current affairs in financial institutions...

CURRENT AFFAIRS IN FINANCIAL INSTITUTIONS AND MARKETS( COMMERCE PAPER I)

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NBFC crisis in India NBFC sector has been facing troubled times for several months is well-known. Now, a top-ranking government official has proclaimed that the sector is facing an “imminent crisis.”“There is a credit squeeze, over-leveraging, excessive concentration, massive mismatch between assets and liabilities, coupled with some misadventures by some very large entities, which is a perfect recipe for disaster,” Corporate Affairs Secretary Injeti Srinivas told the Press Trust of India in an interview. In case you were wondering what the crisis was about and why it is important, here’s a quick FAQ. What’s the NBFC crisis about? NBFCs are facing a liquidity crunch. In other words, they don’t have money to lend or are facing enormous difficulties in raising funds. NBFCs typically borrow money from banks or sell commercial papers to mutual funds to raise money. They on-lend these money to small and medium enterprises, retail customers and so on. When NBFCs don’t have money to lend, that reduces the credit flow to the economy, hits economic growth and causes many borrowers to default on loans. What led to this crisis? There are a couple of things to consider here.

One, the NBFC business model itself is flawed, to begin with. It relied on raising short-term funds which were then lent out as long-term loans. This leads to a situation called an asset-liability mismatch. For example, an NBFC raises money by selling 6-month debt papers and on-lends this as a car loan with tenure of 5 years. This leads to a situation where the NBFC has to roll over (or renew) the 6-month debt paper or raise fresh loans to repay the debt paper. In good times, this happens as a matter of course. But when times are tough, this cycle is broken.

That leads us to the second factor. The cycle was broken by a default of some firms of the IL&FS group. There were fears that this would turn out to be a contagion(the communication of disease from one person or organism to another by close contact.). Simply put, banks, mutual funds and their investors were afraid that more such entities wouldn’t default. As this fear took hold, many institutions refused to give money to NBFCs. The cost of funds rose by as much as 150 basis points for NBFCs.

Were the fears of contagion real? In the last few years, especially after demonetisation, there was excess money sloshing around in the system. That is because a lot of cash was deposited with banks and investors parked more money with mutual funds. As fund managers of debt schemes deployed the funds in money markets, NBFCs were able to access cheap funds easily. They were able to grow their loan portfolios at double the pace of banks. But on the flip side, note that mutual fund managers were chasing high returns for their investors and so too were NBFCs and banks. This led them to take risks and put pressure on the quality of their underwriting standards. Note that this excess money was given not only to NBFCs but also to other companies such as infrastructure players -- as loan against shares -- which have come back to bite now. Why is the crisis a big deal?

As explained earlier, NBFCs are playing an increasingly important part in the economy. Their share of credit has increased because they were lending in sectors where banks refused to go or did not want to go. The used commercial market is a good example here.

Now that NBFCs are finding it difficult to raise money or having to pay a huge cost for doing so, this will choke the flow of credit to the economy. It will hit the MSME sector which is already suffering from the twin blows of demonetisation and the goods and services tax.


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More importantly, it will hit consumption demand in the economy. With investment demand yet to pick up and exports flagging, consumption was the primary engine driving the economy. A reduction in credit further adds to economic slowdown pressures, which are already visible.

Besides, a slowdown in credit could lead to another pile of non-performing assets in sectors such as commercial real estate and infrastructure, which could have economy-wide knockdown effects.

Consider this example, an infra project needs working capital funds for completion so that it can start earning. When funds aren’t available or come at a higher cost, this undermines the feasibility of the project and puts the money already sunk in at risk. This adds to the stressed assets; mutual funds lending to such projects will have to mark down their net asset values; this leads to investors taking money out of mutual funds and in turn mutual funds won’t be able to give money to NBFCs/ other projects, setting off a vicious cycle.

The spate of recent downgrades in NBFCs, housing finance companies and infrastructure projects highlight the problems caused by the crisis.

What now? In the last financial year 2018-19, the Reserve Bank of India bought government debt paper worth Rs 3

lakh crore from the market. Basically, this meant that so much money was given to the banking system to on-lend. This is the only way for RBI to help NBFCs since the central bank can’t lend directly to the latter as they don’t hold government paper for use as collateral.

But the cost of borrowing for NBFCs is still high as banks are risk averse or have reached exposure limits.

This will prompt NBFCs to tap alternative sources such as external commercial borrowings, public bond issuances, or sales of assets. But even then, analysts point out that most of their borrowings will be used to repair balance sheets and refinance liabilities. Even if a full-blown crisis won’t happen, it will take at least 12 months for NBFCs to be back on the lending track.

Question mark over mutual funds: even they are

prone to make you sad.A detailed coverage on recent developments in mutual fund industry.

In April 2019, Kotak MF deferred ‘full redemption’ in six fixed maturity plans (FMPs) that held papers of two Essel subsidiaries — Edison’s Utility Works and KontiInfrapower&Multiventures. Some of these funds had invested in Essel companies despite full knowledge of the group’s losses and negative networth. Kotak MF and nine other asset management companies (AMCs) — including some of the marquee-est names such as Aditya Birla, ICICI, HDFC and Reliance — face default prospects on loans given to Essel Group (holding company of Zee). Some of the important facts are as follows: In January 2019, Subhash Chandra, patriarch of the Essel Group, sought more time to

repay MFs. Interestingly, all the funds agreed! Kotak MF has loaned Rs 378 crore to Essel Group, on the back of 1.27 crore Zee Group

shares as collateral and personal guarantees from promoters. The fund house claims to


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have taken all precautions while lending to Essel companies, including detailed “covenanting” (loan and recovery terms) and adequate security cover.

The fund committed one mistake — of not looking at promoter share-pledge positions… But nobody in the industry ever did that. Fund managers commit that “Henceforth, we’ll be careful about that too… We’ll keep limits on what levels can promoters pledge their shares if they’re taking money from us.”

The past few months have been difficult for debt fund managers. First came the IL&FS credit crisis, where MFs had Rs 3,000 crore of exposure. The likes of Aditya Birla Sun Life, HDFC MF and UTI MF had also invested in papers issued by unlisted IL&FS floated special purpose vehicles (SPVs), which stopped repayments in January. Birla, HDFC and UTI had invested Rs 685 crore, Rs 232 crore and Rs 559 crore, respectively, in three such road project SPVs, the investment values of which had to be marked down 20-25% post default.

While the Rs 24.58-lakh crore MF industry was trying to find a way through the IL&FS rubble, it found itself marooned in a regulatory twilight zone with regards to investments in Essel Group’s debt papers, with Zee’s equity shares as collateral.

MFs invest in secured debentures and the security of equity shares is most liquid. However, in case of a market crash, the security cover gets reduced, leading to trigger sales, further affecting stock price.

IL&FS and Essel Group are two separate issues, if you count out one common thread. Debt fund managers would not have bought IL&FS papers or Essel’s lowly-rated debt had they not been chasing higher yields.

Funds managers such as A Balasubramanian, chief executive, Aditya Birla Sun Life MF, insist that thorough diligence is always the norm and not an exception.

However, most fund houses do not have credit teams to monitor investments on a daily basis. “They solely go by what raters report periodically. In such cases, some defaults are bound to happen,”.

The IL&FS collapse masks a prosaic and often-forgotten truth that financial markets encounter every decade. While the investible surplus has multiplied, the number of top-rated securities hasn’t grown. The surge in assets under management of fund houses – from Rs 5 lakh crore to Rs 23.25 lakh crore during 2008-18 – left fund managers scrounging for securities to bet on. Soon, too much money was chasing too few securities.

SEBI Action Sebi has initiated adjudication against HDFC Asset Management Company Ltd or HDFC AMC and

Kotak Mutual Fund over the so-called Fixed Maturity Plan (FMP) woes. The FMPs of these asset management companies were impacted due to their investment in Essel Group papers forcing Kotak to hold back redemptions and HDFC to rollover the entire FMP.

Sebi’s show cause notices to the two fund houses have cited violation of mutual fund regulations and investor protection. The maturity of the under lying papers of Essel group companies was more than the


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maturity of the FMP which is a violation of Sebi rules. Reliance mutual fund was one of the few AMCs which did not agree to this so-called standstill agreement and sold the Essel papers on 8 May.

To honour this agreement Kotak AMC decided to hold part of the payments that were due to mature on 8 April. HDFC AMC on the other hand, ahead of the maturity date of 15 April, decided to roll over the FMPs that held the Essel paper by more than a year.

Kotak also failed to take consent from investors before deciding to hold back part redemption. This is a fallout of fund managers investing in papers which are backed by pledged shares, popularly known as Loan against Shares (LAS).

More Risk, More Gains: Popularity of Credit Risk Funds Fund managers are arguably taking more risk to drive up portfolio yields.

Their exposure to lowly-rated papers has risen in tandem with total debt MF AUM – currently at Rs 11 lakh crore. Over Rs 1.8 lakh crore of debt MF investments are in papers rated AA and below (securities below AA rating are considered risky). That aside, MFs have invested some Rs 3,770 crore in unrated debt papers.

But what’s prompting fund managers to take more risk? The answer to that lies somewhere between their need to garner more AUMs and meeting the investors’ high-return expectations. Over the years, investors have warmed up to the idea of taking more credit risk to increase portfolio yields. The rising popularity of credit risk funds gives credence to this trend.

Credit risk funds (CRFs) have at least 65% of the corpus in less than AA-rated papers. These funds typically have the potential to give 2-4% higher returns compared to risk-free papers. AUMs with CRFs have grown significantly over the past few years — from Rs 31,356 crore in January 2016 to Rs 81,058 crore four years later, as per Value Research data. Currently, over 90% of CRF assets belong to return-hungry retail investors. In an ideal situation, high portfolio YTM denotes more low rated-high yielding papers.

But in their quest for higher yields, despite due diligence, fund managers could still end up picking up the wrong paper. Funds such as Franklin Templeton, Aditya Birla Sun Life and ICICI Prudential had landed in trouble despite having “strong internal control mechanisms. Franklin Templeton and ICICI Prudential Mutual Fund had to offload Jindal Steel and Power at steep discounts when the company stopped repayments in 2016.

Still, every fund works within a tight casing — with a specified investment policy and mandate. Fund managers work within these pre-set boundaries, says Amit Tripathi, chief investment officer, fixed income, Reliance Mutual Fund. Fund houses also use ‘covenanting’ as a means to protect themselves from potential defaults. In high-risk cases, they take collaterals from the issuer — in the form of equity shares or trade receivables. Although in practice since 2005, this has come to light only after Zee shares plummeted, resulting in a margin call from funds holding Essel papers (raised using Zee shares as collateral). These days, such transactions are called ‘loan against shares.’ Almost all Indian asset managers have subscribed to debt papers of low-rated issuers with collateral backing (mostly equity shares). Such deals are risky


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as in the event of a market crash, MFs holding shares as collateral may not be able to dump these and realise the loan. The NSE Co-location controversy:

After spending an inordinately long time on investigation, the regulator has decided that, though it cannot be concluded that NSE has committed a fraud, the exchange has violated Regulation 41(2) of the SECC Regulation, 2012, that requires exchanges to provide equal, fair and transparent access to all persons in the securities market.The exchange has not exercised the required due diligence in putting together the Tick-By-Tick architecture at its colocation facility. This had led to few entities gaining unfair advantage over others by logging into the system first or gaining access through the secondary server, where the traffic was less. SEBI has rightly held that information dissemination in the period between 2011 and 2014 was not fair and equitable. The NSE colocation controversy has been the subject of speculation, conspiracy theories and even a defamation suit against a media house (Moneylife) which doggedly pursued the issue.SEBI has now sought to bring closure after investigating it for four long years. SEBI’s findings on the whistle-blower complaints are four-fold.

1. Wrong protocol: NSE used a certain protocol (TCP IP) to disseminate order book data to the trading members on its colocation facility. But the TCP-IP protocol sends out data sequentially, bestowing an unfair advantage on members who are ahead in the queue.But SEBI’s investigations found that the lack of proper policies on the allocation of ports and servers before 2015 left NSE’s colocation platform open to manipulation. It didn’t find any proof of trading members with preferential access making undue gains from their trades though.

2. Wrong server: Some trading members, including OPG Securities, were able to switch their connections to NSE’s backup servers (which were less crowded) to gain quicker data access. After issuing perfunctory warnings on this misuse of backup servers, NSE did not take any penal action against them. When taxed with why it didn’t disconnect them, NSE officials told investigators that they didn’t do so as it would have caused ‘disruption of business and large financial losses’ to the members. SEBI found that OPG Securities did make unlawful gains of �15.57 crore through this route.

3. Unauthorised dark fibre: Two brokers — Way2Wealth Brokers and GKN Securities — hired Sampark to lay dark fibre connectivity to the NSE’s colocation facilities for faster trade execution. Sampark did not have the required DoT license to offer such services. NSE officials scotched similar requests from for other brokers and allowed dark fibre access to continue, even after it was evident that the connections were unauthorised. Here, SEBI has taken a stern view. It has hauled up the brokers for engaging an unauthorised network provider in their ‘greed and exuberance’ to achieve high speeds


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and reprimanded NSE for ‘maladministration and mis-governance’ of its entire colocation facility.

4. Doubtful data sharing: An NSE official entered into data sharing arrangements with related parties (Infotech Financial Services, Ajay Shah and others) to help design products for the exchange. But the agreement was prone to conflicts of interest and allowed misuse of data for commercial purposes, violating SEBI’s PUFTP regulations.

The punishment?

On the first two counts, SEBI has acquitted NSE and its officials of charges of fraud and manipulation, because it could unearth no evidence of NSE employees deliberately colluding with or earning kickbacks from the brokers.

SEBI has therefore come down hard on NSE for not complying with the Securities Contracts Regulation Act, which says that one of the cardinal duties of a stock exchange is to provide ‘equal, unrestricted, transparent and fair’ access to all persons trading on it. It has rapped NSE’s top bosses for neglecting their fiduciary duties.

For the negligence, SEBI has asked NSE to ‘disgorge’ a Rs. 624 crore plus penal interest — effectively all the profits made from colocation between FY11 and FY14 and barred it from an IPO for six months. Ravi Narain and Chitra Ramkrishna have been asked to disgorge 25 per cent of their salaries drawn during the period and barred from market institutions for five years.

OPG Securities, Way2Wealth and GKN Securities will need to disgorge their unlawful gains and are barred from dealing in securities for specified periods. Ajay Shah and others have been barred from associating with market entities for two years.

Key take-aways &Regulatory red flags from NSE co-location issue:

1) SEBI’s final orders on the colocation case may seem like an anti-climax to those who were expecting a multi-billion rupee scam, or a sordid trail of kickbacks. What it has exposed instead, is many acts of omission and commission by the exchange that left its doors wide open for market players to game the entire system.

2) To dismiss the NSE colocation case as trivial, just because it hasn’t thrown up eight-figure monetary losses for anyone, would be quite short-sighted. The case raises four big regulatory red flags.

a. One, policymakers in India have always thought of stock exchanges as self-regulatory organisations, expecting them to crack the whip on market players stepping out of line. But the NSE saga reveals that in practise, exchange officials may often be on chummy terms with trading members. In both the dark fibre and backup server cases, NSE employees clearly bent over backwards to accommodate the needs of their clients so that their trading was not interrupted on any count. There’s a clear conflict here, between the exchange employees’ official role as regulators, and their real-life roles as business facilitators for their employer.


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b. Two, with the advent of money-spinning ideas such as colocation racks that give affluent trading members privileged access to trading infrastructure, the profit maximisation goals of stock exchanges are today in direct conflict with notions of equitable access for all and fair play. NSE raked in as much as Rs. 811 crore from colocation charges alone between FY11 and FY14. The wedge between profit motives and the regulatory obligations of exchanges is only likely to widen with more exchanges turning listed entities. Indian policymakers and SEBI therefore need to put in place tighter regulatory oversight, similar to that for other market participants.

c. Three, Indian policymaking has all along assumed that squeaky clean governance at stock exchanges can be ensured through ‘fit and proper’ criteria for promoters and caps on promoter shareholding. But the NSE case clearly tells us that professional managers of a widely held company can be as prone to hubris and negligence, as family promoters. There’s also plenty of scope for collusion, manipulation of systems and corruption at every level of the exchange hierarchy below the top management. Ensuring good governance requires clear fixing of responsibilities for every individual employee’s role and strong deterrent action against individuals found crossing the red line.

d. A final takeaway from this case is that, when it comes to market crimes, prevention is far better than cure. Though SEBI has passed sizeable disgorgement orders against the wrong-doers, it is quite unlikely that the money can be returned to the real losers of the colocation scam — the counter-parties to the dodgy trades put through by the favoured brokers or the market rivals edged out by them.

3) It is also a disturbing thought that none of these serious flaws in exchange processes would have come to light, but for the efforts of one Mr Ken Fong. India’s market institutions, like its companies, need a robust internal whistle-blower mechanism. The SEBI order helps send a few clear messages to market infrastructure institutions.

One, exchanges cannot act in a way that erodes the trust of investors in the markets.

Two, that no market intermediary institution, however large, can flout the regulations and hope to escape without any impact.

Three, exchanges have the responsibility to ensure that all the processes are well-documented and supervised. SEBI’s investigations had shown that NSE did not have defined policies and procedures around secondary server access, except for scant mention in some guidelines. There appears to have been no documented policy or procedure on admonishing trading members from connecting to the secondary servers. It was found that the responsibility of monitoring of connections by members to the secondary server was left to junior staff and was not supervised. Such gaps in processes possibly exist in other exchanges. This order sends the message to all exchanges to plug loopholes.


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While SEBI is right in prohibiting NSE from accessing the securities market for six months and in asking the exchange to carry out internal checks regularly, the ‘punishment’ of asking the exchange to disgorge close to �1,000 crore, appears light, given that stock exchanges are a key part of the market infrastructure, and are first-level regulators. Though the exchange has taken corrective action by adopting Multicast TBT system from April 2014, due to which issues related to benefits from early connectivity and sequential dissemination of ticks have been addressed, it is alarming that processes were weak enough to allow junior employees to collude with market participants.Merely rapping the exchange for lapses does not adequately fix responsibility. SEBI needs to send a tougher message to exchanges to oversee their operations better

WHAT IS ANGEL TAX, latest development about it ?

Angel tax is a term used to refer to the income tax payable on capital raised by unlisted companies via issue of shares where the share price is seen in excess of the fair market value of the shares sold. The excess realisation is treated as income and taxed accordingly. The tax was introduced in the 2012 Union Budget by then finance minister Pranab Mukherjee to arrest laundering of funds. It has come to be called angel tax since it largely impacts angel investments in startups.

According to Feb 2019 notification, investments of up to Rs. 25 crore in an eligible company will be exempt from the angel tax. In addition, investments made by a listed company of a net worth of at least Rs. 100 crore or a turnover of at least Rs. 250 crore would also be exempt. Investments made by non-residents will also be exempt.

An eligible start-up would be one that is registered with the government, has been incorporated for less than 10 years, and has a turnover that has not exceeded Rs.100 crore over that period.

This clarification would help in avoiding potentially significant tax challenges faced by start-ups. Welcoming the move, the start-up community said some issues such as start-ups having already been sent tax notices, and the applicability of Section 68 of the I-T Act still remained and that they would take it up with the tax department. Enterprise Value Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization. EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company's balance sheet. Enterprise value is a popular metric used to value a company for a potential takeover.

The total expense ratio (TER)


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Mutual funds are investments where an investor entrusts his/her money with an investment manager (of an asset management company) to manage the money smartly and efficiently. This money management comes at a cost, which is usually charged as a percentage of the investment. The total expense ratio (TER) is a measure of the total costs associated with managing and operating an investment fund, such as a mutual fund. These costs consist primarily of management fees and additional expenses, such as trading fees, legal fees, auditor fees, and other operational expenses.

The total cost of the fund is divided by the fund's total assets to arrive at a percentage amount, which represents the TER. TER is also known as the 'net expense ratio' or 'after reimbursement expense ratio'.

The size of the total expense ratio (TER) is important to investors, as the costs are withdrawn from the fund, affecting investors' returns. For example, if a fund generates a return of 7% for the year but has a TER of 4%, the 7% gain is greatly diminished to roughly 3%. So, for an investor, TER is an important number to focus on since it has a direct impact on their returns. However, it is not the only number to look at and investors should evaluate funds based on various parameters such as consistency of performance and risk levels. SEBI has lowered the TER that a fund house can charge its investors. The reduction has been anywhere between 0.01% to 0.44%. For very small funds, SEBI has actually increased the allowable expense ratio a little. For mutual fund companies, there will definitely be a loss of revenue, as there will be for other participants in the industry, such as individual financial advisors and distributors.

Altman Z-Score

The Altman Z-score is the output of a credit-strength test that gauges a publicly traded manufacturing company's likelihood of bankruptcy. The Altman Z-score is based on five financial ratios that can calculate from data found on a company's annual 10-K report. It uses profitability, leverage, liquidity, solvency and activity to predict whether a company has high probability of being insolvent. Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E Where: A = working capital / total assets B = retained earnings / total assets C = earnings before interest and tax / total assets D = market value of equity / total liabilities E = sales / total assets NYU Stern Finance Professor Edward Altman developed the Altman Z-score formula in 1967, and it was published in 1968. In 2012, he released an updated version called the Altman Z-score Plus that one can use to evaluate public and private companies, manufacturing and non-manufacturing companies, and U.S. and non-U.S. companies. One can use Altman Z-score Plus to evaluate corporate credit risk. A score below 1.8 means it's likely the company is headed for bankruptcy, while companies with scores above 3 are not likely to go bankrupt. Investors can use Altman Z-scores to determine whether they should buy or sell a stock if they're concerned about the company's


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underlying financial strength. Investors may consider purchasing a stock if its Altman Z-Score value is closer to 3 and selling or shorting a stock if the value is closer to 1.8. Altman Z-Scores and the Financial Crisis

In 2007, the credit ratings of specific asset-related securities had been rated higher than they should have been. The Altman Z-score indicated that the companies' risks were increasing significantly and may have been heading for bankruptcy.

Altman calculated that the median Altman Z-score of companies in 2007 was 1.81. These companies' credit ratings were equivalent to a B. This indicated that 50% of the firms should have had lower ratings, were highly distressed and had a high probability of becoming bankrupt.

Altman's calculations led him to believe a crisis would occur and there would be a meltdown in the credit market. Altman believed the crisis would stem from corporate defaults, but the meltdown began with mortgage-backed securities. However, corporations soon defaulted in 2009 at the second-highest rate in history. The Altman Z-scores computed for 10 major default cases — Jyoti Structures, Era Infra

Engineering, Jaypee Infratech, Alok Industries, Monnet Ispat, Bhushan Steel, ABG Shipyard, Amtek Auto, Lanco Infratech and Electrosteel Steels — throw an interesting result. The Z-scores in 2012 seem to indicate high level of stress (a score of 1.81 or lower) in these cases at least two years prior to the point where downgrading took place. India’s rating agencies have to be more responsible and careful while assigning fresh ratings[ especially before assigning any AAA rating.]

Credit ratings were central to the global financial crisis that began unfolding in 2008. Over the last few years, India has been struggling with its own credit failures. Corporate defaults, such as IL&FS (Infrastructure Leasing & Financial Services), require us to take a critical look at the financial system and learn from these failures.

There’s one question Indian investors affected by these defaults are asking: why were the highly rated papers downgraded so suddenly, and so late?

It is amply clear that India needs to correct something in its financial system. But is it just the failure of the credit rating agencies? Admittedly, rating agencies have to do better in terms of indicating a deterioration in creditworthiness. But there is more to this problem than just their role. All consider the fact that capital market issuances in India are dominated by only highly rated issuers. On the other hand, in the US, currently there are just two AAA issuers, Microsoft Corporation and Johnson & Johnson. In India, almost 80% of outstanding issuances by quantum are by AAA companies.

While majority of the issuances in the US are in the BBB category, the Indian debt market is heavily skewed towards the highest rating, i.e., AAA. In the US, highest rating


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represents just 1% of corporate bond outstanding by quantum. This is despite the fact that the debt market in India is much smaller at just 14% of GDP, compared to 45% of GDP in the US.

While 32% of all US corporate bonds outstanding by quantum represent ‘non-investment grade’ category, for India, that number stands negligible at just 0.6%. Clearly, there is an unjustifiable bias towards higher-rated debt in India. This anomaly limits the size of the domestic capital market and sets expectations of issuers and bond investors unrealistically high, and even distorts the pricing of debt.

One can argue that if rating distribution in India follows the same pattern as in the US — i.e., just 6% in AAA and AA category by quantum — probably the bond market, and even rating agencies, won’t exist.

Adeeper bond market, and an appropriate regulatory framework that facilitates demand from investors for debt papers across rating categories, is needed to help set issuer expectations. This is what makes it possible for rating agencies in the US to be in business, despite having only two AAA corporate bond issuers.

Rating agencies in India have to be more careful while assigning fresh ratings. Their job is to look for downside risk — unlike the job of the equity analysts who look for the growth opportunity. It’s an established fact that investors overwhelmingly support a rating system that offers stable ratings. It may be counterintuitive, but in the bond market, ticker-by-ticker update on credit outlook doesn’t work.

Rating agencies outside India did experiment with analytics-driven ratings that are less stable, but more frequently updated, using quantitative algorithm and analytics. But such ratings make bond investors jittery and bond markets volatile. Given such need for stability, rating agencies have to use the absolute ‘gold’ standard to assign AAA ratings. Focus on BBBackbenchers All stakeholders have to work together to develop the market for lower than AAA-rated papers right up to the BBB category, if not non-investment grade. The investment guidelines for all domestic investors should facilitate investments in higher yield papers. This may help to reduce the pressures on the credit rating agencies to live up to the expectations of large issuers in the market.

Rating agencies have to be more responsible and careful while assigning fresh ratings, especially before assigning any AAA rating. This would ensure that ratings remain stable and does not require overnight correction.

Finally, issuers should be made accountable for high quality and timely disclosure of management action and other information promptly and proactively with the rating agency. In Nov 2018 SEBI issued norms for enhanced disclosures by credit rating agencies. CRAs would now be required to furnish information whether the rating is factoring in

support from a parent, group or government, with an expectation of infusion of funds towards timely debt servicing. They are required to name of such entities, along with rationale for such expectation.


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When subsidiaries or group companies are consolidated to arrive at a rating, list of all such companies, along with the extent (e.g. full, proportionate or moderate) and rationale of consolidation, will be required to provide by CRAs.

Press Release of CRAs would now include a specific section on “liquidity”, which will highlight parameters like liquid investments or cash balances, access to unutilised credit liquidity coverage ratio, adequacy of cash flows for servicing maturing debt obligation, etc. CRAs shall also disclose any linkage to external support for meeting near term maturing obligations.

All CRA would require furnish data on sharp rating actions in investment grade rating category, to stock exchanges and depositories for disclosure on website on half-yearly basis, within 15 days from the end of the half-year.

CRA should publish information about the historical average rating transition rates across various rating categories, so that investors can understand the historical performance of the ratings assigned by the CRAs.

Credibility of credit rating agencies:

The IL&FS saga has brought the spotlight back on credit ratings agencies for all wrong reasons. The last time such a situation arose was in late 2015, when auto ancillary company Amtek Auto defaulted on the repayment of its bonds.The IL&FS episode reminds us that there are issues that still need to be addressed before reliance on credit ratings can increase further.Among other things, there are two elements that warrant a close examination, given their susceptibility to impact the quality of a rating. These are (a) the extent of independence of the ratings committee and (b) quality of the analysis. Independence: Over the years, the membership of the ratings committee has shifted from external experts to employees of the ratings agency. As a result, the ‘independence’ of the members of the rating committee could always come under question. After all, as they say, Caesar’s wife should be above suspicion.Given the large number of ratings issued, which should be in hundreds at any given ratings committee meeting (one ratings agency has issued more than 120 rating releases on October 31), there has to be a mechanism to ensure that the large systemically important issues are addressed through a separate mechanism.Therefore, it may be useful to have an element of ‘independence’ in the ratings committee — at least in cases that involve systemically important entities. Quality of the Analysis. The second element of the ‘quality of analysis’ is a more subjective and difficult issue to handle. Ratings agencies are cautious when credit quality is improving and probably do not want to be ahead of the curve when things are getting better, but the lag continues when there is trouble ahead. There are a few factors that could be addressed in order to ensure better quality of analysis and rating actions.


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The sheer increase in the number of ratings issued and thereby significant work pressure on the ratings agencies. While the processes and standards can be defined and outlined, the output in terms of quality of analysis can’t be regulated or legislated. There will always be pressure from clients to complete the ratings exercise as quickly as possible, which means that the agencies will have to be staffed adequately or even in excess of the requirements, given that bunching of work is very likely. Some of the rating rationales published by the rating agencies reveal the shallow nature of the analysis such as in the case of IL&FS Financial Services. It will be helpful if the requirements of a rating rationale are laid down to ensure the provision of meaningful information.

The ratings agencies seem to be in the race to maximise earnings, thanks to three of them

being listed, which probably has an impact on the quality of the output. It can be seen that the operating margins are consistently at over 40%, with one company even posting a 65% operating margin. Obviously, such high margins are a result of low employee expenses, which is the main head of expenditure for a knowledge organisation.

the credit rating industry, unlike the decade of the 90s and 2000s, does not attract the cream of talent.

Suggestions: Credit ratings is a business where the better you perform professionally, it is more likely

that your client (read the entity that is rated) may not be too happy! It is therefore essential to incentivise rigorous analysis so that the pressure of improved financial performance does not force them to cut corners.

This may be done by standardising the fee structure at least in the case of bond ratings. Having external experts on the ratings committee for large issues and bringing in

safeguards to ensure that the analytical rigour is not diluted are some steps that could help rating agencies regain their credibility.

A case of barking up the wrong tree?

The spotlight is on credit rating agencies (CRAs) once again, this time triggered by the crisis at, and default by, Infrastructure Leasing & Financial Services (ILFS). Indian lenders and bond-holders have been hit by a series of corporate defaults over the last few years and, as a consequence, credit rating agencies are under scrutiny for not alerting investors in time.

In this, the ‘issuer pays’ business model of CRAs seems to have borne the brunt of criticism.

While this appears to be an intuitive response, a comparison of other possible CRA business models would indicate that the problems lie elsewhere.

The tendency to associate CRAs with financial failures dates right back to early 20th century. The most incisive of such inquiries followed the global financial crisis of 2008, conducted by financial regulators including in the US and India.


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What is pertinent, however, is that, after detailed deliberations, the issuer pays model of the CRAs was left untouched by all the regulators. This was an implicit endorsement of the model’s relative superiority, or at the very least, of it being the lesser evil.

It is normal that credit ratings change over time. The primary concern surrounding ILFS’ ratings is about timeliness, abrupt and steep transitions, slow/inadequate change even after evident distress, and inadequate use of ‘outlooks’ – that handy rating prognosis tool.

That warrants questioning of the CRAs concerned in recent cases – CARE, ICRA and India Ratings – and also of others culpable in other instances.

To be sure, the inherent conflict of interest in the issuer pays model is undeniable, since the rated entity is paying for the rating. But it is instructive to consider some nuances. Any CRA business model must facilitate two objectives:

1) Ensure ratings are of high quality, and 2) ensure all market participants have access to such ratings at a reasonable cost. 3) minimal or no conflict of interest. ‘Minimal’ is a considered usage here since conflicts

cannot be entirely eliminated. Three models of Credit Rating

The issuer pays model Under this, the issuer pays the initial and subsequent surveillance fees to CRAs, and the ratings are publicly and freely available. Market dynamics determine the fees and issuers are contract-bound to afford CRAs access to business and financial details, which facilitates better analysis. The cost to investors is virtually zero. For issuers, rating fees count among the smallest components of issue costs. Two aspects need reflection regarding potential conflicts, whereby a CRA might systematically assign inflated ratings to satisfy issuers.

1) One, if a CRA consistently indulges in such a practice, it will be harakiri, for sooner than later, it will lose credibility, which is a critical success factor in the business.

2) Two, typically, CRAs collect upfront 100% of the non-refundable rating fee even before beginning the exercise. This eliminates payment risk and significantly reduces the incentive to assign favourable ratings. Even if an issuer delays or defaults on annual fees, the CRA is obligated to monitor and disclose rating changes.

Therefore, despite the inherent, and potentially subversive, conflict in the model, these two aspects considerably mitigate the risk of malfeasance in practice.

The analytical competencies and standards of CRAs are a different matter altogether, but these are not frailties attributable to the issuer pays model. Three specific statistics lend support to this argument:

1) One, out of ~35,000 ratings currently outstanding in India, nearly three-fourths are in the ‘non-investment grade’ category.


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2) Two, during fiscal 2018, Indian CRAs downgraded over 2,400 ratings. Both these suggest CRAs haven’t shied away from assigning lower ratings or downgrading those who pay for the assessment.

3) Third is the ‘ordinality’ expectation in ratings default performance (higher rated firms expected to have a lower rate of transition-to-default, than lower rated firms). This is a key yardstick of ratings quality. The four largest Indian CRAs have systematically demonstrated lower default rates for higher ratings.

So while CRAs have erred in specific instances, this statistic reflects overall good quality and consistency.

The ‘investor pays’ model The investor pays model has the advantage of precluding the issuer-CRA nexus. But it poses another, equally serious, conflict involving the investors themselves. Private placements of debt account for about 90% of issuances in India, and the secondary market is subdued. Therefore, if investors are the payees, they can influence CRAs to give lower-than-warranted ratings to help them negotiate higher coupon rates. After placement, too, investors can resist downgrades of the securities they hold, as it can trigger mark-to-market losses. The scope for this conflict is real. Then there are other problematic issues.

One, only those who pay for a rating can access it. Two, the cost of rating can be exorbitant since only a few investors may seek it, and

the public would likely be the most deprived. Lastly, under investor pays, issuers may not always share full information with

CRAs, which can, ab initio, jeopardise the quality of ratings.

Therefore, on all counts, the investor pays model is decidedly inferior.

The government (or regulator) pays model Conceptually, the ‘government or regulator pays’ model can eliminate bias in ratings because there is no pecuniary incentive for the CRA (public sector entities could be an exception). Here, the regulator can also mandate free dissemination of ratings to all. So far, so good.

But this model introduces other complexities. 1) One, the choice of the CRA and the payment mechanism are extremely problematic, as it

is difficult to conceive of either the government or the regulator exercising a choice regarding CRA quality beyond a minimum threshold, or paying market-determined/ negotiated fees for ratings.On what basis would the regulator pick a CRA when the value proposition fundamentally differs from that of auditors?

2) Two, if fees are not market-determined, CRAs would be hard-pressed to build capability and retain sharp analysts. Moreover, once business is assured, there may be little incentive for quality and excellence.


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A Parliamentary Standing Committee on Finance recently suggested a review of regulations governing rating agencies. This involves a suggestion to consider an investor-pays model or a mandatory rotation of auditors. The panel also called for stronger supervision.

The most serious problem with this model is the ‘moral hazard’ wherein all ratings can be seen as regulator-endorsed. This is antithetical to efficient market practices, and can pose potentially disastrous consequences for the government/regulator in the event of poor rating calls.Which means, operational and moral hazard issues overshadow the intuitive appeal and advantages of this model. Conclusion: Sure, each model has its pros and cons, and conflict/moral hazard potential. It’s imperative, therefore, to pick the model that best meets the primary objectives of credit rating – high quality and open access – when offering the best opportunity to manage any conflict.

By those yardsticks, the issuer pays model recommends itself. These arguments do not seek to absolve CRAs of poor judgement, lack of timeliness or

the incompetence they have exhibited from time to time.But the cause of serious concerns that typically surface during financial debacles (and therefore solutions) lie elsewhere.

Structurally and behaviourally, there is a need for a deeper understanding of credit rating process, related systemic issues, and a more enlightened approach to evaluation of CRAs. That would facilitate greater transparency, high quality ratings, and healthy competition.

Despite the fact that credit rating agencies have all the systems and procedures in place they may still fail. The reasons for such failures may range from lack of data availability to competitive pressures. Hostile takeovers in India

Larsen and Toubro (L&T) signing a deal with Cafe Coffee Day founder V.G. Siddhartha to buy 20.4 per cent stake in leading services firm Mindtree at Rs 981 per share for about Rs 3,300 crore, in a bid to acquire the firm.

Mindtree on Tuesday came out with a scathing condemnation saying: "The attempted hostile takeover bid of Mindtree by L&T is a grave threat to the unique organisation we have collectively built over 20 years." While India has been witnessing a spurt in the number of merger and acquisitions (M&A) in recent times, the number of hostile takeover attempts has been limited.

Technically, acquisition refers to the process in which a person or a company acquires controlling stake in another firm. It can be friendly or hostile.

A hostile takeover, on the other hand, is the acquisition of one company (target company) by another (the acquirer) that is accomplished by going directly to the company's shareholders or by fighting to replace the management to get the acquisition approved.


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However, the government's policies to curb the concentration of economic power through the introduction of the Industrial Development and Regulation Act, 1951, MRTP Act, FERA Act etc. have made hostile takeovers a difficult proposition. As a result, since its economic liberalisation in 1991, India has witnessed only a handful of hostile takeover attempts. One of the most famous hostile takeover attempts took place in 1983, when London-

based industrialist Swaraj Paul sought to control the management of two Indian companies -- Escorts Limited and Delhi Cloth Mills (DCM) Limited -- by picking up their shares from the stock market. Though Paul ultimately retracted his bid, his hostile threat sent shockwaves through the otherwise complacent Indian business world.

In 1998, India Cements Limited (ICL) made a hostile bid for Raasi Cements Limited (RCL) with an open offer for RCL shares at Rs 300 apiece at a time when the share price on the BSE was Rs 100.But the investors felt cheated as the promoters themselves sold out their stake to the acquirer, leaving little room for them to tender their stake to the acquirer during the open offer. However, ICL also bought out the FIs in the open offer and thereby increased their holding in RCL to 85%.

Another hostile takeover was triggered in 2008 when Emami acquired 24 per cent stake in Zandu from Vaidyas (co-founders) at Rs 6,900 per share. An open offer for 20 per cent followed along with Parikh's (co-founders) giving in their 18 per cent stake after four months of futility to save the company.

Superior voting rights: Can it prove to be a game-changer?

These instruments may make fund-raising easy and reduce the threat to promoters, but checking corp governance is a key challenge. The aim is to facilitate companies with high leverage or asset-light models raise equity without dilution of promoter control and serve as defence mechanism against any hostile takeover bid. The broad idea behind allowing shares with differential voting rights is that promoters/ founders can maintain control as they would hold shares with superior voting rights (SR). Norms for DVRs[In India, currently only DVR shares with inferior voting rights are permitted by SEBI. Four companies — Tata Motors, Jain Irrigation, Future Retail and Gujarat NRE Coke — have DVR shares listed on the bourses]. Investors participating in the shares with lower or fractional voting rights (FR) get the opportunity to participate in the growth of the company through higher dividends, besides gains in case of a sunset clause, even though they have lower voting rights. Companies whose equities are already listed for at least one year, can be allowed to issue FR shares by way of rights, bonus issues and through follow-on public offers, as per the suggestion. The FR shares should not exceed a ratio of 1:10, i.e., one vote as applicable to one ordinary equity share, would be voting entitlement on 10 FR shares. The ratio can be in full numbers from 1:2 to 1:10. Superior voting rights shares can be issued only to the promoters of a company by an unlisted company.


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Systematic Withdrawal Plans (SWPs) in mutual funds. The SWP facility allows investors to withdraw a pre-determined amount at pre-decided

intervals from their mutual fund investments. An SWP is the opposite of a Systematic Investment Plan (SIP) where you invest a fixed

sum at regular intervals. With an SWP, you can customise the cash flow as per your requirement — withdraw

either the capital gains on your investment or a fixed amount. The withdrawal can be either-weekly, monthly, quarterly, half yearly or yearly. SWPs are

allowed only in open-ended funds. On the SWP date, units of your fund with a value equivalent to the withdrawal

requirement are sold, and the proceeds are credited to your bank account. This helps the investor to remain invested in the scheme which can earn market-linked

returns, as well as enjoy regular income. Just like SIPs, investor gets the benefit of cost averaging — selling more units when the

markets are down and less when the markets are up. Many AMCs allow only fixed-sum withdrawals. However, AMCs including HDFC, Aditya Birla Sun Life and Kotak also allow investors to withdraw the capital appreciation. SBI Mutual Fund, through Bandhan SWP, allows investors to re-route the SWP amount to the account of their family members.All AMCs allow SWPs in equity-linked saving schemes (ELSS) post the lock-in period of three years. Taxing SWP: SWP withdrawals from mutual funds attract tax. As per the current tax structure, redemptions made from equity-oriented funds within 12 months from the date of investment attract short-term capital gains (STCG) tax at 15 per cent. Redemption after 12 months qualifies for long-term capital gains (LTCG) tax at 10 per cent. On the other hand, sale of debt funds units within 36 months attracts STCG tax, which is taxed as per the investor’s income-tax slab; sale after 36 months qualifies for LTCG tax at 20 per cent with indexation.Hence, starting SWPs in equity-oriented fund after a year and in debt funds after three years from the date of investment will help lower your tax outgo.

Mutual Funds It raises many troubling issues for the regulator to address

Investors in Fixed Maturity Plans (FMPs) from two of India’s leading mutual fund houses received a rude shock after they were informed that the proceeds/returns they were expecting on their maturing schemes wouldn’t be immediately forthcoming, thanks to their exposure to the troubled IL&FS and Essel groups. While Kotak Mutual Fund repaid the principal and offered to pay returns later subject to realisation of debt, HDFC Mutual Fund sought investor permission to extend its maturity date by a year, ostensibly to ‘lock into’ higher yields.


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In January, a clutch of domestic fund houses which had extended loans to the Essel group’s promoters against pledged shares had agreed to a standstill on invoking those pledges and given the cash-strapped promoters time until September to meet their repayments. This may only be the beginning of troubles for FMP investors, as 56 schemes across six fund houses are said to hold Essel or IL&FS exposures.

Investors in the affected FMPs have no legal grounds for complaint given that such defaults are part of the market risks they signed up for while investing in mutual funds. But the FMP fiasco nevertheless raises troubling questions. First, there’s the question of why, despite being aware of the Essel group’s troubles as early

as January, the two AMCs have informed their investors of their inability to repay the proceeds only at the nth hour. Earlier intimation would have allowed investors to plan their finances better. Other fund houses that have the same exposures in their ongoing FMPs have maintained radio silence even after this fiasco.

Two, despite the many default events roiling debt funds in the last five years, AMCs remain poor at communicating their impact to investors. In this case, while Kotak has been upfront with its investors about the possible loss of returns, HDFC has made no mention of the default, while seeking investor consent for the rollover. It is time for SEBI to evolve a material disclosure regime for mutual funds with standard communication formats, akin to that for listed companies.

Three, there’s also the question of how such concentrated exposures to the doubtful paper came to be held in FMPs, which are supposed to be conservatively managed. To tackle this, SEBI needs to more strictly enforce security-specific limits in debt funds and bar inter-scheme transfers in close-end products.

Mutual fund managers on their part, have a lot of soul-searching to do on whether the extra returns they’re chasing through promoter loan-against-share deals are worth the risk. The Essel and Ambani group episodes clearly show that the collateral in such deals fails bond-holders at the critical hour. It is also about time that fund trustees, tasked with the fiduciary duty of overseeing AMCs, demanded greater accountability from them instead of mutely rubber-stamping all their decisions. Clearly, fixed income investors who were widely mis-sold balanced funds for their ‘regular’ monthly dividends were caught unawares by market risks. The debt category, shaken by both rate uncertainty and default events, saw investors withdraw money from long-term products to park it in the ostensibly ‘safer’ liquid funds. While sustained flow into mutual funds in a difficult year is good news, the above trends flag three problem areas that the industry needs to address on a war footing. One, despite routine disclaimers about market risks, many first-time investors into both

equity and debt funds come in with little understanding of the risks to their capital Two, debt mutual funds have done a poor job of conveying their inherent risks to retail

investors, with supposedly ‘safe’ products such as Fixed Maturity Plans and liquid funds suffering default events. There is thus a strong case for the industry’s investor


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education efforts to veer away from campaigns promoting SIPs or debt funds, to an honest discussion of how market risks work.

Finally, with asset sizes scaling up manifold and the performance gap between active and index products shrinking, the industry needs to get more proactive about lowering costs, without regulatory intervention.

Net Interest Margin of NBFCs likely to come under pressure With limited availability of liquidity and sell-down of portfolios, net interest margins

(NIMs) of non-banking finance companies (NBFCs) might be under pressure across the board, with small- and low-rated NBFCs facing balance sheet contraction.

NIM, which indicates how well a lender manages its assets and liabilities, is measured as the excess of interest income over interest expense scaled by total assets.

In some of the sub-sectors, such as housing finance, the high leverage is a cause for concern, and needs to be addressed appropriately along with efficient asset-liability management (ALM), which will always be critical.

NBFCs, with higher exposure to SMEs/loan against shares and developer loans, may see near-term pain. Due to liquidity crunch in system there is increase in the cost of funds.

NBFCs have been playing an important role in bridging the gap between organised and unorganised lending, and are considered an important pillar of the economy. “In recent times, the regulators have come out with various policy measures, including partial credit enhancement. harmonization, and co-origination as an enabler for the sector.” RBI’s recent announcement of setting up a committee on the Development of Housing Finance Securitisation Market is a welcome move, as a liquid secondary mortgage market would enable competitive interest rates and better asset liability management for financial institutions. Liquidity issues for NBFCs NBFCs are known as India’s shadow banking sector, a big source of credit to the country’s small and medium enterprises, realtors, homebuyers and consumers. Following the IL&FS crisis in August 2018, funds availability to NBFCs went down. Large entities such as Zee Group and Dewan Housing Finance Ltd plunged into crises creating worry for their lenders. Then Reliance Communications decided to file for bankruptcy and Anil Agarwal-promoted Vedanta got downgraded. Mutual funds that lend to these entities through a short-term lending instrument called commercial papers turned off the tap.

As a result, government woke up and asked the Reserve Bank of India to help. RBI made it easier for banks to lend to NBFCs. But this move came only after the financial services industry got its second and third jolt in January and February this year. Edelweiss and other NBFCs of their size and risk management abilities have prepared well for another round of squeeze. But what about the smaller players?


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Can they survive more jolts? The situation can be a corrective phase for NBFCs. For the health of the larger NBFCs, there is no issue. But the smaller ones will have to change the way they borrow and look more at bonds and banks.Debt mutual funds had lent 30 per cent of their money to NBFCs and housing finance companies (DHFL took a large share of that, including up to 30 per cent of specific debt funds).

Rising scrutiny of credit risk in debt funds is likely to keep flows to them volatile, constraining NBFC funding.Large investors in debt mutual funds have instructed managers not to lend to specific entities. The Credit Suisse report points out that as compared to August, the mutual funds’ lending to DHFL has fallen by 60 per cent.

The cost of funds are up, but money is there. Credit flow is still restricted for small NBFCs that were dependent on short term borrowings from mutual funds using commercial papers. The convenient thing about commercial papers is that they are available at a lower rate of 6.9 per cent, which make them more attractive to a buyer than the 6.5 per cent returns from government bonds. While this was the rate at which NBFCs would borrow, they could lend at a little more than benchmark rates of around 8.5 per cent set by large banks such as the State Bank of India.

The problematic part of this model is that while lending by NBFCs is for a longer term, commercial papers are inherently a short-term instrument. So the NBFCs have to keep paying off and raise fresh rounds several times a year.This mismatch between borrowing (liabilities) and lending (assets) is not unusual. Housing finance companies that lend for long term like 20 years have to do it anyway. Problems crop up when suddenly; the tap of commercial paper gets turned off as is happening now.

Some other funding taps may also run dry. Many home buyers prepay loans after 8 to 10 years. When there is a financial crunch, these pre-payments also may not happen. In the short term, large NBFCs have been able to raise their level of liquidity to tide over the crisis.

Liquid assets have gone down to as low as 8 per cent. Higher liquidity comes at a cost called negative carry. It is the difference between interest earned on holding the money in liquid instruments and lending it out. The only way out is to diversify assets and liabilities -- borrow from diverse sources including abroad and lend to a wider range of sectors.

The change of guard at the Reserve Bank also seems to have helped. Das took over on December 12 and delivered a rate cut, apart from making it easier for banks to lend more. However, Das has brought something more to the table.RBI is “far more consultative” now and eager to understand the problems of the sector. The RBI team, he says, took notes of what people from the NBFCs said.

IIFL too has just raised Rs 1,100 cr through non-convertible debentures. As bad news continues to come, IIFL stays liquid, diversifying funding base and securitising our assets.

Balance sheet of NBFCs needs to be efficient, and they should look at selling assets or churning them instead of looking at plain growth. However, there are challenges beyond assets and liabilities and not every player can come out unscathed.


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There is also the pressure on demand in specific segments such as high-tonnage commercial vehicles and real estate and even industries. NBFCs with strong parentage are safe, like Tata Capital or L&T Finance or Mahindra Finance that can go and borrow from their parent groups. There is problem at both ends of the spectrum. NBFCs that are in the middle are safe. The large or the small ones need to be careful.

Recent SEBI reforms (in Sep 2018) All mutual fund commissions and expenses must be paid from the scheme itself. Industry must adopt a full

trail model of commission in all schemes without paying any upfront commission. Trail commissions are payments earned by distributors as long as investors stay invested in the scheme.All-trail model helps better align the distributors’ interest with the investors, thereby benefiting the retail investor. However, it may become difficult for new distributors to enter the market.

Sebi capped the total expense ratio (TER) for equity-oriented mutual fund schemes (close-ended and interval schemes) at 1.25% and for other schemes at 1%. The TER cap for fund of funds will be 2.25% for equity-oriented schemes and 2% for other schemes.The board took note of the benefits of the (Sebi mutual fund advisory committee) proposal with respect to sharing of economies of scale, lowering the cost for investors, bringing in transparency in appropriation of expenses, and reducing mis-selling and churning,".

Sebi also reduced the time period for listing after an initial public offering to three days from six, freeing up locked investor funds faster. Early listing and trading of shares will benefit both issuers and investors. “Issuers will have faster access to the capital raised, thereby enhancing the ease of doing business and the investors will have early liquidity. Unified Payment Interface (UPI) has been introduced as a payment mechanism for retail investors in IPOs.

Sebi allowed interoperability of clearing corporations, helping market participants consolidate their clearing and settlement functions at a single clearing house and reducing the effective trading cost for investors. Interoperability will lead to efficient allocation of capital for the market participants.

The Sebi board approved a framework for enhanced market borrowings by large companies (outstanding borrowing of Rs.100 crore or more), which will come into effect from 1 April 2019 and require firms to raise 25% of their incremental borrowings through bond market.

As a first step for opening up the commodity derivatives markets to foreign participants, the board approved the regulatory framework for permitting foreign entities having actual exposure to Indian commodity markets to participate in the domestic commodity derivatives markets.

Appraisal of above SEBI steps: Main focus of above reforms- Sebi’s announcements were aimed at making the capital markets ecosystem more efficient and attractive for participants. The board took steps to reduce transaction costs, improve liquidity, increase market participation, improve capital allocation, penalize fraudulent activities and protect small investors, besides having a more efficient price discovery system. Permitting foreign entities in the commodity derivatives market will not only help increase market participation, but could also lead to more innovation and increase liquidity.


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Municipal Bonds Municipal bonds (munis) are debt obligations issued by government entities. When you buy a municipal bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity date, and the full amount of your original investment is returned to you. Types of Municipal Bonds Municipal bonds come in the following two varieties:

general obligation bonds (GO) revenue bonds

General obligation bonds, issued to raise immediate capital to cover expenses, are supported by the taxing power of the issuer. Revenue bonds, which are issued to fund infrastructure projects, are supported by the income generated by those projects. Both types of bonds are tax-exempt and particularly attractive to risk-averse investors due to the high likelihood that the issuers will repay their debts.

Credit Risk: Although buying municipal bonds is low-risk, they are not without risk. If the issuer is unable to meet its financial obligations, it may fail to make scheduled interest payments or be unable to repay the principal upon maturity. According to Moody's data, there continues to be a very clear delineation in default rates beginning in 2007. Between 1970 and 2007, Moody's reported an average of only 1.3 defaults per year in the muni bond sphere. That number quadrupled after 2007, highlighted by seven defaults in 2013. The advantages of using municipal bonds to finance urban infrastructure are increasingly evident in India. The Indian Bond Market is becoming vibrant. Ahmedabad Municipal Corporation issued a first historical Municipal Bond in Asia to raise Rs 100 crore from the capital market for part financing a water supply project. An illustrative list of ULBs/parastatals, which have been granted permission to issue Municipal Bonds is given in the table.

National Financial Reporting Authority (NFRA)

On 1ST March 2018 Union Cabinet approved the establishment and functioning of National Financial Reporting Authority (NFRA)1, followed by approval by capital market regulator Securities Exchange Board of India (SEBI).

Ministry of Corporate Affairs (MCA) through its notification dated 21st March 2018, approved the establishment and functioning of National Financial Reporting Authority (NFRA) under section 132 of Companies Act 2013.2 The Authority functioning will be governed by National Financial Reporting Authority (Manner of Appointment and other terms and conditions of service of chairperson and members) Rules 20183.


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OBJECTIVE The purpose behind constitution of NFRA is:

to enhance institutional oversight over auditors and to improve market integrity, transparency and protection of the interest of investors and other stakeholders like banks, lending institutions, suppliers,

etc.

NEED FOR NFRA In the US, failure of ENRON resulted in the introduction of stringent self-regulations by the U.S accounting and auditing profession in 2002, which lead to the need and introduction of the Sarbanes-Oxley Act 2002 that ushered in new corporate governance and disclosure requirements by corporate entities.

In India, the exposure of Satyam Scam resulted in floating the same idea, which was to have an authority to protect the interest of investors and provide true and fair view of financial statements of companies. Further the recent financial scams and defaults on account of debt of big market players ignited the need for such Authority. Moreover 132 listed companies were put under Additional Surveillance Measure List whose scrips were suspended by SEBI for abnormal price rise, not supported by the fundamentals of the companies. Thus reiterating the need for an independent audit regulator.

LEGAL BACKGROUND Section 132 of Companies Act 20134 provides that National Financial Reporting Authority (NFRA) shall be responsible for

a. Making recommendations to the Central Government on the formulation and laying down of accounting and auditing policies and standards for adoption by companies or class of companies or their auditors, as the case may be;

b. Monitor and enforce the compliance with accounting standards and auditing standards in such manner as may be prescribed;

c. Oversee the quality of service of the professions associated with ensuring compliance with such standards, and suggest measures required for improvement in quality of service and such other related matters as may be prescribed; and

d. Have the power to investigate, either suo motu or on a reference made to it by the Central Government, for specified class of bodies corporate or persons, into the matters of professional or other misconduct committed by any member or firm of Chartered accountants.

PENALTY Section 132 of Companies Act 2013 clearly states that where professional or other misconduct is proved, the authority can pass an order for -

1. Imposing penalty of - i. Not less than one lakh rupees, but which may extend to five times of the fees received, in case of

individuals; and ii. Not less than ten lakh rupees, but which may extend to ten times of the fees received, in case of

firms6;


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2. Debarring the members or the firm from engaging himself or itself from practicing as member of the Institute of Chartered Accountant of India for a minimum period of six months or for such higher period not exceeding ten years as may be decided by Authority.

ICAI V/S MCA The Institute of Chartered Accountants of India (ICAI) has expressed dissenting views over the constitution of NFRA. ICAI in its Standing Committee Report clearly stated that constitution of NFRA will lead to-

1. Multiple Regulatory Bodies: Creating NFRA would result in two regulatory bodies (ICAI and NFRA) governing the same audit profession. This would result in duplication of efforts.

2. Constitution of NFRA will be a costly affair. 3. Relevance of NFRA in the context of the Companies Act 2013: The objective of NFRA is to regulate audit

quality and protect public interest. These are also the main objectives of ICAI which strives to be a world class regulator.

4. Auditing Standards: ICAI as a world class regulator would be more aligned to market needs and NFRA regulatory provisions are yet to be examined.

5. The ICAI has sufficient regulatory, supervisory, organizational and budgetary independence as regards to the audit profession.

CONCLUSION Looking at the initial developments National Financing Regulatory Authority (NFRA) has been set up as an oversight body having quasi-judicial authority to oversee matters of professional misconduct by Auditors and Chartered Accountants. It is further observed that similar oversight bodies also exist in other countries, i.e, Financial Services Authority (FSA) in United Kingdom and Public Company Accounting Oversight Board (PCAOB) in United States. However, as issues relating to conflict of mandate with regard to disciplinary matters between the NFRA and ICAI, it should not create two parallel jurisdictions governing the same issue. The NFRA should be able to function without any jurisdictional conflicts. Finally government penal has concluded that: “In view of the critical nature of responsibilities wherein lapses have been seen to cause serious repercussions, the need for an independent body to oversee the profession is a requirement of the day”.

But experts opine that introduction of NFRA is in line with the international practice (for example the US’ Public Company Accounting Oversight Board) of having an independent regulator, which monitors the auditors

Regulatory Sandbox Background: RBI set up an inter-regulatory Working Group (WG) in July 2016 to look into and report on the granular aspects of FinTech and its implications so as to review the regulatory framework and respond to the dynamics of the rapidly evolving FinTech scenario. WG recommended to introduce an appropriate framework for a regulatory sandbox (RS) within a well-defined space and duration where the financial sector regulator will provide the requisite regulatory guidance, so as to increase efficiency, manage risks and create new opportunities for consumers. Accordingly, a structured proposal highlighting the clear principles and role of the proposed RS, bringing out its pros and cons, including the reasons for setting up the RS and the expectations of the RBI, are detailed hereunder. What is Regulatory Sandbox? A regulatory sandbox (RS) usually refers to live testing of new products or services in a controlled/test

regulatory environment for which regulators may (or may not) permit certain regulatory relaxations for the limited purpose of the testing.


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The RS allows the regulator, the innovators, the financial service providers (as potential deployers of the technology) and the customers (as final users) to conduct field tests to collect evidence on the benefits and risks of new financial innovations, while carefully monitoring and containing their risks.

It can provide a structured avenue for the regulator to engage with the ecosystem and to develop innovation-enabling or innovation-responsive regulations that facilitate delivery of relevant, low-cost financial products. The RS is potentially an important tool which enables more dynamic, evidence-based regulatory environments which learn from, and evolve with, emerging technologies.

Objectives The RS provides an environment to innovative technology-led entities for limited-scale testing of a new

product or service that may or may not involve some relaxation in a regulatory requirement before a wider-scale launch.

The RS is, at its core, a formal regulatory programme for market participants to test new products, services or business models with customers in a live environment, subject to certain safeguards and oversight.

The proposed financial service to be launched under the RS should include new or emerging technology, or use of existing technology in an innovative way and should address a problem, or bring benefits to consumers.

Benefits of Regulatory Sandbox: The setting up of an RS can bring several benefits, some of which are significant and are delineated below: 1. RS fosters ‘learning by doing’ on all sides.

Regulators obtain first-hand empirical evidence on the benefits and risks of emerging technologies and their implications, enabling them to take a considered view on the regulatory changes or new regulations that may be needed to support useful innovation, while containing the attendant risks.

Incumbent financial service providers, including banks, also improve their understanding of how new financial technologies might work, which helps them to appropriately integrate such new technologies with their business plans.

Innovators and FinTech companies can improve their understanding of regulations that govern their offerings and shape their products accordingly.

Finally, feedback from customers, as end users, educates both the regulator and the innovator as to what costs and benefits might accrue to customers from these innovations.

2. Users of an RS can test the product’s viability without the need for a larger and more expensive roll-out. If the product appears to have the potential to be successful, the product might then be authorized and brought to the broader market more quickly. If any concerns arise, during the sandbox period, appropriate modifications can be made before the product is launched in the broader market.

3. FinTechs provide solutions that can further financial inclusion in a significant way. The RS can go a long way in not only improving the pace of innovation and technology absorption but also in financial inclusion and in improving financial reach. Areas that can potentially get a thrust from the RS include microfinance, innovative small savings and micro-insurance products, remittances, mobile banking and other digital payments.

4. By providing a structured and institutionalized environment for evidence-based regulatory decision-making, the dependence of the regulator on industry/stakeholder consultations only is correspondingly reduced.

5. RS could lead to better outcomes for consumers through an increased range of products and services, reduced costs and improved access to financial services.

Risks and Limitations of RS: 1. Innovators may lose some flexibility and time in going through the RS process (but running the sandbox

program in a time-bound manner at each of its stages can mitigate this risk).


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2. Case-by-case bespoke authorizations and regulatory relaxations can involve time and discretional judgements (this risk may be addressed by handling applications in a transparent manner and following well-defined principles in decision-making).

3. The RBI or its RS cannot provide any legal waivers. 4. Post-sandbox testing, a successful experimenter may still require regulatory approvals before the

product/services/technology can be permitted for wider application. 5. Regulators can potentially face some legal issues, such as those relating to consumer losses in case of failed

experimentation or from competitors who are outside the RS, especially those whose applications have been/may be rejected. These, however, may not have much legal ground if the RS framework and processes are transparent and have clear entry and exit criteria. Upfront clarity that liability for customer or business risks shall devolve on the entity entering the RS will be important in this context.

Eligibility Criteria for Participating in the Sandbox: The target applicants for entry to the RS are FinTech firms which meet the eligibility conditions prescribed for start-ups by the government. The focus of the RS will be to encourage innovations where

i. there is absence of governing regulations; ii. there is a need to temporarily ease regulations for enabling the proposed innovation;

iii. the proposed innovation shows promise of easing/effecting delivery of financial services in a significant way.

An indicative list of innovative products/services/technology which could be considered for testing under RS is as follows. Innovative Products/Services Retail payments Money transfer services Marketplace lending Digital KYC Financial advisory services etc.

Innovative Technology Mobile technology applications (payments, digital identity, etc.) Data Analytics Application Program Interface (APIs) services Applications under block chain technologies Artificial Intelligence and Machine Learning applications

Regulatory Requirements/Relaxations for Sandbox Applicant Customer privacy and data protection Secure storage of and access to payment data of stakeholders Security of transactions KYC/AML/CFT requirements Statutory restrictions Exclusion from Sandbox Testing: An indicative negative list of products/services/technology which may not be accepted for testing is as follows: Credit registry Credit information Crypto currency/Crypto assets services


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Trading/investing/settling in crypto assets Initial Coin Offerings, etc. Chain marketing services Any product/services which have been banned by the regulators/Government of India Extending or Exiting the Sandbox: At the end of the sandbox period, the regulatory relaxations provided to the entities will expire and the sandbox entity must exit the RS. In the event that the sandbox entity requires an extension of the sandbox period, it should apply to the RBI at least one month before the expiration of the sandbox period. The sandbox testing will be discontinued any time at the discretion of the RBI if the entity does not achieve its intended purpose, based on the latest test scenarios, expected outcomes and schedule mutually agreed by the sandbox entity with the RBI. Further, the RS may also be discontinued if the entity is unable to fully comply with the relevant regulatory requirements and other conditions specified at any stage during the sandbox process. The sandbox entity may also exit from the RS at its own discretion by informing the RBI one week in advance. The sandbox entity should ensure that any existing obligation to its customers of the financial service under experimentation is fully addressed before exiting the RS or discontinuing the RS. Boundary Conditions: RS must have a well-defined space and duration for the proposed financial service to be launched, within which the consequences of failure can be contained. The boundary conditions for the RS may include the following: Start and end date of the RS Target customer type Limit on the number of customers involved Transaction ceilings or cash holding limits Cap on customer losses Consumer Protection: The sandbox participant will be required to ensure that any existing obligations to the customers of the financial service under experimentation is fulfilled or addressed before exiting or discontinuing the RS. It may be noted that entering the RS does not limit the entity’s liability towards its customers. The entities entering the RS must be upfront and, in a transparent way, notify test customers of potential risks and the available compensation and obtain their explicit consent in this regard.

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