Bad bank

One of the key announcements in the FY 2021-22 Union Budget was about the formation of a ‘bad bank’ or National Asset Reconstruction Company (NARCL) to have a one-time resolution of the stressed assets of commercial banks. The idea of a bad bank was first floated in the Economic Survey 2017. However, it did not take off at that time due to lack of consensus. 

A bad bank is an asset reconstruction company (ARC) that takes over the stressed assets of commercial banks, restructures them and sells them to investors, and recovers the money over some time. It helps commercial banks to clean up their balance sheets by taking over bad loans at a value below the book value of the loan.

Mr. Padmakumar Madhavan Nair, the chief general manager in charge of stressed assets in SBI, has already been named the CEO of the NARCL. 

The Bad Bank would help in several ways: 

  • The large NPAs will be moved from the balance sheets of commercial banks to an entity that has the resources and skills to handle stressed assets.
  • This will clean up the financial ecosystem so that it can concentrate on its primary objective of fueling India’s growth aspirations without worrying about loan recovery. 
  • Commercial banks will have free capital for lending. The profitability and credit ratings will improve. 
  • As the bad assets will be under single ownership, the resolutions will be faster and not constrained by the need for consensus among many lenders.

The RBI Governor Shaktikanta Das sums up correctly, "On the back of better assets, banks can look to the future and realise better credit prospects and stronger business. Meanwhile, the ARC can determine how best to turn the non-performing asset around.”

The need for Bad Bank

The Indian economy has been slowing down due to the legacy non-performing assets (NPAs) in the banking sector that had turned the banks risk-averse. The huge infrastructure funding by banks during the boom period of 2005-2008, resulted in an asset-liability mismatch as long-term projects were funded by short-term liabilities. These projects became unviable due to various reasons leading to large NPAs in bank books. Despite a series of measures by the RBI for better recognition and provisioning against NPAs, as well as several tranches of capitalisation of PSU banks by the government, the problem of NPAs continued to fester in the banking sector. Bad assets in the system are now expected to balloon due to Covid-19 pandemic. The RBI has stated in its recent Financial Stability Report that the gross NPAs of the banking sector are expected to shoot up to 13.5% by September 2021, from 7.5% last year, under the baseline scenario. The report also warned that the GNPA can spike to 14.8% if the macroeconomic environment worsens under a severe stress scenario. It is reported that companies in sectors like retail and wholesale trade, roads, tourism and hospitality, and textiles are facing stress. Against this backdrop, setting up a bad bank is a step in the right direction.

Now the question is do we need a bad bank when we already have the Insolvency and Bankruptcy Code (IBC) since late 2016 to deal with bad loans. It is true that with the Bankruptcy code in place, the average time for recovery improved from pre-IBC days but it has been at a standstill due to the Covid-19 crisis. The IBC structure along with various amendments might be capable of dealing with incremental cases due to Covid-19. However, there is a need for a one-time settlement of the enormous stock of bad assets in the financial sector, and trying to resolve that through IBC alone might not be right for the economy at this moment. 

There are several asset restructuring companies already in the market. Asset Reconstruction Company India (Arcil), a private company, is one of the oldest. However, many PSUs were uncomfortable selling their NPAs to a private entity. Moreover, the existing ARCs do not have the capital required to buy large assets. The proposed bad bank with major stake owned by the government and with adequate funding is expected to be better than both the IBC and the ARCs in terms of 'fair pricing' and 'faster resolution’.

Not a new concept

The concept of bad bank is not new. The sovereign bad bank of Malaysia, Danaharta, established after the Asian crisis in 1998, is the oft-quoted success story. Danaharta was established as a national asset management company, for removing NPAs from the financial system and maximizing the recovery value. It received funding from the government and appointed special administrators, foreclosed on property collateral, or took legal action for nonviable borrowers. Danaharta ceased operations by December 2005 after managing to recover about 60% of the face value of NPAs. 

Similarly, the US had launched the Troubled Asset Relief Program (TARP) just after the Lehman crisis in 2008 to deal with stressed assets in the financial system. Citibank, Lloyds, and ING used governmental support to isolate the good assets of their portfolio against losses. The UBS of Switzerland too hived off bad assets to a government fund after the Global Financial Crisis. The assets in that fund turned profitable in 2013 and UBS repurchased the fund for $3.7 bn, which was a profit for the Swiss Central Bank.

Going forward

The bad bank is a one-time solution and cannot be in perpetuity. Usually, a bad bank has a mandate to wind up within a timeline. Going forward, there is a need to improve the governance of public sector banks, their risk assessment system, as well as strengthen auditors, boards, rating agencies, and regulatory supervisors so that we do not have to deal with another cycle of bad loans.

The Bad Bank is an idea whose time has come.     

This blog has been authored by Geetima Das Krishna.

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