Beyond Haircuts and Provisions: Why Indian Banking Needs a Borrower-Linked Precautionary Reserve
Nearly two decades ago, in my 2004 book Management of Non-Performing Advances in Public Sector Banks—published by the Indian Institute of Banking and Finance (IIBF) with a foreword by former Reserve Bank of India (RBI) Governor Dr. C. Rangarajan—I put forward a concept aimed at strengthening the preventive architecture of Indian banking: the Precautionary Margin Reserve (PMR).
The core idea was straightforward yet fundamental: while banks are required to maintain provisions against bad loans, borrowers who benefit from financial credit should also build a dedicated, loss-absorbing financial buffer during good times.
Today, as the banking sector reflects on the massive resolution haircuts accepted in recent years, this 20-year-old proposal deserves a fresh, objective evaluation.
The Math Behind the Resolution Dilemma
Resolving stressed assets is vital for clean balance sheets and economic dynamism. However, the sheer scale of credit sacrifices made during resolution cycles raises an unavoidable policy question. Recent compilation of data shared by the All India Bank Employees' Association (AIBEA)—derived from a reply in the Rajya Sabha—paints a stark picture:
Admitted Dues (2021–22 to 2025–26): ₹8,48,700 crore
Amount Realized by Banks: ₹2,41,666 crore
Sacrifice / Haircuts Taken: ₹6,07,034 crore (~71.5%)
When banking institutions absorb haircuts of this magnitude, the ultimate financial strain trickles down to key stakeholders—depositors, taxpayers, and shareholders. Corrective mechanisms like the Insolvency and Bankruptcy Code (IBC) and debt recovery tribunals are essential, but they act after the asset has already decayed.Should Indian banking rely almost exclusively on post-facto recovery, or is it time to build stronger borrower-side preventive safeguards?
Rethinking Risk: The Precautionary Margin Reserve
The Precautionary Margin Reserve concept operates on a principle of shared risk responsibility:
Borrower-Side Accountability: Rather than placing the entire onus of provisioning on the lending bank, borrowers build a risk-indexed reserve proportional to their loan size, account conduct, and risk profile.
A Cushion for Rainy Days: In times of severe business downturns or account stress, this reserve serves as the primary line of defence to absorb financial shocks before invoking bank provisions or forcing steep resolution haircuts.
Dynamic Risk Pricing: Borrowers with exemplary credit history, low leverage, and strong repayment track records contribute significantly lower margins, creating a direct financial incentive for sound governance.
Adapting a 2004 Concept to a Modern Regulatory Era
The financial landscape has transformed dramatically over the past two decades. Regulatory frameworks have matured, risk architectures are more sophisticated, and frameworks like the Expected Credit Loss (ECL) model are reshaping bank provisioning. The Precautionary Margin Reserve does not need to be implemented exactly as envisioned in 2004. Instead, central bank regulators and financial planners could explore its modern feasibility through flexible mechanisms:
Risk-Indexed Calibration: Designing reserves so they do not restrict liquidity or burden genuine, productive borrowers.
Targeted Pilot Testing: Introducing the reserve framework initially on a trial basis for high-value corporate exposures or specific capital-intensive sectors.
Loss-Absorption Hierarchy: Positioning the borrower reserve as an early-stage buffer before enforcement or haircut-heavy restructurings.
Feasibility Studies: Conducting independent empirical research to analyse how borrower-held cushions impact total system-wide credit costs.
Conclusion: Protecting the Future of Indian Banking
No single policy instrument can completely eliminate non-performing assets or business failures. However, relying solely on corrective tools after defaults occur leaves the financial ecosystem vulnerable to heavy losses.
A suggestion made two decades ago may hold even greater relevance today. By blending strong recovery tools with proactive, borrower-linked preventive mechanisms, the Indian banking system can build a more resilient, equitable, and sustainable ecosystem—one that protects depositors, shareholders, and the broader economy for years to come.
Samastha Loka Sukhino Bhavanthu.
T V G Krishnan
( personal Views)
2 comments:
1. The Borrower’s Perspective: Excessive Capital Strain
Margin Commitments Already Lock Capital:
Borrowers already inject 25%–45% promoter margin. Mandating an extra contingency reserve locks up vital working capital, starving operations.
Asymmetric Risk Exposure:
Unlike banks earning fixed spreads on secured loans, borrowers face uncollateralized market, execution, and competition risks. Inflating compliance costs hampers competitiveness.
Double Drag on Cash Flows:
High nominal interest rates combined with mandatory reserve buildup create severe liquidity pressure, especially during early project gestation.
Exogenous Macro Risks:
Unpredictable government policy shifts, regulatory delays, and global energy/raw material price spikes are macro factors beyond a borrower’s control that cannot be hedged by micro-level reserves.
2. Banking & Structural Root Causes of NPAs
Flawed Credit Appraisals:
Major NPA cycles stem from over-optimistic projections and weak risk pricing by lenders—a reserve buffer cannot fix an unviable loan.
Weak Monitoring & Evergreening:
Delayed detection of stress and "throwing good money after bad" inflate losses far beyond what borrower reserves could cover.
* **Governance Gaps (PSBs vs. Private Banks):** Private banks maintain significantly lower NPAs due to stricter risk-based pricing, agile monitoring, and board accountability, proving governance—not borrower reserves—is the key differentiator.
* **Political Interference:** Farm loan waivers and populist lending mandates undermine repayment culture and distort credit discipline across the ecosystem.
Conclusion: Mandating borrower-held reserves penalizes entrepreneurs taking genuine business risks while deflecting accountability from core banking reforms—such as robust appraisal, real-time cash flow tracking, and insulation from political interference.
The nexus between some borrowers and banks result in NPAs thanks to relaxed appraisal, follow up, window dressed balance sheets and resorting to evergreening of accounts beyond trace by best of scrutiny. Since digitilisation of accounts , the interference of human mind gets minimised, it should be possible for banks and borrowers to monitor each and every transaction and arrive at the correct facts and figures and take very constructive and positive steps to minimise errors and wrong doings. PMR can help to strengthen the Reserves for provisions and spare the innocent depositors, good and honest borrowers and other stake holders of banks and the government. The expenditures to maintain the Secured assets, to fight the cases through recovery processes and and delays etc gets minimised or rather eliminated if PMR gets strengthened through healthy, transparent and straightforward approaches.
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