Four principles to be followed in RBI’s loan restructuring

MoneyControl, August 21, 2020 (with Harsh Vardhan)

In the aftermath of the 2008 Global Financial Crisis, large-scale debt restructuring had taken place in the Indian banking sector. Just about a decade later the Reserve Bank of India finds itself in a similar situation with demands from multiple stakeholders for a recast of the bad loans that would soon pile up on the balance sheets of banks. This time around the context is the ongoing Covid-19 pandemic, and the unprecedented challenges imposed by the resulting economic crisis on India’s businesses. The previous experience had given ‘restructuring’ a bad name. Can this time be made different?

In the post 2008 period, a series of restructuring schemes offered by the RBI to the banking sector had facilitated an ‘extend and pretend’ approach. The underlying asset kept deteriorating for years. When the RBI initiated an asset quality review in 2015, the non-performing assets skyrocketed. This episode triggered a prolonged phase of low growth-low investment in the economy.

As the RBI embarks upon a similar project, lessons from this experience should guide the current thinking. RBI has already issued first-order guidelines that set out key boundary conditions for the restructuring scheme. A next level of filters is now required to prevent a repeat of the past mistakes. To this end, we outline four principles that we think should be embodied in any restructuring scheme that the RBI offers.

Avoid Type 1 and Type 2 errors

The impact of the pandemic and the associated lock down is highly uneven. While some sectors (e.g. hospitality, aviation, automobiles) have been severely impacted, the shock to some other sectors (e.g. pharmaceuticals and fast moving consumer goods) has been modest. Some sectors (e.g. telecom, internet based services) have benefitted from this episode. Even within a sector, businesses have experienced varying degrees of stress depending on their size, financial constraints, geography of their operations, etc. Restructuring must be permitted only for those firms that have been badly hit by the pandemic and not to those who were financially stressed before the outbreak of Covid-19.

In deciding which borrowers get the restructuring, we must avoid what statisticians refer to as Type 1 and Type 2 errors. Type 1 error occurs if a deserving borrower is denied restructuring. Significantly more pernicious from the perspective of the banks and hence the economy, is a Type 2 error where non-deserving borrowers get restructured. Widespread Type 2 errors can ultimately impose a heavy cost on the rest of the economy especially when 70% of the banking system is owned by the Government.

The bankers themselves are best placed to judge if a borrower deserves to be restructured. Hence, one way to avoid these identification errors would be to let the bankers exercise their discretion and judgement as opposed to the banking regulator prescribing the rules.

Ensure accountability of bankers

Restructuring schemes offered by the regulator are by definition accompanied by forbearance and create a risk of moral hazard. In absence of the necessary checks and balances, bankers may get tempted to recast the debt of all their borrowers because they get to keep their books clean. This is especially relevant in cases where a bank’s CEO is about to retire soon. Hence it is important that bankers have a skin in the game and are held accountable for the decisions they take.

This can be achieved in two ways. First, the provisioning requirements on restructured loans must be higher than standard assets and lower than NPAs. There must be an incremental cost of restructuring. Second, adequate disclosures must allow a wide range of external stakeholders to assess the actions of bank management.

Minimise information asymmetry through enhanced disclosures

When a bank implements a restructuring scheme, the information asymmetry goes up. The regulator must take necessary steps to reduce the opacity of the deal struck between the bank and the borrower. This is important because banks deal with public money and with majority of the sector owned by the Government, any lapse on the part of these banks ends up imposing a cost on the tax payer.

The most important way to reduce information assymetry and enhance accountability of bankers is to demand disclosures. Previous restructuring schemes were characterised by scant disclosures and hence the various stakeholders in banks – stockholders, bond investors, other borrowers, depositors, employees, etc had little information.

Any scheme must be accompanied by extensive disclosures on various aspects of the restructuring such as amount of loans restructured, the sectoral break up of restructuring, the stage in the lifecycle of the loan when restructuring is done, assessment of the bank management on the recoverability of the loan, the timeline of recoverability, key conditions of restructuring, and so on. These disclosures should be mandated on a quarterly basis with regular updates on the performance of the restructured portfolio.

Impose conditionalities on borrowers

The borrower who qualifies for a loan recast must pay some price in lieu of the relief obtained, as otherwise there maybe little incentive to abide by the terms of the scheme. The underlying assumption of the relief is that the cash flows of the borrower are impacted by the pandemic and are inadequate to service debt. In that case, the borrower must not be permitted any other discretionary uses of cash flows. Specifically, borrowers must not be allowed to engage in acquisitions, share buybacks and delisting, dividend payment, and even variable compensation to senior management, as long as any of their loans is getting restructured. These restrictions should be the pre-conditions for restructuring.

As we enter into yet another phase of debt restructuring, it is important to note that restoring the health and stability of the banking sector is critical for the recovery of the economy from this crisis. While restructuring provides short-term relief, it does not solve the underlying problem. Most often the hope is that the system will grow out of the crisis and the problem will go away. In the last round of restructuring this hope had backfired. It is vital that we avoid a repeat of that episode this time around.

Modi government and RBI can learn from mistakes made during 2008 crisis, but time’s running out,

The Print, August 19, 2020

Five months into the lockdown, the Covid-19 pandemic is nowhere near its end, while the economy continues to steadily deteriorate. The pandemic is unprecedented in modern India, but its economic impact is familiar: a toxic mix of poor growth, high inflation, and numerous bad loans, similar to the period after the 2008 Global Financial Crisis. This means we can look to the 2008 crisis for lessons that can help us avoid policy mistakes, especially with respect to inflation and bad loans.

Inflation pressure

Let’s first consider inflation. In the aftermath of the Global Financial Crisis (GFC), the Reserve Bank of India (RBI) responded aggressively, lowering the policy rate by more than 4 percentage points in just four months, to 4.75 per cent in December 2009. At the time, the RBI felt it was safe to relax its monetary policy stance, since the wholesale price index (WPI) inflation had collapsed. But the respite in inflation proved temporary, and soon the WPI was rising at a double-digit pace, causing inflation expectations to soar. Bringing this situation under control proved to be difficult. It was not until 2013, when policy rates had been increased to painful levels, that inflation finally began to subside.

In retrospect, the RBI made two mistakes. First, it focused on the WPI, even as more comprehensive indices were signalling towards growing inflationary pressures. The erstwhile CPI (Consumer Price Index)-industrial workers series exceeded 12 per cent, as early as 2009-10. Second, and more critical, even after the WPI itself began to rise the RBI was slow to respond, since it always had reasons to hope that the increases would be temporary.

When the current Narendra Modi-led government came to power in 2014, it seemed determined to not let such a harrowing episode be repeated. Accordingly, it introduced into law a new monetary policy regime, committing the RBI to keeping inflation within a 4-6 percent range, as measured by the CPI — not the WPI. If inflation did exceed 6 per cent for three consecutive quarters, the RBI was required to explain in a report to the government, in a report, what it was doing to bring inflation back to target levels.

The RBI now finds itself in precisely the situation that the law meant to safeguard against? CPI inflation has exceeded 6 per cent for the past 10 months. But the reaction of the RBI has been the same as it was after the GFC. The central bank has been reluctant to increase interest rates, on the grounds that high inflation triggered by supply side constraints is temporary. Without doubt, prices have been pushed up by supply disruptions during the lockdown period, and these will eventually disappear. But the process of restoring supply chains might easily take a year, by which time high inflation expectations could become firmly entrenched. Hence, there is a risk that despite all the efforts to ensure post-GFC mistakes never happen again, they are about to be repeated.

Covid's bad loan crisis

So much for inflation. What about bad loans? After the GFC, slower growth and higher interest rates rendered unviable many of the investment projects initiated during the 2004-08 boom. , making This made it impossible for many firms to repay their bank loans. The RBI responded with a series of restructuring schemes, which failed to resolve the problem. Instead, the schemes facilitated an ‘extend and pretend’ policy which enabled the banking sector to hide the bad loans for years.

The delay in resolution of the stressed assets triggered a prolonged phase of low investment-low growth in the economy, and high risk aversion in the banking sector, from which the economy still hadn’t recovered when it was hit by the Covid-19 pandemic. As these consequences became apparent, the Modi government brought in the Insolvency and Bankruptcy Code (IBC), mandating that bankrupt firms be resolved expeditiously, and in a transparent manner, essentially by auctioning them off to new, financially stronger, owners.

For a time, the IBC was indeed able to whittle down the stock of bad loans. But the Covid-19 shock generated a new wave of stressed assets, which according to the RBI’s latest Financial Stability Reports is likely to propel nonperforming assets (NPAs) to a new peak of 12.5 per cent by March 2021, even under a favourable scenario.

Going forward

It is unclear how the authorities plan to deal with this problem. So far, the government has suspended the initiation of fresh insolvency proceedings for a year, while the RBI has appointed a committee to recommend new restructuring guidelines.

If the new restructuring guidelines follow the same ‘extend and pretend’ strategy chosen after the GFC, the outcome will be the same as before. Or possibly worse, given that in 2008 the corporate and banking sectors were comparatively stronger, whereas even before the virus hit in 2020, they both had been substantially weakened by years of balance-sheet stress. Hence, the effects of delaying resolution this time might be more serious. If the banking sector gets paralysed, unlike the post-2008 period, borrowers will no longer be able to turn to the non-banking finance companies (NBFCs), since the NBFCs are also in a weak condition now.

India, thus, stands at a crossroads now. Soon, the Modi government and the RBI will need to decide whether to deal quickly and decisively with the economic problems that Covid-19 has created, or wait and watch in the hope that they will disappear over time. The stakes in this decision are high, since it will determine the course of India’s economy for the next decade.

Looking back, the GFC episode makes it clear that the decisive strategy is superior. What is unclear is whether this lesson has truly been learned. And we all recall American philosopher George Santayana’s admonition: if we do not learn from history, we are doomed to repeat it.

The Indian corporate bond market: From the IL&FS default to the pandemic

The Indian corporate bond market: From the IL&FS default to the pandemic, (with Harsh Vardhan), The Leap Blog, August 7, 2020.