Evergreening of Loans

What’s in today’s article?

• Why in news?
• What is Evergreening of loans?
• Why do financial institutions engage in evergreening of loans?
• Risks associated with evergreening of loans
• How can evergreening be stopped?
• News Summary: Evergreening of loans
• Evergreening methods used by Banks: as highlighted by the RBI Governor

 

Why in news?

• Recently, Reserve Bank of India Governor, while addressing bank board, raised concerns over banks using innovative methods for evergreening of loans.
• As per him, banks are covering up the real status of stressed loans of corporates – to project an artificial clean image in cahoots with corporates.

 

What is Evergreening of loans?

About

• Evergreening of loans refers to a practice used by financial institutions to extend or renew existing loans to borrowers who are struggling to repay their debts. 
• It involves granting additional funds or rolling over the outstanding debt, often with modified terms or conditions.
• This is done to create the appearance that the borrower is making timely repayments and maintaining a healthy credit profile.
• The evergreening of loans allows borrowers to maintain the illusion of ongoing financial stability by continuously obtaining new loans to cover existing obligations.

 

Why do financial institutions engage in evergreening of loans?

• To avoid recognizing non-performing assets (NPA) on their balance sheets
  • If an account turns into an NPA, banks are required to make higher provisions which will impact their profitability.
    • A loan turns into an NPA, if the interest or instalment remains unpaid even after the due date — and remains unpaid for a period of more than 90 days.
  • So, to avoid classifying a loan as an NPA, banks adopt the evergreening of loans.
• To maintain a positive relationship with borrowers
  • Some banks have even extended such loans to wilful defaulters to keep them out of the defaulters’ books.
  • By providing additional credit, financial institutions can retain clients who might otherwise default on their loans.

 

Risks associated with evergreening of loans

• Inflates the quality of the institution's loan portfolio
  • This practice artificially inflates the quality of the institution's loan portfolio and can mislead investors, regulators, and the public about its financial health.
• Can lead to a cycle of increasing debt
  • This approach may be seen as a short-term solution to prevent immediate defaults.
  • However, it can lead to a cycle of increasing debt and further financial instability for both borrowers and lenders in the long run.
• Problematic for the overall stability of the financial system
  • Evergreening of loans can be problematic for the overall stability of the financial system. 
  • It can mask the true extent of bad loans in an economy, creating systemic risks and distorting the assessment of creditworthiness.
• Sign of misgovernance 
  • This is purely misgovernance, so that bad loans are made to look good many a time by additional lending to troubled borrowers.
  • It normally happens due to the unholy relationship between bankers and borrowers.
    • The CBI had detected several cases of fund diversion by promoters of companies from loans advanced again and again by banks in the last couple of years.
• Contributes to the crowding-out effects
  • In India, there is evidence of a practice called indirect evergreening. 
  • This involves struggling companies borrowing money from weak banks through related parties, but instead of using the funds for productive investments, they increase their debt levels.
  • This kind of activity is often overlooked and not easily detected. 
  • As a result, valuable resources are misallocated, which contributes to the crowding-out effects typically associated with financially vulnerable companies.

 

How can evergreening be stopped?

• As per the Committee to Review Governance of Boards of Banks in India headed by PJ Nayak, wherever significant evergreening in a bank is detected by the RBI:
  • penalties should be levied through cancellations of unvested stock options;
  • claw-back of monetary bonuses on officers concerned and on all whole-time directors;
  • the Chairman of the audit committee be asked to step down from the board.
• The primary defence against evergreening must however come from the CEO, the audit committee and the board.
  • The audit committee, in particular, needs to be particularly vigilant.
• If significant evergreening is detected, it must mean that evergreening is wilful, with support from sections of the senior management of the bank. 
• It then becomes necessary to levy penalties and action against the erring officers.

 

News Summary: Evergreening of loans

• During the supervision of banks, the RBI noticed certain instances wherein banks were using innovative ways to conceal the real status of stressed loans.
• This was revealed by the RBI Governor in his address to the board of directors of public sector and private lenders. 

 

Evergreening methods used by Banks: as highlighted by the RBI Governor

• Bringing two lenders together to evergreen each other’s loans by sale and buyback of loans or debt instruments; 
• Good borrowers being persuaded to enter into structured deals with a stressed borrower to conceal the stress; 
  • In other words, financially sound and reliable borrowers are encouraged to engage in specific agreements or transactions with borrowers who are facing financial difficulties.
  • This is to hide or mask the financial distress of the borrower who is struggling. 
    • By involving creditworthy borrowers in such arrangements, it creates a façade of stability and financial health for the stressed borrower.
• Use of internal or office accounts to adjust borrower’s repayment obligations; 
• Renewal of loans or disbursement of new/additional loans to the stressed borrower or related entities closer to the repayment date of the earlier loans.

 

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Q1) What are crowding-out effects in economics?

Crowding-out effects refer to a phenomenon in economics where increased government spending or borrowing reduces private sector spending or investment. This effect occurs when government activities, such as increased public expenditures or borrowing, lead to higher interest rates or reduced availability of credit, which in turn discourages private sector spending or investment.

 

Q2) What is non-performing assets (NPA)?

Non-performing assets (NPA), also known as non-performing loans (NPL), are loans or advances made by financial institutions (such as banks) that have stopped generating income or have significantly reduced their income due to default or non-payment by the borrowers. In other words, NPAs are assets on a bank's balance sheet that are no longer producing the expected returns.

 

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Source: RBI governor Shaktikanta Das cautions against evergreening of loans: Are banks, corporates still window-dressing loans? | Indian Express | Livemint