RBI’s Next Move — Forbearance Again?

With the 6-month moratorium lapsing on August 31, the moot question before the Reserve Bank of India, banking regulator — Should the forbearance be further extended?

Before we get to the meat of the story, let’s understand the basics.

What is forbearance? For starters, say you have a home loan and you’re undergoing an unexpected financial crunch. Having exhausted all the savings, you try re-negotiating the terms with the lender by, say, reducing the interest rate, extending the repayment period. Well, this is forbearance. This equally applies to business and corporate loans as well.

So, what’s the big deal? The deal is that, in a ‘normal’ scenario on forbearance, RBI mandates the lender to categorize such loans as ‘bad’ and make loss provision. The rationale behind is quite straight forward — forbearance increases the potential default risk.

Now, this means forbearance at a large scale hugely affects the lender’s profitability.

Alright, what did RBI do differently? With the pandemic-led economic crisis, RBI allowed the lenders to forbear loans by way of extending moratorium for six months up to August 31 without categorizing as ‘bad’ subject to some minimal provisioning.

With this background, let’s move on.

The recently published International Monetary Fund’s (IMF) Working Paper titled ‘Forbearance Patterns in the Post-Crisis Period’ shows

One, banks were more likely to grant forbearance measures to the riskiest borrowers. Intuitively, banks have a strong incentive not to flag bad loans but to forbear them because it negatively impacts their profitability and consequently erodes the capital (you know why!). For the stressed lenders, the incentives are even stronger. This could potentially lead to a systemic risk in the financial system.

Two, forbearance significantly increases the probability of default in the long run, while it is effective in the short run. Further the odds of default for a borrower having received any forbearance measure are 20% higher than if the borrower was not treated. This may seem counter-intuitive given that forbearance measures were provided with an objective to ‘reduce’ illiquidity-induced defaults.

Three, banks with high share of forborne loans issue significantly lower new lending. This has unintended consequences — healthy firms are deprived of credit which in turn reduces job creations and investments. This has cascading negative effects on the economy.

What’s in for India?

At the headline level, share of forborne loans stands at 50% of country’s aggregate loan book in April 2020

While this working paper primarily focuses on Irish banks, the study results cannot be simply brushed aside. Taking cues from this, clearly prolonged forbearance measures of any sort (like moratoriums, one-time restructuring) will come with a huge and irreversible cost to the Indian economy in the long-run.

Looks like RBI should perhaps ‘do nothing’ and allow banks’ balance sheets to reflect underlying economic realities — Brace for impact!

Let’s wait and watch until August 6 to know what exactly the six great minds in the Monetary Policy Committee think.