By Vinod Kothari,

Microfinance Focus, September 27, 2011: The RBI released on 27th September the much awaited revised draft of the securitisation guidelines. The first draft was proposed long time back in April 2010.

By way of quick comments, the revised draft guidelines have reduced the required minimum holding period (MHP) and minimum risk retention (MRR) requirements proposed in the April 2010 draft.  In addition, the revised draft has permitted upfront recognition of the cash profit made by the seller in securitisation as well as bilateral sales, thereby the RBI sitting in the capacity, with several conflicts, of an accounting standards body. The revised guidelines have retained the bar in the April 2010 draft in respect of both synthetic transactions as well as revolving securitisation – the basis for which is completely ununderstandable.

The initial feedback of the author is securitisation players in India, armed with the RBI guidelines, will perhaps ignore accounting standards, and use premium structures to book upfront profits in securiitsations. It is notable that accounting standards do not go by true sale as the basis for off balance sheet treatment as well as booking of gain on sale, while the RBI seems to have been overwhelmed by so-called true sale requirements. Thus, securitisation market may get a shot in the arm and may be  back with a bang. Microfinance securitisations as well as portfolio sales – which have been recognized as priority sector exposures in the hands of the buying banks – will still remain subdued to the impractical MHP requirement, and almost a mindless bar on revolving transactions.

The Minimum risk retention: international and Indian norms:

MRR in securitisations is an international regulatory trend to impose the so-called “skin in the game” requirements on originators. EU regulators have recently enforced the MRR requirements at 5% of economic exposure, though in its details, the exposure can be split in various ways as horizontal piece, vertical piece and L piece. In the USA, the massive Wall Street Reform Act requires Federal regulators to frame rules on the issue – the SEC has come up with draft rules still to be finalized.

In India, the RBI’s April 2010 draft had proposed a 10% MRR requirement. The revised draft guidelines make the MRR requirement far more rational, by  laying down a 5% MRR in case of transactions involving loans of original maturity of 24 months or less. In case of loans with original maturity of more than 24 months, the MRR has been set at 10%.

There is, however, a substantial flexibility there. In case of transactions involving tranches, if the first loss tranche is less  than 10%, the originator may hold the equity tranche, and make proportional investments in senior tranches. This becomes the kind of L piece acceptable by EU regulators.

Minimum holding period requirements:

It is notable that EU and US regulations do not lay down minimum seasoning or holding period requirements. In India, this is a reaction to the loans that some smart banks had sold to not-so-smart mutual funds, and the loans busted soon after their sale.

The MHP requirements have been rationalized to some extent:

•    In case of loans having monthly payments, and having an original maturity of upto 24 months, the MHP will be 6 months from the due of date of the first instalment.
•    In case of loans having quarterly payments, and having an original maturity of upto 24 months, the MHP will be 9 months from the due of date of the first instalment.
•    In case loans having original maturity of more than 24 months, the MHP will be 12 months.

Microfinance securitisations will still remain affected as 6 months’ seasoning will be too long for microfinance loans. Given the fact that revolving transactions are not permitted, it only leaves a thin tail to be securitized.

Gain on sale:

The so-called profit booking guidelines, known as gain-on-sale under international accounting norms, are the most interesting part of the RBI guidelines. The Feb 2006 Guidelines of the RBI had prohibited booking of profits, but then the easy way out that the market had found to that was that bilateral transactions were not covered by the Feb 2006 guidelines. Now, bilateral transactions are well covered by the revised draft guidelines. However, as an interesting provision, the revised draft guidelines permit upfront profit recognition, however, to the extent of the profit encashed upfront, that is, the sale consideration exceeding the carrying value of the assets. It will always remain intriguing as to what is “cash profit”  - whether the securities issued by the SPV as a part of the transaction of securitisation will also form a part of the consideration, and therefore, be called a “cash profit”. It cannot, for example, be insisted that the cash consideration for sale should exceed the carrying value of the loans, because the originator has to perforce acquire a stake equal to the MRR, and to that extent, there is no point in the originator paying cash and getting back cash.

It is interesting to see the RBI sitting in the position of an accounting standard setter – the role could have  been best left to accounting standard bodies. There is already an elaborate accounting standard IndAS 39 on the issue – which is at par  with international accounting standard. That standard is far more conservative and far more mature than what the RBI has laid down. As per international rules, off-balance sheet treatment and booking of gain/loss on sale both go hand in hand, and both are independent of legal true sales. A transaction may or may not be a legal sale, and yet profit may or may not be booked. The determination is based on retention of risks and rewards, and surrender of control by the seller. Given the fact that most regulators now impose minimum risk retention requirements, it is generally felt that off balance sheet as well as gain-booking will not be permissible for most securitisation transactions.

While these accounting standards are still intended to be mandatory in India, it is strange to see the RBI writing its own rule on profit-booking. The RBI’s version of the accounting standard is that profits can be booked to the extent of cash profit, and from this cash profit, losses attributable to the seller, including mark to market losses, will be debited against the profit so booked.

References to mark-to-market losses may be taken as implying that the originator will continue to fair value the value of the retained risk, and evaluate how much loss may be attributed to the seller.

Synthetic and revolving transactions not permitted:

In a market which is increasingly using credit derivatives, it is quite strange to find the RBI not permitting synthetic securitisations.

Also, revolving transactions are the norm in case of short-tenure transactions like microfinance receivables. Strangely enough, the RBI has prohibited revolving transactions altogether.

Neither are re-securitisation transactions permitted.

Conclusion

The securitisation market in India has been shaped by regulations – the Feb 2006 made the market primitive by forcing it into the bilateral mode. That party existed for years – till last year, when the RBI came with revised draft of the guidelines. The present draft guidelines are a great improvement on the draft that came in last April; however, there is a substantial scope for rationalization, particularly on the so-called re-set of credit enhancements. The term re-set of credit enhancements has been wrongly understood by the standard-setters. If the MRR is 5%, the percentage is to be applied not to the initial value of the pool, but the-then outstanding value. Clearly, what may be default is the-then value of the pool, and not what has already been paid down. Therefore, repaying subordinated securities proportionally is not a case of re-set of credit enhancements at all.

Also, the bar on revolving and synthetic transactions is completely without any rationale.

About the author:

Mr. Vinod Kothari, based in Kolkata, India is internationally recognised as an author, trainer and expert on securitisation, asset-based finance, credit derivatives and derivatives accounting. He offers about 20 training courses every year on credit risk, securitisation and credit derivatives all over the World. For more information Visit Author`s website: http://www.vinodkothari.com .

Disclaimer: The views expressed in this article are of the author and do not necessarily reflect the views of Microfinance Focus