Banking Industry and the Issue of NPAs NPA Management Need for Asset Reconstruction Companies Global Scenario Interaction with Banks' Executives    Introduction to Securitisation: The Framework Global Securitisation Market Securitisation in india SARFAESI ACT 2002: An Assessment Impact of Basel II on Securitisation PREFACE | FOREWORD | EXECUTIVE SUMMARY | SECURITISATION - AN OVERVIEW | THE INDIAN BANKING INDUSTRY AND NPA's NPA MANAGEMENT AND ARC's| THE BANKING PERSPECTIVE| COMPANY LISTING & PROFILES| LAUNCH EVENT| SPONSORS Alphabetical Listing Total Advances Net NPAs Amount Net NPA Advances Ratio Profiles

The growth in the Indian securitisation market has been largely fuelled by the repackaging of retail assets and residential mortgages of banks and FIs. This market has been in existence since the early 1990s, though has matured significantly only post-2000 with an established narrow band of investor community and regular issuers. According to Industry estimates, the structured issuance volumes have grown considerably in the last few years; though still small compared to international volumes. Asset backed securitisation (ABS) is the largest product class driven by the growing retail loan portfolio of banks and other FIs, investors’ familiarity with the underlying assets and the short maturity period of these loans. The mortgage backed securities (MBS) market has been rather slow in taking off despite a growing housing finance market due to the long maturity periods, lack of secondary market liquidity and the risk arising from prepayment/repricing of the underlying loan.

In the early 1990s, securitisation was essentially a device of bilateral acquisitions of portfolios of finance companies. There were quasi-securitisations for sometime, where creation of any form of security was rare and the portfolios simply got transferred from the balance sheet of the originator to that of another entity. These transactions often included provisions, which offered recourse to the originator as well. In recent years, loan sales have become common through the direct assignment route, which is structured using the true sale concept. Though securitisation of auto loans remained the mainstay throughout the 1990s, over time, the market has spread into several asset classes – housing loans, corporate loans, commercial mortgage receivables, future flow, project receivables, toll revenues, etc that have been securitised.

Within the auto loan segment, the car loan segment has been more successful than the commercial vehicle loan segment, mainly because of factors such as perceived credit risk, higher volumes and homogenous nature of receivables. Other types of receivables for which securitisation has been attempted in the past include property rental receivables, power receivables, telecom receivables, lease receivables and medical equipment loan receivables. Revolving assets such as working capital loans, credit card receivables are not permitted to be securitised.

Market Participants

In India, issuers have typically been private sector banks, foreign banks and non-banking financial companies (NBFCs) with their underlying assets being mostly retail and corporate loans. The key motivations for Indian banks include:

• Liquidity: Securitisation is an easy route than raising deposits that are subject to reserve requirements
• Regulatory issues: Constrains arising out of Provisions, priority sector norms, etc
• Capital Relief: Major investors are mostly mutual funds (money market/liquid schemes), close-ended debt schemes and banks. Long term investors like insurance companies and provident funds are currently not active due to regulatory constraints. Foreign institutional investors are also missing due to regulatory ambiguity. As per guidelines, mutual funds are required to declare their NAV’s on a daily basis due to which they prefer the structure/asset classes which involve low pre-payment rates. The lack of domestic non-traditional hedge fund style investors to participate in equity and mezzanine tranches has led to originators holding them.

Market Activity

At end-June 2007, the book value of total amount of assets acquired by SCs/RCs registered with the Reserve Bank stood at Rs 285,436 mn. The security receipts subscribed to by banks amounted to Rs 68,942 mn. The security receipts redeemed amounted to Rs 6,596 mn .

Details of Financial Assets Acquired by ARCs

–: Nil/Negligible Source :RBI

Regulatory Framework

There is no clear regulatory framework for the securitisation market per se. However, securitisations originated by RBI regulated entities like Banks, FIs and NBFCs are governed by guidelines issued by the RBI. In effect, only the financial sector has a clear framework for participating in securitisation. Enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 (SARFAESI Act 2002) enabled securitisation of the non-performing assets of Banks, which could sell off their NPAs to asset reconstruction companies registered with RBI. The SARFAESI Act laid the framework to the constitution of asset reconstruction companies (ARCs) specialising in securitising distressed assets purchased from banks. The issuance of security receipts has since grown significantly.

The recommendations of the High Level Committee on Corporate Debt and Securitisation (Chairman: Dr.R.H.Patil) in 2005 proved to be the turning point towards the development of the corporate debt and securitisation market. Some of the key recommendations of the Committee on securitisation include:

• Evolve a consensus on the affordable rates and levels of stamp duty on debt assignment, Pass through Certificates (PTCs) and security receipts (SRs) across States
• An explicit tax pass-through treatment to securitisation SPVs / Trust SPVs should be provided. Wholesale investors should be permitted to invest in and hold units of a close-ended passively managed mutual fund whose sole objective is to invest its funds in securitised paper. There should be no withholding tax on interest paid by the borrowers to the securitisation trust and on distributions made by the securitisation trust to its PTCs and/or SR holders
• PTCs and other securities issued by securitisation SPVs / Trust SPVs should be notified as “securities” under SCRA
• Large-sized NBFCs and non-NBFCs corporate bodies established in India may be permitted to invest in SRs as Qualified Institutional Buyers (QIBs). Private equity funds registered with SEBI as venture capital funds (VCFs) may also be permitted to invest in SRs within the limits that are applied for investment by VCFs into corporate bonds
• The Committee also recommended: (i) introduction of credit enhancement mechanism for corporate bonds; (ii) creation of specialised debt funds to cater to the needs of the infrastructure sector; and (iii) fiscal support, like tax benefits, bond insurance and credit enhancement, for municipal bonds and infrastructure SPVs.

In February 2006, the RBI issued guidelines for securitisation of standard assets by Banks, FIs and NBFCs. These guidelines provided the regulatory framework for several critical aspects of securitisation and are expected to take forward the establishment of a robust structured credit market. They clearly defined some of the key aspects such as true sale criteria, capital treatment for credit enhancement, exposure recognition, etc. In view of differing practices by banks and concerns raised regarding accounting, valuation and capital treatment, the RBI issued guidelines were broadly as follows:

• Detailed guidelines to ensure “arms length” relationship between the originator and the SPV
• Credit enhancements provided by the originator for the first as well as second losses to be deducted from the capital
• Any profit/premium arising on account of sale not allowed to be booked upfront and is to be amortised over the life of the securities issued or to be issued by the SPV
• Provision of liquidity facility to be treated as an off-balance sheet item and attract 100% credit conversion factor as well as 100% risk weight
• Disclosure by the originator, as notes to accounts, a comparative position for two years of the following items: 1) the total number and book value of loan assets securitised; 2) sale consideration received for the securitised assets and gain/loss on sale on account of securitisation; 3) form and quantum (outstanding value) of services provided by way of credit enhancement, liquidity support, post securitisation asset servicing, etc.

Though some concerns have been raised regarding these guidelines as being restrictive, RBI is very clearly treading a cautious step adopting an officially termed “incentive-compatible prudential approach towards securitisation” - an approach defensible in the aftermath of the recent sub-prime episode in some developed countries.

In 2007, the Securities Contracts (Regulation) Amendment Act 2007 amended the Securities Contract (Regulation) Act to include “securitised instruments” in the definition of “securities”. The amendment has paved way for listing and trading of securitised debt on stock exchanges.

SEBI has released draft regulations for “Public Offer and Listing of Securitised Debt Instruments” in June 2007 which is yet to be formalised. However, these guidelines envisage a very different transaction structure compared to current market practices.

Mode of Securitisation

Securitisation in India largely adopts a trust structure with the underlying assets being transferred by way of sale to a trustee company. The SPV, formed as a Trustee Company, issues securities that are either Pass through Certificates or Pay through Certificates (PTC). The trustee is the legal owner of the underlying assets in both the scenarios. The investors holding Pass through Certificates are entitled to a beneficial interest in the underlying assets held by the trustee. Investors holding Pay through Certificates are entitled to a beneficial interest only in the cash flows attained from the underlying securities to the extent of the obligation agreed with the holders of primary and secondary tranches of PTC.

Issues facing the Indian Securitisation Market

• Stamp Duty: One of the major hurdles facing the development of the securitisation market is the stamp duty structure. In India, stamp duty is payable on any instrument which seeks to transfer rights or receivables. Therefore, the process of transfer of the receivables from the originator to the SPV involves an outlay on account of stamp duty, which can make securitisation commercially unviable in states that still have a high stamp duty. Few states have reduced their stamp duty rates, though quite a few still maintain very high rates ranging from 5-12 per cent. To the investor, if the securitised instrument is issued as evidencing indebtedness, it would be in the form of a debenture or bond subject to stamp duty, and if the instrument is structured as a Pass Through Certificate (PTC) that merely evidences title to the receivables, then such an instrument would not attract stamp duty. Some states do not distinguish between conveyances of real estate and that of receivables, and levy the same rate of stamp duty.
  
  
  SEBI has suggested to the government on the need for rationalisation of stamp duty with a view to developing the corporate debt and securitisation markets in the country, which may going forward be made uniform across states as also recommended by the Patil Committee.

• Foreclosure Laws: Lack of effective foreclosure laws also prohibits the growth of securitisation in India. The existing foreclosure laws are not lender friendly and increase the risks of MBS by making it difficult to transfer property in cases of default.

• Taxation related issues: There is ambiguity in the tax treatment of mortgage-based securities, SPV trusts, and NPL trusts. Presently, the investors or the buyers (PTC and SR holders) pay tax on the earnings from the SPV trust. As a result the trustee makes income payouts to the investors without any payment of tax. The Income Tax law envisages the taxation of an unincorporated SPV either at the trust SPV level or the investor level in order to avoid double taxation. Therefore, any tax pass through regime merely represents a stance that the investors in the trust will bear the tax liability instead of the Trust being held liable to tax the investors on their respective earnings.

• Issues under the SARFAESI Act: A security receipt (SR) gives its holder a right of title or interest in the financial assets included in securitisation. This definition holds good for securitisation structures where the securities issued are referred to as pass through certificates. However, the rationale fails in the case of pay through certificates with different classes of primary and secondary rights to the cash flow. Also, the SARFAESI Act has been structured such that SRs can be issued and held only to Qualified Institutional Buyers (QIBs). There is a need to expand the investor base by including NBFCs, non-NBFCs, private equity funds, etc.

• Legal Issues: Investments in PTCs are typically held-to-maturity. As there is no trading activity in these instruments, the yield on PTCs and the demand for longer tenures especially from mutual funds is dampened. Till recently, Pass through Certificates (PTC) were not explicitly covered under the Securities Contracts (Regulation) Act, definition of securities. This was however ammended with the Securities Contracts (Regulation) Amendment Act, 2007 passed with a view to providing a legal framework for enabling listing and trading of securitised debt instruments. This will bring about listing of PTCs which in turn will support market growth.