Edelweiss moves its money around and RBI doesn't like it

Maybe don't humour those without a sense of humour

Moving in circles.

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If you’re a bank and you make a loan which goes bad, you have two options:

1. You can try to recover the money. Maybe the borrower is just having some liquidity problems. You can renegotiate terms, send angry notices, seize assets, or even send thugs to intimidate the borrower to pay up (not legal advice).

2. You can sell off the loan. You obviously get less money here than you would have had you recovered the full loan amount, but that’s okay. You can move on.

Both of these options have their pros and cons, but they’re both perfectly fine choices depending on the situation.

But option (2) is slightly more enticing. You’re a bank! You make money by lending money and charging an interest. You want to spend your time and resources in identifying who you should be lending to. That’s what you try to be good at.

Once a loan goes bad, recovering the money is an entirely different skill set. I mean, sure, loan recovery is also a part of what you do, but your bad asset desk is going to be much smaller than your lending desk. (Imagine a bank where it wasn’t.)

If you do decide to go with the enticing option (2), you can sell your bad loans to an asset reconstruction company (ARC). The ARC buys bad loans and spends all its time recovering those loans. The bank takes a loss on some of its bad loans and gets to continue focusing on its core business, lending. The ARC gets to focus on its core business, recovery.

Sometimes the bank and the ARC are owned by the same company… and that can complicate things.

Late in May RBI issued a press release about restrictions it was placing on ECL Finance and Edelweiss ARC. ECL is an NBFC and Edelweiss ARC is an asset reconstruction company. Both are owned by Edelweiss Financial Services.

Here are the restrictions the RBI imposed:

1. ECL Finance can no longer lend to companies using structured transactions.¹ (It can still do so to individuals.)

2. Edelweiss ARC cannot buy any financial assets. That’s pretty much pausing its core business, which is acquiring bad loans and recovering money from them.

RBI elaborates a bit on what triggered these restrictions:

The action is based on material concerns observed during the course of supervisory examinations, essentially arising out of conduct of the group entities acting in concert, by entering into a series of structured transactions for evergreening stressed exposures of ECL, using the platform of EARCL and connected AIFs, thereby circumventing applicable regulations.

Edelweiss’s NBFC, ECL, apparently used Edelweiss ARC and certain Edelweiss funds to evergreen its bad loans. One can imagine how this could happen. ECL could have lent some money, and then figured that it wouldn’t get repaid. It could then sell the loan to Edelweiss ARC. Now, Edelweiss ARC had to recover this money from the borrowing company. So, separately, Edelweiss’s funds could lend it money. The company would then use this money to “repay” the ARC a negotiated amount. It would now have to repay the fund instead.

There’s more:

Incorrect valuation of SRs [security receipts] was also observed in both ECL and EARCL…

One reason a bank usually sells its bad loans to an ARC instead of to any random fund is that an ARC can usually pay a better price for those loans. Because—they don’t need to pay entirely in cash! An ARC can just write out a number on a piece of paper and give the paper to the bank instead of cash. This piece of paper is a “security receipt” and is a type of a promissory note.

I’m being facetious. The ARC can’t write out any number on the paper. Security receipts are supposed to be backed by the assets that the ARC hopes to sell and recover money from. If the loan the ARC bought was backed by property, for instance, it has to estimate the price that it would be able to sell the property for and issue security receipts of that value, save for some cushion.

The RBI says that ECL mis-valued the security receipts it received from Edelweiss ARC. That almost certainly means that it overvalued them. That way, the ARC would need to pay less cash upfront to get those assets off ECL’s books.

There’s even more:

ECL, by taking over loans from non-lender entities of the group for ultimate sale to the group ARC, allowed itself to be used as a conduit to circumvent regulations which permit ARCs to acquire financial assets only from banks and Financial Institutions.

ARCs can pay with security receipts because they are regulated by the RBI.² Of course this privilege comes with restrictions. They can buy bad loans only from a financial institution. This makes sense! The RBI allows ARCs to conjure money into pieces of paper because it wants financial institutions—which are also regulated by the RBI—to be able to rid themselves off their bad loans.³ Everyone else better find a buyer with cash.

Anyway so the RBI also thinks that ECL’s bad loans may not even have entirely been ECL’s loans in the first place.

One of the businesses that Edelweiss owns is Edelweiss Alternatives which is basically a group of funds for rich clients looking to invest in risky assets. Sometimes those risky assets might be loans which don’t get repaid. I can see the allure in selling those loans to its sister company designated to collect bad loans. Unfortunately, it had to do so using ECL as a front.

There’s a lot happening here! The RBI thinks that Edelweiss’s funds sold its bad loans to Edelweiss’s NBFC, which sold its bad loans to Edelweiss’s ARC at a price cheaper than their value, which then recovered those loans with money from Edelweiss’s own funds.

There’s a bit more in RBI’s press release:

Instead of taking meaningful remedial action to rectify the said deficiencies, it was observed that the group entities were resorting to new ways to circumvent regulations. Over the last few months, the Reserve Bank has been engaging with the senior management of the captioned entities and their statutory auditors, but no meaningful corrective action has been evidenced so far, necessitating the imposition of business restrictions.

In all fairness, at least half of finance is figuring out ways to circumvent regulation. In a twisted sort of way, Edelweiss seems to have done its job well. Unfortunately for it the RBI doesn’t have a sense of humour.

Cover Photo by Maria Orlova/Pexels

1. The RBI does not elaborate on what it means by structured transactions, but it’s probably anything that’s not a simple “x amount of money lent at y interest rate”. Stuff like this.

2. I don’t really know the nuances of these regulations, but if you’re interested, here’s the law and here’s an RBI regulation that define what ARCs can and cannot do.

3. One of the RBI’s jobs is to ensure that financial institutions don’t fail. If a bank or NBFC’s bad loans get too large, the RBI is going to get worried.