With the recent Union Budget Bank proposing a bad bank to clean up NPAs, banks have come up with an evergreen problem. Lending greenery is a well-known exercise in which banks restore the default margin by lending more to the same institution. Everyone knows the consequences of evergreens: the reduction of defaults reported in the short term, followed by the eventual explosion at default rates. This pattern is reflected in all major economies, including the US, the European Union, Japan and India. In most cases, the evergreen process is straightforward: the troubled bank lends to the troubled borrower and is therefore identified with some effort. In a recent paper, Nishant Kashyap, Srinivas Mahapatro and I call it ‘indirect green’, in which banks and institutions use institutions related to evergreen loans. The thing to worry about is that both markets and regulators seem to be losing sight of this phenomenon.
In the research paper, we examine the indirect evergreen phenomenon using relevant entities in the Indian context. We look at the 44,196 large corporate loans given out in a decade. Modus operandi can be illustrated by a stylistic example. Consider borrower Bini who borrowed from Bank L. Suppose borrower B is in trouble and is not in a position to repay the loan. To hide this default default default, Bank L can lend directly to the borrower. However, such a transaction is easily recognizable. The sector regulator may ask the bank to justify repeated lending to a distressed borrower. To avoid scrutiny, the bank will give the next loan intended to protect the default edge loan to an entity, say B1, which is the corresponding party of B. It could be a shell company run by the promoters of B, or even an existing subsidiary. B1 then pays the funds to B, who uses the same to repay Bank L. Thus, the loan from Bank L is used by the financially insolvent borrower to repay L’s previous loan.
Such indirect evergreen is more dangerous than giving direct loans to poor-quality firms due to its opaque nature and its consequences. First, we found that 5% of all large loans we studied were indirectly evergreen. Therefore, the phenomenon is economically meaningful.
Second, we found that both financial markets and regulators do a poor job of detecting and preventing indirect evergreens. While banks ’stock prices react negatively to the restructuring and / or low-quality credit restructuring of banks that have large loans on their books, the indirect evergreen escapes the radar of the market. Therefore, borrowers and lenders engaged in the exercise do not need to fear an immediate decline in stock prices, and, therefore, prefer this approach rather than giving direct loans to troubled borrowers or formal debt restructuring.
Third, although the bank regulator conducted a detailed asset quality review (AQR), the phenomenon in question appears to have escaped regulatory scrutiny. Banks are required to report discrepancies between the provisions made for loan losses and those deemed appropriate after the Reserve Bank of India (RBI) AQR. We found that these differences were positively correlated with the direct greening done by debt restructuring. However, our indirect evergreen measurement did not significantly correlate with the reported gaps. In other words, banks engaged in indirect evergreen work were not asked to make additional regulations after the AQR.
We found that indirect greenery practice accelerated after AQR, as direct greening became more difficult through restructuring or lending due to increased RBI monitoring.
Indirect evergreen learning can never continue. Finally, when depositors find out what is going on or when the economy is in shock that banks cannot lend for capital, the indirect evergreen chain breaks down and borrowers begin to default. We have found that evergreen loans eventually end up by default.
Therefore, it is not surprising that banks like Yes Bank, which was less affected by the AQR, saw the explosion of default rates and reached a technical failure. One explanation for this is the construction of toxic properties by indirect evergreens. In fact, by our measure, yes the bank was indirectly in the first place among banks in terms of the ratio of evergreen loans before the collapse.
The implications of indirect greenery for the industrial economy go beyond banking. Industries dominated by indirect evergreen beneficiary firms see significant distortion in credit, with ‘zombie’ firms taking up most of the credit and leaving startups and other manufacturing firms overwhelmed and dry for credit. As the process of Shumperian creative destruction comes to a halt, companies that should have existed for a long time and companies that could not get the resources should take their place. Therefore, overall productivity and employment are much lower than their levels when not evergreen.
Our data sets show a growing trend in indirect evergreen country over time. This method is also prevalent among many co-operative banks and non-banks. Indian regulators need to take action on this issue before it is too late. They need to improve their audit toolkit so that they can detect indirect evergreens. Even a bad bank solution will not work if bad assets are not properly identified in the first place.
Prasanna Tantra is an Assistant Professor at the Indian School of Business