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Budget 2021: FM announces bad bank, why it is a big step towards addressing Indian banks’ toxic assets worries

Banks are facing a resurgence of bad assets in teh aftermath of COVID-19. A bad bank will help to segregate the existing stock of bad assets from the good so that banks can focus on fresh lending.

February 01, 2021 / 12:47 PM IST

After long years of delay, Finance Minister Nirmala Sitharaman has announced the setting up of an entity to address the stressed assets of banks. The organization will be set up through an Asset Reconstruction Company (ARC) model, she said in the 2021 Budget Speech. Details of the proposals are still awaited.

This institution, what is commonly known as ‘bad bank’, will be a major boost for bad asset resolution in the financial system and has been in discussions for long. Banks can transfer bad assets to this entity at a discount. Experts will then attempt for a resolution through a professional approach, while originating banks can focus on new business.

On January 27, Moneycontrol reported that a bad bank is likely to be announced in the Budget. Nearly 8 percent of the total loans have gone bad (overdue more than 90 days) at this stage.

What is a bad bank?

To be sure, the idea of a bad bank itself is not new. In 2018, the government announced a plan for PSBs called 'Project Sashakt', which had a five-point plan for bad loan resolution in public sector banks. The government then spoke of a model, with 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. The functions of this new company will be aligned with the Insolvency and Bankruptcy Code (IBC) process and IBC laws, the government had said.

The government did not call it a bad bank then and made it clear that it won't get involved in the bad asset resolution process and the process will be led by banks. Why the timing of a bad bank is right? There are five reasons why the timing is apt for the creation of a bad bank.

One, NPAs are likely to escalate post-Covid.

The existing stock of bad loans is a big worry for banks. At the end of September 2020 year, the total gross NPAs of the banking system was 7.5 percent of the overall industry loan book. This is expected to shoot up to 13.5 percent by March-September this year, according to the Reserve Bank of India’s (RBI) projection. That is a base case scenario. In a worst-case scenario, the bad loans are likely to rise up to 15 percent of the total loans. This will be a big shock to banks as they will require significantly higher capital to cover the impact of bad loans. Moving the existing stock to a separate entity at the earliest could be an escape route.

Two, it is a less costly exercise now. That’s because the net value of NPA assets with banks has fallen dramatically. A bad bank was not created before because the net book value of NPAs was very high. Transfer of these assets would have been much costlier. But today, the net book value of NPAs is very low—hardly 15 percent in many cases. Banks have made significant provisions already. The point is if there are people specialising on resolution and if all NPAs are brought to one place, bank management can focus on the rest of the business.

Three, COVID-19 has been an extra jolt on the bank balance sheets. The pandemic has impacted the overall economic activity significantly, inflicting pain on the balance sheets of banks. The six-month loan moratorium gave temporary relief to companies. But after the moratorium period, some of these accounts have been restructured by banks. Going by the numbers indicated by banks so far, the weaker banks have been impacted more.

To give an example, Yes Bank, which has one-third of its loans under the stressed category, has restructured around 5 percent of the loan book. Analysts expect overall restructuring in the industry (on account of COVID-19) to be around 3 percent of the loan book. A lot will depend on economic recovery going ahead.

Four, banks can focus on fresh business. Once the large chunk of existing bad loans is transferred to the new company, banks can aggressively focus on new productive lending. The fear of future loans defaults is holding back from banks from taking additional exposure to industries. This, coupled with subdued demand, has slowed the flow of credit to productive sectors. Overall credit growth has slowed to less than 6 per cent on a year-on-year basis, with credit growth to industry actually contracting to several segments. Freeing up banks from the burden of bad loans could help push credit growth.

Five, Slow pace of bad asset resolution:

Slow resolution of sticky assets remains a big problem for Indian banks. With no recovery in sight, banks have resorted to massive loan write-offs in the recent past. Currently, if there is a large corporate NPA, one needs to go to 10-15 banks for resolution. Hence, banks are resorting to large scale write -offs.

To get a perspective. Consider these numbers:

In the last decade alone, Indian banks have written off loans worth around Rs 883,168 crore, a significant chunk of which came from government-owned banks, the latest data from the Reserve Bank of India shows. Of this, public sector banks (PSBs) alone wrote off Rs 667,345 crore worth loans since 2010.

This is about 76 percent of the total written-off loans in the decade, while private banks wrote off loans worth Rs 193,033 crore constituting about 21 percent of the total chunk. Foreign banks wrote off Rs 22,790 crore loans or 3 percent of the total write-off, the RBI data showed.  In the financial year 2019-2020 alone, banks wrote off a total of Rs 2,37,206 crore or about a quarter of the total loan write-offs in the last one decade. Of this, Rs 1,78 lakh crore was by PSBs and Rs53, 949 crore by private banks. These figures do not take into account the loans written off by small finance banks, which is a relatively smaller portion.

The recovery through debt recovery tribunals and Insolvency and bankruptcy code (IBC) mechanism has been limited to only a few large cases. A bad bank could help in better bad loan resolution through an ARC model.

In May 2020, when the IBA submitted its proposal, it had requested the government to put in an initial capital of Rs 10,000 crore. “Today, the net book value of NPAs is very low—hardly 15 per cent in many cases. The point is if there are people specialising on resolution and if all NPAs are brought to one place, bank managements can focus on the rest of the business,” former SBI chairman Rajnish Kumar told Moneycontrol in a recent interview.

“PSBs own 60 percent of the banking system. We can’t transfer (bad loans) to any other entity other than a government-owned company. This is the logic (of saying government has to fund the project),” said Kumar. In this backdrop, the bad bank idea will be a major reform for banking sector if properly implemented. The challenge is on the execution.

(This is an updated version of an earlier story being filed in the context of FM announcement)

Dinesh Unnikrishnan
Tags: #bad bank
first published: Feb 1, 2021 12:47 pm