How The Idea Of A ‘Bad Bank’ Made A Comeback

Nudged by the government, the IBA is once again proposing the creation of a bad bank. Will it work this time?

SBI Logo sits on the entrance of its Peddar Road branch, Mumbai, (Photograher: Anirudh Saligrama/ BloombergQuint)
SBI Logo sits on the entrance of its Peddar Road branch, Mumbai, (Photograher: Anirudh Saligrama/ BloombergQuint)

The Indian Banks’ Association has once again pitched the idea of creating a ‘bad bank’ to help lighten the load of stressed assets on the books of Indian lenders.

The problem of bad loans has plagued the Indian banking sector since at least 2015 now. Over the last few years, structures akin to a ‘bad bank’ have been pitched by many, only to be discarded for reasons ranging from lack of capital to lack of buyers of stressed assets.

The decision to bring the proposal back to the table was driven by concerns that risk aversion in the banking system will delay any relief provided to the economy via relaxed regulations for lending and increased liquidity.

After a nudge from the government to find solutions, the Indian Banks’ Association brought back the idea of a ‘bad bank’ and is now working on a detailed plan, two senior bankers told BloombergQuint on the condition of anonymity.

According to an internal presentation circulated by the IBA among lenders, banks would invest cumulatively Rs 100 crore into a National Asset Management Company. There NAMC will, in turn, hold a special purpose vehicle called National Asset Reconstruction Company, which would be capitalised by the government to the extent of Rs 10,000 crore. BloombergQuint has reviewed a copy of the presentation.

According to five bankers, including the two quoted above, the bad bank would start with a book of about Rs 70,000-75,000 crore worth bad loans.

The bad bank would pay at least 15 percent of the net present value of the assets upfront in cash and the rest will be paid in the form of security receipts, which can be redeemed by banks in the future. The bad bank would aggregate stressed assets from across the banking system and lead resolution efforts.

The NAMCL would complete its due diligence within six to nine months before making an offer for the asset. The entire process will be concluded without interference from bankers, which would help in avoiding conflict of interest. The IBA believes that since the asset transfers are being done with government backing, bankers will not be opposed to selling assets even with a haircut.

As per the proposal, assets will be purchased till March 31, 2021, after which acquisitions will stop. The NARCL would then have a life of 10 years to resolve these assets, after which the security receipts issued by it would be redeemed.

The proposal is now likely to be submitted to the government and Reserve Bank of India for approvals.

Where Have We Heard This Before?

In 2004, when IDBI was converting to a bank, the government created the Stressed Asset Stabilisation Fund, which housed stressed assets worth Rs 9,000 crore of the bank’s stressed assets. The transfer of assets between the bank and the SASF was achieved through a complex structure where the government extended loans worth Rs 9,000 crore to the fund, which invested the money in redeemable government securities with a 20-year tenor. The securities were then swapped for the assets on the bank’s book.

According to the 125th report of the Public Accounts Committee of the Ministry of Finance, submitted for the year 2018-19, only Rs 4,514 crore in bad loans were recovered. The committee noted that the recovery of the rest of the assets remained “complex and difficult”.

In 2015, when the RBI embarked on an asset quality review of the sector, bankers proposed that the non-performing assets detected as part of the review be parked in a bad bank. Raghuram Rajan, who was then RBI governor, was opposed to the idea and felt that private asset reconstruction companies should take the lead in buying bad debt and resolving it.

In the economic survey for 2016-17, then Chief Economic Adviser Arvind Subramanian also suggested a bad bank. The idea found the support of former RBI Deputy Governor Viral Acharya in a speech in March 2017.

Once again, in July 2018, a group of bankers, led by then Punjab National Bank Chairman Sunil Mehta, proposed an AMC/ARC structure to manage stressed loans. The Mehta committee had suggested that multiple such AMCs be created and investments be sought through AIFs set up by banks. The committee also suggested that bank ownership in the AMCs and AIFs be limited to avoid conflict of interest.

Will It Work This Time?

For a bad bank to be effective in unclogging the pipes of the financial system it needs to take away a meaningful chunk of bad loans from banks.

A senior private sector banker, one of the five quoted above, said the initial proposed size of the bad bank seems too small to make any material difference across the system. This banker added that pricing mismatches between the buyer and seller, which have plagued private ARCs, will persist even under the bad bank structure.

At an estimated size of about Rs 75,000 crore, the stressed assets that would be parked in this entity would be less than a tenth of the banking system’s gross non-performing assets of about Rs 9 lakh crore.

Another challenge will be to get the sector together on this.

The head of stressed assets resolution at a large state-owned lender said that while the IBA and the government can create the structure, compliance will depend on the view taken by individual bank board. If a sizeable number of banks do not participate in the sale process, the idea would likely fail, the official said.

Saswata Guha, director for the financial institutions group at Fitch Ratings, said a number of questions remain unanswered.

“A lot of fundamental questions with the bad bank approach still remain unanswered. Is it expected that banks will fund this entity? If so, do banks have requisite capital? Without adequate liquidity, the bad bank will not be able to make much of a difference in the current scenario,” Guha said. He added that since a large chunk of bad loans are on the books of government-owned banks, the structure would need maximum equity support from the state.

Guha also cautioned that such a structure could just end up becoming a warehouse for bad loans if no recovery happens.

In India, stressed assets have been in problem for a while and it is more structural in nature. Whether a bad bank will be able to turn the impaired assets around and make profit on its investment remains a question.
Saswata Guha, Director - Financial Institutions Group, Fitch Ratings