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Regulatory Forbearance: 07

An Emergency Medicine,

Not Staple Diet! CHAPTER

“Those who do not learn from history are condemned to repeat it.”
— George Santayana, Spanish philosopher

The current regulatory forbearance on bank loans has been necessitated by the Covid
pandemic. This chapter studies the policy of regulatory forbearance adopted following the
2008 Global Financial Crisis (GFC) to extract important lessons for the current times.
Regulatory forbearance for banks involved relaxing the norms for restructuring assets,
where restructured assets were no longer required to be classified as Non-Performing Assets
(NPAs henceforth) and therefore did not require the levels of provisioning that NPAs attract.
During the GFC, forbearance helped borrowers tide over temporary hardship caused due
to the crisis and helped prevent a large contagion. However, the forbearance continued
for seven years though it should have been discontinued in 2011, when GDP, exports, IIP
and credit growth had all recovered significantly. Yet, the forbearance continued long
after the economic recovery, resulting in unintended and detrimental consequences for
banks, firms, and the economy. Given relaxed provisioning requirements, banks exploited
the forbearance window to restructure loans even for unviable entities, thereby window-
dressing their books. The inflated profits were then used by banks to pay increased dividends
to shareholders, including the government in the case of public sector banks. As a result,
banks became severely undercapitalized. Undercapitalization distorted banks’ incentives
and fostered risky lending practices, including lending to zombies. As a result of the distorted
incentives, banks misallocated credit, thereby damaging the quality of investment in the
economy. Firms benefitting from the banks’ largesse also invested in unviable projects.
In a regime of injudicious credit supply and lax monitoring, a borrowing firm’s management’s
ability to obtain credit strengthened its influence within the firm, leading to deterioration
in firm governance. The quality of firms’ boards declined. Subsequently, misappropriation
of resources increased, and the firm performance deteriorated. By the time forbearance
ended in 2015, restructuring had increased seven times while NPAs almost doubled when
compared to the pre-forbearance levels. Concerned that the actual situation might be worse
than reflected on the banks’ books, RBI initiated an Asset Quality Review to clean up bank
balance sheets. While gross NPAs increased from 4.3% in 2014-15 to 7.5% in 2015-16 and
peaked at 11.2% in 2017-18, the AQR could not bring out all the hidden bad assets in the
bank books and led to an under-estimation of the capital requirements. This led to a second
round of lending distortions, thereby exacerbating an already grave situation.