How good are Bad Banks and does India really need a Bad Bank?

When a certain organ in the body doesn’t work, doctors tend to remove it for the patient to survive. When we eat something, which is difficult to digest, our body throws up. A rotten apple in a basket must be removed to save other apples from getting spoiled. This is what one bad bank does for the other banks of the economy.

But, what are bad banks?

What is a Bad Bank?

A Bad Bank would buy the bad loans and non-performing assets of banks and other struggling financial institutions, thereby aiding these institutions in clearing and having a stronger-looking balance sheet and financial statements, thus, keeping a check on that bank’s health and its proper functioning. These bad banks usually take the non-performing assets of banks at a discounted price and strive through various means to recover what is left and can be settled.

So, bad banks must be good then, right? Well, appearances are often misleading. Let’s see how.

The lending business in India has shown a rising trend until early 2020, when the pandemic hit and several businesses were forced to shut with growing debt and no inflows. This has led to a worrying surge in NPAs, thus bringing banks into severe stress.

Just to give a hang on, debt is classified as nonperforming when loan payments (principal or interest) have not been made for a period of 90 days (consider them as the body organs which have stopped performing). While 90 days is standard, the amount of elapsed time may be shorter or longer depending on the terms and conditions of each individual loan. 

What’s worrying is that under a severe stress scenario, as per the RBI’s FSR December 2020, these NPAs are slated to rise to as high as 14.8% by September 2021, nearly double that of 2019-20! So, of the various measures that the government is planning to take, setting up an Asset Reconstruction Company or a Bad Bank to provide financial stability to the banking sector is considered a crucial one.

Origin of Bad Banks

Let's first dig upon the origin of Bad Banks and what led India to introduce one.

The first time the concept of a bad bank was pioneered, was at the Pittsburgh-headquartered Mellon Bank in 1988, in response to problems in the bank's commercial real estate portfolio. Due to growing NPAs, the banks were forced to infuse capital, which in turn hindered fresh lending.

During the global financial crisis, various banks from all over the world like the Bank of America, Citigroup, the Swedbank, etc. took on this idea and are now one of the most renowned banks of today.

In India, the government created the Stressed Asset Stabilization fund in 2004. The SASF, basically structured as a Bad Bank, helped IDBI swap funds of around 9,000 crores.

However, the first idea to establish a Bad Bank in India was given in the Economic Survey of 2017. Consequently, the Indian Banks Association (IBA), recommended RBI and the Ministry of Finance, open a Bad Bank in the country to get rid of the problem of bad loans.

Why is Bad Bank in the news?

In Budget 2021-22, the FM announced that the high level of provisioning by public sector banks calls for measures to clean up banks’ books. And as a part of such measures, the IBA will soon move to RBI to set up a Rs 6,000 crore National Asset Reconstruction Company Limited (NARCL) or a bad bank.

A 51% stake would be held by state-run banks with private banks owing the rest. Some 22 dead assets worth around Rs. 90,000 crores are earmarked for transfer to NARCL. Although there have been Asset Reconstruction laws and debt recovery tribunals in place, they are still struggling to count on their recoveries.

As per the reports, a bad bank can help free the capital of over 5 lakh crore that has been locked in by banks, as provision against these bad loans. This will give banks the freedom to use that money to provide fresh lending.

However, banks will be able to use this unused lying money in their balance sheets, only if they get rid of their bad loans. The bad bank's focus would be the recovery of bad loans, thus reducing the burden on banks, promising a speedy recovery, and increasing the profitability of these banks. A bad bank may provide faster decision making which currently, takes years to settle. Furthermore, the security receipts which the bad bank will provide will entitle the holder, a share of the recovery done by ARCs (Asset Reconstruction Companies).

Challenges Ahead

Let’s look at some of the challenges a bad bank may face in India.

The first and foremost would be that the quality of the credit will suffer. Banks are under numerous obligations and supervision, including various internal, statutory and RBI audits during the entire lifecycle of a loan. There is a thin line that suggests that being less vigilant in the credit appraisal would only pave for greater NPAs, especially when banks are under political and bureaucratic pressures pushing reckless lending practices.

An increase in operational and commission expenses while transferring loans to bad banks is another problem. In the times of tight fiscal position owing to the present scenario when the economy is hit by a pandemic, it will be really hard to find buyers for distressed assets which will just lead to shifting of NPAs from one hand to the other. Other challenges include determination of base price, margin at which the NPAs will be transferred, which loans will be taken, what will be the recovery modes and a scepticism that bad banks may use unethical practices of recovery.

Can India’s bad bank, the NARCL succeed?

How well the NARCL (India’s proposed bad bank) will perform will depend on the following factors:

• A bad bank must contain Debt Management Professionals who are experts, especially in sectors like infrastructure, real estate, power etc., with huge ticket sizes having various compliances and covenants.

• A finite tenure or shelf life, say for 5 years, is also one of the major success points that we can learn from the mistakes of China. Once a bad bank has performed its desired operations, it will get disposed of. Otherwise, allowing a bad bank to exist in perpetuity would lead to another financial crisis and potential loss of the same purpose for which it was made.

• A clear price discovery without any political and bureaucratic involvement at an arm's length price (just and accurate).

• Infusion of capital from the Government, AIFs and Private Banks to ensure a strong backbone of the bad bank, with all types of multiple ARCs closure, as suggested by the Narasimham Committee in 1998. 

• Great leadership and focus on restructuring, rather than liquidation can help the NARCL do wonders for modern banking.

Conclusion

The above article would have made you realize that the basic task of a bad bank is to mop up the mess created by regular banks. This process would involve huge costs. As long as this cost is borne by the concerned banks or private players, the impact on the overall economy will be limited; but, if it is financed by the taxpayers’ money, an overall strict and watchful control of bad banks by the government will be necessary.

Going ahead, the government must act in conformity with the Central Bank to reduce the shock to financial markets and thus inject life into financial institutions.

Let’s just hope the Government & the RBI are able to turn a corner.