A poor idea

Bad bank will only kick the can down the road

Economic disruption caused by Covid-19 will push up non-performing assets (NPAs) in the banking sector. According to the latest Financial Stability Report of the Reserve Bank of India (RBI), under the baseline scenario, the gross NPA (GNPA) ratio can go up from 7.5 per cent in September 2020 to 13.5 per cent by September this year. The ratio would worsen if the macroeconomic conditions deteriorate. For the public sector banks (PSBs), it’s even worse. Their GNPA ratio can go up to 16.2 per cent by September 2021 under the baseline scenario, the report said. Clearly, weak bank balance sheets, particularly in PSBs, would affect economic revival. Given the state of the banking system, the government is reportedly considering the setting up of a bad bank to clean up bank balance sheets. RBI Governor Shaktikanta Das recently said the central bank was open to looking at any such proposal.

The idea of establishing a bad bank is not new. Since the banking system has been under stress for many years, the proposal keeps surfacing from time to time. Arguably, bank balance sheets can be cleaned by transferring NPAs to a bad bank, established to hold and resolve such assets. However, there are several reasons why this idea will not work in India. In fact, it could end up worsening the situation by delaying the resolution process. One of the biggest reasons for persistently high NPAs in PSBs is poor lending standards. Forming a bad bank will not solve this fundamental problem. Further, bankers in the public sector are reluctant to recognise bad loans because they can be held against them by investigating agencies. A bad bank established by the government will face the same problem.

Besides, the valuation of assets transferred to a bad bank will remain contentious. If the assets are transferred at relatively high valuations, among other things, the incentive for due diligence in banks would be impaired. Officials in the bad bank may also not get a free hand to act professionally because the resolution of bad debt would require significant write-offs. Attracting the right talent to handle and resolve bad assets in different sectors would be another problem. The private sector might be reluctant to participate because of the way the public sector functions in India. Moreover, establishing a bad bank and optically cleaning up bank balance sheets would not reduce fiscal pressure. Writing down assets either from the books of commercial banks or a bad bank would result in losses for the government and increase capital requirement.

A bad bank would perhaps only be used to kick the can down the road. It cannot fill the void created by lack of hard decisions in the context of PSBs over the years. They need wider reforms to be able to function freely and compete in the market. Till that happens, PSBs will remain a drag on both government finances and economic growth. Also, the government would do well to strengthen the Insolvency and Bankruptcy Code (IBC) to avoid delays in the resolution of bad assets. The extended suspension of the IBC is not helping the system. Therefore, the government would be well advised to address the real issues in the banking sector. Shifting the problem from one institution to another is no solution.