RBI Advisory: Banks’ Investment in Alternative Funds

In response to concerns raised by the Securities and Exchange Board of India (SEBI) regarding potential workarounds for loan repayment rules, the Reserve Bank of India (RBI) issued a revised advisory on March 27, 2024, pertaining to bank investments in Alternative Investment Funds (AIFs). This revision follows a stricter circular released in December 2023 that aimed to curb the concerning practice of “loan evergreening,” where banks essentially disguised bad loans by transferring them to AIFs.

December 2023: A Stringent Approach

The December 2023 circular sent ripples through the financial sector by prohibiting all “regulated entities” (REs), including banks, Non-Banking Financial Companies (NBFCs), and All-India Financial Institutions (AIFIs) from investing in AIFs that had any downstream investment – directly or indirectly – in a company they were currently lending to or had lent to in the preceding 12 months (debtor company). This move, while addressing the evergreening issue, had unintended consequences.

Industry Jitters and Data-Driven Concerns

Industry bodies like the Association of Investment Managers and Advisors in India (AMFI) expressed significant concerns. AMFI data revealed that AIFs held over ₹2 lakh crore (US$24.2 billion) invested by banks and NBFCs as of December 2023. The stringent regulations threatened to disrupt this established investment channel and potentially impede the growth of the AIF sector.

March 2024: A Measured Response with New Data Points

The March 2024 advisory reflects the RBI’s attempt to find a middle ground. Here’s a breakdown of the key changes, incorporating recent data points:

• Reduced Provisioning Burden: Previously, REs had to make a 100% provision on their entire AIF investment if the AIF held any downstream investment in a debtor company. This could have led to a significant financial strain, especially for AIFs with minimal exposure to the RE’s existing borrowers. The new rule allows provisioning only for the portion of the investment that goes towards the existing borrower, significantly reducing the burden on REs. A report by credit rating agency ICRA estimates this change could free up to ₹50,000 crore (US$6.05 billion) for further investments within the AIF sector.
• Equity Carve-Out and Intermediary Exemption: The advisory clarifies that investments in a borrower’s equity shares are exempt from the restrictions. This distinction between debt and equity financing provides REs with more flexibility in their investment strategies. Additionally, banks investing in AIFs through intermediaries like fund-of-funds or mutual funds are not subject to these restrictions. This opens up additional avenues for RE participation in the AIF market, potentially attracting a wider range of investors.
• Focus on Transparency: A Shift in Scrutiny The RBI now emphasizes the importance of transparency in downstream AIF investments. REs are required to conduct thorough due diligence to ensure AIFs they invest in do not engage in practices that could facilitate loan evergreening. This shift in focus, from a blanket ban to risk-based supervision, is expected to foster a more robust and responsible AIF ecosystem. RBI Governor Shaktikanta Das, in a recent speech, highlighted the importance of a “calibrated regulatory approach” that promotes innovation while safeguarding financial stability.

The Road Ahead: Balancing Growth and Stability

The RBI’s revised advisory on AIF investments for banks marks a step towards a more balanced regulatory framework. It provides much-needed relief for REs while maintaining a watchful eye on potential misuse of AIFs. The success of this approach will depend on the industry’s commitment to transparency and responsible investment practices. Additionally, the RBI’s focus on risk-based supervision will be crucial in ensuring the continued growth of the AIF sector while mitigating potential systemic risks.

Recent Blog : Kotak Bank Invests Rs 537 Cr in Sonata Finance Acquisition