and decreases for the high return asset, until the assets’ return to risk ratios converge. At this point, where further swaps that raise returns will also raise risk, the portfolio has reached its optimal level. (Source: Morton Glantz, ‘Managing Bank Risk’, Chapter 9, (Florida: Academic Press, 2003): 299–330.
- Morton Glantz, ‘Managing Bank Risk’, Chapter 9, (Florida: Academic Press, 2005): 299–330.
- Basel Committee on Banking Supervision, ‘Principles for the Management of Credit Risk’, (September 2000): 18.
- We have seen earlier in this chapter that ELs are equal to the exposure times the percentage loss given the event of default times the probability of loss. Hence, actual losses would be the product of the first two factors alone.
- Ibid., 22.
- Ibid., 23.
- Until Basel II formalized the use of PD, this concept was often called Expected Default Frequency (EDF)).
- Please refer the previous chapter for a discussion on these models.
- Table derived by author from presentation material by Michel Crouhy, ‘Credit Risk Assessment: A Comparative Study of Different Methods’, at seminar on ‘Global Risk Management Practices and Emerging Market’s Particular Issues’ at Moscow, (15–16 June, 2004).
- Ibid., 15.
- Nikola A Tarashev, ‘An Empirical Evaluation of Structural Credit Risk Models’, BIS Working Papers no. 179, Bank for International Settlements, (July 2005): 5–8.
- ‘Without recourse’ implies that the issuer of security or the investors will have no recourse to the originator if there is shortfall in asset value at the end of the tenure of the securitized asset. The issuer/investor will have to look solely at the cash flows from the securitized assets for their return.
- For more on transfer of credit risk, please see the section on ‘Credit Derivatives’.
- ISDA-The International Swaps and Derivatives Association.
- A ‘swap’ is an agreement in which two parties (called counter parties) agree to exchange periodic payments. The amount of payments exchanged is based on a notional principal amount. A swap can be viewed as a package of forward contracts, with more liquidity and longer maturity than typical forward contracts.
- The other settlement method is for the protection buyer to make physical delivery of a portfolio of specified deliverable obligations in return for payment of their face amount. Deliverable obligations may be the reference obligation or one of a broad class of obligations meeting certain specifications, such as any senior unsecured claim against the reference entity.
- Called ‘risky debt’ because there is a possibility that the debt may not be repaid in full.
- This is done through a complex method. The put buyer pays a premium for the right to sell to the put seller a specified reference asset and simultaneously enters into a swap in which the put seller pays the coupons on the reference asset and receives 3 or 6 month LIBOR plus a predetermined spread (the ‘strike spread’). The put seller makes an up-front payment of par for this combined package upon exercise.
- ‘Negative carry’ is the loss in income due to investing funds obtained at higher cost in lower yielding investments to ensure liquidity.
- Christian Bluhm, et al., ‘An Introduction to Credit Risk Modeling,’ Chapter 7, ‘Credit Derivatives’, ISBN 1-58488-326-X, Chapman&Hall/CRC (2003).
- Basel Committee on Banking Supervision, ‘Consultative Paper: The Standardised Approach to Credit Risk’, (January 2001): 33–34.
- An asset mismatch occurs when a credit protection contract refers to an instrument that is not the same as the exposure being hedged.
- RBI, ‘Master Circular—Exposure Norms’, (July 1, 2015).
- As defined by the RBI under capital adequacy standards (please see chapter on ‘Capital—Risk, Regulation and Adequacy’) and as per published accounts at the end of the previous financial year. Exposures cannot be taken in anticipation of capital infusion at a future date.
- RBI ‘Master Circular—Prudential Norms on Income Recognition, Asset Classification and Provisioning Pertaining to Advances’, July 1, 2015.
- Any amount due to the bank under any credit facility is ‘overdue’ if it is not paid on the due date fixed by the bank.
- An account should be treated as ‘out of order’ if the outstanding balance remains continuously in excess of the sanctioned limit/drawing power. In cases where the outstanding balance in the principal operating account is less than the sanctioned limit/drawing power, but there are no credits continuously for 90 days as on the date of balance sheet or credits are not enough to cover the interest debited during the same period, these accounts should be treated as ‘out of order’.
- ‘Liquidity facilities’ enable the securitization vehicles to assure investors of timely payments. These include smoothening of timing differences between payment of interest and principal on pooled assets and payments due to investors
- Interest on advances against term deposits, NSCs, IVPs, KVPs and life policies may be taken to income account on the due date, provided adequate margin is available in the accounts. Fees and commissions earned by the banks as a result of renegotiations or rescheduling of outstanding debts should be recognized on an accrual basis over the period of time covered by the renegotiated or rescheduled extension of credit.
- As defined in ‘AS 19—Leases’ issued by the Council of the Institute of Chartered Accountants of India (ICAI).
- A ‘standard’ account is not an NPA. It carries normal business risks, the securities are sufficient to cover the advances made and the firm is currently meeting its interest and principal repayment obligations.
- Considering that higher loan loss provisioning adds to the overall financial strength of the banks and the stability of the financial sector, banks are urged to voluntarily set apart provisions much above the minimum prudential levels as a desirable practice. RBI has been monitoring the accounting treatment of such floating provisions and issuing guidelines from time to time. At the G20 meet in London held in April 2009, the Group agreed to initiate several measures to strengthen the international frameworks for prudential regulation. The Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS) and Committee on Global Financial System (CGFS), along with various accounting bodies, would be working on the proposal to build buffers of capital and reserves in good times, so that the risk to financial stability can be mitigated when conditions worsen.
- SICA—Sick Industrial Companies Act—which has since been repealed.
- Guidelines on ‘Securitization of Standard Assets’ issued by the RBI on 24 January, 2006.
- For the salient features of the Act relevant to banks, please refer ‘Annexure to RBI Guidelines to Banks/ FIs on sale of SC/RC (created under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002) and related issues’, and for the salient features relevant to securitization and reconstruction companies, please refer to RBI, Notification dated 23 April 2003, ‘The Securitization Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003’, as well as subsequent notification and amendments. All the resources can be accessed at www.rbi.org.in. Including RBI master circular “Prudential norms on Income recognition, Asset classification and provisioning” dated July 1, 2015.
- Information from http://www.bizfinance.co.in/page.php?page-id=39#sthash.cId6y40W.dpbs
- RBI Master Circular dated July 1, 2015 can be accessed at https://rbidocs.rbi.org.in/rdocs/notification/PDFs/53MN7BF63B7F465A4A2F9341D423B5773C5A.PDF
- Source: http://www.indiainfoline.com/article/news-top-story/indian-securitization-market-grew-by-45-in-fy16-outlook-positive-in-fy17-116052400757_1.html. The Charts and tables are also accessed from this source
- RBI, 2011, ‘Guidelines on Credit Default Swaps for corporate bonds’, dated May 23, 2011, and ‘Prudential guidelines on credit default swaps’, dated November 30, 2011. RBI, 2013, Revised guidelines on CDS for corporate Bonds, dated January 7, 2013.
- In November 2012, SEBI permitted Mutual funds to enter the CDS market only as ‘users’ – protection buyers
- April 2014, (http://www.bis.org/publ/bcbs283.pdf
- April 2017, (http://www.bis.org/bcbs/publ/d403.pdf
- Frank J Fabozzi, and Vinod Kothari, ‘Securitization: The Tool of Financial Transformation,’ Yale ICF Working Paper no. 07–07, downloaded from http://ssrn.com (31 March 2008)
- Source: CRISIL website : accessed at http://crisil.com/Ratings/Commentary/CommentaryDocs/ABS-MBS-BOOK.pdf, pages 13, 14, 15
- Drawn from various published sources, particularly an article in the Indian Express, , March 14, 2016, From bang to bust: The Kingfisher story, accessed at http://indianexpress.com/article/india/india-news-india/sunday-story-once-upon-a-time-there-was-a-king-