Prudential Norms and Peculiarity of Road Projects

“The provision made by RBI to consider the special rights provided under concession agreement to lenders making the loan as secured lending are important and lenders have to ensure that these critical rights are available to them while considering financing of PPP road projects.”

As per the RBI guidelines, banks classify their advances as secured and unsecured. RBI defines an advance unsecured when realisable value of security is not more than 10 per cent of outstanding advance. Here, the security is defined as tangible security which does not include intangible like guarantee, comfort letters etc. When an unsecured advance turns NPA, the bank has to make additional provisioning (as compared to a secured NPA advance) of 10 percent at the initial stage of Sub-Standard classification and which increases to 100% when the asset class deteriorates to Doubtful categories.

In the above background financing of road infrastructure projects appears to be an interesting subject. Most of the road infrastructure projects are floated by NHAI or State level agencies under Public Private Partnership (PPP) model. These projects are based on competitive bidding under various models like BOT, DBFOT, ANNUITY, HAM, OMT etc. The projects are awarded for long term concession period generally ranging from 15 to 30 years by way of Concession Agreement under which concessionaire gets the rights to use all the project assets during concession period.

Generally when capital intensive projects are developed, tangible assets are created and which are provided as security to the project financing banks. However, in road projects the developer is provided a long term concession period to construct the road and maintain & manage it during the concession period. At the end of the period, the assets revert to the project authority. Hence, a peculiar situation arise where no major tangible assets rests with the project developers which can be auctioned by lenders to recover their loans in case of default by the developer in repayment of loans granted for construction of the road project. In these projects, there are no project assets which can be mortgaged to the bank. In order to safeguard interest of lenders, necessary provisions are made in the Concession Agreement that allows substitution of project concessionaire by banks in case of default under the financing documents. The Concession Agreement allows banks rights to receive annuities/toll collection from the assets, and which can be hypothecated/assigned along with others rights, movable assets and current assets.

RBI guidelines provide that in such PPP projects, the advances can be considered as secured to the extent assured by the project authority in terms of the Concession Agreement, subject to the following conditions:

a) User charges/toll/tariff payments are kept in an escrow account where senior lenders have priority over withdrawals by the concessionaire;

b) There is sufficient risk mitigation, such as pre-determined increase in user charges or increase in concession period, in case project revenues are lower than anticipated;

c) The lenders have a right of substitution in case of concessionaire default;

d) The lenders have a right to trigger termination in case of default in debt service; and

e) Upon termination, the Project Authority has an obligation of (i) compulsory buy-out and (ii) repayment of debt due in a pre-determined manner.

In all such cases, banks must satisfy themselves about the legal enforceability of the provisions of the tripartite agreement and factor in their past experience with such contracts.

India has second largest road networks in the World. The Govt.  of India has target to construct 65000 Km of National Highways by year 2022 at the investment of Rs.5.35 lakh crore. The Govt. has stated to boost corporate investment in road and infrastructure sector projects and encouraging banks/FIs/FDIs for supporting the sector. The recently introduced Hybrid Annuity (HAM) model of developing road projects has received good acceptance by developers as well lenders considering the grant upto 40 percent in the form of annuity payments of the project bid cost from NHAI during construction stage. The remaining 60 per cent is paid by NHAI after project completion based on maintenance performance & quality, in the form of semi annual annuities over the concession period. Therefore, the sector provides at attractive business opportunity for lenders. The provision made by RBI to consider the special rights provided under concession agreement to lenders making the loan as secured lending are important and lenders have to ensure that these critical rights are available to them while considering the PPP road financing projects.

Disclaimer: The views expressed in the article above are personal views of the author and should not be thought to represent official views, ideas, or policies of any agency or institution.

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A fresh lease of life to Trade Credits Business

The banking regular in India has issued revised framework on trade credits policy on March 13, 2019. Trade credits is kind of financing in foreign currency provided by foreign banks, financial institutions, supplier of goods, and other permitted lenders for import of capital and non capital goods in India. These include supplier’s credit and buyer’s credit from recognized lenders. Such financing can be also availed from foreign branches/subsidiaries of Indian banks. In fact, TCs have been one of the important business segments for them.

Trade credits have importance in India considering their benefit as low cost of finance as compared to high cost Rupee debt prevailing in the country. From WC finance angle, TCs have much wider impact on this front. Not only the costing but also depending on the operating cycle of the borrower, TCs have helped in managing cash flows to the companies.

TCs had came into negative news about an year back when the firms of diamond merchant misused the system and created a big scam forcing the regulator discontinuing (in fact exactly one year back on March 13, 2018 !) the LoU/LoC facility from Indian banks for supporting the TCs.  LoUc/LoCs are the kind of foreign bank guarantees extended by Indian lenders in favour of overseas lenders providing the TCs. The comfort of such guarantees from Indian banks, made life easy for Indian firms in raising low cost financing in the form of TCs in quickest of time.

TCs can be availed for import of non capital goods and the tenor permissible is upto one year (three years for shipyards/ship builders) or operating cycle of the borrower, whichever is less. This has huge bearing on the Indian firms operating in globalized world having severe competition on cost and margin fronts. Before the ban on LoU/LoCs, Indian firms were considering the global markets for sourcing of raw materials due to availability of cheap TCs based on LoU/LoC support. The ban in March 2018 closed this door since without LoU/LoC it was not possible for most of the mid/small size Indian firms to avail TCs. 

The external debt of the country as on September 2018 reduced from USD 529 bn of March 2018 to USD 510 billion, of which USD 104 billion was related to short term trade credits. This reflects the magnitude TCs carry on Indian financial markets. Exports of the country in FY 2019 till January are estimated to be USD 440 bn against the imports of USD 531 bn during the same period. Therefore, the country needs to facilitate competitive global financing environment to its industries in order to achieve exports outpacing imports.

In a positive move, the regulator has also increased the limit under automatic route for availing TCs from USD 20 per transaction to USD 50 mn. In fact, the limit under automatic route has been substantially increased to USD 150 mn for specific sector viz.oil/gas refining & mining, airline and shipping companies. This is supportive action and will benefit industries in reducing the procedural time in availing TCs. Although regulator as reduced the ‘All In Cost’ ceiling from Benchmark rate plus 350 bps to Benchmark rate plus 250 which may make TCs less attractive to lenders. The maximum allowed period of TCs for capital goods has been also reduced from five years to three years.  

While TCs provide advantage of low cost of finance, these instruments are also like a double edge sword and can be detrimental if not handled aptly. These instruments carry foreign exchange risks. Many Indian firms have burnt their fingers in the past and some have been completely devastated by unhedged foreign currency exposures. The ECB guidelines also stipulate that firms raising TCs are required to follow the guidelines for hedging with a board approved risk management policy. Therefore, while regulator has reopened the TCBG gate, the borrowers will also need to be alert in managing unhedged risks.

It will take some time to see positive impact of regulator’s move on TCs since most of Indian lenders had cancelled the sanctioned BG lines for availing TCs post ban of March 2018. The lenders would need to reassess borrowers and sanction fresh lines for such TC BGs. Bearing the past mistakes and diamond merchant fiasco in mind, the lenders are expected to tread cautiously this time. Events like NBFC liquidity crisis, increasing defaults in loans against pledged shares etc. are keeping the mood of corporate lending market as sombre. However, over cautious approach under the shadow of high level of NPAs and diminishing confidence in external credit ratings would not be good for industries. The regulator has done its job for supporting industries, now its turn for lenders to believe in Confucius saying that our greatest glory is not in never falling, but in rising every time we fall. 

Disclaimer: The views expressed in the article above are personal views of the author and should not be thought to represent official views, ideas, or policies of any agency or institution.

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The Untold Story of PCA

Prompt Corrective Action (PCA) is a safeguarding framework applied by Reserve Bank of India (RBI) on the functioning of banks in the country. PCA guidelines are prefixed by RBI. PCA risk threshold are mainly defined in terms of Capital, Asset Quality, Profitability, and Leverage:

Exhibit : PCA Indicators
Capital	CRAR- Minimum regulatory prescription for Capital to Risk Assets Ratio + applicable Capital Conservation Buffer (CCB) Current minimum RBI prescription is 10.875% (9% minimum total capital plus 1.875% of CCB). And/Or Common Equity Tier 1 (CET 1 minimum) + applicable CCB. Current minimum RBI prescription is 7.375% (5.5% plus 1.875% of CCB)
Asset Quality	Net Non-performing advances (NNPA) ratio. This should be maintained at less than 6%.
Profitability	Return on assets (ROA) (ROA is the percentage of profit after tax to average total assets). Banks should not have negative ROA for two consecutive years.
Leverage	Tier 1 Leverage ratio. This should be maintained above 4%.

Any bank breaching/ not maintaining the risk threshold set under the guidelines is subject to imposing of PCA restrictions by RBI. Banks falling under PCA face restriction/control on credit expansions, and are required to reduce risk assets, loan concentrations apart from many other corrective actions to be taken as per RBI directives.

The spiralling level of growing NPAs (reached to about Rs.10.39 trillions in FY 18) in the country has led to eleven public sector banks namely Allahabad Bank, Bank of India, Bank of Maharashtra, Central Bank of India, Corporation Bank, Dena Bank, Indian Overseas Bank, IDBI Bank, Oriental Bank of Commerce, Uco Bank and United Bank of India, falling under PCA.

When eleven out of the 21 public sector banks face PCA with resultant credit restrictions/controls then it causes cascading negative effects on the industry and industrial growth which is already struggling in a recessionary environment. However, the issue does not end at the formal credit restrictions. PCA comes with its adverse side effects also.

The credit restriction/controls have not only stopped the new credit dispersion, it has affected also the existing credit baskets. The managements of these banks have become comparatively conservative and cautious in their approach in rolling over of even the existing credit facilities to the industries by increasing the pricing, margins, and stipulating various other terms and conditions which are difficult to afford when industries are still adjusting to the double whammy impact of demonetization and GST. LoU/LoC instruments helping in availing finance at cheaper cost in Buyer’s Credit route have been already discontinued by the regulator. The liquidity crisis caused by IL&FS fiasco has further worsened the situation.

Many of the corporate borrowers already suffering from lower demand, shrinking margins, extended operating cycles, stretched receivable periods, tight liquidity position have been told by PCA banks to find new lenders to shift the existing credit facilities or for meeting their additional credit requirements. However, the non PCA banks have been also treading cautiously in their lending approach towards such borrowers or avoiding exposure to credit starve sectors such as steel, infrastructure, construction, textile etc. In fact some of the non PCA banks lowered their bank line exposure to PCA banks and started directly/indirectly declining discounting of bills issued under the LCs of PCA banks. Such reactions within banking industry have disappointed MSME/mid corporate borrowers. 

As per Economic indicators, the growth in credit to industry was virtually nil in first nine months of FY 2018-19. The growth of 7.70% reflected in bank credits during the first nine months of FY 2018-19 is mainly driven by retail and service sectors and manufacturing sector is lagging behind on this front. As per Index of Industrial Production (IIP) numbers, as of Nov 2018, the growth in IIP was mere 5%. In this environment, the formal impact of PCA on credit control has caused multi fold impact with indirect hit of credit squeeze.

Many borrowers have been cancelled sanctioned limits/loans by PCA banks. This has affected the business plans of corporates specially the MSME/mid corporates. The funding starvation caused by PCA forced many entrepreneurs to scale down/shelve their project plans. The sudden credit squeeze caused by these banks have created enormous pressure on the liquidity of MSME/mid corporates.  Many corporate are still struggling to adjust to this new situation. If the situation persists for long, the entrepreneurs may throw the towel and there could be increase in NPAs.

While efforts are being made by policy makers to salvage the economy from recession and encourage entrepreneurs for increasing private capital expenditure by setting up Greenfield / Brownfield projects, the entrepreneurs are facing a situation where banks are following cautious approach in corporate lending and chasing retail business.

With the Government’s lobbying with regulator in the positive environment of improving recovery through IBC, improving performance of some of the PCA banks, recapitalization of some of the banks by Govt/other stakeholders, change in guard at the regulator etc., it is expected that RBI may bring some banks out of PCA. In fact recently, RBI has decided to release Bank of India, Bank of Maharashtra, and Oriental Bank of Commerce from PCA. The fresh capital infusion announced by GoI for Allahabad Bank and Corporation Bank is also expected to help these banks coming out of PCA. Restoration of LoU/LoC for availing Buyer’s Credit with proper safeguards would be a boost not only to the corporate sector but also to the businesses of the foreign branches of Indian banks. Presently, when banks are competing to garner deposits at higher costs, a low rate of interest regime seems to be a distant dream, but if it happens (considering the GoI’s/regulator’s efforts in this direction), it would be a blessing in disguise for the industries. These positive measures would help in improving the liquidity starving industries and avoid unwanted new NPAs. However, the pain caused by PCA coupled with impact of LoU/LoC ban, IL&FS debacle and other such events, leading to credit squeeze shall be an unforgettable excruciating experience for the entrepreneurs and financial market forever.

Disclaimer: The views expressed in the article above are personal views of the author and should not be thought to represent official views, ideas, or policies of any agency or institution.

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