The recently announced betterthan-expected GDP growth number for 2022-23 has triggered discussions about the current Indian macroeconomic policies. The impressive recovery of the banking sector has contributed significantly to this turnaround. The recent handling of the banking system in India represents a textbook case of learning from past mistakes and using counter-cyclical policies in their true spirit.
A good starting point for understanding the contemporary banking landscape in India is the policy response to the global financial crisis (GFC). Rightly anticipating the spillover effects of the GFC, the Indian policymakers announced several counter-cyclical measures starting in August 2008. The most important among them was allowing banks to restructure loans without treating such loans as nonperforming assets (NPAs). In other words, a forbearance on loan loss recognition.
Banking regulators worldwide require banks to recognize the riskiness of restructuring transactions by treating them on par with NPAs and creating adequate provisions. Such provisions ensure that banks are well capitalized to deal with any future shocks arising from defaults on restructured loans. The requirement also prevents misuse of restructuring to postpone recognising loan losses.
Crisis times are different. Saving businesses from collapsing gets precedence over prudence in bank reporting practices. Justifiably, regulators allow and even encourage banks to restructure loans during such times. The Indian forbearance of 2008 was one such reasonable policy. It likely helped save several businesses that faced liquidity shocks during the GFC.
Problems arose when the policymakers continued the forbearance policy even after achieving full economic recovery. Banks started using forbearance to hide loan defaults: loans of low-quality borrowers were restructured to avoid recognition of losses.
Worse, banks relaxed the quality of screening for new loans as well. They could now lend to known bad-quality borrowers knowing fully well that restructuring can be used to hide loan defaults that may occur in the future.
Not surprisingly, when the forbearance policy was withdrawn in 2015, it was realized that the actual NPAs of banks were in double digits, and most banks did not have the required capital to absorb these losses. Expectedly, the flow of bank credit to the economy collapsed.
The most important learning from the post-GFC forbearance episode was that temporary relaxations granted during crisis periods work well only during the crisis. If they are continued beyond the crisis, they breed perverse effects having the potential to damage the economy in the long run.
Fortunately, the "lesson" learned based on the post-GFC crisis response was fully incorporated into the policy response to the Covid 19 induced crisis. The regulator did announce forbearance and other counter-cyclical policies, such as a temporary loan moratorium. However, all such policies came with well-defined expiration dates, which were adhered to with minor relaxation.
The figure below shows loan restructuring activity over time. The vertical axis represents the weighted average of the ratio between restructured and total assets of govt-owned banks.
The two vertical lines represent the years of the GFC and the Covid crisis, respectively. Notice a sharp increase in restructuring after the GFC; the level of restructuring kept increasing even after the crisis. It is critical to note most of the restructured loans were, in spirit, NPAs evergreened under the forbearance window. In contrast, despite forbearance, the overall level of restructuring hardly increased during and after the Covid crisis.
To understand the contrast more clearly, we plot the sum of restructured and NPAs as a proportion of banks' total assets in the figure below. These can be considered distressed assets. Notice a sharp increase in distressed assets after GFC and continuation of a decreasing trend of distressed assets after Covid crisis.
Finally, we also examine the quality of borrowers. The purpose here is to understand whether banks' exposure to existing low-quality borrowers changed after the two crises. A borrower whose income is less than the total amount required for servicing debt is considered a low-quality borrower. Repeated lending to existing low-quality borrowers is a strong signal of evergreening, where new loans are used to hide defaults on existing loans. We obtain this information from the registry of charges mai ..
In sum, one important reason for the sound health of the banking system in India today is the active policy choices made by the policymakers and their willingness to learn from past mistakes.
Source Name:Economic Times