The bad bank is an idea that comes up every year ahead of the budget as the concept is expected to finally germinate with the government putting funds aside for its training. The thought conjures up arguments that are relevant today because we have a situation where we have a high level of NPAs (non-performing assets) and the future is uncertain. In addition, several attempts have been made to resolve the issue, with the Insolvency and Bankruptcy Code (IBC) being the latest, but progress has been limited. More importantly, the quantum of NPA is likely to increase after the return to normal.
Simply put, the bad bank buys all NPAs or some of the biggest public sector banks (PSBs). Sellers’ balance sheets are shrinking because these assets are off-balance sheet. This saves capital for banks which can initiate new loans. Also, banks are lending agencies and should ideally spend more time on business than on recovery.
There may be different models of bad bank which can also buy loans from private banks and therefore work for the system. But it should be remembered that while NPAs can be transferred from the bank to the wrong bank, the overall quality of the country’s loan portfolio does not really change. It also means that there is a depreciation of the asset which is always a loss to the system.
Recent data from the RBI shows that the average recovery rate of NPAs through IBC, ARC (Asset Reconstruction Companies), DRT (Debt Collection Courts) and SARFAESI is 23 , 2%; this is being pushed up due to the IBC which has a 45 percent recovery rate. The performance of others is lower, varying between 4 and 27 percent.
There is little reason to expect the bad bank to do better than this. Therefore, we will not really solve the problem, but just transfer it to another entity that makes banks’ balance sheets look better. In turn, banks may find it easier to raise capital in the market.
While the bad bank will address the issue of releasing capital from banks, which is a positive outcome, it does not address the central issue of NPAs – namely, why do they keep increasing? A certain number of NPAs will necessarily exist in any system as some businesses will fail and a rule of thumb may be that a rate of around 4% should be tolerable in an emerging market where risks are high, given the economic environment. The surge in NPAs is often due to systemic issues that go unaddressed.
Not a simple affair
Directed credit, where public sector banks must necessarily lend to certain segments, is the main factor that goes beyond RBI regulation. Often, sectors such as SMEs become the backbone of government which in turn compels PSBs to meet targets. Giving quick loans has its merits, but banking is not a simple activity that can be performed on algorithms.
The other factor that leads to such a stack of NPAs is the constant restructuring of debt. The lesson of the history of the loan of 2011 which was directed towards the infra has not yet been assimilated and the justification of such acts leads to this pile-up. Unless that changes and banks have the freedom to manage their accounts as a business and not as a vehicle for social change, these challenges will always emerge.
Therefore, a bad bank can continue to absorb NPAs at a depreciated cost to the banks, and it will be a sustainable flow. It may not be the idea of a bad bank because such a bank is supposed to process a stock of NPA and not subsequent flows. Otherwise, it creates an economic moral hazard on the part of the lending banks and the borrowing clients as it becomes a perverse win-win situation for everyone.
Bank capitalization is a better idea. Let’s see how this plays out. PSBs tend to create more NPAs as they necessarily become the instrument of change for successive governments. As NPAs increase, provisions must be made which decrease their profit or cause losses and which, in turn, deplete their capital.
In such a situation, the bank cannot lend, and this is where the government intervened with capitalization measures. Ideally, the government makes provisions in the budget for the capitalization of banks. The other innovative financial engineering is that of recapitalization bonds. The government issues bonds which are subscribed by the banks and which in turn are returned to the banks as capital. There is no transfer of funds in effect and the government pays interest to the banks on the bonds that have been taken out. Either of these actions is appropriate because the PSBs are government owned and somehow fund the NPAs.
However, when a bad bank comes along, things will be different. The bad bank has to be funded by the government and investors would likely contribute their share. Investors may not be interested as there are already ARCs in the system that haven’t really been effective. The problem with the CRAs was that they wanted the banks to adopt a higher haircut, which was not acceptable.
A bad government-funded bank will have less of a problem as PSBs will willingly sell to the bank at any cost, as both entities are government owned. Once private investors join the BB, things will be different and look like a government owned ARC.
Therefore, the ownership structure of the bad bank will determine the likely success of the business transferring bad assets to a central branch.
The concept of bad bank therefore looks like a loophole to deal with NPAs. Caution dictates that we persevere with the IBC and probably speed up the processes as it has turned out to be a good option. Alternatively, the infusion of capital transfers responsibility directly to the government, which may be more appropriate.
The author is Chief Economist, CARE Ratings. Views are personal