Are bad banks effective options to tackle non-performing assets?

The spread of COVID-19 had stalled economic activities, resulting in large-scale job losses. This has adversely affected the cash flow in businesses with an overarching impact on obligations including interest payments, loan repayments, and tax payments.

There are existing non-performing assets (NPA) amounting to about 9.1 percent of the total assets (as of September 2019) Indian banks. The surge in NPAs had reinitiated discussions around ‘bad banks’ as a strategy to deal with bad loans/NPAs. The Finance Minister too in Union Budget FY 21-22 proposed to set-up to an Asset Reconstruction Company (ARC) or a bad bank to clean up NPAs of banks. This move will seek to provide financial stability to the banking sector.

A bad bank is a corporate structure that isolates illiquid and high-risk assets held by a bank/financial institution or a group of banks/financial institutions. It can help banks clear off their balance sheets by transferring bad loans and focus on core business and lending activities. The first bad bank was created by US-based Mellon Bank in 1988 to hold its “toxic assets”.

The Indian Bank Association (IBA) has proposed to set up a bad bank with the initial investment from the government. In the pandemic bailout, the government announced an economic stimulus package of INR 20 lakh crore, which includes INR 8.01 lakh crore of liquidity measures announced by the Reserve Bank of India (RBI) to ease the financial stress caused by COVID-19. These include moratoriums on term loan instalments, deferment of interest on working capital facilities, and easing of working capital financing.

Bad banks have been institutionalised and considered a success in several countries including the US, Sweden, Finland, Belgium, and Indonesia. In the case of the Mellon Bank Corporation, a new institution was created, called Grant Street National Bank (GSNB), to hold its toxic assets by spinning off its own capital and some board members. GSNB purchased Mellon’s bad loans at a 53 percent discount. It may, however, be noted that GSNB was a private-sector experiment with no capital from a government entity. GSNB focused on the recovery of bad loans under a separate management and was dissolved in 1995 after meeting its objectives. In contrast, the current proposition in India involves initial investments to be made by the government. In such a scenario, it isn’t clear how the bad bank may operate.

Another reason for the revival of the bad bank idea in India is the steep discount on stressed loans for asset reconstruction companies (ARC). The IBA has proposed that the bad bank should purchase stressed assets at book value, net of minimum regulatory provisions, which would circumvent the valuation process and due diligence. Therefore, it is possible that the bad bank may purchase stressed assets at the price desired by banks—leading to distortion in the pricing of the stressed assets. 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 Insolvency and Bankruptcy Code (IBC) is suspended, finding potential buyers for distressed assets can be a significant challenge.

While the concept of a bad bank has been around for a while and also been successful in certain countries, the above-mentioned considerations should determine if this is our best bet in the current situation. More importantly, we must not neglect other structural reforms that are required in parallel to deal with the NPA at large. Some of these will include greater governance and supervision during the lending process, stringent monitoring of loans for early detection of distress signs, and allowing market-driven platforms to sell bad loans for improving the price discovery process for a bad asset.

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