Amid the economic crisis triggered by the Covid-19 pandemic, the expected surge in non-performing assets and its potential impact on the fragile capital base of banks, is alarming. In this post, Srinivasa Rao discusses the current challenges facing the banking sector, and proposes policy measures to address the situation effectively. In his view, it is important to accelerate credit growth – albeit in a cautious manner – in order to revive the economy.
Covid-19 has caused an unprecedented economic crisis. Addressing the collateral damage of the pandemic on the banking sector – like for various other sectors of the economy – is a complex and prolonged process requiring collaboration across multiple actors. Amid the pandemic-induced disarray, non-performing assets (NPAs) are expected to increase, with potential implications for the capital base of banks. With large-scale disruptions, when deterioration in asset quality poses a systemic threat, sustained policy interventions are needed to encourage banks to carry on with their lending operations. Provision of credit is necessary to bailout distressed borrowers, and to accelerate the revival of the economy.
The inevitable fear of a spike in NPAs after the end of the moratorium on loan repayment1, additional provisions against rising NPAs, diminishing profitability, and other adversities have added to the already low risk appetite of banks leading to subdued credit growth. As a result, even the trailing low credit growth of 6.1% as on 27 March 2020, further fell to 5.5% by 28 August 2020, attracting the attention of regulators. Correspondingly, the outstanding bank credit went down by a notch from Rs.103.2 trillion on 27 March 2020 to Rs. 102.11 trillion by 28 August 2020.
Looking at decelerating credit flows, the Reserve Bank of India (RBI) observed that banks are not gearing up to respond to the crisis in an adequate manner, and are unable to rejuvenate credit flow despite abundant liquidity in the banking system and an accommodative monetary policy stance. Moreover, banks continued to park excess liquidity with the RBI under the reverse repo2 route even when its interest rate was brought down to 3.35% to encourage banks to lend. Normally, the RBI provides short-term funds under repo (usually for 7 days, 14 days, and 28 days), but due to the current liquidity situation, the RBI opened up a liquidity window to meet long-term liquidity needs of banks under targeted long-term (up to three years) repo operations (TLTRO). The lacklustre response to sector-specific TLTRO 2.0 conducted by the RBI, has also indicated the protective approach of banks. Thus, the RBI realised that such strong risk aversion of banks could eventually be self-defeating, and banks would have to play a more defining role using the synergy of stakeholder support.
While usual measures of monitoring and follow-up for the recovery of loans should continue, from a practical angle, an overall reduction in NPAs at this point of time may be unlikely as most of the borrowers are in distress and liquidity starved. But comfort can be drawn from past NPA behaviour to build confidence to tackle asset quality woes as and when normalcy restores.
Historical movement of NPAs
As per prudential norms that were adopted under banking sector reforms, assets are classified as non-performing if interest or instalment or both are overdue for a period of 90 days. Accordingly, assets are categorised into ‘standard’ and ‘sub-standard’ (NPAs). Hence, the rise and fall of NPAs are not only linked to macroeconomic disruptions but also to policy shifts. Gross NPAs rose to a new high of 23.2% in 1993 when asset classification norms were implemented as part of banking sector reforms. In the next decade, NPAs came down to 7.26% in 2003-04 and to 3.83% in 2013-14.
Another policy shift came in September 2015 when the RBI introduced ‘asset quality review’ (AQR) and withdrew forbearance of restructuring of loans.3 Gross NPAs first increased to 11.18% in 2017-18 and then reduced to 9.3% in 2018-19. The long-term swings in NPAs are, therefore, a function of changes in the external environment in the form of policy and macroeconomic shifts.
Asset quality woes induced by the Covid-19 crisis
Just before the onset of the pandemic, NPAs of banks had begun to show early signs of improvement, falling from 9.3% in March 2019 to 9% in March 2020. But the situation changed after the pandemic hit the economy. The RBI, in its recent Financial Stability Report (FSR) of June 2020, estimated that NPAs are likely to go up to to 14.7% by March 2021 in severe stress conditions, with 12.5% as the baseline scenario.
But considering the lingering nature of this crisis, banks should gear up to handle NPAs of a level going even beyond the RBI estimates in severe stress conditions. Near-term expectations to cap NPAs in distress situations may be difficult to realise and banks – while continuing to improve their capacity to lend – should be prepared for the long haul in managing asset quality. Given the extraordinary nature of the Covid-19 crisis, banks may have to live with higher NPAs for the next two years or so. But the inevitable asset quality woes should not be allowed to overwhelm the functioning of banks.
Challenges faced by banks in lending
Among several enablers, liquidity and capital adequacy are immediate near-term drivers to activate lending. In response to the ongoing pandemic, the RBI, while bringing down the policy rates, has infused liquidity of close to Rs.10 trillion using various innovative windows, and has assured to pump in more liquidity going forward. Again, based on the FSR (June 2020) data, the capital to risk-weighted assets ratio (CRAR)4 of the banking system was 14.6% in March 2020, and was expected to go down by 133 basis points in baseline scenario to reach 13.3%, with a possibility of falling to 11.8% by March 2021 in case of severe stress.
As part of relaxations in prudential norms, the last tranche of implementation of the Basel-III framework5 was postponed from March 2020 to 30 September 2020 (now postponed to 31 March 2021). It effectively sets the benchmark of the minimum capital conservation buffer (CCB) at 1.875% of risk-weighted assets against the requirement of 2.5%, taking minimum CRAR to 10.875% (minimum CAR of 9% plus CCB of 1.875%). After the end of the moratorium, the default in loan accounts will increase the risk-weighted assets, forcing banks to reach closer to the minimum benchmark of CRAR and they will be cutting it close in maintaining CRAR. Many individual banks may even breach these levels. Hence any aggressive lending approach of banks may lead to a breach of CRAR compliance inviting regulatory action.
Furthermore, the RBI has already introduced a 10% additional provision on restructured loans under its scheme of ‘Resolution Framework for COVID-19-related Stress’. The RBI appointed KV Kamath Committee to draw up the scheme of loans restructuring to tackle Covid-19 induced stress of the borrowers. The committee identified broad parameters related to leverage, liquidity, and debt serviceability for the 26 sectors of the economy. The same has been accepted by the RBI for implementation. The Committee will also be vetting exposure of loans of more than Rs. 15 billion. Rating agency ICRA (Investment Information and Credit Rating Agency) estimates that bank and non-bank loans close to Rs. 10 trillion may become eligible for restructuring. According to the brokerage firm Jefferies, 60% of loans under moratorium may be eligible for restructuring, while the remaining may potentially add to the NPA pile. Hence, banks could be hesitant to lend given the fear that NPAs that are in the making will eat into the fragile capital base.
Policy to boost credit flow
Although a reduction in the growth of credit flow has never been a panacea for improving asset quality, creation of a compatible, collaborative credit-positive ecosystem will be essential. It is critical to lend to revive the economy, most importantly to entrepreneurs at the bottom of the pyramid that support large sections of the population in the hinterland. Recognising the exceptional nature of the pandemic, the Basel Committee released its guidance for facilitating central banks to suitably respond to the Covid-19 outbreak in April 2020. In keeping with the guidance, the RBI permitted zero risk-weight against loans extended under the Emergency Credit Line Guarantee scheme and excluded the moratorium period in classifying assets as NPAs. The Basel Committee extended timelines for implementation of the Basel-III framework till January 2023.
In the present circumstances, the government and the RBI will have to consider policy support going beyond past trends in order to enable banks to lend. Given the fragile capital base, the government is rightly considering infusing capital in public sector banks to the tune of Rs. 200 billion through recapitalisation bonds, without burdening the exchequer. But more action is needed to relax prudential guidelines with fixed timelines for their graded restoration to pre-Covid-19 levels, beginning from the second quarter of 2021-22 and completing the process by March 2023.
Policymakers can explore: (i) reducing risk weights on incremental bank credit granted during Covid-19 with a cut-off date (say 1 September 2020) to conserve capital, (ii) Exploring reduction of capital adequacy ratio requirements from 9% to 8% as emergency response measure that will still be in line with the Basel Committee norms, (iii) Reducing provisions against restructured loan portfolios from 10% to 5% to provide relief to banks that ultimately hits the capital base.
Since it is difficult to extend loans during Covid-19 based on past loan policies, banks need to frame a separate ‘Covid-19 loan policy’ for a period of say, one year only to extend loans to existing standard borrowers whose credit history is already with banks. A set of Covid-19 loan schemes may be introduced for existing borrowers to provide quick cash flows to restart economic activities. Line management should be fully empowered to lend with enhanced powers on relaxed criteria but not compromising regulatory compliances.
In order to expedite loan processing, the banks may adopt more digitisation and simplification of documentation. Digital/online lending windows may be opened to accept loan requests with scanned copies of supporting papers, and verification with originals should be done only at the time of disbursement of loans. As the proposed additional lending is focused on existing borrowers, the credit risk may remain considerably low. Fresh lending to new borrowers may also be undertaken, albeit based on the more rigorous loan policy from pre-pandemic times.
In a situation where the pandemic continues to spread fear and despair and limit the mobility of people – despite restrictions gradually being lifted – the revival of the economy is likely to be delayed. Banks and stakeholders should be prepared for a long fight against the pandemic and its various repercussions.
As such, banks – in collaboration with the regulators and the government – should be able to mitigate the pandemic-induced stress by accelerating credit growth to enable borrowers to restart their activities and provide them space to recoup. Now that the economy is opening up, the demand for goods and services will rise, leading to an increase in demand for credit.
Small steps in tackling the economic distress may not provide the kind of buoyancy needed to rescue distressed enterprises. If pump-priming6 of bank credit is the need, policy support must be in keeping with it. Novel policy interventions are needed to handle a novel crisis by all stakeholders in the ecosystem.
- A moratorium on loan payments refers to a period during the loan term when loan payments are not required to be made. On account of Covid-19, the RBI permitted lending institutions to bring into effect a term-loan moratorium until 1 June 2020 which was extended to 31 August 2020.
- Reverse repo rate is the rate at which the central bank of a country borrows from commercial banks within the country.
- When RBI observed discrepancies between banks’ data on NPAs and those found during the annual inspection by RBI, it was proposed to impose a special audit known as asset quality review (AQR) for closer scrutiny to identify the reasons for the deviations. This led to a spike in NPAs of banks unearthed during AQR. RBI also withdrew the facility of restructuring of loans and restructured portfolio, which added to the stock of NPAs.
- A rise in NPAs would lead to a rise in risk weightage assets and this would shrink capital base leading to a lower CRAR.
- The international norms for maintaining minimum capital in banks are referred to as Basel capital adequacy norms.
- Pump-priming refers to action taken during a recessionary period to stimulate the economy through interest rate and tax reductions, and government spending.
- Basel Committee on Banking Supervision (2020), ‘Basel Committee releases consultative documents on principles for operational risk and operational resilience’, Bank for International Settlements, 6 August.
- Basel Committee on Banking Supervision (2020), ‘Measures to reflect the impact of Covid-19’, Bank for International Settlements.
- ETBFSI (2020), ‘RBI's TLTRO 2.0 gets poor response; what next for NBFCs?’, The Economic Times, 23 April.
- Kamath, KV (2020), ‘Report of the Expert Committee on Resolution Framework for Covid-19 related stress’, Reserve Bank of India, 4 September.
- Rebello, J (2020), ‘60% of loans under moratorium could be restructured’, The Economic Times, 18 August.
- Reserve Bank of India (2019), ‘Statistical Tables Relating to Banks in India’, in Database of Indian Economy.