Resolution framework for Covid19-related stress – financial parameters

In the September 2020 edition of IndianEngineeringExports (Vol.13, Issue 6), Prof. TR Shastri discussed the evolution of stressed assets resolution frameworks that help the banking system in the early detection and resolution of financial distress of lenders and investors. The Reserve Bank of India has incorporated regulatory measures in its Prudential Framework for the resolution of stressed assets aimed at alleviating the lingering impact of Covid19 on businesses and financial institutions

TR SHASTRI

Prof. TR Shastri is a Former Banker, Bengaluru

THE Prudential Framework direction of RBI dated 7 June 2019 (which replaced the 12 February 2018 framework) provides a prin ciple-based resolution framework for addressing borrower defaults under a normal scenario. Any such resolution plan involving granting of any concession entails an asset classification downgrade, except when it is accompanied by a change in ownership, subject to the prescribed conditions. As per this framework, lenders are required to implement a resolution plan in respect of entities in default within 180 days from the end of the review period of 30 days. As a regulatory measure aimed at alleviating the lingering impact of Covid19 on businesses and financial institutions in India, consistent with the globally coordinated action, RBI allowed excluding the period from 1 March 2020 to 31 May 2020 for calculating the 30 days review period and also allowed extension of timeline for resolution (of 180 days) by 90 days from the date on which the 180-day period was originally set to expire, initially in April 2020. In May 2020, RBI extended the extension time of 90 days to 180 days and the period from 1 March 2020 to 31 August 2020 was to be excluded from the calculation of the 30-day review period.

RBI observed that the resultant stress on account of Covid19 can potentially impact the long-term viability of many firms, otherwise having a good track record under the existing promoters, due to their debt burden becoming disproportionate relative to their cash flow generation abilities. Hence this is no more a normal scenario. RBI, therefore, decided in August 2020 to provide a special window under the Prudential Framework to enable the lenders to implement a resolution plan to borrowers having stress on account of Covid19. This 6 August 2020 circular gives detailed guidelines for handling resolutions for loans to individuals (Part A) and also others including corporates (Part B).

An interesting aspect of this special window is that an expert committee was formed to recommend a list of financial parameters which, in their opinion, would be required to be factored into the assumptions that go into each resolution plan, and the sector-specific benchmark ranges for such parameters for borrowers listed in Part B. The parameters covered aspects related to leverage, liquidity, debt serviceability, etc. The expert committee consisted of bankers with none from RBI and secretariat at the Indian Banks Association. The committee submitted its report on 4 September and RBI broadly accepted its recommendations and issued operative guidelines quickly on 7 September 2020.

We discuss here the summary of this special window under the Prudential Framework covering conditions under which this is applicable, briefly the rules as applicable to individual borrowers (personal loans – Part A) and rules as applicable to loans to others (corporates – Part B) incorporating RBI guidelines based on the expert committee recommendations.

Conditions under this special window

  • The lending institutions should frame board-approved policies pertaining to implementation of viable resolution plans for eligible borrowers under this framework.
  • Resolution under this window is extended only to borrowers having stress on account of Covid19 and which were classified as standard but not in default for more than 30 days as at 1 March 2020 with the/any lending institution.
  • It is not applicable to loans to MSME borrowers whose aggregate exposure to lending institutions collectively is Rs25 crore or less, farm credits, agricultural credit societies, financial service providers, government entities, and to lenders’ own staff.
  • Resolution under this framework may be invoked not later than 31 December 2020 and must be implemented within 90 days and 180 days respectively for personal loans and other eligible loans, from the date of invocation.
  • Any resolution plan implemented in breach of the stipulated timeline shall be fully governed by the June 2019 circular or applicable specific guidelines. In other words, the benefits of this special window will not be available, if the time schedule is not adhered to.

Specific guidelines for Part A borrowers

  • Personal loans for this purpose refer to loans given to individuals and include consumer credit, education loan, loans given for creation/enhancement of immovable assets (e.g. housing, etc), and loans given for investment in financial assets (shares, debentures, etc).
  • Moratorium, if allowed, can be for a maximum of two years and will come into force immediately upon implementation of the resolution plan. The overall tenure of the loan may also get modified commensurately. The resolution plans may inter alia include rescheduling of payments, conversion of any interest accrued, or to be accrued, into another credit facility.
  • The resolution plan is considered as implemented only if all of the following conditions are met:
    - Completion of documentation
    -The changes in the terms of conditions of the loans get duly reflected in the books of the lending institutions
    - Borrower is not in default with the lending institution as per the revised terms.

Specific guidelines for Part B borrowers

  • The residual tenure of the loan may be extended by maximum two years with or without payment moratorium. The moratorium period, if granted, shall come into force immediately upon implementation of the resolution plan.
  • The resolution process shall be treated as invoked once lenders representing 75 percent by value and 60 percent by number (majority lenders) agree to invoke the same. If there is only one lender, the date of invocation shall be the date on which both the borrower and lending institution have agreed to proceed with a resolution plan under this framework.
  • Inter-Creditor Agreement (ICA) is to be mandatorily signed by all lenders within 30 days of invocation. If not, the invocation will be treated as lapsed and in respect of such borrowers, the resolution process cannot be invoked again under this framework.
  • Disputes regarding the resolution process are to be settled as per the provisions of the ICA and RBI will not mediate.
  • Lenders are incentivised to sign the ICA, as non-signatories face higher provisioning. RBI has also clarified that mandatory signing of ICA cannot be avoided by higher provisions.
  • In respect of these exposures, any default by the borrower with any of the signatories to the ICA during the monitoring period shall trigger a review period of 30 days. If the borrower is in default with any of the signatories to the ICA at the end of the review period, the asset classification of the borrower with all lending institutions, including those who did not sign the ICA, shall be downgraded to NPA from the date of implementation of the resolution plan or the date from which the borrower had been classified as NPA before implementation of the plan, whichever is earlier. Further upgradation is always subject to implementation of a fresh restructuring under the Prudential Framework.
  • The asset classification may be maintained as standard or may be upgraded to standard (for accounts which may have slipped into NPA between invocation and implementation) if the resolution plan is implemented as per the framework.
  • For aggregate exposures of Rs100 crore or more, an Independent Credit Evaluation is to be obtained from any one credit rating agency authorised by RBI.
  • The resolution plan may involve reorganisation including regularisation of the account by the borrower, sale of the exposures, change in ownership, and restructuring excluding compromise settlements. It may provide for conversion of debt into equity or other marketable non-convertible debt securities provided amortisation and coupon are similar to terms of debt. Valuation for this is to be done as per existing guidelines.
  • For accounts involving consortium or multiple banking arrangements, an escrow account has to be maintained with one of the lending institutions. All receipts by the borrower, all repayments by the borrower to the lending institutions and all additional disbursements to the borrower as per the resolution plan are to be routed through this escrow account. Legally binding agreement between lenders and escrow manager should be entered into for smoothly operationalising this.
  • While arriving at a resolution plan, the lenders make several assumptions. Such plan should factor in the financial parameters and its ranges notified by RBI based on the expert committee recommendations.

Expert Committee’s recommendations as advised by RBI to lenders

As earlier mentioned, an expert committee was formed to recommend a list of financial parameters which, in their opinion, would be required to be factored into the assumptions that go into each resolution plan, and the sector-specific benchmark ranges for such parameters for borrowers listed in Part B. The task before the committee was to:

  • identify the sectors where the impact of Covid19 was visible
  • select parameters based on their relevance while considering the resolution plan (necessarily covering aspects related to leverage, liquidity, debt serviceability, etc.)
  • recommend sector specific threshold parameters, i.e. ranges
  • undertake process validations (i.e. verification in terms of adherence to the conditions prescribed in the resolution, without interfering with the commercial judgment exercised by the lenders) of the resolution plan submitted for borrowers with aggregate exposure of Rs1500 crore and above. Apparently, this may go on till 30 June 2021 when the term of the committee will end, as of now.

Based on the outstanding and the severity impact, the committee (based on meetings, sector-specific reports and company data) selected 26 sectors (with subsectors in two of them) for the purpose of recommending financial parameters to be factored in the resolution plan (and parameters for residual sectors). This covered nearly 75 percent of the corporate debt.

The following five financial parameters were selected based on their relevance while considering the resolution plan with detailed narration of calculation:

  1. Total outside liabilities/adjusted tangible net worth (TOL/ATNW): here net worth is arrived net of investments and loans in the group and outside entities
  2. Total debt/EBITDA
  3. Current ratio
  4. Debt service coverage ratio (DSCR): this is for the relevant year
  5. Average debt service coverage ratio (ADSCR): this is over the period of the loan

All lending institutions should mandatorily consider these key ratios while finalising the resolution plans and the sector-specific thresholds (ceilings or floors, as the case may be) for each of these key ratios listed in the RBI circular (reproduced on page 23-4).

RBI has advised further operational guidelines while implementing the resolution plan.

  • The ratios prescribed are intended as floors or ceilings, as the case may be, but the resolution plans should consider the pre-Covid19 operating and financial performance of the borrower and impact of Covid19 on its operating and financial performance at the time of finalising the resolution plan (the committee had specifically referred to performance in Q1 and Q2, FY21), to assess the cashflows in subsequent years, while stipulating appropriate ratios in each case.
  • Lending institutions are expected to ensure compliance to TOL/ATNW agreed as per the resolution plan at the time of implementation itself. Nevertheless, in all cases, this ratio shall have to be maintained as per the resolution plan by 31 March 2022 and on an ongoing basis thereafter. However, wherever the resolution plan envisages equity infusion, the same may be suitably phased-in over this period. All other key ratios shall have to be maintained as per the resolution plan by 31 March 2022 and on an ongoing basis thereafter. The committee had, on the other hand, recommended that ‘in these financial projections, the threshold TOL/ adjusted TNW and debt/EBIDTA ratios should be met by FY23. The other three threshold ratios should be met for each year of the projections starting from FY22. The base case financial projections need to be prepared as part of RP.’ The difference in the wordings of the committee recommendation and mandatory RBI’s advice is significant. What is to met now is the key ratios as per the resolution plan and not the threshold ratios as per the committee recommendations, but of course one year earlier.
  • Lending institutions are free to consider other financial parameters as well while finalising the resolution assumptions apart from these mandatory five key ratios and the sector-specific thresholds that have been prescribed.
  • These requirements are applicable even in cases when there is only one lending institution.
  • For sectors for which sector-specific thresholds have not been specified, lending institutions have to make their own internal assessments regarding TOL/ATNW and total debt/EBITDA. However, the current ratio and DSCR in all cases should be 1.0 and above, and ADSCR should be 1.2 and above.
  • The committee had recommended that ‘considering the typical nature of Real Estate projects, the parameters to be considered at project level rather than at entity level,’ but RBI did not allow this in the circular. In fact, RBI has advised that the requirements are at borrower account level.
  • For all the industries, the liquidity and earnings-related ratios (current ratio and DSCRs) are same. There is no granular distinction except for a couple of industries for which no ratio is prescribed for reasons cited and except in the two instances. There is steep standard deviation in the permitted ceilings in the leverage ratios ranging from 3 to 12 percent across these identified industries. Very high leverage ratio has been allowed for the real estate sector compared to others. For road sector, these two ratios are considered as not relevant considering the industry practice. For power sector also, total debt/ EBITDA is higher than that for other manufacturing industries. Incidentally, these are the only industry bodies with whom meeting was held by the committee nearly a week before finalising the report.
  • The lenders may use discretion to classify the impact on the borrowers into mild, moderate, and severe and correspondingly adopt a graded approach depending on the severity of the sectoral differentiating impact on the borrowers, as recommended by the committee though neither the committee nor RBI has elaborated on such classification.
    That the entire system was working under time pressure is evidenced by the following inconsistencies, though not serious.
  • The committee recommended (table on page ..., last row) that the current ratio can be decided by the lenders for sectors not specified, but in the body of the report (chapter III, para 3), it mentioned that current ratio shall be 1.0 and above along with other prescriptions.
  • Though one of the terms of reference was to make any other recommendations relating to financial or non-financial conditions to be considered for the resolution plan, there were no such recommendations.
  • As per RBI’s resolution plan of 2019, independent credit evaluation is needed where exposure is Rs100 crore and above, whereas the committee mentioned it as greater than Rs100 crore. One of the eligibility conditions as per RBI is ‘not in default for more than 30 days’ whereas the committee mentioned this as ‘with arrears less than 30 days.’
  • Even RBI appears to have mixed up in its advice. For example, RBI in its circular gave an explanation through an asterisk about road projects but marked it against real estate and omitted what the committee had recommended against real estate.

The committee recommendations and RBI’s guidelines based thereon give a window to corporates to restructure the debt with their lenders before end of December this year, with a maximum grace period of two years. Unlike in earlier instances of RBI’s schemes (like CDR, SDR etc), the success of the present window depends mainly on how soon the Covid19 cases decline and the economy recovers thereafter. The predictions on the shape of recession like U-shaped, V-shaped etc, at best provide good optics. As of now, we should all hope for quick control on Covid19, say in the next couple of months, which will facilitate the success of this new window opened. Otherwise, RBI may have to think of another committee to tackle the challenges of ‘other’ balance sheet in the twin-balance problem.

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Notes
Some of the ratios have been marked as not applicable as they may not be relevant for those sectors.

  1. No threshold has been prescribed for Current Ratio due to the ‘just in time inventory’ business model for raw materials and parts, and finished goods inventory is funded by channel financing available from the dealers.
  2. DSCR thresholds have not been prescribed since most of the airline companies work on refinancing of debt as a financing strategy. Consequently, average DSCR threshold is also not prescribed.
  3. In the roads sector (though marked against real estate in RBI circular), the financing is cash flow based and at SPV level where the level of debt is decided at the time of initial project appraisal. The working capital cycle in this sector is also negative. Accordingly, ratios like TOL/ATNW, debt/EBITDA, and current ratio may not be relevant at the time of restructuring in this sector
  4. Most of the companies in the sector do not use long-term debt for funding their operations and are unlisted. Hence DSCR and average DSCR may not be relevant for the sector
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