RBI Tightens Regulations on Banks' Investments in Alternative Investment Funds

Key Takeaways:

1. RBI aims to prevent evergreening of loans through AIF investments

2. New rules clarify downstream investment restrictions and provisioning requirements

3. Subordinated units in AIFs with priority distribution models face capital deductions

4. Guidelines affect banks, co-operative banks, financial institutions, and NBFCs

5. Immediate implementation of the new regulations is required

Detailed Narrative:

The Reserve Bank of India has taken significant steps to address regulatory concerns surrounding investments in Alternative Investment Funds (AIFs) by banks and other regulated entities. This move comes in response to observed transactions that raised red flags about potential loan evergreening practices.

The initial circular, dated December 19, 2023, laid out the foundation for these new regulations. It prohibited regulated entities (REs) from investing in AIF schemes with downstream investments in their debtor companies. A debtor company, in this context, is defined as any company to which the RE has had a loan or investment exposure within the preceding 12 months.

To ensure compliance, the RBI mandated that if an AIF scheme in which an RE has invested makes a downstream investment in a debtor company, the RE must liquidate its investment in that scheme within 30 days. Failure to do so would result in a 100% provision requirement on such investments.

The circular also introduced a capital deduction requirement for investments in subordinated units of AIF schemes with a 'priority distribution model', as defined by the Securities and Exchange Board of India (SEBI) in their circular dated November 23, 2022.

However, recognizing the need for clarity and uniformity in implementation, the RBI issued a follow-up circular on March 27, 2024. This new circular provided several important clarifications:

1. Downstream investments now exclude equity shares of the debtor company but include all other investments, including hybrid instruments.

2. The 100% provisioning requirement is limited to the extent of the RE's investment in the AIF scheme that is further invested in the debtor company, not the entire investment in the AIF scheme.

3. The capital deduction for subordinated units only applies when the AIF has no downstream investment in a debtor company of the RE. If there is such a downstream exposure, the RE must comply with the provisioning requirements instead.

4. Capital deductions for subordinated units should be equally split between Tier-1 and Tier-2 capital.

5. The term "subordinated units" includes all forms of subordinated exposures, including sponsor units.

6. Investments made through intermediaries like fund of funds or mutual funds are excluded from these regulations.

These guidelines apply to a wide range of financial institutions, including commercial banks, small finance banks, local area banks, regional rural banks, urban co-operative banks, state co-operative banks, central co-operative banks, all-India financial institutions, and non-banking financial companies (including housing finance companies).

The RBI has emphasized that these instructions are effective immediately, underscoring the urgency of addressing the regulatory concerns surrounding AIF investments.

FAQs:

Q1: Why has the RBI introduced these new regulations?

A1: The RBI aims to prevent potential evergreening of loans through indirect exposures via AIFs and address related regulatory concerns.

Q2: Which financial institutions are affected by these guidelines?

A2: The guidelines apply to all commercial banks, co-operative banks, financial institutions, and non-banking financial companies, including housing finance companies.

Q3: What happens if a regulated entity can't liquidate its investment in an AIF scheme within 30 days?

A3: If liquidation isn't possible within the prescribed time, the regulated entity must make a 100% provision on such investments.

Q4: Are all downstream investments by AIFs prohibited for regulated entities?

A4: No, only downstream investments in debtor companies of the regulated entity are restricted. Equity share investments are now excluded from this restriction.

Q5: How does the capital deduction for subordinated units work?

A5: Investments in subordinated units of AIFs with priority distribution models are subject to full deduction from the regulated entity's capital funds, equally from Tier-1 and Tier-2 capital.

Q6: Are investments made through mutual funds affected by these regulations?

A6: No, investments in AIFs through intermediaries such as fund of funds or mutual funds are not included in the scope of these circulars.

Key Precedents:

1. RBI Circular DOR.STR.REC.58/21.04.048/2023-24 dated December 19, 2023: This circular introduced the initial set of regulations on investments in AIFs by regulated entities.

2. RBI Circular DOR.STR.REC.85/21.04.048/2023-24 dated March 27, 2024: This follow-up circular provided clarifications and additional instructions to ensure uniformity in implementation of the previous circular.

3. SEBI Circular SEBI/HO/AFD-1/PoD/P/CIR/2022/157 dated November 23, 2022: This circular defined the 'priority distribution model' for AIFs, which is referenced in the RBI's regulations.

4. Banking Regulation Act, 1949 (Sections 21, 35A, and 56): These sections provide the legal basis for RBI's authority to issue these regulations for banks.

5. Reserve Bank of India Act, 1934 (Chapter IIIB): This chapter grants RBI the power to regulate financial institutions.

6. National Housing Bank Act, 1987 (Sections 30A, 32, and 33): These sections empower RBI to issue regulations for housing finance companies. These precedents collectively form the legal and regulatory framework under which the RBI has issued its new guidelines on AIF investments, aiming to strengthen the financial system and prevent potential misuse of investment routes.

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CIRCULAR

SEBI/HO/AFD-1/AFD-1-PoD/P/CIR/2024/42

May 13, 2024

To,

All Alternative Investment Funds

Sir/Madam,

Sub: Certification requirement for key investment team of manager of AIF

1.In terms of Regulation 4(g)(i)of SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”), the key investment team of the Manager of an Alternative Investment Fund(AIF)shall have at least one key personnel with relevant certification as may be specified by SEBI from time to time, as an eligibility criterion for obtaining certification of registration as an AIF. The said Regulation has come into force with effect from May 10, 2024.

2.Further, SEBI (Certification of Associated Persons in the Securities Markets) Regulations, 2007have also been amended and notified on May 10, 2024 stipulating the following –

‘At least one key personnel, amongst the associated persons functioning in the key investment team of the Manager of an Alternative Investment Fund, shall obtain certification from the National Institute of Securities Market by passing the NISM Series-XIX-C: Alternative Investment Fund Managers Certification Examination as mentioned in the communiqué No. NISM/ Certification/ Series-XIX-C: Alternative Investment Fund Managers/2024/01 dated January 10, 2024 issued by the National Institute of Securities Market.’

3.In this regard, the following is specified:

3.1.The requirement for at least one key personnel of the key investment team of manager of AIF to obtain the aforesaid certification, shall be applicable as an eligibility criterion to all the applications for registration of AIFs and launch of schemes by AIFs filed after May 10, 2024.

3.2.Further, the aforesaid requirement of obtaining the certification shall be complied with on or before May 09, 2025, for the following–

(i)Existing schemes of AIFs; and,

(ii)Schemes of AIFs whose application for launch of scheme pending with SEBI as on May 10, 2024.

4.The trustee/sponsor of AIF, as the case may be, shall ensure that the ‘Compliance Test Report’ prepared by the manager in terms of para 15.2 of SEBI Master Circular No. SEBI/HO/AFD-1/AFD-1-PoD/P/CIR/2024/39dated May 07, 2024, includes compliance with the provisions of this circular.

5.The provisions of this circular shall come into force with immediate effect.

6.This circular is issued with the approval of the competent authority.

7.This circular is issued in exercise of powers conferred under Section 11(1) of the Securities and Exchange Board of India Act, 1992 to protect the interests of investors in securities and to promote the development of, and to regulate the securities market.

8.The circular is available on SEBI website at www.sebi.gov.in under the categories “Legal framework -Circulars" and "Info for -Alternative Investment Funds”.

Yours faithfully,

Sanjay Singh Bhati

Deputy General Manager

Tel no.: +91-22-26449222

ssbhati@sebi.gov.in