The Indian Banking system has been crippled with bad loans for a while now. When the borrower stops paying the interest or principal on a loan, that loan is a Non-Performing asset for the lender. These bad loans are toxic. As the NPAs pile up, investors frown upon the bank. They do not want to invest in the institution anymore. The bank has to pay an outrageous amount of interest to lend money from outside. This means the losses will soar and the bank won’t be able to extend loans to businesses, hurting the economy at large. It is a vicious cycle.
This problem is prevalent, particularly in state-owned banks. The NPAs of Public Sector Banks (PSBs) stood at ₹7.27 lakh crore as on September 30, 2019. But all loans are backed by collateral right? Banks can recover the amount by selling that collateral. But the concern here is that banks do not do this daily. They do not have the expertise to handle these transactions. Then how to tackle this problem?
A Bad Bank is the answer.
To begin with, a bad bank buys non-performing loans of the banks at a discount, resolves them over a period of time, and leave the banks with clean balance sheets. These banks can now make a fresh start, raise capital on better terms, and continue extending loans to borrowers.
Why not sell to existing ARCs?
Asset Reconstruction Companies (like Blackstone) do the same job. But banks are reluctant to sell the bad loans to ARCs because they demand a sharp discount. For example, if a ₹1000 crore loan has turned bad, ARCs would buy it for say, ₹590 crores or ₹400 crores. Selling off the loans at deep discounts is seemingly a loss for the bank. This is where bad banks come into play.
Moreover, the COVID pandemic and the subsequent lockdown is sure to send banks’ NPAs shooting up. Keeping this situation in mind, The Indian Banks Association (IBA) has proposed setting up a bad bank with an initial capital of ₹10,000 crores. But the government is unlikely to approve this proposal.
Is setting up a bad bank a bad idea?
The idea is perhaps not a great one because, if the PSBs, which account for two-thirds of the banking sector, continue doing business the same way then there will be a hoard of bad loans in no time. Presently, the morale of PSBs is quite low, especially in the recently merged entities. Therefore, the government’s argument of focusing on structural reforms and setting up the right governance is a persuasive one. The government first wants to ensure the initiation of structural reforms to boost the performance of the existing ARCs.
Moreover, the transfer will be from one public sector entity to another, and the government ought to capitalize both. Looking at India’s soaring fiscal deficit, this move is completely insupportable.
The key to success- Collective Ownership
Ownership of the bad bank can be distributed among the PSBs, in proportion to their total bad loan portfolio. It will ensure that the profits accrued from the loan resolved, go to the banks themselves. And the loss borne from the discounted sale will become more acceptable.
Another plausible solution would be combined ownership of public and private entities. The focus of the bad bank managers will exclusively be on getting the maximum value from the acquired assets.
However, the baton is in the government’s hands and we’ll have to wait and watch what it does with these bad loans.