How well will a bad bank work for us?

The Finance Minister, in the Budget of 2020-21, proposed the establishment of a bad bank. There have been commentaries on the need for, and benefits from, a bad bank. Several analysts, including this writer, had advocated, in 2017, the need for establishing a bad bank. It has been four years since and a lot of water has flowed under the bridge. Now that it is finally being launched, can we make the best of a bad bank? Let us lookat how much a bad bank is likely to be of help to us — in today’s context.

The idea of a bad bank has been there since the 1980s when the US and Sweden became its early adopters. Several countries, governments, and banks have since then adopted the idea with mixed results.

Bad bank is actually a good idea

A recent paper by Brei, Gambacorta, Lucchetta, and Parigi (Bad Bank Resolutions and Bank Lending, BIS Working Paper No. 837, February 2020, https://ssrn.com/abstract=3535900) has investigated whether impaired asset segregation tools, otherwise known as bad banks, and recapitalisation lead to a recovery in the originating bank’s lending and a reduction in non-performing loans (NPLs). The results of the study were based on a novel data set covering 135 banks from 15 European banking systems over the period 2000-16.

The main finding was that bad bank segregations were effective in cleaning up balance sheets and promoting bank lending only if they combined recapitalisation with asset segregation. Used in isolation, neither tool would suffice to spur lending and reduce future NPLs. Exploiting the heterogeneity in asset segregation events, the authors found that asset segregation was more effective when: (i) asset purchases were funded privately; (ii) smaller shares of the originating bank’s assets were segregated; and (iii) asset segregation occurred in countries with more efficient legal systems.

So, to what extent does our idea of establishing a bad bank conform to the findings in the BIS paper? Our policy makers may like to keep the above in mind while designing the final blueprint, as well as during implementation.

Beyond the international evidence, I wish to also address, here, the issue of seeming over-confidence in the benefits from a bad bank. Some of the benefits from a bad bank that are often considered as given may deserve a second look. Let us examine them.

The doubtful arguments

1. Bad bank will release capital for the banks and enable them to re-start lending.

There are actually two issues in the above statement. Let’s deal with both of them.

Firstly, will the bad bank help release capital for the banks? In a fair market transaction, a selling bank will sell the bad loan at its fair value. If the book value of a bad loan, net of provisions, is lower than its fair value, the selling bank will make a profit, and thus, have a boost in its capital. Most banks have made a significant amount of provision against their bad loans. But, in the current situation of low profits, most of the banks would have made provisions only to the extent required.

Will the bad bank appeal to everybody’s palate?

Secondly, lending by the banks is today not constrained by capital. Banks lack the risk appetite to lend to lower rated borrowers. While the aggregate credit by banks to commercial borrowers is growing at 5.6 per cent, their investment in government securities is growing at 18.2 per cent. Hence, providing them with additional capital will not help in boosting the level of lending. The public sector banks (PSBs) are relatively more willing to lend to the small and medium enterprises (SMEs), which are perceived to be relatively riskier. However, their shareholder is the government, whose objective is not to maximise profits but to enhance lending to the SMEs. A recent example is the reported sealing, by administrative order, of a branch of a large PSB, since it had not lent enough to street vendors under the PM SVANidhi programme. Such directed lending is well known to suffer from the issues of moral hazard and poor incentives to recover dues from the borrowers.

2. A bad bank will be more professional and hence be better able to recover the dues from the borrowers.

The professionals who are expected to manage a bad bank will be drawn from the same existing system, which has not been able to recover the dues from borrowers to our “desired” extent. The banks, non-banking finance companies (NBFCs), asset reconstruction companies (ARCs), and special purpose funds have been in the business of recovering dues for a long time. If they have been unsuccessful, it is not because there are not smart or sincere professionals in these financial institutions. It has been because of huge systemic bottlenecks that they have been confronting, and are well known by now. Some of these are as follows:

Poorly designed regulations: These have been overly prescriptive on who could buy or sell bad loans, at what price, in which form, and so on.

Slow moving judicial architecture: We have had tribunals overloaded with cases, multiple appeals, and even lopsided laws in favour of the defaulting borrowers. The last part has been corrected, though only partially, by the Insolvency and Bankruptcy Code (IBC).

Lopsided policies and incentives: The FIs have had a culture of setting short-term, pro-cyclical, and sub-optimal goals and rewards for the credit and relationship managers. The balance between the incentives for increasing the loan book and collecting the overdues has traditionally been skewed in favour of the former, at the level of individual FIs. At a macro level, we value the preservation of an insolvent borrower more than allowing it to close down, even when the business becomes uneconomical. This is one of the shortcomings of our IBC, as well. Exits from businesses need to be as smooth as entries into them.

Governance deficiencies: The issues of lack of competence and misaligned incentives with regard to the boards of directors of PSBs is well-known. When was the last time the Board of a PSB was questioned by the shareholders for poor recovery efforts? The poor level of governance in PSBs is on account of the government being the largest shareholder, and its Board and the Management faced with seriously conflicting objectives.

We must have these systemic issues materially addressed. It is unfair to put the blame of the systemic flaws onto merely the specific institutions or professionals.

With a longer-term view, we need to set right the incentives of our lending system. We know that when a private entrepreneur sells her goods on credit, she also needs to be good enough in collecting her dues from the customers. If we think that our financial institutions should be specialists only in lending and not in recovering dues because the latter is a specialised task, it goes against the fundamentals of lending business. The concept of “know your customer” (KYC) encompasses the relationship through the life cycle of a customer.

3. Many other countries have successfully adopted the idea of a bad bank, and hence we can also do the same.

If the practice of establishing a bad bank to solve the problem of bad loans were straightforward, every country would have achieved success with the resolution of bad loans. We know that each country has its own idiosyncrasies of political, economic, social, legal, and regulatory systems.

As the paper cited above demonstrates, we need to understand our limitations and correct them in time, before expecting the bad bank to work well for us. After all, a chain is only as strong as the weakest link in it.

The author is Associate Professor, Finance, at Bhavan's SPJIMR