Evergreening” loans in India-Evergreening of loans still remains a bane of banking

Source: The post evergreening” loans in India has been created on the article “Evergreening of loans still remains a bane of banking” published in “Live min” on 21st December 2023.

UPSC Syllabus Topic: GS paper 3-Indian economy (banking)

News: This article discusses the issue of “evergreening” loans in India, where banks give new loans to prevent defaults on existing ones. It highlights the Reserve Bank of India’s concerns and actions against such practices, emphasizing the risks to the banking system and the need for regulatory vigilance.

What is the evergreening of loans?

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What are the RBI’s findings on the practice of evergreening loans in India?

Banks’ Innovative Methods: Banks were found using creative ways to hide stressed loans, like, a) sale and buyback arrangements between two banks to reset the history of a stressed loan, b) Banks were extending loans to entities related to already stressed borrowers, using this to hide the actual stressed nature of the original loans.

Use of Alternate Investment Funds (AIF): Banks invested in AIFs, which then bailed out stressed entities, indirectly continuing the cycle of evergreening.

Note: Alternate Investment Funds (AIF) in India are investment vehicles that pool funds to invest in non-traditional assets like real estate, hedge funds, and derivatives. They are lightly regulated by the Securities and Exchanges Board of India (Sebi) and are typically subscribed to by high-net-worth individuals or entities, aware of the associated risks.

Use of Commercial Paper (CP): Mutual funds heavily invested in CPs issued by banks, which offered higher returns than government securities. Banks then used CP proceeds for short-term funding, contributing to indirect evergreening.

Rapid Growth of unsecured loan: Non-Bank Finance Companies (NBFCs) unsecured loan assets grew by 51% up to 2022-23, raising concerns about under-reported stressed loans.

What are the implications of evergreening loans in India?

Misrepresentation of Loan Quality: Banks using evergreening tactics distort the actual health of their loan portfolios.

Governance and Audit Failures: Such practices indicate lapses in the governance and audit mechanisms within banks.

Round-Tripping : The practice of mutual funds investing in commercial papers and returning funds to banks , this will lead to a) increases the correlation between bank and mutual fund performances, escalating market concentration risk, b) If banks face liquidity issues, mutual funds might be unable to redeem commercial papers, possibly triggering a liquidity crisis, c) Evergreening through such round-tripping hides the true credit risk, as commercial papers might be underpriced compared to the actual borrowing cost.

Regulatory Challenges: Continual adaptation of evergreening methods poses significant challenges for regulators like RBI to ensure financial stability.

Way forward

To tackle evergreening in India, it’s vital that regulatory bodies like the RBI and SEBI increase their oversight and seal regulatory gaps. Improving transparency in loan reporting, especially in fast-growing areas like non-bank financial companies, is key. Moreover, reinforcing governance and audit processes in banks and dealing with the complexities of cross-regulatory financial instruments is crucial to uphold the financial system’s integrity and stability.

Terminology used:

Commercial Paper (CP): It is an unsecured money market instrument issued in the form of a promissory note (legal instrument). It was introduced in India in 1990 with a view to enabling highly rated corporate borrowers/ to diversify their sources of short-term borrowings and to provide an additional instrument to investors.
Question for practice:

Discuss the concept of evergreening loans in India and its implications.