An evergreening exercise that has gone unnoticed for too long

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The issue of evergreening by banks has come to the fore with the recent union budget proposing a bad bank to clean up bank NPAs. Evergreening is a well-known exercise in which banks, by granting further loans to the same company, revive a loan on the verge of default. The consequences of evergreening are well known: a short-term reduction in reported defaults, followed by an eventual default rate explosion.

In all major economies, including the US, the European Union, Japan, and India, the pattern has manifested itself. The process of evergreening is direct in most instances: a troubled bank lends to a troubled borrower, and therefore, with some effort, is detectable. Nishant Kashyap, Sriniwas Mahapatro and I highlight what we call ‘indirect evergreening’ in a recent paper in which banks and companies use associated entities to make evergreen loans. Worryingly, this phenomenon is seemingly missed by both markets and regulators.

We examine the phenomenon of indirect evergreening using associated entities in the Indian context in the research paper. 44,196 large corporate loans lent over a decade were examined. It is possible to explain the modus operandi through a stylized example. Consider borrower B, who has a bank L loan. Suppose borrower B is in trouble and is not able to repay the loan. Bank L could directly grant borrower B a loan in order to hide this expected default. Such a transaction is easily detectable, however.

The bank could be asked to justify repeated lending to a borrower in trouble by the industry’s regulator. The bank lends the subsequent loan, intended to rescue the loan on the verge of default, to an entity, say B1, which is a related party of B, in order to avoid scrutiny. It might be a shell company run by B’s promoters, or even an existing subsidiary. Then B1 passes the funds on to B, who then uses the same money to repay Bank L. Thus, a loan from bank L is used to repay L’s previous loan by a financially insolvent borrower.

Such indirect evergreening, both due to its opaque nature and its consequences, is more dangerous than direct lending to poor-quality firms. First, we found that nearly 5% of all the large loans we studied were evergreened indirectly. The phenomenon is therefore economically meaningful.

Second, we find that there is a poor job of unearthing and preventing indirect evergreening in both financial markets and regulators. While bank stock prices react negatively to the renewal and/or restructuring by banks with large bad loans on their books of low-quality debt, indirect evergreening seems to escape the radar of the market. Borrowers and lenders engaged in the exercise, therefore, need not be afraid of an immediate decline in stock prices and are therefore likely to prefer this path over direct lending to troubled borrowers or formal restructuring of debt.

Third, the phenomenon in question appears to have escaped regulatory scrutiny even though the bank regulator conducted a detailed asset quality review (AQR). Banks were required to report discrepancies between their provisions for loan losses and what was considered appropriate by the Reserve Bank of India (RBI) after the AQR.

These differences are positively correlated with direct evergreening by means of credit restructuring, we find. Our measure of indirect evergreening, however, is not associated significantly with the gaps reported. In other words, after the AQR, banks engaged in indirect evergreening were not asked to make further provisions.

We also find that after the AQR, the practice of indirect evergreening accelerated, as direct evergreening through restructuring or lending became difficult due to increased supervision by the RBI.

The indirect evergreening practice can not go on forever. Ultimately, the chain of indirect evergreening will break down and borrowers will begin to default, either when depositors realize what is going on, or when the economy faces a shock such that banks can not keep lending for want of capital. We discover that evergreen loans ultimately end up in default.

Therefore, it is not surprising that banks such as Yes Bank, which was relatively less affected by the AQR, saw a default rate explosion and reached a point of technical failure. One possible explanation for this might be the build-up of toxic assets through indirect evergreening. Indeed, according to our measure, Yes Bank ranked No. 1 among banks in terms of the proportion of indirectly ever-greening loans just before it collapsed.

The consequences of indirect evergreening go beyond the industrial economy to banking. Industries dominated by companies that are beneficiaries of indirect evergreening see a major credit distortion, with ‘zombie’ firms cornering most of the credit and leaving high and dry for want of credit for startups and other productive firms.

The process of creative destruction by Schumpeter is halted, with companies that should have ceased to exist lingering longer and companies that should have taken their place unable to obtain resources. Thus, in the absence of evergreening, overall productivity and employment end up being far lower than their likely levels.

With time, our data sets show an increasing trend in the country of indirect evergreening. Among many cooperative banks and non-banks as well, the practice seems to be prevalent. Before it is too late, Indian regulators must take up this issue and act. To be able to detect indirect evergreening, they will have to improve their audit toolkit. If bad assets are not properly identified in the first place, even a bad bank solution won’t work.