The Economic Survey has put the blame of the current banking crisis on the zombie lending following the Global Financial Crisis in 2008.
The survey said this engendered the recent banking crisis that brought down investment rates and thereby economic growth in the country.
"The first lesson for policymakers is to treat emergency measures as such and not to extend them even after recovery: when an emergency medicine becomes a staple diet, it can be counterproductive", the survey said.
The current regulatory forbearance on bank loans has been necessitated by the Covid pandemic.
Among the measures, the survey has suggested that forbearance should be accompanied by restrictions on zombie lending to ensure a healthy borrowing culture.
A clean-up of bank balance sheets is necessary when the forbearance is discontinued, the survey said.
The asset quality review must account for all the creative ways in which banks can ever-green their loans. In this context, it must be emphasized that advance warning signals that do not serve their purpose of flagging concerns may create a false sense of security, it added.
It has also recommended that a clean-up exercise should be accompanied by mandatory recapitalization based on a thorough evaluation of the capital requirements post an asset quality review.
Apart from re-capitalizing banks, it is important to enhance the quality of their governance. Ever-greening 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, the survey said.
Therefore, to avoid ever-greening and zombie lending following the current round of forbearance banks should have fully empowered, 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 ever-greening is discovered as part of the toolkit of ex-ante measures, the survey recommended.
Regulatory forbearance for banks involved relaxing the norms for restructuring assets, where restructured assets were no longer required to be classified as Non-Performing Assets (NPAs henceforth) and therefore did not require the levels of provisioning that NPAs attract.
The survey noted that during the GFC, forbearance helped borrowers tide over temporary hardship caused due to the crisis and helped prevent a large contagion.
"However, the forbearance continued for seven years though it should have been discontinued in 2011, when GDP, exports, IIP and credit growth had all recovered significantly. Yet, the forbearance continued long after the economic recovery, resulting in unintended and detrimental consequences for banks, firms, and the economy", the survey said.
Noting the bad effects of this, the survey said that given relaxed provisioning requirements, banks exploited the forbearance window to restructure loans even for unviable entities, thereby window-dressing their books.
"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. Undercapitalization distorted banks' incentives and fostered risky lending practices, including lending to zombies", the survey noted.
As a result of the distorted incentives, banks misallocated credit, thereby damaging the quality of investment in the economy. Firms benefitting from the banks' largesse also invested in unviable projects.
By the time forbearance ended in 2015, restructuring had increased seven times while NPAs almost doubled when compared to the pre-forbearance levels. Concerned that the actual situation might be worse than reflected on the banks' books, RBI initiated an Asset Quality Review to clean up bank balance sheets.
While gross NPAs increased from 4.3% in 2014-15 to 7.5% in 2015-16 and peaked at 11.2% in 2017-18, the AQR could not bring out all the hidden bad assets in the bank books and led to an under-estimation of the capital requirements. This led to a second round of lending distortions, thereby exacerbating an already grave situation, the Economic Survey said.
(Only the headline and picture of this report may have been reworked by the Business Standard staff; the rest of the content is auto-generated from a syndicated feed.)