Essential reform or regulatory overkill?
India’s central bank released a controversial draft of securitisation rules in June that market participants warn may kill off an industry that was just starting to thrive.
The Reserve Bank of India has sparked a furious debate with a proposed new framework for securitisation. The draft rules for banks and non-banking financial institutions are open for discussion, but offer more than a sneak preview of the final rules that market participants expect to be enacted before the end of the year.
The debate focuses on the RBI’s introduction of two controversial concepts - a minimum holding period and a minimum retention requirement. To some extent, the RBI move mirrors what is happening in other, more developed markets, after a meeting of the G20 in London in April 2009 agreed that all member countries, including India, would implement such a requirement. The European Union has since brought in regulations that will require banks to retain at least 5% of deals from the beginning of 2011. In the US, the Financial Regulatory Reform Bill has introduced similar rules, although the securitisation industry has had some success in pushing back against the more restrictive proposals contained in earlier proposals.
Regulators worldwide are focused on preventing a return to the runaway securitisation market that contributed to the 2008 credit crisis, while, at the same time, preserving economically useful structures that spread risk outside the banking system. In India, however, market participants are worried that the draft rules represent another instance of central bank overkill, where heavy-handed regulation will stop a developing market in its tracks.
The concerns are genuine. Securitisation was first introduced in India in the early 1990s, but the market only really began to develop after 2000 and had been growing rapidly until the 2008 crisis. Asset backed securities make up the largest component of the Indian securitisation market but the industry is still at a nascent stage.
The RBI’s draft guidelines require an originator to hold, for the entire life of the paper, a first-loss piece with a minimum risk of 5% for deals with the backing of receivables up to 24 months in maturity and 10% for those with the backing of receivables with maturities over 24 months. The guidelines also specify that the credit enhancements should not exceed 20%, while complex structures are strictly prohibited.
The guidelines also call for banks and other issuers to hold securitised assets on their books for a minimum period. Loans of up to 24 months must be held for nine months, while those of longer tenors must be held for 12 months. That, bankers warned, would rule out securitisation of short-term assets, such as microfinance or gold loans. Similarly, Hemant Sethia from CARE Ratings noted that auto finance loans of four or five years typically come with durations of 18-24 months, which would leave only six to 12 months of economic cash flows to be securitised.
This so-called “skin-in-the-game” approach has already divided the industry. Designed to discourage issuers, especially banks, from using securitisation to get round higher capital requirements in an “originate-to-distribute” model, the rules have attracted their fair share of criticism, with many arguing against the concepts of a minimum holding period or minimum retention, or that the rules should be handled differently.
“Most securitisation deals are Triple A rated, underlying a strong credit. What’s the use of having such stipulations that lock-in someone in a deal?” asked a senior Mumbai-based banker at a private-sector bank.
“It would be more appropriate to link the MHP with principal amortisation of underlying loans: the MHP can be until the time of 10% of principal amortisation and can be capped at 12 months” said Sethia.
Not all oppose the introduction of MHP and MRR. “The implementation of a minimum holding period requirement under the proposed guideline will result in a minimum period of seasoning for the assets that are put forward for securitisation. If loans in a securitisation pool are seasoned by six to 12 months, assuming that only performing assets are included in a portfolio at the point of securitisation, such portfolios are more likely to have a better credit profile than portfolios of more newly-originated assets, other things remaining same,” said Sandeep Singh, director, structured finance, Fitch India Ratings.
According to Singh, there could be some merit in distinguishing pooled securitisations (ABS and RMBS) from single loan securitisations. The MHP requirement could be applied at the aggregate pool level (weighted average holding period), rather than for each loan in the pool. This would provide originators with some flexibility in pool selection even while meeting the larger aim of discouraging ’originate-to-distribute’ models.
As regards MRR, Singh said: “While most Indian transactions have a credit enhancement of more than 5% at the highest rating level of AAA(ind) at which most issuances happen, at lower rating levels, the credit enhancement could be lower than 5% of the book value of the loans being securitised in some cases. Given this, the minimum retention could be stated as a percentage of the credit enhancement proposed, rather than of the book value of loans being securitised”
“RBI is examining the responses and the final guidelines for banks, as well as the non-banking financial companies will be issued after taking into account the feedback,” Shyamala Gopinath, one of RBI’s four deputy governors, said at a Securitisation summit in Mumbai in August.
Her comments, however, highlight regulators’ concerns of the impact of securitisation on retail banking customers, and few expect the final rules to be watered down.
“The downside of securitisation is the absence of alternative solutions available to borrowers to restructure their loans when there is a downturn with the originator since the banker-customer relationship is snapped when the loans are securitised”, she said. “Any restructuring requires consent of the final investors and in the long chain of intermediaries it becomes difficult to restructure debt.”
Gopinath, however, stressed that “sustainable securitisation” in an Indian context could indeed play a positive role in financial intermediation provided there was a genuine transfer of risk away from the banking system.
“The existing and proposed guidelines are in line with international practices and may appear stringent, but, in the long term, it is imperative that securitisation market develops for the right reasons,” she added.
In the immediate term, the RBI is co-ordinating with the capital markets regulator, the Securities and Exchange Board of India, to set up a reporting mechanism for the primary and secondary structured finance market to encourage better exchange of information and reduce investors’ reliance on rating agencies.
The central bank has also stressed the need to keep investors updated on essential information such as loan pool composition and ongoing performance details.