More than a decade after the global financial crisis, the exit from an ultra-loose monetary policy — such as near-zero interest rates and helicopter money — in the US is still a work in progress. The US Federal Reserve’s balance sheet has expanded from under $1 trillion before 2008 to $4.5 trillion in the aftermath of the financial meltdown. The Covid outbreak has further pushed the unwinding as the Fed’s balance sheet is expected to jump to 50 per cent of the country’s GDP from the current 34 per cent. The eventual exit would mean liquidity tightening and higher interest rates in the US, which would have implications for emerging markets, including India, by way of dollar outflows from stock market and currency depreciation.
The Reserve Bank of India (RBI), too, gave regulatory for bearance to banks post the financial crisis. It followed an extended period of loan-restructuring relaxations without classifying stressed loans as non-performing assets (NPAs). This created huge hidden stress in the banking system in the last decade by way of under-reporting of NPAs, lower provisioning, over-stating of profits and capital levels, and encouraging zombie lending (the practice of providing credit to entities that do not have the capability to repay). A delayed exit from forbearance, after almost seven years of the crisis, saw NPAs rising to a high of 11.5 per cent by March 2018, and led to losses in banks’ books, depleting capital levels and companies defaulting on loan obligations. The Indian banking system, which is still to come out of 2008 shock, has entered the new crisis with very weak financials. Former Chief Economic Advisor Arvind Subramanian once described Indian policymakers’ predicament as Mahabharata’s chakravyuha challenge — ‘the ability to enter but not exit’.
Once again, governments and regulators world over are caught in a chakravyuha — This time the question is how and when to exit? “The size and scale of monetary policy expansion is at an unprecedented level. There are not one, but dozens of regulatory relaxations to banks. The monetary policy has been used to the hilt,” says the CEO of a public sector bank. Any delay in exit could have far-reaching consequences. It could lead to hyper inflation, higher interest rates, a weak RBI balance sheet, currency depreciation and massive fall in asset prices in the future. Also, regulatory relaxations create an artificial sense of robustness in the financial system by hiding NPAs.
So, what should be the roadmap for exit from exceptional monetary and regulatory measures without impacting economic recovery and disrupting the banking sector and the financial market?
Ending Regulatory Forbearance
The RBI has been quite accommodative ever since Governor Shaktikanta Das took charge in December 2018. The central bank’s focus was to revive growth and protect the NBFC sector post the IL&FS debacle. In the last 18 months, the RBI has taken a series of measures, including higher lending to corporate groups, and reduction and rationalisation of capital allocation on consumer loans and loan moratorium, to protect balance sheets of banks and help corporates, especially MSMEs and retail borrowers, from defaulting post-Covid. The big challenge now is to back-pedal the relaxations in a time-bound manner to protect banks and also create cushions by way of capital and provisions from profits to absorb future shocks. “The regulatory forbearance has an expiry date built into it,” says R. Gandhi, Former Deputy Governor, RBI. The danger is the extension of such relaxations.
“When the second wave of Covid gets under control, it would be time to go back on capital forbearance related to some aspects of Basel III implementation and build capital levels proactively. Capital is necessary, but not sufficient. It should be backed by reforms in the banking sector covering areas such as corporate governance etc,” says Anand Sinha, Former Deputy Governor, RBI. Basel III rules, set after 2008 financial crisis, further strengthen banks’ regulations and risk management.
One area that needs urgent stress testing is banks’ MSME loan portfolio, according to experts. There is a lot of stress hidden in these small loans because of a government guarantee cover for collateral-free loans and a one-time restructuring scheme, they add. For instance, the RBI had announced a restructuring scheme for MSME loans up to ₹25 crore, which was to end in March 2020, but was extended for another year due to the Covid outbreak. The government had come out with an emergency credit line guarantee scheme of ₹3 lakh crore offering 100 per cent credit guarantee on loans disbursed to MSMEs. The RBI had also offered a one-time, two-year restructuring of retail and corporate loans. So, if not a stress test, there is at least a need for higher provisioning from profits to avoid major defaults. “Given their role in employment and income generation, stress in MSME segments need flexible restructuring and resolution measures than additional provisioning or AQR ( asset quality review),” says Gandhi.
GROUND RULES FOR EXIT FROM REGULATORY FORBEARANCE
Setting a threshold of economic recovery for exit — a minimum of 5 percent of GDP is sufficient
Initiating an asset quality review of banks, NBFCs after exit; providing for stressed loans
Fresh capital infusion after a cleanup; putting in place buffers for provisioning and likely losses
Focus on quality of governance; Board should have diverse representation, including former regulators
Strengthening legal infrastructure, pre-packs (out-of-court preparation of turnaround plans) and other building blocks to support IBC
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