Beyond bad banks

The Reserve Bank of India Governor recently indicated that he is not averse to the idea of a “bad bank” — a vehicle which uses capital infused by the government and others to acquire sub-standard loans from financial firms and pools them for reconstruction or sale, so that the rest of the system is able to lend freely. With RBI's recent Financial Stability Report estimating that banking sector NPAs may reach 13.5 per cent of gross advances by September 2021 in a baseline stress scenario, it is not surprising that the bad bank idea has re-entered the public discourse. It was mooted by the Economic Survey 2016-17 as a sort of PPP to deal with the ‘twin balance sheet’ woes of banks and India Inc. While the idea may be worth exploring, the timing appears to be a little premature. With the Supreme Court standstill on NPA recognition in place, the true picture on banking NPAs resulting from Covid is as yet unclear. If India’s economy rebounds sharply in the first half of 2021-22, the situation may be less dire than the FSR projects. Prior to the pandemic, bank balance sheets had begun to show significant asset quality improvements. Therefore, the case for capitalising a bad bank generously, which is what an alarmist view of the banking sector leads up to, must be weighed carefully in a time of fiscal constraints. If investment appetite is slow to pick up, this could just lead to public money being parked in it idling when it can be fruitfully invested to spur demand.

A bad bank can be considered if the NPA situation turns out to be dire once accounting is normalised. Even so, it should be created as a one-time move; else, it would contribute to the moral hazard problem, where domestic banks repeatedly build up doubtful assets in every boom period. Banks, public sector ones in particular, should be compelled to improve governance. Effective oversight by the RBI, accompanied by functional autonomy, should replace the arbitrary ways of the CVC and CBI.

A bad bank will also need to be equipped with the skills to ascertain whether a unit can be revived, which entails hands-on knowledge of the sector in question — bankers often fall short on this. Asset reconstruction companies (ARCs), which seek to get the most out of a discounted asset, must be better placed to apply for management control by converting debt into equity. Under the Sarfaesi Act, they cannot easily change the line of business, even as the Bankruptcy Code (IBC) allows ARCs to apply for turning around an entity. The cross-currents between Section 29(1) of the IBC Act and Section 230 of the Companies Act — the former outlawing existing promoters and the latter giving them a chance — must be dealt with. The Centre must go beyond empowering creditors under IBC, to giving debt-strapped businesses a second chance if they are doing things right. Building better sector appraisal and analytical skills within lenders is therefore critical, irrespective of whether India takes the bad bank route or not.