One problem that banks face is that sometimes they lend to people or companies that don’t pay them back. This causes two problems:

1. The banks lose money! Of course.
2. The banks can lend less in the future. A mistake now doesn’t just affect the money the bank makes today but also the money the bank can potentially make in the future.

Problem (1) is straightforward and the consequences for the bank are direct. In some sense, the consequences are also acceptable for the bank. It made a bet that didn’t work out so it lost money. Problem (2) though is partially the result of regulation. If a bank makes a loan that goes bad, it has to then put the same amount of money in a vault that it can’t touch and give it a fancy name (“provisions”). [1]

From a regulatory point of view, this is important! You have to ensure that banks don’t make too many bad loans and if they do, they compensate for it by “cancelling out” those bad loans by keeping money in this vault. From the bank’s point of view though, this is annoying. Sure, it made a bad loan. But any money it keeps in this vault is money it isn’t able to lend out and make more money with. It would’ve been nice if a bank could just ignore its bad loans instead always be in the pursuit of making more money from more loans.

I’m obviously slightly exaggerating here and making banks look like a bunch of whiny children trying to avoid facing the consequences of their actions. But my larger point is that risk assessment is a result of both bank policy and regulatory policy. Both expect bad loans to happen and there’s a constant push and pull about stuff like just how many bad loans are okay, when exactly does a loan count as a bad loan, how much money should be put into that vault (if at all), etc. India’s banks and its regulator, RBI, which has always been relatively conservative, have sort of lived alongside this.

But, of course, not everyone likes to be conservative. Some banks, NBFCs, and other financial institutions might prefer not listening to the RBI and might look for workarounds. Here’s one:

1. A bank realises that a loan that it made is about to go bad
2. Instead of putting money into a vault, the bank invests this money into an external fund.
3. This fund then invests this money into the borrower company that didn’t repay the initial loan in the first place.
4. This borrower then uses that money to “repay” the bank. So the bad loan doesn’t really look like a bad loan.

This magically solves both problems (1) and (2) for the bank that I mentioned earlier. Technically, the bank didn’t lose any money because it did get repaid. And it also didn’t have to keep money sitting in a vault and was able to lend (or invest) it and earn more interest.

But of course this doesn’t really solve the problem. If the borrower is unable to repay the original loan in time, lending more money to them might not be the brightest idea. [2] Last month, on the cusp of the new year, RBI decided that this is a problem that needs to be solved. From RBI:

In order to address concerns relating to possible evergreening through this route, it is advised as under:

(i) REs shall not make investments in any scheme of AIFs which has downstream investments either directly or indirectly in a debtor company of the RE.

…

(ii) If an AIF scheme, in which RE is already an investor, makes a downstream investment in any such debtor company, then the RE shall liquidate its investment in the scheme within 30 days from the date of such downstream investment by the AIF. If REs have already invested into such schemes having downstream investment in their debtor companies as on date, the 30-day period for liquidation shall be counted from date of issuance of this circular. REs shall forthwith arrange to advise the AIFs suitably in the matter.

(iii) In case REs are not able to liquidate their investments within the above-prescribed time limit, they shall make 100 percent provision on such investments.

If a bank or NBFC has lent money to a company, RBI says that it should not invest in a fund that invests in the same company. Or if the bank or NBFC is already an investor in a fund and the fund later invests in a company that has borrowed from that bank, the bank has to sell off its investment in that fund.

There are so many problems! For one, the lending arm of a bank should not be deciding where the investing arm puts its money. If you’re the person deciding where to invest for the bank, you don’t want to be blocked out because the fund that you’re interested in has 2% of its portfolio in a company that someone else in your bank decided to also lend to.

It’s worse when a bank or NBFC is already an investor in a fund. The funds that RBI is targeting here, alternative investment funds (AIFs), are risky and competitive. These include venture capital funds that invest in startups, private equity funds that invest in mature companies, or hedge funds that might be trading stocks. If you’re a fund manager that decides to invest in a company… are you going to check with your bank investors if they have already lent to this company? Or are your bank investors going to share a list of the companies they have already lent to so that you can avoid them? [3] Are you going to allow someone else to dictate where you can and can’t invest the money you’re managing?

Of course, if you’re this fund manager, RBI isn’t restricting you from investing wherever you like. But if you know you have bank or NBFC investors in your fund, and that they would be forced to sell, you don’t want them writing angry emails to you and selling off their holdings in the market. That would be bad! So you might prefer checking beforehand, or even better, getting rid of them as investors entirely.

Oh and this assumes that the bank or NBFC can even sell its holdings in the market. AIFs come with long lock-in periods, so its investors can’t just sell and move on (venture capital funds usually have 10 year lock-ins). RBI doesn’t seem to care.

It would’ve helped if RBI had also backed up its decision with some kind of data. “80% of all AIF investments by banks which have downstream investments in companies the banks have lent to are attempts at evergreening,” it might have said. And penalised some of those banks. It would still not have made complete sense to disallow these investments entirely but one could’ve empathised.

But RBI is choosing to complicate lending for banks and investing for AIFs without giving a single example of just how bad the problem that it’s trying to solve is in the first place.

Footnotes
[1] Not always! The amount of money that a bank will have to provision for a bad loan (that is, keep in the vault) will depend on the ratio of good loans to bad loans as well as how much money the bank has already provisioned (provision coverage ratio).

[2] I think the converse holds true too. If a bank lends to a company that is a good borrower and is repaying the bank in time, the bank might actually want to invest in the company via fund. It has already done some due diligence and it’s working out!

[3] No, they won’t. This is confidential information.

Many tks for preparing excellent notes with good data points.

Keep up the good work.

What about LT foods? Its numbers are better than KRBL and seems better placed as major business is exports. Just one query: Reason for fall from Rs.90 to Rs.19 between Jan 2018 to Aug 2019? What happened during this time to have such a steep fall? Also ROCE is less than 20…But at 15 and increasing trend.

Great to see some good research on this stock.
Quite a few Marquee investors have entered the stock via preferential allotment . Including Ashish kacholia at the price of 412 .

At 5,000 cr sale at 5 % profit will result in operating profits will go to 250 cr yearly, net profit around 220 cr .At a PE of 20 the stock should be trading at around 4500 market capitalization in 2-3 years .
The question is what PE should be given to such a company , if it can grow consistently even after 2-3 years that above 25 % + and is indicating a secular trend like the jewellery retails , market can give this company a PE of 30 or 40 also .At those PE market valuations should be closer to 6500 or 8500 cr once they achieve yearly net profit of 200-220 cr.
I don’t believe PE of 70 or 80 makes sense like the retail jewellery companies as companies like sky gold are way down the value chain , have limited moats and limited pricing power .

There are still areas and ways in which the management can increase their margin in the future as well as accelerate growth of revenues . The money raised from the preferential allotment will be used in the coming year for those purposes too .

A current risk is the swift rise of the share price which has happened in the past months, if Q3 results disappoint due to whatever reason or any bad news , the stock can correct drastically to 750 levels .

Invested from Rs 300 level in the stock .

Mutual Funds add another 4,50,000 shares of Redtape in December taking MF’s holding to over 7%