Top-up lending or prop-up lending: RBI cautions against NBFCs lending practices

– Anita Baid, Senior Vice President | anita@vinodkothari.com

The recent press reports highlighting the RBI’s focus or nudge towards NBFCs regarding their lending practices, particularly those that raise concerns about evergreening of loans, demand a comprehensive analysis. 

Extending further credit to a borrower already facing financial distress can be similar to the cautionary tale of an archer trying to locate a lost first arrow by shooting a second in the same spot, only to lose both. Similarly, if lenders take additional exposure on distressed borrowers, there is a risk of compounding existing defaults into a larger and unmanageable crisis.

RBI during its inspections and reviews has been raising concerns on the systemic practice of NBFCs for masking underlying stress in its loan assets. This risk of evergreening is not new to the lending industry. The practice of suppressing the stress in loan accounts and fueling further funds in a way artificially sustains the health of a lender’s loan book despite the underlying credit risk that is persisting or deteriorating. In fact this impacts both the financial stability of the NBFC sector and the broader health of the financial ecosystem. 

What is the concern with a second loan?

Evergreening fundamentally involves issuing a new loan or credit facility to an existing borrower who is already under stress, with the sole or primary purpose of enabling them to repay the existing non-performing or stressed loan obligation. On paper, this makes the original asset appear healthy, delaying the mandatory provisioning which is required when a loan is classified as Non-Performing Asset.

While repeat business is commercially desirable given the benefit of hindsight, a high proportion of new lending consistently going to existing, mostly stressed customers even before the previous loan is closed raises red flags. It suggests that the borrower may be relying on continuous refinancing rather than genuine income generation to service their debt obligation.

The supervisory inspections conducted by the RBI have already exposed and flagged this systemic practice across several prominent NBFCs. Evergreening leads to an overstatement of the NBFC’s profitability and capital adequacy, thereby misleading investors and other stakeholders. The regulator has in fact signaled that the era of regulatory forbearance and turning a blind eye to window-dressing is over. However, it is critical to understand the stance taken by the RBI. The core message is one of discipline and transparency, not an outright ban on providing a second loan to existing borrowers.

How to identify stress in a loan?

The trigger for a stress in a loan transaction is default on part of the customer. At times, there could be impact on the repayment capabilities of the borrower, due to losses in business, loss of employment, deterioration in the collateral value, etc. Banks and NBFCs that are engaged in lending business and have a customer interface are required to identify the stress in the loan accounts and accordingly classify them and create provisions against the same. The SMA and NPA classification is required to be ensured pursuant to occurrence of default based on the DPD (days past due) status. Accordingly, necessary provisions are also created against the said assets.

For NBFCs with a net worth more than ₹250 crores are required to adopt Indian Accounting Standards. Under the IndAS, the loans are staged based on the credit impairment and the provisioning is determined based on the expected losses. 

While the intent is to identify stress, staging of loans is not the same as classification as SMA or NPA, and is applicable only for NBFCs with IndAS applicability. 

Bar on lending to existing borrowers?

The RBI has not barred NBFCs from extending fresh credit to borrowers who are experiencing genuine, temporary financial distress. However, the second loan should be strictly conditional upon proper evaluation of the customer’s credibility. To distinguish legitimate financial assistance from fraudulent evergreening, it is important that NBFCs should establish a formal, board-approved policy governing the extension of any additional or new credit to borrowers with existing stress. 

1. The credit policy must explicitly list out the safeguards for extension of such loans.

2. In case NBFCs are intending to take fresh exposure on the existing borrower, the credit policy must list out the specific justifiable commercial rationale for extending the additional credit. It cannot be merely for the purpose of repaying the existing loan. There should be a credible objective or business plan or future prospects of the borrower that justifies the funding requirement. 

3. Every new loan application, irrespective of whether the borrower is a repeat customer, must undergo an independent credit assessment. This includes a fresh analysis of the borrower’s cashflow, income stability, debt-to-income ratio, and the purpose of the new loan. 

4. If required, the sanction may also be subject to a higher level of scrutiny, possibly requiring approval from a higher credit authority or an independent risk officer.

5. The disbursement from the new loan must not be used to set off the outstanding amount of the existing loan. Both loans should remain active and amortise according to their respective agreed repayment schedules.

6. NBFCs must list out the specific control mechanisms and due diligence steps undertaken to ensure that the new credit is demonstrably not being used to merely conceal the stress in the original loan. This could involve end-use monitoring of funds or increased security cover for the additional funding. 

7. A significant percentage of the existing loan must be repaid, say 60-75% or a reasonable time interval must pass before the new unrelated loan is sanctioned. 

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