Regulatory Measures on Bank and NBFC Investments in Alternative Investment Funds

RBI/2023-24/90

DOR.STR.REC.58/21.04.048/2023-24 December 19, 2023

The RBI circular addresses all regulated entities, including banks and NBFCs, concerning
their investments in Alternative Investment Funds (AIFs). The primary motivation behind this
circular is to prevent the practice of evergreening loans, which was being circumvented by
certain market players through indirect investments. Specifically, some banks were investing
in AIFs associated with their borrowers, enabling these borrowers to repay prior loans and
thus avoid classifying them as non-performing assets (NPAs). This practice falsely improved
the financial outlook of both the borrower and the bank.

The circular aims to close this loophole, ensuring that banks with sufficient capital do not
engage in risky lending disguised as investments. It prohibits banks from investing in AIFs
that have downstream investments in debtor companies of the bank within the previous 12
months. Additionally, the circular mandates that if such investments exist, banks must
liquidate them within 30 days, or otherwise, they are required to provision 100% capital for
these investments. This safeguard is designed to protect depositors and maintain the integrity
of the banking system.

Talking about the likely negative impact, the circular may reduce the investment flexibility of
banks and NBFCs, limiting their ability to diversify portfolios. It could also impact the
liquidity and growth of the AIF market, as companies reliant on AIFs for capital might
struggle to access funding. The 30-day liquidation requirement could create operational
challenges, forcing banks to exit investments quickly, potentially at a loss. Additionally, if
banks fail to meet this timeline, they must provision 100% capital, straining reserves and
reducing lending capacity. Borrowers dependent on AIFs may also face higher borrowing
costs due to reduced access to funds.

Lastly, while the circular imposes short-term costs like reduced flexibility and operational
challenges, the long-term benefits outweigh them. By preventing loan evergreening and
improving transparency, the circular ensures banks manage risks better, strengthening
financial stability. Though there may be temporary disruptions, such as tighter investment
rules and AIF market constraints, the enhanced discipline and risk management promote a
healthier, more resilient banking system, ultimately safeguarding the broader financial
ecosystem.

Regulatory measures towards consumer credit and bank credit to NBFCs

RBI/2023-24/85

DOR.STR.REC.57/21.06.001/2023-24 November 16,

In this circular, RBI is raising the risk weights associated with various types of consumer
credit (excluding housing, education, and vehicle loans) from 100% to 125% for both banks
and NBFCs and credit card receivables to 150% for banks and 125% for NBFCs. This
increase effectively means that banks and NBFCs must hold more capital against this type
of credit exposure to maintain their capital adequacy ratios, thereby reducing their leverage
and increasing their ability to absorb potential losses. By requiring these institutions to
allocate more capital, the RBI is tightening its regulatory grip to mitigate risks in the financial
system.

The motivation for this seems to be coming from the rapid growth in certain segments of
consumer credit and the increasing reliance of NBFCs on bank borrowings, which signals
heightened financial risk in these areas. The central bank is concerned that unchecked
expansion of credit, particularly in unsecured consumer loans (such as personal loans and
credit card debt), may lead to an accumulation of non-performing assets (NPAs), which could
lead to liquidity issues or defaults if not managed properly.

This regulatory change will force banks and NBFCs to raise additional capital, which could
lead to a slowdown in unsecured lending. The fintech sector, which predominantly relies on
consumer credit, is expected to face the most significant challenges. With advancements in
technology, fintech companies have been able to offer unsecured loans to individuals and
small businesses that lack a credit history or collateral. However, with the increased capital
requirements, fintech companies will find it more difficult to extend loans to these borrowers,
many of whom are small businesses relying on fintech for their credit needs. Although these
loans are generally considered safer due to the fintech sector's ability to track daily cash
flows, the higher risk weight on these credits will reduce the volume of loans fintech
companies can extend, ultimately impacting their profitability and hence innovations.
In the short term, the costs of the RBI's regulatory changes outweigh the benefits,
particularly for fintech companies and unsecured loan providers. The increased risk weights
for banks and NBFCs, while improving financial stability and risk management, limit lending
capabilities by forcing these institutions to raise additional capital. This reduction in leverage
is especially challenging for fintech companies, which rely on consumer credit to serve
underserved segments like small businesses and individuals without collateral. As a result,
access to unsecured loans may diminish, reducing profitability and lending capacity in these
sectors. Despite the long-term benefits of enhanced risk management and a more resilient
financial system, the immediate impact on credit availability suggests that the costs are more
significant in the short run.