Once again, talks for the creation of a bad bank are back in India as commercial banks set to witness a spike in NPAs, or bad loans, in the wake of the contraction in the economy as a result of the Covid-19 pandemic. Currently, loans in which the borrower fails to pay principal and/or interest charges within 90 days are classified as NPAs and provisioning is made accordingly.
What is a Bad Bank?
Bad Bank is a financial institution that takes over the non-performing assets and other illiquid assets of banks so that the banks are left with clean books. Such a mechanism helps a bank segregate its good assets from bad ones, making it easier for it to raise capital by issuing equity or debt or both. The segregation of toxic assets helps generate confidence among potential investors who can then examine the financial health of the lender with greater clarity. Further, by transferring sour loans to a bad bank, lenders can prioritize financing businesses, while letting a specialized institution such as Asset Reconstruction Company (ARC) focus on maximizing loan recovery, which is generally sponsored by the government.
Where did the idea of bad bank come from?
Originally, the idea was first proposed in the 1980s by the US-based Mellon bank. In 1988 it resorted to the creation of a bad bank i.e., the Grant Street National Bank which was dissolved in 1995 upon serving its purpose.
In India, the Government set up the Industrial Reconstruction Corporation of India (IRCI) in April 1971, under the Indian Companies Act mainly to look after special problems of sick units’ and provide assistance for their speedy reconstruction and rehabilitation, if necessary, by undertaking the management of the units and developing infrastructure facilities like those of transport, marketing etc. In 1984, GOI passed an act converting the Industrial Reconstruction Corporation of India (IRCI) into the Industrial Reconstruction Bank of India (IRBI) which failed. All bad loans were kept aside in one bank and nothing came out of it. The problem with this type of mechanism was that assets were transferred at book value, which basically moved it from under one government pocket (Public Sector Banks) to another government pocket (IRBI).
According to Bloomberg Quint, the government created a Stressed Asset Stabilization Fund in 2004 when IDBI was converting to a bank. The SASF basically structured as a bad bank and helped IDBI swap funds of about Rs. 9,000 Crore.
Further to that, after the 2008 crisis, various banks from all over the world like Bank of America, Citigroup, Swedbank, etc. took on this idea and are one of the renowned banks today. A number of countries like Belgium, Ireland, Indonesia, Germany and others have set up bad banks in response to the financial crises over time. But in India, a bad bank has not been set up; rather, private asset reconstruction companies (ARCs) have been buying NPAs from various banks—and 29 ARCs are in the business of buying bad assets but the model has not yielded desired results. ARCs act merely as recovery agents because they lack the bandwidth to reconstruct any company under stress which is sold as going concern. The efficacy of the ARC model is under question. The CVC, some time ago, submitted a report to the government after examining cases above Rs 50 crore that were sold to ARCs between 2013-14 and 2017-18 by PSBs. The report mentions that, in at least 48 cases, assets were sold to ARCs below the realizable value of the security. Besides the accounts which were sold as going concern, the value of stocks and equipment were not factored in while fixing the reserve price. Setting up a bad bank, undoubtedly, is a way forward in such conditions.
How serious is the NPA issue in the wake of the pandemic?
The RBI noted in its recent Financial Stability Report that the gross NPAs of the banking sector are expected to shoot up to 14.8% of advances by September 2021, from 7.5% in September 2020. Among bank groups, the NPA ratio of PSU banks, which was 9.7% in September 2020, may increase to 16.2% by September 2021 under the baseline scenario.
The K V Kamath Committee, which helped the RBI with designing a one-time restructuring scheme, also noted that corporate sector debt worth Rs 15.52 lakh crore has come under stress after Covid-19 hit India, while another Rs 22.20 lakh crore was already under stress before the pandemic.
The panel led by Kamath, a veteran banker, has said companies in sectors such as retail trade, wholesale trade, roads and textiles are facing stress. Sectors that have been under stress pre-COVID include NBFCs, power, steel, real estate and construction.
Banks and other financial institutions are the key drivers of economic growth, as they are the formal channels of credit. As things stand, lenders, particularly the state-owned ones, are saddled with massive bad loans. This has made them risk-averse and eroded their capacity to lend to help spur economic recovery from the shock of the covid-19 pandemic that has roiled the world. Banks will find it tough and exorbitantly expensive to raise capital from the market if the asset-quality trajectory remains uncertain, delaying and even jeopardizing, economic growth.
Dilemma of Public Vs. Private Bad Bank
If majority stakes of a bad bank are with the government then it would render the bad bank with issues of governance and capitalization as Public Sector Banks.
If majority stakes are with private companies then it could invite criticism of Favoritism and Corruption if the loans are not priced appropriately when traded to a bad bank.
What has been the stand of the RBI about resolving stressed loans?
Viral Acharya, when he was the RBI Deputy Governor, had said it would be better to limit the objective of these asset management companies to the orderly resolution of stressed assets, followed by a graceful exit. He suggested two models to solve the problem of stressed assets in consideration with the above dilemma-
First what kind of loans will be taken over? Will only those loans that have turned stressed due to the economic distress stemming from the COVID-19 pandemic be included? Or will loans extended to firms in sectors like power and real estate, which had soured even before the pandemic had hit, also be brought into its ambit? Considering that banks have in the past been reluctant to decide on the extent of haircut they were willing to take, how will the prices at which these loans are transferred to the bad bank be determined? Who will absorb the losses? And will the new entity be professionally managed, operating at an arm’s length from the political dispensation? Or will political considerations influence decision making?
What has been the stand of the Government for setting up a bad bank?
To the extent that a bad bank will take sour loans off the balance sheets of banks, it is a good idea. However, the Centre isn’t smitten by the idea as yet. After all, there exist several private asset reconstruction firms that buy bad loans at a discount. The government has significantly capitalized state-owned banks in recent years and pursued consolidation in the PSU banking space. In the last three financial years, the government has infused equity of Rs 2.65 lakh crore into state-owned banks. Also, the Bankruptcy Code, though not perfect, has helped in higher recoveries. There is also the question of a moral hazard that a government-funded bad bank can create by allowing reckless lending to continue. There is also the fear that it ends up as another case of throwing good money after bad.
Will a bad bank solve the problem of NPAs?
Despite a series of measures by the RBI for better recognition and provisioning against NPAs, as well as massive doses of capitalization of public sector banks by the government, the problem of NPAs continues in the banking sector, especially among the weaker banks. Having a Bad Bank will complement other measures taken by RBI & government to clean up banking sector. In the coming months, as and when the COVID-related stress pans out, proponents of the concept feel that a professionally-run bad bank, funded by the private lenders and supported the government, can be an effective mechanism to deal with NPAs. Many other countries had set up institutional mechanisms successfully such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system in the wake of 2008 financial crisis.
Banks and other financial institutions are the key drivers of economic growth. However, many borrowers may find it difficult to service their loans, requiring lenders to set aside capital to cover those losses. A bad bank can free them up to start lending. However, adequate measures need to be put in place so as to overcome the pitfalls of bad bank