Why A Bad Bank Is A Good Idea

06/08/2015 8:19 AM IST | Updated 15/07/2016 8:25 AM IST
A customer hands over Indian Rupee notes for a deposit to a bank cashier in Mumbai on November 22, 2011. The Indian rupee hit a record low against the dollar, as fears about eurozone debt and the global economy as well falling local stock markets provoked further selling of the currency. The weakening rupee is expected to fuel domestic inflation because oil imports priced in dollars will become more expensive, translating into higher prices for local consumers and businesses. AFP PHOTO/ Indranil MUKHERJEE (Photo credit should read INDRANIL MUKHERJEE/AFP/GettyImages)

Niti Aayog vice chairman Arvind Panagariya in a recent interview mooted the idea of a "bad bank", essentially a financial institution set up to hold and manage non-performing assets (NPA) acquired from other banks. It is like an isolation ward to prevent the spread of an infectious disease. Last year, too, there were talks of a NAMCO (National Asset Management Company) on similar lines. Opponents to the idea have come up with the arguments that it is unwarranted and will transmit negative signals and create moral hazards.

To start with let us set the context with the proper perspective. During the last fiscal, credit growth of the banking sector was just 9.7% -- the lowest in a decade. Meanwhile, alarmingly, the stressed assets of the banking system went up to 11%. While India's growth trajectory will benefit from a favourable external environment -- falling crude and commodity prices and a slowdown in China creating a space for our exports to move up -- credit growth is a necessary prerequisite to drive GDP growth. Further, banks require almost Rs 4-5 lakh crores in capital to meet Basel III by 2019. Because of huge NPAs, banks do not get a good valuation and cannot access the capital market. Most of the public sector banks are trading below their book value.

"The concept of a bad bank is geared towards absorbing short-term pain and transforming it into long-term gain for all stakeholders, including the government, banks and the economy at large."

The solution to all this starts from shifting toxic assets to a bad bank. There have been successful models tried and tested globally. The banks will get rerated after cleansing the balance sheet and are likely to attract better valuations and be in an improved position to meet regulatory capital requirements. All this will propel the Make in India initiatives and help in meeting the growth expectations of an aspirational India. There is a huge requirement for investment particularly in infrastructure sectors. Banks saddled with a huge amount of bad debt are hardly in a position to stand up and play a meaningful role in boosting the India Growth Story.

There are a few arguments against introducing the concept.

1. There are fears it may encourage defaulters to take the banking system for granted and will encourage borrowers to take banks for a ride. This misgiving is based on a misconception. When a defaulting loan gets transferred to the bad bank, the entity and its active directors will continue to be treated as defaulters as long as the loan is not repaid and a clean chit obtained from the transferee bad bank. They will have no access to the credit delivery channels of the banks.

2. The second argument is that the continuance of such bad loans is a painful reminder of the failures of the due diligence process in the bank and weaknesses in our legal recovery process. Out of sight, out of mind, so think the critics. Let us honestly introspect -- while there are loans where this laxity played a role, many have also turned into NPAs because of a change in the operating environment, including regulatory roadblocks. Poor bankers cannot be made responsible for all such NPAs. While there is absolute merit in improving the due diligence process, identifying early warning signals and taking prompt corrective action, there is no need of to allow NPAs to hang over banks like a Damocles sword to drive home this point. The need for having a more effective foreclosure system and an integrated bankruptcy code, however, needs to be reiterated for restoring confidence in the financial system.

"[A] bad bank is possibly the only good and sensible idea at present to revive a stressed banking sector, allowing it to effectively play a meaningful role in accelerating economic growth..."

In a recent event in New Delhi, former finance minister Mr Yashwant Sinha drove home the points raised above with his great intellectual charm. There are three types of borrowers - the first type are wilful defaulters. They should be treated like criminals. Second, the promoters are good but lack suitable managerial skillsets and vision. A change in management or skill upgradation is the answer to these borrowers. Finally, category three borrowers are those whose management is competent but the projects are stalled because of factors beyond their control like say delay in clearances etc. Here a detailed workout is required, in which regulators are involved and solutions sought to clear policy logjam. The bad bank has to have separate workout modules to handle these varied categories of NPAs with proper regulatory empowerment for effective delivery of time-bound results.

In the recent past, successful government intervention has been demonstrated, albeit in a different fashion, in the USA. The Troubled Asset Relief Program (TARP) was designed as a program of purchase of assets and equity from financial institutions to strengthen its financial sector in 2008 to address the subprime mortgage crisis. With the improvement in the US economy, the TARP revenue as on December 2014 has totalled $441 billion against $ 426 billion invested.

The concept of a bad bank -- a direct government intervention to tackle the problem -- is geared towards absorbing short-term pain and transforming it into long-term gain for all stakeholders, including the government, banks and the economy at large. The modalities like funding, process of acquisition, ownership structure, administrative set up, special dispensations required, financial instruments to be deployed and their tenure and yield, eligible loans etc can be worked out once there is a consensus that we are nearing a crisis which merits out-of-the-box thinking and a radical departure from the status quo. I'd go as far as to say that a bad bank is possibly the only good and sensible idea at present to revive a stressed banking sector, allowing it to effectively play a meaningful role in accelerating economic growth in the coming years.

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