Split verdict on bad bank

With a change in guard at the Reserve Bank of India (RBI), rumours of creating a bad bank to deal with the issue of bad loans have once again cropped up.

The idea, which was mooted earlier, had been shot down by former RBI governor Raguram Rajan. The renewed interest in the idea could perhaps be construed as acceptance of the severity of the bad loan problem plaguing the system, which continues to persist.

Theoretically, a bad bank or an asset management company could be set up with government money to buy non-performing assets from banks. By selling souring loans to the bad bank, banks would be free of providing for these loans. This would also free up precious capital which could then be used to boost credit flow to industry. To resolve these soured loans, the bad bank could explore various options such as closing down plants, selling them off or going to court to resolve pestering issues. But, such a proposal raises many troubling questions. First, who will pay for the potential losses?

For the sake of argument, let’s assume that a bad bank is set up with a capital base of Rs 10,000 crore. It can then issue Rs 40,000 crore worth of government-backed bonds, totalling up to Rs 50,000 crore. These funds will then be used to buy loans from banks. But, as only a fraction of these loans are likely to be recovered, the government will end up bearing the costs (the difference between Rs 50,000 crore and the amount actually recovered). For example, take the case of IDBI.

The Stressed Asset Stabilization Fund to which the loans were hived off was only able to recover 45 per cent over nine years.  Second, at what prices will these loans be bought from banks? Will the loans be bought at the book value — in which case banks don’t bear costs – or will they be bought at discounted rates, in which case banks do bear a portion of the loss.  “Some structure could be worked out where banks are paid a portion as upfront cash and the balance is paid depending on recovery,” says Vibha Batra, former head of financial sector ratings at Icra.

If banks are willing to sell loans at a haircut, wouldn’t it make more sense to allow asset reconstruction firms, which have the required expertise in this area, to be major players?

“Given the scale of the problem in India, a bad bank may not be needed. You can resolve this through asset reconstruction companies. But, the question is of the haircut — how much banks are willing to take,” says Pronab Sen, former chairman, National Statistical Commission.  

The third issue is of moral hazard. If the government indeed sets up a bad bank, the fear is banks would continue with their reckless lending.

While Ajay Shah of the National Institute of Public Finance and Policy disagrees on the creation of bad bank on account of moral hazard, other economists contend that at the current juncture, concerns of growth override that of moral hazard.

“It (bad bank) does create the problem of moral hazard as it creates incentives for banks to be reckless. But today, the banking system is in a bad shape. It’s a good idea,” says Madan Sabnavis, chief economist, CARE. “But, it depends on how it is structured,” he adds.

Batra concurs. “Yes, moral hazard is a problem. But, at the present juncture, the gains outweigh the costs. It could free up precious management bandwidth and capital that can be used to boost credit to industry,” she says. “The success of the bad bank depends on its governance structure, incentives for staff as well as quality of staff.” Lastly, the issue of how much capital is required and from where it will come needs to be addressed.

On the issue of capital required, the first step entails getting firm estimates of the scale of the problem. While currently, gross non-performing loans stand at 8.5 per cent of total advances, analysts contend that even stressed assets should be included to arrive at the final figure.

While this will cause the figure of capital required to blow up, analysts believe that only big loan accounts should be transferred to the bad bank, leaving banks to deal with only the small loan accounts. “The focus should be on large accounts while leaving banks to deal with smaller accounts,” says Batra.

On the issue of funds, while a cash-strapped government may find it difficult to cough up the entire amount, simply providing Rs 20,000 crore as the capital base could be a start. This amount could be leveraged up to arrange funds totalling to Rs 1 lakh crore.