BAD BANK, GOOD IDEA? : The Global ANALYST

The Global ANALYST, April 2017

Bad Bank, Good Idea?

M G Warrier

Since independence GOI and RBI have revamped and rejuvenated existing institutions at various levels in the financial sector and established new ones wherever a need was felt. The makeover of Imperial Bank to State Bank of India at national level to recent emergence of Payment Banks at ground level and setting up of specialized institutions like IDBI, Exim Bank and NABARD are the result of the joint effort of GOI and RBI. Institutions so established have been playing their role fairly well. The present proposal to have a separate institutional arrangement for handling stressed assets of the banking system has built-in features which can be harmful for the financial sector in the long run. Put bluntly, besides acting as a disincentive for professionalizing appraisal and credit delivery and recovery departments of the banks,  the institutionalization of ‘stressed assets’ can further weaken the supervisory and regulatory bodies in the financial system.

Economic Survey 2016-17 bases its argument supporting  establishment  of a Public Asset Rehabilitation Agency ( PARA, now loosely referred to as ‘Bad Bank’ in common parlor) on the following grounds:

1. It’s not just about banks, it’s a lot about companies. So far, public discussion of the bad loan problem has focused on bank capital, as if the main obstacle to resolving TBS was finding the funds needed by the public

sector banks. But securing funding is actually the easiest part, as the cost is small relative to the resources the government commands. Far more problematic is finding a way to resolve the bad debts in the first place.

2. It is an economic problem, not a morality play. Without doubt, there are cases where debt repayment problems have been caused by diversion of funds. But the vast bulk of the problem has been caused by unexpected changes in the economic environment: timetables, exchange rates, and growth rate assumptions going wrong.

3. The stressed debt is heavily concentrated in large companies. Concentration creates an opportunity, because TBS could be overcome by solving a relatively small number of cases. But it presents an even bigger

challenge, because large cases are inherently difficult to resolve.

4. Many of these companies are unviable at current levels of debt requiring debt write-downs in many cases. Cash flows in the large stressed  companies

have been deteriorating over the past few years, to the point where debt reductions of more than 50 percent will often be needed to restore viability.

The only alternative would be to convert debt to equity, take over the companies, and then sell them at a loss.

5. Banks are finding it difficult to resolve these cases, despite a proliferation of schemes to help them. Among other issues, they face severe coordination

problems, since large debtors have many creditors, with different interests.

If PSU banks grant large debt reductions, this could attract the attention

of the investigative agencies. But taking over large companies will be politically difficult, as well.

6. Delay is costly. Since banks can’t resolve the big cases, they have simply

refinanced the debtors, effectively “kicking the problems down the road”.

But this is costly for the government, because it means the bad debts keep rising, increasing the ultimate recapitalization bill for the government  and the associated political difficulties. Delay is also costly for the economy, because impaired banks are scaling back their credit, while stressed companies are cutting their investments.

7. Progress may require a PARA. Private Asset Reconstruction Companies

(ARCs) haven’t proved any more successful than banks in resolving bad debts. But international experience shows that a professionally run central

agency with government backing – while not without its own difficulties -- can overcome the difficulties that have impeded progress.

The observations “Like all financial firms, central banks hold capital to provide a buffer against the risks they take…. Measuring these risks and calculating how much buffer should be provided against them is difficult. For that reason, central bank capital holdings vary widely. RBI is an outlier (in shareholder equity to assets ratio) with an equity share of about 32 per cent, second only to Norway and well above that of the US Federal Reserve Bank and the Bank of  England, whose ratios are less than 2 per cent. If the RBI were to move even to the median of the sample (16 per cent), this would free up a substantial amount of capital to be deployed for recapitalizing the PSBs,” contained in the Economic Survey 2015-16 was contested on grounds of accuracy of facts and the then RBI Governor Dr Raghuram Rajan had offered to guide those who wrote Economic Survey to understand RBI Balance Sheet  (Dr Rajan kept his word and did exactly what he promised, in a speech he delivered in Delhi the day before he completed his three year tenure as RBI Governor and returned to academia. )

Suffice to say, those who are aware of the interlink between RBI’s  balance sheet and GOI finances are not in favour of  using the RBI’s capital and reserves to fund the non-performing assets (NPAs) of public sector banks.

Budget 2017-18

Finance Minister Arun Jaitley in his Budget speech made the following observations:

“The focus on resolution of stressed legacy accounts of Banks continues.  The legal framework has been strengthened to facilitate resolution, through the enactment of the Insolvency and Bankruptcy Code and the amendments to the SARFAESI and Debt Recovery Tribunal Acts.  In line with the ‘Indradhanush’ roadmap, I have provided ` 10,000 crores for recapitalisation of Banks in 2017-18.  Additional allocation will be provided, as may be required.

Listing and trading of Security Receipts issued by a securitization company or a reconstruction company under the SARFAESI Act will be permitted in SEBI registered stock exchanges. This will enhance capital flows into the securitization industry and will particularly be helpful to deal with bank NPAs.”

FM doesn’t look keen on taking forward the Economic Survey ideas about managing stressed assets so soon. In a post-budget interview, he said a bad bank is a potential solution but it cannot be supported by the government alone. He also said that he won’t be able to comment on what solution will eventually emerge. Possibly Jaitley has in view the impact of bad bank funding on macroeconomic stability. The finance minister has committed to a fiscally balanced budget with a fiscal deficit target of 3.2% for 2017-18, government-debt-to-gross domestic product (GDP) target of 60% by 2023 and net market borrowing target of Rs3.5 trillion in 2017-18. These commitments do not account for bad bank funding.

The creation of a bad bank will put pressure on government finances at least initially. Even if the government funds only 20% of stressed assets in the banking system, it would have a heavy impact on the net market borrowing target in 2017-18. This will adversely affect achieving committed targets for fiscal deficit and government-debt-to-GDP ratio.

On March 15, 2017, addressing the first meeting of the Consultative Committee  constituted by the Reserve Bank of India, attached to the Ministry of Finance, FM Jaitley said that dealing with NPAs was a challenging task. According to him the he core problem of NPAs was with very large corporates, though few in numbers, predominantly in the steel, power, infrastructure and textile sectors. On the issue of setting up a ‘bad bank’, Jaitley said that several possible alternatives exist and the issue is being debated on public platforms.  The government was also considering setting up more Oversight Committees that would look into cases referred to it by different banks.

Reserve Bank’s perception

Speech delivered by RBI Deputy Governor Viral Acharya at the Indian Banks’ Association Banking Technology Conference held in Mumbai, on February 21, 2017 would guide us on the present thinking within RBI about handling stressed assets of banking system. Viral Acharya said there is a “sense of urgency” to decisively resolve Indian banks’ stressed assets. One of his proposed solutions is the creation of a Private Asset Management Company (PAMC) for sectors in which assets are economically unviable in the short-to-medium term, like the power sector. Acharya feels, this plan 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.

Let us not institutionalize a bad idea

The bad bank idea, which was mooted last year didn’t find favour with the then RBI governor Raguram Rajan. The change of guard at Mint Road together with the compulsions arising from the severity of the bad loan problem plaguing the system, which has not so far been responding much to normal ‘treatment’, helped media and analysts to make a second attempt.

Theoretically, a bad bank or an asset management company could be set up with government money to buy non-performing assets from banks. By  transferring dead loans to the bad bank, banks  become free of providing for these loans and making efforts to recover whatever is left recoverable. This would also free up precious capital which could then be used to boost credit flow to industry. But, banks with huge amount of stressed assets are also big enough to do whatever a newly constituted institution can do to make them perform or close the accounts after recovery of whatever part is recoverable. With appropriate legislative and legal support from GOI in the same manner banks form consortiums to lend to large projects banks can make joint efforts to pool resources and make joint recovery efforts. Such joint efforts will reduce the chances of borrowers shifting from one bank to another for softer treatment in regard to financial discipline.

Any proposal to institutionalize stressed assets raise  questions like, who will pay for the potential losses? If banks are willing to sell loans at a haircut, wouldn’t it make more sense to allow asset reconstruction firms, which have the required expertise in this area, to be major players?

Like the disinclination to repay unleashed by agricultural loan waivers, the very concept of a GOI-owned “bad bank” does create the problem of moral hazard as it creates incentives for banks to be reckless. The responsibility to recover or ‘provide for’ loans disbursed going bad should remain with the lender. Shifting this responsibility to another institution and funding the losses from taxpayers’ money raises the more serious question of public perception and potential damage to the government’s reputation.

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