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Bad Bank and debate around it GS: 3 "EMPOWER IAS"

Bad Bank and debate around it GS: 3 "EMPOWER IAS"

In news:

  • The idea of setting up a bad bank often comes up for debate, especially when stress in the banking sector is projected to rise in the near term.

 

Impact of the COVID-19 on banking sector

  • Several economists and agencies project a recession in the Indian economy this year, due to the adverse effects of the pandemic on economic activity. 
  • Probability of rise in stressed assets
    • A slump in earnings of companies and individuals could lead to a jump in non-performing assets.
    • It is being said by various analysts that the proportion of stressed assets in the banking system could jump to as high as 18 percent from around 11 percent at present.
  • Cumulative impact: According to a report by India Ratings and Research (Ind-Ra) 
    • The impact of the pandemic and the associated policy response is likely to result in an additional Rs 1,67,000 crore of debt from the top 500 debt-heavy private sector borrowers.
    • This is over and above the Rs 2,54,000 crore anticipated prior to the onset of the pandemic, taking the cumulative quantum to Rs 421,000 crore.
  • Corporate stress could increase further
    • A scenario wherein funding markets continue to exhibit heightened risk aversion, corporate stress could increase further by Rs 1.68 lakh crore, resulting in Rs 5.89 lakh crore of the corporate debt becoming stressed in FY21-FY22. 
    • Due to this, 20.84 percent of the outstanding debt could be under stress in the agency’s stress case scenario.

 

COVID induced NPAs

  • Several economists and agencies project a recession in the Indian economy this year, due to the adverse effects of Covid-19 on economic activity.
  • This will hit the banking and financial sector in particular, as a slump in earnings of companies and individuals could lead to a jump in NPAs, reversing the early trends.
  • Various analysts suggest that in a couple of years, the proportion of stressed assets in the banking system could jump to as high as 18 per cent from around 11 per cent at present.
  • To tackle this upcoming challenge, the banking industry has proposed the setting up of a government-backed bad bank.

 

What is the Bad Bank?

  • A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution.
  • The entity holding significant NPAs will sell these holdings to the bad bank at market price.
  • By transferring such assets to the bad bank, the original institution may clear its balance sheet—although it will still be forced to take write-downs.
  • A bad bank structure may also assume the risky assets of a group of financial institutions, instead of a single bank.

 

Rationale of Bad Bank

  • Easing Provisioning Requirement: High level of non-performing assets (NPAs) makes the lending difficult for banks, as they have to keep supplementary capital (provisioning requirement) under the  Basel Accord.  This reduces its capital base and the resulting losses erode depositor confidence — the lifeblood of any bank.
    • Bad bank by way of absorbing NPAs, will ease the provisioning requirement by the banks and help them to get on with business as usual.
  • Re-assuring Trust: Moreover, the creation of a bad bank allows the segregation of a bank’s good assets from its bad assets. This allows investors to assess its financial health with greater clarity and for banks to grow financially.
    • Aside from this, a government-led initiative may perhaps make it more palatable or even an attractive opportunity for investors to invest their money- both domestic and foreign.
  • International Precedent: The 2007-2010 financial crises led to the creation of bad banks in many countries.
    • In the US, as part of the Emergency Economic Stabilisation Act of 2008, a bad bank was suggested to address the subprime mortgage crisis (real estate loans default).
    • In Ireland, the National Asset Management Agency was established in 2009 to respond to the financial crisis.
  • Concerns About IBC Code: Many lenders are concerned over huge haircuts they have to endure after a resolution through the Insolvency and bankruptcy code.
    • Also, NPAs in the power sector can't be resolved through the IBC system as factors like the lack of coal linkages and the absence of purchase power agreements make them unfit for a resolution through the IBC.
    • The bad bank structure could help banks park their money to separate agencies to find a solution in a long time.
    • Moreover, banks feel the assets having future demand-supply issues face liquidation under the IBC, a problem that can be solved under the bad bank.
    • Thus, a bad bank may save a defaulting firm from liquidation and closure.

 

Challenges

  • Mobilising Capital: Finding buyers for bad assets in a pandemic hit economy will be a challenge, especially when governments are facing the issue of containing the fiscal deficit.
  • Not Addressing the Underlying Issue: Without governance reforms, the Public sector banks (accounted for 86%, of the total NPAs) may go on doing business the way they have been doing in the past and may end up piling-up of bad debts again.
     
    • Also, the bad bank idea is like shifting loans from one government pocket (the public sector banks) to another (the bad bank).
  • Provisioning Issue Tackled Through Recapitalization: Union Government, in the last few years, has infused nearly Rs 2.6 lakh crore in banks through recapitalisation.
     
    • Those who oppose the concept of bad banks hold that the government has on its part recapitalised the banks to compensate for the write-offs and hence, there is no need for a bad bank.
  • Market-related Issues: The price at which bad assets are transferred from commercial banks to the bad bank will not be market-determined and price discovery will not happen.
  • Moral Hazard: Former RBI Governor Raghuram Rajan had said that a bad bank may create a moral hazard and enable banks to continue reckless lending practices, without any commitment to reduce NPAs.

 

What is the recent proposal of a bad bank?

  • The banking sector, led by the Indian Banks Association (IBA), had in May submitted a proposal for setting up a bad bank to the finance ministry and the RBI.
  • The IBA proposed for having equity contribution from the government and the banks.
  • This was based on an idea proposed by a panel on faster resolution of stressed assets in public sector banks headed by former PNB Chairman Sunil Mehta.
  • This panel had proposed an asset management company (AMC), ‘Sashakt India Asset Management’, for resolving large bad loans two years ago.
  • There were talks about creating a bad bank in 2018 too, but it never took shape.

 

Government’s take on the proposal

  • Following three steps are seen as adequate to tackle the challenge of bad loans by the government
    • Asset reconstruction company
      • The government’s opinion is that bad loan resolution should happen in a market-led way, as there are many asset reconstruction companies already operating in the private space.
    • Capital infusion drive
      • The government has significantly capitalised state-owned banks in recent years and pursued consolidation in the PSU banking space. 
      • In the last three financial years, the central government has infused equity of Rs 2.65 lakh crore into state-owned banks.
    • Insolvency resolution under the IBC
      • Insolvency and Bankruptcy Code(IBC), 2016 provides a time-bound process for resolving insolvency in companies and among individuals.

 

 

What is the RBI view?

  • The RBI has so far never come out favourably about the creation of a bad bank with other commercial banks as main promoters.
  • Former RBI Governor Raghuram Rajan had opposed the idea of setting up a bad bank with a majority stake by banks, arguing it would solve nothing.
  • Rajan argued that a government-funded bad bank would just shift loans “from one government pocket (the public sector banks) to another (the bad bank) and did not see how it would improve matters”.
  • Indeed, if the bad bank were in the public sector, the reluctance to act would merely be shifted to the bad bank.
  • Alternatively, if the bad bank were to be in the private sector, the reluctance of public sector banks to sell loans to the bad bank at a significant haircut would still prevail.

 

What kind of NPA spike is expected during this outbreak?

  • The impact of Covid-19 and the associated policy response is likely to result in an additional Rs 1,67,000 crore of debt from the top 500 debt-heavy private sector borrowers turning delinquent between FY21 and FY22.
  • Given that 11.57 per cent of the outstanding debt is already stressed, the proportion of stressed debt is likely to increase to 18.21 per cent of the outstanding quantum.

 

Way ahead

Alternatives to a bad bank

  • Many experts argue that the enactment of IBC has reduced the need for having a bad bank, as a transparent and open process is available for all lenders to attempt insolvency resolution.
  • The view is that an IBC-led resolution, or sale of bad loans to ARCs already existing, is a better approach to tackle the NPA problem rather than a government-funded bad bank.

 

Former RBI Deputy Governor Viral Acharya has proposed two models:

1) Private Asset Management Company

  • The first model is a Private Asset Management Company (PAMC) which would be suitable for sectors where the stress is such that assets are likely to have economic value in the short run, with moderate levels of debt forgiveness.

 

2) Setting up National Asset Management Company (NAMC)

  • The second model is a NAMC for sectors where the problem is not just of excess capacity, but possibly also of economically unviable assets in the short- to medium-term, such as in the power sector.
  • The NAMC would raise debt for its financing needs, keep a minority equity stake for the government, and bring in asset managers such as ARCs and private equity to manage and turn around the assets.

What is the definition of NPA?

  • Non-performing asset (NPA), a loan whose borrower has stopped repaying interest or principal amount since last 90 or has not repaid 3 EMIs. These NPAs are also called bad loans.
  • A non-performing asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days.
  • The Indian Banking Association has recommended to the Reserve Bank and the Ministry of Finance that a bad bank should be opened in the country to get rid of the problem of this bad loan.