assignment rbi circular

India: RBI'S Framework For Transfer Of Loan Assets

As an anticipated measure for the banking and financial sector, the Reserve Bank of India (RBI) has, towards the close of past week, issued the comprehensive framework for the sale or transfer of loan assets. Taking immediate effect from the date of its issuance, the framework titled ' Master Directions - Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021 ' issued vide circular DOR.STR.REC.52/21.04.048/2021-22 dated September 24, 2021 (the ' Master Directions ') is being seen as a pivotal move by the Regulator towards introducing an efficient secondary market for loans and ensuring proper credit-risk pricing, besides improving transparency in the identification of embryonic stress in the banking system as well as resolution of stressed loan exposures.

The Master Directions owes its genesis to the ' Draft Framework for Sale of Loan Exposures ' which was released by RBI in course of the first COVID-19 induced lockdown in the Country. The draft had taken into consideration the recommendations of the ' Task Force on Development of Secondary Market for Corporate Loans ' constituted by RBI under the chairmanship of Mr. T.N. Manoharan in May, 2019 and comments from the stakeholders were invited. One of the key components of the Task Force's recommendation was to separate the regulatory guidelines for direct assignment transactions from the securitisation guidelines and treat it as a sale of loan exposure. The RBI had, accordingly, reviewed the recommendations and thought it prudent to comprehensively revisit the guidelines for sale of loan exposures, both standard as well as stressed, which were earlier spread across various circulars. The erstwhile guidelines or circulars on sale of loan exposures were particular to the asset classification of the loan exposure being transferred and / or the nature of the entity to which such loan exposure is transferred as well as the mode of transfer of the loan exposures. The need for a review also stemmed from the necessity to dovetail the guidelines on sale of loan exposures with the Insolvency and Bankruptcy Code, 2016 (' IBC ') and the Prudential Framework for Resolution of Stressed Assets dated June 7, 2019 (" Prudential Framework "), which has witnessed substantial traction and developments towards building a robust resolution paradigm in India in the recent past.

The consolidation by RBI of a self-contained, comprehensive, and independent set of regulatory guidelines on transfer/sale of loan exposures is being seen as a laudable step in the direction of putting together a ' robust secondary market in loans which can be an important mechanism for management of credit exposures by lending institutions and also create additional avenues for raising liquidity '. This write-up attempts to briefly summarize some key components of the Master Directions.

The Master Directions whilst superseding a host of existing circulars/directions (or a portion thereof) in relation of transfer of loan exposures (Chapter VI), has put forth a unified and singular framework for the sale of loan exposures by banks and other financial institutions. The exhaustive breadth of the framework is quite evident from the Chapters under the Master Directions which not only provide for ' General Conditions applicable to all Loan transfers ' (Chapter II), but also cater specifically to transfer of loan exposures of standard assets (Chapter III) as well as stressed loan exposures (Chapter IV), including their respective and intrinsic modalities. The framework concludes with the imperative of ' Disclosures and Reporting ' (Chapter V) and stipulates the mechanism for the stakeholders in that regard.

Applicability

On expected lines, nearly all constituents of the Financial sector regulated by RBI are mandated to ensure compliance to the Master Directions, both as a transferor as well as transferee of the loan exposures – Scheduled Commercial Banks, all NBFCs (including HFCs), Regional Rural Banks, Co-operative Banks, All India Financial Institutions and Small Finance Banks. In addition, the Master Directions also permits asset reconstruction companies (ARCs) 1 and companies 2 (save a financial service provider 3 ) to be 'transferees' of the loan exposures only if the same is pursuant to the resolution plan under the Prudential Framework and if they are permitted to take on loan exposures in terms of a statutory provision or under the regulations issued by a financial sector regulator.

It would be pertinent to take note that though all lenders permitted to acquire loans are required to ensure compliance to the extant Master Directions; yet, the acquisition of loans pursuant to securitisation are required to be independently dealt under the provisions of RBI's ' Master Directions – RBI (Securitisation of Standard Assets) Directions, 2021 ' dated September 24, 2021 (the 'Securitisation Guidelines'). The coverage of the Master Directions includes transfer of loan exposures through novation, assignment, or risk participation. In cases of loan transfers other than loan participation, legal ownership of the loan shall be mandatorily transferred to the Transferee to the extent of economic interest transferred under the loan exposures.

For the Transferees which are financial sector entities (not falling under clause 3 of the Master Directions) and the ARCs, the prudential norms (asset classification, provisioning norms etc) of their respective sectoral regulators (SEBI, IRDA, PFRDA etc) shall be applicable post-acquisition of loan exposure under the Master Directions.

Basic Ingredients

Before venturing into the other nuances, it is an imperative that one accounts for the understanding of some key 'constructs' which cut across the Master Directions:

• Transfer : Quite apparently, the expression denotes the process of transfer of the economic interest in a loan exposure by the transferor and acquisition of the same by the transferee. The subject matter of transfer being the ' economic interest ' of the transferor in the loan exposure, it is important that the risks and rewards associated with loans are clearly demarcated and separated in favour of the transferee; especially when some portion of the economic interest in the loan exposure is retained by the transferor.

It is significant to take note that the transfer of the said economic interest can be with or without the transfer of underlying contract. Essentially, even loan participation transaction have also been recognised under the Master Directions (for transfer of standard loans) wherein the transferor transfers all or part of its economic interest in a loan exposure to transferee without the actual transfer of the loan contract, and the transferee(s) fund the transferor to the extent of the economic interest transferred which may be equal to the principal, interest, fees and other payments, if any, under the transfer agreement.

• Transferor : Often referred as 'assignor' (in assignment transactions) or 'grantor' (for risk participation), transferor under the Master Directions would include Clause 3 entities which transfer their economic interest in the loan exposures.
• Transferees : These refer to entities in whose favour the economic interest in the loans are transferred and would include Clause 3 entities as well as the ARCs/companies to the extent permitted under the Master Directions. It is clarified that the transferee should neither be a person disqualified under the IBC 4 nor, in cases of loan exposures where frauds have been identified, belong to an existing promoter group 5 of the borrower or its subsidiary / associate / related party 6 (domestic as well as overseas).
• Minimum Holding Period (MHP) : As the expression suggests, the MHP refers to a threshold period for which the transferor should hold the loan exposures, along with its risks and rewards, before the economic interest in respect thereto is transferred. The intent of having a MHP is to ensure that the loan has been seasoned in the books of the originator (or the transferor) for a certain specified time period. The MHP for loans with tenor upto 2 years and more than 2 years, as per the Master Directions, have been capped at 3 months and 6 months, respectively.

The holding period for the Transferor, in case of secured exposures, is to be computed from the date of registration of the underlying security interests; unless, of course, the loan is unsecured in which case the MHP runs from the date of first repayment under such unsecured exposure. However, in case of project loans, the foregoing months of MHP is required to be calculated from the date of commencement of commercial operations of the project being financed. Besides, the loans acquired by the Transferor itself are required to have a MHP of atleast 6 months from the date of acquisition of the loan on the books of the Transferor, irrespective of the tenor of the loan exposures.

It would be of significance to note that the MHP criteria prescribed under the Master Directions do not apply for loans transferred by an arranging bank under a syndication arrangement.

• Permitted Transferees : These include (i) Scheduled Commercial Banks, (ii) NBFCs (including HFCs), (iii) All India Financial Institutions and (iv) Small Finance Banks. The significance of carving out the foregoing financial sector entities from Clause 3 of the Master Directions lies in the fact that the transferor is permitted to transfer its loans (which are not in default) to permitted transferees only through novation, assignment, or loan participation. For the stressed exposures, the transfer is mandated only to such permitted transferees and ARCs and singularly through assignment or novation of such loan exposures.

Underlying Elements

The finer nuances of the Master Directions would certainly surface once the provisions have been widely given effect to by the stakeholders; however, as it stands, the framework undoubtedly promises to streamline the procedures and requirements for the stakeholders considering transfer of their loan exposures – standard as well as stressed. Some fundamental provisions of the Master Directions have been summarized as below:

• Overarching Transfer conditions : Quite categorically, the Master Directions stresses on the necessity of delineation of Transferor's 'risks and rewards' associated with the loan exposures to the extent of the transfer. In fact, it is stated that not only should the transferee have the unrestrained and unconditional entitlement to transfer or dispose of the loans to the extent of economic interest acquired by it, but also in the event of any economic interest in the loan exposure is retained by the transferor, the loan transfer agreement should demarcate the distribution of the principal and interest income from the transferred loan between the transferor and the transferee. The Master Directions also caution against any modification of terms of the underlying financing agreement and require that any change, in course of such transfer, should withstand the test of not being categorised as 'Restructuring' under the Prudential Framework. It would be significant to take note that the transfer of loan exposures under the Master Directions not only should be without recourse to the Transferor, but also the transferor or transferee should not be constrained to obtain consent from the transferee/ transferor, as the case may be, in the event of resolution or recovery in respect of the beneficial economic interest retained by or transferred to the respective entity. In addition to the foregoing, the Master Directions also prescribe for the enumerated conditions applicable to all transfers of loan exposures:
• The Transferor shall have no obligation to re-acquire or fund the re-payment of the loans or any part of it or substitute loans held by the Transferee or provide additional loans at any time;
• If the security interest is held by the Transferor in trust with the Transferee as the beneficiaries, the Transferee shall ensure that a mutually agreed and binding mechanism for timely invocation of such security interest is put in place;
• Any rescheduling, restructuring or re-negotiation of the terms of the underlying agreement attempted by Permitted Transferee, after the transfer of assets to the transferee, shall be as per the Prudential Framework;
• The Clause 3 entities, regardless of whether they are transferors or otherwise, should not offer credit enhancements or liquidity facilities in any form in the case of loan transfers.

In case the transfer of loan exposures which are not compliant with the requirements mentioned in the Master Directions, the onus is on the Transferee to maintain capital charge equal to the actual exposure acquired and the Transferor is required to treat the transferred loan in its entirety, as if it was not transferred at all in the first place, and the consideration received by it shall be recognised as an advance.

• Board-approved Policy : The Transferors are mandated to put in place a comprehensive Board-approved policy for transfer and acquisition of loan exposures under the Master Directions. These guidelines must, inter alia , lay down the minimum quantitative and qualitative standards relating to due diligence, valuation, requisite IT systems for capture, storage and management of data, risk management, periodic Board level oversight, etc. Further, the policy must also ensure the independence of functioning and reporting responsibilities of the units and personnel involved in the transfer/acquisition of loans from that of personnel involved in originating the loans.
• Transfer of Standard Assets : The transfer of loan exposures classified as 'standard' can be undertaken through the mechanisms of assignment or novation or a loan participation. The transfer of such loan exposures should be only on a cash basis to be received at the time of transfer of loans; besides, the requirement of the transfer consideration being arrived at in a transparent manner on an arm's length basis. The Master Directions require the Transferees to monitor, on an ongoing basis and in a timely manner, the performance information on the loans acquired, including through conducting periodic stress tests and sensitivity analyses, and take appropriate action required, if any. Further, the Transferor's retention of economic interest, if any, in the loans transferred should be supported by legally valid documentation supported by a legal opinion.

The requirements of Chapter III of the Master Directions are, however, not applicable to certain identified loan transfers, as below:

• transfer of loan accounts of borrowers by a lender to other lenders, at the request/instance of borrower;
• inter-bank participations as per the RBI's circulars;
• sale of entire portfolio of loans consequent upon a decision to exit the line of business completely;
• sale of stressed loans; and
• any other arrangement/transactions, specifically exempted by the RBI.
• Minimum Risk Retention : The Master Directions are explicit in their requirement of the requisite due diligence in respect of the loans exposures and mention that the said exercise cannot be outsourced or delegated by the Transferee. In order to ensure a systemic departure from the conventional practice of placing solitary reliance on the due diligence of the originator (or the Transferor), the Master Directions mandate the Transferee to undertake the due diligence of the loan exposures through its own staff, at the level of each loan, and as per the same policies as would have been done had the Transferee been the originator of the loan. In case the due diligence of entire portfolio is undertaken by the Transferee, the requirement of a minimum retention requirement (MRR) of the Transferor can be dispensed with.

However, in case of loans proposed to be acquired as a portfolio, if a transferee is unable to perform due diligence at the individual loan level for the entire portfolio, the Transferor shall retain at least 10% of economic interest in the transferred loans as MRR. In such a case as well, the Transferee is required to undertake due diligence at the individual loan level for not less than one-third (1/3 rd ) of the portfolio by value and number of loans in the portfolio. As per the Master Directions, in case of multiple Transferees, the MRR would still be on the entire amount of transferred loan, even if any one of the transferee is unable to perform the due diligence at an individual level.

• Transfer of Stressed Assets : Chapter IV of the Master Directions deals specifically with the transfer of stressed loan exposures to ARCs and other Permitted Transferees. It is specifically stated that the mechanism for transfer of such stressed accounts can be consummated only through assignment or novation. Besides the requirement of a Board-approved policy for transfer as well as acquisition of stressed loan exposures and the parameters thereof, the Master Directions mandate such transfers to ARCs and other Permitted Transferees only. Importantly, the Transferor is necessarily required to undertake an auction through a ' Swiss Challenge method ' both in cases where (i) the aggregate loan exposure to be transferred is Rs. 100 crore or more after bilateral negotiations; and even under (ii) a transfer pursuant to the Resolution Plan approved in terms of the Prudential Framework (irrespective of the monetary threshold).

The transfer of such stressed loan exposures, as per the Master Directions, should be bereft of any operational, legal or any other type of risks relating to the transferred loans including additional funding or commitments to the borrower / transferee. In fact, it is specifically required for the transferor to ensure that no transfer of a stressed loan is made at a contingent price whereby in the event of shortfall in the realization of the agreed price, the Transferor would have to bear a part of the shortfall.

In addition, the Transferor is required transfer the stressed loans to transferee(s) other than ARCs only on cash basis and the entire transfer consideration should be received not later than at the time of transfer of loans. The stressed exposure can be taken out of the books of the Transferor only on receipt of the entire transfer consideration.

Quite significantly, the Master Directions prescribed that if the Transferee of such stressed loan exposure (except ARCs) have no existing exposure to the borrower whose stressed loan account is acquired, the acquired stressed loan shall be classified as "Standard" by the transferee. However, in case the Transferee has an existing exposure to such borrower, the asset classification of the acquired exposure shall be the same as the existing asset classification of the borrower with the Transferee, irrespective of whether such acquisition is pursuant to the transferee being a successful resolution applicant under the IBC.

Further, the Master Directions require the Transferee to hold the acquired stressed loans in their books for a period of at least 6 months before transferring to other lenders; however, such holding period is not applicable in case the transfer of stressed loan exposure is to an ARC or is pursuant to a resolution plan approved in terms of the Prudential Framework.

As regards the mandate of undertaking the 'Swiss Challenge method' is concerned, the Master Directions require the lenders put in place a Board-approved policy which should, interalia , specify the minimum mark-up over the base-bid required for the challenger bid to be considered by the lender(s), which in any case, shall not be less than 5% and shall not be more than 15%. However, for transfer of stressed exposure under the Prudential Framework, the minimum mark-up over the base-bid required for the challenger bid is to be decided with the approval of signatories to the ICA representing 75% by value of total outstanding credit facilities and 60% of signatories by number.

Additionally, the Master Directions provide for sharing of surplus between the ARC and the Transferor, in case of specific stressed loans; though, the clarity in respect of such specific stressed loans is not mentioned. The repurchase of stressed loan exposures is also stipulated from the ARCs in cases where the resolution plan has been successfully implemented

• Accounting : In the event the transfer of loan exposures results in loss or profit, which is realised, the same should be accounted for and, accordingly, reflected in the P&L account of the Transferor for the accounting period during which the Transfer is consummated. However, the unrealised profits (if any) arising out of such Transfers, shall be deducted from the Common Equity Tier 1 (CET 1) capital or net owned funds of the Transferor for meeting regulatory capital adequacy requirements till the maturity of such transferred exposures. The Master Directions prescribe maintenance of borrower-specific accounts both by the Transferor as well as the Transferee of the retained and transferred loan exposures, respectively. It has been further clarified that the extant requirements of RBI for 'income recognition, asset classification, and provisioning' shall, accordingly, be ensured by the transferor and the transferee with respect to their respective shares of holding in the underlying loan exposures.

Though it would be quite nascent to present an analysis of the Master Directions even before it has been actually implemented, yet there are indeed some crucial aspects which underline the significance of the Master Directions issued by RBI which can be summarized as follows:

• Identification and Resolution of Stressed Exposures : Though quite a premature assessment, yet it is felt that the framework under Master Directions could facilitate the development of a robust distressed asset ecosystem and speed-up the resolution of various stressed exposures, which could be driven by the ensuing characteristics of the Master Directions:
• Early Identification and Resolution of Stressed Exposures : The framework has expanded the definition of stressed exposures ('stressed loans') to include both non-performing assets (NPAs) and special mention accounts (SMAs). Also, the deregulation of the price discovery process will enable faster and more efficient pricing of exposures – especially when coupled with a wider range of eligible investors.
• Enhanced Viability of Stressed Asset Takeover Structures :More importantly, the Master Directions allow investors in stressed assets to classify the exposure as standard, although subject to any other exposure to the same entity on the investor's books not being sub-standard on the date of the acquisition of the asset. This could significantly lower capital charge and provisioning requirements for the acquirer/investor of the stressed assets. Given that most stressed assets are restructured as well – often including a complete management overhaul, the rationalisation of the capital charge and provisions could make such assets more attractive to prospective acquirers.
• Impetus to Long-Term Funding structures : The Indian credit markets have for long been bereft of avenues for mobilising capital through long-term debt instruments. As a result, liability structures for corporate borrowers in sectors such as power generation and roads front load cash outflows during the project life. This, at least in part, reflects the non-availability of long-dated liabilities for the financial sector. Therefore, an ecosystem which allows lenders to off-load long-dated exposures after a certain time period with reasonable foresightedness could enable borrowers to raise long-term debt instruments from the financial system in a cost-efficient manner.
• Independent Credit Evaluations Could Prove Critical : The Master Directions mentions that transferees may have the loan pools rated before acquisition so as to have a third-party view of their credit quality in addition to their own due diligence; though, the latter is a mandatory requirement and cannot substitute for the due diligence that the transferee(s) are required to perform. Also, in case of transfer of stressed assets, it becomes critical to ensure that the valuation of the exposure and associated risk capital allocation are based on an assessment of the asset to meet its contractual debt obligations. Even restructured accounts have subsequently come under stress in some cases due to fundamental weaknesses in the business profile, heightened management risk/weak governance structures and unsustainable debt levels even after restructuring. Though not prescribed as a mandatory requirement under the Master Directions, yet a third-party evaluation by a credit rating agency could provide an added layer of assessment and valuations for such exposures along with subsequent capital charge and provisioning norms could be linked to the outcome of such evaluation.

1. Registered with the Reserve Bank of India under Section 3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002

2. Sub-section (20) of Section 2 of the Companies Act, 2013

3. Sub-section (17) of Section 3 of the Insolvency and Bankruptcy Code, 2016

4. Section 29A of the Insolvency and Bankruptcy Code, 2016

5. As defined under SEBI (ICDR) Regulations, 2018

6. As defined under the Insolvency and Bankruptcy Code, 2016

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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RBI increases responsibilities of loan transfer parties

T he Reserve Bank of India (RBI) issued the Transfer of Loan Exposures Directions, 2021 (directions) in September 2021, which prescribe a comprehensive and robust framework to facilitate the sale, transfer and acquisition of loan assets, both standard and stressed, in the secondary market by lenders. These directions are applicable to all forms of loan transfers, including novation, assignment and loan participation.

Based on the recommendation of the Task Force on the Development of Secondary Market for Corporate Loans, the Committee on Development of Housing Finance Securitisation Market in India and the public responses received, it was decided to separate the regulatory guidelines for direct assignment transactions from the securitisation guidelines, and to revisit the guidelines for the sale of both standard and stressed exposures, which currently are contained in a number of circulars.

The directions make existing guidelines consistent with the changed resolution paradigm in the form of the Insolvency and Bankruptcy Code, 2016 (IBC) and the Prudential Framework for Resolution of Stressed Assets issued by way of the circular of 7 June 2019 (prudential framework). The directions are specific to the asset classification of the loan exposure being transferred; the nature of the entity, and the mode of transfer.

Other important provisions of the directions include situations where, in loan participation transactions, the legal ownership remains entirely with the transferor even after the beneficial interest has been transferred to the transferee. In such cases, the roles and responsibilities of the transferor and transferee shall be clearly delineated contractually. Loan transfers should result in the transfer of economic interest with no change in the loan contract. If there are any modifications, such as take-out financing, they shall be evaluated against the definition of restructuring contained in the prudential framework.

A loan transfer should result in the immediate removal of the transferor from the risks and rewards associated with loans to the extent that the economic interest has been transferred. In the case of any retained economic interest, the loan transfer agreement should clearly specify the distribution of the principal and interest income. The transferee should have the unfettered right to transfer or otherwise dispose of the loans free of any restraining conditions, including any consent requirement when it comes to resolution or recovery, to the extent of the economic interest transferred to them.

Lenders, regardless of whether they are transferors or otherwise, should not offer credit enhancements or liquidity facilities in any form in the case of loan transfers. A transferor cannot re-acquire a loan exposure, either fully or partially, that has been transferred by the entity previously, except under the prudential framework or the IBC.

In domestic transactions, the transferee should ensure that the transferor has strictly adhered to the minimum holding period requirements (MHP), which are three months for loans up to two years, and six months for loans of longer periods. For project loans, the period is calculated from the date of commencement of commercial operations of the project being financed. MHP is not applicable to the transfer of syndicated loans.

A transferor may transfer a single loan or a portfolio of loans that are not in default to permitted transferees through assignment or novation, or a loan participation contract. The transfer shall be for cash, received no later than at the time of transfer, transparently on an arm’s length basis. Where transfers result in a change of lender of record under a loan agreement, the transferor and transferee should ensure that the existing loan agreement provides for consent by the borrower to such transactions.

The transfer of stressed loans must be through assignment or novation only, not through loan participation. Lenders shall transfer stressed loans, including by way of bilateral sales or e-auction platforms, only to permitted transferees and asset reconstruction companies. The transferor must not assume any operational, legal or any other type of risks relating to the transferred loans, including additional funding or commitments to the borrower or transferee that relate to the loan transferred.

Aditya Vikram Dua is an associate partner and Parvathi Menon is an associate at SNG & Partners .

SNG & Partners One Bazaar Lane, Bengali Market New Delhi – 110001 India

www.sngpartners.in

Contact details Tel: +91 11 4358 2000 Email: [email protected]

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Accounting for Direct Assignment under Indian Accounting Standards (Ind AS)

By Team IFRS & Valuation Services ( [email protected] ) ([email protected])

Introduction

Direct assignment (DA) is a very popular way of achieving liquidity needs of an entity. With the motives of achieving off- balance sheet treatment accompanied by low cost of raising funds, financial sector entities enter into securitisation and direct assignment transactions involving sale of their loan portfolios. DA in the context of Indian securitisation practices involves sale of loan portfolios without the involvement of a special purpose vehicle, unlike securitisation, where setting up of an SPV is an imperative.

The term DA is unique to India, that is, only in Indian context we use the term DA for assignment of loan or lease portfolios to another entity like bank. Whereas, on a global level, a similar arrangements are known by various other names like loan sale, whole-loan sales or loan portfolio sale.

In India, the regulatory framework governing Das and securitisation transactions are laid down by the Reserve Bank of India (RBI). The guidelines for governing securitisation structures, often referred to as pass-through certificates route (PTCs) were issued for the first time in 2006, where the focus of the Guidelines was restricted to securitisation transactions only and direct assignments were nowhere in the picture. The RBI Guidelines were revised in 2012 to include provisions relating to direct assignment transactions.

Until the introduction of Indian Accounting Standards (Ind AS), there was no specific guidance regarding the accounting of direct assignment transactions, therefore, a large part of the accounting was done is accordance with the RBI Guidelines. The introduction of Ind ASes have opened up several new challenges for the financial entities.

Following issues are relevant:

• Whether DA would lead to de-recogntion?
• Whether there will be a gain on sale upon such de-recognition?
• Whether DA should be be treated as a partial transfer of asset or transfer of the whole asset?
• Continuing valuation of retained interest?

In this article, we intend to discuss those issues and suggest potential solutions for those as well.

Prior to addressing the above issues, the following is a comparison between DA and securitisation for a better understanding:

De recognition in case of Direct Assignment

Ind AS 109, provides a clear guidance as to the de recognition principles to be followed. Para 3.2.2 says that:

“3.2.2 Before evaluating whether, and to what extent, derecognition is appropriate under paragraphs 3.2.3–3.2.9, an entity determines whether those paragraphs should be applied to a part of a financial asset (or a part of a group of similar financial assets) or a financial asset (or a group of similar financial assets) in its entirety, as follows.

 (a) Paragraphs 3.2.3–3.2.9 are applied to a part of a financial asset (or a part of a group of similar financial assets) if, and only if, the part being considered for derecognition meets one of the following three conditions.

(i) The part comprises only specifically identified cash flows from a financial asset (or a group of similar financial assets). For example, when an entity enters into an interest rate strip whereby the counterparty obtains the right to the interest cash flows, but not the principal cash flows from a debt instrument, paragraphs 3.2.3–3.2.9 are applied to the interest cash flows.

 (ii) The part comprises only a fully proportionate (pro rata) share of the cash flows from a financial asset (or a group of similar financial assets). For example, when an entity enters into an arrangement whereby the counterparty obtains the rights to a 90 per cent share of all cash flows of a debt instrument, paragraphs 3.2.3–3.2.9 are applied to 90 per cent of those cash flows. If there is more than one counterparty, each counterparty is not required to have a proportionate share of the cash flows provided that the transferring entity has a fully proportionate share.

 (iii) The part comprises only a fully proportionate (pro rata) share of specifically identified cash flows from a financial asset (or a group of similar financial assets). For example, when an entity enters into an arrangement whereby the counterparty obtains the rights to a 90 per cent share of interest cash flows from a financial asset, paragraphs 3.2.3–3.2.9 are applied to 90 per cent of those interest cash flows. If there is more than one counterparty, each counterparty is not required to have a proportionate share of the specifically identified cash flows provided that the transferring entity has a fully proportionate share.

(b) In all other cases, paragraphs 3.2.3–3.2.9 are applied to the financial asset in its entirety (or to the group of similar financial assets in their entirety). For example, when an entity transfers (i) the rights to the first or the last 90 per cent of cash collections from a financial asset (or a group of financial assets), or (ii) the rights to 90 per cent of the cash flows from a group of receivables, but provides a guarantee to compensate the buyer for any credit losses up to 8 per cent of the principal amount of the receivables, paragraphs 3.2.3–3.2.9 are applied to the financial asset (or a group of similar financial assets) in its entirety.”

If the de recognition criteria is not met in entirety, then all the conditions mentioned in para 3.2.2(a) has to be satisfied, which talks about fully proportionate share of total cash flows from the financial asset and fully proportionate share of specifically identified cash flows of the financial asset. If these conditions are met, then partial de recognition is possible. The part that is still recognized, is not connected with de recognition and further accounting related to de recognition. However, for actually de recognizing the asset, the de recognition criteria in para 3.2.3 and para 3.2.6 has to be looked at.

Para 3.2.3 goes as follows:

“3.2.3 An entity shall derecognise a financial asset when, and only when:

(a) the contractual rights to the cash flows from the financial asset expire, or

 (b) it transfers the financial asset as set out in paragraphs 3.2.4 and 3.2.5 and the transfer qualifies for derecognition in accordance with paragraph 3.2.6.”

Thus, if the contractual rights to the cashflows expire, then the asset can be de-recognized. If the condition is not met, then it has to be seen that whether the asset is transferred as per para 3.2.5 and the transfer meets the de recognition conditions set out para 3.2.6.

Para 3.2.6 states that:

“3.2.6 When an entity transfers a financial asset (see paragraph 3.2.4), it shall evaluate the extent to which it retains the risks and rewards of ownership of the financial asset. In this case:

(a) if the entity transfers substantially all the risks and rewards of ownership of the financial asset, the entity shall derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer.

 (b) if the entity retains substantially all the risks and rewards of ownership of the financial asset, the entity shall continue to recognise the financial asset.

 (c) if the entity neither transfers nor retains substantially all the risks and rewards of ownership of the financial asset, the entity shall determine whether it has retained control of the financial asset. In this case:

(i) if the entity has not retained control, it shall derecognise the financial asset and recognise separately as assets or liabilities any rights and obligations created or retained in the transfer.

 (ii) if the entity has retained control, it shall continue to recognise the financial asset to the extent of its continuing involvement in the financial asset (see paragraph 3.2.16).”

Para 3.2.6 brings out that, if all the risks and rewards of ownership of financial asset is transferred, then the asset shall be de recognized. If the risks and rewards incidental to ownership of financial asset is not transferred, then obviously the asset cannot be de recognized. However, if there is a partial transfer of risks and rewards of ownership, then the surrender of control has to be evaluated. If there is surrender of control, then the asset can be de recognized. If not, there shall be partial de-recognition, that is, the asset shall be recognized in the books of the seller only to the extent of continuing involvement.

Computation of Gain on Sale

It is a general notion that a sale results in a gain or loss, be it arbitrary or anticipated, the same is required to be accounted for. In case of a direct assignment, there is a sale of the loan portfolios, however, the same completely depends upon whether the assigned loan portfolio is getting derecognised from the books of the assignor or not. If it is not derecognised from the books of the assignor, then the question of recognising a gain or loss on sale does not arise. However, if the sale qualifies for de-recognition, then the seller must book gain or loss on sale in the year of sale.

Upon reading of Ind AS 109 and study of example stated in application guidance in para B3.2.17, the way of computing the same can be derived as follows:

Gain on sale = Sale consideration – Carrying value of asset*Fair value of transferred portion/(Fair value of transferred portion + Fair value of retained portion)

This can be explained with the help of the following example:

The gain or loss on sale does not depend on the sale consideration completely. There may be cases where the carrying value of the transaction and sale consideration are same, i.e. at par transactions. As per Ind AS 109, the computation of gain on sale remains same in cases of at-par or premium structured transactions, however, even at-par transactions could lead to a gain or loss on sale..

The reason for same is that the computation of gain on sale takes into account the retained interest by the Assignor comprising of the difference between the interest on the loan portfolio and the applicable rate at which the direct assignment is entered into with the assignee, also known as the right of excess interest spread (EIS) sweep.

The above settles for the computation of the gain/loss, however, the bigger change seen in the present regime is on the part of recognition of such a gain in the books of the Assignor.

In the present scenario, Ind AS 109 prescribes that the gain on sale or de recognition be recorded upfront in the profit and loss statement.

For reference, para 3.2.12 states that:

“ 3.2.12 On derecognition of a financial asset in its entirety, the difference between:

(a) the carrying amount (measured at the date of derecognition) and

(b) the consideration received (including any new asset obtained less any new liability assumed) shall be recognised in profit or loss.”

Further in case of de recognition of a part of financial asset, para 3.2.13 states that:

“3.2.13 If the transferred asset is part of a larger financial asset (eg when an entity transfers interest cash flows that are part of a debt instrument, see paragraph 3.2.2(a)) and the part transferred qualifies for derecognition in its entirety, the previous carrying amount of the larger financial asset shall be allocated between the part that continues to be recognised and the part that is derecognised, on the basis of the relative fair values of those parts on the date of the transfer. For this purpose, a retained servicing asset shall be treated as a part that continues to be recognised. The difference between:

(a) the carrying amount (measured at the date of derecognition) allocated to the part derecognised and

(b) the consideration received for the part derecognised (including any new asset obtained less any new liability assumed) shall be recognised in profit or loss.”

Hence, it is clear that the gain on de recognition should be recorded in the profit and loss statement.

From a practical standpoint, the above recognition is seen as a demotivation for entering into a direct assignment transaction, since the same would result in a volatility or irregularity in the profit or loss statement of the NBFCs.

This approach is in stark contrast to what has been prescribed in the RBI Guidelines on Securitisation, which requires gain on sale to be amortised over the life of the transaction. As per the RBI Guidelines provide the following:

As per para 20.1 of RBI Guidelines on Securitisation of Standard Assets issued in 2006:

“In terms of these guidelines banks can sell assets to SPV only on cash basis and the sale consideration should be received not later than the transfer of the asset to the SPV. Hence, any loss arising on account of the sale should be accounted accordingly and reflected in the Profit & Loss account for the period during which the sale is effected and any profit/premium arising on account of sale should be amortised over the life of the securities issued or to be issued by the SPV. ”

Also, as per para 1.4.1. of RBI Guidelines on Securitisation of Standard Assets issued in 2012:

“The amount of profit in cash on direct sale of loans may be held under an accounting head styled as “Cash Profit on Loan Transfer Transactions Pending Recognition” maintained on individual transaction basis and amortised over the life of the transaction .”

As the accounting treatment offered by Ind AS defaces the profit and loss statement by distorting the income recognition pattern of the NBFCs, NBFCs are not in favour of recording this gain upfront. The concern is aggravated due to the liquidity crunch currently faced by the NBFCs caused by recent downfall of IL&FS. The default on payment obligations of loans and deposits amounting to approximately Rs. 90,000 crore, by India’s leading infrastructure finance company, shook the confidence of the lenders and triggered a panic sentiment amongst the market lenders including NBFCs. As a result of the panic, banks are unwilling to lend to the NBFCs and their cost of funds are going up. However, the banks are showing interest in acquiring their loan portfolios instead. Therefore, the NBFCs are somewhat being forced to accept this distortion in their profit or loss statement.

Another question that arises is- whether de-recognition in books of assignor affects recognition in the books of the assignee.

As per para 3.1.1 of Ind AS 109, an entity shall recognise a financial asset or a financial liability in its balance sheet when, and only when, the entity becomes party to the contractual provisions of the instrument. Therefore, the transferee should recognise the financial asset or financial liability in its balance sheet only when he becomes a party to the contractual provisions of the instrument.

Para B3.2.15 of the same standard, provides that if a transfer of a financial asset does not qualify for de-recognition, the transferee does not recognise the transferred asset as its asset. In such a case the transferee is required to derecognise the cash or other consideration paid and recognises a receivable from the transferor. The transferee may measure the receivable at amortised cost (if it meets the criteria in paragraph 4.1.2) if the transferor has both a right and an obligation to reacquire control of the entire transferred asset for a fixed amount (such as under a repurchase agreement).

Therefore, de-recognition from the books of the seller is clearly a determinant for recognition in the books of the buyer.

Impact on GST on the gain on sale

In the last couple of years, if there is anything that has bothered the financial entities in India, other than IndAS, then it has to be GST. Therefore, it becomes pertinent to take a look at whether GST will become applicable in any manner whatsoever.

Under GST regime, assignment of loans are treated as dealing in securities and are therefore exempted from GST. Link to our detailed writeup in this regard has been provided in the footnote [1] .

Reporting of Retained Interests

A partial de-recognition is where the transferor transfers only a part of the asset and retains a part of it.

Currently, as per the RBI Guidelines, NBFCs are required to comply with the minimum retention requirement of 10%, that is, they should have a continuing interest of 10% on the loans that it intends to transfer. Therefore, if an NBFC is intending to sell of a portfolio of Rs. 100 crores, it has to retain at least 10% of the said portfolio and can sell of only Rs. 90 crores representing the remaining part.

Therefore, this becomes a classic case of partial de-recognition.

The value of retained interest should be accounted for as per the original accounting criteria as and when it was originated. For instance, if the pool recognised under FVOCI method, the retained interst must continue to be valued at FVOCI.

The manner of recognition or valuation of the retained interest will not change when a part of the pool is sold off.

Before the introduction of Indian Accounting Standards, RBI guidelines were followed for de recognizing the asset and recording the gain on sale after de recognition. There was no accounting guidance for financial instruments and their de recognition. In the absence of it, RBI guidelines were followed which talked about true sale. In case, the conditions of true sale were satisfied, then the asset was de recognized and the gain was regularised over the period by amortising the gain on de recognition.

While a well-documented piece of legislation is welcomed, however, every new thing has some shortcomings. In this case, the irregularities in the profit and loss and the complexities surrounding the de-recognition test comes as shortcomings. However, it is expected, with the passage of time, these shortcomings will also be settled.

[1] http://vinodkothari.com/2018/06/gst-on-assignment-of-receivables-wrong-path-to-the-right-destination/

Can the Originator recognise a lower upfront income by giving impact of historical pre-terminations while discounting the future cash flows? This will reduce the impact of irregular upfront income to some extent.

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