To reduce the burden on banks for financing infrastructure projects, and to promote the use of the corporate bond market for this purpose, the Reserve Bank of India (RBI) permitted banks to provide partial credit enhancements (PCEs) to corporate bonds in 2015. PCEs were intended to enhance the credit rating of bonds, thereby encouraging long-term investors such as insurance funds and pension funds to invest in such bonds.
Following its September 2015 circular, banks were permitted to provide PCEs by way of non-funded subordinated contingent line of credit facilities, which could be drawn on in case of shortfalls in cash flows for servicing interest and principal payments on bonds supported by PCEs.
This PCE facility was limited to companies and special purpose vehicles funding infrastructure projects. The September 2015 circular expressly restricted banks from providing PCEs by way of guarantee, presumably so as to avoid a situation of the credit rating of the bonds “piggybacking” on the credit rating of the bank.
Notably, an RBI direction on guarantees prescribes that providing guarantees for “a corporate bond or any debt instrument not only have significant systemic implications but also impede the development of a genuine corporate debt market”.
While PCEs that could be provided by a bank were initially capped at 20% of the bond issue, this was later raised in 2016 to 50% of the bond issue with a sub-limit of 20% of the bond issue for each bank providing the PCE.
In view of recent developments in domestic and international financial markets, among the measures introduced to improve funding for the financial sector, the RBI’s 2 November circular allowed banks to provide PCEs for bonds issued by systemically important non-deposit taking non-banking financing companies (SI-NBFCs) and housing finance companies (HFCs).
While the circular does not provide the rationale for this change, it is believed to have been introduced to promote fund flows to NBFCs keeping in mind that credit growth over the last three years has largely been driven by such entities. The conditions for providing such PCEs include: (a) the minimum maturity of bonds issued by SI-NBFCs and HFCs that are supported by PCEs should be at least three years, (b) the proceeds of such bond issues can only be used for refinancing of existing debt.
In this regard, the bank providing the PCE would need to ensure that “appropriate mechanisms to monitor and ensure that the end use condition is met”, and (c) a bank’s exposure by way of PCEs will be limited to one percent of the capital funds as well as single and group-borrower limits applicable to the bank. Additionally, unlike the enhanced aggregate limit of PCEs of up to 50% of the bond issue, the PCE that can be provided by a bank for a bond issue by an SI-NBFC or an HFC is limited to 20% of the bond issue.
While the RBI circular intends to provide a fillip to fundraising by NBFCs through the corporate bond market, the measure may not have its intended effect as it only applies to bonds issued by SI-NBFCs and HFCs. While these entities are known to have been affected by the current stringent liquidity conditions, they are higher in the pecking order of investor interest than comparatively smaller NBFCs that are not large enough to be classified as “systemically important”. It is possible that the latter require access to funding on a more urgent basis.
Further, although the original 2015 circular intended PCEs to be provided for bonds issued for infrastructure projects, and its prescriptions were structured in a manner appropriate to such financing, the changes introduced in the recent RBI circular merely extend these provisions to bonds issued by SI-NBFCs and HFCs for refinancing. Limited consideration appears to have been given to the implementation of this circular in the context of NBFCs.
Moreover, PCEs as instruments have not yet acquired a great deal of popularity, and transactions based on PCEs have been few. Historically, participation in corporate bond issues in India by long-term investors such as insurance companies and pension funds has been at a low level for various reasons including the lack of availability of highly rated bonds. Such subdued interest is perhaps a sign that much needed systemic reforms such as improved dispute resolution mechanisms and liquidity in the domestic corporate bond market, rather than ad hoc crisis triggered mechanisms, are required to promote funding through the corporate bond market.
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