In today’s Finshots, we tell you how the Reserve Bank of India is clamping down on an unholy practice known as evergreening.

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The Story

Imagine you’re a non-banking financial company (NBFC)*. You don’t have a banking license so you can’t give customers a savings account and stuff. But you can accept fixed deposits. And then you can use your own money and also a part of these FDs to indulge in the lending business. You hand the money over to a borrower at a certain interest and ask them to pay it back on a predetermined date. This is how you make money.

But sometimes, things could wrong. Let’s say the borrower is a real estate developer who borrowed ₹10 crores. And they run into some financial difficulties. Maybe they ask for a grace period of an additional 6 months. You’ve been monitoring the finances and their real estate projects for a while now. And you feel that in all likelihood they’ll pay it back if you give them the leeway.

But you can’t grant their wish. Because you’re regulated by the Reserve Bank of India. And the RBI tells you that if there’s a delay of more than 90 days, you have to classify it as a bad loan. Or in industry jargon, it’s a Non-Performing Asset (NPA).

And that’s not a good thing for you because investors are constantly looking at your NPA figures. If they see that the NPA is rising, they’ll panic. They might sell your stock (if you’re listed on the stock markets). Also, credit rating agencies might downgrade your credit rating. They might worry that you’re struggling to stem the rate of defaults and it’ll hurt your operations. All of this potentially means that you’ll find it hard to raise money for your own needs. Everyone will ask you to pay a higher interest rate when you want to borrow.

Then, you’re hit by a brainwave. You go to the real estate developer and say, “Look, how about we bring in an AIF to solve this dilemma?”

For the uninitiated, these are Alternative Investment Funds. They’re not under the RBI’s scrutiny, but rather, under the Securities and Exchange Board of India (SEBI). These funds accept only a minimum of ₹1 crore as investment from really rich individuals or other firms. They pool these crores together and then invest in a whole myriad of things — in the stock markets, in bonds, and even real estate projects. They just have to specify what’s their preferred investment strategy before they raise money from investors.

Anyway, you tell the developer to issue some bonds. And then the AIF will use its corpus to buy these bonds and save the real estate business.

But why on earth will the AIF even do that, you ask? What’s in it for them to buy bonds of a real estate developer who is struggling a bit financially?

Well, it’s thanks to the unholy practice of evergreening!

So here’s what happens…

You — the NBFC — first promise to invest money into the AIF. The AIF uses this money to buy those fresh bonds issued by the real estate developer. Then, the developer pays you back the original sum of borrowed money — ₹10 crores.

Problem solved!

Now you can then tell the RBI, “Look. the developer paid me back that money. Within those 90 days. So I don’t have to declare it as an NPA.”

But in reality, you simply used the AIF’s backdoor and extended the term of the loan to the developer.

Ingenious, no?

But hold on…what if the developer defaults on the loan given by the AIF? That means you — the NBFC — wont get back the money anyway, no?

Well, for starters, the AIF is an ‘investment’ you made. So even if the builder defaults immediately on the loan, it won’t matter to you. It doesn’t come under any NPA norms.

The other thing is that when AIFs raise money, they typically have a fixed time period before the fund matures. Or before they return money to investors. And this period is usually 7 years. So as an investor in the AIF, you have around 7 years before you have to deal with this problem again. And hopefully, the developer salvages their business during those years and they manage to pay up.

This way, in theory, no one gets hurt. But it’s still quite a dubious affair.

And it’s no wonder the RBI isn’t happy now. The regulator believes these things could mask problems in NBFCs. So on Tuesday, it banged its gavel and issued a diktat to NBFCs (and other financial entities that it regulates). It said:

  1. Sure, an NBFC can invest in an AIF. But, first, it should verify if the AIF has bought bonds of any company that has ‘banked’ with the NBFC in the previous 12 months. If that’s the case, then the NBFC can’t deal with the AIF.
  2. Now if such a nexus already exists, then the NBFC will have to speak to the AIF and get an exit within 30 days.
  3. If the NBFC can’t do this, then it has no choice but to make a new provision in its books. This means that an NBFC has invested ₹10 crores in such an AIF, then it has to set aside ₹10 crores from its own books. Basically, it’s an added expense for the NBFC.


But how will this impact the NBFC industry, you ask?

Well, if there are NBFC’s who’ve become experts at evergreening, they’ll be caught with their pants down now. They might be forced to declare a few defaults. And that in turn could affect their stock prices or even credit rating like we mentioned earlier. We'll have to see how it pans out.

Oh, and it'll probably hurt AIFs too. You see these funds do raise money from financial entities such as Small Industries Development Bank of India (SIDBI). And SIDBI might have lending relationships with many companies that the AIF wants to invest in too. But with this rule in place, SIDBI might be cautious. It could end up taking a step back from this segment and that'll hurt the AIF's fund raising prospects.

So yeah, the next 30 days are going to be very interesting.

Until then…

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*You might be wondering why we focused on NBFCs in this story despite the RBI circular saying it’s a diktat for all of its regulated entities. The reason is simple — last year, SEBI warned RBI specifically about a few NBFCs who were resorting to this particular brand of evergreening.

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