On 18 May 2017, the Reserve Bank of India (RBI) issued a circular on 'Partial Credit Enhancement to Corporate Bonds' (Circular) which rationalises the existing "Guidelines on Partial Credit Enhancement to Corporate Bonds by Banks" dated 24 September 2015 (PCE Guidelines) on the capital requirements during the lifetime of the bond in respect of which partial credit enhancement (PCE) is provided by banks.
PCE Guidelines – Brief Snapshot
PCEs are financial assistance to issuer companies to enhance their credit ratings in order to attract more investors, particularly long-term investors, such as provident funds, pension fund and insurance companies. The PCE Guidelines were issued bearing in mind the large financial requirements of the infrastructure sector and the risks associated with it. Typically, infrastructure projects have long gestation periods and require long term financing corresponding to the cash flows generated from the project. Banks, which are the traditional financiers for infrastructure projects, are unable to provide such long-term financing due to asset-liability mismatch and liquidity risks. As an alternative, insurance funds, pension funds and provident funds are better suited to provide infrastructure financing due to their long investing horizon. However, this requires the bonds to be of a certain investment grade with a high credit rating. Given the nature of the risks associated with an infrastructure project, one of the challenges for project companies is to obtain such high credit rating during the life cycle of the project. To resolve the limitations faced by the banks and overcome the regulatory bottlenecks faced by the funds, the PCE Guidelines were issued by the RBI to permit banks to offer PCE in the form of 'non-funded irrevocable contingent line of credit'.
PCE provided by the bank should always be subordinated and should only be drawn in case of a shortfall in cash flows for servicing the bonds so as to avoid a sinking credit rating of the bonds.
Overview of the PCE Guidelines
The PCE Guidelines outline the key features of the PCE facility which includes, inter alia:
- Irrevocable facility (not by way of guarantee) to be provided at the time of the bond issue where pre-enhanced rating of the bond should be a minimum of BBB minus or higher and should not exceed 20 percent of the issue size;
- Banks should have in place a board-approved policy broadly covering issues such as quantum of PCE, underwriting standards, assessment of risk, pricing, setting limits etc.
- Where the PCE facility is partly drawn and interest accrues on the same, the unpaid interest should be adjusted to reflect the remaining amount left to be drawn;
- The PCE facility may be a revolving facility subordinate to the bonds;
- The effect of the PCE facility on the credit rating of the bond is required to be disclosed upfront in the offer document; and
- The aggregate PCE exposure of the bank should not exceed 20 percent of its Tier I capital.
Capital Requirements for Banks providing PCE
In addition, the PCE Guidelines require the PCE providing banks to fulfil certain capital requirements to the extent of the entire bond issuance amount as if the entire issuance was held by the banks. The capital requirement is computed as a difference between the capital required on the bond amount corresponding to the pre-credit enhancement and post-credit rating enhancement risk weights applicable as per the Basel III Capital Regulations. This requirement would, however, vary vis-à-vis the changing rating notches between pre-enhanced rating and enhanced rating scenarios subject to a floor i.e. the capital requirement at the time of issuance of the bonds. The PCE Guidelines set out detailed illustrations on capital calculations basis change in ratings. The RBI upon review of the capital requirements calculations has rationalised the process by introducing additional requirements for corporate bonds to be eligible for PCE.
Additional requirements under the Circular
For a corporate bond to be eligible for PCE, the Circular states as follows, in relation to capital requirement:
- The corporate bonds are required to have two ratings from external credit rating agencies, as opposed to one under the earlier PCE Guidelines.
- While the PCE Guidelines required the offer document to give an analysis of the bond credit rating outside of PCE, the Circular stipulates that two rating reports should be obtained - initial and subsequent - disclosing both standalone credit rating (without accounting for PCE) and an enhanced rating (after taking into account the PCE).
- For the purpose of capital computation, the lower of the two standalone ratings and the corresponding enhanced rating from the same rating agency is to be considered.
- If a reassessed credit rating reflects an improvement in the credit rating as against the standalone rating taken at the time of issuance, the capital computation will be calculated taking the reassessed enhanced rating without taking into consideration the capital floor or difference in notches which was the basis for calculation under the PCE Guidelines.
The premise for issuing the PCE Guidelines was to facilitate smooth transitioning of infrastructure funding from bank financing to the corporate bond market. To that extent, RBI has constantly been reviewing the framework to facilitate liquidity in the bond market and attract long term investors. The introduction of two ratings by the Circular will provide comparable rating statistics for the bonds, thereby offering more comfort to the banks. As regards the capital requirements, the Circular provides some flexibility for the banks for the maintenance of capital. However, even with these changes, the PCE Guidelines are skewed against the banks as they are required to maintain capital for the entire bond issuance as against the PCE funding done by the banks. We will have to wait and watch if further changes are introduced which will make PCEs an effective trading tool.
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