Evergreening of Loans, Risk and Mitigation Strategies

Context: The Reserve Bank of India (RBI) has imposed business restrictions on two Edelweiss group companies, Edelweiss Asset Reconstruction Company (EARC) and ECL Finance Ltd (ECL), due to concerns related to evergreening of loans observed during supervisory examinations.

What is Evergreening of Loans?

• Evergreening is a financial tactic where institutions extend or renew loans for borrowers who cannot meet repayment deadlines.
• Purpose: It’s done to make it appear as though borrowers are timely in their payments, thus maintaining an image of financial health.
• Reasons for Evergreening:
  • Avoiding NPA Classification: Financial institutions engage in evergreening to prevent loans from becoming non-performing assets (NPAs), which require increased provisioning and affect profitability.
  • Maintaining Relationships: Evergreening helps preserve client relationships, keeping even wilful defaulters from appearing in defaulters’ books.

Risks of Evergreening

• Inflating Portfolio Quality: This practice can misleadingly enhance the perceived health of a loan portfolio, deceiving investors and regulators.
• Debt Cycle Risk: It might prevent immediate defaults but leads to increasing debt and potential long-term financial instability.
• Systemic Financial Risks: Evergreening masks the actual volume of bad loans, posing risks to the overall financial system’s stability.
• Governance Issues: Often indicative of poor governance, evergreening can result from improper relationships between bankers and borrowers.
• Examples and Indicators:
  • Misuse of Funds: Instances of fund misappropriation by borrowers have been noted, where loans intended for business development are diverted.
  • Indirect Evergreening: In India, indirect evergreening involves weak banks lending to struggling companies through intermediaries, which then misuse these funds, exacerbating financial vulnerability.

Mitigation Strategies

• Regulatory Actions: The Reserve Bank of India (RBI) can impose penalties such as the cancellation of unvested stock options and clawbacks of bonuses for involved officers and directors.
• Role of Governance Bodies: The CEO, audit committee, and board are crucial in preventing evergreening. The audit committee must be vigilant and proactive in detecting and addressing any signs of evergreening.
• Penalties and Accountability: If evergreening is detected, it’s essential to hold the responsible parties accountable to maintain integrity and discipline within the banking system.

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