Regulatory Forbearance an emergency medicine, not staple diet! | Economic Survey & Government Reports - UPSC PDF Download

 Page 1


CHAPTER
07
Regulatory Forbearance:  
An Emergency Medicine,  
Not Staple Diet!
“Those who do not learn from history are condemned to repeat it.”
—?George Santayana, Spanish philosopher 
The current regulatory forbearance on bank loans has been necessitated by the Covid 
pandemic. This chapter studies the policy of regulatory forbearance adopted following the 
2008 Global Financial Crisis (GFC) to extract important lessons for the current times. 
Regulatory forbearance for banks involved relaxing the norms for restructuring assets, 
where restructured assets were no longer required to be classified as Non-Performing Assets 
(NP As henceforth) and therefore did not require the levels of provisioning that NP As attract. 
During the GFC, forbearance helped borrowers tide over temporary hardship caused due 
to the crisis and helped prevent a large contagion. However, the forbearance continued 
for seven years though it should have been discontinued in 2011, when GDP , exports, IIP 
and credit growth had all recovered significantly. Yet, the forbearance continued long 
after the economic recovery, resulting in unintended and detrimental consequences for 
banks, firms, and the economy. Given relaxed provisioning requirements, banks exploited 
the forbearance window to restructure loans even for unviable entities, thereby window-
dressing their books. The inflated profits were then used by banks to pay increased dividends 
to shareholders, including the government in the case of public sector banks. As a result, 
banks became severely undercapitalized. Undercapitalization distorted banks’ incentives 
and fostered risky lending practices, including lending to zombies. As a result of the distorted 
incentives, banks misallocated credit, thereby damaging the quality of investment in the 
economy. Firms benefitting from the banks’ largesse also invested in unviable projects.  
In a regime of injudicious 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 quality of firms’ boards declined. Subsequently, misappropriation 
of resources increased, and the firm performance deteriorated. By the time forbearance 
ended in 2015, restructuring had increased seven times while NP As almost doubled when 
compared to the pre-forbearance levels. Concerned that the actual situation might be worse 
than reflected on the banks’ books, RBI initiated an Asset Quality Review to clean up bank 
balance sheets. While gross NP As increased from 4.3% in 2014-15 to 7.5% in 2015-16 and 
peaked at 11.2% in 2017-18, the AQR could not bring out all the hidden bad assets in the 
bank books and led to an under-estimation of the capital requirements. This led to a second 
round of lending distortions, thereby exacerbating an already grave situation. 
Page 2


CHAPTER
07
Regulatory Forbearance:  
An Emergency Medicine,  
Not Staple Diet!
“Those who do not learn from history are condemned to repeat it.”
—?George Santayana, Spanish philosopher 
The current regulatory forbearance on bank loans has been necessitated by the Covid 
pandemic. This chapter studies the policy of regulatory forbearance adopted following the 
2008 Global Financial Crisis (GFC) to extract important lessons for the current times. 
Regulatory forbearance for banks involved relaxing the norms for restructuring assets, 
where restructured assets were no longer required to be classified as Non-Performing Assets 
(NP As henceforth) and therefore did not require the levels of provisioning that NP As attract. 
During the GFC, forbearance helped borrowers tide over temporary hardship caused due 
to the crisis and helped prevent a large contagion. However, the forbearance continued 
for seven years though it should have been discontinued in 2011, when GDP , exports, IIP 
and credit growth had all recovered significantly. Yet, the forbearance continued long 
after the economic recovery, resulting in unintended and detrimental consequences for 
banks, firms, and the economy. Given relaxed provisioning requirements, banks exploited 
the forbearance window to restructure loans even for unviable entities, thereby window-
dressing their books. The inflated profits were then used by banks to pay increased dividends 
to shareholders, including the government in the case of public sector banks. As a result, 
banks became severely undercapitalized. Undercapitalization distorted banks’ incentives 
and fostered risky lending practices, including lending to zombies. As a result of the distorted 
incentives, banks misallocated credit, thereby damaging the quality of investment in the 
economy. Firms benefitting from the banks’ largesse also invested in unviable projects.  
In a regime of injudicious 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 quality of firms’ boards declined. Subsequently, misappropriation 
of resources increased, and the firm performance deteriorated. By the time forbearance 
ended in 2015, restructuring had increased seven times while NP As almost doubled when 
compared to the pre-forbearance levels. Concerned that the actual situation might be worse 
than reflected on the banks’ books, RBI initiated an Asset Quality Review to clean up bank 
balance sheets. While gross NP As increased from 4.3% in 2014-15 to 7.5% in 2015-16 and 
peaked at 11.2% in 2017-18, the AQR could not bring out all the hidden bad assets in the 
bank books and led to an under-estimation of the capital requirements. This led to a second 
round of lending distortions, thereby exacerbating an already grave situation. 
200 Economic Survey 2020-21   V olume 1
The prolonged forbearance policies following the GFC thus engendered the recent 
banking crisis that brought down investment rates and thereby economic growth in the 
country. The first lesson for policymakers is to treat emergency measures as such and 
not to extend them even after recovery: when an emergency medicine becomes a staple 
diet, it can be counterproductive. Second, while the learnings from the previous episode 
must be employed to avoid a recurrence, ex-post analysis of complex phenomena must 
be disciplined by the insights highlighted in Chapter 7 of the Survey. Specifically, to 
enable policymaking that involves an exercise of judgement amidst uncertainty, ex-post 
inquests must recognise the role of hindsight bias and not make the mistake of equating 
unfavourable outcomes to either bad judgement, or worse, malafide intent.
INTRODUCTION
7.1 To address the economic challenges posed by the Covid-19 pandemic, financial regulators 
across the world have adopted regulatory forbearance. India is no exception. Emergency 
measures such as forbearance prevent spillover of the failures in the financial sector to the real 
sector, thereby avoiding a deepening of the crisis. Therefore, as emergency medicine, forbearance 
occupies a legitimate place in a policy maker’s toolkit; see Box 1 for an explanation of the 
economic rationale for forbearance. However, caution must be exercised so that emergency 
medicine does not become a staple diet because borrowers and banks can easily get addicted to 
such palliatives. When emergency medicine becomes a staple diet, the negative side effects may 
not only be large but may also last for a while. Therefore, carefully examining and understanding 
the implications of previous forbearance episodes is relevant to guide future policy. In 2008, 
anticipating the global financial crisis, RBI introduced the policy of regulatory forbearance. It 
relaxed the norms for restructuring stressed assets - downgrading the asset to non-performing 
status was no longer mandatory and required no additional provisioning; see Box 2 for the 
description and timeline of the same. This chapter studies the impact of the 2008 forbearance 
policy on banks, firms, and the economy in general to glean important lessons for the current 
times. As Spanish philosopher George Santayana cautioned, “Those who do not learn from 
history are condemned to repeat it.”
Box 1: Economic Rationale for Forbearance
The following illustration describes banks’ choices while dealing with a stressed asset with 
and without forbearance. In this context, we must keep in mind that when a bank creates 
additional provisions to account for loan losses, the bank’s profits decline and thereby lead to 
a reduction in the bank’s equity capital. Therefore, the incentives to provision for bad loans 
gets significantly impacted by regulatory forbearance. 
Without Forbearance
1. If the project is viable, the bank would 
restructure the asset and downgrade it 
to a Non-Performing Asset (NPA) and 
provision for the same.
With Forbearance
1. If the project is viable, the bank would 
restructure the asset. As restructured 
assets do not require the same level 
of provisioning as NPAs, inadequate 
provisions are made.
Page 3


CHAPTER
07
Regulatory Forbearance:  
An Emergency Medicine,  
Not Staple Diet!
“Those who do not learn from history are condemned to repeat it.”
—?George Santayana, Spanish philosopher 
The current regulatory forbearance on bank loans has been necessitated by the Covid 
pandemic. This chapter studies the policy of regulatory forbearance adopted following the 
2008 Global Financial Crisis (GFC) to extract important lessons for the current times. 
Regulatory forbearance for banks involved relaxing the norms for restructuring assets, 
where restructured assets were no longer required to be classified as Non-Performing Assets 
(NP As henceforth) and therefore did not require the levels of provisioning that NP As attract. 
During the GFC, forbearance helped borrowers tide over temporary hardship caused due 
to the crisis and helped prevent a large contagion. However, the forbearance continued 
for seven years though it should have been discontinued in 2011, when GDP , exports, IIP 
and credit growth had all recovered significantly. Yet, the forbearance continued long 
after the economic recovery, resulting in unintended and detrimental consequences for 
banks, firms, and the economy. Given relaxed provisioning requirements, banks exploited 
the forbearance window to restructure loans even for unviable entities, thereby window-
dressing their books. The inflated profits were then used by banks to pay increased dividends 
to shareholders, including the government in the case of public sector banks. As a result, 
banks became severely undercapitalized. Undercapitalization distorted banks’ incentives 
and fostered risky lending practices, including lending to zombies. As a result of the distorted 
incentives, banks misallocated credit, thereby damaging the quality of investment in the 
economy. Firms benefitting from the banks’ largesse also invested in unviable projects.  
In a regime of injudicious 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 quality of firms’ boards declined. Subsequently, misappropriation 
of resources increased, and the firm performance deteriorated. By the time forbearance 
ended in 2015, restructuring had increased seven times while NP As almost doubled when 
compared to the pre-forbearance levels. Concerned that the actual situation might be worse 
than reflected on the banks’ books, RBI initiated an Asset Quality Review to clean up bank 
balance sheets. While gross NP As increased from 4.3% in 2014-15 to 7.5% in 2015-16 and 
peaked at 11.2% in 2017-18, the AQR could not bring out all the hidden bad assets in the 
bank books and led to an under-estimation of the capital requirements. This led to a second 
round of lending distortions, thereby exacerbating an already grave situation. 
200 Economic Survey 2020-21   V olume 1
The prolonged forbearance policies following the GFC thus engendered the recent 
banking crisis that brought down investment rates and thereby economic growth in the 
country. The first lesson for policymakers is to treat emergency measures as such and 
not to extend them even after recovery: when an emergency medicine becomes a staple 
diet, it can be counterproductive. Second, while the learnings from the previous episode 
must be employed to avoid a recurrence, ex-post analysis of complex phenomena must 
be disciplined by the insights highlighted in Chapter 7 of the Survey. Specifically, to 
enable policymaking that involves an exercise of judgement amidst uncertainty, ex-post 
inquests must recognise the role of hindsight bias and not make the mistake of equating 
unfavourable outcomes to either bad judgement, or worse, malafide intent.
INTRODUCTION
7.1 To address the economic challenges posed by the Covid-19 pandemic, financial regulators 
across the world have adopted regulatory forbearance. India is no exception. Emergency 
measures such as forbearance prevent spillover of the failures in the financial sector to the real 
sector, thereby avoiding a deepening of the crisis. Therefore, as emergency medicine, forbearance 
occupies a legitimate place in a policy maker’s toolkit; see Box 1 for an explanation of the 
economic rationale for forbearance. However, caution must be exercised so that emergency 
medicine does not become a staple diet because borrowers and banks can easily get addicted to 
such palliatives. When emergency medicine becomes a staple diet, the negative side effects may 
not only be large but may also last for a while. Therefore, carefully examining and understanding 
the implications of previous forbearance episodes is relevant to guide future policy. In 2008, 
anticipating the global financial crisis, RBI introduced the policy of regulatory forbearance. It 
relaxed the norms for restructuring stressed assets - downgrading the asset to non-performing 
status was no longer mandatory and required no additional provisioning; see Box 2 for the 
description and timeline of the same. This chapter studies the impact of the 2008 forbearance 
policy on banks, firms, and the economy in general to glean important lessons for the current 
times. As Spanish philosopher George Santayana cautioned, “Those who do not learn from 
history are condemned to repeat it.”
Box 1: Economic Rationale for Forbearance
The following illustration describes banks’ choices while dealing with a stressed asset with 
and without forbearance. In this context, we must keep in mind that when a bank creates 
additional provisions to account for loan losses, the bank’s profits decline and thereby lead to 
a reduction in the bank’s equity capital. Therefore, the incentives to provision for bad loans 
gets significantly impacted by regulatory forbearance. 
Without Forbearance
1. If the project is viable, the bank would 
restructure the asset and downgrade it 
to a Non-Performing Asset (NPA) and 
provision for the same.
With Forbearance
1. If the project is viable, the bank would 
restructure the asset. As restructured 
assets do not require the same level 
of provisioning as NPAs, inadequate 
provisions are made.
201 Regulatory Forbearance: An Emergency Medicine, Not Staple Diet!
2. If the project is unviable, the bank would 
not restructure the loan and declare the 
asset as non-performing. Crucially, 
banks do not gain by restructuring 
unviable projects in this case.
2. Capital-starved banks now have an 
incentive to restructure even unviable 
projects to reduce provisioning and 
avoid the consequent hit on capital.
Absent forbearance, a bank must decide to restructure based on the viability of the 
firm/project because the cost of restructuring an unviable firm is significant. But, with 
forbearance, banks do not suffer any near-term cost from restructuring. Therefore, banks 
prefer restructuring, as this choice allows them to declare fewer NPAs and avoid the 
costs due to loan provisioning. Forbearance thus incentivizes banks to take risks by 
restructuring stressed assets even if they are unviable. Capital-constrained entities are 
particularly susceptible to investing in risky projects, a phenomenon called risk-shifting 
in academic literature (Jensen and Meckling, 1976). Consider the case where a bank has 
a large outstanding against a borrower who is on the verge of default. If the borrower 
defaults, the bank would have to recognize the debt as NPA, incur a loss, and possibly 
re-capitalize on account of the depleted capital. Given the borrower’s solvency concerns, 
lending a fresh loan, or restructuring its current loan(s) is extremely risky and may result 
in further losses for the bank. However, in the unlikely case that the fresh credit helps the 
borrower recover, banks would get back all their debt with interest and therefore face no 
reduction in capital. Notice that the recognition of loss impacts equity holders. They get 
no return on their investments and are forced to recapitalize to maintain sufficient capital 
adequacy. In such a scenario, a capital-starved bank, where equity owners have little “skin 
in the game”, is likely to continue lending to the risky borrower. With low capital, equity 
owners have little to lose from the fresh lending in the likely scenario where the borrower 
fails. However, the unlikely case of firm revival would result in a significant upside for 
them. Depositors do not have any marginal upside in the case of risky investment but may 
incur some costs if the firm fails. Hence equity owners gain if the risks pay off and if the 
risks fail the cost would be borne by the depositors, bondholders, and/or the taxpayers. 
Forbearance further allows equity owners to restructure loans without any additional cost. 
Capital-constrained banks, therefore, choose to restructure even unviable projects when 
the opportunity arises under a forbearance regime, thereby shifting risk away from equity 
holders to depositors and taxpayers.
The above phenomenon of forbearance-induced risk-shifting is apparent in the case of 
privately held banks where equity owners could act in their own interests. In a few Indian 
banks, promoters administer management and decision-making, directly or indirectly, by 
virtue of their controlling shareholding and/or management rights. Given their controlling 
stake, perverse incentives of promoter-managers in the presence of forbearance are 
understandable. However, most Indian banks are widely held or controlled by the 
government, and hence, their incumbent managements do not own sizeable stakes in these 
institutions. How forbearance distorts banks’ incentives in this context, therefore, needs 
an explanation. The rationale includes two key points. First, guided by their personal 
career concerns, the incumbent bank managers always have incentives to report strong 
performances during their tenure. Sarkar, Subramanian, and Tantri, 2019 show that bank 
CEOs’ post-retirement career benefits, such as future corporate board memberships, 
Page 4


CHAPTER
07
Regulatory Forbearance:  
An Emergency Medicine,  
Not Staple Diet!
“Those who do not learn from history are condemned to repeat it.”
—?George Santayana, Spanish philosopher 
The current regulatory forbearance on bank loans has been necessitated by the Covid 
pandemic. This chapter studies the policy of regulatory forbearance adopted following the 
2008 Global Financial Crisis (GFC) to extract important lessons for the current times. 
Regulatory forbearance for banks involved relaxing the norms for restructuring assets, 
where restructured assets were no longer required to be classified as Non-Performing Assets 
(NP As henceforth) and therefore did not require the levels of provisioning that NP As attract. 
During the GFC, forbearance helped borrowers tide over temporary hardship caused due 
to the crisis and helped prevent a large contagion. However, the forbearance continued 
for seven years though it should have been discontinued in 2011, when GDP , exports, IIP 
and credit growth had all recovered significantly. Yet, the forbearance continued long 
after the economic recovery, resulting in unintended and detrimental consequences for 
banks, firms, and the economy. Given relaxed provisioning requirements, banks exploited 
the forbearance window to restructure loans even for unviable entities, thereby window-
dressing their books. The inflated profits were then used by banks to pay increased dividends 
to shareholders, including the government in the case of public sector banks. As a result, 
banks became severely undercapitalized. Undercapitalization distorted banks’ incentives 
and fostered risky lending practices, including lending to zombies. As a result of the distorted 
incentives, banks misallocated credit, thereby damaging the quality of investment in the 
economy. Firms benefitting from the banks’ largesse also invested in unviable projects.  
In a regime of injudicious 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 quality of firms’ boards declined. Subsequently, misappropriation 
of resources increased, and the firm performance deteriorated. By the time forbearance 
ended in 2015, restructuring had increased seven times while NP As almost doubled when 
compared to the pre-forbearance levels. Concerned that the actual situation might be worse 
than reflected on the banks’ books, RBI initiated an Asset Quality Review to clean up bank 
balance sheets. While gross NP As increased from 4.3% in 2014-15 to 7.5% in 2015-16 and 
peaked at 11.2% in 2017-18, the AQR could not bring out all the hidden bad assets in the 
bank books and led to an under-estimation of the capital requirements. This led to a second 
round of lending distortions, thereby exacerbating an already grave situation. 
200 Economic Survey 2020-21   V olume 1
The prolonged forbearance policies following the GFC thus engendered the recent 
banking crisis that brought down investment rates and thereby economic growth in the 
country. The first lesson for policymakers is to treat emergency measures as such and 
not to extend them even after recovery: when an emergency medicine becomes a staple 
diet, it can be counterproductive. Second, while the learnings from the previous episode 
must be employed to avoid a recurrence, ex-post analysis of complex phenomena must 
be disciplined by the insights highlighted in Chapter 7 of the Survey. Specifically, to 
enable policymaking that involves an exercise of judgement amidst uncertainty, ex-post 
inquests must recognise the role of hindsight bias and not make the mistake of equating 
unfavourable outcomes to either bad judgement, or worse, malafide intent.
INTRODUCTION
7.1 To address the economic challenges posed by the Covid-19 pandemic, financial regulators 
across the world have adopted regulatory forbearance. India is no exception. Emergency 
measures such as forbearance prevent spillover of the failures in the financial sector to the real 
sector, thereby avoiding a deepening of the crisis. Therefore, as emergency medicine, forbearance 
occupies a legitimate place in a policy maker’s toolkit; see Box 1 for an explanation of the 
economic rationale for forbearance. However, caution must be exercised so that emergency 
medicine does not become a staple diet because borrowers and banks can easily get addicted to 
such palliatives. When emergency medicine becomes a staple diet, the negative side effects may 
not only be large but may also last for a while. Therefore, carefully examining and understanding 
the implications of previous forbearance episodes is relevant to guide future policy. In 2008, 
anticipating the global financial crisis, RBI introduced the policy of regulatory forbearance. It 
relaxed the norms for restructuring stressed assets - downgrading the asset to non-performing 
status was no longer mandatory and required no additional provisioning; see Box 2 for the 
description and timeline of the same. This chapter studies the impact of the 2008 forbearance 
policy on banks, firms, and the economy in general to glean important lessons for the current 
times. As Spanish philosopher George Santayana cautioned, “Those who do not learn from 
history are condemned to repeat it.”
Box 1: Economic Rationale for Forbearance
The following illustration describes banks’ choices while dealing with a stressed asset with 
and without forbearance. In this context, we must keep in mind that when a bank creates 
additional provisions to account for loan losses, the bank’s profits decline and thereby lead to 
a reduction in the bank’s equity capital. Therefore, the incentives to provision for bad loans 
gets significantly impacted by regulatory forbearance. 
Without Forbearance
1. If the project is viable, the bank would 
restructure the asset and downgrade it 
to a Non-Performing Asset (NPA) and 
provision for the same.
With Forbearance
1. If the project is viable, the bank would 
restructure the asset. As restructured 
assets do not require the same level 
of provisioning as NPAs, inadequate 
provisions are made.
201 Regulatory Forbearance: An Emergency Medicine, Not Staple Diet!
2. If the project is unviable, the bank would 
not restructure the loan and declare the 
asset as non-performing. Crucially, 
banks do not gain by restructuring 
unviable projects in this case.
2. Capital-starved banks now have an 
incentive to restructure even unviable 
projects to reduce provisioning and 
avoid the consequent hit on capital.
Absent forbearance, a bank must decide to restructure based on the viability of the 
firm/project because the cost of restructuring an unviable firm is significant. But, with 
forbearance, banks do not suffer any near-term cost from restructuring. Therefore, banks 
prefer restructuring, as this choice allows them to declare fewer NPAs and avoid the 
costs due to loan provisioning. Forbearance thus incentivizes banks to take risks by 
restructuring stressed assets even if they are unviable. Capital-constrained entities are 
particularly susceptible to investing in risky projects, a phenomenon called risk-shifting 
in academic literature (Jensen and Meckling, 1976). Consider the case where a bank has 
a large outstanding against a borrower who is on the verge of default. If the borrower 
defaults, the bank would have to recognize the debt as NPA, incur a loss, and possibly 
re-capitalize on account of the depleted capital. Given the borrower’s solvency concerns, 
lending a fresh loan, or restructuring its current loan(s) is extremely risky and may result 
in further losses for the bank. However, in the unlikely case that the fresh credit helps the 
borrower recover, banks would get back all their debt with interest and therefore face no 
reduction in capital. Notice that the recognition of loss impacts equity holders. They get 
no return on their investments and are forced to recapitalize to maintain sufficient capital 
adequacy. In such a scenario, a capital-starved bank, where equity owners have little “skin 
in the game”, is likely to continue lending to the risky borrower. With low capital, equity 
owners have little to lose from the fresh lending in the likely scenario where the borrower 
fails. However, the unlikely case of firm revival would result in a significant upside for 
them. Depositors do not have any marginal upside in the case of risky investment but may 
incur some costs if the firm fails. Hence equity owners gain if the risks pay off and if the 
risks fail the cost would be borne by the depositors, bondholders, and/or the taxpayers. 
Forbearance further allows equity owners to restructure loans without any additional cost. 
Capital-constrained banks, therefore, choose to restructure even unviable projects when 
the opportunity arises under a forbearance regime, thereby shifting risk away from equity 
holders to depositors and taxpayers.
The above phenomenon of forbearance-induced risk-shifting is apparent in the case of 
privately held banks where equity owners could act in their own interests. In a few Indian 
banks, promoters administer management and decision-making, directly or indirectly, by 
virtue of their controlling shareholding and/or management rights. Given their controlling 
stake, perverse incentives of promoter-managers in the presence of forbearance are 
understandable. However, most Indian banks are widely held or controlled by the 
government, and hence, their incumbent managements do not own sizeable stakes in these 
institutions. How forbearance distorts banks’ incentives in this context, therefore, needs 
an explanation. The rationale includes two key points. First, guided by their personal 
career concerns, the incumbent bank managers always have incentives to report strong 
performances during their tenure. Sarkar, Subramanian, and Tantri, 2019 show that bank 
CEOs’ post-retirement career benefits, such as future corporate board memberships, 
202 Economic Survey 2020-21   V olume 1
are associated with distortionary practices during their tenure. Forbearance provides 
incumbent managers an opportunity to window-dress their balance sheets, show good 
performance during their tenure, and thereby enhance post-retirement career benefits. 
Consequently, bank managers resort to distortionary practices under forbearance. Second, 
banks’ management may use forbearance as a shield to cover up outright corruption and 
nepotism. The events with the Punjab National Bank or recent allegations of deceit against 
former bank CEOs corroborate this possibility. Notice that forbearance allows banks to 
hide bad loans by delaying the recognition of losses. Bank managers, therefore, foresee 
very little downside in making unviable loans to connected parties, against the upside of 
making quick personal gains.
Box 2: Regulatory Forbearance provisions
1. As per regulations prevalent before August 2008, non-industrial non-SME accounts 
classified as ‘standard assets’ were to be re-classified as ‘sub-standard assets’ upon 
restructuring. The new relaxed norms entitled borrowers to retain the same asset 
classification upon restructuring, subject to a few conditions. 
2. Since accounts would no longer be classified as sub-standard on restructuring, banks 
were no longer required to make the general provision on total outstanding for 
substandard assets.
3. The relaxed norms were extended to already restructured loans as well. Note, 
before 2008, only loans with no prior history of restructuring were considered for 
restructuring. Below is a timeline of announcements relating to the forbearance 
regime of 2008-2015:
 
THE ORIGINAL SIN: THE SEVEN-YEAR FORBEARANCE!
7.2 The forbearance policies had desired short-term economic effects. GDP growth recovered 
from a low of 3.1% in FY2009 to 8.5% within two years, as shown in Figure 1. There was 
Page 5


CHAPTER
07
Regulatory Forbearance:  
An Emergency Medicine,  
Not Staple Diet!
“Those who do not learn from history are condemned to repeat it.”
—?George Santayana, Spanish philosopher 
The current regulatory forbearance on bank loans has been necessitated by the Covid 
pandemic. This chapter studies the policy of regulatory forbearance adopted following the 
2008 Global Financial Crisis (GFC) to extract important lessons for the current times. 
Regulatory forbearance for banks involved relaxing the norms for restructuring assets, 
where restructured assets were no longer required to be classified as Non-Performing Assets 
(NP As henceforth) and therefore did not require the levels of provisioning that NP As attract. 
During the GFC, forbearance helped borrowers tide over temporary hardship caused due 
to the crisis and helped prevent a large contagion. However, the forbearance continued 
for seven years though it should have been discontinued in 2011, when GDP , exports, IIP 
and credit growth had all recovered significantly. Yet, the forbearance continued long 
after the economic recovery, resulting in unintended and detrimental consequences for 
banks, firms, and the economy. Given relaxed provisioning requirements, banks exploited 
the forbearance window to restructure loans even for unviable entities, thereby window-
dressing their books. The inflated profits were then used by banks to pay increased dividends 
to shareholders, including the government in the case of public sector banks. As a result, 
banks became severely undercapitalized. Undercapitalization distorted banks’ incentives 
and fostered risky lending practices, including lending to zombies. As a result of the distorted 
incentives, banks misallocated credit, thereby damaging the quality of investment in the 
economy. Firms benefitting from the banks’ largesse also invested in unviable projects.  
In a regime of injudicious 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 quality of firms’ boards declined. Subsequently, misappropriation 
of resources increased, and the firm performance deteriorated. By the time forbearance 
ended in 2015, restructuring had increased seven times while NP As almost doubled when 
compared to the pre-forbearance levels. Concerned that the actual situation might be worse 
than reflected on the banks’ books, RBI initiated an Asset Quality Review to clean up bank 
balance sheets. While gross NP As increased from 4.3% in 2014-15 to 7.5% in 2015-16 and 
peaked at 11.2% in 2017-18, the AQR could not bring out all the hidden bad assets in the 
bank books and led to an under-estimation of the capital requirements. This led to a second 
round of lending distortions, thereby exacerbating an already grave situation. 
200 Economic Survey 2020-21   V olume 1
The prolonged forbearance policies following the GFC thus engendered the recent 
banking crisis that brought down investment rates and thereby economic growth in the 
country. The first lesson for policymakers is to treat emergency measures as such and 
not to extend them even after recovery: when an emergency medicine becomes a staple 
diet, it can be counterproductive. Second, while the learnings from the previous episode 
must be employed to avoid a recurrence, ex-post analysis of complex phenomena must 
be disciplined by the insights highlighted in Chapter 7 of the Survey. Specifically, to 
enable policymaking that involves an exercise of judgement amidst uncertainty, ex-post 
inquests must recognise the role of hindsight bias and not make the mistake of equating 
unfavourable outcomes to either bad judgement, or worse, malafide intent.
INTRODUCTION
7.1 To address the economic challenges posed by the Covid-19 pandemic, financial regulators 
across the world have adopted regulatory forbearance. India is no exception. Emergency 
measures such as forbearance prevent spillover of the failures in the financial sector to the real 
sector, thereby avoiding a deepening of the crisis. Therefore, as emergency medicine, forbearance 
occupies a legitimate place in a policy maker’s toolkit; see Box 1 for an explanation of the 
economic rationale for forbearance. However, caution must be exercised so that emergency 
medicine does not become a staple diet because borrowers and banks can easily get addicted to 
such palliatives. When emergency medicine becomes a staple diet, the negative side effects may 
not only be large but may also last for a while. Therefore, carefully examining and understanding 
the implications of previous forbearance episodes is relevant to guide future policy. In 2008, 
anticipating the global financial crisis, RBI introduced the policy of regulatory forbearance. It 
relaxed the norms for restructuring stressed assets - downgrading the asset to non-performing 
status was no longer mandatory and required no additional provisioning; see Box 2 for the 
description and timeline of the same. This chapter studies the impact of the 2008 forbearance 
policy on banks, firms, and the economy in general to glean important lessons for the current 
times. As Spanish philosopher George Santayana cautioned, “Those who do not learn from 
history are condemned to repeat it.”
Box 1: Economic Rationale for Forbearance
The following illustration describes banks’ choices while dealing with a stressed asset with 
and without forbearance. In this context, we must keep in mind that when a bank creates 
additional provisions to account for loan losses, the bank’s profits decline and thereby lead to 
a reduction in the bank’s equity capital. Therefore, the incentives to provision for bad loans 
gets significantly impacted by regulatory forbearance. 
Without Forbearance
1. If the project is viable, the bank would 
restructure the asset and downgrade it 
to a Non-Performing Asset (NPA) and 
provision for the same.
With Forbearance
1. If the project is viable, the bank would 
restructure the asset. As restructured 
assets do not require the same level 
of provisioning as NPAs, inadequate 
provisions are made.
201 Regulatory Forbearance: An Emergency Medicine, Not Staple Diet!
2. If the project is unviable, the bank would 
not restructure the loan and declare the 
asset as non-performing. Crucially, 
banks do not gain by restructuring 
unviable projects in this case.
2. Capital-starved banks now have an 
incentive to restructure even unviable 
projects to reduce provisioning and 
avoid the consequent hit on capital.
Absent forbearance, a bank must decide to restructure based on the viability of the 
firm/project because the cost of restructuring an unviable firm is significant. But, with 
forbearance, banks do not suffer any near-term cost from restructuring. Therefore, banks 
prefer restructuring, as this choice allows them to declare fewer NPAs and avoid the 
costs due to loan provisioning. Forbearance thus incentivizes banks to take risks by 
restructuring stressed assets even if they are unviable. Capital-constrained entities are 
particularly susceptible to investing in risky projects, a phenomenon called risk-shifting 
in academic literature (Jensen and Meckling, 1976). Consider the case where a bank has 
a large outstanding against a borrower who is on the verge of default. If the borrower 
defaults, the bank would have to recognize the debt as NPA, incur a loss, and possibly 
re-capitalize on account of the depleted capital. Given the borrower’s solvency concerns, 
lending a fresh loan, or restructuring its current loan(s) is extremely risky and may result 
in further losses for the bank. However, in the unlikely case that the fresh credit helps the 
borrower recover, banks would get back all their debt with interest and therefore face no 
reduction in capital. Notice that the recognition of loss impacts equity holders. They get 
no return on their investments and are forced to recapitalize to maintain sufficient capital 
adequacy. In such a scenario, a capital-starved bank, where equity owners have little “skin 
in the game”, is likely to continue lending to the risky borrower. With low capital, equity 
owners have little to lose from the fresh lending in the likely scenario where the borrower 
fails. However, the unlikely case of firm revival would result in a significant upside for 
them. Depositors do not have any marginal upside in the case of risky investment but may 
incur some costs if the firm fails. Hence equity owners gain if the risks pay off and if the 
risks fail the cost would be borne by the depositors, bondholders, and/or the taxpayers. 
Forbearance further allows equity owners to restructure loans without any additional cost. 
Capital-constrained banks, therefore, choose to restructure even unviable projects when 
the opportunity arises under a forbearance regime, thereby shifting risk away from equity 
holders to depositors and taxpayers.
The above phenomenon of forbearance-induced risk-shifting is apparent in the case of 
privately held banks where equity owners could act in their own interests. In a few Indian 
banks, promoters administer management and decision-making, directly or indirectly, by 
virtue of their controlling shareholding and/or management rights. Given their controlling 
stake, perverse incentives of promoter-managers in the presence of forbearance are 
understandable. However, most Indian banks are widely held or controlled by the 
government, and hence, their incumbent managements do not own sizeable stakes in these 
institutions. How forbearance distorts banks’ incentives in this context, therefore, needs 
an explanation. The rationale includes two key points. First, guided by their personal 
career concerns, the incumbent bank managers always have incentives to report strong 
performances during their tenure. Sarkar, Subramanian, and Tantri, 2019 show that bank 
CEOs’ post-retirement career benefits, such as future corporate board memberships, 
202 Economic Survey 2020-21   V olume 1
are associated with distortionary practices during their tenure. Forbearance provides 
incumbent managers an opportunity to window-dress their balance sheets, show good 
performance during their tenure, and thereby enhance post-retirement career benefits. 
Consequently, bank managers resort to distortionary practices under forbearance. Second, 
banks’ management may use forbearance as a shield to cover up outright corruption and 
nepotism. The events with the Punjab National Bank or recent allegations of deceit against 
former bank CEOs corroborate this possibility. Notice that forbearance allows banks to 
hide bad loans by delaying the recognition of losses. Bank managers, therefore, foresee 
very little downside in making unviable loans to connected parties, against the upside of 
making quick personal gains.
Box 2: Regulatory Forbearance provisions
1. As per regulations prevalent before August 2008, non-industrial non-SME accounts 
classified as ‘standard assets’ were to be re-classified as ‘sub-standard assets’ upon 
restructuring. The new relaxed norms entitled borrowers to retain the same asset 
classification upon restructuring, subject to a few conditions. 
2. Since accounts would no longer be classified as sub-standard on restructuring, banks 
were no longer required to make the general provision on total outstanding for 
substandard assets.
3. The relaxed norms were extended to already restructured loans as well. Note, 
before 2008, only loans with no prior history of restructuring were considered for 
restructuring. Below is a timeline of announcements relating to the forbearance 
regime of 2008-2015:
 
THE ORIGINAL SIN: THE SEVEN-YEAR FORBEARANCE!
7.2 The forbearance policies had desired short-term economic effects. GDP growth recovered 
from a low of 3.1% in FY2009 to 8.5% within two years, as shown in Figure 1. There was 
203 Regulatory Forbearance: An Emergency Medicine, Not Staple Diet!
a marked improvement in other economic indicators ranging from exports to the Index of 
Industrial Production (IIP), as highlighted in Figures 2 and 3. Figure 4 shows that the growth 
in total revenue of listed firms also recovered from a low of 4.88% during the crisis to a high 
of over 20% in 2011. As shown in Figure 5, growth in bank credit, which had fallen from 
22.3% in FY2008 to 16.9% in FY2010, recovered quickly to 21.5% in FY2011. The time was 
therefore ripe to withdraw the forbearance; after all the emergency medicine had worked in 
restoring the health of the economy. However, the central bank decided to continue with the 
same. As shown in Box 2, the forbearance continued for five more years till 2015, even when 
its withdrawal was recommended – a clear case of emergency medicine that was chosen to be 
made into a staple diet.
Figure 1: Growth rate of Real GDP
 Source: NSO 
Figure 2: Growth in Exports
 Source: Department of Commerce