At a public conference nearly two weeks ago, Reserve Bank of India (RBI) Governor Shaktikanta Das stated that if a proposal for the creation of a “bad bank” was put forward, the monetary regulator would examine it.
While a “bad bank” was the subject of numerous pre-budget discussions In years past, Das’s statement means that all eyes are on the budget that follows February 1. Will she do it? Or, isn’t it?
There are a lot of problems for an economy affected by a pandemic. Indeed, the Minister of Finance Nirmala Sitharaman has one too many on her plate. And yet the bad debts of the banks could still prove to be the biggest of his worries.
Public sector banks alone are sitting on a big pile of bad debt. In its recent intervention, the RBI rightly pointed out that the banking system is already familiar with Asset Reconstruction Companies (ARCs) and how they operate.
These ARCs are akin to the vulture funds popular in Western economies. They buy distressed loans at low prices and derive maximum value from the assets available as securities for distressed loans. So a loan of Rs 100 that has a secured asset is supported at Rs 25 for example and the vulture fund would try to maximize the collateral realization and could get Rs 40 and make a profit of Rs 15. there would be instances where the realization could also result in a loss. These funds have built-in capabilities – essentially legal expertise – to squeeze borrowers and extract the maximum amount of pounds of flesh.
However, ARCs in India have not had much impact.
The concept of a bad bank is in some ways similar to an ARC. The way it is designed and funded, however, could be different. Simply put, a bad bank is essentially established to separate stressed assets held by an ordinary bank from its performing assets. Once the separation is effected, the stressed assets are removed from the balance sheet of the ordinary bank. This allows the cleaning of the ordinary bank. At the same time, the bad bank takes care of the service of the transferred stressed assets and their liquidation in time.
An inventory of the situation will give a clue or two to the emerging dark scene on the bad debt front. Bad debts in the banking system are expected to swell. The fear is not unfounded after all. The contraction of the economy – which has moved into a negative zone in the wake of COVID-19 – has put many sectors in virtual disarray. In its recent financial stability report, the RBI indicated that gross NPAs (non-productive assets) in the banking sector could increase to 13.5% of advances by September 2021, against 7.5% in September 2020, in the baseline scenario, because “a recovery at several speeds struggling to gain ground “amid the pandemic. If the macroeconomic environment degenerates into a severe stress scenario, the ratio could climb to 14.8%. The NPA ratio of public sector banks, which was 9.7% in September 2020, could increase to 16.2% by September 2021 in the baseline scenario, according to the RBI.
The KV Kamath committee, which helped RBI craft a one-time restructuring plan, estimated corporate sector debt worth Rs 15.52 lakh crore was under pressure after COVID-19 hit the India, while another Rs 22.20 lakh crore was already stressed before the pandemic. This effectively means that Rs 37.72 crore (72% of banking sector debt to industry) remains under stress. This represents almost 37% of total non-food bank credit. According to the commission, sectors such as retail, wholesale, roads and textiles are facing tensions. Sectors that were under pressure before Covid include NBFCs, power, steel, real estate and construction.
In this context, the idea of the bad bank takes on a considerable importance, even if it will not fail to ignite the platforms of political and economic discussion.
To be sure, the origins of the “bad bank” date back to the late 1980s. A drop in real estate and oil prices combined to push many banks in the United States to the brink of collapse. Mellon Bank, based in Pittsburgh, was the hardest hit. Mellon created a new bank in the name and style of Grant Street National Bank (GSNB) and transferred its toxic assets. The purchase of toxic assets by GSNB was funded by a public issue of expandable payment notes and the dividend from Mellon shareholders. After nearly eight years, GSNB disappeared following the liquidation of toxic assets. Following Mellon’s experience, the US government created Resolution Trust Corporation, an asset management company, to take over stressed assets from banks declared insolvent.
Japan then drew on the American experience. Thus was born a cooperative credit buying company that bought the stressed assets of Japanese banks at a discount. In this case, the credit union was funded by the banks who sold it the toxic assets.
In Europe, Sweden was one of the first countries to create a bad bank. The failing bank in this case was financed by a combined bank loan and a government equity injection. After the 2008 global financial crisis, Germany passed a law to address the problem of toxic assets. The German model provided for a twin model – one to solve the problems of private banks and the other to public banks. Here, these special purpose entities issued state guaranteed bonds to distressed asset transfer banks. Ireland and Spin also followed the Mellon experiment in 2009 and 2012, respectively.
So, the concept of bad bank is not something new and has been in vogue in different countries in different formats. The heart of the concept is the separation of stressed assets from banks. Indeed, there are many possibilities to do this. Should this be done in a separate entity? Should this be done through the IPO of a special purpose entity? Should this be done by establishing a separate bad bank? There are many ways to separate stressed assets.
Perhaps the bad bank we’re talking about right now is calling for the transfer of all the toxic assets of the banking industry into one. This raises many questions. Who will fund this? Who will handle this? What will be the sale price of the toxic assets? What is the timeframe for such a bad bank to liquidate toxic assets? Indeed, this calls for a broader discussion. If the country opted for such a bad bank, what would be the legal requirements to establish it?
One thing is irrefutable, however. India’s legal system, riddled with political overlays in any economic endeavor, has often proven to be the Waterloo of the insolvency and collection process. Securities can often be fictitious, such as disputed title property or, more outrageously, goodwill that only exists in the computer system but not in warehouses. The influence of the borrower in society and multiple factors can determine the pace and level of collection. The performance of the insolvency system over the last five years of its existence will attest to its veracity.
This is one side of the discussion. There is also another side to this. The bank that sold its loan of Rs 100 for Rs 25 must recognize the loss of Rs 75. It may have to find new equivalent capital or accumulated profits to compensate for it. To put this in context, assuming the bad bank can arise and acquire the bad debts of, say, Rs 20 lakh crore at, say, worth 30%, the amount of Rs. 6 lakh crore has to be found by the government to be infused into the wrong bank to redeem toxic loans. Banks will need new capital and reserves of Rs 14 lakh crore to match their balance sheets! Such numbers do not exist in our economy. So much so that all PSBs will operate with huge accumulated losses, which technically represent an insolvent state. The bad bank has Rs 6 lakh crore of taxpayer money represented by distressed assets covered by so called securities. Whereas the bad bank will have a ‘sarkari‘-style of operation, it is not difficult to visualize the potential outcome.
There is a different argument, however. According to this, the banks wrote off these toxic loans anyway (as per the rules of the Reserve Bank of India). Any recovery, even marginal, could only add to its income, it is still argued.
The moot point, however, is this: Who owns the money that banks simply have to write off? Someone has to pay for the loss. Simply because the ultimate payer remains invisible, banks cannot claim the luxury of a simple write-off. Notwithstanding the many positive aspects of starting a bad bank, there are many negative aspects that cannot be ruled out or at least require careful consideration before making a “bad bank” decision.
On the one hand, a bad bank could create a feeling of nonchalance in the decision-making process in the context of a loan disbursement. Either way, someone is there to take over stressed assets. This kind of thinking could result in less than fair due diligence when granting a loan. On the other hand, a bad bank could also experience external influence – political or otherwise – in its decision-making process.
It could be even worse for the system as a whole. Since toxic assets are turned over to the wrong bank at a discount, there could be a forced sale of toxic assets of a similar nature at large discounts. What is needed is a legal framework that allows a bad bank to do its job without hassle and without interference of any kind. On top of all this, it requires providing a failing bank with sufficient numbers of truly trained staff to manage and recover stressed assets.
Ultimately, the Indian government has so far been reluctant to go ahead with the idea of a bad bank. If we see one next week, surely there will be a larger debate.
KT Jagannathan is a senior journalist based in Chennai. V. Ranganathan is a Chartered Accountant based in Chennai.