Why bad bank is a good idea

The RBI in the financial stability report (FSR) released in January 2021 highlighted that though the growth in bank credit was subdued, the gross non-performing asset (GNPA) ratio of commercial banks had declined to 7.5% from 8.4% during the quarter ended September 2020.

However, it cautioned that macro stress tests incorporating the estimates of GDP for 2020-21 indicated that the GNPA ratio of commercial banks may increase to 13.5% by September 2021 under the baseline scenario and may escalate to 14.8% under a severe stress scenario. If you take in to account the total advances of Rs 104 lakh crore of commercial banks, a quick back of the envelope calculation tells you the extent of gross NPAs in the system. The FSR further emphasised the need for proactive building up of adequate capital by banks to withstand possible asset quality deterioration.

So, it is in this context that a setting up of a bad bank as mooted by Finance Minister Nirmala Sitharaman during the Budget speech will be a good idea. She was suggesting a mechanism which would help banks to transfer their toxic assets to a separate entity.

This idea of bad bank had also been suggested by Union Minister Piyush Goyal in 2018, when he unveiled ‘Project Sashakt’, which had a five-pronged strategy for resolution of bad loans in public sector banks. Though he did not mention anything about setting up of a bad bank, he had hinted at the guiding principles of an Asset Management Company (AMC) resolution approach, under which an independent AMC would be set up to focus on asset turnaround, job creation and protection. He had also said that the functions of this new company would be aligned with the Insolvency and Bankruptcy Code (IBC) process and IBC laws.

What is a bad bank? A bad bank, as proposed in the budget speech, is not really a bank and hence does not accept deposits and lend money like any commercial bank does. It will be an Asset Reconstruction Company that takes over the bad loans of Public Sector Banks (PSBs), manages them through restructuring, explore turnaround options and resolves them by finding potential buyers. These buyers could be alternate investment funds or vulture investors. The idea is to clean up the balance sheet of PSBs and free them from the burden of NPAs so that they can focus on lending fresh loans.

Of course, the PSBs may have to take huge haircuts as it involves selling of bad loans below the book value. This should not worry them so much as most of the PSBs have already provided for these loans. The Indian Banks Association (IBA) has already started the process by writing to banks instructing them to identify and submit a list of all such NPAs of over Rs 500 crore. The government has said that it will only provide guarantee for the bank. The initial capital which is likely to the tune Rs 15,000 crore will be provided by the lenders themselves.

New entity

RBI governor Shaktikanta Das said recently that the new entity will be set up by PSBs themselves and that this ARC will in no way jeopardise the functioning of existing ARCs which have been functioning for nearly two decades now. The Asset Reconstruction Company India (Arcil), promoted by State Bank of India, IDBI Bank, ICICI Bank and Punjab National Bank, is the oldest ARC in India. Phoenix ARC promoted by Kotak Mahindra Bank is also well capitalised to go for big ticket buys of NPAs.

The bad bank idea is not new and has been tried in other countries. Mellon Bank was the first bank in the US to use the concept of a bad bank because of the problems it faced in its commercial real-estate portfolio. It set up the Grant Street National Bank in 1988. The Republic of Ireland formed a bad bank, the National Asset Management Agency, in 2009 in response to the country’s financial crisis. The idea has been applied elsewhere in past banking crises in Sweden, France and Germany.

There is a flip side to the setting up of a bad bank. The opponents of bad banks claim that selling bad loans encourages banks to take undue risks by adopting a lackadaisical attitude knowing fully well that any wrong decision will not attract punitive measures. There are complexities surrounding asset valuation too. K V Subramaniam, the chief economic adviser, had said last year that setting up of a bad bank may not be a potent idea as there are many ARCs in the country.

Let us at least hope that setting up of a bad bank is an idea whose time has finally come; it could be a gamechanger for PSBs and can restore investors’ faith in them.

(The writer is a CFA and a former banker and currently teaches at Manipal Academy of Banking, Bengaluru)