Can 'bad bank' save our stressed economy?

The Indian economy has been reeling under the stress of non-performing loans for quite some time now, and the government and the Reserve Bank of India (RBI) have, over time, introduced several measures to contain the rising growth of stressed assets. Even before the COVID-19 pandemic, the incumbent stress had slowly but steadily blown into a crisis. Unfortunately, with the COVID-19 pandemic affecting economic sectors across the board, this problem has become worse. Enter: ‘Bad Bank‘. The term has found itself in much limelight again after the Finance Minister’s 2021 annual Budget speech. While many are hopeful that this is perhaps the need of the hour, others are quite skeptical due to India’s previous experience with this.

Proposal to establish a bad bank

The annual Budget envisages the setting up of a bad bank in the form of an asset reconstruction company or an asset management company. Such entity will purchase stressed assets from banks, restructure them and sell them to investors, seeking to resolve them over time. In the process, the banks selling such stressed assets will be able to clear their balance sheets and consequent adverse implications and use their capital more optimally.

Impact on stress and potential challenges

In the present pandemic-affected market, the RBI has provided various relaxations to borrowers (in the form of an option to avail a loan moratorium or loan restructuring). However, a similar relaxation has not been provided to banks, who are expected to continue to repay their obligations. Therefore, transfer of stressed assets from a bank’s books could provide banks with the much-needed respite. Broadly speaking, banks would:

  • be able to focus on lending instead of loan recovery
  • have availability of free capital that can be used more efficiently, since additional provisioning in connection with the transferred bad loans would not be required to be made
  • see an improvement in credit ratings
  • potentially see an overall improvement in banking business as investors, depositors and borrowers are more likely to engage with profitable banks.
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India’s earlier experience with bad banks seems to have left a feeling of skepticism. In 2004, when Limited’s bad loans were bought out by a government fund, neither did the fund realise sufficient value from it, nor did IDBI Limited’s lending record improve substantially. Critics therefore consider the bad bank as eyewash over accountability.

This time, however, it appears that the proposal for establishing a bad bank is designed differently, drawing from experiences globally. We understand that the bad bank is proposed to be set up by state-owned banks and private sector banks, without any equity infusion from the government. Such bad bank will be purchasing stressed loan accounts exceeding Rs 500 crore against issue of security receipts to a wide pool of investors, including Alternative Investment Funds (AIFs). There may potentially be a sovereign guarantee to back the security receipts but that would fundamentally be to help banks meet regulatory requirements. Assuming that banks will in fact be relieved of significant stress upon hiving off only those bad loans that are over Rs 500 crore, there are many positives here:

  1. Part ownership of the bad bank by private banks is likely to improve price discovery and related transparency of the sale of stressed loans by banks.
  2. Only part ownership by Government banks translates to lesser burden on the exchequer.
  3. With the backing of a sovereign guarantee, private banks are likely to be incentivised to participate in the capitalisation of the bad bank.
  4. Permitting AIFs to invest in the bad bank would widen the capital pool and involve market participation.
  5. The various credit guarantee schemes introduced by the Government to improve accessibility of cheaper credit to micro, small and medium enterprises (MSMEs) may see fruition, as banks will have increased availability of capital to lend to MSMEs.
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While we may be able to take inspiration from the success of bad banks in foreign markets, its impact on the Indian market depends on its implementation. In order for the proposal to work efficiently, the Government and the RBI must ensure that sufficient bells and whistles are put in place – with a potential eye on improving lending behaviour.

For instance, ensuring that banks do not compromise on their due diligence merely because a bad bank will stand behind it. The price at which stressed assets are being transferred is also an important consideration, especially when the transferring bank is an investor in the proposed bad bank. Also, taking a leaf out of Germany and Sweden’s experience, tapping on the expertise of distressed asset management professionals to run bad banks would be hugely beneficial.

The proposal to establish a bad bank may be a positive move to relieve banks of their stress temporarily, given the present market situation particularly exacerbated by the pandemic. Having said that, it may be pertinent to note that shifting of stress from one entity to another should not be considered a ticket to solving the problem of stressed assets.

(The writers are Anish Mashruwala, Partner and Neelasha Nemani, Associate at J. Sagar Associates)

(The one-stop destination for MSME, ET RISE provides news, views and analysis around GST, Exports, Funding, Policy and small business management.)

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