Criteria For Rating Hybrid Instruments Issued By NBFCs & HFCs
10th October 2019 (Version 3)


Introduction

The recent changes in the regulatory framework governing the capital adequacy requirements for non-banking finance companies (NBFCs), including Housing Finance Companies (HFCs), have resulted in the introduction of several hybrid instruments aimedat strengthening the regulatory capital basefor these financial institutions. Financial institutions have been issuing such instruments sinceFY2008-09 and the volumes have increased significantly over the last five years. These instruments have attributes of both - equity and debt-instruments and are differentiated based on their loss absorption characteristics.

These instruments typically carry higher risk mainly because the issuers could face restrictions on servicing the coupon on these instruments in case their capital adequacy below the levels stipulated by the Reserve Bank of India, National Housing Bank (in case of HFCs) or in case of losses incurred by the issuer.

Type of Instrument Characteristics*
Maturity Capital Treatment Seniority Discretion Regarding Coupon payment Loss Absorption Capacity
Lower Tier II Debt Instruments  (Sub-Debt) Minimum 5 years A portion of the Lower Tier II Debt forms a part of the Regulatory Capital of the issuer These bonds are subordinated to other creditors/ senior debt None None
Upper Tier II Instruments Minimum 15 years Upper Tier II Capital and Lower Tier II Capital cannot be in excess of the total Tier I Capital Subordinated to all creditors - excluding Tier I debt Coupons may be deferred and are cumulative Principal may be written down in case of shortfall in regulatory capital
Tier I Bonds
(Perpetual Debt)
Perpetual Part of the Tier I Capital upto a maximum of 15% of the total Tier I Capital. Excess quantum shall be included as a part of the Tier II Capital Subordinated to all other creditors Coupons are deferred if the regulatory capital falls below the statutory requirement; or in case payment of the coupon results in the regulatory capital falling below the statutory requirement In case of accumulation of losses/shortfall in regulatory capital requirements, principal amount may be written down

Rating Framework

Acuité's evaluation of hybrid instruments is a three step process:

  1. The long term conventional bond ratingof the issuer is evaluated in line with the relevant rating criteria. The criteria for rating NBFCs is available on: https://www.Acuité.in/criteria-nbfc.htm
  2. Subsequently, the Resource Mobilisation Ability of the issuer is examined by considering the degree of parent/group support, shareholding pattern, funding profile and demonstrated ability to augment its capital structure from diverse sources.
  3. The rating so arrived at based on step 1 and step 2will be the upper cap for the rated hybrid instrument.Acuité believes that any instance of default on the senior debt or the Lower Tier-II debt shall inevitably lead to default on the issuer's hybrid instruments. Acuité may equate the rating of the subordinated debt instrument with that of the conventional debt due to the absence of significant loss absorption characteristics in such instruments.

  4. The final rating for the Hybrid Instrument is then either equated or notched down based on factors like the issuer's:
    1. Current Capital Adequacy Ratio (CAR) and the cushion available with regard to the regulatory requirement
    2. Expected movement in CAR over the medium term vis the expected growth rate in Risk Weighted Assets
    3. Probability of Servicing the coupon/interest in the event of loss

Based on the above factors, Acuité may notch up the ratingby up to three notches.

Acuité also notes that in the recent past, the financial sector regulators (RBI and NHB) have allowed issuers to service their interest/coupon commitments on hybrid instruments despite reporting losses - subject to complying with minimum regulatory capital requirements. However, Acuité takes note that in certain unforeseen circumstances, such approvals may be withheld by RBI/NHB and thus the sameconstitutes an important risk factor in the evaluation of hybrid instruments.

Treatment of Preference Shares

Preference shares (Other than those issued to Promoters) shall be treated as debt unless they are compulsorily convertible into equity shares. Acuité shall also be guided by the coupon rate and the residual tenure of the preference shares while deciding the analytical treatment to be accorded. From a legal standpoint, a lender, in distress situation, is in a senior position vis a vis a preference shareholder about claims on the cash flows and the assets. Notwithstanding the legal position , an issuer of preference shares may find it difficult to renege on his commitments to the preference shareholders as such an event will be construed as indicative of deterioration in the credit quality of the issuer , thereby having implications for future fund raising and pricing of debt. 

Preference shares issued to Promoters will be treated as equity only if the promoters furnish an undertaking that these shares will be not redeemed till the currency of the bank facilities & any redemption will be refinanced through promoter infusion of an equal amount through equity or equity like instruments 

Default Risk Drivers

The default risk arising out of non-payment of coupon/interest on hybrid instruments is linked to the likelihood of the Capital Adequacy Ratio (CAR) of the issuer falling below the regulatory requirement.
Acuité evaluates two risk factors to ascertain the probability of occurrence of any of the above events of default:

  1. Capital adequacy and historic volatility in CAR: The CAR requirement varies across categories of issuer. NBFCs are required to maintain a CAR of 15% while HFCs need to maintain 12%. Acuité examines the individual components of CAR (such as Common Equity Ratio etc.) and how it compares to the regulatory requirements.
  2. Acuité further assesses the available headroom between the current CAR of the issuer vis the regulatory requirement. The historical volatility in CAR enables Acuité to estimate the propensity of the issuer's CAR deteriorating below the regulatory requirement.

    Acuité evaluates the expected movement in the internal accretion to the issuer's net worth and movement in the risk weights in the issuer's portfolio. An issuer's CAR may experience significant deterioration in case the issuerdecides to take on relatively riskier lending practices or experiences a sudden spike in delinquency levels. Such movements in CAR are affected by the macroeconomic conditions, sectoraland geographic composition of the asset portfolio, collateralisation level, capital structure and interest spreads of the issuer. Acuité relies on expected movements in indicators such as Net Interest Margin and Return on Average Assets to assess the quality of internal accretions to the net worth of the issuer over the medium term.

  3. Likelihood of servicing the coupon on Hybrid Instruments in the event of loss: The issuer must seek the approval of RBI/NHB in order to service the coupon due on such instruments in the event of loss - even if adequately capitalised in line with regulatory requirements.

Treatment of Default on Preference Shares

From a default perspective a slippage of a single dividend payment ( even if the issue provides for cumulation of dividends ) or slippage on redemption dates ( whether a regular redemption or an early redemption through exercise of option by the preference shareholder) will be treated as default. 

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