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.
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