Heed The Important, If Less Obvious, Lesson From The Global Financial Crisis

Context: Excessively accommodative monetary policy and aggressive lending practices need to be re-calibrated to mitigate the risks of emerging post-2008 financial crisis like scenarios.

Pandemic mitigation policy measures

• Continuing excessively accommodative stance by RBI: If necessary, by arm-twisting markets to keep interest rates low.
• Phenomenon of behest-lending by public sector banks (PSBs) at the diktat of government: Especially, to MSME sector.
• Restructuring and credit guarantee: Banks been urged to restructure ‘temporarily impaired MSME loans’ under various schemes like Emergency Credit Line Guarantee Scheme (ECLGS).

Risks and challenges associated with these measures

• Risk of inflation: The signs are ominous. At 6.3%, inflation in May 2021 has already crossed the upper end of RBI’s tolerance band of 6%.
• A potential repeat of post-2008 financial crisis scenario: Where aggressive bank lending to infrastructure sector resulted in rise in NPAs in later years.
• If aggressive lending and monetary pumping are not restricted, it may soon lead to the vicious cycle of high NPAs, leading to high provisioning, capital impairment and finally, capital infusion in PSBs at taxpayer expense.
• Financial Stability Report (FSR) warns, “Despite restructuring (to the tune of Rs 56,866 crore), the stress in MSME portfolio of PSBs remains high”.
• FSR notes, “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.”
• Inherent issues in credit guarantee schemes like ECLGS: 
• Could trigger adverse selection due to the prospect of a 100% guarantee and faced with pressure from the government to increase lending to MSMEs.
• Only kicks the can down the road - Credit guarantee is only delaying the crisis as it cannot as such resolve the economic challenges. Leakages remain as claims could be turned down on various grounds.