External Credit Ratings: Time to Change the Process and the Gold Standard of Rating

The Union Budget has proposed a new credit rating process for infrastructure projects. This is expected to support fund raising on reasonable terms for such projects. At this juncture of Economy when need for such a different rating system has been envisaged, then it would be also of importance to review the traditional process of external rating system.

The credit rating agencies are meant to provide lenders with an informed analysis of the risk associated with debt instruments. These ratings are usually characterized by a letter grade, the highest and safest being AAA, with lower grades moving to double and then single letters (AA or A) and down the alphabet from there. The ratings approved by these agencies have widespread implications for lenders.

Lot has been said about the failing of credit rating’s efficiencies in warning the defaults since year 2008. The big three global rating agencies had come under intense scrutiny in the wake of the global financial crisis. These agencies in year 2008 were accused of offering overly favourable valuations of insolvent financial institutions and approving risky mortgage related securities.

The Fee Model of Rating Industry: Subscribers Pays or Issuer Pays

Most of the credit rating agencies follow the Issuer Pay model wherein the borrower who is getting its debt rated pays to the rating agency. Therefore, the borrowers who need certain ratings in order to sell their debt to lenders may have been willing to pay more for their preferred rating. It is noted that under Issuer Pay model the borrowers shop with the credit rating agencies for the desired/lenient rating band. The competition among the rating agencies at one hand benefits the borrowers but on the other hand affects the interest of lenders. It is evident in the market that many borrowers, who are rated below investment grade shop with the rating agencies, change their rating agency and are able to get investment grade ratings if not very high but at least at lower end of the scale. This helps such unscrupulous borrowers in passing the muster of lenders for getting loans sanctioned.  Lenders carry out their own internal credit rating of the loans. The external rating presents an external independent view. However, if the external view is investment grade, it may create some positive impressions over the internal ratings also.

Its time to take control of the Wheel

For long time, the process of credit rating has been allowed to be handled by borrowers. When the Budget envisages need for different rating system for infra projects then there are enough good reasons for relooking at the rules for existing rating process also. Excluding the rating process, many other exhaustive monitoring related activities like Stock Audit, Concurrent Audit, Lenders Independent Engineer, Valuations etc. are controlled and efficiently, cost effectively managed by lenders. From that sense isn't the time ripe to control the external ratings process of the loans also?

Like controlling the exercises (which are lengthy and complex) of Stock Audits and Concurrent Audits, lenders can also control/handle the External Rating process of the loans. This would provide better information to rating agencies (since the existing informal channel of interactions between the two will turn into a formal one to one dialogue as it happens in Stock and Concurrent Audits), facilitate information, and the open interaction between two would help in deeper understanding the critical issues.

There are pros and cons of everything. External credit rating has great importance since it is expected to present an unbiased view on probability of default. Their independence can not be compromised and allowed to be influenced by bigger forces (banks/FI etc.) in the financial market. I agree that the above suggestion also has some chances of influencing the freedom of credit rating agencies decisions as they would need to deal with much bigger and powerful set of customers (lenders/banks) who could then threat diverting business to the competitors following lenders views.

Benefit in Interest Rates/Subsidies

A balancing solutions would be to have credit ratings from two agencies, one obtained directly by the borrower and other done through the lender. This could be adopted for loans of Rs.500 million and above. In case of large difference between the two, decision makers will have enough warning signals for analysing the matter before taking their call. For loans between Rs.100 million to below Rs.500 million government may come out with schemes for subsiding the cost of second credit rating. National Small Industries Corporation (NSIC) provides reimbursement of credit rating fees to the small scale industries (http://www.nsic.co.in/creditrating.asp ). However, the option of two external ratings would further increase the cost of borrowing and involve extra time & energy. To reward for the pain taken by the borrower and reducing the cost, lenders may benefit borrowers going for two ratings system by providing some concessions in interest rates/processing charges.

Regulatory Compulsion for Rating

One of the other effective solutions could be putting restriction on changing the credit rating agency within a period of 3 years from their appointment and making the external rating compulsory for loans of above Rs.100 million before availing sanction of loans from lenders. The borrowers who do not get their rating re-validated timely or are not keeping their rating live may be compulsory penalized by increase in applicable interest rates. Regulatory framework may be developed in this regard.

The Gold Standard of Rating

The rating agencies community also need to come out with a standardized product of Gold Standard Rating supported by necessary changes in regulations, where the common high standards of uncompromised rules and procedures may be defined. The borrowers may be encouraged to go for such high standard Gold Ratings. The reward for such ratings would come in the form of high investors/lenders interest with premium pricing. Adoption of these high standards may be made more attractive by allowing certain low ticket Gold Standard rated loans eligible for Priority Sector Lending (PSL) (https://en.wikipedia.org/wiki/Priority_sector_lending). The Gold Standard rating would reflect the rigorous due diligence passed by the borrower and reflects its high standards on accounting & audits, cash flow management & monitoring, corporate governance, professionalism of management like aspects. The rating agencies could be heavily penalized for comprising any rule under such Gold Standards.   

Time to Re-write Rules of BGs?

Over the years banks have been in business of guarantees which generated handsome commissions. However, past few years of downturn have given lessons with sleepless nights to issuers. The beautiful business turned into ghost. During the growth period few years back mostly in infrastructure/EPC long period guarantees (Performance/Mobilzation/Advance) were issued in general however what could not be noticed was the insertion of onerous clauses or deletion/compromise of standard clauses. This along with unconditional nature of the guarantees gave upper hand to the beneficiaries and allowed freedom to the borrower in diversion of funds. Many standard clauses in BGs such as auto reduction in BG with performance of contract or effectiveness of BG only on crediting the advance payments to the contractors account with the BG issuance bank could have helped. It’s not that bankers had not objected to such deviations however going by the experience I can say that to some extent it was stubborn nature of the beneficiaries taking the benefit of cut throat competition in banking. But does it not mean that regulators need to control competition or three regulator/appex association of banking  need to define standard clauses which can not be comprised ? Further, any large BG is as good as a loan and requires the equal due diligence and monitoring. Lessons already learnt.

Current Assets and Margin Money for Non Fund Based Limit

We had discussed about the Working Capital Assessment (Working Capital) and margin money for Non Fund Based limits (The Essence of Margins for Non Fund Based WC Limit) in previous articles.

I have come across many discussions on the issue of whether the margin money/cash margin/Fixed Deposit Receipt (FDR) margin provided by a company/borrower for availing non fund based limits(LC/BG), should be part of Current Assets while arriving at the Working Capital (WC) MPBF or not? In this context, let’s review the standard method of WC assessment with the following example:

A company is at the beginning stage of a business. The company needs to purchase current assets (materials) worth INR 100 million. The suppliers are ready to supply 25% of material at clean credit period of 90 days and balance with cash payment on delivery. The company also needs to provide Performance Bank guarantee (PBG) of INR 100 million to some party for getting a business contract. XYZ Bank is ready to provide PBG with 20% FDR Margin. With this information let’s assess the limit:

(A) Current Assets (CA) - Inventory Estimate : 100

(B) Margin Money for PBG Estimate  : 20

Total Assets: 120

(C) Current Liabilities (CL) – Sundry Creditors (excluding bank borrowing for WC) Estimate :25

Total liabilities: 25

NFB Limit (PBG) Estimate : 100

Under the standard MPBF assessment method, the WC gap (i.e. the difference between CA and CL (excluding the bank finance) is considered eligible for WC finance subject to 25% of CA to be funded by promoters.

Important point to remember here is that WHATEVER is INCLUDED HERE IN THE CURRENT ASSETS (AND IS HYPOTHECATED TO BANK AS PRIMARY SECURITY), IS ACCEPTED FOR FINANCING BY WC BANK. In the above example, the BG is for performance purpose. It does not result in materials/current assets on which bank will have hypothecation charge. In this example, there will be fund requirement of INR 20 million (20% of PBG required) for obtaining the PBG from bank. Since the WC banks provide finance against the hypothecation of current assets, and by establishment of PBG there will not be any creation of CA (the primary security for the bank against which lending is done), the bank will not consider this margin money as part of CA. Hence MPBF will be:

(D) WC GAP : A – C = 75

(E) Less : 25% of CA i.e. = 25

Balance eligible under MPBF (D – E) = 50

The estimated balance sheet will look like as following:

Current Assets	Current Liabilities
Inventory :100	Sundry Creditors : 25
	WC Bank Borrowing : 50
Non Current Assets
FDR Margin : 20	Non Current Liability
	Promoter’s Contribution for CA : 25
	Promoter’s Contribution for PBG FDR Margin:20
Total : 120	Total: 120
Current Ratio (Current Assets Divided by Current Liabilities)	1.33 times

With the above explanation, it can be concluded that if the NFB limit does not result in increase in equivalent CA (which are hypothecated to bank as primary security), the FDR margin cannot be treated as part of CA for arriving at the MPBF.

Now, lets consider an additional assumption in the above example. Suppose that the material supplier is willing to provide 25% of the materials on 90 days credit only if equivalent irrevocable LC is established in his favour. Bank stipulates 20% FDR margin for LC establishment. So, now the company additionally needs 20% funds of the 25% of the material value i.e.    100*25%*20%= INR 5 millions.

Again the question: whether this estimated FDR margin can be included in the CA for arriving at the MPBF? Since establishment of Usance LC will result in increase in inventory on which WC bank will have hypothecation charge, therefore, can this FDR margin be included in the CA while calculating the MPBF?

Here we need to look at the Usance LC process. It may be observed that at the time of establishing the LC, there is no current asset against this, and we have established above that WC bank finance is provided against CA (which are stored at an identified location). When LC will mature, the company can make payment by debiting its Fund Based A/c limit (generally Cash Credit A/c), and this utilization will be allowed by bank since material would have arrived and will become paid stock under the hypothecation charge of the bank. However since at the time of LC establishment there is no CA, therefore bank will not agree to fund the margin required for establishing the LC. This margin will have to be brought in by the company/promoters.

(1) If we look at the transaction from another angle, it can be also said that instead of funding the 20% margin, the bank may very well ask company/promoters for bringing 25% FDR margin instead of 20%. Why? Because under MPBF method since bank agrees to fund 75% of the CA and 25% is contributed by company/promoters, therefore future expected material delivery has to be funded in the same ratio(i.e 75:25). Hence at the time of LC establishment itself, the bank may ask for 25% margin by promoters/company. Agreeing to a lower margin (i.e. 20%) may be only on the following assumptions:

- Company/Promoter’s contribution in funding the existing CA is more than 25% resulting in Current Ratio of more than 1.33 times.

- Bank is willing to agree to a lower contribution by promoter’s/company (i.e. bank accepting Current Ratio less than 1.33 times)

(2) The bank may also ask the company/promoter to bring 100% margin. Why? Because if the company is maintaining exact 1.33 times Current Ratio  before opening of the LC, then there is no additional current asset available as a primary security to the bank. Actually, there has to be additional current assets (which are hypothecated to bank as primary security) equivalent to the difference between the LC value and FDR margin provided by company. In the absence of this validation, if the bank agrees for issuance of LC at the stipulated FDR margin, it is done on the following strength:

(1) The bank is ready to take non fund based unsecured exposure equivalent to the difference between the LC amount and FDR Margin.

(2) The company has provided sufficient collateral security which ensures that bank’s exposure is always 100% secured.   

The estimated balance sheet will look like as following:

Current Assets	Current Liabilities
Inventory : 100	Sundry Creditors:25
	Bank Borrowing  Inventory: 50
Non Current Assets	Non Current Liabilities
FDR Margin for PBG: 20	Promoter’s Contribution for CA : 25
FDR Margin for materials LC : 5	Promoter’s Contribution for FDR PBG Margin:20
	Promoter’s Contribution for FDR LC Margin:5
Total: 125	Total : 125
Current Ratio (Current Assets Divided by Current Liabilities)	1.33 times

Hope you like the article.

Corporate Finance Segment of NBFCs and Bank Finance

Non Banking Finance Companies (NBFCs) are one of the important entities in the financial sector.  The general factors of NBFCs business success lies in their cost effective delivery model, sector focused approach, faster delivery, last mile connectivity, prompt action and efficiency.

In the corporate finance sector, the prime areas of NBFC lending involves promoter funding, funding against shares, subordinated debts, senior debts, short term debt etc.

Sources of funds for on-lending business to an NBFC are promoters funding, bank finance, public deposits, commercial papers, debentures, inter corporate deposits etc. where  bank finance forms one of the major sources. There are several restrictions on use of bank funds by NBFC for on-lending like use of such funds for investment into shares, debentures, unsecured loans, inter-corporate deposits, loans & advances to subsidiaries/group companies etc.  

Recently, in two of transactions (debt funding) encountered, it was analysed that while the transactions could not pass the due diligence and guidelines of the bank, these same transactions were later on found to be present in the asset book of one of the NBFCs presented to the bank for financing.

This is one of the reasons I thought to discuss the NBFC financing. Does it mean that some NBFCs consider those transactions which are not able to pass through the banks regular due diligence/guidelines?

Under the corporate finance segment, the NBFCs get major space in lending on short term basis with prompt delivery and efficiency especially in circumstances where funds are required on very short notice. Apart from fulfilling the financing needs against shares, these NBFCs also get space in unsecured/subordinated lending. The rate of interest & transaction cost of NBFC finance under corporate segment is also generally on higher side as compared to banking channels. It appears that unless the time or non-acceptability of general banking covenants, are the key to the transaction (eligible for direct bank finance), the transaction may not be attract towards NBFC.

With the above description, the emphasis which can be derived is that bank finance to NBFCs (especially having major corporate finance segment) is a critical financing segment and it appears that reputation of NBFC/promoter group and their financial strength becomes one of the most important factors of due diligence apart from strong financials, credit rating and compliance with regulatory guidelines by the NBFCs.

Wish you all a very Happy New Year 2015.

Long Term Export Advance

I had mentioned in my earlier articles about the Pre-Shipment and Post Shipment Export Credit Advances available to Corporates (Pre-shipment Credit / Post-Shipment Credit). These are the short term facilities [maximum period of upto 360 days (preshipment) and 365 days (postshipment)] for boosting the exports from the country. The interest rate to be charged in these lines are not controlled/capped by Reserve Bank of India (RBI).

In order to ensure availability of long term finance at internationally competitive pricing to the exporters, RBI in May 2014 has allowed exporters having a minimum of three years satisfactory track record to receive long term export advance upto maximum tenor of 10 years to be utilized for execution of long term supply contract for export of goods subject to certain conditions. The exporter is allowed to provide SBLC/BG from banks in India for guaranteeing the export performance. Some of the key conditions of the guidelines are as following:

1. Firm irrevocable supply orders should be in place.

2. Company should have capacity, systems and process in place

3. Such advances should be adjusted through future exports.

4. Rate of interest payable, if any, should not exceed Libor + 200 bps.

5. Double financing for working capital for execution of export orders should be avoided.

6. SBLC/BG facility will be extended by banks only for guaranteeing export performance.

7. BG/SBLC may be issued for a term not exceeding 2 years at a time and further rollover of not more than 2 years at time may be allowed subject to satisfaction with relative export performance as per the contract.

8. BG/SBLC should cover only the advance on reducing balance basis.

9. BG/SBLC issued from India in favour of overseas buyer should not be discounted by the overseas branch/subsidiary of bank in India.

Service Tax on the value of interest received on Bill Discounting facility

Recently there was an interesting case between a Public Sector Bank (PSB) and Revenue Authorities wherein one of the issues was applicability of Service Tax on the value of interest received on Bill Discounting facility extended by the PSB to its customers.

Readers may like to read my earlier post on Bill Discounting : Issue of applicability of TDS in Bills Discounting

In the present case regarding applicability of Service Tax, the PSB argued that the interest collected on Bill Discounting was exempted from levy of Service Tax by virtue of Notification No.29/2004-ST dated September 22, 2004.

The deciding authority CESTAT accepted the argument of PSB and held that as per the first part of the said Notification, the subjects for exemption from Service Tax are OD facility, CC facility, or Bill Discounting facility and objects are value equivalent to interest or discount, as the case may be i.e. as per the circumstance. Therefore, the value of interest as well as discount in connection with providing the services of OD facility, CC facility, or Bill Discounting facility would be exempted from Service Tax under section 66 of the Finance Act 1994.

Export Credit Finance Limits

Export Credit limits is provided by the banks in India in the form of Pre-Shipment Credit and Post Shipment credit. These financing lines are provided to boost the Exports of the country. I had mentioned about these limits earlier (Pre-shipment Credit / Post-Shipment Credit). The limits are extended for a maximum period of upto 360 days (preshipment) and 365 days (postshipment).

Although the interest rate to be charged in these lines are not controlled/capped by RBI (which was the case in the past i.e. upto June 30, 2010), schemes are intended to facilitate financing to the Exporters at internationally comparable rates. 

RBI provides facility to banks for getting refinanced (upto 32 percent of the Outstanding) their Rupee Export Credit Finance portfolio for a maximum period of 180 days, thereby the loss (of margins) of deployment of funds [i.e upto 32 percent (reduced from 50 per cent to 32 per cent in June 2014)] by banks at subsidized interest rate (at Repo Rate under LAF; The World of Regulatory Rates) under these lines, is passed on to the RBI. This way the banks funds (upto 32 per cent of the Export Credit portfolio) gets unlocked, and banks can redeploy the same for generating better margins.

Although, as per RBI guidelines, the Export Credit limits should be excluded for bifurcation of the working capital limit into loan and cash credit components, generally it is observed that Export Credit limits are sanctioned by banks as part of umbrella Working Capital (WC) limits. Many times, the Export Credit limits are set as inner limit or sub limit to Cash Credit (CC)/Fund Based (FB) WC limits.

The system of Cash Credit limit requires the borrower to submit Stock & Receivable Statement based on which Drawing Power is arrived. In case, the Export Credit limits are sanctioned as inner limit to the CC limit, the Export Credit limit will also fluctuate depending on the DP arrived based on Stock & Receivable Statement. It may be observed that while the CC limit is based on MPBF (i.e under Eligible WC Limit method) arrived taking into account the Current Assets, Current Liabilities and NWC, the Export Credits limit needs to be arrived taking into account Export Orders of the borrower. It may be mentioned that while calculating the minimum required NWC, the Export Receivables are excluded from the Current Assets i.e. benefit is provided to Exporters for facilitating the 100% Export Finance. The practice of associating the Export Credit limit with the umbrella WC limit many a times leads to inappropriate assessment/management for Export Credit limit if the intention is to promote Exports from the country by providing Export Credit Finance.

RBI guidelines mention that for creditworthy Exporters, banks should calculate the need based Export Credit limit taking into account the anticipated Export turnover and track record of the Exporter. Banks should adopt any of the methods, viz. Projected Balance Sheet method, Turnover method or Cash Budget method, for assessment of working capital requirements of their Exporter-customers, whichever is most suitable and appropriate to their business operations.

In light of the above and considering RBI’s thrust on extending the Export Credit Finance for supporting the Exports of the country, there needs to be a Standard approved mechanism with clarity for arriving/calculating the limits and DPs for Export Credit Finance which may be followed by all the banks. This would standardize the system of Export Credit Finance to the Exporters.