The policy choices that RBI’s new bad loan rules present

The exercise of cleaning up bank balance sheets, which started in 2015, and a signal by the Reserve Bank of India to put an end to forbearance — or the easing of rules — will now mean a longer wait for better results.

Written by Shaji Vikraman | Updated: April 25, 2018 8:32:17 am
Experience has shown that regulation often lags risk-taking by banks. (Representational)

Over the next few weeks, expect many banks in India to report weak results. That won’t be just because of the lingering pain of the economic slowdown of the last couple of years and the inability of many companies or borrowers to repay some of their borrowings. The poor numbers for lenders will be due more to the progressive tightening of rules on dealing with bad loans. The exercise of cleaning up bank balance sheets, which started in 2015, and a signal by the Reserve Bank of India to put an end to forbearance — or the easing of rules — will now mean a longer wait for better results.

The latest trigger

Historically, the approach to dealing with bad loans (where either the principal or interest or both of a loan is due after 90 days) in India has been relatively lenient — to allow banks time to set aside funds to provide for potential losses on such loans, and greater leeway to lenders to negotiate with borrowers. There has been a reluctance to address the issue head-on because of pressure from influential borrowers — especially large corporates — and resistance from the government, which owns a large number of banks, and even the banks themselves. Tighter rules would mean stumping up more cash, lower profits, and restrictions on the ability to lend more.

With the new insolvency law coming into force in 2016, and growing outrage against instances of corporate fraud, promoter-driven firms leaving banks bleeding, and banking supervisors who have been criticised for the pile of bad loans, this regulatory forbearance may now be coming to an end.

In February, the RBI did away with several schemes such as strategic debt restructuring, which allowed banks to grant extra time to borrowers to repay. Next, rules were tightened to classify a loan as ‘bad’ or a ‘Non-Performing Asset’ (NPA) if the borrower failed to repay by even a day or two — triggering worries among borrowers, banks, and the government. But the regulator appears to be standing firm — RBI Deputy Governor N S Vishwanathan said last week that the sanctity of the debt contract needed to be restored. When a company raises money through bonds from the market and then defaults, its rating is downgraded, the yields on the bonds rise, its cost of financing goes up, and investors file suits, Vishwanathan said — no such reaction was, however, seen in case of bank borrowings.

Cleaning up vs growth

It is argued that this approach would cramp lending by banks at a time when most indicators show that growth is on the upswing. The government and the RBI discussed this in 2015-16 as well. In 2016, a few months before his term ended, RBI Governor Raghuram Rajan said, “In sum, (on) the question of what comes first, clean up or growth, I think the answer is unambiguously clean up.” That was the lesson from every other country that had faced financial stress, Rajan had said then.

This is the approach that Rajan’s successor Urjit Patel has adopted. Another central banker, Viral Acharya, too, has acknowledged the mistakes that RBI has made in this regard earlier. At an event last year, Acharya said: “Unfortunately for a variety of reasons, RBI has engaged in various forbearance schemes saying you can take another 18 months or two years (on bad loans).” In one way or the other, he had said, RBI had actually contributed to the NPA problem becoming more acute over time. At the end of December 2017, bad loans had reached Rs 8.87 lakh crore, and were expected to rise even higher by the end of March 2018.

The lessons elsewhere

A tougher environment governing lending by banks may lead to tensions between the regulator and the owner of banks, which in India is overwhelmingly the government. Some of that is already visible — but the positive spin-off has been behavioural changes on the part of borrowers, specially of companies whose promoters fear the loss of control, as also of banks who have to monitor lending far more closely. Since the 2008-09 financial crisis, banks in the West, too, have been subject to far rigorous standards and changes of rules, and have been forced to set aside funds in their balance sheets for expected losses in the future — complete with an expected-loss model, a strategy for tackling non-performing loans (NPL), dedicated NPL units, early warning engines, etc.

India first announced the adoption of global rules on setting aside capital for bad loans in 1992, at the peak of the balance of payments crisis. Yet, it was almost 2003 before those early rules were implemented. In between, every time the issue of enforcing tighter rules came up, it was argued that since there was no crisis, there was no need to carry out disruptive changes — and that India, with a dominant state-owned banking system with an implicit guarantee of the sovereign, did not need to be rigid. In the brief periods during which rules on bad loans were tightened, they were a reflection more of political will — shown, for example, by the Prime Minister and Finance Minister of the day a few years ago.

The choice this time

The financial policy committee of the Bank of England, which came into vogue after the 2008 crisis, is focussed on a financial system that serves households and businesses in bad times as well as good: a system that doesn’t disrupt the economy, but still delivers for it. And where the rules do not do that, the rules need to be changed, Alex Brazier, Executive Director for Financial Stability, Strategy and Risk of the Bank of England, stressed in a recent speech. “There is no rulebook that’s good for all seasons, let alone all time,” Brazier said. “And when risk-taking increases, it must not be at the expense of the resilience of lenders to any future downturn in the economy. They must remain capable of serving in the bad times as well as the good.”

For policymakers, it is a difficult choice to make. It requires political stamina to endure longer timeframes to clean up bank balance sheets and a return to robust lending to firms and households. Experience has shown that regulation often lags risk-taking by banks. Policymakers in India will have to decide whether the difficult choice they have to make will lead to a “cliff-edge effect”, as they call it in the West. Pulling back could mean a setback to the behavioural changes in promoter attitudes and accountability that are already under way, besides posing the risk of more public funds being put to use for bank capital and promoting financial and overall integrity. All these hinge on governance practices — not just in the financial sector, but elsewhere, too.

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