Evergreening of loans still remains a bane of banking (2024)

The ink has not dried on the governor’s speech, when comes another warning. RBI has barred banks from investing in Alternate Investment Funds (AIF) that in turn bail out stressed entities already indebted to the same bank and near default. This is yet another innovative way of evergreening. All kosher, since no laws were being broken, until this latest move. AIFs have light-touch regulation from the Securities and Exchanges Board of India (Sebi) since they pool investor funds into non-traditional assets such as real estate, hedge funds and derivatives. Unlike mutual funds, the beneficial owners of AIFs are not always transparently known. The investors are supposed to be high net worth individuals or entities who know what risks they are taking. And the route of the evergreening goes through a Sebi (lightly)-regulated entity into a RBI regulated entity. Such a trans-regulator arena is ripe for arbitrage. Hence the caution and circular putting an end to this evergreening.

The loan books of non-bank finance companies (NBFCs) are expanding at an astonishing pace. Collateral-free or unsecured loans by large NBFCs have risen to a share of 30% of all loans, up 7 percentage points in two years. The unsecured loan assets of 12 large NBFCs grew by a whopping 51% up till 2022-23. The worry about growing stress in these loan categories is but natural. And it is NBFCs that have been found to use AIFs for creative ways to under-report their rising stressed loans. No wonder, right after RBI’s circular, shares of some large NBFCs fell sharply.

Nine years ago, RBI began the process of an asset quality review (AQR) of banks as well as non-bank lenders. The problem still persists, even as back then the AQR was wrongly blamed for a credit flow slowdown. Some banks were temporarily barred from issuing fresh loans under the prompt corrective action framework. The solution of automatically pushing defaulters into bankruptcy proceedings failed due to Supreme Court action. Hence, the evergreening of loans remains a real risk that demands regulatory vigilance. This is a never-ending tussle, since the lock breakers will always be ahead, however unbreakable the lock design. Evergreening creativity knows no limits.

Some years ago, there was a rather egregious example of regulatory arbitrage, which was a sort of precursor to what we saw with the present AIFs. Mutual funds were subscribing to commercial paper (CP), or unsecured promissory notes issued by banks, in large quantities. Liquid funds find investing in CPs more attractive than government securities since they fetch higher returns. The banks in turn used the CP proceeds to meet their short-term funding needs, including indirect evergreening. The funds often flowed from banks to mutual funds that subscribed to CPs and deposited that cash back into the same (group of) banks. This is essentially round-tripping and can increase the risk of instability. Firstly, it increases the correlation of bank and mutual fund performance, thereby increasing market concentration risk. Secondly, in case banks face a liquidity crunch, mutual funds might fail to redeem the CPs, aggravating panic and leading to a liquidity crisis. Lastly, it is an anomaly and hides the true credit risk picture, since bank CPs might be priced lower than their true cost of borrowing. This is yet another aspect of evergreening.

Public sector banks have written off about ₹15 trillion of bad loans in the past six years. The bad loan ratio has been halved from above 11% in 2017-18 to about 5.5% now. Bank performance has been very healthy during the past fiscal year, but the caution from the governor in his speeches and the recent circular on evergreening points to lurking dangers of stressed loans. Stress might arise from unsecured personal loans, including loans to micro and small entrepreneurs, as well as Mudra loans.

The debt situation of the sovereign and sub-sovereigns (the states) has not improved and is far from the benchmark set by the fiscal responsibility committee. The government’s borrowing appetite continues to be voracious even as companies are hungry for more loans. On one hand is the headache of dealing with the risk of an evergreening of stressed loans. On the other is the imperative of ensuring adequate fresh credit for the growing needs of the Indian economy. Squaring this circle is indeed a big challenge for the regulator.