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Why a government-controlled bad bank is not a good idea

A bad bank is essentially an entity which bundles together all the bad assets in the banking industry, buys it at a discounted price from banks and tries to find buyers by putting a turnaround plan in place

May 22, 2020 / 09:39 AM IST

A government-controlled bad bank is being projected by a section of experts as a panacea to the massive NPA (non-performing assets) problem in India. It is not. In fact, a state-owned/controlled bad bank could lead to a major anomaly in the pricing of bad assets. That will be counter-productive for the health of the banking system in the long-term.

The government, which does not have enough money to recapitalise state-run banks or have an alternative plan to address the NPA problem, seems to be pushing the bad bank creation. The government is reportedly considering a proposal from the banking industry lobby, the Indian Banks Association (IBA) and the viability of the proposal is being looked at right now.

Going by the IBA proposal, the bad bank will have an ARC-AMC model and an alternative investment fund (AIF) will be set up to buy the stressed assets from the banking system. Logically, the government will invest in the proposed bad bank initially while in due course banks and outside investors will pool in money. The creation of a bad bank supported by the government and industry is being pitched as a critical banking reform in Asia's third largest economy. Indian banks have nearly Rs 9 lakh crore non-performing assets (NPAs) as at end December.

But does the idea of a government-controlled bad bank really make good sense?

What is a bad bank?

A bad bank is essentially an entity which bundles together all the bad assets in the banking industry, buys it at a discounted price from banks and tries to find buyers by putting a turnaround plan in place. The purpose of creation of a bad bank is not very different from a typical asset reconstruction company (ARC).

The idea of a bad bank is not new. In 2018, the government had 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 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. With this, an alternative investment fund (AIF)-based resolution approach for loans above Rs 500 crore was also discussed under which an AIF would raise funds from institutional investors. Banks, too, will have an option to participate, if they wish to participate on the upside. The idea could not be executed for various reasons.

The talk about 'bad bank' bears a resemblance to 'Project Sashakt', albeit in a different avatar. The idea is good and more workable now since banks have already made 70-80 percent provisions on the NPAs after the mega clean-up exercise. They can remove the remaining by transferring the assets to a different entity.

Why it may not work

There are two parts to the problem. Taking the bad assets off the books of PSBs to a new entity and eventually selling to a willing buyer based on a turnaround plan. The first one is easy, the second is not.

The reason why banks want to create a government-owned asset reconstruction company and not to sell the bad loans to any of the existing 27 ARCs is the pricing. Typically, ARCs ask for a steep cut while purchasing stressed loans. Bankers bargain, ARCs bargain and both go home with no deal. Once the government/ banks-owned bad bank comes into existence, this issue won't crop up.

Since the idea of creation is clear, the 'bad bank' won't bargain much while taking over the stressed assets as the government has already given the funding. This will actually lead to a serious distortion in pricing of stressed assets. But, since the bad bank is government controlled and majority of the banking system (by assets) is also government controlled, bad banks may be forced to buy the bad assets at a price the bank desires.

This, in effect, will mean that bad assets are not bought by the second party at market discovered price and based on business viability (potential sale at a later stage). This will mean the whole transaction would only help to move the NPAs from entity to the other. This could temporarily help the government to show that a solution has been arrived at for the NPA problem. But, beyond that, such a series of transactions will not help to address the actual rot in the banking system?

But, the even bigger issue arises later--when it comes to the second part—while selling these loans to a potential buyer and resolving the underlying crisis in the system. The sharp deterioration in economic conditions on account of Covid-19 and global economic slowdown would mean that finding sellers for distressed assets will be a key challenge.

Now, if there are no deep-pocket buyers willing to put money on the table or if there is lack of private participation, the resolution plan may hit a roadblock. In the absence of a strong turnaround plan, the bad bank plan can backfire since this will be only transferring the risky assets in the banking system from one place to the other.

It is better to leave the business of bad banks to the existing bad banks (there are many of them in India) and have the market discover the prices of NPAs.

Dinesh Unnikrishnan
Dinesh Unnikrishnan
first published: May 22, 2020 07:50 am