[Vedaant and Shivankar are students at National Law University, Jodhpur. The following post won the second prize in the Second IRCCL Blog Writing Competition (2021-22), organised in association with Khaitan & Co.]
The Indian securitization market does not feature among the most dynamic or high stakes domains of finance in current times. The lack of investor appetite for securitization has in turn resulted in low volume of trade in the securitization market over the course of decades. In order to boost the performance of the securitization market, the government has recently taken several proactive steps to ensure higher liquidity in the market by freeing up the assets on the bank’s balance sheets to ensure higher credit availability in the economy. With a view to revitalizing the secondary market for standard assets, recently, RBI introduced the Master Directions on (Transfer of Loan Exposures) Directions 2021 and Master Directions on (Securitization of Standard Assets) Directions 2021. This was followed by a Report by the Sub-Committee to Review the Working of Asset Reconstruction Companies towards the end of the year.
While the objective of the government was giving a much needed boost to the securitization market during the pandemic for increasing the liquidity in the sector, previous experiences with securitization are a testament to the fact that it requires a delicate balancing exercise between optimism and caution. The authors in this post seek to analyze the aforementioned reforms in the securitization market in this context.
The article will first briefly describe the legal regime governing securitization while understanding the implications of the changes brought in by the above discussed reforms. The latter part of the article will identify the pitfalls and benefits offered by the reforms such as anomaly created by the revised definition of 'securitization', dilution of risk retention requirements under the revised directions and proposed inclusion of ARCs in resolution of companies under the Insolvency and Bankruptcy Code 2016 (IBC). In conclusion, the article will recommend the additional changes which can be incorporated in the Indian regime to rejuvenate the Indian securitization ecosystem.
In India, securitization of standard assets and stressed assets is regulated under different frameworks. The securitization of stressed assets and their enforcement is formally governed and regulated by the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 (SARFAESI Act), whereas securitization of standard assets was governed by master directions issued by the RBI from time to time.
Securitization of stressed assets
The primary aim of SARFAESI Act is to off-load the burden of non-performing assets (NPA) and relieve the ailing financial sector. The enactment, towards this end, envisages a market mechanism that reduces the time spent by banks and financial institutions on loan recovery process and enables them to salvage those NPAs by employing measures such as reconstruction or securitization. Resultantly, freeing-up the balance sheet of the banks so as to enable them to maintain liquidity in the market.
The SARFAESI Act, essentially, empowers the secured creditors (i.e. Banks and Financial Institution) to take possession of securities charged on the loans (classified as NPAs) without the intervention of the court. Once in possession, banks can transfer the stressed assets to a Special Purpose Vehicle (SPV) towards immediate realization of its dues. The SPV would aggregate all such stressed assets to further re-package the loans through 'securitization' into marketable securities and sell the security receipt (SR) to the investors. Thus, in this context, securitization is the process of conversion of the underlying pool of stressed assets into marketable securities.
An important feature of this process, considered to be an innovation of the SARFAESI Act, is the introduction of Asset Reconstruction Company (ARC). These ARCs are companies registered with the Reserve Bank of India (RBI) under Section 3 of the SARFAESI Act to conduct the business of asset reconstruction and securitization. Accordingly, ARCs are those SPVs that take over the stressed assets from banks, clearing up their balance sheet. The main task is to convert this pool of NPAs into performing assets, while repacking and securitizing them into marketable securities. Accordingly, ARCs are expected to play a critical role in reducing the mounting NPAs, coupled with recovery of stressed business and assets.
However, the performance of ARCs has been unsatisfactory, with uninspiring improvement in terms of resolution of stressed assets. This is mainly attributable to “vintage NPAs being passed on to ARCs, non-availability of additional funding for stressed borrowers, and difficulty in raising of funds by the ARCs”. Taking note of these challenges, RBI constituted the Committee to Review the Working of Asset Reconstruction Companies (Committee) to evaluate the business model of ARC. RBI released the report on 2 November 2021 which recommended inter alia early sale of stressed assets to ARC, transparency and uniformity in the process of sale, making additional funding available for stressed borrowers and infusing liquidity for ARC.
Securitization of standard assets
Securitization of standard assets is governed by the RBI, originally, under Guidelines on Securitization of Standard Assets vide circular dated 1 February 2006. Acknowledging the need for a robust securitization market in India, while incentivizing simpler securitization structures, RBI also recently issued two new master directions – RBI (Transfer of Loan Exposures) Directions 2021 and RBI (Securitization of Standard Assets) Directions 2021 vide circular dated 24 September 2021. These master directions, aimed at rejuvenating the securitization market, have introduced sweeping changes and reforms in the ecosystem. However, some pitfalls have also been created through this direction which the authors seek to analyze through this article.
Definition of Securitization of Standard Assets
One of the departures under the RBI (Securitization of Standard Assets) Directions 2021 from the previous regime is with respect to the definition of 'securitization'. The earlier definition of securitization as laid down in the revised master directions of 2012 specifically excluded the single assets from being securitized. To understand the counter-productive nature of securitization of single assets, it is necessary to discuss the objective of securitization.
One of the major objectives to securitize the assets is to ensure that the risk attached to the asset is redistributed and spread over a large base of investors so that no single investor or entity bears all the brunt of default in an underlying loan. The risk borne by the large set of investors is also greatly offset by pooling and tranching of different assets, which ensures that during the life of the transaction the risk of default is distributed among the tranches. In contrast, in single asset securitization, a solitary default has the risk of bringing the castle down.
This objective is affirmed by the definition of 'securitization' as it exists in the European Union which maintains 'tranching' and 'pooling' of assets to be crucial to classify any transaction as securitization. Similarly, the requirement of a transaction to distribute risk through subordination of tranches ensures that transactions should be structured in such a manner that a single default does not bring the transaction crashing like a house of cards.
Similarly, the definition of securitization as mentioned in the Basel III norms also provides that a structure can be classified as a securitization transaction if the cash flow from an underlying pool of assets is used to service at least two stratified risk positions or tranches reflecting different degrees of credit risk. The requirement of the tranches to comprise two different assets is to mitigate the loss in case of default in either of the assets. This can be further affirmed by the following statement in the Basel III Norms:
“The stratified/tranched structures that characterize securitizations differ from ordinary senior/subordinated debt instruments in that junior securitization tranches can absorb losses without interrupting contractual payments to more senior tranches, whereas subordination in a senior/subordinated debt structure is a matter of priority of rights to the proceeds of liquidation.”
This was the main reason why single asset securitization was excluded from the definition of securitization as it is counterintuitive to the objective of risk distribution. This was also identified by the 2012 Revision of RBI Guidelines on Securitization of Standard Assets. However, the banking regulator has included single asset securitization within the new definition. The authors consider this to be counterproductive, as rather than affirming the trust of investors, this will dissuade them from investing in the secondary market of loans due to lack of risk distribution, as the entire transaction will fail with a single default leaving the investors high and dry.
Easing of Minimum Retention Requirement
MRR for securitization of standard assets
Economic downturn in 2008 which had a debilitating impact all across the world economies was probably one of the darkest phases of the securitization. This was mainly fuelled by reckless securitization of asset backed mortgages and lack of due diligence by the originator banks, which led to massive fall in the prices of Asset Backed Securities (ABS). In response to that, the economies around the world sprung into action by mandating that originating banks have a “skin in the game”. This was ensured by directing them to hold a minimum percentage of the asset they seek to securitize, which came to be known as the Minimum Retention Requirement (MRR).
While this ensures self-imposed checks and balances on the originating banks by aligning their interests with the performance of securities. It also adversely impacts their ability to securitize the assets as it leaves them reduced liquidity. Therefore it requires a careful balancing act between caution and optimism where erring on either side would entail disastrous outcomes.
Interestingly, the United States, unarguably the country most affected by the 2008 recession, took the first steps very cautiously by fixing the rate of retention at an unreasonably high level of 20 percent under the first draft of the Dodd- Frank Act 2013. This was later eased in the revised draft to 5 percent in light of fierce opposition. This decreased rate of MRR was in line with the rates that prevailed in Japan and European Union conforming to the liberal ecosystem of the securitization market.
However, astonishingly, India did not subscribe to this liberal rate and inhibited the securitization market by imposing a stricter limit of 10% for securitization of standard assets under the relevant RBI directions. This problem was also identified by the Report of the Committee on the Development of Housing Finance securitization Market where the increased rate of MRR was ascribed as the reason for lack of growth in the securitization market. Fortunately, this problem seems to have been solved by the recently issued RBI (Securitization of Standard Assets) Directions 2021 which reduces the MRR to 5%. According to the authors, this will definitely have a positive impact on the ability of the originator banks to securitize more assets in the coming period. However, staggered implementation of this rule to apply it to the loans with a maturity period of less than 24 months shows a hint of reluctance by the banking regulator to fully and confidently follow the international standards.
MRR for securitization of stressed assets
While this problem is solved in the market for standard assets, the securitization of stressed assets by the ARCs still requires it to maintain a ratio of 15:85 while issuing the SRs. The recent report released by the Committee has underlined the problem of lack of liquidity, inhibiting their growth. In this light they have suggested the RBI revise the minimum investment in SRs by an ARC at 15% of the lenders’ investment in SR or 2.5% of the total SR issued, whichever is higher. The authors are of the opinion that this seems to be a pragmatic position considering the low recovery rates of NPAs by ARCs so as to make sure that their interests are aligned with the performance of the securities.
Incompatibility of ARC as a resolution applicant under IBC
The Committee in its report recommended that ARCs should be allowed to participate as a Resolution Applicant in the insolvency resolution process under IBC. This issue has been in the center of the storm since RBI rejected the resolution plan submitted by UV Asset Reconstruction Company Limited in the corporate insolvency resolution process (CIRP) of Aircel Limited. While there has been strong legal opinion favoring the participation of ARCs in processes under IBC, the authors are of the firm belief that the same should not be implemented considering the incompatibility of ARCs under SARFAESI Act to resolve assets under IBC. Interestingly, one of the primary reasons to disallow ARC's participation is its specialized nature of business to recover the debt under the SARFAESI Act.
ARC is an entity established with the sole focus of recovery of debt from stressed assets. Section 2(ba) of the SARFAESI Act defines ARC as an entity primarily established to conduct the business of securitization and asset reconstruction. To further this specialized business objective, an ARC under Section 9 can employ measures such as sale or lease of the business of the borrower, rescheduling the payment of debts, settlement of dues payable, and enforcement of security interest to effectively carry on asset reconstruction business. Notably, an ARC can also take over the management of the business or convert any portion of debt into equity of the borrower company. Since these later tools are also used under insolvency proceedings, the Committee endorsed ARC as a prime vehicle for resolution under the IBC. However, it ignored a very crucial aspect that ARC is envisioned as a debt recovery tool and not a mechanism to maintain the business as a going concern which forms the basis of IBC.
It is important to note that ARCs have rarely used its power to take over the management or convert debt to equity. As a matter of fact, the RBI’s report is a testament to this anomaly, wherein they have confessed to the fact that takeover of management or conversion of debt to equity has been negligible. The seldom use of such powers for resolution of stressed assets, translates into lack of willingness and operational inexperience on part of the ARC, dissuading its inclusion and participation under IBC.
Moreover, even if ARC does opt to take over management of the company, Section 15(4) mandates the ARC to restore the management on complete realization of debt. Indicating the legislative intent to mandate ARC’s exit from the company post recovery of dues. Accordingly, the operational boundaries of ARC under the current framework makes it a dysfunctional resolution vehicle under IBC.
Regardless, the Committee has argued that inclusion under IBC would allow ARCs to gain the necessary experience in resolution and revival of stressed assets. While the desirability and outcome is yet to be seen, its infeasibility is apparently visible under SARFAESI Act. This line of argument is antithetical to the scheme and purpose of SARFAESI Act, wherein the primary function of ARC is to offload NPAs from banks towards recovery of debt and hand the management back to promoters after realization of dues.
The resolution of stressed assets under IBC is a costly affair which requires extensive capital infusion by the incoming resolution applicant. Resultantly, the resolution applicant has to burn cash for an elongated timeline before being able to derive profits from these assets.
However, ARCs are required to redeem SR’s within a period of maximum 8 years, meaning that ARCs cannot burn holes in their pocket and are required to recover their dues within a tight timeline. Accordingly, the luxury of a long gestation period is not available with ARCs making them unsuitable for resolution of stressed assets under IBC. Due to aforementioned reasons, it is apparent that ARCs governed under the framework of SARFAESI Act are only meant to recover the dues from stressed assets. They neither have the operation expertise, nor the structural compatibility to resolve the assets under the framework of IBC. Therefore, including them in the resolution mechanism under IBC is a big mistake.
Securitization plays an integral role in the period following recovery from pandemic by infusing liquidity into the market and freeing up banks resources for facilitating the credit disbursal. In this context, the proactive steps taken by RBI to revitalize the securitization regime are welcomed by the authors. However, there remain some creases to be ironed out for establishing a robust and stable framework.
Despite being well intentioned, RBI goes overboard by relaxing the definition of securitization beyond necessary. In this pursuit, the banking regulator fails to conform to the fundamental objectives of securitization by ignoring the risk mitigation aspect of securitization and throwing caution to the wind.
Moreover, the intermingling of ARCs with resolution under the IBC manifests a lack of clear approach in addressing the NPA crisis. In this context, authors express concerns regarding the incompatibility of SARFAESI and IBC and cautions against allowing ARCs to apply as resolution applicants under IBC. In conclusion, though RBI has erred in some respects, its resolve to re-energize the securitization market is commendable.