Fiscal policy must match banking reality in bad loans amid economic shifts

India’s economic transformation in the twenty-first century has been catalysed by bank lending, infrastructure funding, agriculture, and social development. Credit to micro, medium and small enterprises has enabled entrepreneurship. Banks have navigated significant global and domestic volatility throughout this period, acting as financial stabilisers amid macroeconomic stress. 

The Reserve Bank of India (RBI) has calibrated its regulatory oversight on bank lending through targeted interventions. Its actions include the introduction of prudential norms for income recognition and asset classification in 2004; tighter provisioning requirements for restructured loans after the 2008 global financial crisis; increased provisioning mandates in 2014 to counter systemic stress; adjustments to provisioning logic to align with the Insolvency and Bankruptcy Code, and temporary relaxations during Covid-19. Most recently it overhauled provisioning norms under the RBI (Project Finance) Directions, 2025, effective October 1.  

The new framework introduces a principle-based regime, harmonises treatment across banks and non-banking financial companies (NBFCs), and reduces provisioning requirements for under-construction projects — from 5 per cent to 1 per cent — to ease funding and enhance regulatory consistency. 

In contrast, the Income Tax law has remained static. Section 36 (1) (viia) of the Income Tax Act, 1961 (‘the Act’) allows Indian banks a deduction to provision for bad and doubtful loans as a percentage of (a) their total income (8.5 per cent), (b) aggregate average advances made by rural branches of such banks (10 per cent) or (c) doubtful or loss assets (5 per cent); computed in a prescribed manner. Foreign banks are permitted a deduction of up to 5 per cent of their total income (computed before this and Chapter VI A deductions). NBFCs were not entitled to this deduction until the Finance Act, 2016, when the Income Tax law was aligned with that for foreign banks. A deduction is also available to banks and NBFCs for irrecoverable amounts written off, provided the write-off exceeds amounts previously claimed as a provision. Separately, banks may recognise a deferred tax asset when RBI-mandated provisions exceed those deductibles under the Act, anticipating future tax relief. 

This divergence illustrates how the tax law imposes an artificial prescription for the deductibility of provisions for bad and doubtful debts, distinct from the prudential norms set by the sectoral regulator. The law undermines the adequacy/appropriateness of a provision that the RBI considers necessary to reflect the true health of a bank’s balance sheet. Since the tax law remains static unless specifically updated, it tends to be uncoordinated with the times, especially when the RBI revisits (and has indeed revisited) its provisioning norms in response to evolving economic conditions. 

Ultimately, tax deduction for bad loan provisions is a matter of timing. A dissonance between the two provisions results in banks maintaining dual-accounting logic: one for the RBI and one for the Indian Revenue authorities. With stable tax rates, buoyant direct tax collection and high dividends from the RBI, there is a compelling case for aligning the timing of tax deductibility with regulatory provisioning. Linking deduction to the regulatory prescription ensures congruence between two frameworks and makes the tax treatment flexible. 

As India targets a fiscal deficit of 4.4 per cent of its GDP in FY26, down from 4.8 per cent in FY25, the government must balance consolidation with sectoral resilience. The banking sector is tasked with funding growth while managing rising credit risks. It deserves policy coherence that reflects economic realities. Taxing unrealised income from non-performing assets not only distorts profit recognition but also undermines the prudential logic of provisioning. Any policy intervention should simultaneously be extended to NBFCs. A dynamic tax framework that mirrors RBI’s evolving norms would reduce compliance friction, reinforce systemic stability and support credit expansion without materially compromising fiscal discipline.

 

The writer is Partner, Deloitte India. The column was edited for space.