Economic Survey seeks fresh AQR after end of Covid-19 forbearance

The Economic Survey 2020-21 has made a case for carrying out a fresh asset quality review (AQR) once the ongoing forbearances related to Covid-19 come to an end. Any such exercise must be accompanied by a round of bank recapitalisation, it argued, as the previous experience of AQR only aggravated the problems created by forbearance.

The Survey said that forbearance represents emergency medicine that should be discontinued at the first opportunity when the economy exhibits recovery, not a staple diet that gets continued for years.

“Therefore, policymakers should lay out thresholds of economic recovery at which such measures will be withdrawn. These thresholds should be communicated to the banks in advance so that they can prepare for the same. Prolonged forbearance is likely to sow the seeds of a much deeper crisis,” the Survey said.

In a subtle dig at the Reserve Bank of India (RBI), the Survey said that the events at Yes Bank and Lakshmi Vilas Bank corroborate that the AQR did not capture evergreening carried out in ways other than formal restructuring. Had the AQR exercise detected evergreening, the increase in their reported non-performing assets (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 Survey said. The fact that both these banks had to be rescued by the regulator also goes against the RBI’s assumption that the private banks should have been able to raise the required capital after the clean-up, the document said.

Forbearance should be accompanied by restrictions on zombie lending to ensure a healthy borrowing culture, and a clean-up of bank balance sheets is necessary when the forbearance is discontinued. While the 2016 AQR exacerbated the problems in the banking sector, the lesson from it is not that an AQR should not be conducted. “Given the problem of asymmetric information between the regulator and the banks, which gets accentuated during the forbearance regime, an AQR exercise must be conducted immediately after the forbearance is withdrawn,” the Survey said.

The review must account for all the creative ways in which banks can evergreen their loans. In this context, advance warning signals that do not serve their purpose of flagging concerns may create a false sense of security, according to the Survey. The banking regulator needs to be more equipped in the early detection of fault lines and must expand the toolkit of ex-ante remedial measures.

A clean-up unaccompanied by mandatory capital infusion exacerbates bad lending practices, the Survey said. “Expecting banks to get recapitalised on their own on account of economic recovery may not be prudent. Therefore, a clean-up exercise should be accompanied by mandatory recapitalisation based on a thorough evaluation of the capital requirements post an asset quality review,” it said.

Apart from recapitalising banks, it is important to enhance the quality of their governance. Evergreening of loans by banks as well as zombie lending is symptomatic of poor governance, suggesting that bank boards are “asleep at the wheel” and auditors are not performing their required role as the first line of defence. Therefore, to avoid evergreening and zombie lending following the current round of forbearance, banks should have fully-empowered and capable boards.

“Sound governance is a key metric to ensure that banks do not engage in distortionary lending post capital infusion. The regulator may consider penalties on bank auditors if evergreening is discovered as part of the toolkit of ex-ante measures,” the Survey said, adding that this would create incentives for the auditor to conduct the financial oversight more diligently.

To enable policymaking that involves exercise of judgement amidst uncertainty, ex-post inquests must recognise the role of hindsight bias and not make the mistake of equating unfavourable outcomes to either bad judgement, or worse, mala fide intent.

Finally, the legal infrastructure for the recovery of loans needs to be strengthened de facto, the Survey said. The Insolvency and Bankruptcy Code (IBC) has provided de jure powers to creditors to impose penalties on defaulters. However, the judicial infrastructure for the implementation of IBC – composed of debt recovery tribunals, National Company Law Tribunals, and the appellate tribunals — must be strengthened substantially.