Lender of Last Resort for the Borrowers and Critical Financial Illness Cover

Over the years, I have dealt with many cases that included stressed assets also. In case of stressed assets when the stress starts reflecting in the account, it starts creating some sort of panic to the lenders. Situation becomes like this that at one end, the borrowers struggles with its liquidity issues, and on the other end, the lenders struggles with the borrower to recover their dues/loans. Many of such stressed cases undergo Debt Restructuring. Under restructuring, generally most of the borrowers seek additional funding from the existing lenders in order to cope up with the liquidity issues. However, none of the lenders, generally by Heart & Soul is ready to extend such additional finance. Such additional finance is extended only at the minimum level and after lot of follow up by the borrower. Many of the times, such additional funding comes very late by which time situation (financial troubles, liquidity) becomes grave for the borrower.

This scenario forces us to think that when there is a borrower facing genuine difficulties then why the additional finance (a kind of nursing solution) is generally not available or available after hell lot of follow ups and not on right time (a patient needs Oxygen on right time, isn’t it!). In case of bankers, if any of the bank faces any liquidity issues, the regulatory authority (i.e. Reserve Bank of India) stands as the lender of last resort for them. Why is such lender of last resort is not available to the borrower who can take the responsibility and act like a lender of last resort for the borrowers?

I would like to bring attention in this direction towards IRBI. The Industrial Reconstruction Corporation of India Ltd. was set up in 1971 for rehabilitation of sick industrial companies, and was reconstituted as Industrial Reconstruction Bank of India (IRBI) in 1985. Later on, IRBI was converted into Industrial Investment Bank of India Ltd. (IIBI) in March 1997 to offer a wide range of products and services. In 2006-2007 it was decided to close IIBI. In light of the above thoughts for specialized needs of the stressed companies, perhaps now there is much deeper experience gained over the years which justify the need of an IRBI type of institution on a long term basis for supporting the restructuring needs of corporates, and who can perform some sort of lender of last resort role for such companies.

As an alternative, it also forces us to think about a solution for the borrowers to have an arrangement of a critical financial illness event funding available as an immediate finance in the form of insurance cover for protection from the financial illness a borrower may face in future. Such types of critical illness insurance protections are available to the individuals from the Life Insurance companies. This leads us to the idea of having lenders/insurers/agencies/product available in financial markets with an obligation to extend immediate finance on triggering financial stress (or some other types of events which leads to the requirement of restructuring) event at the borrower. Such type of product would come at the cost of premium to be paid by the borrower. Such critical illness cover may be triggered on happening of events like LC Devolvements, frequent Overdrafts requirements, losses reaching to a particular pre-decided level, etc. and the other signs reflecting stress situations illustrated in the RBI guidelines on Framework for Revitalising Distressed Assets in the Economy.

I would like to mention here about the existence of Credit Default Swap product for protection of the lenders (but not for nursing of the borrowers).  A credit default swap (CDS) is a financial swap agreement under which the seller of the CDS compensates the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS fee) to the seller and, in exchange, receives a payoff if the loan defaults. There are also products like Mortgage Insurance which compensates lenders or investors for losses due to the default of a mortgage loan.

In India, specialized insurance cover products are available to the Exporters and Banks from Export Credit Guarantee Corporation of India Ltd. (ECGC).

There is also Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE). This scheme seeks to reassure the lender that, in the event of a MSE unit, which availed collateral free credit facilities, fails to discharge its liabilities to the lender, the Guarantee Trust would make good the loss incurred by the lender up to 75 / 80/ 85 per cent of the credit facility.

In light of the above, the history of existence of institutions like IRBI, the availability of insurance products from ECGC/CGTMSE, product like CDS, and larger experience gained over the last 4-5 years of the specialized needs of the stressed companies, it appears that the financial markets are open to product like critical financial illness cover, and also for the IRBI type institution to act as lender of last resort for the stressed companies.

The Essence of Margins for Non Fund Based Working Capital Limits

Corporates require different kinds of non fund based facilities from the Working Capital Lenders mainly in the form of Letter of Credit and Bank Guarantees. Depending on the business activity of the corporate, their requirement on nature (Inland LC, Foreign LC, EMD BG, Retention BG, Performance BG, Financial BG, SBLC, etc.)  of these non fund limits may vary.

The WC lenders at the time of assessment of the limits assess the requirement of these NFB limits by the corporate and accordingly sanction limits. Although these limits are secured by the security provided by the corporate (generally first pari passu charge on the current assets and second pari passu charge on the fixed assets), the lenders follow a practice of stipulating margin based on the utilization of these limits. This margin is stipulated in the form of cash margin (float in the current account) or Fixed Deposit Receipt (FDR) margin. The margin is generally stipulated as a percentage of the limit utilization and ranges generally between 0% to 25% e.i. if the requirement for LC is INR 50 million and margin is 5% then the corporate has to provide margin in the form of FDR equivalent to INR 2.5 million.

These margins stipulation more depend on how better satisfactory track record, years of banking, and Current Ratio corporate has been maintaining with the lender. Generally, with the increasing years of satisfactory track record, financial performance and maintaining better Current Ratio than stipulated, the margin is brought down.

The question arises when the fund based limits are released by the lender relying on the security offered, then what is the need for additional cash margin for the non fund based limits?

It needs to be observed here how the crystallization of non fund limits happens, specially in the context of LCs. When an LC matures, the Cash Credit (CC) account of the borrower is debited and LC is liquidated. In case the CC is fully drawn, then the borrower is required to credit the required funds in the CC account from its other bank/facilities accounts. In case borrower, is not able to bring the required funds, LC has to be devolved i.e. the lender has to make the payment from its own funds. In this situation, the non funds based exposure converts in to the fund based exposure.

This is the point where the cash margin provided by the borrower/corporate becomes helpful to the lender. The lender uses these margins for crystallization of the LCs for devolvement. Now, if we go to the mechanics of the transaction working, one can simply analyze from where this margin money would have been brought/arranged by the corporate. Of-course, these margins are created by the borrower by using the fund based limits extended by the lender. Therefore, these were not the funds of the borrower but the funds of the lender only. 
This is true when the Current Ratio goes below stipulated norm [i.e. 100 divided by (100 - margin on Current Asset which is generally 25%)] i.e 1.33 times (generally stipulated). The margin mechanism ensured reduction in fund based limit utilization (i.e. actually limiting transfer of funds outside the lender bank) by conserving the limit for crystallization of future LC payments. Therefore, the margin structure explains the views of the lender, how much fund based limit utilization it would like borrower to conserve for meeting its future non fund based limits liquidation. A borrower with small non fund based facility may not face difficulty in crystallization of its non fund based obligation, however, for a borrower with larger limits, it could be a major issue if the fund based limits are fully utilized. In case of sudden market difficulties (similar of depreciation of INR seen in the past), the cash flow of the borrower may be hugely affected and it may be short of cash.

Since, providing margin affects the borrower by increasing its transaction cost (it utilizes fund based limit say at interest rate of 13.50% for creation of FDR, gets interest on FDR say at the rate of 9%, also pays LC commission, and may be also forgoing cash discounts in case of Usance period allowed by the supplier), it forces borrower to bargain for better terms from its suppliers or try to avoid non fund based transaction by maximizing the fund based utilization. It encourages borrower to better manage its cash flows resulting in low utilization of non fund based limits.