Securitisation just got costly

Banks must provide 100% deduction of credit enhancement from capital.

Securitisation of loan assets today got more expensive for banks with the Reserve Bank of India (RBI) stipulating a stiff 100 per cent deduction from capital the amount of credit enhancement provided.

Credit enhancement is the support provided, including through cash collaterals, so that the credit rating of a pool of assets securitised gets enhanced.

Securitisation is a process by which banks and non-banking finance companies (NBFCs) sell loan assets to a special purpose vehicle (SPV) in return for an immediate cash payment.

In the second stage, the security interests representing claims on incoming cash flows from the pool of assets are repackaged and sold to third party investors by issuance of tradable debt securities.

RBI, in its final guidelines on securitisation of standard assets, has brought in two levels of credit enhancements (first loss and second loss facilities), requiring banks to do away with the current practice of just a single credit enhancement facility.

RBI said banks, financial institutions and NBFCs originating securitisation of assets have to deduct 50 per cent each of first loss facility and second loss facility from Tier 1 capital and another 50 per cent each from Tier 2 capital.

RBI has capped the first loss facility at the amount of capital that the bank would have been required to hold for the full value of assets, had they not been securities.

The treatment of credit enhancement provided by a third party (other than the originator) is a little less harsher. The first loss credit enhancement provided by third party service providers will be reduced from capital to the full extent, but just prescribed a 100 per cent risk weight for the amount of the second loss credit facility.

Bankers said the 100 per cent deduction from capital for the second loss credit enhancement provided was unwarranted as it would get activated only after the first loss facility gets consumed.

The first loss facility is provided to ensure the pool of assets securitised get the bare minimum investment grade rating and the second loss facility is an additional cushion for obtaining a higher rating.

Banks till hitherto applied the normal capital adequacy norm considering a 100 per cent risk weight for the amount of credit enhancement provided.

Securitisation issues had totalled Rs 22,300 crore in 2004-05, 176 per cent higher than in the previous year. Credit enhancement provided ranges from 5 per cent to 10 per cent of the issue sizes.

The new capital treatment will mean banks have to deduct from capital the 100 per cent of the credit enhancement, against 9 per cent capital adequacy (Rs 9 for every Rs 100 of credit enhancement) cover provided now.

RBI also said the liquidity facility provided should be to smoothen temporary cash flow mismatches and will remain drawn only for short periods.

If the drawings under the facility are outstanding for more than 90 days, it should be classified as a non-performing asset (NPA) and fully provided for.

The commitment to provide liquidity facility, to the extent not drawn would be an off- balance sheet item and attract 100 per cent credit conversion factor as well as 100 per cent risk weight for capital adequacy purposes.

RBI said when the originator is providing the liquidity facility, an independent third party, other than the originator's group entities, should co-provide at least 25 per cent of the liquidity facility that shall be drawn and repaid on a pro-rata basis.

The originator must not be liable to meet any shortfall in liquidity support provided by the independent party.

RBI said the sale of assets through securitisation should result in immediate legal separation of the originator from the assets which are sold to the new owner, viz. the SPV.

The assets should stand completely isolated from the originator, after its transfer to the SPV, i.e., put beyond the originator's as well as their creditors' reach, even in the event of bankruptcy of the originator.