Making a Bad Bank a good solution

In the light of the recent idea put forward by the Chief Economic Advisor, Arvind Subramanian, as well as Viral Acharya, the new Deputy Governor of RBI, backed by the Finance Ministry to set up a “Bad Bank”, the question arises as to whether this idea will help in addressing the problem of Non-Performing Assets (NPAs), or troubled loans to be specific, in the Indian banking sector.

What is a Bad Bank?

A bank that is set up with the sole purpose of buying the bad loans of other banks along with other NPAs at market prices is known as “Bad Bank”. By transferring the bad loans to the bad bank, a bank will be able to clear its balance sheet from bad loans. Banks that end up becoming insolvent as a result of this process can be recapitalized, liquidated or nationalized.

This concept was first introduced in 1988 when the Grant Street National bank that was set up to house the NPAs of the Pittsburgh-headquartered Mellon Bank.

Why should we be concerned about the growing NPAs?

The amounts of bad loans from all the Indian banks taken together are nothing but dead weight to the country’s economy. With almost 12.34% of the total borrowers, which accounts for Rs.7Lakhs Crores, defaulting on loans it is actually high time that the Government steps up and get its act together. As per the Government’s own statistics, 75% of the total amount owed by 57% of the top 100 debtors is unlikely to be paid back as they cannot afford to pay the interests on the amount of loans taken.

The RBI as well as the Government has taken several measures in the past like Strategic Debt Restructuring (SDR), Scheme for Sustainable Structuring of Stressed Assets (S4A), Asset Quality Review (AQR) and the 5/25 Scheme but all those initiatives were in vain. In fact, stressed assets, as reported by banks, have doubled since 2013 onwards. So it is time that the Government intervenes and takes some long-term measures.

Bad Bank in India – Need for a “surgical strike” on NPAs rather than piecemeal measures

In 31st January 2017, the idea of setting up of a bad bank in India was put forward in the Economic Survey under the name of “Centralized Public Sector Asset Rehabilitation Agency” (PARA), which would take up the most challenging cases of NPAs in the banking system. A government-owned bad bank has been the “need of the hour” for quite some time now as the public sector banks as well as the commercial banks in India is finding it difficult to deal with NPAs, mostly bad loans.

Why will a Bad Bank work in the present scenario in India?

  • A single Government-run organization will be more apt in taking decisions rather than 28 individual PSBs
  • A Government-run organization will be also be more competent in forming a proper framework because it has the necessary regulatory control as well management skills
  • Foreign investors will be in favor of a Government-run organization as the regulatory risks would be comparatively mitigated in the various steps of resolution which will also include take-outs

Things to be considered before setting up a Bad Bank

  • 1st criteria is that any such action that creates moral hazard should be eliminated
  • 2nd criteria is that a strict performance standard has to be set for the banks who will be selling their NPAs
  • 3rd criteria is that the whole process of buying assets should be transparent and a pecking order can be drawn up where the restructured assets will get more priority
  • 4th criteria will be to create a competitive environment in the whole process so that the banks push each other to work hard so as to qualify for the sale of bad assets to the bad bank. This in turn will set better governance standards.

The bad bank can be set up under a special statute, mandating PSBs to transfer NPAs in a timely manner in a one-time period of 6-9 months. The bad bank will be deemed as a Public Financial Institution (PFI) and will own all the powers of an Asset Reconstruction Companies (ARCs). The process of transfer of asset by a bank to this Government agency will be kept outside the scope of judicial scrutiny.

Implementation of “Bad Bank” proposal

Even though the idea sounds tempting and simple, its implementation is actually quite the opposite. Numerous organizational and financial options are to be considered before designing a bad bank.

According to a report named “Understanding the Bad Bank” by McKinsey & Co, there are 4 different organizational models namely on-balance-sheet guarantee, internal restructuring unit, special-purpose entity and bad-bank spin-off. These models are based on the following factors –

  • Firstly, the decision of whether or not to keep the stressed assets on the bank’s balance sheets
  • Secondly, the decision of whether the assets of the bad bank will be housed and managed in a banking entity or a Special Purpose Vehicle (SPV)

Not many supporters within the Government itself for “Bad Bank” proposal

Some Government officials are of the opinion that this issue should be left in the hands of the banks itself as the Government doesn’t have the necessary resources to meet the capitalization needs o the process. At the same time, they also do not want to “bail out’ troubled banks and companies with so much resources when the same resources can be utilized in a more effective manner elsewhere.

Besides, there are numerous ARCs that have been strengthened through amendments of law and overseas funds like KKR, JC Flowers and the Canadian Pension Fund who are lined up with $6-8Bn to take over NPAs.

In addition to all these, banks are themselves showing interest in resolving NPA cases as they have already referred 8 cases to a 2-member committee constituting of former Central Vigilance Commissioner Pradeep Kumar and former SBI Chairman Janaki Ballabh. 6 out these 8 cases have already been cleared while the remaining 2 has been asked to rework the process by the panel.

Conclusion

From the above discussion it is clear that setting up of a bad bank, however lucrative, is a complex process in nature, owing to the complexity and cost of the model. So the most efficient approach to solving the NPAs problem in India will be to create tailor-made solutions for different parts of the problem and use “Bad Bank” only as a last resort once all other methods fail.

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