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Budget 2021: Government Announces a "Bad Bank" for Swift Debt Recasts, Banking Sector Clean-up

Feb 5, 2021 6:30 AM 5 min read

One of main announcements in Budget 2021 was the Government's decision to set up a "bad bank" that would ring fence distressed or non-performing assets (NPAs) off the books of scheduled commercial banks (SCBs) and potentially non-banking financial companies (NBFCs).

This entity would pursue loan recovery on its own so that other lenders, with their balance sheets now clean, can resume activities with a clean slate, so to speak.

What Exactly is a Bad Bank?

Here’s the raison d'être. Indian banks and NBFCs have a lot of bad loans. Lenders have as much as ₹2.25Lcr ($30.8bn) of unresolved bad assets. And the coronavirus-driven recession only aggravated the crisis. According to the RBI, NPAs could rise to 13.5% of total advances by September - up from 7.5% a year ago - one of the highest levels among major economies. If the number holds till the end of FY22, it would be the worst bad loan quagmire faced by the banking sector since 1999.

Budget 2021: Government Announces a This is where the concept of a “bad bank” comes in. What if you could gather all bad loans from multiple banks into a single and separate entity?

So what remains of these multiple banks would be the...“good bank” part. Ergo, these good banks could release provisions held against NPAs, find it easier to raise capital from investors and grow and expand and issue fresh and - you get it.

As for the newly-minted bad bank, its sole focus would be on winding down the ring-fenced loans - either by restructuring them, resolving them or selling them. It would be designed akin to an Asset Reconstruction Company (ARC). And these bad assets could be bought by specialist institutional investors such as hedge funds or PE firms at a deep discount, who would further sell them at a premium once the underlying performance improves and earn a profit.

Thus, everyone’s happy and Indian banking can look forward to a fresh start. Well, at least that’s the theory.


Bad Bank - Good or Bad?

Now, aggregating soured assets under one entity has obvious advantages. The main one being that it could expedite loan recasts, which when done by individual lenders is an arduous and lengthy process. The emergence of clean-slated banks without bad loans anchoring them would also renew their growth prospects and make them more attractive to investors, both domestic and foreign.

Having said that, there are critics of the idea. One of them was former RBI Governor Raghuram Rajan, who opined that it “would solve nothing”. If the endeavour was funded from the Government’s kitty, the bad loans would practically be shifting from PSBs to the bad bank - but on the whole remain in the public sector. On the other hand, if the bad bank was in the private sector, “the reluctance of public sector banks to sell loans to the bad bank at a significant haircut would still prevail”.

In a September 2020 paper published by Mr. Rajan with former RBI Deputy Governor Viral Acharya, he adds: “...public sector banks worry about the price they will sell loans at (especially since this involves recognising a loss immediately, with possible recompense only later when the loan is partially repaid). Moreover, while the private bad bank may not have qualms in writing down loans, it (and sellers) may be subject to political scrutiny if it turns out to be successful – were loans sold to it at too low a price?”

Who will fund the bad bank? How would the criteria and price of bad loan purchases be designed, while ensuring transparency and fairness? How will the limited secondary market for stressed assets be dealt with? (After all, the bad bank would be negotiating with the same potential buyers individual lenders have been dealing with all along.)

And then there’s the very real danger of throwing public and private banks a lifeline without penalising them for poor lending practices - this could create a moral hazard.

This Bloomberg article argues that creation of a bad bank could inflate the price of distressed assets. Such an entity could reduce pressure on loan owners to price such debt at discounts attractive enough to draw other buyers (the “significant haircut” Mr. Rajan was talking about).

FYI: In 2019, the Government asked the RBI to set up a fund to buy out stressed assets of the country’s top 25 NBFCs in order to revive the shadow banking sector. The Central Bank, however, was reluctant to do so, finding the step to be too “drastic”.


What is the Centre’s Proposal?

As per the Budget proposal, the Government will not invest any equity in the proposed bad bank or be involved in its management, putting the onus instead on lenders (both public and private) to create and manage the entity on their own.

This is in contrast to the Indian Banks’ Association’s earlier proposal for setting up a state-run entity with an initial capital infusion of ₹10,000cr ($1.37bn).

The envisioned entity would function in a 15:85 mechanism, wherein banks would get 15% upfront payment as cash and 85% value as receipts, as per Debasish Panda (Secretary - Department of Financial services).

FYI: While the Government may not directly shell out capital for the venture, it will inadvertently be indirectly involved in that it would lay the groundwork for the process to kickstart. Moreover, PSBs’ bad loan crisis is far worse than private banks’. And the Government has over 70% ownership in 10 PSBs and over 90% in three.

Many measures have been adopted in recent years to clean up the banking sector. These include the Sick Industrial Companies Act (SICA), the SARFESI Act, the Insolvency and Bankruptcy Code, Debt Reduction Tribunals, setting up ARCs etc. But debt recovery has proceeded at a slow pace, weighing down already-burdened banks with extra provisions and unresolved debt.

The fine print regarding how the bad bank - the latest such measure - would function, its governance structure and capital requirements is yet to be made public. Based on whether or not it takes into account the loopholes of creating such an entity and the execution of this entire process, the bad bank could either be a much-needed saviour for Indian banking...or yet another futile attempt at reinvigorating an ailing sector.

It might be pertinent to end with a quote by Keynes:

If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.


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