Chapter-7: Regulatory forbearance: An Emergency medicine, not staple diet

1) Theme
 The current regulatory forbearance on bank loans has been necessitated by Covid pandemic. This
chapter studies the policy of regulatory forbearance adopted following the 2008 Global Financial
Crisis (GFC) to extract important lessons for the current times.
Regulatory forbearance is a regulatory policy that permits  financial institutions with depleted capital
to continue operating by allowing extended period of time to comply with regulatory requirements.

2) Summary

 During GFC, forbearance helped borrowers tide over temporary hardship and helped prevent a large
contagion. However, it continued for 7 years even though economy recovered significantly by 2011
resulting in detrimental consequences for banks, firms, and the economy.
o Restructured loans for unviable entities: Given relaxed provisioning requirements, banks
restructured loans even for unviable entities. The inflated profits were used to pay increased
dividends. As a result, banks became severely undercapitalized.
o Risky lending practices: Undercapitalization distorted banks’ incentives and fostered risky
lending practices, thereby damaging quality of investment in the economy.
o Decline in the quality of firms’ boards: In a regime of injudicious credit supply and lax
monitoring, a borrowing firm’s management’s ability to obtain credit strengthened its influence
within the firm, leading to deterioration in firm governance
o Decline in firms’ performance: Due to weak board oversight, misappropriation of resources
increased, and the firm performance deteriorated.
o Important learnings:
 It is necessary to treat emergency measures as such and not to extend them even after
recovery  when an emergency medicine becomes a staple diet, it can be
counterproductive.
 Ex-post analysis amid uncertainty should not equate unfavourable outcomes to bad
judgement, or worse, mala-fide intent.

3) Introduction
 To address the economic challenges posed by Covid-19 pandemic, financial regulators across the
world have adopted regulatory forbearance. Therefore, as emergency medicine, forbearance
occupies a legitimate place in a policy maker’s toolkit. However, caution must be exercised so that
emergency medicine does not become a staple diet leading to serious negative side-effects.
Economic rationale for regulatory forbearance
 When a bank creates additional provisions to account for loan losses, its profits decline leading to
 a reduction in bank’s equity capital. Therefore, incentives to provision for bad loans gets
significantly impacted by regulatory forbearance.
 Without forbearance: Bank must decide to restructure based on the viability of firm/project
because the cost of restructuring an unviable firm is significant.
 With forbearance: Banks do not suffer near-term cost from restructuring and hence prefer
restructuring as this allows them to declare fewer NPAs and avoid costs due to loan provisioning.
 Forbearance incentivizes banks to take risks by restructuring stressed assets even if they are
unviable due to the phenomenon of risk-shifting.
Understanding risk-shifting
 Suppose a bank has a borrower who is on the verge of default. In this case, restructuring may
result in further losses. However, recognition of loss impacts equity holders.
 A capital-starved bank, where equity owners have little “skin in the game” (less affected by the
end result), is likely to continue lending to risky borrower because with low capital base, equity
owners have little to lose but in the unlikely case of firms’ revival, they would see significant
upside.
 Depositors do not have any upside in the case of risky investment but may incur costs if firm fails.
 Equity owners gain if risks pay off and if risks fail the cost would be borne by depositors,
bondholders and/or taxpayers  risk shifting from equity holders to depositors and taxpayers.
Forbearance-induced risk-shifting
 Forbearance allows equity owners to restructure loans without any additional cost. Capital-
constrained banks choose restructuring even unviable projects under forbearance regime.

3.1 THE ORIGINAL SIN: THE SEVEN-YEAR FORBEARANCE

 The forbearance policies had desired short-term economic effects:
o GDP growth recovered from a low of 3.1% in FY-2009 to 8.5% within two years.
o Growth in revenue of listed firms recovered from 4.88% during the crisis to over 20% in 2011.
o Growth in bank credit also recovered from 16.9% in FY-2010 to 21.5% in FY-2011.
 By 2011, time was ripe to withdraw the forbearance. However, it continued till 2015 – a clear case of
emergency medicine that was chosen to be made into a staple diet.
 During the initial years of forbearance policy, banks selected genuinely distressed, but viable
borrowers for restructuring. However, once banks got a signal about the continuation of
forbearance despite economic recovery, distortions crept in.
o The share of restructured loans increased from 0.74% in FY-2008 to 6.94% in FY-2015. However,
reported gross NPAs of banks increased only modestly from 2.2% in FY-2008 to 4.3% in FY-2015.
 During forbearance window, proportion of firms in default increased by 51% after their
loan(s) got restructured. Compared to this in pre-forbearance era, there was only a marginal
6% increase in likelihood of defaults after restructuring  Forbearance helped banks to
hide a lot of bad loans
 The P. J. Nayak Committee highlighted the twin concerns stemming from forbearance regime:
o Ever-greening of loans by classifying NPAs as restructured assets
o Resultant undercapitalization of banks

3.2 Cost of extended forbearance v/s Early resolution of banking crisis: International Evidence
 The pattern of evolution of NPAs across G20 countries has been analysed to understand this
relationship.
o Some countries recognized their bad loans early. Their NPAs reached their peak during 2009 and
2010. These countries are called “Early Resolvers”.
 o “Late Resolvers” are countries that delayed recognition of NPAs. Consequently, NPAs in these
countries reached their peak in 2015-19.
 Important learnings:
o “Late Resolvers” ended up with much higher peak NPAs than “Early Resolvers.” On an average,
NPAs for late resolvers were more than thrice that for early resolvers.
o The impact on GDP growth for late resolvers (1.7% on average) was significantly worse than that
for the early resolvers (0.8% on average).

3.3 ADVERSE IMPACT OF FORBEARANCE ON BANK PERFORMANCE AND LENDING

 A policy of prolonged forbearance leads to overstating actual capital and creating a

false sense of security, thereby, allowing undercapitalized banks to operate without
raising capital.
 Implications:
o Dividend to shareholders: Banks may consider capital above regulatory
minimum as “excess” and start paying dividends  usual order, where debt is
repaid before equity, gets reversed.
 This was visible in Indian banking sector. The difference in average dividend
payout ratio between banks with a higher share of restructured loans and
Undercapitalization banks with a lower share of restructured loans was as high as 9% in 2012-
of Banks 13.
o Reduced infusion of fresh capital: Banks with a high share of restructured loans
raised less fresh capital than banks with a low share of restructured loans.
 The former raised 1.67% of average assets during forbearance period
compared to 2.04% by the latter.
 More dividend payments and less capital infusion exacerbated the
undercapitalization of banks due to extended forbearance.
 Undercapitalization distorts incentives of bank owners and management. With less
of their own money at stake, banks find risky lending to unproductive firms
Lending to zombie (zombies), attractive.
firms o The share of new loans to zombie firms increased from 5% in 2007-08 to a
whopping 27% in 2014-15.
 Forbearance resulted in increased lending to firms with poor fundamentals.
o India’s GFC Formation as a share of GDP reduced from 34.7% in 2008 to 28.7%
in 2015  Industrial credit growth from 2008-09 to 2014-15 failed to translate
Ever-greening of into a higher investment rate
loans  A lesser proportion of new loans were used for capital asset creation while larger
part have been used for ever-greening.
 Increased credit supply to firms during forbearance was not used productively but
diverted for the private benefit of management.
 Incumbent managers’ ability to get loans restructured under the forbearance policy
Weakening of strengthened their influence within the firm, thereby, reducing board’s ability to
Corporate control the managers.
Governance  Increased influence of management weakened firms’ governance.
 The non-promoter directors on the board act as watchdogs against likelihood of
firms’ management indulging in unhealthy practices.
 Deterioration in the
Quality of the Board

 The percentage of non-promoters decreased after restructuring during forbearance

regime, while it slightly increased upon restructuring before forbearance.
 Boards were dominated by firms’ promoters during forbearance.
 Aided by poor governance, beneficiary firms under forbearance regime
misallocated capital in unviable projects.
Inefficient allocation o Stalled projects increased by 40% during forbearance, while same witnessed a
of capital by decline of 12% pre-forbearance.
borrowers that  In pre-forbearance period, firms’ re-initiated stalled projects after restructuring,
benefited from whereas firms’ in forbearance window witnessed additional stalling, indicating
forbearance misuse of increased credit supply.
 Strong management influence leads to increase in benefits being redirected to
firms’ management.
Mis-appropriation of o As a proportion of total expenses, related party transactions (RPTs) to key
resources by personnel increased by over 7%. In comparison, among firms restructured
borrowers that before forbearance, RPTs to key personnel decreased by 1.5%.
benefited from  Lax restructuring resulted in misappropriation of firm resources at the cost of
forbearance minority shareholders.
 Due to weakened governance, impacted firms’ performance deteriorated.
o Significant increase in leverage (15.7%), measured as ratio of debt to equity,
Deterioration in accompanied by 27.2% decline in interest coverage for firms restructured
performance of during forbearance regime.
borrowers benefiting o Firms restructured before forbearance reported a 3.4% decrease in leverage,
from forbearance and a 49.6% increase in interest cover after their loan was restructured.
 Firm fundamentals improved upon restructuring in pre-forbearance era, they
significantly declined under forbearance.
 The average credit rating for a firm deteriorated by 7.7% upon restructuring during
forbearance regime while the same marginally improved (0.33%) before forbearance.
Increased defaults by  The forbearance regime was accompanied by an increase in defaults by restructured
borrowers firms when compared to a decrease in the same in the pre-forbearance era.
benefitting from o Proportion of restructured firms that became defaulters increased by 51% in
forbearance forbearance period, while pre-period increase was 6%.
 Restructuring in pre-forbearance era helped distressed borrowers in repaying debt
but firms benefitting during forbearance window started defaulting more.
 On macroeconomic front, under forbearance window, a higher share of restructured firms within an
industry was also associated with a decrease in entry of new firms in the industry.
3.3 BANK CLEAN-UP WITHOUT ADEQUATE CAPITALIZATION
 The regulatory forbearance was withdrawn in 2015. Further, RBI decided to conduct a detailed Asset
Quality Review (AQR) to know the true status of banks’ NPAs. However, AQR exacerbated the
problem as it was not supported by measures to keep banks adequately capitalized.
a) The crucial difference vis-à-vis bank clean-ups in the rest of the world
 India’s AQR differed from typical bank clean-ups in two key aspects.
o The clean-up was undertaken when the country was not undergoing an economic crisis. RBI
assumed that markets would supply the required capital to banks once their books are cleaner.
o Forced recapitalization was not provided for by RBI under the presumption that the extent of
provisioning required due to AQR would not require for a severe recapitalization of the banks.
b) The inadequate clean-up of bank balance sheets
 AQR exercise under-estimated the full extent of NPAs as well as the recapitalization required.
o In terms of additional (gross) NPAs, public sector banks added about INR 5.65 lakh crores from
FY 2016 to the end of FY 2019, equivalent to 7.9% of the total tax revenue over this period.
 AQR was mostly restricted to targeting bad lending through restructuring, rather than identifying
subtle ever-greening activities.
c) Under-estimation of required bank capital
 The intended plan to recapitalize public sector banks was INR 45,000 crore in next 3 years under
Mission Indradhanush. However, by the end of FY-2019, the GoI had infused INR 2.5 lakh crores.
Consequently, the banks were left significantly undercapitalized.
d) Adverse impact on lending
 Due to undercapitalization, banks reduced their lending. The affected banks, however, increased
their exposure to risky borrowers. Thus, the second wave of under-capitalization caused by AQR
created perverse incentives to lend even more to the unproductive zombie borrowers.
e) Decline in Firm’s Capital Investment
 Banks’ tightening of credit supply negatively impacts healthy borrowers as it forces firms to cut
down on their investments and capital expenditures. Thus, the likelihood of stalling of ongoing
projects increases.

3.4 IMPLICATIONS FOR THE CURRENT FORBEARANCE REGIME

 The presented analysis of regulatory forbearance and its negative impacts offers key learnings for
the current regime of regulatory forbearance following the Covid crisis.
o Forbearance represents emergency medicine that should be discontinued at first opportunity
when economy exhibits recovery, not a staple diet that gets continued for years. Therefore,
policymakers should lay out thresholds of economic recovery at which such measures will be
withdrawn.
o A clean-up of bank balance sheets is necessary when forbearance is discontinued. While 2016
AQR exacerbated the problems in banking sector, the lesson is not that an AQR should not be
conducted. Further, AQR must account for all the creative ways in which banks can evergreen
their loans.
o A clean-up unaccompanied by mandatory capital infusion exacerbates bad lending practices.
Therefore, a clean-up exercise should be accompanied by mandatory recapitalization.
o Apart from re-capitalizing banks, it is important to enhance quality of their governance. Ever-
greening of loans by banks as well as zombie lending is symptomatic of poor governance.
o Legal infrastructure for the recovery of loans needs to be strengthened de-facto.