Should India create a ‘bad bank’ to battle NPA’s? Financial Express Debate: 12th July 2016

The subject of non-performing assets (NPAs) has caused sufficient worry for the banking system, especially when restructured assets are also included. The number of 11.5% is quite scary and needs to be addressed. One idea which is not really a bad concept is the concept of a ‘bad bank’. As the name suggests, such a bank will buy bad assets or NPAs from banks and then get around to reviving them or disposing them off. They will be bought at a lower value and could reside in the books of the bad bank until they are sold or even be returned to the bank once they cease to be delinquent.

In fact, it does resemble the outcome of the Bankruptcy Bill, with the difference being that instead of banks getting together and deciding, the assets are offloaded to this new entity and thenceforth it will be business-as-usual for banks.

 The objective is to have banks clean up their balance sheets. If they are permanently selling their bad assets, they write off the loss in year one, and then restart on a clean slate. The capital adequacy ratio improves as they are shrinking their balance sheets, and the level of NPAs and the provisions that have to be made come down sharply. This appears to be a panacea for public sector banks (PSBs) which are currently the focus of attention. Once the balance sheets are cleaned, then they can raise capital as they become stock-market worthy.

The issue is as to who will start this bad bank? Such a bank needs share capital and will have to raise funds to buy these assets and pay off the banks. One idea is to have the government start such a bad bank.

This is different from capitalising a PSB as it involves actually purchasing the assets and then trying to realise the best value. In case of capitalising the bank, one is only covering the liabilities side and not addressing the issue. When assets are bought, it directly lowers the delinquent assets and is hence superior.

As the problem has arisen due to a large-scale clean-up operation of the Reserve Bank of India (RBI)—and the banks affected the most are government-owned institutions—it makes sense for the government to buy the assets, which, in a way, is analogous to a loan waiver scheme in a modified form, as the recoveries will accrue to the government. Having the private sector create a bad bank is similar to an asset reconstruction company (ARC), which currently does not have the financial strength to handle these large amounts.

The creation of bad banks has been pursued after the Asian crisis in 1997 in the East Asian economies. The model has involved an outright purchase, which is called the Swiss approach, and a repurchase option, which is the German way of doing things. The idea is nonetheless compelling because it addresses the issue in a full-hearted manner. There, however, have to be conditions attached to such a bank being crafted which buys bad assets.

The first is that it should be based on a criterion as any such exercise creates a moral hazard which should be eschewed. Second, there have to be strict performance criteria for the banks selling such assets. This can be through a multi-stage approach where these assets are bought piecemeal by the bad bank based on how future incremental assets perform. Third, the criteria for buying assets should be transparent and a pecking order must be drawn up where probably the restructured assets get priority. Last, a competitive approach should prevail among the banks so that they work hard to qualify for the sale of bad assets to the bad bank. This, in fact, will ensure better governance standards too.

We certainly need to attack this problem and, given the scale, the government has to play a role here. The challenge is to structure it in such a way that moral hazard is avoided, which is also the issue with all loan waiver schemes. Fiscal support is a corollary that has to be provided for in the budget and has to be done. Similar to how the UDAY scheme involves state governments working out ways to reduce losses of state electricity boards, the Union government has to take on this responsibility to address the bad assets created by banks owned by them. This would be the ultimate justification for the same.

This clean-up operation will make banks stronger and in a position to lend money when the economic cycle seems to be on the verge of looking up. If it is not done, the regulatory factors could constrain their lending ability. Therefore, this option should be explored and implemented.