Will RBI’s bad loan solution engender moral hazard?

After the NPA ordinance handing it sweeping powers, RBI has decided to strengthen the oversight committee for bad loan resolution at banks. Photo: Aniruddha Chowdhury/Mint

A student who studies well can get good grades and can improve upon them if the subject teacher pays extra attention. But what if the teacher offers to write the exam instead of the student? Sure, the grades would improve but will it set the right example? With a new set of framework to follow for resolving the bad loan mess, the Reserve Bank of India (RBI) will do just that—step in to write the exam for banks.

The central bank will strengthen the oversight committee, expand the committee’s scope to include more cases and involve all stakeholders in discussions on resolution.

RBI is also thinking of choosing the rating agencies itself to avoid rating shopping.

With this, the banking regulator will be sitting at every negotiation table for resolving bad loans. Right from identifying the viability of the borrower, the decision to liquidate or restructure the borrowing company, and even, to an extent, the loan haircuts and the cost involved will be either overseen or determined by RBI.

This unmistakably puts the onus of resolution on the central bank, and the banks and borrowers will, presumably, sign on the dotted line.

What precedence does this set for banks? In the business of lending, one cannot wish away bad loans. There will be slippages even when the economy is doing well. Banks will be lending to the same companies that are now bad assets in their books. If the regulator steps in to clean up the mess, there is little incentive for the lender to strengthen risk management practices and risky lending practices may continue.

As for the corporate borrower, a lot will depend on how this mess is cleared. How much writedown in value do banks take and how much does the borrower bear? Do the promoters feel the pinch or not? At its worst, if a chunk of value writedown is seen on bank books, with little pain for companies, there is no guarantee that future corporate borrowers will be a more disciplined lot.

It is unsettling that the only entity determined to clean up the bad loan mess is RBI. That itself shows lenders and borrowers lack the discipline and prudence to turn the close to Rs10 trillion of stressed loan pile into performing loans.

The banking regulator needs to send a strong message that its involvement in the clean-up is not a guarantee of future bailouts both for banks and borrowers. Otherwise this