Bad bank: "EMPOWER IAS"

In news:

• The article explains the important role bad bank can play in cleaning up the balance sheets of the banks.

 

How India banks dealt successfully with pandemic

• Indian banks were written off in the early days of the pandemic due to expectations of an exponential jump in non-performing assets.
• Only after the banks consistently talked about the lower number of restructuring requests, and the higher provision coverage ratios that the markets began to get convinced.
• What finally turned the corner were the budget announcements related to the financial sector
• There are several reasons for this good performance by the banks.
• First, banks in India and globally were much better capitalised prior to the pandemic.
• Second, Indian banks had built up a sizeable buffer to provide for bad assets negating any surprise on balance sheets during and even after the pandemic.
• Third, independent research shows that as the size of the middle class grows to about two-thirds of Asian households.
• Banks in Asia, including in India, have begun to adjust for this steady growth in the size of pie by experimenting with new business models, rationalising costs and providing faster and superior customer digital experience, as was clear during pandemic.
• Fourth, Indian banks and the RBI brought about financial discipline much before the pandemic.

 

Creation of Bad Bank

• The budget this year has the provision for reation of a bad bank.
• The proposed structure envisages setting up of a National Asset Reconstruction Company (NARC) to acquire stressed assets in an aggregated manner from lenders, which will be resolved by the National Asset Management Company (NAMC). 
• A skilled and professional set-up dedicated for Stressed Asset Resolution will be ably supported by attracting institutional funding in stressed assets through strategic investors, AIFs, special situation funds, stressed asset funds, etc for participation in the resolution process.
• The net effect of this approach would be to build an open architecture and a vibrant market for stressed assets.

 

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: Th e 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.

 

Associated 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.

 

How it will work

• Banks may first transfer those assets to the proposed bad bank with a 100 per cent provision on its book and then based on the experience they will decide on transferring assets with less than 100 per cent provisioning at a later date.
• It is also being speculated that of the total amounts recovered, a specified percentage will be in the form of security receipts.
• These receipts will reside in the bank balance sheets, but will carry a zero-risk weight, with full government guarantees for a specified period of time.

 

How it will benefit the banks

• The benefits of this process includes the recovered value, and significant lending leverage because of three factors:
• One, capital being freed up from less than fully provisioned bad assets.
• Two, capital freed up from security receipts because of a sovereign guarantee.
• Three, cash receipts that come back to the banks and can be leveraged for lending, also freeing up provisions from the balance sheet.
• There are several international success stories of a bad bank accomplishing its mission and there is no reason to believe why India cannot accomplish its objective.
• The current Indian approach will drive consolidation of stressed assets under the AMC for better and faster decision making.
• This will free up management bandwidth of banks enabling them to focus on credit growth, leading to an enhancement in their valuations.
• Governance of the AMC and its independence is central to its successful functioning, there are multiple suggestions to make.
• These include keeping majority ownership in the private sector, putting together a strong and independent board, a professional team, and linking AMC compensation to returns delivered to investors

 

Merits of Having Bad Bank–

• Banks’ Burden is Reduced: The burden of recovering those loans is reduced for other banks.
• Specialisation leads to faster recovery: Speed of recovery will be better as Bad Bank’s main work is recovery and they are specialised in that.
• Positive Impact on Financial Sector: Bad Bank will help improve the banking sector’s health and fasten the recovery aspects of ailing by putting back frozen assets back into economic circulation.
• Increased Profitability of Banks: Bad Bank increases profitability of other banks as they can focus more on lending, acquiring more customers and upgrading technology without spending too much time on recovery or resolution of bad loans
• Feasibility: Bad banks can make profits as they usually keep high margin before acquiring the bad loans. The concept of Bad Bank has been implemented in other countries including Sweden, Finland, France and Germany.

 

Demerits of Bad Bank-

• Shifting of Problem: Former RBI Governor Raghuram Rajan had opposed the idea of setting up a bad bank in which banks hold a majority stake. He was of the opinion that bad bank idea as merely shifting loans from one government pocket (the public sector banks) to another (the bad bank).
• Reckless Lending: Other banks may not concentrate on the quality of loans as they always an option of shifting bad loans to ARC/ Bad Bank. This leads to doling out loans without proper diligence leading to reckless lending
• Efficacy Debate: Bad banks may not acquire critical loans which are difficult to recover and only concentrate on easily recoverable loans. As a result, troubled Commercial banks continue to face the issue of bad loans. There is also the fear that it end up as another case of throwing good money after bad.
• Profitability of Banks: High margin of Bad banks may curtail the profits of other banks which can in turn impact their lending capabilities.
• Moral Issues: Due to pressure bad banks may employ some unethical ways to recover loans. Another issue is that other banks may not show the actual position of loan accounts by doing window dressing.