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Regulatory Forbearance: An Emergency Medicine, Not Staple Diet! 201

2. If the project is unviable, the bank would 2. Capital-starved banks now have an
not restructure the loan and declare the incentive to restructure even unviable
asset as non-performing. Crucially, projects to reduce provisioning and
banks do not gain by restructuring avoid the consequent hit on capital.
unviable projects in this case.

Absent forbearance, a bank must decide to restructure based on the viability of the
firm/project because the cost of restructuring an unviable firm is significant. But, with
forbearance, banks do not suffer any near-term cost from restructuring. Therefore, banks
prefer restructuring, as this choice allows them to declare fewer NPAs and avoid the
costs due to loan provisioning. Forbearance thus incentivizes banks to take risks by
restructuring stressed assets even if they are unviable. Capital-constrained entities are
particularly susceptible to investing in risky projects, a phenomenon called risk-shifting
in academic literature (Jensen and Meckling, 1976). Consider the case where a bank has
a large outstanding against a borrower who is on the verge of default. If the borrower
defaults, the bank would have to recognize the debt as NPA, incur a loss, and possibly
re-capitalize on account of the depleted capital. Given the borrower’s solvency concerns,
lending a fresh loan, or restructuring its current loan(s) is extremely risky and may result
in further losses for the bank. However, in the unlikely case that the fresh credit helps the
borrower recover, banks would get back all their debt with interest and therefore face no
reduction in capital. Notice that the recognition of loss impacts equity holders. They get
no return on their investments and are forced to recapitalize to maintain sufficient capital
adequacy. In such a scenario, a capital-starved bank, where equity owners have little “skin
in the game”, is likely to continue lending to the risky borrower. With low capital, equity
owners have little to lose from the fresh lending in the likely scenario where the borrower
fails. However, the unlikely case of firm revival would result in a significant upside for
them. Depositors do not have any marginal upside in the case of risky investment but may
incur some costs if the firm fails. Hence equity owners gain if the risks pay off and if the
risks fail the cost would be borne by the depositors, bondholders, and/or the taxpayers.
Forbearance further allows equity owners to restructure loans without any additional cost.
Capital-constrained banks, therefore, choose to restructure even unviable projects when
the opportunity arises under a forbearance regime, thereby shifting risk away from equity
holders to depositors and taxpayers.
The above phenomenon of forbearance-induced risk-shifting is apparent in the case of
privately held banks where equity owners could act in their own interests. In a few Indian
banks, promoters administer management and decision-making, directly or indirectly, by
virtue of their controlling shareholding and/or management rights. Given their controlling
stake, perverse incentives of promoter-managers in the presence of forbearance are
understandable. However, most Indian banks are widely held or controlled by the
government, and hence, their incumbent managements do not own sizeable stakes in these
institutions. How forbearance distorts banks’ incentives in this context, therefore, needs
an explanation. The rationale includes two key points. First, guided by their personal
career concerns, the incumbent bank managers always have incentives to report strong
performances during their tenure. Sarkar, Subramanian, and Tantri, 2019 show that bank
CEOs’ post-retirement career benefits, such as future corporate board memberships,