Heed the not-so-obvious lesson of the 2008 global financial crisis

It has become commonplace, if not de rigeur, to compare the situation today with the post-2008 crisis period. The parallel most often drawn is between the action of central banks (read: loose monetary policy) then and now. In the Indian context, between the flood of liquidity unleashed by the Reserve Bank of India (RBI) in the aftermath of the global financial crisis, and its easy monetary policy after the pandemic.

With RBI seemingly determined to continue its excessively accommodative stance, if necessary, by arm-twisting markets to keep interest rates low, will we see a replay of the corollary to an overly accommodative monetary policy? A surge in inflation similar to that witnessed post the 2008 crisis? The signs are ominous. At 6.3%, inflation in May 2021 has already crossed the upper end of RBI’s tolerance band of 6%.

But there is another no less important parallel that has escaped attention so far. This is the phenomenon of behest-lending by public sector banks (PSBs) at the diktat of the government, and its corollary, a rise in non-performing assets (NPAs). If the post-2008 period saw banks increase lending to the infrastructure sector at the behest of the then FM, P. Chidambaram, we now see PSBs being exhorted to lend to the MSME sector (micro, small and medium enterprises) by finance minister Nirmala Sitharaman.

Aggressive bank lending to the infrastructure sector, driven by the United Progressive Alliance government’s desire to keep the wheels of the economy moving after the 2008 crisis, boomeranged on PSBs, and ultimately the economy, in the form of high NPAs. In a scenario where commercial judgement (unhindered by government bullying) would have demanded conservative lending practices, PSBs lent hand over fist to the infrastructure sector to keep the finance ministry happy. Today, we are still grappling with the consequences of those lending excesses.

In a similar vein, will aggressive bank lending to MSMEs at the behest of government backfire and result in a rise in NPAs? It is a no-brainer that lending, whether to infrastructure projects or to MSMEs, is much riskier when normal business activity has been severely disrupted, be it on account of a financial crisis or a pandemic. Having burnt our fingers once, one would expect the authorities to exercise some restraint this time round and leave lending decisions to the commercial judgement of banks.

Unfortunately, we don’t seem to have drawn the right lessons from our past experience. Once again, the government is pushing banks to lend, this time to MSMEs rather than infrastructure projects. Banks have been urged to restructure what have euphemistically been termed ‘temporarily impaired MSME loans’, under various schemes. Boosted by schemes like the Emergency Credit Line Guarantee Scheme (ECLGS), net credit flow to stressed MSMEs during March 2020-February 2021 has risen dramatically. Inevitably, PSBs restructured loans much more aggressively than their private sector counterparts (which have the luxury of not having the finance ministry breathe down their necks). No wonder, RBI’s Financial Stability Report of July 2021 released last week warns: “Despite re-structuring (to the tune of ₹56,866 crore), stress in the MSME portfolio of PSBs remains high”. Further: “While banks have remained relatively unscathed by pandemic-induced disruptions, cushioned by regulatory, monetary and fiscal policies, they face prospects of a possible rise in non-performing loans, particularly in their small and medium enterprises (SME) and retail portfolios, especially as regulatory support starts getting wound down.”

More ominously: “While banks’ exposures to better rated large borrowers are declining, there are incipient signs of stress in the micro, small and medium enterprises and retail segments.” Ironically, despite admitting that “since 2019, weakness in the MSME portfolio of banks and NBFCs has drawn regulatory attention”, RBI, as the banking sector regulator and guardian of financial stability, doesn’t seem to have restrained the government from going down this tried-and-failed path.

The transition from low- and medium-risk MSME borrowers to the high-risk segment, is “noteworthy” and implications of business disruptions following the resurgence of the pandemic could be “significant”, says the report. Read that as RBI gobbledegook for impending disaster, given that for much of the period in question, the Supreme Court had imposed a standstill on asset classification. The net result? As with past lending to infrastructure, we are likely to reap the same unhappy result—a rise in NPAs.

On paper, schemes like ECLGS might seem just like what the doctor would order in a pandemic. But the danger is two-fold. One, they could well trigger adverse selection. Beguiled by the prospect of a 100% guarantee and faced with pressure from the government to increase lending to MSMEs, PSBs could end up lending to unviable borrowers/ventures in the MSME sector.

Second, such schemes only kick the can down the road. On paper, the ECLGS guarantee is 100%, but there is nothing automatic about it. The National Credit Guarantee and Trustee Company (NCGTC) is committed to give only 75% of an ‘eligible’ claim preferred by the bank within 30 days. The balance 25% is paid on conclusion of recovery proceedings or when the decree gets time-barred, whichever is earlier.

Thus, there is many a slip between the cup and the lip. As with the earlier Credit Guarantee Corporation (the NCGTC’s predecessor, prior to 2014), claims could be turned down on various grounds. In which case, it will be back to the vicious cycle of high NPAs, leading to high provisioning, capital impairment and finally capital infusion in PSBs at taxpayer expense.

Mythili Bhusnurmath is a senior journalist and a former central banker.