Bad Bank - A Good Idea?

Summary :

This article helps the reader to understand the whole concept of Bad Bank, The need of Bad bank, Benefits, challenges, Demerits, Alternative options of Bad bank and many other aspects in most simple way.

Covid-19 pandemic induced economic slowdown and as a result of this commercial banks are about to witness the spike in NPAs, or bad loans. To deal with this, Reserve Bank of India (RBI) Governor is considering the proposal for the creation of a bad bank. Various analysts speculated that the proportion of stressed assets in the banking system could jump to 18% from around 11% at present, in the coming few years.

Introduction:

The idea of a bad bank has been there since the 1980s when the US and Sweden became its early adopters. Several countries, governments, and banks have since then adopted the idea with mixed results. Indian lenders (Banks & Financial institution) wants from the government to provide up to $2 billion contribution 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. The Finance Minister, in the Budget of 2020-21, proposed the establishment of a bad bank. There have been commentaries. The government has said that it will only provide guarantee for the bad bank. The initial capital which is likely to the tune Rs. 15,000 crore will be provided by the lenders themselves.

What is Bad Bank:

Bad Banks are the corporate structures set up to buy the bad loans and other illiquid holdings of other financial institutions. Illiquid holdings are assets that are difficult to sell because of its expense, lack of interested buyers or some other reasons. Setting up a Bad Bank reduces the burden on the bank by taking bad loans off their balance sheets and getting them to lend again to the customers without constraints. The bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans. The takeover of bad loans is normally below the book value of the loan and the bad bank tries to recover as much as possible subsequently. A Bad bank is kind of asset reconstruction company (ARC), involved in management and recovery of bad loans or NPAs of other banks.  A bad bank conveys the impression that it will function as a bank but has bad assets to start with. Generally, these Banks are initially funded by the government and gradually, banks and other investors start to co-invest in them.  

Benefits of Bad Bank:

• Specialization leads to faster recovery: Speed of recovery will be better as Bad Bank’s main work is recovery and they are specialized in that.
• Banks’ Burden is Reduced: The burden of recovering those loans is reduced for other banks.
• Positive Impact on Financial Sector: Bad Bank will help improve the banking sector’s health and fasten the recovery aspects of ailing by putting back frozen assets back into economic circulation.
• Increased Profitability of Banks: Bad Bank increases profitability of other banks as they can focus more on lending, acquiring more customers and upgrading technology without spending too much time on recovery or resolution of bad loans.
• Centralised Recovery: 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.
• Feasibility: Bad banks can make profits as they usually keep high margin before acquiring the bad loans. The concept of Bad Bank has been implemented in other countries including Sweden, Finland, France and Germany.

Demerits of Bad Bank:

• Shifting of Problem: Former RBI Governor Raghuram Rajan had opposed the idea of setting up a bad bank in which banks hold a majority stake. He was of the opinion that bad bank idea as merely shifting loans from one government pocket (the public sector banks) to another (the bad bank).
• Reckless Lending: Other banks may not concentrate on the quality of loans as they always an option of shifting bad loans to ARC/ Bad Bank. This leads to doling out loans without proper diligence leading to reckless lending
• Efficacy Debate: Bad banks may not acquire critical loans which are difficult to recover and only concentrate on easily recoverable loans. As a result, troubled Commercial banks continue to face the issue of bad loans. There is also the fear that it end up as another case of throwing good money after bad.
• Profitability of Banks: High margin of Bad banks may curtail the profits of other banks which can in turn impact their lending capabilities. 
•  Moral Issues: Due to pressure bad banks may employ some unethical ways to recover loans. Another issue is that other banks may not show the actual position of loan accounts by doing window dressing.

Need in India:

• Economic Recovery: With the pandemic hitting the banking sector, the RBI fears a spike in bad loans in the wake of a six-month moratorium it has announced to tackle the economic slowdown.
• Government Support: Professionally-run bad banks, funded by the private lenders and supported by the government, can be an effective mechanism to deal with Non Performing Assets. The presence of the government is seen as a means to speed up the clean-up process.
•  Financial Stability Report: The RBI noted in its recent FSR that the gross NPAs of the banking sector are expected to shoot up to 13.5% of advances by September 2021, from 7.5% in September 2020.
•  Rising NPA: Noted that corporate sector debt worth Rs 15.52 lakh crore has come under stress after Covid-19 hit India, while another Rs 22.20 lakh crore was already under stress before the pandemic. 

Possible Alternatives of Bad Bank :

• 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.
•  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.

As per latest available RBI data, as a percentage of claims, banks recovered on average 42.5% of the amount filed through the IBC in 2018-19, against 14.5% through the SARFAESI, 5.3% through Lok Adalats and 3.5% through Debt Recovery Tribunals. The view is that an IBC-led resolution, or sale of bad loans to ARCs already existing, is a better approach to tackle the NPA problem rather than a government-funded bad bank.

Two Models Suggested for Bad Bank:

Two models suggested by former RBI Deputy Governor, Viral Acharya. He suggested two types of Bad banks. The possibility of these two models can be explored before setting up of Bad Bank. The models were: 

• Private Asset Management Company (PAMC): This model is suitable for stressed sectors where the assets are likely to have an economic value in the short run, with moderate levels of debt forgiveness.  
• National Asset Management Company (NAMC): This is for the sectors where the NPA problem is in excess capacity and also of economically unviable assets in the short to medium terms.

Proposed Shareholders of First Bad Bank:

All the 11 shareholders will hold 9 % share with no one holding more than 10 % share, with a provision of having more shareholders to join later. 11 banks will infuse an amount of Rs 7000 crores in its formation. These 11 shareholders are from Public sector banks, Private bank &Non-banking Shareholder, as follows:

•  PSBs: SBI, Bank of Baroda, PNB, Canara Bank, Union Bank of India, Bank of India 
• Private Banks: Axis bank, ICICI, IDBI
• Non-Banking stakeholders: Power Finance Corporation, Rural Electrification Corporation.

Concerns in setting up of Bad Bank:

The bad bank will require significant capital to purchase stressed loan accounts from public sector banks and the chances of private participation are low unless investors are allowed a major stake in the governance of the new entity. 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 and the larger focus must be on the ‘Twin Balance Sheet’ (TBS) problem of corporates and banks. Instead of recapitalizing the banks year after year, it would be better for the government to focus on recovery. Just setting up one PARA (Public Sector Asset Rehabilitation Agency) 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.

Will a bad bank solve the problem of NPAs?

• Complements Previous Measures: Despite a series of measures by the RBI for better recognition and provisioning against NPAs, as well as massive doses of capitalization of public sector banks by the government, the problem of NPAs continues in the banking sector, especially among the weaker banks. Having a Bad Bank will complement other measures taken by RBI & government to clean up banking sector.
•  Helps solve economic aftershocks of Pandemic: As the result, Covid-related stress pans out in the coming months, proponents of the concept feel that a professionally-run bad bank, funded by the private lenders and supported the government, can be an effective mechanism to deal with NPAs. 
•  Experience from Other Countries: Many other countries had set up institutional mechanisms such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system in the wake of 2008 financial crisis.

Conclusion:

Union Government, in the last few years, has infused nearly Rs 2.6 lakh crore in banks through recapitalization. A bad bank can free up the Banks to start lending which helps in economic growth. However, adequate measures need to be put in place so as to overcome the pitfalls of bad bank. The bad bank idea is like shifting loans from one government pocket (the public sector banks) to another (the bad bank). The criteria for buying assets should be transparent to make Bad Bank-A Good Idea.

Authors Details

Author’s Name- SHOBHIT JAISWAL

Email- [email protected] / [email protected]