The Reserve Bank of India (RBI) has just clarified its communication to banks on modifications to asset classification norms, in the context of ensuring that credit continues to flow to viable businesses. One of the major concerns in the current economic situation is that, even as policy interest rates are being cut and more liquidity is being infused into the system, the end users of credit are simply not seeing the benefits. And, if credit is not flowing to companies and consumers who would use it to buy goods and services, the economy is not going to turn around. But, under the circumstances, banks do have a case for being cautious and conservative. Businesses are seeing significant contractions in sales and margins, increasing the risks of defaulting on their loans. Every missed payment requires banks to provide for the exposure out of their earnings, thus diluting their own financial performance. The problem has become particularly acute since September 2008, when the extremely constrained liquidity situation knocked a number of businesses off the rails. As is normal practice, companies that were unable to meet scheduled interest payments and loan repayments would have been classified as doubtful or sub-standard assets, requiring banks to both stop lending to them and provide for anticipated losses. Given the severity of the liquidity crunch during that period, a large number of otherwise reasonably healthy businesses would have suffered that fate, essentially destroying any hopes they might have had about recovering from the blow. This could escalate to the macroeconomic level, and has to an extent done so, leading to the weak impact of monetary measures. In policy announcements since December, the RBI has attempted to find ways of ensuring credit flows to such businesses by allowing them to re-structure their obligations to banks, thereby avoiding re-classification and the stopping of credit.
This approach is not without risks. A mere re-structuring of loans does not guarantee that future obligations will be met. Given the business environment, many borrowers may still end up delinquent. The problem may only have been postponed, not resolved. Clearly, there is no foolproof solution, but the RBI has found a reasonable middle ground. It has clarified that assets will not be reclassified unless borrowers and lenders agree on a re-structuring plan. This will give the lenders a chance to assess the business prospects of the borrower in terms of whether the problems are essentially liquidity-related or lie somewhat deeper. This should ensure that credit resumes flowing to reasonable prospects. On the banking side, the pressure to provide against losses will be alleviated, making banks a little more willing to lend. The guidelines reduce risks by making eligible only those borrowers whose accounts were in proper shape at the end of September. They also accommodate capacity constraints in banks by letting the process continue over the year, with retrospective re-classification once an agreement is reached.
Against the backdrop of the debate on accounting changes required to bring financial systems back on an even keel, this is a good balance between flexibility and prudence. Permanent changes in standards carry the risk of adverse long-term effects. Something like this is better suited to the essentially temporary nature of the problem. Monetary policy and banking practice can now become more aligned with each other, which is central to an economic recovery.
