Bad bank should have been set up 3-4 years back, not now: Kotak Securities report

Establishing a bad bank today would aggregate but not serve the purpose that has been observed in other markets, Kotak Securities Ltd (KSL) said in a report.

Bad bank is perhaps well served in the initial leg of the loan recognition cycle, it added.

“While we are unaware of its probability and design, creation of a bad bank would have been most fruitful three-four years back (perhaps just after the Asset Quality Review) or earlier when the stress was just building up and banks were looking to delay recognition for various reasons.

“Today, the banking system is relatively more solid with slippages declining in the corporate segment for the past two years and high NPL (non-performing loan) coverage ratios, which enable faster resolution,” said KSL analysts M B Mahesh, Nischint Chawathe, Abhijeet Sakhare, Ashlesh Sonje and Dipanjan Ghosh.

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Based on insights gained from two key reports of BIS and IMF, the report observed that a successful bad bank needs a critical mass (healthy buy-in from lenders) of impaired assets, robust legal framework for debt resolution, along with strong commitment to reforms.

The analysts observed that segregation of impaired assets without sufficient recapitalisation has insignificant impact on future loan growth and NPL creation. A bad bank is expensive to establish, needs a well-defined mandate, and clear exit strategy.

Further, timing of formation and pricing of assets are crucial as the objective is to release stress from lenders early in the cycle so that they can refocus efforts in creating credit. Finally, there are instances of bad banks not achieving their desired objective, the analysts said.

After nearly a decade of elevated slippages, FY2019-20 saw a much lower slippage trend with evidence of it moving closer to normalisation before the impact caused by Covid-19, the report said.

The analysts said they are yet to assess the impact of Covid-19 but in their view the corporate portfolio appears to be holding quite well.

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Public sector undertaking (PSU) banks PSU, in particular, have gone through this with fresh equity (about ₹3.5-lakh crore over FY2016-21 by the government/Life Insurance Corporation of India) in the past three years and provision coverage ratio (PCR) improving to about 70 per cent from about 40 per cent in the past three-four years.

“A high coverage ratio ensures that faster consensus building is also no longer an issue. We have seen the introduction of IBC as well as consolidation in public banks. We had limited systemic risk from a liability perspective,” the analysts said.

The report observed that one of the key objectives of segregating impaired loans is to restore faith in bank balance sheets and help unlock funding market access. However, PSU banks control a large part of the banking system with a high contribution to NPLs.

“Managerial incentives across organisations are probably still fully not aligned to maximising value through early recognition of bad loans,” the analysts opined.

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Further, given the high contribution of retail deposits, funding stability of these banks is uncorrelated with their financial performance for an extensive period of time.

The analysts said lack of credit growth, especially in the corporate segment, is often attributed to PSU banks’ risk aversion (low capital/high NPLs in the past).

“However, we do argue that corporate deleveraging has been quite slow and credit demand, especially by the better-rated and large wholesale borrowers, has been slower,” they added.

The behaviour of PSU banks has been different with respect to retail and micro, small and medium enterprise (MSME) lending, as these banks have been helping credit growth, especially in recent years and much higher than trend levels post the Covid-19 outbreak.