RBI proposes partial credit enhancement for corporate bonds by banks

Credit enhancement for the bonds raised to set up the infrastructure project would help to improve credit ratings and better access to corporate bond market

The Reserve Bank of India (RBI) is proposing to allow banks to provide partial credit enhancements to the debt instrument, in a bid to deepen the nascent corporate bond market.

The central bank has released a draft circular on allowing partial credit enhancements to corporate bonds and invited comments from stakeholders by the end of next month.

The mechanism of improving the credit rating of a bond issued for funding infrastructure projects by Companies/SPVs is to separate the debt of the project company into senior and subordinate tranches. The credit enhancement provided by banks will be able to provide such bonds with partial credit enhancement in the form of a subordinated instrument - either a loan or contingent facility - to support senior project bonds issued by the Companies/SPVs, and thereby improve their credit rating.

The objective of allowing banks to extend partial credit enhancement is to enhance the credit ratings of the bonds raised to set up the infrastructure project so as to enable corporates to better access the funds from corporate bond market.

Partial credit enhancement provided by banks shall be limited to the extent of improving the credit rating of bonds (assigned by a recognized external credit rating agency) by a maximum of two notches [including modifiers {"+" (plus) / "-"(minus)} e.g., migration from AA- to AA+ will be considered as an improvement by two notches] or 20% of the entire bond issue, whichever is lower. The above restrictions would apply at the time of issuance of the bond as also when the senior bond amortizes.

Credit enhancements are typically subordinated to the senior bond in terms of repayment priority, but should rank ahead of remaining liabilities of the project such as equity. These act as 'first loss piece' and improve the credit quality of the senior bond.

As a subordinated instrument, partial credit enhancement should serve to increase the credit rating of the senior bonds but not to extend the bank's credit rating to the infrastructure project. Banks cannot also provide partial credit enhancement by way of guarantee.

Credit facilities to the extent funded or drawn in case of non-funded contingent line of credit facilities should be treated as advances in the balance sheet. Credit facilities, typically being 'first loss positions' will attract a risk weight of 1111%.

Non-funded contingent line of credit facilities would be off-balance sheet item and reported under 'Contingent Liability - Others'. They will attract 100% Credit Conversion Factor (CCF) and 1111% risk weight.

If interest/installment (including maturity proceeds) are due and remain unpaid for more than 90 days, the exposure/credit facility becomes non-performing and needs to be fully provided for.

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