It’s Budget Season. And That Means Talk of a ‘Bad Bank’ Yet Again.

With the RBI governor open to taking a look at a proposal if it is presented, if we see one next week, surely a wider debate will be in order.

In a public lecture almost two weeks ago, Reserve Bank of India (RBI) Governor Shaktikanta Das stated that if a proposal for the creation of a ‘bad bank’ was put forward, the monetary regulator would look at it.

While a ‘bad bank’ has found itself the subject of many pre-budget discussions in past years, Das’s statement means that all eyes are on the ensuing budget on February 1. Will she? Or, won’t she?

There are problems aplenty for a pandemic-hit economy. Indeed, finance minister Nirmala Sitharaman has one too many on her plate. And, yet, the bad loans of banks could yet prove the biggest of her worries.

Public sector banks alone are sitting on a large pile of bad loans. In his recent talk, the RBI rightly pointed out that the banking system is already familiar with asset reconstruction companies (ARCs) and the modalities of their functioning.

These ARCs are akin to the vulture funds that are popular in western economies. They buy distressed loans cheaply and squeeze maximum value out of the assets available as securities to the distressed loans. Thus, a loan of Rs 100 that has an asset secured against is taken over at say Rs 25 and the vulture fund would try and maximise the realisation of the security and may get say Rs 40 and make a profit of Rs 15. Of course, there would be instances where the realisation may actually result in a loss as well. These funds have built-in capabilities – essentially the legal expertise – to squeeze the borrowers and extract the maximum pound of flesh.

ARCs in India have not made much impact, however.

The bad bank concept is in some ways similar to an ARC. The way it is conceived and funded, however, could be different. Simply put, a bad bank essentially is established to separate the stressed assets held by a regular bank from its performing assets. Once the separation is done, the stressed assets go off the balance sheet of the regular bank. This enables the cleaning up of the regular bank. At the same time, the bad bank takes over the servicing of the transferred stressed assets and their liquidation over a period of time.

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A stock-taking of the situation will give a clue or two to the emerging grim scene on the bad loan front. Bad loans in the banking system are expected to balloon. The fear is after all not unfounded. The contraction in the economy – which has slipped into a negative zone in the wake of COVID-19 – has put many sectors in a virtual disarray. In its recent Financial Stability Report, the RBI has indicated that the gross NPAs (non-performing assets) of the banking sector could scale up to 13.5% of advances by September 2021, from 7.5% in September 2020, under the baseline scenario as “a multi-speed recovery is struggling to gain traction” amidst the pandemic. Should the macro economic environment degenerate into a severe stress scenario, the ratio may escalate to 14.8%. The NPA ratio of public sector banks, which was 9.7% in September 2020, could increase to 16.2% by September 2021 under the baseline scenario, according to the RBI.

The K.V. Kamath Committee, which helped the RBI to design a one-time restructuring scheme, has estimated that debt worth Rs 15.52 lakh crore of the corporate sector to be under stress after COVID-19 hit India, while another Rs 22.20 lakh crore was already under stress before the pandemic. This effectively means Rs 37.72 crore (72% of the banking sector debt to industry) remains under stress. This is almost 37% of the total non-food bank credit. According to the committee, sectors such as retail trade, wholesale trade, roads and textiles are facing stress. Sectors that have been under stress pre-Covid include NBFCs, power, steel, real estate and construction.

Coming as it does against these backdrops, the bad bank idea assumes considerable importance, even if it is bound to ignite intense heat in political and economic discussion platforms.

To be sure, the ‘bad bank’’s origins go back to the late 80s. A fall in real estate and oil prices combined to push many banks in the US on the verge of collapse. Pittsburgh-based Mellon Bank was the most hit among them. Mellon created a new bank in the name and style of Grant Street National Bank (GSNB) and transferred its toxic assets. The purchase of toxic assets by GSNB was funded by a public issue of extendable pay-through notes and dividend of shareholders of Mellon. After nearly eight years, GSNB went out of existence following liquidation of the toxic assets. Following Mellon’s experiment, the US government set up Resolution Trust Corporation, an asset management company, to take over the stressed assets of banks that were declared insolvent.

Japan subsequently took a leaf out of the American experience. Thus came into being a Credit Co-operative Purchasing Company which bought the stressed assets of the Japanese banks at a discount. In this instance, the Credit Co-operative was funded by the banks which sold it the toxic assets.

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In Europe, Sweden was among the earliest countries to set up a bad bank. The bad bank in this case was funded by a combination bank loan and government equity infusion. Post the 2008 global financial crisis, Germany came out with a law to address the toxic asset issue. The Germany model provided for a twin model – one to address the problems of private banks and the other the public ones. Here, these special purpose entities issued government-guaranteed bonds to the stressed asset transferring-banks. Ireland and Spin, too, followed the Mellon experiment in 2009 and 2012, respectively.

So, the bad bank concept is not something new and has been in vogue in different countries in different formats. The core of the concept is the separation of stressed assets from banks. Indeed, there are multiple possibilities to do this. Should it be done within through a separate entity? Should it be done through floatation of a special purpose entity? Should it be done through the establishment of a separate bad bank? There are many ways of separating the stressed assets.

A man counts Indian currency notes inside a shop in Mumbai, August 13, 2018. Photo: Reuters/Francis Mascarenhas/Files

The bad bank that is being discussed at the moment perhaps calls for transfer of all toxic assets in the banking industry into one entity. This throws up many questions. Who will fund this? Who will manage this? What will be the transfer price for toxic assets? What is the time-frame for such a bad bank to liquidate the toxic assets? Indeed, it calls for a wider discussion. Should the country go in for such a bad bank, what will be legal requirements for establishing that?

One thing is irrefutable, however. The Indian legal system, riddled with the political overlay in any economic endeavour, has often proved to be the Waterloo of the insolvency and recovery process. The securities may often be fictional, like a real estate with disputed title or, more outrageously, stock-in-trade that exists only in the computer system but not in the warehouses. The influence of the borrower in the society and multi-various factors may decide the pace and level of recovery. The performance of the insolvency system in the last five years of its existence will attest to the truth of this.

This is one facet of the discussion. There is another side, too, to this. The bank which sold its loan of Rs 100 for Rs 25 has to account for the loss of Rs 75. It may have to find an equivalent new capital or accumulated profits to set it off. To put this into context, assuming that the bad bank can come into existence and acquires the bad debts of say Rs 20 lakh crore at say a 30% value, the amount of Rs. 6 lakh crore has to be found by the government to be infused into the bad bank to buy off the toxic loans. The banks will need new capital and reserves of Rs 14 lakh crore to make their balance sheets tally! Such figures don’t exist in our economy. So much so, all PSBs will be functioning with huge accumulated losses, which, technically, represent an insolvent state. The bad bank has Rs 6 lakh crore of taxpayers’ money represented by distressed assets covered by so called securities. Considering that the bad bank will have a ‘sarkari’-style of functioning, it is not difficult to visualise the potential outcome.

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There is a different argument, though. According to this, the banks have anyway written off these toxic loans (as mandated by the rules of the Reserve Bank of India). Any recovery, even if marginal, could only add up to its income, it is further argued.

The moot point, however, is: Whose money is this for banks to just them write off? Somebody must be paying up for the loss. Just because the ultimate payer remains invisible, banks cannot arrogate themselves the luxury of simple write-off. Notwithstanding the numerous positives in creating a bad bank, there are plenty of negatives that could not be wished away or at least require careful scrutiny before making a `bad bank’ decision.

For one, a bad bank could set in a sense of nonchalance at the decision-making process in a loan disbursal. Anyway somebody is there to take over the stressed assets. This sort of thinking could result in less than fair due diligence while granting a loan. For another, a bad bank could also come under external influence -–political or otherwise – in their decision-making process.

This could be worse still for the system as a whole. Since the toxic assets are palmed off to the bad bank at a discount, there could be a forced-selling of toxic assets of similar kinds at deep discounts. What is required is a legal framework that facilitates a bad bank to carry out its task hassle-free sans interference of any kind. Besides all these, this calls for staffing a bad bank with sufficient number of really-trained personnel in managing and recovering the stressed assets.

Ultimately, the Indian government has so far been hesitant to go ahead with the idea of a bad bank. If we see one next week, surely, a wider debate will be in order.

K.T. Jagannathan is a senior journalist based out of Chennai. V. Ranganathan is a chartered accountant based out of Chennai.