The survey said most of the non-performing loans were lent and restructured during the forbearance phase and RBI’s audit missed some of the severe cases of ever-greening that the two lenders did.
In the wake of the Global Financial Crisis, RBI had in 2008 introduced the policy of regulatory forbearance. It relaxed the norms for restructuring stressed assets, and downgrading the asset to non-performing status was no longer mandatory and required no additional provisioning.
Without a forbearance, the bank would restructure the asset only if the project is viable. Else, it would downgrade the asset into a non-performing asset (NPA) and make provision for the same. But with forbearance, banks did not require the same level of provisioning as NPAs and, thus, the provisions made were inadequate, the survey noted.
“In absence of 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, incentivises banks to take risks by restructuring stressed assets even if they are unviable,” the survey noted.
For example, if a bank has a large outstanding against a borrower, who is on the verge of default and if the borrower defaults, the bank would have to recognise the debt as NPA, incur a loss, and possibly re-capitalise on account of the depleted capital.
“Given the borrower’s solvency concerns, lending a fresh loan, or restructuring its current loans are 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,” the survey said.
The Economic Survey suggested that the fact that both YES Bank and LVB had to be rescued by the regulator goes against RBI’s assumption that private banks should have been able to raise the required capital after the cleanup, the survey noted.
The recognition of loss impacts equity holders, the survey noted. “They get no return on their investments and are forced to recapitalise 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,” the survey said.
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.
Forbearance, meanwhile, 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 taxpayer,” it said.
The survey noted that the incumbent bank managers always have incentives to report strong performances during their tenure.
“Forbearance provides incumbent managers an opportunity to window-dress their balance sheets, show good performance during their tenure, and thereby enhance post-retirement career benefits. Consequently, bank managers resort to distortionary practices under forbearance. Secondly, banks’ management may use forbearance as a shield to cover up outright corruption and nepotism. The events with the Punjab National Bank or recent allegations of deceit against former bank CEOs corroborate this possibility,” the survey pointed out.
The survey said that if the AQR had correctly identified all the hidden bad quality assets on banks’ books, all the increase in NPAs and the necessary provisioning would have concluded by the stated deadline of FY2017.
However, the gross NPAs in the Indian banking sector only increased to 11.2 per cent by FY2018. A massive surge in loan loss provisioning also occurred in FY2018 – a year after AQR was supposed to make bank balance sheets healthy.