Securing the future of stressed assets

By Sawant Singh and Aditya Bhargava, Phoenix Legal
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Securitisation is the aggregating of commercial debt and repackaging it as capital market instruments. India has separate regulatory frameworks for the securitisation of standard or performing assets, which involve banks and financial institutions, and non-performing assets, which involve asset reconstruction companies.

Sawant Singh
Sawant Singh
Partner
Phoenix Legal

By volume, the securitisation of standard or performing assets is served by a larger and more developed market. This market is seeing increasing participation by institutional and non-institutional investors. Looking to expand financial markets, and based on feedback, in its September 2022 statement on developmental and regulatory policies, the Reserve Bank of India (RBI) proposed a new framework for the securitisation of stressed assets similar to that for standard assets. In preparation, the RBI in January 2023 issued a discussion paper, the Securitisation of Stressed Assets Framework (SSAF).

The SSAF does not set out a new regulatory framework for the securitisation of non-standard assets. It gives examples of international experience and poses questions for feedback. The SSAF notes the “lower degree of certainty of cash flows” and the involvement of specialist third-party entities in achieving resolution as differentiating the securitisation of standard and non-standard assets. The SSAF considers whether stressed assets should include only non-performing assets or whether standard assets suffering varying degrees of stress should also be included. The advantage of the latter would be in cash flow, but disadvantages include regulatory arbitrage and complexity in asset resolution.

Aditya Bhargava
Aditya Bhargava
Partner
Phoenix Legal

The SSAF notes that the existing framework for standard assets prevents some assets, such as revolving loans and loans with a bullet payment of interest and principal, from being securitised. Refreshingly, the SSAF considers that this approach might not be attractive, analysing factors such as enforcement, resolution and pricing. The RBI also recognises that large ticket corporate loans have downsides, including uncertain cash flows, dependence on decision-making by committees of creditors and skewed representation priorities by resolution professionals (RP).

Following the global financial crisis of 2008, minimum retention requirements (MRR), popularly, if impolitely, referred to as skin in the game, have been ubiquitous in securitisation structures. MRR are economic interests kept by an originator to ensure economic alignment with investors. The SSAF notes that as the underlying assets would already be in default, the originator would no longer wish to be associated with non-performing assets and would have limited economic alignment with investors. The SSAF asks whether MRR should be borne by the originator or by an RP, whether MRR should be distributed between the originator and an RP or whether these matters should be left to the market. As an originator’s assistance may be needed in the resolution process, a solution is for the originator to invest in subordinated high-yielding securities issued by the securitisation structure, with investors holding senior securities paid out in priority to other securities. The RP would hold mezzanine securities paying a moderate yield, but only redeemed after the senior investors have been paid.

Credit enhancement in securitisation transactions bridges the gap between the expectation of investors and the uncertainty of underlying cash flows. Credit enhancement improves the creditworthiness of securitisation structures and encourages investors to participate. The SSAF recognises this and poses the question whether credit enhancement should be allowed only for senior tranches. As the underlying assets are stressed, the traditional approach of imposing a ceiling on credit enhancement would not be workable. The RBI should also consider removing ceilings on credit enhancement unless provided by the originator.

The SSAF is a good initiative. However, a new framework for stressed assets should only be considered once hurdles to successful resolutions of stressed assets in existing regulations and enforcement mechanisms have been removed. The addition of a new framework for stressed assets to the existing patchwork of regulations adds a new layer of complexity. While this could expand financial markets, it will not succeed in the absence of effective enforcement mechanisms.

Sawant Singh and Aditya Bhargava are partners at Phoenix Legal

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