All you wanted to know about...Bad bank

How do you restore faith in a country’s financial system when large chunks of its bank loans are turning bad? After going around in circles, policy-makers often come back to just one idea: set up a bad bank. In India, with accumulated bad loans soaring past the ₹10-lakh-crore mark recently, the bad bank idea has sprung up time and again, with new and different packaging.

When a bank is sitting on mountainous non-performing loans (NPLs), provisions eat into its capital base, slow recoveries hamper its lending and the resulting losses erode depositor confidence — the lifeblood of any bank. When the problem becomes pervasive and too big for individual banks to handle, governments often propose the setting up of a bad bank to buy out all toxic loans from banks. This helps banks get on with business as usual, while the bad bank grapples with recovering the loans or realising cash from selling the underlying assets.

India has toyed repeatedly with the idea of a bad bank to resolve its bad loan mess. In 2017, the Economic Survey suggested Public Sector Asset Rehabilitation Agency or PARA, to buy out the largest NPLs from Indian banks. Recently, in proposing Project Sashakt, a five-point plan to revive Indian banks, the Sunil Mehta panel suggested that a new Asset Management Company (AMC) be set up to tackle mammoth bad loans of over ₹500 crore. The AMC will in turn set up alternative investment funds that will buy up stressed assets in different sectors, from asset reconstruction companies, then try to auction them off to raise cash. However, the global experience with such methods suggest that they often don’t deliver results.

In 1999, China set up four state-controlled AMCs — Cinda, Huarong, Great Wall and Orient — to mop up bad loans from the country’s ailing banks. In 2012, after teetering on the brink of a payments crisis, Spain set up a bad bank — Sareb — to take over about €50 billion worth of property and loan assets from the country’s ailing banks, with the intention of turning the loans around. But while the bad banks of China and Spain have helped take doubtful assets off the banks’ hands, they themselves haven’t succeeded in fully restructuring these assets or making money off them. China’s AMCs have found restructuring not so lucrative, and have ventured into lending and investing in foreign bonds for profits. Spain’s Sareb has remained a loss-making entity from the word go.

If you’re a bank depositor or an investor in bank stocks, don’t cheer too soon for the bad bank idea.

If you are in the habit of accumulating a lot of useless stuff at home, you have two options. You could sell off all the stuff at raddi value, write off the money you spent on it, and start on a clean slate. Or you could refuse to sell at raddi value and lock all of it in a room.

The bad bank idea is the equivalent of the second option. When banks offload their non-performing assets to a bad bank, they’ll have to take immediate haircuts on the value they realise from those assets. If they refuse to do so, they’d be stuck with the loans. Also remember that someone has to cough up the capital to fund the AMC. If that someone is domestic banks, we’re back to square one.

You can pass the parcel on bad loans to a bad bank, AMC or AIF. But when the music stops, someone has to the pay the price and that’s likely to be the taxpayer.

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