Announced in the Union Budget earlier this year, India’s so-called bad bank is beginning to take shape. Finance Minister Nirmala Sitharaman announced on September 16 that the Union Cabinet had cleared a proposal to provide Rs 30,600 crore government guarantees for security receipts issued by the National Asset Reconstruction Company (NARCL) as part of the resolution of bad loans.
Security receipts represent an undivided right or interest in a financial asset. Typically, asset reconstruction companies or a bad bank buy distressed assets paying 15 percent cash and the balance 85 percent in security receipts.
"We are also setting up an India Debt Resolution Company Ltd to manage the non-performing assets (NPAs). In this company, public sector banks (PSBs) and state-owned financial institutions will own 49 percent stake," the minister said. She added that private sector banks will also hold a stake.
Why a bad bank?
The finance ministry and public sector banks wanted one more option to get rid of their bad debts and clean up their books even though we already have the Insolvency and Bankruptcy Code (IBC), asset reconstruction companies (ARCs) and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act.
Bad banks abroad
The idea of a bad bank has been there since the 1980s when the US and Sweden became their early adopters. Bad banks have been institutionalised and considered a success in several countries including the US, Sweden, Finland, Belgium and Indonesia.
Countries like Malaysia created a bad bank sponsored by the government, the US launched the Troubled Asset Relief Program (TARP) in 2008, Ireland, too, had set up a National Asset Management Agency (NAMA) in 2009. But conditions in these countries were far different from what is being tried in India.
Also read: Analysis | What the Bad Bank deal really means for Indian lenders
Late entry into India
Former Reserve Bank of India (RBI) governor Raghuram Rajan opposed the idea of a government-led bad bank and instead suggested that private sector asset reconstruction companies be strengthened to have adequate capital to make all-cash purchases of bad loans from banks.
While there are 28 private ARCs, sales of bad loans have not picked up, as the banks and the reconstruction companies differ on the fair value of these assets, so the need was felt for government-backed security receipts. That is why bad banks move by the government is the need of the hour.
How a bad bank works
A bad bank is a special type of financial institution that buys bad debtors of a bank at a mutually agreed value and attempts to recover the debts or associated securities by itself.
The bad bank takes over a portion of the debts that are recognised as non-performing assets (NPAs). All the rights held by the lender (the bank) in respect of the debt are transferred to the bad bank.
Also read: Two charts that show why a bad bank is critical for Indian banking
What are non-performing assets?
Banks and other financial institutions are required to classify the debts owned by them into the following four categories:
a) Standard: It is a kind of performing asset which creates continuous income and repayments as and when they become due.
b) Sub-standard: Loans and advances which are non-performing assets for a period of 12 months.
c) Doubtful: The assets considered as non-performing for a period of more than 12 months
d) Loss: All those assets which cannot be recovered by the lending institutions
Out of the above four, a non-performing asset would be either a sub-standard, doubtful or a loss asset.
Challenges for bad banks
Coming to the bad bank, most of these bad assets are already fully provided for, written down on the books of banks. The banks no longer nurture hopes of a meaningful recovery.
From these assets, the most critical part will be how banks arrive at a valuation for the transfer of these assets to the bad bank. The ability of the bad bank to resolve these assets in a time-bound manner will be critical for future provision write back by banks.
Another issue, which may arise, is selling stressed assets to potential buyers and resolving the underlying crisis in the system.
In the current situation, when economic conditions are deteriorating and the IBC suspended, finding potential buyers for distressed assets can be a significant challenge. Also, the public sector banks will be both shareholders and customers of the bad bank—and it leads to the danger of the bad bank being nothing more than a means to shift some bad debt from one book to another.
It will help lenders get rid of bad assets by transferring them to the bad bank and clean up their books. The bad bank will release capital for the banks and enable them to re-start lending. It will be more result-oriented and hence be better able to recover the dues from the borrowers.
As it is supported by the government, it will not delay resolution due to governance deficiencies, slow-moving judicial architecture, poorly designed regulation, etc—the major issues faced by ARCs. Overall, it will give a huge boost to the macro economy.
We cannot miss the fact that a bad bank can’t prevent NPAs in the future. The government needs to find ways to reduce NPAs, the main reason for banks accumulating losses and pushing back the economy.Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.