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Insights into Editorial: Designing the bad bank of India

 

 


Insights into Editorial: Designing the bad bank of India 


 

Summary:

The name ‘bad bank’ itself suggests that it deals with something bad in the financial sector. The idea of starting a bad bank by the government was recently proposed in the Economic Survey presented in January under the name ‘Centralized Public Sector Asset Rehabilitation Agency’ (PARA) that could take charge of the largest, most difficult cases, of non-performing assets (NPAs) in the banking system. The need for a government-owned bad bank has been felt for some time as the commercial banks are finding it difficult to deal with NPAs or bad loans.

 

Why be concerned about bad loans?

Indian banks’ pile of bad loans is a huge drag on the economy. It’s a drain on banks’ profits. Because profits are eroded, public sector banks (PSBs), where the bulk of the bad loans reside, cannot raise enough capital to fund credit growth. Lack of credit growth, in turn, comes in the way of the economy’s return to an 8% growth trajectory. Therefore, the bad loan problem requires effective resolution.

 

Background:

The concept was pioneered at the Pittsburgh-headquartered Mellon Bank in 1988 in response to problems in the bank’s commercial real-estate portfolio. According to McKinsey & Co, the concept of a “bad bank” was applied in previous banking crises in Sweden, France, and Germany. 

 

How does a bad bank work?

While the government has not charted out any guidelines on the structure of a bad bank, such an institution would be largely based on the principles of an asset restructuring company (ARC), which buys bad loans from the commercial banks at a discount and tries to recover the money from the defaulter by providing a systematic solution over a period of time. Since a bad bank specialises in loan recovery, it is expected to perform better than commercial banks, whose expertise lies in lending.

 

A report by McKinsey & Co., “Understanding The Bad Bank”, proposes four organizational models for a bad bank based on two decision factors:

  • First is to decide whether or not to keep the bad assets on the bank’s balance sheet. Moving assets off the balance sheet is better for investors and counterparties and provides more transparency into the bank’s core operations. But it is more complex and expensive.
  • Second, is to decide whether the bad-bank assets will be housed and managed in a banking entity or a special purpose vehicle (SPV).

 

Depending on the choices, the four basic bad-bank models are: on-balance-sheet guarantee, internal restructuring unit, special-purpose entity and bad-bank spin-off.

On-balance-sheet guarantee: In the on-balance-sheet guarantee structure, the bank gets a loss-guarantee from the government for a part of its portfolio. The model is simple, less expensive and can be implemented quickly. However, the transfer of risk is limited and bad assets continue to remain on the bank’s balance sheet, clouding its core performance. This approach is useful for stabilizing a bank in trouble.

Internal restructuring unit: An internal restructuring unit is like setting up an internal bad bank. The bank places bad assets in a separate internal unit, assigns a separate management team and gives them clear incentives. This works well as a signalling mechanism to the market and increases the bank’s transparency, if the results are reported separately. It is clear that this model relies on the existing management team to restructure assets. However, if the existing management is looking to kick the can down the road, as is the case for many banks in India, this is not an effective solution.

Special-purpose entity: In a special-purpose entity structure, bad assets are offloaded into a SPV, securitized and sold to a diverse set of investors. The model works best for a small, homogeneous set of assets. The bad loan problem in India is concentrated in a few sectors like infrastructure and basic metals. An effective solution would be to transfer bad loans from these distressed sectors into sector-specific SPVs, securitize them and sell them in an auction. If the pricing is determined by the market, PSU bankers will receive less blame for losses to the exchequer.

Bad-bank spin-off: A bad-bank spin-off is the most familiar, thorough and effective bad-bank model. In a spin-off, the bank shifts bad assets into a separate banking entity, which ensures maximum risk transfer. But the model is complex and expensive because it requires setting up a separate organization, equipped with a skilled management team, IT systems and a regulatory compliance set-up. Also, the problem related to asset valuation and pricing will be the most severe in this model. The Public Sector Asset Rehabilitation Agency (PARA) proposed by the Economic Survey 2016-17 falls in this category. However, given the complexity and cost of the model, it is recommended to be used as a last resort, after all other initiatives fail.   

 

Why a bad bank is likely to succeed?

  • A single government entity will be more competent to take decisions rather than 28 individual PSBs.
  • Capacity building for a complex workout can be better handled by the government which has regulatory control and has management skillsets in public sector enterprises.
  • Foreign investors with both risk capital and risk appetite would be more in a government- led initiative, knowing that regulatory risks would stand considerably mitigated in various stages of resolution, including take outs.

 

badb loan bank

 

Things to consider while creating a bad bank:

  • The first is that it should be based on a criterion as any such exercise creates a moral hazard which should be eschewed.
  • Second, there have to be strict performance criteria for the banks selling such assets. This can be through a multi-stage approach where these assets are bought piecemeal by the bad bank based on how future incremental assets perform.
  • Third, the criteria for buying assets should be transparent and a pecking order must be drawn up where probably the restructured assets get priority.
  • Last, a competitive approach should prevail among the banks so that they work hard to qualify for the sale of bad assets to the bad bank. This, in fact, will ensure better governance standards too.

 

Is there a way in which the positives can be realised without creating a bad bank that itself requires too much capital and is too big to manage?

One answer may be to set up a bad bank to deal with NPAs at some of the weaker PSBs, instead of one that picks up NPAs from all PSBs. It would prove less controversial if the government had a majority stake in it. Let us see how the experiment goes.

This must be complemented with other steps. The government must infuse more capital into the better-performing PSBs. It must also create, through an act of Parliament, an apex Loan Resolution Authority for tackling bad loans at PSBs. The authority would vet restructuring of the bigger loans at PSBs. This would mitigate the paralysis that has set in at the PSBs because of the fear factor and get funds flowing into stalled projects.

 

Conclusion:

Resolution of bad loans and restoring the health of PSBs is among the biggest challenges the economy faces today. It’s a challenge that requires a response on multiple fronts. A bad bank cannot be the sole response. Setting up a bad bank is a very complex process. It is not a silver bullet which will solve all the problems in the Indian banking sector. More importantly, a one-size-fits-all approach to designing a bad bank can be very expensive and less effective. Just setting up one PARA will not be enough to get the banking sector back on track. The most efficient approach would be to design solutions tailor-made for different parts of India’s bad loan problem.