RBI disclaims regulation of non banking financial sector(NBFC) LLPs

 In an earlier blog post in Jan-13, I'd written http://financeandcapitalmarkets.blogspot.in/2013/01/warren-buffets-investment-partnerships.html that RBI regulations apply to NBFCs(non banking financial COMPANIES) and not to firms, why should the LLP be subject to this? Section 14 of the LLP Act 2008 states that On registration, a limited liability partnership shall, by its name, be capable of.....(d)  doing and suffering such other acts and things as bodies corporate may lawfully do and suffer. Section 2(d) of the LLP Act2008 defines body corporate.... “body corporate” means a company as defined in section 3 of the Companies Act, 1956 (1 of 1956) and includes..Therefore, since LLP is a body corporate under the Act and subject to other acts applicable to body corporates, the RBI NBFC norms will apply to it to the same extent that they would apply to companies. 

However, in its circular yesterday, the RBI expressed the view that
rbi.org.in/scripts/FAQView.aspx?Id=92  LLPs are regulated by the Ministry of Corporate Affairs and not by it. Is this a case of regulatory arbitrage, given that LLPs are explicitly an alternate to private sector companies? And more importantly, will the Registrar of Companies dispense with RBI approval for LLPs on the basis of this circular? only time will tell.

Will the draft Indian GAAR guidelines discourage creative structuring?

Earlier this year, the Indian Revenue Department released its position paper on implementing the much awaited anti tax avoidance rules, expectedly on pro revenue lines. What was of interest in the paper (http://finmin.nic.in/the_ministry/dept_revenue/Draft_GAAR_GuidelineITAct1961.pdf) besides the illustrations, was the criteria for defining  impermissible avoidance arrangement  as one whose

(a) its main purpose is to obtain a „tax benefit‟, and,

(b) it also has one of the following characteristics:

(i) it creates rights and obligations, which are  not normally created between parties dealing at arm‟s length; (ii) it results in misuse or abuse of the provisions of the tax law; (iii) it lacks commercial substance; (iv) it is carried out by means or in a manner which is normally not employed for an authentic (bona fide) purpose.

It is point b(iv) that bears interest here. Structuring of transactions(for my earlier posts on structuring read these posts    ), needs ample creativity, customization and is often only constrained by the regulations/tax laws which it aims to circumvent. Such an explicit provision will give the Revenue leverage to attack innovative structures, and therefore defeat the first mover advantage of the early adopters. Of course, this may only ensure legal wars over the meaning of ‘normally not employed’ and so on, but this puts innovative structures at risk. Hence, till more clarity on this point, those structuring transactions for Indian clients would be well advised to exercise caution. 

How banks price their loans and products

When I googled this title, guess how many results I got? Zero.zilch.nada. That in itself spurred me on to write something on which there is little organized information. I am not(yet!) an expert on pricing but from what I have seen of the structuring, trading and risk sides of banks, I think I can venture some informed views on this manner. More knowledgeable readers are welcome to comment on this primer in FAQ form.

1. Every business needs to price its products. What is so exotic about banks? Other businesses may view increased volumes as a success of their pricing strategy. But for a bank, a spurt in volumes may merely mean that is pricing model is broken, and that others are taking advantage of that till the bug is fixed! Hence, risk pricing is error prone, yet important.
2. How is risk priced in? We do not have(yet) that one universal calculator which will spit out an integrated figure for all risks. So often the systems are fragmented. Credit risk calculations are often bifurcated into counterparty(interbank/other FIs) and client risk(normal corporate transactions). And there are many ways to splice other transactions. So finally, an excel/other manual systems are needed to make sense of this mess of figures
3. But why does not some one automate it? It is a control issue. Given the high sensitivity of prices, and the subjective adjustments needed, there is a limit to everything-even for flow trading! 
4. We learn this in marketing 101. Do those principles apply here? Yes and no. Yes because the exact pricing decision will depend on how well the pricer knows the client, which is again related to marketing. But no because the performance management system of banks ensure that the cost of funds charged to the trader, is often determined post facto, and so there need to be relatively accurate and robust models available for trade negotiation and evaluation. And while geeks/quants can design it, the end users need to know the ins and outs of the model, including its limitations, so that for extreme cases they can use modifications. For example, while executing a large trade which will move the ALM curve and the market, the liquidity adjustments among others would need to be made upfront. 
5. Floating or fixed rate? Depends totally on the risk appetite of the bank and the relationship/focus on that client. For example, Indian banks give fixed rate education loans to IIT/IIM/other top colleges students, while the ordinary student is exposed to floating rate risk.

IF you require a diagram to explain a transaction then it is a structured finance transaction!

The building blocks of financial products are fairly simple-equity and debt. One can mix and match to get convertible debt, preferred stock, subordinated debt but finally they all boil down to a combination of those. Gone were the days where a transaction between A & B would mean a direct fund transfer from A to B. In today's era of risks, tax, legal structures, contractual protection etc, even simple transactions are routed through SPVs. But where legal vehicles are used to split the cash flows, risks and contracts, there are issues there and structured finance comes in then.

Take the typical project finance example. Lenders would demand inbuilt safeguards of SPVs, holding operating cash flows in trust to repay their dues etc. Also, expropriation scarred MNCs may demand an offshore vehicle to hold the assets with a domestic vehicle typically guaranteeing the debt. One can make the structure as complex as possible mixing and matching LLPs, firms, companies, trusts, JVs, association of persons etc(thereby enriching their lawyers/accountants in the process). And at times, it is commercially justified to become more complex if by that, you can split your assets into different pools(with lower credit risk) and issue debt in tranches(thus expanding your investor base). The reason that infrastructure, pharma and banking companies have such complex structures(and plenty of jurisdictions), is to be able to use the right structure to tap an investor base at the best possible rate.

Structuring-the art of making the 'impossible' into reality

People managing the Sales & Distribution functions in a complex indirect tax environment (like India) like India, have long known that sometimes you sacrifice commercial rationale to achieve the most efficient post tax outcome. Luckily, such sub optimal structures are less common in financial structuring, where the client and bank jointly work to tailor existing products to the client needs. To use an analogy, a structurer does not create value out of thin air, he merely stitches the threads of accounting, legal, tax, financial, capital etc together to obtain a structured product. While structured products were blamed for the financial crisis, and are still accused as being too complex(and thus hard to value), we should note that their purpose is to solve a client problem. And that basic need does not change even for structures aimed at regulatory arbitrage.

So how does the impossible become possible? Lets see some examples

1. You are a mutual fund prohibited from investing in certain asset classes, which would aid your strategy. Try investing in a structured note(seemingly debt) that mirrors your investment view. The payoff diagram would then hopefully achieve what was earlier prohibited
2. As an investor, you cannot exceed your ownership limits in listed securities without making an open offer. Try a total return swap to get economic ownership without the hassle of legal title
3. You want principal protection yet need a good upside-which conventional debt products do not permit. Take a principal protected note which is a zero coupon bond(or variants) with the balance invested in very risky instruments to achieve the upside for the entire amount
4. You would like to participate in a derivative product but the dealers will only deal with other banks/or margin requirements may be too high. The bank would therefore package this into a structured note.
5. As a bank/private company, you want to reward your top people with market linked incentives but cannot/do not want to issue shares. Offer performance shares/restricted stock etc

 I can go on and on but the message is clear. The job of Structuring is to design a way for an investor to express his investment view. Where restrictions/internal issues do not permit for conventional products, then structured products prevail. Some of them get internalized into every day jargon like convertible bond, repo etc.