Bad bank is actually a good idea
The concept of a bad bank was brought to light when our Minister of Finance recently announced in the Union budget that an Asset Reconstruction Company (ARC) and an Asset Management Company (AMC) would be created to deal with the stressed debt of 2.25 lakh crore in the banking sector. .
The main objectives of the creation of the bad bank are (a) to clean up the balance sheets of banks in India, (b) to enable banks to reach the required level of equity by raising new capital from the market, and ( c) focus on credit growth to stimulate investment and ultimately economic growth. Essentially, a bad bank would help Indian banks cut their losses and focus on their core business, credit. Let’s discuss the same in detail.
Bad debts at a glance
Risk is inherent in any business, and even more so in the bank. Assets under pressure for Indian banks have grown due to a host of factors such as the persistent global economic slowdown exacerbated by Covid-19, stalled infrastructure projects associated with cost overruns, undue delay in obtaining various authorizations, land acquisition problems, etc.
According to the Reserve Bank of India Trends and Progress Report 2020, the gross non-performing assets (GNPA) of Indian banks reached 8.2% (equivalent to 9 lakh crore) at the end of March 2020 against 9.1% (equivalent to ₹ 9.36 lakh crore) at the end of March 31 . 2019. In fact, Public Sector Banks (PSB) GNPAs stood at 10.3% (equivalent to 6.78 lakh crore) as of March 31, 2020.
The rapid growth of credit during the period 2005-12, coupled with the absence of strong standards of credit assessment and supervision and deliberate defaults are the main reasons for the huge amount of bad debts during of the last period. Although the absolute volume of GNPA of Indian banks decreased slightly, mainly due to massive amortizations amounting to 2.38 lakh crore in 2019-2020, the total of restructured standard advances fell from 0.36% to 0.43% in March 2020, reflecting the onset of stress in the sector.
The increase in GNPA would have been even higher in the absence of the status quo on asset quality provided by the RBI as a Covid-19 relief measure. The RBI predicted in its report that the asset quality of the Indian banking system could deteriorate sharply in the near future. To remedy this, the Economic Survey suggested the recapitalization of banks as well as the consolidation of their balance sheets.
The proposed bad bank is better than the existing asset rebuilding companies because it will be owned by the government. Once NPAs are transferred to the bad bank, PSBs do not need to resort to higher provisioning and would be better placed to raise capital in the market. Since there has been a sharp increase in discount rates from 30 to 60 percent of the carrying value of bad debts due to the regulatory standard of 15 percent upfront cash payment by CRAs, the timing from the wrong bank is appropriate.
Banks in India have been very slow to sell assets to existing ARCs as neither ARCs nor banks were prepared to bear the losses which prolonged the recovery process.
The path to follow
Over time, a vicious circle has formed in the Indian banking sector: increasing the level of the NPA requires higher provisioning, resulting in lower capital adequacy and moderate levels of profitability. This further leads to moderate growth in lending capacity which in turn increases NPAs. Banks specialize in lending, but not in solving gigantic stressed assets; they neither have the required level of legal expertise nor the environment conducive to the recovery of MPAs.
In addition, banks need to focus on building the capacity and re-qualification of their internal staff in loan recovery, risk management, etc. in order to stay ahead of the learning curve.
While the government is willing to privatize PSBs, this can amount to a massive sell-off at unattractive valuations. In this scenario, a bad bank seems like a good idea among the options available. If the failing bank is designed with a good business model, it can also solve the dual problem of India’s balance sheet and the problem of capital adequacy.
To ensure the success of the bad bank, the evaluation of NPAs must be undertaken by recognized, professional and independent institutions. However, establishing the wrong bank is not that easy given the Indian government’s off-balance sheet exposure and other legal hurdles.
Srikanth is Associate Professor, National Institute of Rural Development and Panchayati Raj, Hyderabad, and Saravanan is Professor of Finance and Accounting, Indian Institute of Management Tiruchirappalli