The government must get rid of the forbearance window, provided by banks to borrowers due to COVID-19 induced economic challenges, as soon as the economy starts to revive as it is only an "emergency medicine" and not a "staple diet", the Economic Survey for 2020-21 has suggested.
Financial regulators across the globe adopted the regulatory forbearance measures to tide over the economic challenges posed by COVID-19 and India was no expectation, said the Economic Survey 2020-21 presented on Friday ahead of the general budget.
Emergency measures such as forbearance prevent spillover of the failures in the financial sector to the real sector, thereby avoiding a deepening of the crisis, according to the survey tabled in Parliament by Finance Minister Nirmala Sitharaman.
"Therefore, as emergency medicine, forbearance occupies a legitimate place in a policy maker's toolkit...forbearance represents an emergency medicine that should be discontinued at the first opportunity when the economy exhibits recovery. It is not a staple diet that gets continued for years," said the Economic Survey 2020-21.
Highlighting the problem of asymmetric information between the regulator and the banks, which gets accentuated during the forbearance period, the survey has suggested an immediate Asset Quality Review (AQR) as soon as the forbearance is withdrawn.
"The legal infrastructure for the recovery of loans needs to be strengthened de facto," it said.
The regulatory forbearance for banks were through measures like relaxing the norms for restructuring assets, where restructured assets were no longer required to be classified as Non-Performing Assets (NPAs) and hence did not require the levels of provisioning that NPAs attract.
Noting that the current regulatory forbearance on bank loans has been necessitated by the COVID-19 pandemic, the survey said during the global financial crisis, forbearance helped borrowers' tide over temporary hardship caused due to the crisis and helped prevent a large contagion.
However, the forbearance continued long after the economic recovery, resulting in unintended and detrimental consequences for banks, firms, and the economy.
In the current Covid-ravaged scenario, that there is a relaxed provisioning requirement, banks have exploited the forbearance window to restructure loans even for unviable entities, thereby window dressing their books, it said.
As a result of the distorted incentives, banks mis-allocated credit, thereby damaging the quality of investment in the economy. The inflated profits were then used by banks to pay increased dividends to shareholders, including the government in the case of public sector banks. As a result, banks became severely undercapitalized, the survey pointed out.
"Undercapitalization distorted banks' incentives and fostered risky lending practices, including lending to zombies. Firms benefitting from the banks' largesse also invested in unviable projects. 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," it added.
As per the government data, the gross non-performing assets (NPAs) or bad loans of the banks have fallen from 8.2 per cent by end of March 2020 to 7.5 per cent by end of September 2020. In case of public sector banks, it has fell from 10.25 per cent to 9.4 per cent.
Whereas the restructured standard advances (RSA) ratio of the banks increased from 0.36 per cent to 0.41 per cent during this period.
As per the survey, the various measures announced during the pandemic provided asset classification reliefs to borrowers, it would affect the true recognition of financial stress on the borrower accounts.
Highlighting the impact of forbearance during the global financial crisis, the Survey stated that such policies had desired short-term economic effects and the GDP growth recovered from a low of 3.1 per cent in FY2009 to 8.5 per cent within two years.
Growth in bank credit, which had fallen from 22.3 per cent in FY2008 to 16.9 per cent in FY2010, recovered quickly to 21.5 per cent in FY2011.
"The time was therefore ripe to withdraw the forbearance; after all the emergency medicine had worked in restoring the health of the economy. However, the central bank decided to continue with the same the forbearance continued for five more years till 2015, even when its withdrawal was recommended - a clear case of emergency medicine that was chosen to be made into a staple diet," it said.
Once the forbearance policy was discontinued in 2015, the RBI conducted an Asset Quality Review to know the exact amount of bad loans present in the banking system.
As a result, banks' disclosed NPAs increased significantly from 2014-15 to 2015-16. In the absence of forbearance, banks preferred disclosing NPAs to the restructuring of loans.
Thus, the roots of the present banking crisis go back to the prolonged forbearance policies followed between 2008 and 2015, the survey pointed out.