May 25, 2024

Bad Banks

Introduction

  • In her latest Budget speech 2021-22, Finance Minister revived the idea of a ‘bad bank’ by stating that the Centre proposes to set up an asset reconstruction company(ARC) to acquire bad loans from banks.
  • While the problem of bad loans has been a perennial one in the Indian banking sector, the COVID-19 pandemic-triggered lockdown last year and the moratorium subsequently extended to borrowers by the Reserve Bank of India (RBI) have worsened the crisis.
  • With banks expected to report worse loansthis year, the idea of a ‘bad bank’ has gained particular significance.

Background

  • The 2015 Asset Quality Review(AQR) conducted by Reserve Bank under Governor Raghuram Rajan, which forced banks to recognize problem accounts as non-performing assets(NPAs), had sparked a debate on bad bank as a possible solution.
  • The 2017 Economic Survey also examined this idea, suggesting the creation of a Public Sector Asset Rehabilitation Agency (PARA).

Why bad loans are a concern for Indian economy?

  • The 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 a higher growth trajectory. Therefore, the bad loan problem requires effective resolution.

The budget 2021 proposes:

  • The creation of a bad bank under an Asset Reconstruction Company (ARC)-Asset Management Company (AMC) structure, wherein the ARC will aggregate the debt, while the AMC will act as a resolution manager.
  • The proposed structure envisages setting up of a National Asset Reconstruction Company (NARC) to acquire stressed assets in an aggregated manner from lenders, which will be resolved by the National Asset Management Company (NAMC).
  • A skilled and professional set-up dedicated for Stressed Asset Resolution will be supported by attracting institutional funding in stressed assets through strategic investors, AIFs, special situation funds, stressed asset funds, etc for participation in the resolution process.
  • The net effect of this approach would be to build an open architecture and a vibrant market for stressed assets.

Characteristics of a BAD BANK:

  • The entity (say, a commercial bank) holding significant non-performing 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.

Benefits:

  • This helps banks or financial institutions to clear-off their balance sheets by transferring the bad loans and focus on its core activity i.e. lending to businesses.
  • Large debtors have many creditors. Hence bad bank could solve the coordination problem, by centralizing the net debt with a single agency.
  • It will support faster 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.

Why do we need to tread cautiously ?

  • Former RBI governor Raghuram Rajan has been one of the critics, arguing that a bad bank backed by the government will merely shift bad assets from the hands of public sector banks, which are owned by the government, to the hands of a bad bank, which is again owned by the government.
  • There is little reason to believe that a mere transfer of assets from one pocket of the government to another will lead to a successful resolution of these bad debts, when the set of incentives facing these entities is essentially the same.
  • There is a huge risk of moral hazard. Commercial banks that are bailed out by a bad bank are likely to have little reason to mend their ways.
  • Other analysts believe that unlike a bad bank set up by the private sector, a bad bank backed by the government is likely to pay too much for stressed assets, which is bad news for taxpayers, who will once again have to foot the bill for bailing out troubled banks.

Other alternatives to consider

  • Instead of creating a Bad Bank, infusing the capital that would be given to the bad bank directly into the public sector banks is an option.
  • The enactment of Insolvency and Bankruptcy Code (IBC) has reduced the need for having a bad bank, as a transparent and open process is available for all lenders to attempt insolvency resolution.
  • According to RBI, banks recovered on average more than 40% of the amount filed through the IBC in 2018-19, against just over 20% in total through the SARFAESI, Lok Adalats and Debt Recovery Tribunals.
  • A model of Private Asset Management Company (PAMC) which would be suitable for sectors where the stress is such that assets are likely to have economic value in the short run, with moderate levels of debt forgiveness, can be set up.
  • National Asset Management Company (NAMC)for sectors where the problem is not just of excess capacity, but possibly also of economically unviable assets in the short- to medium-term, such as in the power sector can also be set up.

Way Forward:

  • The larger focus must be on the ‘Twin Balance Sheet’ (TBS) problem of corporate houses and banks.
  • Instead of recapitalizing the banks year after year, it would be better for the government to focus on recovery.
  • The most efficient approach would be to design solutions tailor-made for different parts of India’s bad loan problem.
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