RBI eases restrictions on Bank investments into AIF – Why and what next?

Introduction

RBI’s latest restrictions on the practice of ‘evergreening’ appear well justified given the systemic risk the practice creates. But, despite two rounds of clarification and consultation, bona fide market players may remain restricted. As a result, the effect on the banking and the AIF industry has been quite unsettling – with large write offs across leading banks, NBFCs, financial institutions, etc.¹ (“Banks”, for easy relatability).

The objective of the evergreening restrictions, introduced through two sets of circulars, was to ensure that Banks do not misuse AIF structures to avoid potentially stressed assets appearing on their balance sheets – millstones round the necks of Banks. Banks would first subscribe to subordinate units of alternative investment funds (“AIFs”) which in turn invested debt into the Bank’s borrower. The borrower then used the funds to retire the outstanding loan of the Banks. This effective ‘evergreening’ of loans could even continue beyond the AIF’s lifecycle by employing similar practices – the AIF could down-sell their troubled assets to another similarly funded AIF.

The December Circular² – A bull in a china shop

RBI’s initial set of restrictions to tackle the misuse were arguably stricter than required, and did misfire in a few situations that were not initially thought of. Such restrictions included requiring Banks to:

The circular was a clear and straightforward attempt to mitigate various systemic risks, notably: (i) concerns relating to substitution of direct loan exposures with indirect exposures; (ii) the growing interlinkages between AIFs and traditional debt segments; and (iii) the misuse of regulatory arbitrage.

The immediate effect, however, was that Banks were forced to sell/transfer their now contaminated AIF portfolios (mostly illiquid) at discounts, that is, if they were even able to find buyers ready to absorb such sizeable portfolios (take for example, HDFC Bank setting aside INR 1220 crores, ICICI setting aside INR 627 crores, or Piramal having to write down its entire investment in AIFs for a total loss of INR 2377.59 Crores)³ though, a few AIF managers did make money by buying those fire sale assets.

The real impact was, however, felt by the AIF managers. Fundraising cycles of AIFs were disrupted as Banks did not honor their capital commitments in fear of breaching the December Circular. One such case was SBI refusing a capital call from the National Investment and Infrastructure Fund.

Compared globally, India’s AIF industry is still in its nascent stages (and relatively, quite heavily regulated). Furthering that problem, and in sudden fashion, may not bode well for the industry’s growth.

The March Circular⁴ – pulling back on regulation?

After significant complaints from the AIFs and banking industry representatives, RBI re-examined the restrictions imposed by the December Circular and issued the March Circular which relaxed and clarified positions. Key relaxations include:

1. Provisioning limited to AIF exposure in the borrower. Limiting provisioning only to the extent of the AIFs exposure in the borrower, instead of provisioning for an amount equal to the entire investment in the AIF.
2. Exemption of ‘indirect investments’ via mutual funds or fund of funds. Exempting investments made through intermediaries such as funds of funds or mutual funds in AIF.
   
   This is naturally welcome, but, it also presents an internal disconnect on what the RBI’s underlying principle is. If funds of funds and mutual funds are carved out because the Bank has no control over decision-making over where the mutual fund or downstream fund invests, then AIFs which are truly acting independently of Banks should also be carved out (say, if the AIF independently invests into a portfolio unaware that it in fact borrowing from a unitholder in the AIF). We believe a simpler solution could be to punish the intent, and not the act itself.
3. Equity investments exempted. Exempting equity investments, i.e., if AIFs are only investing into the equity shares of a borrower, then Banks are not required to divest or provision, though investments in hybrid instruments (like compulsorily convertible debentures and compulsorily convertible preference shares) remain prohibited. This is of course welcome since equity instruments were never being used to evergreen in the first place.

What about bona fide transactions?

Consider a ‘Scenario A’ where an AIF, which has received funding from a Bank, invests into debt instruments of an unrelated portfolio company in the natural course of its business. A few months later, the portfolio company raises money from that same Bank and thereby becomes a borrower. Will the Bank now be required to create provisions/ down-sell?

Consider another ‘Scenario B’, where the AIF buys the instrument of a borrower in the secondary market. Since there is no inherent interlinkage between the Bank, AIF and the borrower, should Banks still be required to make provisions/ down-sell?

Unfortunately, under the current scheme of the regulation, both Scenario A and B could entail the Bank creating minimum provisions or down-selling, i.e., they would be covered by the prohibition on ‘direct or indirect on investment’ in a borrower as per the December Circular.

Conclusion

We think there is no perfect solution that cannot be misplayed. But as for all rule-making, the rules must be made such that bona fide players are not adversely impacted. While it’s easy to give back-seat instructions and we do understand RBI’s predicament, possibly an approach that addresses the intent (and not the act in isolation) could be the solution – inasmuch as Banks shouldn’t be held liable if they couldn’t have controlled or weren’t aware of the portfolio companies conduct.

If RBI really does want to move towards a strict regime and regulate even bona fide players, then it should take that decision and inform the market well in advance to ensure that players have adequate time to absorb that change. The RBI should also be mindful of the effect its regulation would have on a nascent funds industry, which needs support – and also seek consultation from funds and the market regulator (SEBI) well in advance, and not subsequent to regulation

¹ Note. RBI’s regulation regulates ‘Regulated Entities’, i.e., all Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks); all Primary (Urban) Co-operative Banks/State Co-operative Banks/Central Co-operative Banks; all All-India Financial Institutions; and all Non-Banking Financial Companies (including Housing Finance Companies).
² Note. This refers to RBI’s circular on investments into AIFs dated 19 December 2023 – accessible here.
³ Note. News articles – accessible here and here.
⁴ Note. RBI’s circular on investments into AIFs dated 27 March 2024 – accessible here.