"The Dirty Dozen” was the eponymous name granted to 12 companies that had dragged down India’s banking system to the verge of a collapse by being responsible for 25% of the non-performing loans in the banking industry in late 2016.  

These 12 firms were representative of a process that had been introduced and adopted as emergency medicines but slowly sidled its way into a permanent feature – regulatory forbearance.  

Regulatory forbearance, a policy tool used during times of economic distress, allows banks to avoid classifying restructured loans as nonperforming assets (NPAs). This approach can prevent immediate bank collapses but carries long-term risks, if extended beyond the initial crisis period.

The 2008 Global Financial Crisis (GFC) was a watershed moment for economies worldwide, and India was no exception. As the crisis unfolded, the Reserve Bank of India (RBI) implemented regulatory forbearance in August 2008 allowing lenders to restructure loans without classifying them as NPAs.  

Intended as a temporary measure, forbearance continued long after the Indian economy began to recover in 2010-11, remaining in place until 2015. The postponed bad debt recognition artificially inflated banks’ health, thus providing short-term relief, but lying groundwork for what came in next.  

Instead of sticking to a strict short timeline, the regulatory kept extending the forbearance and banks used it as a tool to not just avoid addressing problems of distressed firms but also ballooning their debt by evergreening loans, in an attempt to mask the issue.  

When the forbearance was withdrawn in 2015, the long-term impact of this policy became evident. By this time, the Indian banking sector was facing a full-blown crisis. The Asset Quality Review (AQR) conducted by the RBI IN 2016 revealed that the actual level of NPAs was higher than previously reported, leading to a dramatic increase in recognized bad loans. The overstatement of capital adequacy also became apparent, with many banks finding themselves undercapitalized and in need of substantial recapitalization.

The impact of forbearance was not uniform across all banks. Those with higher exposure to certain sectors, particularly infrastructure, were more affected. The preferential treatment given to infrastructure loans during the forbearance period is a critical aspect of this policy and its long-term consequences.

Indian debt restructuring 

In March 2016, state-controlled lender REC Limited sanctioned an INR 13.55 billion additional loan to distressed power producer KSK Mahanadi Power Company Limited. At the time the loan was sanctioned, the company had already defaulted on its existing debt. Further, the same lender sanctioned additional loans to Lanco Babandh Power Limited and sister company Lanco Vidharbha Thermal Power Limited when the promoters of these projects and the project companies themselves were in default.

A 2017 report by the Comptroller and Auditor General of India which examined lending practices of just two state-owned lenders – REC and Power Finance Corporation Ltd – threw up dozens of examples of bad lending practices executed through blatant misuse of the forbearance lifeline.

Forbearance alters banks' decision-making by allowing them to restructure loans without immediate costs, even if the loans are unviable. Without forbearance, banks must assess the viability of a firm before restructuring, as doing so with an unviable firm is costly.  

For example, the CAG noted how the two lenders continued lending additional amounts to projects that were clearly unviable.  

However, with forbearance, banks preferred restructuring to avoid recognizing and provisioning for NPAs in their books. This encourages risk-shifting, where capital-constrained banks invest in risky projects, called as “risk-shifting.”  

This risk-shifting is pronounced in privately held banks, where equity owners might exploit forbearance for personal gain. In some Indian banks, promoters with significant control may use forbearance to benefit themselves.  

Bank CEOs often engage in distortionary practices to enhance their post-retirement prospects, using forbearance to "window-dress" performance. Forbearance can also cover corruption and nepotism, as it allows managers to delay the recognition of bad loans, making unviable loans to connected parties with minimal immediate risk.  

Cases like the Punjab National Bank scandal also highlight how forbearance can facilitate unethical practices for personal gain.

The alphabet soup of Indian debt restructuring schemes has witnessed a steady stream of options since 2001.  

It kicked off with Corporate Debt Restructuring (CDR) in 2001 with enthusiasm. However, it was soon apparent that the CDR cell – a special group of bankers constituted to examine requests to admit distressed accounts under CDR – was overworked and the solution was short-lived.  

Enter Reserve Bank of India Governor Raghuram Rajan in September 2013 who saw that the regulatory forbearance for asset quality instituted by the regulator till date was just papering over some serious cracks in India’s banking system.  

The term “evergreening” was used by the then-RBI Governor as he issued blanket orders to Indian lenders to recognise and provision for bad debt. While the regulator refused to grant special dispensation, it also unleashed a host of debt restructuring schemes – whose benefit – is debatable.

This brought in the next era of regulatory forbearance options – the joint lenders forum (JLF) and the corrective action plan (CAP) in January 2014. When it became apparent that infrastructure companies were primary culprits of the stressed debt pile – the RBI introduced the mouthful, “Flexible Structuring of Long Term Project Loans to Infrastructure and Core Industries” (better known as the 5/25 scheme) in July 2014 followed by the strategic debt restructuring (SDR) scheme in June 2015 and finally the Scheme for Sustainable Structuring of Stressed Assets (S4A) in June 2016.

All these schemes were suspended when India enforced the Insolvency and Bankruptcy Code in late-2016, pushing errant firms from the regulatory oversight and into a quasi-judicial process that aimed at organizing the recovery of distressed entities.  

Hidden Risks Beneath Healthy Metrics

Fast forward to the present day, and the Indian banking sector presents a complex picture. On the surface, the sector appears to have turned a corner, with the NPA ratios showing marked improvement. 

According to the 2023-24 financial results, 26 of the 40 listed banks in India—spanning private, public, and small finance banks—reported net NPAs below 1%. The consolidated average net non-performing assets (NNPA) ratio across all Indian scheduled commercial banks (SCBs) reached a record low of just 0.8%. This is a far cry from the situation between 2017 and 2018, when the overall banking sector’s asset quality deteriorated, with NNPA ratios exceeding 6%. During that period, banks faced significant profitability challenges, with some requiring recapitalization to stay afloat.

This apparent improvement in NPA ratios is attributed to several factors, including higher provisioning, recoveries of bad loans, regularization of NPAs by borrowers, and write-offs.  

However, a Morning Context data report, shows that reduction in GNPAs due to write-offs is currently at 2.4 times the levels seen during the bleak asset quality period of 2015-16. This indicates that while GNPAs have come down, the improvement is due to the aggressive use of write-offs rather than actual recoveries or upgradations of bad loans.

This trend is concerning because it suggests that the reduction in NNPAs is not quite a sign of improved asset quality but rather the result of financial engineering. Write-offs, while useful in cleaning up balance sheets, do not address the underlying issues that lead to the accumulation of bad loans in the first place. The also represent a loss of potential recovery for the bank, which can have long-term implications for profitability and financial stability.

Another significant point is the divergence in the behaviour of private and public sector banks. While private banks have managed to maintain relatively low NPA ratios, their slippage ratios (which measure the fresh accretion of NPAs as a percentage of total standard assets) have been higher than those of public sector banks since 2020-21. This indicates that private banks are experiencing higher levels of stress in their loan portfolios, particularly in the retail and unsecured lending segments.

The post-pandemic spike in credit growth, in the personal loan segment, introduces a new array of risks. Banks have been expanding their lending portfolios, leading to a significant increase in credit-deposit (CD) ratios.  

Annual credit growth for banks has remained above 15%, leading to a decrease in NPAs as a percentage of total loans. However, this trend is not sustainable in the long term. As the CD ratio continues to rise, banks will face liquidity pressures, leading to a slowdown in credit growth. When this happens, the arithmetic will reverse, and bad loans as a percentage of total loans are expected to increase.

RBI Governor Shaktikanta Das, in July 2024, expressed concerns about the rapid pace of credit growth compared to deposit growth could expose the banking system to structural liquidity challenges.  

Das noted that households are shifting towards capital markets and other intermediaries over traditional bank deposits, leading banks to rely more on short-term borrowings, thereby increasing their sensitivity to interest rate fluctuations and complicating liquidity management.

Since April 2022, bank credit growth has outpaced deposit growth, with the latest RBI data showing a year-on-year credit growth of 13.9% compared to a 10.6% growth in deposits as of June 28, 2024.  

He pointed out the recent banking collapses in USA and Switzerland, which sparked discussions about the Basel liquidity standards.  

The issue isn’t just in state-owned banks. HDFC Bank, Axis Bank, and Kotak Mahindra Bank are among the banks with high CD ratios, which exceed 90% in some cases.

There are also questions of the quality of credit being raised with the RBI noting that the outstanding borrower credit is higher for subprime borrowers, suggesting a higher flow of credit to relatively riskier segments.

The implications of this trend are significant. As the proportion of risky loans increases, so does the likelihood of defaults, which could lead to a deterioration in asset quality and an increase in NPAs. This is quite concerning for smaller banks, which have less tolerance for lower profitability and less wiggle room for provisioning against future NPAs.

Take a page from history

To understand the full extent of the risks facing the Indian banking sector, it is essential to compare the current situation with historical precedents and analyse the data-driven findings from recent years.

A 2024 study by Indian School of Business (ISB) showed that forbearance served as a strong incentive for banks who were allowed to restructure loans to engage in more restructuring during the past crisis, delaying the recognition of bad loans. Banks showed a 1.04 percentage point increase in restructured loans, marking a substantial 136.84% rise from their pre-intervention levels.

Further examination showed that this increase in restructuring led to undercapitalization in these banks by the end of the crisis. The necessity for these banks to maintain capital adequacy ratios, while avoiding NPA recognition, compelled them to persist in restructuring even after the immediate effects of the crisis had subsided.

“All solvent but undercapitalized banks should be required to present time-bound restructuring plans—showing how they intend to remain profitable and solvent—and should be subject to intensive reporting and monitoring,” a 2003 International Monetary Fund (IMF) study observed.

The study also found that undercapitalized banks were more likely to extend new loans to high-risk, or "zombie firms”—those that are financially insolvent but continue operating due to ongoing credit support.  

A 2023 paper published by NYU-Stern examined Japanese banks after a real estate crisis observed that, evergreening in zombie lending occurs when banks choose to roll over loans to struggling borrowers instead of recognizing losses and starting fresh with new, healthier borrowers. This decision is often driven by the desire to avoid the costs associated with switching to new borrowers and the need for recapitalization, when banks are already undercapitalized. The more expensive it is to recognize these losses and switch borrowers, the higher the likelihood of banks continuing its support of unviable, "zombie" firms.

The ISB study observed that banks with higher exposure to infrastructure debt were found to be 1.7 times more likely to lend to such firms during the post-crisis forbearance phase compared to the crisis phase itself. As mentioned earlier, this is classic risk-shifting behaviour.

A 2021 study added a further observation on impact of such risk-shifting by noting that banks deliberately align their failure with that of their counterparties which increases the probability of an industry-wide financial system collapse, thus elevating systemic risk.

Political factors also influence forbearance policies, with banks more inclined to restructure loans for firms located in politically significant constituencies. A February 2019 study highlighted political factors that shaped banking practices.

Post-crisis, banks paid high dividends, mostly using restructuring profits to reward shareholders and maintain confidence despite compromised financial health.  

Banks burdened with high nonperforming loans relative to their capital and provisions were showed higher trend to extend forbearance measures, such as increased loan limits or extended maturities, to the riskiest borrowers, as shown July 2020 paper.

Building Resilience

Indian federal financial crimes investigation agency The Enforcement Directorate (ED), in December 2019, filed a chargesheet against Punjab and Maharashtra Co-operative Bank (PMC) alleging an INR 66.7 billion scam which including evergreening of loans.

The 35-year-old bank’s operations were severely curtailed in September 20191 until it finally merged its remainder with Unity Small Finance Bank in January 2022.

Former Reserve Bank of India Governor Raghuram Rajan had thrown the spotlight on evergreening of loans by Indian banks in 2013 noting that, one "can put lipstick on a pig but it doesn't become a princess."

“Restructuring is a legitimate attempt to deal with changes that have happened, but ever-greening is trying to ignore the problem and taper over for later period and thus create large problems in future,” Rajan noted.   

It’s now 2024 but the problem seems as relevant today as it did more than a decade ago. The RBI flagged tens of thousands of “fake” accounts identified as a tool to evergreen distressed debt.  

The Indian banking sector is at a critical juncture, where improved NPA ratios mask underlying risks that threaten long-term stability. Both private and public sector banks face distinct yet significant challenges, highlighting the need for a deeper understanding of asset quality and financial resilience.

“The past decade has underscored the importance of transparency in financial reporting and the rigorous oversight of asset quality. While the aggressive use of write-offs has helped manage NPA ratios in the short term, it postpones the recognition of financial distress and creates a misleading sense of security,” Indian School of Business Associate Professor Prasanna Tantri said, adding that this practice does not provide a sustainable solution to the underlying problem of bad loans.

Current trends in credit growth and risky lending practices suggest that the Indian banking sector remains vulnerable to future shocks. High credit-deposit ratios at major private sector banks, coupled with a growing proportion of risky loans, could lead to liquidity issues and asset-liability mismatches if credit growth slows. Public sector banks, with their high GNPA ratios and lower provisioning levels, are less prepared to absorb potential losses, posing a systemic risk to the financial system.

To address these challenges, policymakers and regulators must take decisive action. This includes tightening oversight of asset quality, ensuring adequate provisioning, and promoting prudent lending practices. Greater transparency in financial reporting is essential to reflect the true state of NPAs and prevent future crises.

The Indian banking sector’s ability to withstand future shocks depends on learning from past mistakes and adopting a more cautious, transparent approach to asset management. By addressing the root causes of bad loans and reinforcing financial discipline, the sector can build a more resilient foundation for sustainable growth and long-term stability.