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Four principles to be followed in RBI’s loan restructuring

It is important to note that restoring the health and stability of the banking sector is critical to the recovery of the economy from this crisis

August 21, 2020 / 04:46 PM IST

Harsh Vardhan and Rajeswari Sengupta

In the aftermath of the 2008 Global Financial Crisis, large-scale debt restructuring had taken place in the Indian banking sector. Just about a decade later the Reserve Bank of India (RBI) finds itself in a similar situation — this time due to the COVID-19 pandemic — with demands from multiple stakeholders for a recast of the bad loans that would soon pile up on the balance sheets of banks. The previous experience had given ‘restructuring’ a bad name. Can this time be different?

In the post-2008 period, a series of restructuring schemes offered by the RBI to the banking sector had facilitated an ‘extend and pretend’ approach. The underlying asset kept deteriorating for years. When the RBI initiated an asset quality review in 2015, the non-performing assets (NPAs) skyrocketed. This episode triggered a prolonged phase of low growth-low investment in the economy.

As the RBI embarks upon a similar project, lessons from this experience should guide the current thinking. The RBI has already issued first-order guidelines that set out key boundary conditions for the restructuring scheme. A next level of filters is now required to prevent a repeat of the past mistakes. To this end, we outline four principles that we think should be embodied in any restructuring scheme that the RBI offers.

Avoid Type 1 And Type 2 Errors


The impact of the pandemic and the associated lockdown is highly uneven. While some sectors (e.g. hospitality, aviation, automobiles) have been severely impacted, the shock to some others (e.g. pharmaceuticals and fast moving consumer goods (FMCG)) has been modest. Some sectors (e.g. telecom, Internet-based services) have benefitted from this episode. Even within a sector, businesses have experienced varying degrees of stress depending on their size, financial constraints, geography of their operations, etc. Restructuring must be permitted only for those firms that have been badly hit by the pandemic, and not to those who were financially stressed before the outbreak.

In deciding which borrowers get the restructuring, we must avoid what statisticians refer to as Type 1 and Type 2 errors. Type 1 error occurs if a deserving borrower is denied restructuring. Significantly more pernicious from the perspective of the banks, and hence the economy, is a Type 2 error where non-deserving borrowers get restructured. Widespread Type 2 errors can ultimately impose a heavy cost on the rest of the economy, especially when 70 percent of the banking system is owned by the government.

The bankers themselves are best placed to judge if a borrower deserves to be restructured. Hence, one way to avoid these identification errors would be to let the bankers exercise their discretion and judgement as opposed to the banking regulator prescribing the rules.

Ensure Accountability Of Bankers

Restructuring schemes offered by the regulator are by definition accompanied by forbearance and create a risk of moral hazard. In absence of the necessary checks and balances, bankers may get tempted to recast the debt of all their borrowers because they get to keep their books clean. This is especially relevant in cases where a bank’s CEO is about to retire. Hence, it is important that bankers have a skin in the game and are held accountable for the decisions they take.

This can be achieved in two ways. First, the provisioning requirements on restructured loans must be higher than standard assets and lower than the NPAs. There must be an incremental cost of restructuring. Second, adequate disclosures must allow a wide range of external stakeholders to assess the actions of bank management.

Minimise Information Asymmetry

When a bank implements a restructuring scheme, the information asymmetry goes up. The regulator must take necessary steps to reduce the opacity of the deal struck between the bank and the borrower. This is important because banks deal with public money and with majority of the sector owned by the government, any lapse on the part of these banks ends up imposing a cost on the tax payer.

The most important way to reduce information asymmetry and enhance accountability of bankers is to demand disclosures. Previous restructuring schemes were characterised by scant disclosures and hence the various stakeholders in banks — stockholders, bond investors, other borrowers, depositors, employees, etc — had little information.

Any scheme must be accompanied by extensive disclosures on various aspects of the restructuring, such as amount of loans restructured, the sectoral break up of restructuring, the stage in the lifecycle of the loan when restructuring is done, assessment of the bank management on the recoverability of the loan, the timeline of recoverability, key conditions of restructuring, and so on. These disclosures should be mandated on a quarterly basis with regular updates on the performance of the restructured portfolio.

Conditions on Borrowers

The borrower who qualifies for a loan recast must pay some price in lieu of the relief obtained, as otherwise there may be little incentive to abide by the terms of the scheme. The underlying assumption of the relief is that the cash flows of the borrower are impacted by the pandemic and are inadequate to service debt. In that case, the borrower must not be permitted any other discretionary uses of cash flows. Specifically, borrowers must not be allowed to engage in acquisitions, share buybacks and delisting, dividend payment, and even variable compensation to senior management, as long as any of their loan is getting restructured. These restrictions should be the pre-conditions for restructuring.

As we enter into yet another phase of debt restructuring, it is important to note that restoring the health and stability of the banking sector is critical for the recovery of the economy from this crisis. While restructuring provides short-term relief, it does not solve the underlying problem. Most often the hope is that the system will grow out of the crisis and the problem will go away. In the last round of restructuring this hope backfired. It is vital that we avoid a repeat of that episode this time around.

Harsh Vardhan is an Executive-in-Residence at the Center for Financial Studies and an Adjunct Faculty at the SP Jain Institute of Management and Research, Mumbai. Rajeswari Sengupta is an Assistant Professor of Economics at the Indira Gandhi Institute of Development Research, Mumbai. Views are personal.
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