Managing bad loans

Bank balance sheets would need to be quickly repaired

The economic disruption caused by Covid-19 is likely to push up non-performing assets (NPAs) in the banking system, as the contraction in economic activity is affecting revenues and the ability of businesses to repay debt. While a number of firms, which were in the middle of expanding capacity, would re-evaluate demand conditions and may decide to postpone investment activity, firms with stalled projects would find it difficult to service loans. The government has also suspended some sections of the Insolvency and Bankruptcy Code for six months, which would affect the bargaining power of lenders. Additionally, the Reserve Bank of India (RBI) in a recent note on household finances underlined that borrowing increased in the January-March quarter, partly because of Covid-related hardship. Given the economic difficulties, the recovery of such loans could become difficult and add to NPAs. 

The banking regulator is obviously alert to such possibilities. As reported by this newspaper, the RBI has asked banks to carry out detailed stress tests and start working on capital-raising plans if necessary. The tests would evaluate all key financial parameters related to the quality of the books and account for even a severe stress scenario. This might force some banks to raise capital. The government would also need to infuse more capital into public sector banks (PSBs). The banking regulator is also expected to review the trigger points for additional provisioning. The RBI, however, may consider relaxing rules for a short period to accommodate difficulties arising because of the pandemic. Besides, it is expected to allow a one-time restructuring of loans. The central bank has done well to initiate discussions with banks as some amount of regulatory flexibility may be warranted in the current economic environment. The regulator, however, would need to be careful while relaxing regulations to make sure they are not used to hide bad assets, nullifying the hard-won gains on this front. To be sure, the actual impact of the lockdown and contraction in economic activity would be visible on bank balance sheets after the end of the repayment moratorium. 

A slow rebound in economic activity would only escalate the pain in the banking system. In fact, apart from the containment of Covid-19, revival itself would depend to a large extent on the state of the banking and financial system. The central bank has infused a substantial amount of liquidity into the system to aid the functioning of the bond market. However, debt financing in India is dominated by banks and their ability to lend has a significant bearing on economic activity. The fact that the Indian banking system and particularly banks in the public sector were not in a good shape even before the Covid crisis would only make things more difficult. In fact, Indian banks never fully recovered from the financial crisis of the last decade and excessive lending in its aftermath. The impaired state of the banking system was one of the main reasons for slower growth in recent years. Thus, how quickly bank balance sheets are repaired would be critical for recovery from the current Covid-19 shock. The government, of course, will need to take the lead and capitalise PSBs adequately.