RBI curbs welcome, but why are banks even allowed to invest in AIFs?

The Reserve Bank of India (RBI), through its notification dated December 19, 2023, has said regulated entities (REs, that is, banks/NBFCs) shall not make investments in any scheme of Alternative Investment Funds (AIF) which has downstream investments either directly or indirectly in a debtor company of the RE.

The story that is unfolding now resembles that of inter-corporate deposits brokered by banks in the 1990s.

This happened sometime before 1997. In those days, banks were paying interest on their term deposits as decided by the RBI. Only with effect from October 22, 1997, the RBI gave commercial banks the freedom to fix interest rates on domestic term deposits of various maturities. With effect from October 25, 2011, the RBI deregulated interest on savings bank accounts, too.

Solution for resource crunch? 

Mr KS was the manager of a bank's main branch in a city. He had a corporate customer whose finance controller was willing to make some crores of rupees as deposits. But he wanted higher interest rates than the card rate as decided by the RBI. The bank was in desperate need of funds. It could not lend even to its top-class clients due to a resource crunch. Finally, Mr KS decided to use the opportunity.

The bank received the funds from the company and directly credited the account of another corporate borrower client. There was some understanding of the interest to be paid for the so-called deposit and also the interest to be paid by the corporate client at whose disposal the funds were placed. The bank termed it an 'inter-corporate deposit' (brokered by it). The difference in interest (spread) was the bank’s profit.

As the bank did not show the funds as deposits in its books, it did not take into account the funds for the calculation of the Cash Reserve Ratio and Solvency Liquidity Ratio. (This should have been viewed as a serious violation.)

What started as a one-time measure continued later as well. Many other banks also followed the same method. But then some corporates that received funds defaulted. The banks could not refuse payment to the provider of funds. Then some people, mostly the managers who acted on the oral instruction of head office, were made scapegoats.

What AIFs stand for

Investment of banks in AIFs seems to be on similar lines to help some borrowers who otherwise may not be eligible for lending by banks. The RBI has said, “Certain transactions of REs involving AIFs that raise regulatory concerns have come to our notice.”

An 'AIF' refers to any fund established or incorporated in India that is a privately pooled investment vehicle collecting funds from select investors for investing under a defined investment policy for the benefit of its investors. AIFs are subject to registration with SEBI, and should be operated per the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.

An AIF is not permitted to make an invitation to the public to subscribe to its securities. It's a privately pooled investment vehicle. AIFs shall raise funds through private placement by issue of information memorandum or placement memorandum, by whatever name called. An AIF may raise funds from any sophisticated investor, whether Indian, foreign or non-resident Indians, who inter alia undertakes the risk of investing in primarily unlisted or illiquid securities.

New RBI rules on AIF investment

Now, the RBI has notified that REs like banks/NBFCs shall not make investments in any scheme of AIFs that has downstream investments – either directly or indirectly – in a debtor company of the RE. The debtor company of the RE, for this purpose, shall mean any company to which the RE currently has or previously had a loan or investment exposure anytime during the preceding 12 months.

If an AIF scheme in which an 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. In case REs are not able to liquidate their investments within the above-prescribed time limit, they shall make 100 per cent provision on such investments.

Outright ban need of the hour

The steps taken by the RBI are in the right direction. Banks should not be allowed to finance their non-eligible customers through the AIF route. But one wonders why banks should even be permitted to invest in AIF. Even with the revised guidelines, it is possible to circumvent some investment rules. It is possible that Bank X may invest in an AIF which deploys the funds of a firm financed by Bank Y. Bank Y may reciprocate by investing in an AIF which finances a firm financed by Bank X.

In the preceding five years (from June FY19 to June FY24), the AIF industry has experienced a remarkable Compound Annual Growth Rate (CAGR) of 26%, resulting in impressive assets under management (AUM) of ₹13.74 lakh-crore. This growth rate surpasses the mutual fund industry's performance, which registered a CAGR of 13% and managed an AUM of ₹46.63 lakh-crore as of August 2023, highlighting the industry's growth at more than twice the rate.

With the galloping growth of AIF, it is better to be cautious, and go for outright curbs on banks investing in AIFs. There can’t be any compelling reason for a bank to invest in AIFs. After all, they are using the funds of depositors and they must use it judiciously.