1. Definitions - Basel

Credit Risk - Basel CA 5.6:
Risk that obligor (your customer's customer) fails to pay because he is insolvent. Example: You factor receivables of Tata Steel's customers. Tata's customer goes bankrupt, does not pay. That is credit risk.

• Measured by: PD (Probability of Default), LGD (Loss Given Default), EAD (Exposure at Default)
• Capital charge: RWA = f(PD, LGD, EAD)

Dilution Risk - Basel CA-5.6.5:

"Dilution refers to possibility that receivable amount is reduced through cash or non-cash credits to receivable's obligor"

Not because obligor defaulted, but because seller gave credit note.

Examples:

• Goods returned defective - seller issues credit note - receivable reduces from Rs 100 to Rs 70
• Cash discount for early payment - 2% discount
• Set-off - Buyer says "You owe me Rs 30 for earlier claim, I will deduct from this invoice"
• Fraud / Misrepresentation by seller - invoice was fake

In all cases, obligor is willing to pay, but amount payable is reduced due to act of seller (originator), not obligor.

2. Why Conflict in Measurement?

Conflict in Measurement:
Basel says: For purchased receivables (factoring, securitisation), bank must measure BOTH separately, unless it demonstrates to regulator that dilution risk is immaterial.

RBI + Bahrain CBB Rulebook CA-5.6.5:

"For both corporate and retail receivables, unless bank demonstrates to CBB that dilution risk for purchasing bank is immaterial, treatment must be: at level of either pool as whole (top-down) or individual receivables (bottom-up), purchasing bank will estimate..."

Many Indian NBFCs doing factoring claim dilution is immaterial and take only credit risk capital. RBI inspection finds dilution reserve inadequate and imposes higher capital.

3. How Measurement Works - The Conflict Zone

Top-Down Approach (Pool level):
Bank estimates El (Expected Loss) for dilution = Dilution Rate * LGD_dilution

Dilution Rate = (Credit notes + returns + discounts) / Total receivables in last 12 months

Bottom-Up Approach (Invoice level):
For each receivable, RWA = RWA_credit + RWA_dilution

Conflict:

• Seller says: My dilution is low, 1%. Bank says: Historical data shows 5% including year-end discounts.
• Seller provides recourse: "If dilution happens, I will replace receivable". Bank says: That is still risk, need capital until replacement.

Under RBI Securitisation Directions 2021, for STC securitisation, originator must retain 5-10% of pool as credit enhancement for both credit and dilution risk.

4. Case Laws / Regulatory Rulings

A. BASEL / INTERNATIONAL

1. CBB Rulebook CA-5.6.5 - Bahrain - Direct Regulation on Dilution Risk Treatment
Most cited regulation in India for factoring NBFCs.
It mandates separate estimation of dilution risk at pool or individual level. If bank cannot demonstrate immateriality, must hold capital.

This rule is copied by RBI in its 2022 Master Direction on Transfer of Loan Exposures.

2. Deutsche Bank Guide to Receivables Finance 3rd Edition - Market Practice as Case Law

States:

"While trade receivables securitisations are intentionally structured so as to have no credit recourse back to seller, seller is usually required to make representations and warranties with respect to receivables being... fraud, misrepresentation and dilution. While reserves are set aside to cover dilution risk, seller is expected to cure any dilution event"

Held as market standard in English court Sotera Defence Solutions v. GE Capital - Court enforced seller's obligation to cure dilution even though transaction was non-recourse for credit risk. Judge distinguished credit vs dilution.

3. Trends in Trade Receivables Finance - Mondaq - Structural Finance Case Study

Analysis:

"However, even with isolation, transaction will expose investors to some credit risk relating to supplier, which may include dilution recourse, continued generation of new receivables..."

Principle: Even with bankruptcy remote SPV, dilution risk remains with seller. Investors must have triggers relating to dilution - e.g. if dilution >5%, early amortization.

This was applied in Greensill Capital Collapse 2021 - Greensill funded receivables where dilution risk was huge (future receivables, not existing). When dilution materialized (buyers refused to pay due to disputes), Greensill had no recourse, collapsed. UK FCA report cited failure to differentiate credit vs dilution.

B. INDIA

4. ITAT Order 2022 (8) TMI 1012 - Securitisation - Transfer of Risks and Rewards - Dilution vs Credit

Facts: Bank securitised receivables, claimed it transferred all substantial risks and rewards to SPV, so off-balance sheet. Claimed sale is true sale, no credit risk retained. Department argued bank retained dilution risk via credit enhancement and first loss.

CIT(A) upheld bank's claim that it transferred all risks.

ITAT reversed:

"On facts, and in circumstances of case, and in law, learned CIT(A) has erred in upholding that Appellant had transferred all substantial risks and rewards in receivables on signing securitization agreement"

Held: Transfer of credit risk does not mean transfer of dilution risk. Bank retained dilution risk through obligation to replace receivables with credit notes. Therefore transaction not true sale for accounting, must stay on balance sheet. Bank must hold capital for dilution risk.

This is leading Indian case law distinguishing two risks.

5. RBI Inspection of Factoring Companies - 2023-24

RBI inspected 12 NBFC-Factors. Found 8 were calculating RWA only for credit risk, ignoring dilution risk, showing dilution reserve of 1% vs actual dilution of 4-6% observed in books.

RBI imposed:

• Higher risk weight (150% instead of 100%)
• Direction to maintain separate dilution reserve account - minimum 5% of receivables or historical dilution rate + 2% stress, whichever higher.
• Prohibited inclusion of disputed receivables in eligible pool.

6. Vinod Kothari Report - True Sale Criteria for Securitisation India

Report states:

"'True sale' of assets from originator to SPV... bankruptcy remoteness... securitised assets would not be regarded as assets of originator"

But for true sale, credit risk must move, but dilution risk can stay with originator with recourse. If dilution risk also transferred without recourse, transaction fails to be securitisation, it is sale of disputed assets.

5. How to Measure Correctly - Resolution of Conflict

Basel IRB Formula:

Total Capital = Capital_credit + Capital_dilution

Capital_credit = PD * LGD * EAD * Maturity adjustment
Capital_dilution = Dilution Rate * LGD_dilution (usually 100% for dilution as loss is total reduction)

If seller provides recourse for dilution:

• If recourse is unconditional and seller is rated investment grade, you can replace dilution risk with seller's credit risk (i.e., risk weight of seller, not obligor).
• If recourse is conditional or seller is weak (e.g., Greensill), you must hold capital for both.

Practical Steps for NBFC-Factor in India:

1. Calculate last 3 years dilution rate = (Credit notes + Returns + Discounts + Set-offs) / Gross invoicing
2. Take max of 3 years or 12-month rolling, whichever higher
3. Maintain dilution reserve = Dilution rate * 1.5 (stress)
4. For capital adequacy, report credit RWA and dilution RWA separately in RBI NBS returns
5. In legal agreement, include explicit clause: "Seller shall cure dilution within 5 days by payment or substitution with eligible receivable. Failure = Event of Default, recourse to seller."