RBI Strengthens Regulations to Curtail Loan Evergreening via AIF Investments

The Reserve Bank of India (RBI) recently issued directives preventing regulated entities, including banks and non-banking finance companies (NBFCs), from engaging in investments within Alternate Investment Funds (AIFs) that have ties to existing or recent borrowers.

Scope of Restriction

As outlined by the RBI, these restrictions extend to companies where lenders currently hold exposure through investments or loans or have had such connections within the past 12 months.

Addressing Concerns of Financial Transparency

The heightened regulations come in response to apprehensions surrounding instances where AIFs, especially private credit funds, were utilized to obscure non-performing loans within the financial ecosystem.

Guidelines for Liquidation and Provisions

Under the new guidelines, lenders must liquidate their investments in AIFs within 30 days if the fund holds investments in an existing borrower. Failure to comply will necessitate a 100% provision on these investments, ensuring greater transparency and accountability.

Impact on Investments in 'Priority Distribution' Model

The Reserve Bank of India (RBI) specifies that investments by regulated entities in subordinate units of funds following a 'priority distribution' model will be subject to substantial deductions from the entity's capital. Subordinate units typically receive lower priority for payouts under this model.

Immediate Implementation of Rules

These stringent regulations are effective immediately, marking a decisive move by the RBI to enhance transparency and prevent potential misuse of AIFs.

Market Investigation and Implications

In a parallel development, India's market regulator has initiated investigations involving an estimated 150 billion to 200 billion rupees ($1.8 billion to $2.4 billion). These probes aim to address cases where AIFs have allegedly been misused to circumvent regulations, particularly in concealing bad loans within the financial system.

The RBI's measures aim to fortify financial integrity by disallowing connections between AIFs and borrower entities, reinforcing transparency, and preventing malpractices in India's financial landscape.

New Rules of RBI at a glance 

To tackle this issue, the RBI has implemented tough new regulations:

• Ban on Investments in AIFs with Borrower Exposure: Banks and NBFCs are prohibited from investing in any AIF that has investments in companies to which they already have exposure (loans or investments) or had exposure in the past 12 months.

• Forced Liquidation for Non-Compliance: If an AIF invests in an existing borrower of a regulated entity, the entity must liquidate its investment in that AIF within 30 days. Failure to do so will result in mandatory 100% provisioning on the investment.

• Capital Deducting Priority Distribution: For investments in subordinate units of AIFs with a "priority distribution" model, the entire investment amount will be deducted from the entity's capital. In this model, certain investors get paid before others, placing subordinate units at a disadvantage.

The Scope of the Problem: Millions at Stake

The RBI's action comes in the wake of reports about potential misuse of AIFs to the tune of ₹150-200 billion ($1.8-2.4 billion), as per a Reuters investigation in October. These stricter norms aim to prevent such practices and safeguard the financial health of the system.

Conclusion 

By taking decisive action, the RBI aims to prevent the masking of bad loans and promote greater transparency and accountability in the financial system. The new regulations, while impactful, also highlight the need for continued vigilance to ensure robust risk management practices across the sector.