India’s crackdown on financial risks puts industry on watch

By Preeti Singh, Saikat Das and Advait Palepu

A week after India barred lenders from investing in alternative investment funds that hold stakes in their borrowers, the market is counting the cost.

The Reserve Bank of India (RBI) said the move is designed to prevent an unstable build up of assets in the country’s financial system. But, lawyers and analysts say alternative investment fund managers could see costs ramp up and the rules will make it harder to raise cash in the future.

“This is a sledge hammer to the industry,” said Vinod Joseph, partner at Economic Laws Practice, a legal firm.

The top seven shadow lenders in the country had invested around Rs 135 crore in these so-called AIFs, according to their most recent annual reports. Shares of these firms dived after the new rules, that directed existing investments to either be liquidated in 30 days or for lenders to provision their investment in the AIFs.

The RBI’s move added to jitters in the market. Sentiment was already shaken after the central bank last month imposed stricter rules to stem the relentless rise in risky consumer loans, actions called “draconian” by one analyst. Its report on financial stability risks is set to be released this week.

RBI has been concerned about round-tripping of potentially bad loans, rise of unsecured lending and heavier linkages between AIFs and regulated entities, all of which can “potentially build up stress in the financial sector,” said Abizer Diwanji, financial services leader at Ernst & Young India.

Risks

The Securities & Exchange Board of India (SEBI), the country’s capital markets regulator, had identified several dozen cases involving billions of dollars where AIFs were being used to get around rules, Ananth Narayan, a whole-time member at SEBI said.

The flurry of new rules are coming at a time when India’s economy and financial system have remained resilient despite global headwinds of geopolitical tensions, elevated interest rates and inflation. Soured-debt ratios have narrowed to their lowest in a decade, with banks and shadow lenders boasting strong balance sheets as they reap gains from the rising demand for credit.

Still, “seeds of vulnerability often get sown during good times when risks tend to get overlooked”, RBI Governor Shaktikanta Das wrote in the financial stability report last December.

“We do not wait for the house to catch fire and then act,” Das said separately while presenting the country’s monetary policy earlier this month. “Prudence at all times should be the guiding philosophy, both for the regulators and the regulated entities.”

The regulations are already taking effect.

Piramal Enterprises Ltd for example said more than 80 per cent of its Rs 3820 crore ($459 million) investment in AIFs went to debtor companies it had previously given loans to. The firm planned to adjust this amount via capital funds or provisions, the firm said in a filing.

Another shadow lender IIFL Finance said Rs 910 crore in outstanding investments in AIFs will not be impacted by the RBI rule. However, its housing finance arm will need to liquidate or make provisions for Rs 160 crore worth of investments in AIFs, it said in a filing.

Impact

SEBI’s Narayan said that any circumvention of financial rules by large lenders need to be addressed without imposing lopsided restrictions on those who comply.

There can be unintended consequences however.

It’s highly unlikely that lenders can find buyers for their stakes in the next 30 days, which would lead to losses as they make full provisions and take mark-to-market losses, EY’s Diwanji said. Some of these entities, especially the shadow lenders, may have to raise fresh funds after their capital gets depleted by the provisioning, he added.

Future fundraising and deployment could however be impacted as banks and shadow lenders figure out how to avoid conflicts with their AIFs’ investments, according to Joseph, the partner at Economic Laws Practice.

Already, some fund managers are pushing back and want the rules to be modified.

These provisions “should be applicable to only investments in companies where the end use is towards refinancing existing debt and not towards growth,” said Eshwar Karra, chief executive officer at Kotak Strategic Situations Fund.