Can changes in the co-lending model ease credit availability for the priority sector?
To provide the much-needed competitive edge for credit to the priority sector, the Reserve Bank ( RBI ) in 2018 had put in place a framework for co-origination of loans by banks and Non-Banking Financial Companies (NBFCs) for lending to the priority sector subject with certain conditions. The benefit of such a co-lending scheme was that the end borrower shall get loans at a very affordable and competitive rate because of the lower cost of funds from banks and greater reach of the NBFCs. Pursuant to the framework, both the lenders were supposed to approve a case before disbursement and jointly contribute to the exposure at facility level. However, this model faced operational challenges since, even though the credit parameters are predefined between the co-lenders, the turn-around time of banks for approvals are much longer than NBFCs which blunts the sharpness/ competitiveness of the model.Now, basis the feedback received from the stakeholders, to better leverage the respective comparative advantages of the banks and NBFCs in a collaborative effort, RBI had, in November 2020, issued a revised scheme rechristened as Co-Lending Model (CLM) which was purported to give greater operational flexibility to the lenders while requiring them to conform to the regulatory guidelines on outsourcing, KYC , etc. Pursuant to the revised model, the lenders have two options to choose to structure their co-lending products on the banks part, either as pre-disbursal contribution to a loan under a mechanism for ex-ante due diligence or post disbursal takeover of banks share in the loan on a back-to-back basis.The conceptualization is very well in line with the intention of the regulator to improve the flow of credit to the unserved and underserved sector of the economy, considering the static culture and strict hierarchy in lending institutions particularly in PSUs. However, these options have some critical operational challenges.The first option above is similar to the earlier model of co-origination, where the banks are supposed to approve the case originated by NBFCs before disbursement and entails joint contribution. In this option, as per the RBI guidelines, banks are categorically required to undertake a pre-disbursal due diligence and ensure compliance with outsourcing guidelines and KYC directions. Now, though on literal interpretation, banks can rely upon NBFCs (being a regulated entity) on various loan process and KYC aspects, banks typically tend to take a stricter version of the directions thereby limiting the scope of NBFCs to take charge in the arrangement which wrecks the efficacy of the marriage and delays the process again.In the second option which was specifically devised to give operational flexibility to the process, the NBFCs are supposed to disburse the loans and the banks shall after disbursement perform due diligence and acquire its share in the loans on a cherry-picking basis akin to a direct assignment. This looks like a much simpler option since the industry is already versed with the procedures and requirements of such direct assignment transactions. However, direct assignment in a co-lending model typically with a bank calls for various critical challenges, as below.The co-lending model requires that the taking over bank shall ensure compliance with all the requirements of direct assignment guidelines except the Minimum Holding Period (MHP) requirement. Now, in a traditional direct assignment transaction, the direct assignment happens for a pool of assets through execution of an assignment deed, payment of stamp duty on the deed, seeking legal opinion on true sale, among others. Replicating the same in co-lending would mean execution of assignment deeds for each customer, payment of stamp duty on a case-to-case basis and so on. Now this will not only increase the documentation/ procedures but also add to the cost of lending to the end borrower.The co-lending model very conveniently mentions that the co-lenders shall arrange for creation of security and charge as per mutually agreeable terms and same for monitoring and recovery too. In practicality, the bank which is to typically own a larger share in the exposure would want the security to be created in its name. However, the loan is getting disbursed by the NBFC and the security is created before even knowing the banks decision on its participation. It is not practically possible to create the security in the name of a bank. So, to resolve this issue four options could be explored. One, by transferring the security in the name of the bank along with the assignment, but it would duplicate the security creation cost. Two, security creation can be done post disbursement after the banks decision, but it is practically not viable to chase the customer for the same after disbursement. And third, security to be created in the name of NBFC and it shall continue to hold the same as agent of bank, but banks typically dont agree to buy this option since it then implies banks need to rely on the NBFCs for recovery and other operations while there also lies an apprehension about the bankruptcy risk, typically when it comes to younger NBFCs. The fourth option which seems practically viable is to introduce a third partner to the structure i.e, a security trustee and create security in its favour which shall hold the security in favour of the NBFC. And whenever a bank agrees to take over the loan, the bank shall be included in the trustee arrangement by way of a deed of accession. This certainly involves a lot of cost and procedural lags. Similarly for recovery also, the security trustee will be in charge and take necessary actions on behalf of the lender/s.The transaction in the co-lending arrangement involving post disbursal takeover of banks share in the loan, is akin to direct assignment and the cases will be sourced as per the pre-agreed parameters. However, banks still want to do a 360 degree diligence within their internal policies while cherry picking the loans and tend to follow an ideal co-origination approach. This consists of KYC check, vetting of title documents from an independent lawyer, public advertisement for creation of mortgage, among others. This defeats the purpose and flexibility offered under the model. Banks for some reason, particularly PSUs, have always been unconvinced about the processes and practices of NBFCs. Perhaps, an offer of credit enhancement embedded in the transaction/ arrangement in the form of FLDG or guarantee would mean some comfort or succor to banks for relying on the due diligence done by NBFCs, as intended by the regulator too. Though the direct assignment guidelines restrict credit enhancement by seller NBFC, the co-lending scheme provides/ entitles banks to seek representations and warranties which the originating NBFC shall be liable for in respect of the share of the loans taken into its books by the bank.Despite its multiple operational challenges, the direct assignment mode of co-lending has done justification in drawing a lot of confidence amongst the banks. The attributing factor being the familiarity of its structure and practical aspects. Riding on the same, combined with the greater objective of leveraging the collaborative efforts effectively towards financial inclusion, would certainly garner positive results, in the time to come. ( The writer is Chief Legal & Compliance Officer, U GRO Capital