Economic Survey 2020-21: Vol 1 Ch 7: Regulatory Forbearance: An Emergency Medicine, not Staple Diet!

The policy of regulatory forbearance which started during the 2008 Global Financial Crisis(GFC), yet continued long after the economic recovery resulted in unintended and detrimental consequences for banks, firms, and the economy.

To address the economic challenges posed by the Covid-19 pandemic, financial regulators across the world have adopted regulatory forbearance. India is no exception. Under these circumstances, the economic survey talks about the importance of Regulatory forbearance, long-term threats if continued policy after recovery, and measures to be adopted during the post-forbearance phase.

Regulatory forbearance: It is a policy that allows banks and other financial firms to continue with their operations even after exhausting their funds. This strategy was set up by the central bank and other regulatory authorities to prevent banks from being bankrupt and maintain their stability. In simple terms, 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.

Regulatory Forbearance provisions:

In 2008, anticipating the global financial crisis, RBI introduced the policy of regulatory forbearance with the following provisions:

• The new relaxed norms entitled borrowers to retain the same asset classification upon restructuring, subject to some conditions.
• Banks were no longer required to make the general provision on total outstanding for substandard assets.

Benefits of the policy of regulatory forbearance:

Lets us understand the benefits of this policy by comparing some important economic indicators between FY2009 and FY2011:

• GDP growth recovered from a low of 3.1% in FY2009 to 8.5% within two years ie in FY2011.
• There was a marked improvement in other economic indicators ranging from exports to the Index of Industrial Production (IIP) in FY2011 when compared with FY2009.
• The growth in total revenue of listed firms also recovered from a low of 4.88% during the crisis to a high of over 20% in 2011.
• Growth in bank credit, which had fallen from 22.3% in FY2008 to 16.9% in FY2010, recovered quickly to 21.5% in FY2011.

During the period of the global financial crisis (GFC), the policy worked well with banks selecting genuinely distressed, but viable in the long-run, borrowers for restructuring. However, Economic Survey is of the view that the policy of forbearance should have been ended in FY2011, which by FY2011 have recovered the economy by giving the above benefits.

The prolonged continuation of the regulatory forbearance has brought a long-term impact on the lending practices of banks and also on the economy overall. Hence prolonged continuation has made emergency medicine a staple diet.

ADVERSE IMPACT OF FORBEARANCE ON BANK PERFORMANCE AND LENDING

• Undercapitalization of Banks: A policy of prolonged forbearance has the effect of overstating the actual capital and creating a false sense of security. For example, consider a bank with a capital adequacy ratio(CAR) of 12% now without forbearance the bank would make provisions for restructuring, reducing the capital, and raises fresh capital to reach CAR. However, with forbearance, the bank can restructure troubled loans and still report the capital adequacy ratio at 12%. Hence forbearance lets undercapitalized banks operate without raising capital.
• Repaying capital to the incumbent owners as dividends: since equity capital is privately expensive to the owners of banks, the banks may use the forbearance window to withdraw their capital by considering the capital above the regulatory minimum as “excess” to pay dividends.
• Liquidity mismatch: Banks are in the business of converting illiquid loans(bank's deposits) into liquid liabilities(lend to projects with long gestation periods). Hence they face risks of liquidity mismatch, due to an unexpected surge in borrower default(because of forbearance).
• Lending to Zombie Firms: With less of their own money at stake, banks become increasingly risk-seeking and witnessed an increase in lending to unproductive firms, popularly referred to as zombies.
• Ever-greening of Loans: To protect their already depleted capital. Banks followed two ways:
  • One way of ever-greening loans is lending a new loan to a borrower on the verge of default, near the repayment date of an existing loan, to facilitate its repayment(i.e lending to a zombie firm).
  • The second way is lending to other healthy firms in the business group to which those borrowers belong(i.e lending to zombie business group).
• Forbearance resulted in increased lending to firms with poor fundamentals and higher lending to inefficient projects. A lesser proportion of new loans were used for capital asset creation as capital is used to keep the dead loans alive.

FORBEARANCE IMPACTING THE BORROWERS:

• Inefficient allocation of capital by borrowers: The forbearance regime witnessed a significant increase in credit supply to corporates that were not used productively by firms. Total stalled projects (as a proportion of all Capex projects) increased by 40% (30%) during forbearance.
• Weakening of Corporate Governance: The role of the incumbent manager has significantly increased, to persuade bankers to restructure loans, plausibly even unviable ones. This ability made the incumbent management’s influence stronger. It became difficult for the firm’s board to overthrow such managers even if they were otherwise inefficient. Affecting the governance of the corporate.
  
• Deterioration in the Quality of the Board: As evident, the percentage of non-promoters on the board decreased significantly after restructuring during the forbearance regime.
• The bank monitoring declined as a lower number of bank-nominated directors occupied board seats.
• Deterioration in performance of borrowers benefiting from forbearance: the firm's profitability, measured as profits as a proportion of the firm's assets suffered a sharp decline of over 138% in the forbearance era.
• Increased defaults by borrowers benefitting from forbearance: It is observed that the average credit rating for a firm deteriorated by 7.7% upon restructuring during the forbearance regime. The proportion of restructured firms that became defaulters increased by 51% in this period.

Hence internal governance of the firms weakened, misappropriation of resources increased, and their fundamentals deteriorated. Not only this, but the forbearance period was also associated with a decrease in the entry of new firms in the industry.

Finally, after continuing forbearance for seven years, the RBI decided to withdraw regulatory forbearance starting from April 2015. The RBI also decided to conduct a detailed Asset Quality Review (AQR) to know the true status of banks’ NPAs. However, the AQR exercise exacerbated the problem rather than controlling it because:

• AQR exercise neither mandated capital raising by banks nor provided a capital backstop even though it was certain that the bank's capital would be adversely impacted following the AQR.
• There was neither a forced recapitalization of the banks nor was an explicit capital backstop provided for banks unlike countries like the USA, European Union.
• AQR was mostly restricted to targeting bad lending through restructuring, rather than identifying subtle ever-greening activities. Thus unable to curb distortionary lending. The recent events at Yes Bank and Lakshmi Vilas Bank corroborate that the AQR did not capture ever-greening carried out in ways other than formal restructuring.
• Under-estimation of required bank capital: The actual capital required by public sector banks significantly exceeded the amount that the RBI seems to have estimated before the AQR. Hence both private and public did not recapitalize themselves adequately after the clean-up.

• Forbearance represents emergency medicine that should be discontinued at the first opportunity when the economy exhibits recovery. Prolonged forbearance is likely to sow the seeds of a much deeper crisis.
• A clean-up of bank balance sheets is necessary when the forbearance is discontinued.
• An AQR exercise must be conducted immediately after the forbearance is withdrawn. AQR exercise must include/account for all the creative ways in which banks can evergreen their loans.
• A clean-up exercise should be accompanied by mandatory recapitalization based on a thorough evaluation of the capital requirements post an asset quality review.
• Apart from re-capitalizing banks, it is important to enhance the quality of their governance too. Banks should have fully empowered, capable boards.
• Finally, the legal infrastructure for the recovery of loans needs to be strengthened de facto. The Insolvency and Bankruptcy Code (IBC) has provided the de jure powers to creditors to impose penalties on defaulters.