New Delhi: As banks in India are staring at a fresh wave of loan defaults originating from the Covid-19 pandemic, the latest Economic Survey cautions the government to be wary of zombie lending as it can amplify the crisis in the banking sector.
Presenting details of the Economic Survey 2020-21 to media on Friday, the Chief Economic Advisor (CEA) Krishnamurthy Subramanian pointed out that extended regulatory forbearance after the Global Finance Crisis of 2008 gave way to irresponsible lending by banks to ‘zombies’ and caused damage to the economy.
Since India entered into another round of regulatory forbearance to tide over the challenges posed by Covid-19 induced disruptions, the CEA suggested that new policies must be in place to avoid recurrence of such incidents.
What is zombie lending?
In business parlance, zombies are those firms that are unable to meet interest obligations from their income. From a financial standpoint, these firms are obsolete but kept alive in account books by pumping new loans to facilitate payment of existing loans.
This continuous use of fresh loans to repay previous loans by a firm is also known as ever-greening of loans.
What is regulatory forbearance and how it is related to zombie lending?
When the businesses are hit by unforeseen incidents or pandemics, regulatory forbearance is used as a tool to help banks as well as borrowers.
Under normal circumstances, if interest or principal is not paid for a stipulated period of time the loan is classified as a non-performing asset (NPA) and banks initiate a restructuring process.
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On the other hand, during regulatory forbearance, banks can initiate restructuring without classifying bad loans as NPAs.
The survey noted that during the Global Financial Crisis of 2008, forbearance helped borrowers tide over temporary hardship caused due to the crisis and helped prevent a large contagion.
However, the survey also observed that extending the forbearance beyond the economic recovery did more harm than good to banks.
As per the survey, one of the most unintended consequences for banks was zombie lending.
“Given relaxed provisioning requirements, banks exploited the forbearance window to restructure loans even for unviable entities, thereby window-dressing their books,” it said.
The economic fallout of zombie lending
As the banks continue to lend to unviable firms, good borrowers and projects being denied credit. The resultant drop in the investment rate of the economy could then lead to the slowdown of economic growth, said the survey.
Interestingly, the survey also pointed out that in a regime of imprudent credit supply and lax monitoring, a borrowing firm’s management’s ability to obtain credit strengthened its influence within the firm, leading to deterioration in firm governance.
The way forward
Among the measures, the survey has suggested that forbearance should be accompanied by restrictions on zombie lending to ensure a healthy borrowing culture.
A clean-up of bank balance sheets is necessary when the forbearance is discontinued, the survey said.
Terming zombie lending is symptomatic of poor governance, the survey noted that bank boards are “asleep at the wheel” and auditors are not performing their required role as the first line of defence.
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As a remedy, the survey argued for more empowered bank boards in the country.
“To avoid zombie lending following the current round of forbearance, banks should have fully empowered, capable boards,” it said.
(With inputs from Prasanna Tantri, Asst Professor at Indian School of Business, Hyderabad. Prasanna’s joint research along with CEA Krishnamurthy Subramanian and his colleague Sarkar A formed the basis for the above observations of Economic Survey)
