ICRA RATING FEATURE

May 2012

STRUCTURED FINANCE

RBI FINAL GUIDELINES ON SECURITISATION AND DIRECT ASSIGNMENT TRANSACTIONS SIGNIFICANT DECLINE IN VOLUMES EXPECTED
Contacts
Structured Finance Ratings Group
Kalpesh Gada HeadStructured Finance (91) 22-3047 0013 kalpesh@icraindia.com

Background
The RBI, on 7 May 2012, has put out the final guidelines on securitisation and direct assignment of loan receivables. This is the first time the RBI has issued separate guidelines for Direct Assignment transactions. These guidelines are largely similar to the draft guidelines released in September 2011, other than some differences the key ones pertain to Minimum Holding Period (MHP) requirement and credit enhancement reset.

Impact Summary
The biggest impact of the Guidelines is expected to be on Direct Assignment transactions that formed about 75% of the market in FY2012 (as per ICRAs estimates)). Under the Guidelines, no credit enhancement is permitted for these transactions. Given the prohibition on credit enhancement, the investing banks will be exposed to the entire credit risk on the assigned portfolio, which most banks may not be comfortable with. Hence the volume of such assignment transactions is expected to be severely affected. One of the key objectives of the banks to acquire loan pools was to meet their Priority Sector Lending (PSL) targets, particularly post RBIs Master Circular of July 2011 on Priority Sector Lending as per which loans by banks to NBFCs no longer qualify as PSL. Given that the need to meet PSL targets would continue to be there, banks could shiftat least partlyto the securitisation route to meet these targets. However, the deterrents to such a shift to securitisation are two-foldhigh capital charge for Originators1 and impact of mark-to-market for the Investing Banks. Further, the unresolved issue of the Income Tax authorities claim of taxing the Special Purpose Vehicle (SPV) involved in securitisation transactions as a separate entity is another factor likely to constrain a wide-spread move towards securitisation. Other key provisions of the Guidelines pertain to Minimum Holding Period (MHP) and Minimum Retention Requirement (MRR). These requirements are not expected to have any major impact on the securitisation or assignment of any underlying asset class, as these are relatively easy to comply with. Investing banks are expected to stress test their securitisation investments / acquired portfolio and continuously monitor the same. Further, banks acquiring loan pools directly are expected to meet strict own due diligence requirements and have skilled manpower and systems to carry out the process. However, some banks may not have adequate systems or processes in place to comply with these requirements.

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Indian Securitisation MarketFY2012

Key Highlights of the Guidelines and their impact

MHP and MRR Requirement more standardised pool compositions likely
The final guidelines of May 2011 have essentially reviewed the Minimum Holding Period (MHP) and Minimum Retention Requirement (MRR) prescribed in April 2010 and subsequently in September 2011; while the MHP requirement has been reduced to an extent, the MRR remains largely unchanged. These guidelines are aimed at ensuring Originators do not compromise on due diligence of the assets generated for the purpose of securitisation or Assignment, curbing the originate-to-securitise business model, and bringing in greater alignment of interest between the Issuers of and Investors in securitised paper. The final MHP requirement and MRR are discussed below.

Table 1: Minimum Holding Period (MHP) Requirement Repayment Frequency Type of Loan Original Maturity of less than 2 years Original Maturity of 2-5 years Original Maturity of more than 5 years Weekly 12 18 Fortnightly 6 9 Monthly 3 6 12 Quarterly 2 3 4 More than quarterly 2 2 2

In the final guidelines, MHP has been defined as minimum number of instalments to be paid prior to securitisation rather than minimum number of months on book of the Originator. The impact of the MHP requirement on asset classes such as Commercial Vehicles (CV), Car, Tractors where the initial tenure of typically 3-5 years is not expected to be material, since most of these pools typically have been observed to be having an average seasoning (at the time of securitization) of around 6 monthsand thus largely compliant on this front already. Similarly, the MHP is unlikely to be a constraint for home loan securitization. However, the MHP requirement would constrain pools of one-year maturity loans (mainly pools of microfinance institutions). Nevertheless, from the perspective of MFIs, the final guidelines are an improvement over the September 2011 draft, which had a tougher MHP requirement.

Table 2: Minimum Retention Requirement (MRR) for Securitisation

Type of Loan Original Maturity of 24 months or less MRR 5% of book value of loans securitised Description of MRR For transactions with no credit enhancement and no tranching, the MRR would be met by way of investing in 5% of the securities issued. For transactions with no credit enhancement, the MRR would be met by way of investing in 5% of the equity tranche. For transactions with credit enhancement, the MRR would be met by way of investing in 5% of any of the first-loss credit enhancements. For other transactions, the MRR would be met through Originator taking an exposure to equity stake, first-loss credit enhancements and pari passu tranche of 5% all taken together. For transactions with no credit enhancement and no tranching, the MRR would be met by way of investing in 10% of the securities issued. For transactions with credit enhancement, the MRR would be met by way of investing in 10% of the first-loss credit enhancements. For transactions having no credit enhancement, the MRR would be met by taking up exposure to equity stake or to the extent of 5%, and the balance 5% in the form of pari passu investment in all the tranches of the securities For other transactions, the MRR would be met through Originator taking up a minimum equity stake or any of the first-loss credit enhancements of 5%, and the balance in the form of pari passu investment in all the tranches of the securities. Similar to loans with Original Maturity of more than 24 months for transactions with no credit enhancement and no tranching and for transactions with credit enhancement. For transactions having no credit enhancement, the MRR would be met by taking up exposure to equity stake or to the extent of 10% For other transactions, the MRR would be met through Originator taking an exposure to equity stake, first-loss credit enhancements and pari passu tranche of 10% all taken together.

Original Maturity of more than 24 months

10% of book value of loans securitised

Bullet Repayment Loans/ Receivables

10% of book value of loans securitised

The MRR continues to be largely in line with the draft guidelines. In the case of Direct Assignment transactions, the amount to be retained is in line with those laid down for securitisation transactions for 24 month or less and more than 24 months maturity loans; however, the same can be retained on a pari- passu basis with the assigned cashflows only. The impact of MRR on transactions is expected to be insignificant.
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ICRA Rating Feature

Indian Securitisation MarketFY2012

In addition to this, the total exposure of banks to loans securitised should not exceed more than 20% of total securitised instruments issued that includes meeting MRR, all cash collateral and over-collateralisation but excludes EIS. Any excess exposure initially will attract higher risk weight of 1111%.

Release of residual EIS a positive but final view on reset of credit enhancement critical
The guidelines clarify that periodic release of residual unutilised Excess Interest Spread (EIS) to the Originator is permissible, which is a positive. However, the issue of reset of credit enhancement for securitisation transactions is expected to be covered through a separate circular subsequently. The draft guidelines had provided for reset of credit enhancement subject to various conditions. The RBIs final position on this issue would also be one of the important factors determining Originators motivation to securitise its assets. The credit enhancement provided by the Originator for securitisation transactions needs to be reduced from its capital. Over the tenure of the pool, the underlying pool would amortise, and in the absence of downward reset, the credit enhancement, in % terms, would keep increasing. Thus, the annual cost of capital associated with the transaction would rise significantly in the subsequent years, which is one of the deterrents to securitisation.

Requirements to be met by investing Banks could be a constraint for some banks initially
Banks investing in securitisation transactions are expected to be able to demonstrate a comprehensive and thorough understanding of the risk profile of their investments. They are also expected to perform appropriate stress testing pertaining to their positions and monitor the performance of the underlying exposures on a regular basis. Given that many banks may not have the adequate systems in place to comply with the stipulated requirements, they have been given a time frame till 30 September 2012 to put necessary systems and procedures in place to be able to comply with the requirements of the guidelines. Failure to meet the norms would attract a risk weight of 1111% to the securitisation exposures from 1 October 2012 onwards.

Direct Assignment transactions likely to be severely affected

While the MHP requirement and the broad stipulation under MRR and monitoring by investing banks is similar for Direct Assignment and securitisation transactions, some key areas of difference from the provisions for securitisation are summarised belowThe guidelines prohibit any credit enhancement for direct assignment transactions, based on the premise that the investors in such cases are generally institutional investors who should have the necessary expertise to appraise and assume the exposure based on their own due diligence. In the absence of credit enhancement, the bilateral assignment transactions would require a precise valuation; in other words an estimation of the cashflows actually likely to materialise would be required. Given the nature of the underlying loan pools, such a precise valuation would be a huge challenge. There may be no meeting ground between the buyer and seller on the expected losses in the pool. Moreover, the Originators in the case of Assignment transactions are also prohibited from re-purchasing any assets through exercise of clean-up call options. The capital adequacy treatment for direct purchase of retail loans, will be as per the rules applicable to retail portfolios directly originated by banks2. No benefit in terms of reduced risk weights will be available to purchased retail loans portfolios based on rating. Nevertheless, in the absence of credit enhancements, the rating of a typical retail loan pools is anyway expected to be very low, thus the prospect of reduced risk weight is minimal. These regulations are expected to significantly reduce the volume of direct assignment transactions going forward. Albeit, some portion of the issuances could be expected to be routed through the conventional securitisationor PTC issuanceroute. However, the deterrents to such a shift to securitisation are two-foldhigh capital charge for Originators3 and impact of markto-market for the Investing Banks. Further, the unresolved issue of the Income Tax authorities claim of taxing the Special Purpose Vehicle (SPV) involved in securitisation transactions as a separate entity is another factor likely to constrain a wide-spread move towards securitisation. In a broader sense, the likely dip in volumes of off-book funding is a negative for NBFCs, especially those for whom securitisation / bilateral assignments were an important funding source.

Securitisation Activities not permitted

Banks are not permitted to undertake securitisation activities or assume securitisation exposures pertaining to re-securitisation of assets, synthetic securitisation and securitisation with revolving structures. However, such transactions are not popular in the Indian market in any case.
2

except in cases where the individual accounts have been classified as NPA, in which case usual capital adequacy norms as applicable to retail NPAs will apply 3 Credit enhancement offered is to be reduced from capital

May 2012

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