Delayed Bank Recap Key To India’s Pre-Covid Slowdown, Shows New Research

Financial sector crises leave a long tail. That much has now been long proven. As such when India went into a clean-up of bank balance sheets, it was anticipated that the impact would play out over an extended time period, in many ways.

But one assumption made at the time of the clean-up, which since proved to be incorrect, has worsened its impact. It was thought that as a truer picture of bank balance sheets emerges, these lenders will be able to at least partially raise capital from the markets. On that assumption, the recapitalisation of government-owned lenders was staggered over a period of three years.

The lack of upfront and adequate recapitalisation led to a significant fall in credit flow, a surprising increase in lending to zombie firms, and eventually, lower economic growth, said a paper co-authored by Yakshup Chopra, Krishnamurthy Subramanian, Prasanna L. Tantri and published in the Review of Financial Studies. Subramanian is currently India’s chief economic advisor.

In its conclusion, the paper found that a balance sheet clean-up alone may not lead to improved credit market efficiency. It should be accompanied by policies leading to recapitalisation or a capital backstop by the sovereign if necessary.

“Otherwise, the cure can possibly be worse than the disease itself,” the paper said.

The Four Findings

Finding One

The first finding of the paper is not a surprising one: the asset quality review conducted starting 2015 led to a slowdown in supply of bank credit. The extent of decline in the supply of credit, though, is noteworthy.

The supply of bank loans declined by close to a quarter as a result of the asset quality review, the paper found.

When the review was first announced, then Reserve Bank of India Governor Raghuram Rajan had said the clean-up had the full support of the government. That support, however, when judged in terms of the recapitalisation funds provided by the government, was not as forthcoming as assumed.

The government provided capital equal to only 8.7% of the total gross non-performing assets unearthed in the first year of AQR. Even in the second and third years of the AQR, the government provided 63% less than the additional NPAs from 2016 to 2018.

Finding Two

The second finding is that lending to zombie firms actually rose in the aftermath of the AQR. Zombie firms are defined as those with an interest coverage ratio of less than one, among other parameters.

A study of bank loan and MCA data showed that the proportion of zombie loans in the overall portfolio of highly affected banks increased in the post AQR period.

While regulators may be watching lenders closely post a balance sheet clean-up, “creative bankers having incentives to lend to zombies are likely to figure out other creative ways, including accounting manipulation,” the paper said. These incentives may include the possibility of greater upside on weaker credit via structuring, leading lenders to take additional risk.

Finding Three

The third finding dispels a popular belief during the period when Urjit Patel was governor, which was that stronger lenders would get stronger post the clean-up as they swoop in and capture the gap left by weaker and under-capitalised banks.

Going by data presented in this paper, that was not the case.

Firms highly exposed to the clean-up are likely to receive 38% lower credit when compared to other firms, the paper found. “The result shows that the decline in bank lending is not made good from other sources.” These companies were also unable to raise equity or obtain related party funding to replace lost credit.

The decline in firm borrowing has real consequences as investments by these firms fell and ongoing projects of these companies had a higher chance of stalling.

Finding Four

The fourth finding is what ties the clean-up and the delayed, inadequate recapitalisation to the broader economy. Remember, the Indian economy had seen slowing growth even before the Covid-19 crisis hit. GDP growth had slowed from above 8% in FY17 to 5% in FY20. Even accounting for some impact of the Covid crisis in the quarter ended March 2020, the steady slowdown in growth has been undeniable.

The findings of the paper suggest this may have been at least partly due to the mistake of delayed recapitalisation.

The authors studied general economic activity using night lights data. They identified affected districts based on the concentration of branches of the affected banks and assessed change in economic activity. “We find that such [affected] districts experience lower growth in night lights after the intervention.” There was also a higher demand for “workfare” as a proxy for local economic distress. “We find a significant increase in demand for workfare in affected districts,” the study said.

The Key Lessons

Subramanian, chief economic advisor, declined to discuss the paper’s findings citing paucity of time but co-author Prasanna Tantri said one of the takeaways from the study is that recapitalisation of banks is key and worth the fiscal burden.

This will hold true even at the current time when banks are bracing for another rise in bad loans. “We think that recapitalisation is key and worth the fiscal burden. We hope that the planned privatisation leads to recapitalisation, else problems are likely to persist,” Tantri told BloombergQuint.

When asked whether delayed recapitalisation emerges as a key reason behind India’s slowdown, Tantri said he sees it slightly differently.

Recapitalisation should have been a part of the AQR package itself like the Japanese 1998 (The Takenaka plan) intervention or the U.S. intervention (Capital Assistance Program, a part of TARP). The central bank got into a clean-up assuming that the capital available and promised will be sufficient....Unfortunately, capital seems to be slow moving here due many frictions.

Prasanna Tantri, Co-Author, Bank Cleanups, Capitalization, and Lending: Evidence from India

He added that the danger of undercapitalised banks reducing normal lending and increasing risky lending was not factored in. “In short, while AQR was necessary and was a great step, its design could have been better.”

Finally, Tantri said the central bank needs a better way of capturing zombie lending. Risk weights do not necessarily reflect the quality of a firm, he said.