The Reserve Bank of India (RBI) took a cautious step towards harmonizing regulations for bank investments in Alternative Investment Funds (AIFs) with a recent advisory issued on March 27, 2024. This revision follows a December 2023 circular that caused a ripple effect within the banking sector, with estimates suggesting a potential freeze on ₹2 lakh crore (US$24.2 billion) of bank investments in AIFs .
December Regulations and Unintended Consequences
The December 2023 circular, aimed at curbing the practice of “evergreening” of loans through AIFs, restricted banks and other financial institutions from investing in AIFs that have downstream investments in companies to which they have existing loans. While intended to strengthen financial stability, this move triggered unintended consequences:
- Divestment Challenges: Banks faced difficulties in selling off existing AIF holdings within the mandated 30-day timeframe. A report by CRISIL, a credit rating agency, highlighted that nearly 60% of bank investments in AIFs could have been impacted by the December rules.
- Provisioning Pressure: The requirement to make a 100% provision on such holdings created significant pressure on banks’ capital adequacy ratios (CAR). Industry reports suggested a potential decline in CAR by up to 100 basis points for some banks, potentially restricting their lending capacity.
March 2024 Advisory: A Sigh of Relief and Measured Approach
The March 2024 advisory offers significant relief to banks by providing greater clarity on how to calculate “downstream exposure.” Here’s a breakdown of the key changes and their implications:
- Downstream Exposure Definition Narrowed: The December regulation deemed any investment by an AIF other than equity shares in a debtor company as downstream exposure. This broad definition is now refined. Experts believe this revision addresses a key industry concern, as equity investments in stressed assets were not the primary target of the regulations.
- Focus on Specific Investments: The new advisory specifies that only specific investments, excluding equity holdings and potentially including hybrid instruments like convertible debentures, will be considered for calculating downstream exposure. This offers banks more flexibility in managing their AIF portfolios, allowing them to participate in a wider range of AIF products.
- Proportionate Provisioning: The 100% provisioning requirement is replaced with a more proportional approach. Banks now need to set aside provisions only for the portion of their investment in an AIF that is further invested in the debtor company. This significantly reduces the immediate financial burden on banks.
Industry Reactions and Potential Benefits
The banking industry has welcomed this change, viewing it as a positive step towards a more balanced approach. “The revised framework strikes a better balance between curbing potential risks and allowing banks to benefit from the diversification offered by AIFs,” said a spokesperson for the Indian Banks’ Association (IBA) . Analysts predict a potential revival of bank interest in AIFs, leading to increased investment flows of ₹50,000 crore (US$6.05 billion) within the next year . This could benefit the AIF industry as a whole, fostering innovation and potentially leading to the launch of new AIF products tailored to banks’ risk appetites.
The Road Ahead: Balancing Risk and Opportunity
The RBI’s actions highlight the importance of striking a balance between ensuring financial stability and fostering innovation in the financial sector. AIFs offer banks a gateway to a wider range of investment opportunities, potentially boosting returns and portfolio resilience. However, it’s crucial to prevent practices that undermine credit discipline and financial health.
The recent advisory suggests that the RBI is committed to finding a middle ground. By providing clear and concise guidelines, the RBI can enable banks to leverage AIFs for diversification while mitigating potential risks associated with downstream exposure. This revised framework has the potential to benefit both banks and the AIF industry as a whole, fostering a more robust and dynamic financial ecosystem. Experts believe that ongoing regulatory consultations and industry collaboration will be key in ensuring the successful implementation of these changes.
Recent Blog : Sonata Finance Acquired by Kotak Bank for Rs 537 Cr