Government Mulls Bad Bank Solution To Bad Loans, Seeks Expert Views

The government has informally sought views from financial sector professionals on the concept of a bad bank, as it continues to seek a way to resolve over Rs 6 lakh crore in bad loans on bank balancesheets.

According to two people who have had recent discussions with the government, officials are keen to understand how a bad bank structure could work and what its pros and cons are. A third person familiar with the matter said that a number of options to speed up the resolution of bad loans, including a bad bank, are being discussed. All three requested anonymity as the discussions were confidential.

The government is keen to understand the global experience with bad banks and has asked for a presentation on the same, said the first person quoted above. The second person added that the passage of the Insolvency and Bankruptcy Code 2016 has raised hopes that the legal framework for resolution and recovery would improve, which could make a bad bank a more feasible option.

On October 2, the Indian Express first reported that the option of a bad bank may be back on the policy table.

What Does A Bad Bank Do?

A bad bank is essentially an entity to which lenders can transfer their troubled loans. The idea is to take non-performing assets off the books of banks and allow them to focus on their core business. This would also reduce the amount of capital needed by banks for provisioning.

The specialized entity, which holds these bad loans, can then focus solely on the process of resolution and recovery. This entity, however, would also need to be capitalised, in this case, by the government.

Former RBI governor Raghuram Rajan had opposed the idea of a government led bad bank. He had instead suggested that private sector asset reconstruction companies (ARCs) be strengthened in a way that they have adequate capital to make all-cash purchases of bad loans from banks. Currently, ARCs pay 15 percent in cash upfront and the rest in security receipts to be redeemed later. For this, the government has allowed 100 percent foreign direct investment in ARCs under the automatic route.

So far, however, sales of bad loans to private ARCs have not picked up as banks and reconstruction companies differ on the fair value of these assets.

On Tuesday, RBI governor Urjit Patel acknowledged that resolution of bad loans remains slow and added that dealing with stressed assets will require “skill and creativity.” He did not comment on any specific options that may be up for discussion but said that the government and the RBI are working together to deal with the issue of bad loans.

Not An Easy Option

A bad bank, however, is not an easy option and has been dismissed in the past.

For one, the government would still need to capitalise a bad bank, said Ashvin Parekh, managing partner of Ashvin Parekh Advisory Services.

“When you take a stressed account away from a bank that has been dealing with it, the recovery process can actually slow. On the other hand, you can argue that a focused entity may be better at recovery,” he added. Parekh, however, cautioned that allowing banks to transfer bad loans to another entity could prove to be a moral hazard and added that in an environment where credit quality is improving, banks should be encouraged to focus on recovery internally.

The third person quoted above expressed similar concerns and said that each stressed asset has to be resolved individually. Clubbing all the bad loans together into one entity which doesn’t have a clear understanding of the history of the account could actually slow recovery. This person also noted that the tools of recovery that would be available to a bad bank are the same as those available to existing lenders, suggesting that the track record of a bad bank in recovery of bad loans may not be much better than that of existing banks.

The Global Experience

The global experience with the bad bank concept has been mixed.

The US, for instance, announced the Troubled Asset Relief Program (TARP) to purchase assets from troubled institutions. TARP was set up after the collapse of Lehman Brothers in 2008 and initially allowed the US government to purchase up to $700 billion in troubled assets. By the end of 2014, TARP had been wound down with profits of nearly $15 billion.

Ireland, too, had set up the National Asset Management Agency (NAMA) in 2009 for a period of 10 years. On 8 June, the agency predicted that it would make a profit of 2.3 billion euro by the time it winds down, according to a report by Reuters. The agency had taken over almost 74 billion euro in bad loans from Irish banks in the aftermath of the crisis. NAMA, however, has run into trouble. On 15 September, BBC reported that the Irish government has reached an agreement to investigate allegations of impropriety and political interference in the sale of some assets by the agency.