The Reserve Bank of India (RBI) recently issued a directive targeting the prevalent practice of loan evergreening, particularly through Alternative Investment Funds (AIFs) in an audacious move to strengthen financial integrity. RBI’s this regulatory crackdown has thrust non-banking financial companies (NBFCs) like Piramal Enterprises, Edelweiss, and Indiabulls into the spotlight, triggering discussions about the potential ripple effects across the financial sector. The purpose of this article is to delve into the complexities of the RBI’s directive, to investigate its implications for NBFCs and AIFs, and to assess the broader implications for the financial market.

Understanding the RBI’s liquidity Challenge for NBFCs Including Piramal and Edelweis

At the heart of the matter lies the illiquid nature of AIF structures, a factor that experts believe will pose a significant challenge for RBI-regulated entities attempting to withdraw investments within the mandated 30-day period. The anticipated outcome of this directive is higher provisioning and a potential surge in non-performing assets for select NBFCs in the forthcoming quarters.

Decoding the RBI’s Directive and Unwinding Positions:

Issued on December 19, the RBI’s directive expressly prohibits regulated entities, including banks and NBFCs, from investing in AIF schemes with downstream connections to debtor companies. The primary aim is to curb the deceptive practice of shifting loans to AIFs, thereby presenting a cleaner facade on balance sheets. The RBI’s directive also mandates the unwinding of positions within 30 days if downstream investments occur in debtor companies. Failing to comply within this timeframe invites a punitive 100 percent provision on the investments.

Challenges Faced by NBFCs:

The practicality of liquidating AIF units within the stipulated 30-day window is considered by experts as a formidable challenge. Many AIFs come with prescribed lock-in periods, making the swift liquidation of assets a complex task. This raises red flags concerning the potential impact on NBFCs, with Piramal Enterprises, Indiabulls Housing Finance, and Edelweiss emerging as entities with a higher share of AIF investments.

Potential Impact on Lenders:

While banks, with investments below 10 percent, are expected to experience minimal impact, the concentration risk in a few NBFCs introduces a potential cascading effect. This emphasises the importance of being cautious when managing investments, as well as the need for regulators and market participants to be vigilant.

Concentration Risk and Market Response:

The concentrated risk associated with these investments has sparked concerns among industry insiders. The potential cascading effect on net worth has been highlighted, with estimates suggesting a significant impact on certain NBFCs if provisions are made against their entire AIF exposure. The market’s response to these revelations will likely influence future investment strategies and risk management practices.

AIFs and the Aftermath:

While the RBI’s notification is aimed at cleansing the financial system, AIFs are not immune to the repercussions. The directive is expected to shrink the pool of investments for AIFs, leading to a potential decline in interest from banks and NBFCs in these structures. The aftermath for AIFs, as well as their ability to adapt to these changes, remains an area of close scrutiny.

Expert Opinions:

As stakeholders grapple with the potential ramifications, expert opinions have emerged to provide insights into the regulatory landscape. Industry experts believe that clarity from the RBI is crucial to avoid unintentional harm to regular AIFs. Shyamal Karmakar of RV Capital emphasises the importance of addressing potential conflicts to safeguard investor interests, underlining the delicate balance between regulatory interventions and the smooth functioning of financial instruments.

Positive Reception and Ethical Considerations:

Despite the concerns raised, there is a positive reception to the RBI’s regulation, particularly from market observers like Deepak Shenoy of Capitalmind. Shenoy views the regulation as a necessary measure to prevent NBFCs from engaging in evergreening practices through AIFs. He stresses the need for transparency and ethical practices in the financial sector, signalling a broader shift towards responsible financial conduct.

Analysing the Market Landscape:

To comprehend the broader implications, it is essential to delve into the intricacies of how loan evergreening operates. In a consultation paper issued in May, the Securities and Exchange Board of India (SEBI) explained how NBFCs, in collaboration with AIFs, were employing the priority distribution method or ‘tranching’ for evergreening of loans.

Tranching Explained:

Tranches represent different degrees of credit risk within a financial instrument. A senior tranche of investors is prioritised in the distribution of proceeds over the junior tranche. Senior tranches receive lower yields, reflecting their reduced risk. On the other hand, subordinate tranches, being junior to the senior tranche, absorb losses first and consequently receive higher yields due to the added credit risk.

The Mechanism of Evergreening:

If a lender, be it a bank or an NBFC, wishes to remove loans at risk of default from its books, it subscribes to the junior tranche of an AIF scheme established for this purpose. The regulated lender’s investment size is determined by the expected loss on the loan portfolio at the time of structuring, often referred to as the ‘haircut.’ Subsequently, the AIF attracts investors willing to subscribe to the senior class of units. Once the funds are collected, the AIF lends the money to the same risky borrower to repay the loans. This strategic manoeuvre helps make the lender’s books appear clean by avoiding the recognition of non-performing assets (NPAs).

Examining the Need for Regulation:

SEBI’s consultation paper and the subsequent RBI directive underscore the imperative to address loopholes that permit such practices. The regulation aims not only to curtail evergreening but also to foster a more transparent and responsible financial ecosystem.

Clarity and Future Developments:

While concerns about the practicality of unwinding AIF positions persist, the financial landscape is eagerly awaiting clarity from the RBI regarding the impact on regular AIFs. Stakeholders, including investors, regulators, and market participants, are preparing for potential shifts that could reshape the dynamics of financial investments.

Conclusion:

RBI’s decisive move to crack down on loan evergreening through AIFs marks a significant step in fortifying the transparency and integrity of the financial system. While challenges loom, the regulation has been generally welcomed as a necessary measure to curb unethical financial practices. As stakeholders brace themselves for potential shifts in the financial landscape, the emphasis on responsible financial conduct and transparent practices has gained prominence. The road ahead involves navigating the complexities of unwinding AIF positions, adapting to regulatory changes, and fostering a financial ecosystem that prioritises integrity and accountability.

Disclaimer: The information in this “Stock Profile” blog post is for informational purposes only. It is not financial advice. Always consult a qualified expert before making investment decisions.