What is the twin balance sheet problem?

In February 2016, public-sector banks started coming out with financial results for the December quarter. And the numbers were enough to send the stock markets into a tizzy. Their non-performing assets or NPA had soared dramatically, to an extent that provisioning had overwhelmed operating earnings. Their net income had plunged deeply into the red.

According to the 2017-18 economic survey, investors dumped the stocks of PSU, bringing their prices to such low levels that at one point HDFC was valued as much as 24 public sector banks put together.

A twin balance sheet is a scenario where banks are under severe stress and the corporates are overleveraged to the extent that they cannot repay their loans.

During a boom period and the economic growth is robust, corporates are encouraged to invest and expand aggressively. The economic survey of 2017-18 put it simply. A twin balance sheet problem follows a standard path. Their companies expand during a boom, leaving them with obligations that they cannot repay. So, they default on their debts, leaving bank balance sheets impaired, as well.
 

Something similar happened during the mid-2000s. The Indian economy was booming, where GDP annual growth hovered around 9-10%. With corporate profitability at its highest, India Inc launched massive projects worth lakhs of crores and were riding on huge amounts of debt, mostly financed by banks.

By 2007-08, the investment to GDP ratio reached almost 38% and the amount of non-food bank credit doubled from 2004-05 to 2008-09. However, following the global financial crisis, growth and revenue projections fell and finance costs went up due to higher interest rates, resulting in stress on the books of both corporates and banks. The RBI had to step in to control the damage to the economy.

But the country’s finances are in good condition now. Public sector banks recorded an 81% year-on-year rise in net profit in the last quarter on higher net interest incomes and reduction in provisions for bad loans, a Business Standard analysis showed.