Why setting up a ‘bad bank’ is a bad idea

The severe slowdown in the economy caused by the lockdown — now well into its second month and likely to continue in a modified form — is sure to send banks’ non-performing assets shooting up. Seeing this, banks, through the Indian Banks Association, have refloated an old idea — creating a ‘bad bank’.

The idea, last formally proposed a couple of years ago, has not found a taker in the government. This is because the NDA government has become increasingly careful about keeping the fiscal deficit under control and does not wish to spare the cash needed to capitalise the bad bank.

The structure that has been proposed is that of an asset reconstruction company, which will take over already heavily written-down bad debts of banks, pay in cash and security receipts, the latter then sought to be traded in a secondary market. The government’s declared position is that since in the last few years, banks have been recognising NPAs for what they are and writing them off; and the government has on its part recapitalised the banks to compensate for the write-offs, there is no need for a bad bank.

But that was the pre-coronavirus era. The present is an entirely different ball-game, with none knowing when the economy will get back on its feet to reach the pre-lockdown level of economic activity, and how long it will take to achieve a respectable rate of growth. The great fear is if there is a surge in infections after some relaxation in the lockdown, the government may have no option other than reimposing a stricter lockdown. That will put paid to hopes of reviving economic activity.

Skin in the game

The government is also seriously plagued by the inability or unwillingness of banks to lend to NBFCs, HFCs and MFIs even though the RBI has opened enough windows to make available the necessary liquidity. Banks are reluctant to lend because those in the shadow banking sector most in need of cash do not have an investment-grade rating. Going by the current RBI guidelines, banks will have to lend to them at their own risk.

As these are totally exceptional times which are being likened to the Great Depression of nearly a century ago, the regulators have to do unconventional things. What the RBI and the government can do is take a look at the way central banks in the US, Europe and Japan are ready to embrace the idea of buying paper directly from governments (known in popular parlance as ‘printing money’) to help fund their stimulus packages.

The RBI and the government can, in particular, look at what the US Federal Reserve and the US Treasury are doing. The Fed has made dollars available to foreign countries for their dollar swap programmes and financial firms facing a rush of individuals wishing to get out of securities and into cash. It is also buying bonds directly from not just big companies but also from small businesses (never done before), bypassing nervous banks. Additionally, it is buying bonds from local governments with welfare expenditure commitments, as the municipal bond market has dried up.

In funding large and small businesses as also municipalities, the US Treasury is also putting in funds, thus indicating its skin in the game and sharing the risk. These moves by the US Fed have boosted overall demand and lowered interest rates. The main concern of Indian banks in lending to shadow banks is that the government is not sharing the risk. If some of the US practices are adopted in India, then its economy can get a demand boost by bypassing reluctant banks. Hence there will be no need to immediately relieve banks of their bad debts through a bad bank so as to get them to lend aggressively. Banks can go on with their regular asset classification and write-offs.

PSB governance

Further, the idea of a bad bank is not such a great one because it takes care of the stock of bad debts, and not the flow. If banks’ balance sheets are considerably cleaned up, they will have both the resources and the mental frame to start lending again. But the critical problem is that if PSBs, which account for two-thirds of the banking sector go on doing business the way they have been doing in the past, then over time there will be a pile-up of bad debts again.

So long as PSB managements remain beholden to politicians and bureaucrats, their deficit in professionalism will remain. The Banks Board Bureau, when it was set up, was meant to improve the quality of senior bank managements and act as a buffer between them and the rest of the world, so that they could go on functioning professionally without having to look over their shoulders.

Currently, morale in public sector banks is extremely low, particularly in the new entities that have emerged as a result of mergers. Officials of banks which have been merged remain worried about their seniority and also have a problem with the brand name. The brands they used to work for are no longer there, and developing a loyalty to a new brand will take time. Setting up a bad bank before setting right the governance of PSBs is to get the sequencing wrong.

The writer is a senior journalist

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