Reserve Bank of India Taps the Brakes on Short-term Loan Structures

Once again demonstrating a firm but steady grasp on managing the future of its structured finance market, the Reserve Bank of India (“RBI“) announced some tweaks to its earlier announced guidelines for securitization in the local market.  The specific aim of this week’s announcement is the market for securitization by banks and other finance companies that securitize short-term or “micro loans” in the domestic market. 

The announcement this week adds clarity to two important considerations for both issuers and investors:

1)  Issuers will be required to hold assets to be included in securitized structures for a minimum period of time, thereby eliminating the temptation for issuers to engage in what has become commonly known as the “originate to distribute” model.  In less civilized conversations this has also been called the “pump and dump” model.  For most of its history in the US, issuers of securitized debt would typically “season” their portfolios in order to build track records and confidence in the performance of the collateral prior to placing these assets into a securitized structures.  Rating Agencies, investors and other counterparties would routinely require this activity for private market securitizations.  This practice, which was largely and successfully self-regulated by the securitization industry for more than two decades, became  “unfashionable” in the middle of the last decade.  In their guidelines, the RBI will require issuers in most cases to have held or “seasoned” micro loans for nine months before placing these assets into a securitization.  Since many or most of these types of  loans have a maturity of one year, this will either force a change in the underlying structure of these loans (e.g. extending the term) or it will eliminate many of these micro-loan structures from the market.  For loans with a maturity of two years, the guidelines call for the originator holding those loans on their books for a full year.

2)  The second major issue tackled by the India central bank in this announcement is the requirement for issuers to retain a percentage of these types of loans on its balance sheet.  The objective is to eliminate undue risk being passed to investors and to add integrity to the underwriting process.  For loans with a maturity of less than two years the requirement is 10%.  For longer term loans, this requirement drops to 5%.  Obviously, the objective is to acknowledge the greater risk associated with the shorter term collateral.

At the height of activity in the India market a large number of specialty finance firms known as NBFC’s (Non-Bank Financial Company) and MFI’s (Micro-Finance Institution) became very active in the short-term loan market and, clearly, many of these firms utilized the liquidity of the securitization markets to fund their operations.  We find a comparison of the hundreds of specialty residential mortgage finance companies that sprung up in the US market in the early part of the last decade to these MFI’s in India to be compelling, as the temptation to cut corners in both markets seems to have been irresistible. 

However, unlike the new regulations proposed in the US market which have chosen not to single out specifically egregious structures or classes of issuers, the RBI has done just that by essentially splitting the legitimate parts of the securitization markets away from the decidedly less legitimate parts of the market.  In other words the RBI has chosen to address the obvious problem and taken steps to cut it out.

How can you not like the straightforwardness and “transparency” of their objectives.  To the RBI it seems more than logical to acknowledge that a “one size fits all”  set of remedies is not the answer.  They have chosen to acknowledge the obvious.

Something that US regulators still have time to learn from.

About markferraris
Managing Principal Orchard Street Partners LLC

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