Why creating a ‘bad bank’ is a better idea than simply throwing money at PSBs

The financial year 2017-18 was among the bleakest for public sector banks (PSBs) as they together reported a record loss of Rs 85,370 crore.

The banks had to make higher provisions for bad asset recognition as the Reserve Bank of India’s latest guidelines meant they could no longer restructure loans the way they had been doing in the past.

Much of the government’s capital committed for ailing public sector banks appears to have been consumed in this exercise. With little capital to take on fresh risk and no decisive end to the toxic asset problem in sight, the idea of “bad bank” is once again finding takers within the government.

We feel the “bad bank” may be a workable solution to expedite bad loan resolution and free up management bandwidth at public sector banks before the next dose of capital infusion by the government.

What is a “bad bank”?

A “bad bank” is a corporation established to isolate bad loans of a bank or financial institution. Creating a bad bank is a way to segregate non-performing assets from a bank’s core business.

In theory, once the bad assets are removed from the balance sheet, the bank will be able to start lending again and over time, will earn enough interest from new good loans to cover the losses from bad loans of the past.

Sweden, Finland and Ireland have all used bad banks to help end financial crises. In Asia, South Korea and China had resorted to creation of bad banks as well. Even though the bad loans don’t go away, getting the bad loans off a bank’s balance sheet can give the bank additional time to repair itself.

The genesis of the idea in India

In India, the Economic Survey suggested the idea of a centralised Public Sector Asset Rehabilitation Agency [PARA] that could take charge of the largest, most difficult cases, and make politically tough decisions to reduce debt.

It was suggested that the funding for PARA would come from government- issued securities, the capital market and the RBI, which would transfer some of the government securities in its portfolio to PARA. Consequently, RBI’s capital would decrease, while that of PARA’s would increase with no implications on monetary policy.

RBI’s Deputy Governor Viral Acharya had suggested in the past the creation of a resolution agency like Private Asset Management Company (PAMC) and a National Asset Management Company (NAMC).

The former is suitable for sectors such as steel and textiles where some sectoral recovery is in sight, whereas the NAMC, in which the government would play a larger role, would be more appropriate for infrastructure investments such as power where the assets may appear to be unviable in the short to medium term.

Both would be expected to bring in asset managers such as Asset Reconstruction Companies (ARCs) and private equity firms to manage and turnaround the assets.

Why now?

The Indian banking sector’s reported gross NPA crossed Rs 10 lakh crore in FY18, with close to 87 percent coming from the PSBs. For them, the ratio of gross non-performing assets has crossed 16 percent and could worsen further.

The participation of PSBs in economic activity has dwindled. However, thanks to the regulatory diktat, their provision cover (without technical write off) has improved to 49 percent from 44 percent at the end of FY17.

A decent beginning has been made for resolving the stressed assets problem with the IBC (Insolvency and Bankruptcy Code), and there have been some successes. Going forward, companies with hard assets are likely cheer bankers up as most banks already carry sufficient provision on these assets.

But NCLT itself is saddled with a long pipeline. Beyond the first two identified lists, the quantum of granular problematic accounts is large. These may not find ready takers without a viable turnaround strategy. Also, the task is large enough to consume bankers’ bandwidth and that could prevent them from focusing on new businesses.

bad bank

The challenges?

A government initiative to create a “bad bank” makes a lot of sense because it is bank to which all the toxic assets of the Indian banking system can be collectively transferred.

The key hurdle in the process is the valuation of the assets transferred. However, in the current context, there are two silver linings. Firstly, most banks have now achieved a good provision cover and can therefore absorb some haircut. Secondly, the ongoing resolution at NCLT will enable establishing a valuation range for the stressed asset portfolio.

Nevertheless, the key issue to be addressed is the capitalisation of the “bad bank”. Beyond the three routes suggested by the Economic Survey, a section of experts suggest issuance of zero-coupon perpetual bonds to capitalise the bad bank, which will attract zero risk weightage.

The focus of the bank will generally be to restructure and revive projects and improve the value of the assets. The resolution strategy will be to extract maximum value from the underlying assets.

The bad bank will encourage investors to enter at various stages of resolution and will also facilitate resolution outside NCLT. However, in order to expedite resolution and maximise recovery, a robust “buyout” ecosystem is an essential prerequisite.

For growth in the economy, credit creation is a must. The prevalent toxicity in the system needs to be taken out before the new growth capital can start contributing meaningfully.

The Indian banking sector has witnessed several failed experiments of restructuring and has only now seen some early success with the NCLT. The end of the bad asset recognition process is near and provision levels are higher.

So the creation of a bad bank can go a long way in reviving credit growth and the long-halted investment cycle. Although the ailing PSBs will still require capital (more doses of recapitalisation bonds), a cleanup with the creation of bad bank may be essential before any fresh capital infusion.