Why a ‘bad bank’ may not work well

Madan Sabnavis | Updated on January 15, 2021

While shifting toxic assets to a bad bank will help banks lend more, it does not address the core issue of NPAs

Bad bank is an idea which comes up every year before the Budget because there are expectations that the concept will finally germinate with the government setting aside funds for its formation. The thought evokes arguments which are relevant today as we have a situation where we have high level of NPAs (non-performing assets) and the future is uncertain. Also, there have been several attempts made to resolve the issue, with the IBC (Insolvency and Bankruptcy Code) being the latest, but the progress has been limited. More importantly, the quantum of NPAs is likely to increase post returning to normalcy.

Simply put, the bad bank buys all NPAs or some of the larger ones of public sector banks (PSBs). The balance sheet of the sellers shrink as these assets are off their balance sheets. This saves capital for banks which can start fresh lending. Besides, banks are lending agencies and should ideally spend time more on business rather than recovery.

There can be different models of the bad bank which can buy loans of the private banks too and hence work for the system. But one should remember that while the NPAs can be transferred from the bank to the bad bank, the overall quality of the loan portfolio of the country does not really change. It also means that there is a write-down of the asset which is still a loss for the system.

The RBI’s recent data show that the average recovery rate on NPAs through IBC, ARCs (asset reconstruction companies), DRTs (debt recovery tribunals) and SARFAESI is 23.2 per cent; this is pushed up due to IBC that has a recovery rate of 45 per cent. The performance of others is lower, ranging between 4 per cent and 27 per cent.

There is little reason to expect that the bad bank will do better than this. Hence we will not really be solving the problem, but merely transferring it to another entity which makes the balance sheets of banks look better. In turn, banks may find it easier to raise capital in the market.

While the bad bank will address the issue of freeing capital of banks which is a positive outcome, it does not address the core issue of NPAs — that is, why do they keep rising? A certain amount of NPAs are bound to exist in any system as some firms will fail and a thumb rule can be that a rate of around 4 per cent should be tolerable in an emerging market where risks are high, given the economic environment. The spurt in NPAs is often due to systemic issues that are not addressed.

Not a simple business

Directed lending, where banks in the public sector perforce have to lend to certain segments, is the main factor which goes beyond RBI regulation. Often sectors such as SMEs become the pivot for the government which, in turn, compels PSBs to meet targets. Giving quick loans have merits but banking is not a simple business which can be run on algorithms.

The other factor that leads to such pile up of NPAs is the constant restructuring of debt. The lesson of the 2011 lending story which was directed to infra has not yet been absorbed and the justification of such acts leads to this pile-up. Unless this changes and banks are given the freedom to run their books as a business and not as a conduit for bringing about social change, these challenges would always surface.

Therefore, a bad bank can keep absorbing the NPAs at a written-down cost from banks, and this will be a perennial stream. This may not be the idea of a bad bank as such a bank is supposed to deal with a stock of NPAs and not the subsequent flows. Else, it creates the economic moral hazard on the part of both the banks which lend and the customers who borrow as this becomes a perverse win-win situation for everyone.

Bank capitalisation is a better idea. Let us see how this plays out. PSBs tend to create more NPAs as they perforce become the instrument of change for successive governments. As the NPAs increase, provisions have to be made which lower their profit or leads to losses and which, in turn, denudes their capital.

In such a situation, the bank cannot lend, and this is where the government has stepped in through capitalisation measures. Ideally, the government makes provisions in the Budget for capitalising banks. The other innovative financial engineering is the recapitalisation bonds. The government issues bonds which are subscribed by banks which in turn is passed back to the banks as capital. There is no transfer of funds in effect and the government pays an interest to the banks on the bonds that have been subscribed. Either of these actions is appropriate because the PSBs are owned by the government and in a way pays for the NPAs.

However, when a bad bank comes in things will be different. The bad bank has to be funded by the government and probably investors would put in their share. Investors may not be interested as there are already ARCs in the system which have not really been effective. The problem with ARCs was that they wanted banks to take a higher hair cut which was not acceptable.

A government funded bad bank will have less of an issue as PSBs will happily sell to the bank at any price as both the entities are government owned. Once private investors join the BB, things will be different, and will resemble an ARC with government ownership.

Therefore, the ownership structure of the bad bank will determine the likely success of the enterprise which transfers bad assets to a central agency.

The bad bank concept hence looks like an escape route to deal with NPAs. Prudence dictates that we persevere with the IBC and probably expedite processes as it has proved to be a good option. Alternatively, providing capital directly shifts the onus to the government which may be more appropriate.

The writer is Chief Economist, CARE Ratings. Views are personal

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Published on January 15, 2021
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