The practice of evergreening loans makes bad loans look good by extending fresh credit to struggling borrowers. It puts lenders at risk of massive defaults and undermines the integrity of their loan books.
It goes against the RBI’s norms and constitutes misgovernance. The audit committee of a bank must be vigilant against this practice.
Misrepresentation of Loan Quality
The governor of the Reserve Bank of India recently raised red flags over banks’ innovative methods for covering up the actual status of stressed loans. One such practice is evergreening, whereby financial institutions extend additional funds to borrowers who are struggling with debt repayments. This allows the borrower to avoid defaulting on their debt payments and maintain a clean credit profile, but it can mask the proper level of financial strain and create systemic risks.
The practice of evergreening can take several forms, including rolling over existing debts with modified terms and conditions, transferring outstanding loans to other entities, and using internal accounts or related party transactions to hide the loan’s status. It can also involve selling or buying back loans or debt instruments between lenders to avoid classifying them as non-performing assets (NPAs) or persuading good borrowers to enter structured deals with distressed borrowers to conceal their debt troubles.
While these strategies may appear to keep loans from defaulting in the short term, they can lead to a cycle of increasing debt and higher provisioning requirements in the long run. Additionally, evergreening can distort the accurate picture of a bank’s loan portfolio and obscure significant trends in lending and economic performance.
Indirect evergreening is also problematic because it diverts resources from productive companies to zombie firms that are already in trouble. This prevents the process of Schumpeterian creative destruction from taking place and leaves startups and other influential companies unable to obtain the necessary funding.
Furthermore, indirect evergreening is a form of loan laundering, as it involves concealing the origins of a loan by routing funds through third parties. This can allow corrupt politicians and bureaucrats to divert public money to their private interests or to finance their political campaigns.
In addition to the blatant mismanagement of public funds, direct and indirect evergreening can also lead to significant losses for the banking sector. It can expose banks to a number of risks, including governance and audit failures, and can also increase the amount of non-performing assets on their books. Moreover, it can also lead to a loss of confidence in the banking sector.
Misrepresentation of Provisioning Requirements
Banks often engage in evergreening to avoid classifying their loans as non-performing assets (NPAs). But this practice comes with a price. It masks the proper level of stress on a bank’s balance sheet and misrepresents its financial health. It also leads to a lack of transparency in the banking sector. It becomes difficult for regulators, investors, and students preparing for exams to assess a bank’s financial health.
When a loan is on the verge of default, banks try to revive it by providing more funds to the borrower. This is known as ‘evergreening’. Banks do this to prevent the troubled debt from being marked as an NPA, which may require them to make higher provisions. This allows them to maintain their profit margins and continue lending money.
However, the problem with this practice is that it deprives other borrowers of credit. It also makes it hard for regulators to identify and address bad lending practices. This year, the Union Budget proposed a scheme to clean up the NPA mess. This is a crucial step towards improving the health of our banking sector.
But even after this, the issue of bad loans will remain. The reasons are many. Banks must focus on improving their risk assessment, customer grievance handling, and fraud reporting. They must also implement robust corporate governance practices and take disciplinary action against errant managers.
Indirect evergreening is a significant problem because it distorts the industrial economy by keeping zombie companies alive longer and hampering newer firms’ ability to access credit. As a result, the process of Schumpeterian creative destruction is stalled, and productivity is lower than it could have been.
The best way to prevent evergreening is by imposing stricter penalties on banks that break the rules. Penalties should include cancellations of unvested stock options, clawback of monetary bonuses for officers, and the removal of whole-time directors. This is necessary because the wilful violation of RBI norms by senior management is equivalent to misgovernance. The audit committee of banks must be vigilant and take disciplinary action against such officials if they find significant instances of evergreening.
Diversion of Resources
The evergreening of loans diverts resources away from the real economy, depriving start-ups and small and medium businesses (SMEs) of the funds they need to expand or invest in new projects. It also leads to crowding-out effects, where weak firms increase leverage through borrowing from bank-related entities but do not make good use of the capital, thus depriving healthy companies of the resources they need. As a result, the overall economy is weakened. The Reserve Bank of India is aware of the issues associated with evergreening and has repeatedly warned banks against it. This is why the RBI has strengthened regulations for regulated entities in an attempt to prevent it.
Indirect evergreening involves extending new loans to borrowers who are already struggling with debt repayments and concealing the actual status of those loans on the bank’s books. This is often done to avoid classifying them as non-performing assets (NPAs), which would require higher provisions and impact profitability.
Regulatory bodies such as the RBI are concerned about this practice because it allows banks to hide the severity of stress on their books, which can then evolve into a crisis over time. Moreover, it can lead to systemic economic risks by distorting the creditworthiness of the entire banking sector.
There are several ways in which banks can engage in evergreening, including adjusting the borrower’s repayment schedule through internal or office accounts, extending loans to wilful defaulters by giving them more time to repay their existing loans, and selling and buying back debt instruments between two lenders to avoid classification as NPAs. Indirect evergreening can also involve persuading good borrowers to enter into structured deals with stressed borrowers to hide their defaults.
Banks and supervisors must be vigilant against these practices and have the necessary tools to detect them. For example, it is essential to improve transparency in loan reporting, especially for fast-growing areas such as non-bank financial companies. In addition, strengthening governance and audit processes is crucial to preventing evergreening. Finally, it is essential to levy penalties and take action against erring officers when significant evergreening is detected.
Systemic Economic Risks
The evergreening of loans upsc poses systemic economic risks and distorts the actual state of a bank’s loan portfolio. It allows banks to conceal stress on their books and can eventually evolve into a crisis. The Reserve Bank of India has repeatedly asked banks to avoid this practice. However, many lenders continue to use innovative methods to make their stressed loans evergreen. These strategies include selling off assets and transferring debt to other entities. Banks also use these techniques to avoid classifying distressed loans as non-performing assets (NPA), which would require them to make provisions and reduce their profitability.
These practices may seem harmless in the short run, but they can lead to a vicious cycle of increasing debt and financial instability for both borrowers and lenders. It is crucial for lenders to provide accurate and transparent reporting on their loan portfolios and to implement stricter rules against evergreening.
In a recent speech, the Reserve Bank of India governor raised red flags over banks adopting “innovative methods” to cover up the actual status of stressed corporate loans. He warned that such schemes could pose grave risks to the banking sector and tarnish the reputation of the RBI. He noted that these innovative ways to evergreen loans involve selling off assets, transferring the debt to other entities, and even bringing together two lenders to evergreen the same loan. This is a clear violation of the principle of good governance, and it can have severe consequences for both the lender and the borrower.
Moreover, evergreening loans can divert resources away from other projects and lead to the crowding-out effect. This can cause other financially healthy companies to suffer from a lack of capital, which in turn can affect the economy as a whole. The central government recently announced plans to strengthen banks’ audit committees in an effort to reduce evergreening and promote transparency in the banking sector. Aspirants for exams should familiarize themselves with concepts like evergreening and interest coverage ratio to understand the significance of these issues.
In addition, the P J Nayak Committee highlighted that there is a mismatch between loan write-offs and evergreening. Loan write-offs are a process of removing bad loans from the books of banks after making adequate provisions for them, whereas evergreening involves extending new or additional loans to already existing borrowers.