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Regulatory Forbearance: An Emergency Medicine, Not Staple Diet! 211

third section examines the clean-up phase, and finally, the concluding section discusses the
policy implications.

ADVERSE IMPACT OF FORBEARANCE ON BANK PERFORMANCE
AND LENDING

Undercapitalization of Banks
7.10 Banks are in the business of converting illiquid loans into liquid liabilities (Diamond
and Dibvyg, 1983). In other words, while banks issue deposits repayable on demand or after
a specific period, they lend to projects with long gestation periods. Therefore, they face risks
both from (i) the mismatch in timing of their inflows and unexpected outflows (referred to as
liquidity mismatch) and (ii) also due to unexpected surge in borrower default. Normal defaults
and regular outflows are usually priced in and provided for within the regular asset-liability
management (ALM) framework. Capital provides a cushion that helps banks navigate through
times of abnormal depositor withdrawals and increased losses on the lending portfolio.

7.11 A policy of prolonged forbearance has the effect of overstating the actual capital and
creating a false sense of security. Consider a bank with a capital adequacy ratio of 12% before
forbearance . Assume that during the crisis, the bank restructures 10% of its books. Absent
1
forbearance, the bank would make provisions for such restructurings, and the capital would
be reduced to the extent of such provisioning. To operate further, the bank will have to meet
the regulatory threshold by raising fresh capital. However, with forbearance, the bank can
restructure troubled loans and still report the capital adequacy ratio at 12%. Viewed differently,
forbearance lets undercapitalized banks operate without raising capital. Inadequate capital is
similar to owners not having adequate skin in the game. A long literature in finance, starting
from Myers (1976), has discussed the implications of inadequate “skin in the game” among the
incumbents running any organization.

7.12 Several implications follow. First, since equity capital is privately expensive to the
owners of banks, the banks may use the forbearance window to withdraw their capital. For
instance, in the illustration above, the bank can keep reporting healthy capital figures while
the true numbers, without forbearance, might actually be lower than the regulatory threshold.
If forbearance is continued for an extended period, the bank may consider the capital above
the regulatory minimum as “excess” and start repaying capital to the incumbent owners as
dividends (Mannil, Nishesh, and Tantri, 2020). Thus, the usual pecking order of finance
(Myers (1977), Modigliani & Miller (1958)), where debt is repaid before equity, gets
reversed. Eventually, when forbearance gets withdrawn, either depositors or the taxpayers
are called upon to foot the bill.
7.13 The phenomenon described above transpired in the Indian banking sector during
forbearance. Banks that benefited more from forbearance increased their dividend payments
to incumbent management, including the government. As seen in figure 12, the difference in
the average dividend payout ratio between banks with a higher share of restructured loans and
banks with a lower share of restructured loans was as high as 9% in 2012-13.

1 Banks in India are required to maintain a capital adequacy of 9%. We ignore other types of statutory
capital buffers requires as the example is for illustration purpose only.