Indian lenders want the government to provide up to $2 billion to set up a “bad bank” at a time when their heavy pile of soured debt is expected to double in size due to the COVID-19 pandemic, according to media reports. The banks have proposed that the government set up an asset reconstruction company (ARC) to initially buy non-performing loans worth up to a total of 1 trillion rupees. The Indian Banks’ Association (IBA) has drafted the proposal and sent it to the government and the Reserve Bank of India for their approval, according to the same media reports.
Concept of Bad Bank:
- A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution.
- The entity holding significant nonperforming assets will sell these holdings to the bad bank at market price. By transferring such assets to the bad bank, the original institution may clear its balance sheet—although it will still be forced to take write-downs.
- A bad bank structure may also assume the risky assets of a group of financial institutions, instead of a single bank.
- Bad banks are typically set up in times of crisis when long-standing financial institutions are trying to recuperate their reputations and wallets. While shareholders and bondholders generally stand to lose money from this solution, depositors usually do not.
- Banks that become insolvent as a result of the process can be recapitalized, nationalized, or liquidated. If they do not become insolvent, it is possible for a bad bank’s managers to focus exclusively on maximizing the value of its newly acquired high-risk assets.
- Some criticize the setup of bad banks, highlighting how if states take over non-performing loans, this encourages banks to take undue risks, leading to a moral hazard.
- The 2017 Economic Survey examined this idea, suggesting the creation of a Public Sector Asset Rehabilitation Agency (PARA).
- Before that, the 2015 Asset Quality Review conducted by Reserve Bank under Governor Raghuram Rajan, which forced banks to recognise problem accounts as non-performing assets, had also sparked a debate on bad bank as a possible solution.
- In short, the idea is not novel and has been suggested by various people at different points of time.
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.
Is the current framework equipped to handle NPAs?
- If there is no appetite for AMCs, AIFs and ARCs to take over bad loans, it could be because the owners of those assets want a price higher than the fair market value.
- ARCs will buy those pools of stressed assets only if they see continued viability of those pools being recovered and if they are able to get higher returns than the original purchase price.
- This helps banks or FIs clear-off their balance sheets by transferring the bad loans and focus on its core business lending activities.
- Large debtors have many creditors. Hence bad bank could solve the coordination problem, since debts would be centralised in one agency.
- It can effect speedier settlements with borrowers by cutting out individual banks.
- It can drive a better bargain with borrowers and take more stringent enforcement action against them.
- It can raise money from institutional investors rather than looking only to the Government.
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.
- The bad bank will require significant capital to purchase stressed loan accounts from public sector banks.
- The chances of private participation are low unless investors are allowed a major say in the governance of the new entity.
- Bad bank will not address more serious corporate governance issues plaguing public sector banks that led to the NPA problem.
- Setting up a new institution would be very time-consuming.
- Challenges on its ownership structure as well as the pricing of bad loans taken over from banks.
- The larger focus must be on the ‘Twin Balance Sheet’ (TBS) problem of corporates and banks.
- Instead of recapitalising the banks year after year, it would be better for the government to focus on recovery.
- 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.