The sine qua non for achieving growth and inflation-the two main objectives of monetary policy formulation in a bank dominated financial economy, is a robust monetary policy transmission framework that transmits its impulses through the banking system. As signaled, effective monetary policy transmission is largely dependent upon sound health of the banks’. Healthy banks with low default risks accelerate monetary policy transmission by amplifying the effect of changes in money market interest rates (short-term policy) on lending interest rates, by changing their lending standards and their use of non-price measures while sanctioning loans. These banks are better able to pass on interest rate changes of the RBI symmetrically on its deposits and loans as compared to banks with a high level of prospective or realized non-performing assets (NPAs) who tend to push up the lending rates and their net interest margins (difference between the net income generated by banks and the amount of interest paid out to their lenders) on account of building up provisions by loading credit risk premium on its performing loans.

Regulatory forbearance; Propulsion to Asset Quality Review

The Reserve Bank of India, in the aftermath of the global financial crises of 2008, relaxed norms for restructuring assets, allowing companies to recoup from the funding imbalance and repay their debts. However, these companies classified troubled assets as standard assets rather than non-performing assets, hence eliminating the need to create provisions, those non-performing loans would attract. This allowed the banks to not set aside provisions for such loans with the expectation that once the economy turns around, the borrower’s fortunes shall improve along with improvement in the quality of the asset in the bank’s books.

RBI believed that banks were simply postponing their bad loan recognitions under the forbearance regime. Banks on the other end insisted on delaying their bad loan recognition and not calling their loans bad even after 3 years of non-payment of loan. This erratic behavior of banks caused colossal amounts of apprehensions on the investors’ part.

This regulatory forbearance regime was sought to end in 2015 when RBI pointed out that the classification of the restructured assets was not in line with the international best practices and that the total restructured assets in the economy have significantly outgrown total non-performing assets. In an attempt to ensure that banks across the nation took steps to clean their balance sheets and are adequately capitalized, RBI worked with the senior national supervisors and unfolded the Asset Quality Review (AQR).

AQR – causing stir in the banks’ balance sheets

Owing to the rising NPAs within the banking systems, often regarded as the leading financial sector problem, RBI set in motion, as a part of its routine annual financial inspection (AFI- annual inspection of banks’ books by RBI), a special inspection of sample of loans to ensure that the asset classifications are in line with the loan repayments and that the banks have made adequate provisions. This special inspection was called asset quality review. AQR is essentially an endeavor to value the asset to ascertain the credit risk associated with it; assessing the value of the asset in books of the lender, evaluating the collateral provided by the borrower and his repayment capacity in order to compute the value of the loan closest to its perceived value and determine whether a provision is to be made or it should be written off from the books.

A Bloomberg Quint study comparing the results of 42 listed banks reported in the December 2016 quarter with the results reported in the September 2015 quarter (i.e. before AQR was conducted), revealed that the bad loans nearly doubled from ₹3.4 lakh crores to ₹ 7 lakh crores., just how much the banks were hiding! According the study, the gross NPA of private sector banks increased from ₹33,634 crores in September 2015 to ₹ 80,409 crores. The bad loan pile of public sector banks which stood at ₹3.06 lakh crores in September 2015, swelled to ₹6.2 lakh crores in December 2016.  Clearly, both public and private sector banks were guilty of hiding the true quality of their balance sheets!

The aftermath

Data source- Centre for Monitoring Indian Economy

 Post RBIs clampdown on bank defaults in 2016, the share of public sector banks in overall lending decreased at a rapid pace from 71.6% in 2015 to 57.1% in December 2019, while the private sector banks took away the majority of the share that public sector banks lost. During the same period, the share of private sector banks in total outstanding loans in the economy nearly doubled from 17.4% to 35%. The profits of public sector banks were severely affected as compared to the private sector banks. Between March 2015 and March 2020, the former grew by just 4.1% per year as compared to the latter which grew by 20.1% per year.

However, the private sector banks seem to be lagging behind since December 2019. Their share in over all lending is said to have decreased by 60 basis points to 34.4% while an increase of same amount has been observed in public sector banks’ share which climbed to 51.7%. Economists believe that this stark reversal is due to recapitalization of public sector banks by the government, AQR and prompt corrective actions taken by the RBI.

But wait, what about NBFCs?

Is the Indian economy nearing its completion of bad loans’ recognition? Not at all! Almost a year ago, in august 2019, the current RBI governor Shaktikanta Das denied any plans of conducting asset quality review of non banking financial companies (NBFCs). Even after the financial pressure over several quarters due to the dramatic default by Mumbai based Infrastructure Leasing & Financial Services (IL&FS, that began the liquidity squeeze causing a downward cycle in the economy, and severe mismatch in the books of other NBFCs facing credit squeeze, RBI resorted to closely monitoring them and their interconnectedness with banks while recommending  NBFCs with a size of over Rs 5,000 crores to appoint functionally independent chief risk officers with clearly specified role and responsibilities in a bid to bring in professional risk management system.

The Future

Businesses, supply chains and individual incomes have been severely affected by the nationwide lockdown to contain the spread of Coronavirus. The recent measure- extension of 90 day moratorium on recognition of impaired loans to 180 days along with severe relaxations in the bank lending limits, announced by the RBI puts the banks with already weekend balance sheets at a greater risk. According to the Fitch Ratings, a leading credit rating provider, Indian banks are looking at significant asset challenges for the next two years despite the regulatory measures.

Impaired bank loan recognition will be stretched longer. As more and more relaxation in lending norms is provided by the RBI, lower earnings along with the risk of solvency and balance sheet risks heightens for banks-specially public sector banks that have a greater share of loan books under moratorium as compared to private sector banks. Strong capital support to the banks from the state governments is critical along with gaining control over the rising cases of Coronavirus patients to reverse the currently tepid consumer demand, so as to gain momentum on India’s economic revival.

This article has been written by Neha Haldia, a 3rd year student of Bcom (H) at SRCC.

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