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AIEFS NEWSLETTER
AIEFS is a non-profit academic organization founded in 1975 at Bloomsburg State University, Pennsylvania

Volume 10 Issue 1 March 15, 2017

Association Objectives
Promote interest in
the study of Indian
Economics & Finance Has regulatory intervention been effective in maintaining stability of
Encourage inquiry Indian banks?
into, and analysis of the
problems facing the
Indian economy
M. Mostak Ahamed and Sushanta K. Mallick**

Facilitate communi-
cation and discussion To address the challenges that Indian corporates faced in the early 2000s in
among Scholars meeting their debt-servicing obligations to banks/financial institutions, RBI
introduced a corporate debt restructuring program in 2002. This column finds
Executive Committee that in the absence of a strong legal system, this out-of-court regulatory
2013-2015 mechanism has indeed helped Indian banks remain stable, as there has been no
President bank failure in India unlike in other countries.
Amitrajeet Batabyal
Rochester Inst. of
Technology
Dealing with private-debt distress became a major policy challenge for regulators
Executive Director in many emerging-market economies in the last decade in the absence of a strong
Chandana Chakraborty legal framework. In India, bankruptcy reforms were enacted for the first time in
Montclair State University 2016 in the form of a unified Insolvency and Bankruptcy Code. In this context,
Assistant Executive World Bank estimates suggest that if banks lend one dollar in India, they can only
Director
Meenakshi Rishi recover 26 cents in times of distress, and it takes, on average, 4.3 years twice as
Seattle University long as in China (Economist, 2015) to recover the loan. The longer the
bankruptcy process takes to recover the loan the lower will be the recovery
Treasurer amount, when assets are divertible. Kingfisher is the most high-profile case of
Artatrana Ratha such bad loans where the company assets are valued significantly less today than
St. Cloud University

what it would have been if the assets were sold in 2012 to recover the loans.
Elected Members
Kalyan Chakraborty Corporate debt restructuring
Emporia State U niversity During the early 2000s, Indian corporates faced increasing challenges in meeting
Shailendra Gajanan their debt-servicing obligations to banks/financial institutions. High corporate-
University of Pittsburgh-
Bradford debt overhang poses a risk to banks balance sheets and financial stability due to
Sushanta Mallick increasing non-performing assets (NPAs) and corporate bankruptcies. With no
Queen Mary Univ. London unified bankruptcy code, the Reserve Bank of India (RBI) had introduced an out-
Sudipta Sarangi of-court restructuring program in the form of corporate debt restructuring (CDR)
Virginia Tech
Bansi Sawhney
University of Baltimore


School *School of Business, Management and Economics, Room 229, Jubilee Building, University of Sussex, Falmer, Brighton
Ex-officio BN1
Member

9SL, UK; E-mail: m.ahamed@sussex.ac.uk

Kusum Ketkar
**
School **School of Business and Management, Queen Mary University of London, Mile End Road, London E1 4NS, UK;
E-mail: s.k.mallick@qmul.ac.uk; Tel.: +44 (0)20 7882 7447.
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in 2003. The intention was to provide a speedy, cost-effective, and market-friendly
alternative to in-court restructuring procedures in order to reduce

Risk taking of banks faced with defaulters, and to avoid bankruptcy of viable corporates in the
absence of a sound bankruptcy process. CDR system has enabled many companies to stay
solvent, restructure, and finally revive, and has also helped member banks (lenders) that
participated into CDR program to reduce non-performing loans (NPLs) and stay stable. Most of
the member banks, particularly public sector banks, made use of CDR mechanism and
restructured a substantial portion of their distressed assets. These banks could retain the asset
classification of restructured assets upon restructuring, without slipping into lower asset
categories (example, sub-standard), and could even upgrade non-performing restructured assets
to the standard (performing) category after a specified period and charge less to their net income
for loan loss provisions1, as RBI supported this extensive regulatory forbearance on such
restructured assets.

Regulatory forbearance and bank risk-taking

The implied guarantee that was provided in the form of a moratorium on loan loss provision on
restructured assets has two opposing effects on bank risk. The market discipline view argues
that when banks get generous regulatory support, it diminishes investors incentive to monitor
banking activities, which encourage more risk-taking (lower stability), amplifying the moral
hazard problem. The contrary view is related to banks valuation arguing that generous
regulatory support for banks can lower risk-taking, as perceived support inflates profitability and
thereby bank valuation reducing the probability of bank failure. The question as to whether
regulatory forbearance/government guarantees mitigate bank instability has been studied in the
context of advanced economies, but it is still an unanswered question in the context of emerging-
market economies such as India.

Assessing impact on bank stability

In the absence of any detailed analysis of the effectiveness of CDR mechanism that existed for
over a decade, we assess the usefulness of such an institutional mechanism in maintaining bank
stability in India2. In particular, first, we (Ahamed and Mallick 2017a) assess how the volume of
restructured assets at the bank level impacted risk-taking of Indian banks over the time period
2003-2012. Establishing a causal effect in this issue is challenging: favorable regulatory support
is extended to augment financial stability of banks, and it often applies to all banks; therefore, it
is hard to discriminate the effects of such intervention. Our second study (Ahamed and Mallick
2017b) overcomes this challenge by exploiting variation in the membership status of banks vis--
vis the CDR program.

In the second study, we use a modelling strategy that is appropriate to establish causal inferences
and to investigate the effectiveness of the implementation of CDR among member and non-
member banks for the period 1994-2012. In this paper, we, therefore, investigate whether the
banks that made use of regulatory forbearance on the restructured corporate loans could increase
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their stability significantly due to a concessional provisioning relished by the
member banks on those assets.

Main findings
To address our research questions, we use data from the RBI and from the Centre for Monitoring
the Indian Economys (CMIE) Prowess database. In general, our findings show that higher levels
of restructured assets significantly reduced risk-taking as banks benefitted from low
provisioning, and this relation is more pronounced for banks that had lower loan loss provisions.
We also find that by restructuring distressed assets, public sector banks benefitted significantly
more in improving their stability than private sector domestic and foreign banks (Ahamed and
Mallick 2017a).

Figure 1. Evolution of banking stability, by CDR programme membership

105
95
85
75
Bank stability

65
55
45
35
25
15
94

96

98

00

02

04

06

08

10

12
19

19

19

20

20

20

20

20

20

20

Non-member banks Member banks

Note: The time series of bank stability are plotted for CDR member and non-member banks.
Bank stability is proxied by z-score3, which is the sum of return-on-assets and equity-asset ratio,
divided by standard deviation of return-on-assets of each bank.

In Figure 1 (Ahamed and Mallick 2017b), we separately plot the time series of z-score (a proxy
measure for bank stability) for both the member and non-member banks. The stability of the
member and non-member banks moved roughly together immediately before the inception of
CDR mechanism. From 2005 to 2012, the stability of member banks increased substantially
compared to non-member banks, as CDR was fully operational in the year 2004, and naturally,
bank stability went up once they started reaping benefits of regulatory forbearance.
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In addition, since market power is one of the important determinants of banking

stability, we also investigate the interactive effects of CDR on stability at different levels of
market power. We find

that the positive effect of CDR diminishes at the higher levels of market power of the member
banks. We argue that member banks with high market power possibly opted for originating risky
assets under the auspices of this program (as reflected in their risk-weighted assets). The special
regulatory support on asset classification and provisioning under CDR gave more opportunities
to member banks to understate NPAs and overstate net income. In April 2015, RBI effectively
stopped providing regulatory forbearance on any restructured loans when the provisioning from
raised to 15% from 5% in 2013, which probably explains why the size of the NPAs increased to
8.3% of total loans in June 2016, up from 4.3% by end-March 2015. The rising NPAs also
suggest that CDR mechanism was beneficial for Indian banks, which kept NPAs under 4%
during 2005-06 and 2013-14, but the restructuring mechanism cannot be a permanent solution.

Conclusions

Overall, it can be claimed that by reducing NPAs overhang under the guise of CDR system,
RBIs intention of having a stable banking sector has largely been achieved for the studied
period. However, since 2013, the uptrend in restructuring corporate debt was worrisome due to
hike in CDR provisioning norms and therefore, the regulator effectively brought the CDR system
to an end in 2015 with even higher provisioning; but they should tighten the macro-prudential
norms and emphasize on international best practice in asset classification and provisioning of
restructured corporate loans ensuring no scope for evergreening4. With higher NPAs, banks will
have to increase provisioning on existing restructured loans gradually, otherwise, any substantial
losses might lead them to exhaust capital base to a point when insolvency or illiquidity would be
inevitable. As other emerging-market economies are facing similar corporate distress (example,
Brazilian companies), our finding implies that such type of mechanism with judicious regulatory
forbearance can be an effective temporary tool for regulators in order to forestall bankruptcy of
viable corporates on the one hand, and to avoid accumulating bad debt and thereby fragility of
financial institutions on the other.

Notes:
1. Loan loss provisioning is an expense item for banks that is allocated for risky/defaulted
loans. According to provisioning norms, in respect of sub-standard assets of secured
category, banks are required to keep 10%, and for the unsecured exposures, an additional
10%.
2. Since we only have evidence from the creditors perspective (not from the debtors
(corporates) side), we focus on stability of banks rather than firm solvency.

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3. Z-score can be interpreted as the number of standard deviation (SD) below
the average by which returns would have to drop before all equity in the bank gets
depleted. SD is a measure that is used to quantify the amount of variation or dispersion of
a set of values.
4. Evergreening refers to the process of banks granting new loans in the hope of partially
repaying old, bad loans, instead of writing off bad loans.

Further Reading
Ahamed, M Mostak and Sushanta Mallick (2017a), House of restructured assets: How
do they affect bank risk in an emerging market? Journal of International Financial Markets,
Institutions and Money, Forthcoming.
Ahamed, M Mostak and Sushanta Mallick (2017b), Does regulatory forbearance matter
for bank stability: Evidence from creditors' perspective, Journal of Financial Stability, 28: 163-
180.

This article originally appeared on Ideas for India (www.ideasforindia.in), an economics and policy portal.

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Kindly make the check payable to the Association of Indian Economic and
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About AIEFS

AIEFS is a non-profit academic organization founded in 1975 at Bloomsburg State University, Pennsylvania.
Economists with interest in India felt a need to develop an identity for those involved in scholarly research on Indian
economic and financial issues, to give publicity to their research outcomes and to educate the world at large on the
realities of changing India. AIEFS objectives are to promote interest of the study of Indian Economics and Finance in its
broadest sense, to encourage inquiry into, and analysis of the problems and issues facing the Indian economy and to
facilitate communication and discussion among scholars working towards the above objectives.

AIEFS sponsors sessions at the annual ASSA, Western Economic Association and Eastern Economic Association. It
also holds biennial meetings either in the US or India. First biennial meeting in India was held in collaboration with
Research and Information System for Developing countries (RIS) in June 2011 in Delhi. The 2013 and 2015 biennial
meetings were held in collaboration with Indira Gandhi Institute of Development Research in Mumbai, and the Central
University of Hyderabad respectively. The 2017 biennial meeting has been scheduled to take place at NCDS,
Bhubaneswar, India.

AIEFS brings out Newsletter twice a year fall and in spring. From time to time, AIEFS also publishes edited books or
proceedings of papers presented at ASSA and biennial meetings. In recent years, papers have been published in special
issues of peer reviewed journals like South Asia Economic Journal, International Journal of Economic Policy in
emerging Economies, International Journal of Public Policy, and International Journal of Business and Emerging
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