bad bank: can the “bad bank” save our struggling economy?



The Indian economy has been reeling from non-performing loans for some time now, and the government and the Reserve Bank of India (RBI) have, over time, introduced several measures to contain the growing growth of distressed assets. Even before the COVID-19 pandemic, the existing stress had slowly but surely turned into a crisis. Unfortunately, with the COVID-19 pandemic affecting all economic sectors, this problem has worsened. Enter: ‘Bad bank’. The term has once again found itself in the limelight after the finance minister’s annual speech on the 2021 budget. While many hope it may be the need of the moment, others are quite skeptical. because of India’s previous experience in this area.

Proposal for the creation of a failing bank

The annual budget provides for the establishment of a bad bank in the form of an asset reconstruction company or an asset management company. This entity will buy distressed assets from banks, restructure them and sell them to investors, seeking to resolve them over time. In the process, banks that sell these stressed assets will be able to clear their balance sheets and the negative implications that flow from them and use their capital more optimally.

Impact on stress and potential challenges

In today’s pandemic-hit market, the RBI has granted various eases to borrowers (in the form of an option to benefit from a loan moratorium or loan restructuring). However, a similar easing has not been given to banks, which are expected to continue to repay their bonds. Therefore, transferring stressed assets from a bank’s books could provide banks with much-needed respite. In general, banks:

  • be able to focus on loans rather than loan collections
  • have free capital that can be used more efficiently, as there would be no need to make additional provisioning in relation to the bad debts transferred
  • see an improvement in credit scores
  • potentially see an overall improvement in banking operations as investors, depositors and borrowers are more likely to engage with profitable banks.

India’s previous experience with bad banks seems to have left a feeling of skepticism. In 2004, when IDBI Limited’s bad debts were bought out by a government fund, neither the fund earned sufficient value, nor IDBI Limited’s loan record significantly improved. Critics therefore view the bad bank as an eye drop on liability.

This time, however, it appears that the proposal to create a bad bank is framed differently, drawing on experiences from around the world. We understand that it is proposed that the bad bank be set up by state banks and private sector banks, without any capital injection from the government. This bad bank will buy stressed loan accounts exceeding Rs 500 crore against the issuance of security receipts to a wide range of investors, including alternative investment funds (AIFs). There could potentially be a sovereign guarantee to back up securities receipts, but that would basically be to help banks meet regulatory requirements. Assuming that banks will in fact be relieved of significant stress by only paying off bad loans that exceed Rs 500 crore, there are many bright spots here:

  1. Partial ownership of the bad bank by private banks is likely to improve price discovery and the related transparency of the sale of distressed loans by banks.
  2. Only part of the ownership by government banks translates into a lesser burden on the chessboard.
  3. With the support of a sovereign guarantee, private banks are likely to be encouraged to participate in the capitalization of the bad bank.
  4. Allowing AIFs to invest in the wrong bank would broaden the capital pool and involve market participation.
  5. The various credit guarantee programs introduced by the government to improve the accessibility of cheaper credit to micro, small and medium enterprises (MSMEs) could bear fruit, as banks will have greater availability of capital to lend to individuals. MSME.

If one can draw inspiration from the success of bad banks in foreign markets, its impact on the Indian market depends on its implementation. For the proposal to work effectively, the government and the RBI must ensure that enough bells and whistles are in place – with a potential eye on improving lending behavior.

For example, ensuring that banks don’t compromise their due diligence just because a bad bank will back it up. The price at which stressed assets are transferred is also an important factor, especially when the transferring bank is an investor in the bad proposed bank. In addition, drawing on the experience of Germany and Sweden, it would be extremely beneficial to call on the expertise of troubled asset management professionals to manage failing banks.

The proposal to create a bad bank may be a positive measure to temporarily relieve banks of their stress, given the current market situation particularly exacerbated by the pandemic. That said, it may be relevant to note that transferring stress from one entity to another should not be seen as a way to solve the problem of stressed assets.

(The authors are Anish Mashruwala, partner and Neelasha Nemani, partner at J. Sagar Associates)

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