Servicing retained by the originator: servicing fees paid

Refinance companies often leave the borrower relationship with the originating bank, which keeps collecting instalments and pays them over after deducting a servicing fee. Two questions follow for the buyer. First, presentation: interest income should be recognised on the full contractual cash flows the buyer owns, with servicing fees shown as an expense, not netted. Second, substance: if the originator keeps a 'fee' well above normal compensation for servicing, part of what it retains is really a share of the interest (an interest strip), and the buyer has bought only the net cash flows. Treating that excess as a servicing expense overstates both interest income and expenses and misstates the asset purchased. The arrangement also creates a short-term receivable from the servicer for collections not yet remitted, with its own credit risk.

Under the purchase agreement, which cash flows did the refinance company acquire: all principal and interest, or principal and interest less a retained portion? Is the servicing fee a market rate for the services performed (collections, arrears management, reporting), supported by benchmarks such as fees charged by third-party servicers? Does any part of the 'fee' vary with the loans' interest rate rather than with servicing effort, which suggests an interest strip? Is the fee deducted at source, and is interest income recorded gross with the fee as an expense? How long does the originator hold collections before remitting, are they segregated, and is ECL recognised on amounts due from the servicer? Did the buyer pay any upfront amount for servicing set-up, and is it a transaction cost or a prepaid service cost?

1. Identify the cash flows acquired under the purchase agreement. If the buyer acquired all contractual cash flows and pays the originator a separate fee for servicing, recognise the full loans and full interest income.
2. Assess whether the servicing fee is adequate compensation for the services. If the originator retains an amount that exceeds adequate compensation, the excess is a retained share of the interest: the buyer has acquired only the remaining cash flows, and both its initial carrying amount and its EIR should reflect the net cash flows.
3. Recognise market-rate servicing fees as an operating expense when the services are received; they are not transaction costs and are not included in the EIR, because they are payments for future services rather than incremental costs of acquiring the loans.
4. Present interest income and servicing expense gross, without offsetting, unless the buyer has acquired only net cash flows as described in step
5. 5. Recognise collections held by the servicer and not yet remitted as a receivable from the servicer (a financial asset at amortised cost), apply ECL to it, and monitor concentration on the servicer.
6. Treat an upfront payment to the originator: as a transaction cost if it is incremental and directly attributable to the purchase, or as a prepayment of servicing if it pays for future services.

Servicing expense per period = agreed fee rate x balance serviced (or as defined), recognised as incurred. Where an excess retained spread exists, the buyer's asset is measured at the price paid for the net cash flows, and interest income is the EIR on those net cash flows; the 'normal' servicing component is still recorded as an expense if it is separately payable. The receivable from the servicer is measured at the amount collected and not yet remitted, less ECL reflecting the servicer's credit risk and any commingling risk.

Disclose: (1) the servicing arrangements with originators and the accounting policy for servicing fees; (2) servicing expense for the period; (3) amounts due from servicers, their credit quality and any concentration; (4) judgments on whether retained spreads represent servicing compensation or a retained share of interest; (5) related party disclosures where the servicer is a shareholder or related party, including fee terms.

• Recognising interest income net of the servicing fee deducted at source, with no servicing expense
• including ongoing servicing fees in the EIR as if they were transaction costs
• treating an above-market retained spread as servicing expense, inflating interest income
• ignoring amounts collected by the servicer but not yet remitted at period end
• applying no ECL to receivables from servicers on the assumption that banks do not default
• failing to disclose servicing fees paid to a shareholder bank as a related party transaction