Another round of AQR once Covid-forbearance is lifted

The Economic Survey suggested that there should be one more round of asset quality review (AQR) of banks after the Covid-related forbearance is over, even as it severely criticised the Reserve Bank of India (RBI) for not being able to unearth the full extent of bad debt mess in banks in the previous round of such an exercise.

The Survey said the present round of forbearance measures should not be dragged for long, but should be “discontinued at the first opportunity when the economy exhibits recovery”, adding, it is like an emergency medicine that can have lasting side-effects and lead to deeper crisis if continued for long.

The policymakers should lay out the thresholds of economic recovery at which such measures should be withdrawn. These thresholds should be communicated to the banks in advance. “Forbearance should be accompanied by restrictions on zombie lending to ensure a healthy borrowing culture,” the Survey said.

The last round of forbearance, undertaken after the global financial crisis of 2008, should have ended in 2011. “The roots of the present banking crisis go back to the prolonged forbearance policies followed between 2008 and 2015,” the Survey said. It resulted in “unintended and detrimental consequences for banks, firms, and the economy”.

Gross non-performing assets (NPAS) increased from 4.3 per cent in 2014-15 to 7.5 per cent in 2015-16 and peaked at 11.2 per cent in 2017-18. Early resolutions of banking crises should have limited the damage, but the RBI “dragged its feet in biting the bullet”.

The banks took advantage of relaxed provisioning requirements and window-dressed their books by restructuring loans of unviable entities. The inflated profits were paid back to the owners as dividends, including the government, rendering the banks severely undercapitalised. This led to risky lending practices, including lending to ‘zombies’.

During the forbearance window, the proportion of firms in default increased 51 per cent after their loans got restructured, against 6 per cent increase in pre-forbearance times. “Forbearance thus, helped banks hide a lot of bad loans.”

By the time forbearance ended in 2015, restructuring had increased 7x, while NPAS almost doubled.

The AQR was done subsequently, but “could

not bring out all the hidden bad assets in the bank books and led to an under-estimation of capital requirements. This led to a second round of lending distortions, thereby exacerbating an

already grave situation”.

The fact that the AQR exercise “significantly under-estimated the full extent of NPAS”, and failed to prevent evergreening in banks was evident by the recent events at YES Bank and Lakshmi Vilas Bank, it said.

“Had the AQR exercise detected evergreening, the increase in their reported NPAS should have been in the initial years of the AQR. Our analysis clearly shows that most of the non-performing loans were lent and restructured during the forbearance phase. Hence, the RBI audit missed some severe cases of evergreening by these banks.”

The RBI also assumed faultily that private banks would be able to raise capital after the clean-up. The AQR, therefore, “must account for all the creative ways in which banks can evergreen their loans”. The banking regulator needs to be more equipped in the early detection of fault lines and must expand the “toolkit of exante remedial measures”.

There should be mandatory capital infusion after clean-up of bad debt, and the quality of governance should be improved. “Evergreening of loans by banks, as well as zombie lending, is symptomatic of poor governance, suggesting bank boards are ‘asleep at the wheel’ and auditors are not performing their required role as the first line of defence”. If evergreen is discovered later, such auditors should be penalised, suggested the report.