EVERGREENING OF LOANS - A STOP DIKTAT FROM THE REGULATOR!

The regulators have not defined the contours for the term ‘ever greening’ and it is probably intentional, as there is indeed no one way to describe these transaction structures

A cross advanced as well as emerging economies, financial lenders have been known to provide last mile credit to borrowers they know to be insolvent or are likely to become insolvent. This practice is colloquially referred to as evergreening, extending and pretending, zombie lending or forbearance lending. Scholars have proffered various explanations behind this phenomenon. Often lenders evergreen bad loans to avoid writing-off their existing capital as per applicable provisioning norms. This ultimately causes misallocation of credit and regulatory intervention is therefore justified to keep a watch on such practices.

Indian banking sector is not new to this problem. Interestingly though, the regulators have not defined the contours for the term ‘evergreening’ and it is probably intentional, as there is indeed no one way to describe these transaction structures. In a new twist to this age-old vice, the private credit market is now in the spotlight for evergreening.

In May 2023, the RBI governor Shaktikanta Das revealed that the central bank had noticed some innovative ways of concealing the real status of stressed loans. In October 2023, SEBI WTM Ananth Narayan G. specifically noted that many AIFs have been structured to allow NBFCs to circumvent extant regulations on recognition and disclosure of stressed assets. Against this backdrop, the structure that became prevalent was where the NBFC along with other investors invests in units of an AIF’s scheme. Typically, the NBFC takes higher risk by investing in junior or subordinate tranches of AIF units, while other investors take lesser risk by investing in senior tranches. The AIF then lends this money to a stressed debtor company (which is also a borrower of the NBFC)by purchasing its bonds. The debtor company in turn uses this money to pay back the NBFC, avoiding immediate default on its loan. Effectively, an NBFC could use this structure to make additional investments into a stressed debtor company through an AIF only to avoid immediate default, bypassing the need to set aside capital for provisioning. While this is a simple classic example of evergreening, it is well known in the market that based on this model, various innovative transactions were structured, especially in cases of exposure to real estate and other risky sectors.

It was therefore not completely surprising that the RBI issued an instruction on December 19, 2023to its regulated entities (REs) including NBFCs to curb evergreening through AIFs. RBI prohibited an RE from investing in an AIF which has direct or indirect downstream investments in a company to which the RE currently has or anytime during the preceding 12 months had a loan or investment exposure. The RBI in a surprising move also stipulated that the REs that violate this rule must liquidate their investments in such AIF within 30 days or make 100% provision on such investments. Further, investments by REs in subordinated units of any AIF scheme with a ‘priority distribution model’ shall be subject to full deduction from the RE’s capital funds. While it has always been an issue which the RBI has highlighted to its RE during the course of its yearly inspection, such a diktat which has punitive ramifications is indeed new from the regulator.

As reference, Piramal Enterprises Ltd. (PEL) disclosed investments of Rs. 3817/- crores in AIF units. Out of this, only Rs. 653 crores have no exposure to any debtor company of PEL.PEL now plans to adjust the remaining Rs. 3164/- crores through capital funds or provisions. Similar impact would be seen on various other REs.

Beyond such immediate impact, this circular would have wider unintended ramifications as some industry veterans have cautioned. This is because the circular prohibits an RE from making any ‘investment in any scheme of AIFs which has downstream investments either directly or indirectly in a debtor company of the RE’. Evidently, the circular does not merely restrict debt transactions.

Take for instance that National Investment and Infrastructure Fund (NIIF), which is registered as Category II AIF. If an RE (say a public sector bank) has invested in units of any scheme of NIIF, then NIIF would be prohibited from investing in the equity of any company which has borrowed from such a RE in the last 12 months.

Similarly, Small Industries Development Bank of India (SIDBI) is a critical provider of capital for SMEs and invests through AIFs. Such AIFs can no more invest in the equity of an SME if SIDBI has given a loan to such an SME within the preceding 12 months. Therefore, the RBI circular is likely to have wider implications for the financial sector beyond NBFCs.

Finally, this circular once again raises a larger regulatory governance issue. In June 2022, the Regulations Review Authority 2.0 had recommended that RBI should ideally place all draft instructions on its website for stakeholder comments and finalise them only after considering the feedback. While RBI has been following this practice, this process was not followed before issuing the December 19 circular. Probably, the warnings through the inspection reports were deemed sufficient by the RBI!

Having said the above, the regulatory intent behind the December 19 circular cannot be faulted on principles of financing. As a regulator, the financial health of its REs is of utmost importance and that is indeed the check the RBI is trying to keep. The uncertainty in the market that has followed could probably have been avoided through a discussion paper and public consultation, so as to make room for genuine cases of refinancing, as opposed to ever greening, to continue.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.