Lenders to Hotel Leela, a 5-star chain that is more than two months behind in payments on $700 million of debt, are likely to bite the bullet and amend the loan terms rather than declare it in default, say bankers involved in the talks.

Restructuring corporate loans - allowing banks to dilute payment terms without classifying loans as bad - is on the rise in Asia's third-largest economy, providing a lifeline to borrowers struggling in a sharp economic slowdown, but piling more stress on bank balance sheets.

Hidden weaknesses in bank balance sheets are a greater risk as Indian banks' reserve coverage ratio - the buffer a bank has to set off against loan losses - is among the lowest in Asia.

Officially, 3 percent of loans in India are bad. Including restructured or 'impaired' loans, for which banks don't have to set aside heavy provisions in case of default, the figure is about 7 per cent, according to analysts.

The reality is worse, say some bankers and industry experts, who say many loans are restructured outside official channels, with some banks and borrowers taking advantage of harder-to-track 'evergreening' of loans to avoid declaring default.

Under evergreening, banks provide additional loans to stressed borrowers, often indirectly, to enable them to repay existing loans. That can keep a loan from going sour, but it ratchets up a bank's exposure to a troubled credit.

It's estimated that at least a tenth of loans to the real estate sector - where restructuring rules are stringent - are stressed, as against the 3-4 per cent cited by banks, said Amit Goenka, head of capital markets at UK-based Knight Frank.

"There's a certain amount of under-reporting arising out of evergreening of loans, which can never be precisely derived," said A.S.V. Krishnan, banking analyst at Mumbai brokerage Ambit Capital.

Lenders are also staring at the prospect of more bad loans as the economy shudders. Standard & Poor's has warned that India could become the first of the BRIC economies to lose its investment-grade status on slowing growth and political roadblocks to economic policymaking.

In the year to end-March, Indian banks sought to restructure a record $12 billion in corporate loans through the Corporate Debt Restructuring Cell (CDR), an RBI-approved consortium of lenders - an increase of 156 percent on the year before.

And that excludes billions of dollars in loans restructured outside the official channel, including $4 billion of Air India debt and about $5.5 billion of loans at loss-making state electricity boards.

"Going to CDR has almost become fashionable these days. Borrowers are exploiting the CDR mechanism without exhausting other genuine avenues of redressing their problems around over-leverage," Ambit's Krishnan said.

The recent surge in loan restructuring may just be putting off the inevitable, though. Ratings agency CRISIL expects new loan restructuring over fiscal year 2012 and 2013 to hit $36 billion, and analysts warn that 25-50 per cent of such loans are likely to turn bad and hit banks' profitability. Fresh restructuring of loans in the year to March 2011 was negligible.

"Restructuring helps the company sometimes, but if you step back and see it leads to 'evergreening' of loans which can cause problems going forward," said Vikram Bajaj, director at Renaissance Capital Advisors, which advises companies on debt restructuring.

"Basically, what you're doing is taking a call that the borrower may come out of the situation and you're giving him more money, but the odds, in most cases, are against it. Kingfisher Airlines is the biggest example of that."

In the best-known recent example of a restructured loan turning sour, liquor baron Vijay Mallya's Kingfisher Airlines defaulted to most banks on a $1.4 billion loan.

PERILOUS PRACTICE

Bankers defend the practice of restructuring loans, which typically entails extending tenure on the loan, easing interest rates or even converting debt into equity.

"Actively restructuring loans has helped us in controlling slippage," said Pratip Chaudhuri, chairman of State Bank of India, the country's biggest lender. "We have to live with high restructurings now and look for recoveries tomorrow."

The problem is that many such loans are never recovered and turn non-performing, adding to the challenge of collecting on bad loans in a country where there is no bankruptcy law - the absence of which makes banks more inclined to help borrowers rather than declare a loan to be in default and receive nothing.

At SBI, 43 per cent of loans restructured in the year to March 2010 were declared non-performing within two years, said Soundara Kumar, a deputy managing director at the bank.

Central Bank of India, a mid-sized state lender, learned the hard way how quickly a restructured loan can go bad. In November, it agreed to restructure an $80 million loan to steelmaker Electrotherm, which was having difficulty with an order for a client in Tanzania.

Within months of giving a breather to a long-time customer, Central Bank downgraded the loan to non-performing, and was the only listed bank to report a net loss for the March quarter.

"They weren't able to execute the order. So they asked us to restructure the loan, and, in the March quarter, the account slipped. It happened very quickly," said a senior executive at Central Bank of India, who did not want to be identified.

Another state-run lender, UCO Bank, ended its ties with Electrotherm when the steelmaker failed to make timely payments even when it was able to, a bank official told Reuters.

"Electrotherm did not pay us the dues even when they had the liquidity and were still making profits," said UCO Bank chairman Arun Kaul.

UCO has classified the account as non performing and is in the process of recovering the loan, he said.

Electrotherm's investor relations officers could not be reached for a comment for this article.

In another case, lenders including SBI, Power Finance Corp and Rural Electrification Corp restructured loans to a hydropower project, which was mired in environmental clearances.

The account turned bad within two years of being restructured, said a senior bank executive involved with the loan.

Morgan Stanley expects 'impaired loans' - bad and restructured loans put together - for all Indian banks to double to 10 per cent of total debt within 18 months.

Although the Reserve Bank of India is concerned about banks' rising bad loans, it does not see a risk due to aggressive debt restructuring.

"I believe banks are doing it with understanding, with discretion," said RBI Deputy Governor K.C. Chakrabarty. "If they are not doing, we need to pull them up."

EVERGREENING

While restructuring is allowed by the RBI, the murkier 'evergreening' of loans is frowned upon. Several bankers said it is widespread, but declined to give details.

The practice is said to be particularly common in commercial real estate, where tougher restructuring guidelines require banks to classify a loan as non-performing and set aside more funds as provisions - effectively removing any official middle ground between a performing loan and a default.

"Banks have been working actively to avoid such provisioning and classification," said Knight Frank's Goenka.

"Real estate provisioning is seen adversely by the regulator and pushes up the cost of lending. This may have led to some evergreening-like measures within the financial institutions."

Hotel Leela, which borrowed heavily for projects in Delhi and Chennai and recently sold a property to raise money, is seeking additional bank loans to pay its debt, said two sources directly involved in the restructuring.

One of its lenders, Syndicate Bank, wants Leela's controlling shareholder to put in another 3-4 billion rupees in equity from the sale of a hotel in Kerala before it agrees to restructure the loan, a stance most of its lenders support, said an executive at another bank who has loans to Leela and is involved in the discussions.

Hotel Leela vice-chairman Vivek Nair did not respond to several calls from Reuters seeking comment for this article.

"Leela is asking for about 600 crore more (6 billion rupees). Banks aren't willing to give as they want this to pay off some debt. That's evergreening. Banks want promoters to get more contribution, equity upfront," said another lender, who asked not to be named given the sensitivity of the matter.