Since 2014, India has seen a spate of changes centred on improving the banking regulatory environment in India and trimming the proverbial “fat” in the system. To its credit, the Reserve Bank of India (RBI) identified the upcoming crisis on non-performing assets (NPAs) in the banking system, and compelled Indian banks to recognise and to provide for faulty loans – bitter medicine which initially hurt banks’ profit margins, but which markedly strengthened their ability to absorb losses from bad loans. The RBI has also made various moves to diversify the pool of financial sector entities – some of its measures include allowing diversified bank licensing for the first time in the form of payment bank licenses (banks which cannot provide loans, have restrictions on accepting deposits, and whose primary function is to enable processing of payments) and small finance bank licenses (banks which provide basic banking services and which are intended to improve penetration of banks into the unbanked portions of India). In a departure from a previously unsaid and uncodified understanding, the RBI has also issued guidelines allowing granting of universal bank licenses “on tap” as opposed to previous instances where banking licenses were granted only once every few years. The RBI has also taken steps to reduce the dependence of providing finance on the banking system and has taken steps to improve the bond market in India (which is still at a nascent stage of development). The measures taken include allowing foreign portfolio investors (FPIs) to invest in unlisted debt securities, issuing a discussion paper on partial credit enhancements of bonds (followed by guidelines on partial credit enhancements and an amendment to these guidelines to increase limits for participation by banks), and issuing a discussion paper on making borrowing by large borrowers more expensive thus incentivising such borrowers to access the bond market. This article will consider some of the regulatory measures taken by the RBI to improve India’s banking regulatory environment.
Framework for Revitalising Distressed Assets
One of the first regulatory moves that signaled a change in the approach of the RBI was the issuance of the “Framework for Revitalising Distressed Assets in the Economy” (the Framework). The Framework was issued on 30 January, 2014 and followed the issuance of a discussion paper in December 2013 on tackling the growing incidence of NPAs in the Indian financial system. The measures prescribed by the Framework include continuous monitoring and classification of accounts at various levels of “stress”, and the formation of a joint lenders’ forum (JLF) for early resolution of a stressed account before it turns into an NPA. As part of banks’ continuous monitoring obligations under the Framework, banks’ now have to identify accounts that show “incipient stress” as special mention accounts (SMAs), and also classify such accounts as: (a) SMA-0, where principal or interest payment is not overdue for more than 30 days, (b) SMA-1, where principal or interest payment is overdue between 31 and 60 days, and (c) as SMA-2, where principal or interest is overdue between 61 and 90 days.
As soon as a borrower’s account is classified as SMA-2, its lenders will need to come together to form a JLF if the aggregate exposure to the borrower exceeds INR 1 billion (USD 14.97 million approx.). Banks also have the option of forming a JLF when the aggregate exposure is below INR 1 billion (USD 14.97 million approx.) and the account is not reported as SMA-2. Borrowers too can request that lenders form a JLF on the grounds of “imminent stress”.
The aim of constituting a JLF is to explore various options to resolve a stressed account and to formulate a corrective action plan (CAP). The resolution options for a CAP formulated by a JLF include obtaining specific commitments from the borrower to regularise its account so that it does not become an NPA, restructuring the borrower’s account, and initiating recovery proceedings against the borrower.
Timelines for Regulatory Approvals
The Financial Sector Legislative Reforms Commission (FSLRC) was constituted under the chairmanship of retired Supreme Court justice BN Shrikrishna, to comprehensively review, rewrite and clean up the laws governing India’s financial system “to bring them in tune with current requirements“. The FSLRC submitted its report to the Central Government in March 2013. One of the non-legislative recommendations of the report of the FSLRC was that all financial sector regulators should move to a time-bound approvals process for providing permissions to conduct business as well as for the launch of new products and services.
Following this recommendation, and in a bid to demystify the inner workings of the RBI and to increase transparency, on 23 June 2014, the RBI released timelines within which its approval could be expected for matters such as licences for private banks, the issuance of licences to non-banking financial companies (NBFCs) and external commercial borrowings (ECBs) not covered under the automatic route. In parallel, the RBI also placed a “Citizens’ Charter” on its website, providing timelines within which various departments would be able to provide services for matters such as permission for waiver of forms for exports and overseas investment not covered under the automatic route. The timelines provided vary from seven days for trade credits under the approval route, to one hundred and eighty days for compounding of contraventions under the (Indian) Foreign Exchange Management Act, 1999.
Partial Credit Enhancements
In the Second Quarter Review of Monetary Policy 2013-14, the RBI observed that the lack of depth and liquidity in India’s corporate bond market is leading to “significant dependence on bank financing“. The review proposed the issuance of guidelines to allow banks to offer partial credit enhancements (PCEs) to corporate bonds by way of credit facilities and liquidity facilities (and not by way of a bank guarantee). On 24 May, 2014, the RBI issued draft guidelines allowing banks to provide PCEs to corporate bonds issued by companies and special purpose vehicles for financing infrastructure projects. On 24 September, 2015, the RBI issued guidelines on banks providing PCEs for corporate bonds issued for a project. These guidelines allow banks to offer PCE (in aggregate) up to 20% (twenty percent) of the bond issue size in the form of a non-funded irrevocable contingent line of credit. This limit has been raised to 50% of the bond issue subject to a limit of 20% for each bank. The providing of PCEs (together with the enhancement of limit) is intended to increase the credit ratings of lesser rated issuers and special purpose vehicles, and make bonds offered by them more attractive for bond market investors.
Overhauling NBFC Regulations
The global financial crisis of 2008 turned a stark spotlight on “shadow banking”. Minimisation (if not removal) of the risk posed by these entities to the financial system came into sharp focus. Shadow banking, in rudimentary terms, can be described as the exposure of non-regulated financial entities to the financial system. In India, the activities of NBFCs which traditionally enjoyed “light touch” regulatory oversight became an increasing cause for concern. The regulatory advantages enjoyed by NBFCs over banks also led to concerns of “regulatory arbitrage”. For instance, while banks had to declare an asset as “non-performing” at the end of 90 days, for NBFCs this period was 180 days and 12 months in certain cases. Similarly, guidelines for the restructuring of advances by NBFCs were only issued in January 2014.
In November 2014, the RBI overhauled the regulatory framework for NBFCs bringing about many seminal changes in the way NBFCs conduct business. While some are transitional – for instance, the declaration of assets as non-performing after 90 days will only commence from 2018 – others had earlier application, such as 31 March, 2015 for the tightening of the application of the “fit and proper criteria” for directors of systemically important NBFCs. Enhanced corporate governance disclosures, such as registrations/licences obtained from other financial sector regulators, penalties levied by any regulator, extent of financing of parent company products, and details of securitisation and assignment transactions, are now required from all non-deposit-taking systemically important NBFCs and all deposit-taking NBFCs.
While criticised in some circles as disadvantaging NBFCs, the overhaul of the regulatory regime for NBFCs was largely welcomed in industry circles. The alignment to a large extent of regulations applicable to NBFCs and banks has markedly reduced the possibility of regulatory arbitrage that may have led to systemic financial instability.
Strategic Debt Restructuring
As a follow-up to the Framework and the JLF-CAP mechanism, through its circular of 8 June, 2015, the RBI introduced the “Strategic Debt Restructuring” (SDR) scheme, to allow banks to convert a part of their debt to a delinquent borrower into equity so as to facilitate a change in management and exit from exposure to such borrower. The intent behind the SDR scheme is to resolve borrowers which cannot be turned around due to inherent operational and managerial inefficiencies.
The SDR scheme requires the scheme of a JLF to include provisions in the agreement with a borrower for conversion of the restructured debt into equity if prescribed conditions are not fulfilled. The JLF must obtain all appropriate authorisations for such conversion upfront at the time of restructuring of the borrower. Further, conversion of debt into equity must result in the JLF holding at least 51% of the shareholding of the borrower and such conversion must take place within 30 days of the review being conducted by the JLF for the borrower’s non-compliance with the conditions prescribed by the JLF. The detailed prescriptions of the SDR scheme also include the price at which conversion of the debt into equity must take place.
Rupee Denominated Bonds
The report of the Committee to Review the Framework of Access to Domestic and Overseas Capital Markets submitted in February 2015 included a recommendation that the market for local currency denominated bonds should be encouraged as it provides an alternative source of debt financing for private and public sector borrowers which does not expose them to currency fluctuation risk. The report also rationalised that by reducing currency mismatches and lengthening the duration of debt, such bonds could also augment financial stability. In its bi-monthly monetary policy statement of 7 April, 2015, the RBI mentioned that it intended to allow Indian bodies corporate to raise ECBs through Rupee Denominated Bonds. This was followed up by the release of the draft framework for the issuance of Rupee Denominated Bonds on 9 June, 2015 for public comments.
The RBI notified the framework for the issuance of Rupee Denominated Bonds under the overall ECB framework on 29 September, 2015. While the draft framework had received a lukewarm reception, the notified framework received a warm welcome as it appeared to have rectified many shortcomings of the draft framework. For instance, the notified framework allows all bodies corporate including real estate investment trusts and infrastructure investment trusts to raise debt under the ECB policy by issuing rupee denominated bonds. The only end-use restrictions in the notified framework are that funds raised cannot be used for real estate activities (other than for development of integrated township/affordable housing projects), capital market and domestic equity investment, activities prohibited under the foreign direct investment policy, on-lending for any of the above, and the purchase of land. Further, the only all-in-cost restriction is that the all-in-cost should be “commensurate with prevailing market conditions“.
The framework on Rupee Denominated Bonds was further liberalised by the RBI through its circular of 13 April, 2016, which reduced the minimum maturity for Rupee Denominated Bonds from 5 years to 3 years.
It is possible to attribute some of the steps that the RBI has taken since 2014 to the dynamism of former Governor Raghuram Rajan. However, due care should be taken on this count, as the RBI has previously shown itself to be proactive (albeit somewhat conservative). It is quite possible that these steps were already in the offing, and were merely accelerated due to the presence of Governor Rajan.
This article covers only a few regulatory moves that have been made by the RBI and is not exhaustive. There are also many background steps and relatively minor regulatory tweaks that the RBI has made to operationalise these steps. For instance, along with the government and the Securities and Exchange Board of India, the RBI is also considering measures for improving the secondary market for bonds (by making bond-trading easier) and also the tertiary market for bonds (by introducing/improving existing instruments such as the GMRA). Notably, as part of a shift in the regulatory rulemaking mindset, the RBI appears to be shifting from prescriptive rulemaking to a mix of principle-based and prescriptive rulemaking, thereby more closely aligning itself with regulatory rulemaking in more developed economies.
While these steps have stoked a quiet revolution in the banking regulatory environment in India, much still remains to be achieved. We watch and we wait.