[Shubham is a student at National Law University Odisha.]
A non-performing asset (NPA) is a debt or credit that is unlikely to be repaid in finance. This can occur for several reasons, including the borrower's failure to make payments, the borrower's bankruptcy, or the value of the collateral guaranteeing the loan falling below the amount owed. NPAs are a key source of concern for banks and other lenders (like non-banking financial companies (NBFCs)) since they can result in substantial financial losses.
In India, the Reserve Bank of India by its norms states that all those loans or advances for which the principal or interest payment remained overdue for 90 days will be treated as NPA. Investors closely watch NPAs; a rise can trigger panic selling of stocks, particularly for listed banks or NBFCs. Credit rating agencies may then downgrade their credit rating, making it difficult to raise funds as lenders demand higher interest rates. Overall, a growing NPA figure adversely affects financial health and financing capabilities for banks or NBFCs.
NPAs particularly hurt NBFCs due to their lower capital, volatile funding, and riskier loans. Lacking access to savings accounts, they depend on sources like short-term bonds and market borrowings. Consequently, to overcome the 90-day NPA definition, they often resort to the method of evergreening.
Evergreening – A Relationship between Alternative Investment Funds and NBFCs
Evergreening of loans involves a practice where NBFCs utilize alternative investment funds (AIFs) to prolong the term of a loan on the brink of being declared an NPA. To illustrate, if an NBFC has a loan from a struggling company, it may establish an AIF, invest in it, and use the AIF's funds to purchase bonds issued by the company. The company uses the bond proceeds to repay the original loan to the NBFC, creating the appearance of timely repayment. In reality, the loan term has been extended through the AIF. If the company defaults on the AIF loan, it initially does not impact the NBFC as it is treated as an 'investment' and is not subject to immediate NPA norms. This practice raises concerns about transparency in financial health and is being scrutinized by regulatory bodies such as the Securities and Exchange Board of India (SEBI) and the RBI.
On 19 December 2023, the RBI released a significant notification titled "Investments in Alternative Investment Funds (AIFs)." This regulatory action marked a pivotal moment as it directed attention to the practice of evergreening loans orchestrated by NBFCs through the use of AIFs. In this article, we will analyze the notification while understanding its impact.
Understanding the Notification
In this notification, RBI stated that NBFCs and banks (regulated entities or REs) are now prohibited from investing in any AIF directly or indirectly in the companies they've provided loans or investments to within the past year. This rule directly tackles the root of the evergreening problem by cutting off the indirect exposure route.
For existing AIF investments, a 30-day grace period is provided. If an AIF in which the RE is already invested acquires shares in a debtor company, the REs must sell its AIF shares within 30 days. This provision allows REs to adjust their portfolios within a reasonable timeframe but prevents them from using AIFs to indefinitely postpone bad loans.
However, what if an RE cannot sell its AIF shares within the timeframe? In such cases, a stricter measure kicks in. The RE must make a 100% provision on those AIF investments, essentially recognizing them as potential losses on their books. This discourages REs from simply ignoring potentially bad investments.
Additionally, a specific restriction applies to investments in AIF structures with a "priority distribution model." These models prioritize returns for certain investors, potentially leaving others at a disadvantage. Therefore, any RE investments in such AIFs will be fully deducted from their capital funds, further ensuring sound financial practices.
Analysis
In this notification, the RBI comprehensively addresses all facets of evergreening, and notably, it adopts a time-neutral approach, providing instructions applicable to past, present, and future investments by REs. The notification expressly prohibits REs, both for present and future investments, from directly or indirectly investing in any AIF associated with companies to which they have extended loans or investments. This stringent directive aims to curtail the practice of evergreening and ensure a transparent and accountable financial landscape.
To further strengthen these measures, the RBI introduced a 12-month prohibition on investments, effectively discouraging any engagement in evergreening practices. This strategic move allows for a 90-day period for NPAs to be assessed without the interference of evergreening. Moreover, the notification addresses existing AIF holdings in debtor companies by granting a 30-day sell-off window. This provision serves as a safeguard, preventing the manipulation of accounting books through evergreening bad loans via AIFs.
The practice of evergreening, often employed to artificially bolster the appearance of financial health in accounting books, is effectively countered by the RBI's comprehensive approach. The 12-month prohibition ensures a hiatus in investments, providing a window for accurate NPAs evaluation without evergreening interference. Furthermore, the 30-day timeframe for selling AIF shares linked to debtor companies reflects a commitment to transparency, as failure to do so mandates the acknowledgement of associated risks, revealing the true financial position. The RBI's measures thus present a robust and holistic strategy to curb evergreening and promote integrity in financial reporting. This will also help the RBI to keep its tracking of NPAs across the country more accurate, as REs can no longer rely on evergreening and must disclose actual non-performing assets.
Conclusion
The RBI’s notification may look harsh, but it perfectly curbs the issue of evergreening. However, industry experts anticipate potential exits from AIF schemes or write-downs on certain investments due to the RBI's decision. The RBI must stay vigilant as industry participants navigate the notification, sparking increased activity and adjustments. The financial sector is entering a dynamic phase, with efforts to align with the outlined stipulations leading to a period of transition. Close monitoring of these developments is imperative for the RBI to ensure compliance and maintain the integrity and stability of the financial sector during this transitional period.