Navigating Regulatory Shifts: Exploring RBI’s Measures On AIF Investment Norms

Introduction

In the realm of Indian banking, a concerning trend has emerged involving the practice of evergreening through the Alternative Investment Fund (AIF) route. This caused the Reserve Bank of India (RBI) to take regulatory action, and on December 19, 2023, the RBI released notice 2023-24/90 with instructions intended to regulate AIF’s investing methods. This notification applies to all the Commercial Banks, Financial Institutions and Non-Banking Financial Companies.

As part of their routine investment activities, regulated entities (REs) invest in units of AIFs. An AIF is essentially, a type of privately pooled investment vehicle that takes investor money and uses it to make investments for its members benefit based on a predetermined investment policy. However, certain transactions by Regulated Entities which make investments through AIFs have posed regulatory questions. The practice of “evergreening,” which is simply a bank’s attempt to keep a loan from defaulting by making a new loan to pay off the old one so that it does not show up as a non-performing asset (NPA) on its books, has been recently gaining traction.

Regulation of investments

The Central Bank has now instructed Regulated entities to not make any investments in AIFs which have downstream investments in a debtor firm owned by the RE, either directly or indirectly. If such investments are made by the RE, then the investments are to be liquidated within 30 days of downstream investment.

If REs has already engaged in such schemes with downstream investments in their debtor enterprises as of today, the 30-day liquidation period will begin on the date this circular is issued. REs must immediately take steps to appropriately advise the AIFs on the subject. A 100% provision on their investments must be made if they are unable to liquidate them within the time frame specified above.

Further, REs’ investments in any AIF scheme that has a “priority distribution model” in its subordinated units will be fully deducted from their capital funds. 

Impact

The AIF investment regulations are being enforced in response to a remark made by RBI Governor Shaktikanta Das. In his remarks, he cited examples in which supervisors of central banks discovered creative ways in which lenders were hiding the true state of stressed loans.

The directive, which restricts such investments and requires a prompt liquidation procedure within 30 days, highlights a clear move in the direction of increased financial prudence. The regulatory commitment to correcting current schemes is emphasised by the application of a 100% provision in non-compliance instances. In addition, it is to be noted that, the requirement to set aside a 100 percent provision will limit banks’ ability to use the specified amount for any other type of funding.

The measure is also likely to have an impact on capital flows to AIFs; while the aim is to avoid loan evergreening, investing in an AIF is almost impossible for any organisation under the new RBI regulation, especially banks and NBFCs.

Further, any lender obliged to withdraw its investment from the AIF within the 30-day redemption window specified in this circular must use the AIF’s current Net Asset Value (NAV). As a result, since these AIFs are designed to provide returns for their investors over a more extended period, they may experience a significant decline in the value of their original investment.

Given that the RBI has long been on the lookout for evergreening and concealed NPAs, this move is not unexpected. It highlights the Central Bank’s proactive stance in addressing potential vulnerabilities within the financial system, particularly concerning AIF investments. and the notification will undoubtedly create an enhanced system compliance and deter lenders from engaging in such practices in the future.