In an attempt to regulate the securities market in a more sophisticated direction and open up newer avenues, the Reserve Bank of India (‘RBI’) on June 8,2020 introduced the ‘Draft Framework for Securitisation of Standard Assets’ (‘Framework’), accompanied by a draft framework for ‘Sale of Loan Exposures’. It is expected that India’s securitisation market will undergo a much-anticipated overhaul, which has been in the RBI’s line of sight since it set up a Task Force on the Development of Secondary Market for Corporate Loans and a Committee on Development of Housing Finance Securitisation Market in 2019.
Securitisation acts as a reliable source of funding for the financial institutions, while also supporting them in managing their structural asset liabilities. It generates credit for the businesses and households, and infuses liquidity into the economy. Since the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (‘SARFAESI’) Act of 2002 dealt only with the securitisation of stressed assets, a set of Guidelines was issued by the RBI in 2006, under the powers conferred to it by the Banking Regulation Act and the RBI Act, to regulate the securitisation of non-stressed or standard assets. However, as the securities market of the United States was at the center of the financial crisis in 2007-08, which crumbled the global economy, it forced the major economies of the world, including India, to rethink their securities regulations and re-model them with more transparency and vigil. This led to two major amendments to the guidelines, introduced in 2012 and 2013, which set forth various changes to safeguard the Indian market from manufacturing a similar crisis.
With the introduction of the new framework, the RBI has decided to create a regulatory scheme which not only allows development of a strong and robust liquid secondary market in securitised assets, but also follows the international standards, most importantly the Basel III and IFRS guidelines. One of the major recommendations of the two committees set up by the RBI was that direct assignment transactions were understood to be in the nature of a ‘loan sale’, and securitisation of standard assets and sale of loan exposures should be regulated separately, furthering their operational clarity. This resulted into the bifurcation of guidelines for ‘Sale of Loan Exposures’ from the Securitisation Guidelines.
Revamping the Current Securitisation Model
The securitisation framework has introduced a wide number of changes from the previous guidelines, as the RBI has sought to give more leeway to the institutions without sacrificing its stronghold upon them. The major revisions that have been introduced by the Draft Securitisation Framework, have been critically analysed below.
A more inclusive definition of ‘securitisation’
The framework has completely replaced the earlier definition of ‘securitisation’ with a modified one, keeping in view its international understanding. Earlier, securitisation was defined as the sale of performing assets to a bankruptcy remote special purpose vehicle (‘SPV’), in return for an immediate cash payment. However, the framework has inculcated the concept of ‘tranching’in its very definition [guideline 5(u)], which was missing in the earlier guideline. ‘Tranching’ is the process of dividing the credit portfolio in segments. The RBI has noted that “…only transactions that result in multiple tranches of securities being issued reflecting different credit risks will be treated as securitisation transactions”. Further, the payment and losses are now to be determined by the performance of exposures and subordination of tranches, respectively.
Tranching is essential for providing a structure and rating to any pool of exposures, and leads to a greater understanding of the credit risks by the lender and the investors. Non-tranched portfolios have a risk of containing bad debts, and may lead to defaults on a major part of the exposures pool. Making tranching of credit risks, a necessary condition for sale of securities, is a measure that has been followed all over the world. By inculcating this, the RBI has made the much required amendment that has been long overdue.
Furthermore, guideline 6 specifies the instruments that can and cannot be securitised. It states that all on-balance sheet standard exposures, except the following, will be eligible for securitisation by the originators:
- Revolving credit facilities (e.g. Cash Credit accounts, Credit Card receivables etc.);
- Loans with bullet repayments of both principal and interest; and
- Securitisation exposures.
Aligning the market with Basel III
The framework has brought its capital measurement approaches in alignment with the Basel III framework of securitisation, which is in effect since January 1, 2018; and has made the requirements applicable to both banks and other financial institutions, including housing finance companies (‘HFCs’). The Basel requirement of having stratified risk positions in exposures is fulfilled by the presence of tranches, and the framework (guideline 81) has provided two options of credit review and ratings to banks [Securitisation External Ratings Based Approach (‘SEC-ERBA’) & Securitisation Standardized Approach (‘SEC-SA’)], out of four present in Basel III.
The SEC-ERBA is based on external ratings of the exposure. In case of unrated positions, inferred ratings may be used. The standard risk weightings are ascribed to securitisation positions by rating, seniority and maturity, with an adjustment for thickness of the tranche. The SEC-SA is based on the pool capital requirement calculated under the standardised approach for credit risk (known as “KSA“) with inputs for the attachment and detachment points of the tranche and the ratio of exposure in default to the whole pool. It uses the capital requirement for the underlying exposures using the standardised approach for credit risk as an input.
For other institutions, only the SEC-ERBA is allowed. Though the framework has left it upon the banks to choose between the two, Basel has provided that the SEC-SA is to be used only when the SEC-ERBA is not permissible.
The RBI is fashioning the market in harmony with these international standards, as they are considered simpler, more risk-sensitive, prudently calibrated and broadly consistent with the underlying framework for credit risk. Presence of such standards enhances transparency and comparability across banks and jurisdictions. By a uniform application of these standards, the process of securitisation can be made more effective and profitable.
Broadening the concept of securitisation
The framework has introduced two special instances of securitisation which are Single Asset Securitisation (‘SAS’); and a Simple, Transparent and Comparable Securitisation (‘STC’). These provisions are included for broadening the ambit of securitisation, and for developing a parallel securities market. The SAS will help incentivize investors to acquire loans through secondary market. This will be another step in the direction of various regulatory measures undertaken by the RBI to promote sale of corporate loans, which includes permitting transfer of borrowal accounts from one bank to another, and transfer of assets through securitisation. The term single-asset was present in the original guidelines of 2006. However, the RBI later changed its stance as it was considered to be against the economic objectives of securitisation in the 2012 revision, where it stated that “The single asset securitisations do not involve any credit tranching and redistribution of risk.” This however, has now been revised as in the current guidelines, the RBI has re-instated its original position of the 2006 Guidelines.
STC securitisation emanates from Basel, and STC compliance, results into an alternative regulatory capital treatment with lower risk rates. Further, the framework has removed the restriction upon securitisation of exposures purchased from a ‘third party’, with a condition that the originator holds the exposures for at least 12 months, and conducts appropriate due diligence.
Relaxing the residential mortgage-backed securitisation
One major step, which is based upon the considerations of Committee on Development of Housing Finance Securitisation Market, is to lower the requirements of Residential Mortgage-Backed Securitisation (‘RMBS’) from other forms of debt-securitisation. For RMBS, the Minimum Holding Period (‘MHP’) and Minimum Retention Requirement (‘MRR’) are lower than other securities. The Committee has opined that since residential mortgage is considered safer than other credit forms, it should not be subject to the equally restrictive conditions. The underlying security for home loans is much stronger as it is an immovable property. Also, the value of the property generally appreciates increasing the security cover over its life unlike other asset backed securities. However, given how the bad housing loans were at the center of the financial crisis of 2007, the need for strict scrutiny of these arrangements cannot be more emphasized.
Three other major changes, taken to keep up with the international arena, are listing of securities, payment priorities, and replenishing structures. All of these provisions have been introduced keeping in mind the international perspective of securitisation, such as the European Union (EU) framework of securitisation. Any value of exposures in a RMBS which is more than Rs. 500 Crore, will mandate a complete listing of underlying securities. It is a beneficial provision as it will allow easy exit, transparency that listing brings with it and liquidity. Priorities of payment of securitisation has to be listed in the contract of transfer of securities, as it leads to better transparency and understanding between the lenders and investors. Finally, the framework has introduced the concept of replenishing or revolving structures, in which the investors use the cash flows from the securitised assets to acquire more assets. After the termination of the replenishment period, the securitisation converts into an amortising one. This will help investors package shorter tenor loan deals and ensure better return to them.
The present framework is a welcome change. These changes would have a major role to play as the market revives in the aftermath of the Covid crisis. The framework seeks to streamline and standardize the practice of securitisation, leading to a robust securities market in India. It is supposed to be the culmination of a long series of steps undertaken by the RBI to foster the securities sector, and to promote securitisation as a well-developed mechanism in the financial sector. It also clears the air around the permissibility of certain structures that remained uncertain before this. The RBI, with this, has strived towards securitising certain loans which were not available before. This will not only help achieve a more investment friendly market, but also a more diverse one, which would in turn increase the liquidity and will tackle bad loans in various financial institutions. The increase in liquidity and minimizing the risk of bad loans particularly, would provide the much-required boost in the revival of market in a post-Covidera. The new introductions are also the RBI’s bid to make room for a more transparent scheme which will further lower the chances of someone getting bamboozled in the market chain. After all, building a more robust national securitisation regime will help manage and diversify risks, which would give the economy a much-needed stability as we enter the post-Covid era.
– Adesh Sharma & Saksham Shrivastav