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Blank checks in the bad debt rules
Vinod Kothari | May 08, 2003
In April 2003, nearly 11 months after the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act came into effect and nearly one month after a ridiculous deadline for applying for registration, the Reserve Bank of India brought into force guidelines for securitisation and asset reconstruction companies.
In all, there are six notifications or circulars that bring the regulatory framework for SARCs into place. Under various provisions of the SARFAESI Act, the RBI has issued the 2003 guidelines and directions.
Precision of language is not a virtue with many draftsmen these days, but one is intrigued by 'guidelines' and 'directions'. To a layman, it is obvious that directions imply something that is mandatory, while guidelines are a guide to good conduct but not necessarily mandatory.
Section 12 of the Act empowers the RBI to give directions -- guidelines, being merely for guidance, do not need a statutory power as such. Thus, the use of the words 'guidelines' and 'directions' will fox anyone who wants to distinguish those parts of the guidelines and directions that are mandatory from those that are not.
For example, Rule 7, which goes into the niceties of the operations of ARCs and prescribes almost biblical rules of good behaviour, is more like a guideline than a direction.
A curious exception to the scope of the directions is that most of the operative part of the directions applies to a direct acquisition of assets by a SARC. But it does not apply if such assets are held as a trustee for a trust. So to fall outside the discipline of the directions, all that the SARC has to do is to settle a trust, be a trustee to such a trust, and acquire assets as a trustee.
The obvious question is: what is it that would motivate a SARC to hold any of the financial assets it acquires directly? And if everyone chooses the easy way out anyway, what is the relevance of the directions?
Another curious provision is in paragraph 4 (iii) of the directions. It says: "Any entity not registered with the Bank under Section 3 of the Act may conduct the business of securitisation or asset reconstruction outside the purview of the Act." Section 3 of the parent law clearly puts a bar on the business of securitisation and asset reconstruction without being registered with the RBI.
Of course, the words 'securitisation' and 'asset reconstruction' relate only to certain assets under that law -- for instance, they relate to the assets of a bank originator. So, obviously, the provisions of the Act do not apply if someone were to securitise assets of a non-banking originator.
But if the directions, in which the meaning of the words 'securitisation' or 'asset reconstruction' could not be different from what it is under the Act, say that the business of securitisation or asset reconstruction can be done outside the purview of the Act, it defies the purpose of the mandatory nature of Section 3 of the Act.
By settled rule, a subordinate instrument cannot travel beyond the parent law: therefore, Section 3 should remain unaffected by Rule 4 (iii) of the directions and the latter should be simply read down.
The directions seem to be suggesting that securitisation transactions will be done by acquiring assets in the name of trusts to be settled by the SARC. But the trust is not an entity; the trustee is. So it is the SARC that is the entity.
The directions seem to be suggesting that the SARC will first buy the assets and then transfer them to the trust -- this does not make sense because the trust is, in fact, nothing but the SARC.
Instead of first acquiring assets as a beneficial owner, and then declaring a trust, the SARC might acquire assets as a trustee in the first place. The security receipts will be created by the trust (that is, by the trustee in its capacity as a trustee).
The directions also provide what we have earlier construed to be rules of good conduct for reconstruction activities. This is Rule 7, which essentially lays down various policies, all of which are internally to be framed and implemented.
It should not have been necessary for the RBI to put in such basic rules of business in a quasi-legislative instruments: no regulator should make the mistake of substituting corporate governance by such rudimentary rules.
A 15 per cent capital adequacy has been prescribed for SARCs on risk-weighted assets. The risk weights are similar to those under the Basle I convention. SARCs are supposed to deploy their 'surplus' funds only in gilts and bank deposits. 'Surplus', of course, is what is not invested in accordance with the scheme of investments.
But many revolving securitisation transactions may provide for investment in a particular mode as a part of the scheme of investments, which is not a surplus money. Interestingly, this requirement too, like most of the operative requirements of the directions, does not apply to acquisition of assets in the name of trusts.
Another curious part of the directions is its approach to bad debt recognition by SARCs. It is common knowledge that ARCs are really 'bad banks' -- they represent a bunch of bad assets hived off from the originating banks.
By presumption, the assets must have been non-performing from the start (though the Act or the directions do not limit ARCs to buying bad loans only). But they turn into performing assets from the day they are bought up by the ARC, and remain performing for at least six months. It is only after failure of interest and/or principal after six months of acquisition that they become non-performing.
Once they become thus non-performing, they will start qualifying for provisioning requirements. This, coupled with the requirement that the ARC's securities must be interest-bearing, is a sure prescription for the ARC to show losses on its balance sheet.
By mandatory requirements of the Act, if an ARC does not make profits for three consecutive years, it must be disqualified and wind up. It would not be surprising, therefore, that the combined effect of the directions would be to make the whole business of ARCs unviable except for vulture financiers.
Importantly, the RBI has also given directions to banks that contain both a provision for regulatory capital relief as well as issues such as the recognition of profits and losses and so on. Paragraph 3 of these guidelines gives the impression that banks can sell only non-performing loans to SARCs.
Once again, the RBI has made the elementary mistake of confusing securitisation with reconstruction and vice versa since securitisation, as distinct from asset reconstruction, is done in the case of performing assets. But bankers, who swear by the letter and not spirit of the RBI directives, are unlikely to take these guidelines as limited to asset reconstruction.
The guidelines do contain certain important clarifications that will help securitisation. These are:
However, the guidelines also put some extremely impractical limitations on the nature of the SARC's securities. Paragraph 5 A (b) says that the securities must not have a term exceeding six years; they must be non-contingent (unconditional undertaking to pay, not related to the realisation of the assets by the SARC), and must carry a minimum rate of interest of the bank rate plus 150 basis points. Bankers will take this to mean that zero-coupon bonds cannot be issued by the SARC.
At the same time, the bond/debenture must not be subordinated, as the condition of an 'unconditional undertaking to redeem' cannot be satisfied by a subordinated instrument. Apparently, this requirement is applicable to bonds and debentures, but it would be ridiculous to think that it can be skipped in the case of pass-through certificates.
ARCs are not financial intermediaries. They are recovery devices. There is no way ARCs can externally fund their acquisitions except by bringing in external investors. Such external investors are unlikely to accept a subordination to the transferring banks, as that does not make commercial sense.
Therefore, there is no option but for the originating banks to accept a subordination of their bonds/debentures. Since the RBI guidelines provide that the debentures cannot have a legal final maturity beyond six years, and they must be redeemable in cash, the only way would be to take the ARC to bankruptcy after six years if the assets have failed to pay off completely by then. And a complete payoff within six years will be extremely difficult to expect.