The aggregate non-performing assets of the banking sector stood at ₹6.5 trillion, that is, 8.6 per cent of loans, at the end of June 2016. Adding another 3.5 per cent of restructured loans, 4.5 per cent of loans which are still to be recognised as NPA or restructured assets, and including stressed assets, the number comes close to 20 per cent of advances, according to a Credit Suisse research report.

Looking at sheer numbers, it should be no surprise that the concept of setting up a bad bank to isolate these loans is being actively discussed .

Ask why Broadly, a bad bank was conceptualised to serve two purposes:

1. De-risk public sector banks (PSBs) and make them more attractive to investors for raising funds, which basically translates to capitalisation

2. To focus on NPAs and stressed assets alone so that PSBs can focus on credit growth

In our case, it may be necessary to extend it to private banks also as most project loans are financed by a consortium of private and public sector banks.

Firstly, to understand the uncertainties associated with a bad bank, let us ask a few questions. Who decides which are the assets to be transferred to the bad bank? Should we go for a mass clean-up and move all stressed assets or look at a select few? In the former case, where will the bad bank find funds to purchase these loans? Surely, the Government doesn’t have that kind of capital. At least, that is how it looks from the meagre allocation of ₹10,000 crore for bank capitalisation in Arun Jaitley’s budget.

Can the RBI’s surplus be utilised, and what are the long-term implications if we were to do so. Should the private sector be brought in? If so, how is it any different from an asset reconstruction company (ARC)? After all, a bad bank is nothing but a government-owned ARC. Should we raise funds from investors by bundling bad loans into bond like securities? In order to make such bonds less risky for investors, the bad loans need to be sold at a significant discount, implying a higher haircut for banks. To make it attractive to private investors and foreign funds, should we back it up with a government guarantee?

Well, to address the capital issue, let us say we pick and choose assets to be sold to the bad bank. According to ministry of finance, the top 20 NPA accounts of PSBs amount to ₹1.54 trillion. Even if we assume that banks agree to take a 50 per cent haircut, we are looking at raising about ₹77,000 crore to fund the purchase. The mere dearth of funds makes it imperative to involve the private sector.

An unreasonable assumption Further, the assumption of 50 per cent haircut is unreasonable, going by the lack of activity in the ARC space. Today, banks are haunted by the thought of investigative agencies questioning their credit calls taken years ago. With their board decisions being scrutinised and top brass being summoned for investigation, bankers don’t seem comfortable taking a call towards a negotiated settlement for their bad loans. As for the brave ones who do, the sheer procedural complication involved in securing approvals from all consortium lenders kills the already stressed company before it reaches the ARC. All these issues will remain for a bad bank.

Secondly, while choosing the assets to be moved, it would be wise to look at only those projects that cannot be revived in the near future. A bad bank should be resorted to only if debt levels are unsustainable; the present RBI recast schemes will not help. Devising a transparent method, free from political interference and conflict of interest, for identifying such projects will be a key challenge in the design of a bad bank. A once-size-fits-all approach will not work.

A bad bank would work better for banks with a sizeable portion of their advances portfolio exposed to unviable projects. In the instant case, a bad bank might not serve its true purpose. Individual PSBs have a higher chance of resolving issues or recovering their dues, since they understand their asset book and clientele better. Further, the time required for execution of the bad bank idea would have costly implications for assets struggling to stay afloat. What is required is greater autonomy to banks in the decision-making process by setting up qualified stressed asset management teams, with targets and incentives, reporting to a central regulatory authority.

The truth is, if the bad bank is going to be government run, banks will want to get rid of their messy loans the easy way. Identification of unviable assets and inability to agree on sale price will continue to be an issue and cause delay The aim should be to cut losses and recover as much as possible. The sooner we understand that, the less fresh capital we need to inject into the system. It is more important to address the root causes so that we don’t fill the bucket with potential bad loans again.

The writer is a Chennai-based finance professional

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