Why 'Bad Bank' is a bad idea for India

A few months ago, there was a proposal presented to the government, to set up a "Bad Bank" in the form of an Asset Reconstruction Company (ARC), to move the NPA portfolio from banks (at book value and not at the lower market value, it would command) into the new entity (to be set up with a capital of Rs 10,000 crore).  

This is purportedly to reduce the impact of the losses that the banks will face due to provisioning for non-performing assets and the recapitalisation of banks that the government (as majority owner in most PSBs) may be forced to spend on. With the upcoming Union budget's preparation, the clamour, and industry lobbying pressure to set up a 'bad bank' is back on.  

Banks & banking on?  

A bank's or non-bank lender's core business is to lend money and collect it until the last amount due, hopefully on time and every time. On the liabilities side, the Indian regulations permit banks to raise deposits from the market, which in turn they use as fuel for their lending activity.    

Without much ado, the business of finance is simply to "price the risk". Non-performing assets (NPA) are very much a part of this business.

Also Read: Coronavirus crisis: All dat's bad about a 'Bad Bank'

Any business could become a stressed one, due to a variety of reasons, including an industry cycle shift, poor business strategy or execution, nefarious intent of the promoter (which the law provides to be dealt with differently). The COVID-19 crisis is unprecedented in its fury and has disrupted global economies and local (consumer and investor) sentiments too.  

The Insolvency and Bankruptcy Code, 2016 (IBC), the bankruptcy law of India allows debtors, creditors, and the companies themselves to ask for a particularly stressed business to be sold to another set of promoters.  

The critical philosophy of the IBC was the concept of "creditor in possession and control", rather than "debtor". Due to the current coronavirus crisis, the government has suspended the IBC until March 31, 2021.  

Earlier the banking regulator RBI had brought in the concept of offering a three-month moratorium from all lenders (banks and non-banks) to their customers; this was extended by three more months. And due to a case filed in the Supreme Court (SC), this topic of moratorium is currently subjudice, whose outcome could change the balance sheet provisioning for the entire banking and finance sector.  

However, RBI has not permitted a corresponding leeway to lenders. This has necessitated that lenders continue repaying their obligations, without the ability to collect from their customers.  

The KV Kamath committee of RBI formulated a way to restructure lenders' exposure to specific sectors that meet certain financial ratios.

Bankers have been worried that any decision around bad loans could unduly invite the 4Cs - Courts, CVC, CBI, CAG. It might be useful to look at the other 'C' (Cabinet) - to bring in legislative protection to bankers for taking credit calls and selling the NPAs in the market, under the current regulations.  

This could be a game-changer for ensuring that the capitalist model of market-pricing is respected and sets the tone for financial decisions, and would allow bankers, and not bureaucrats, to take commercial decisions and with full governance norms.

Also Read: Centre mulls setting up bad bank among other options to improve banking sector: DEA Secretary

Bad banks vs stand-alone ARCs  

A bad bank is simply a corporate structure that isolates liquidity and high-risk assets held by a bank or a financial organisation, or perhaps a group of such lenders. Bad banks as a concept works efficiently when the domestic debt market is deep and the number of market participants is wide enough to allow sufficient price-discovery and market-making.  

In the current stressed economy and a thin coffer that might be at governments' disposal, the pressure to recapitalise its public sector banks (of which it is the majority owner) is bound to be a challenge. In the same breath, there has been no public discussion or executive decision if there could be immediate monetisation of the stakes that the Centre holds in its public sector banks and other financial institutions.  

Asking the government to fund a new entity to house the "bad loans" can be avoided by directly provisioning for them on lenders' books and then seeking additional capital infusion from the investors. This would be a transparent way of telling public investors how their capital is being spent.  

Isn't it poor governance to move a bad loan from one account to another entity, that the same bank or the original shareholder owns? And to expect the same set of banks to revamp the asset to recover monies when they failed in the first place?  

Structurally, ARCs are better suited for restructuring and/or turning around indebted companies. They are registered with RBI under Section-3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Most bad loans over the past many months have emerged, thanks to regulatory pressure on lenders to clean-up their books.  

Currently, there are many licensed ARCs in India, which provide turn-around specialists (with specific sectoral skills) and not just credit underwriting understanding. If there's no appetite for ARCs to take over bad loans, it could be mismatched pricing, that's not attracting them to pick those pools of potentially turnaroundable assets.

Also Read: Need multiple bad banks to address NPAs, get credit cycle back in action: CII

ARCs will only buy those pools of stressed assets if they see business-viability of those pools. If the current ARCs need more capital, that's another topic totally; it would be pragmatic to simply widen the capital pool available by allowing foreign portfolio Investors (FPIs) and Alternative Investment Funds (AIFs) to purchase NPAs and to partner with ARCs.  

The Financial Sector Legislative Reforms Committee (FSLRC 2012) recommended a regulatory architecture that would propose setting up a resolution agency, outside the scope of the banking regulator. Assuming the same argument for dealing with NPAs, the banks would have sold their stressed portfolio to an outside ARC (regulated by a different regulator). Moral hazarding has no place in the high-pressure banking sector, especially in the midst of an economic whirlwind.  

More importantly, as India seeks the interest of global investors to partner it in its economic growth, the country needs to demonstrate its non-interference-led-markets-philosophy; by having the (distress) assets sold at market pricing and not to package them in various forms to force-sell it or account-for-it at book value (which is many a times much higher than market pricing).  

India needs a market mechanism that can stand up to the tests of market vagaries, rather than a one-off solutioning.  

Let's not shift issues from one balance sheet to another. Let's not roll-over the problem(s) to yet another quarter.  

(The author is an independent markets commentator.)