Chapter 7 of Economic Survey dealing with the banking crisis strongly emphasizes that the continuation of the policy of forbearance followed in the wake of Global Financial Crisis (GFC) even after 2011 was the primary reason for the banking sector crisis. The survey argues “the forbearance continued long after the economic recovery, resulting in unintended and detrimental consequences for banks, firms, and the economy”. It further identifies issues of lending to ‘zombie firms’, restructuring and ever greening of bad loans, relaxed provisioning norms, reduction of independent directors on the board and undercapitalization during this extended period of forbearance compounding to the NPA crisis.

It also points out that the Asset Quality Review (AQR) implemented in 2015 by former RBI governor Raghuram Rajan was inadequate. According to the survey “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 is claimed to be the reason for the second wave of ‘lending distortions’ that further deepened the crisis. The chapter was seen as a scathing critique of the policies followed by RBI under Raghuram Rajan’s term and calls for a fresh AQR.

Seven Year Forbearance: The Original Sin?

The Economic Survey is correct in pointing out that extending forbearance had aggravated the crisis in Indian banks and the other associated problems mentioned above. But, the Economic Survey is wrong in pinning it as the primary reason for the crisis – the original sin.

In doing so, the Economic Survey misses a few fundamental problems associated with commercial banks’ lending to large scale development projects.

Shift from DFIs:

If we are at all looking for an original sin, one cannot miss the shifting of the burden of large scale lending from Development Financial Institutions (DFI) to commercial banks. DFIs, established in post-colonial India, grew into a system focusing on the credit needs of industries state-wise and sector specific over three decades. They formed the foundations of industrial growth in the country, primarily lending long term.

With the introduction of new economic policies, there was a deliberate push to do away with the DFIs. In 2002, the government considered DFIs as ‘not viable’ and the burden of lending large scale projects was imposed on the commercial banks. Instrumental to this shift was the Narasimham Committee Recommendation:

“The Committee is of the view that with such convergence of activities between banks and DFIs, the DFIs should, over a period of time, convert themselves to banks. There would then be only two forms of intermediaries, viz. banking companies and nonbanking finance companies. If a DFI does not acquire a banking licence within a stipulated time it would be categorised as a nonbanking finance company.”

With the intent to further new economic policies, the burden of lending long term was shifted onto the commercial banks, despite the inherent problems of Asset-Liability Mismatch associated with commercial banks. RBI itself has in multiple papers and reports recognized “deposit liabilities of banks are of relatively shorter maturity. And about four-fifths of bank deposits are of a tenor of less than five years. In view of this, long-term lending could induce the problem of asset-liability mismatches”. Universal Banking became a desirable goal, for which the commercial banks were forced to taken up roles of development banks. Doing so, knowing that large scale / long term lending invariably creates issues of NPAs (which was one of the reasons stated for the dilution of DFIs) was the first among the many blunders.

Lack of Safeguard Policies:

Commercial had not incorporated adequate safeguards to protect their lending.. Development projects have historically had adverse effects on the communities and environment where these projects  have been located. It is decades of struggle by the people’s movements across the world that have ensured that International Financial Institutions (IFIs) develop and adhere to social and environmental (S&E) safeguard policies. Today safeguard policies are seen as a standard practice for large scale investments that intends to ‘do no harm’. Indian financial institutions, including the commercial banks however have relied on the environmental clearance and other clearances from the ministries for their loans. It was not seen as the ‘banks’ job’ to get into safeguard policy.

RBI as the regulator of banks failed to ensure both S&E and proper due diligence for lending. Due to the problematic nature of the development projects many had been resisted by the people against forceful and wrongful land grab, attaining environmental clearances without consultations on the ground etc. these have been one of the major problems for both the banks and the people. Even as late as 2018, as many as 435 infra projects (road) were stuck due to land acquisition and clearances and yet debates on safeguard policies have still not gained prominence. The rise of NPAs due to the delay of projects is never seen with the seriousness as it should be, considering its implications on the banks and the people. This, coupled with lending without proper collateral or due diligence on the borrowers have also been one of the major problems for the NPA crisis.

While RBI has responded to the crisis with multiple policy changes on restructuring of the loans, lenders forum, changing NPA norms, provision norms and a host of others in the last decade; it never for once tightened lending policies or even initiated any serious debate on safeguard policies.

Lack of Stringent Recovery Mechanisms:

The current government introduced Insolvency Bankruptcy Code (IBC) with much fanfare in 2016, though things have been in process over past two decades of bringing an uniform insolvency and bankruptcy law in India, drawing from the developments in other advanced economies. IBC was projected as a panacea for addressing the NPA crisis and it was said that this would bring a major respite to the banks grappling with the NPA crisis, especially where large scale bad loans were in picture. After four years of its functioning, IBC has hardly been able to recover even 50% of the NPAs.  On an average, since its inception IBC has only made 43% (June 2019) recovery. The same article highlights “Until 30 June, of the 2,162 cases that have been referred to the corporate insolvency resolution process (CIRP), only 120 have seen resolution plans; 1,292 are still under CIRP. Hence, of the 870 cases that are out of CIRP, only 13.8% have seen resolution plans. This is very low. As many as 475 cases have been closed by liquidation. Of these, liquidation has happened in only 11 cases and the recovery is next to nothing.” Another points out the high rate of haircuts that the banks are forced to pay in the IBC process. For claims amounting to Rs. 8.19 lakh crore, banks have had to take a haircut of Rs. 6.46 Lakh crore in a total of 970 cases. It also points that out of Rs. 9,870 crore worth of liquidation claims, only Rs. 96 crore were received by the creditors.

The IBC as a recovery mechanism has proved to be a costly one for the banks. It has been a long pending demand of the bank unions to enforce stringent mechanisms for recovery, including criminalization of willful defaulters. Knowing that large scale lending was being done by commercial banks, RBI should have ensured such mechanisms. It had failed to do even have proper norms classifying willful default. This is in sharp contrast when compared to the recovery mechanisms for smaller loans / personal loans, like the Debt Recovery Tribunals (DRTs) established under Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI, 2002).

This trifecta of causes addresses the root of the problems of NPA, which is neither recognized nor attempted to be changed by the government or the RBI. Without addressing these fundamental problems, reviewing asset quality periodically is going to be as ineffective as the previous policies critiqued by this year’s Economic Survey.