‘Bad Banks’ in India: Solution for Stressed Assets?

The Indian Public Banking System has been grappling with the problems of bad loans and is unable to find more than a band aid solution for it. The Reserve Bank of India, under the leadership of Raghuram Rajan, made it very clear to the banks that the system has to not only provide cushioning (“provisions”) but also clean up the balance sheet. To formalize this dictum in the form of a possible regulatory move, the proposition of “bad banks” was made in the Economic Survey of India 2017-2018.

It’s the government’s way of saying “It’s high time we get our act together”. The bad bank concept means that all of the stressed assets of a bank will be transferred into a separate legal entity, providing relief to the bank’s balance sheet and facilitating expeditious resolution (since the focus will be only on dealing with stressed assets). Before delving into the concept of bad banks at a more granular level, let’s first familiarize ourselves with the scenario of stressed assets in Indian financial system and why prior solutions haven’t worked.

Stressed assets were a priority for R.Rajan

The Gross Non-Performing Assets (Gross NPA) as a percentage of total book, which is a measure of the bad loans existent in a bank, today stands at 7+% in the Indian public banking system. Inefficiencies in the credit risk assessment process and corruption from the borrower’s end to get the loan sanctioned are the 2 main reasons stimulating this problem. This is transpiring to a situation where the problem of bad loans is a severe drag on the economy. Public banks are required to make provisions for these bad loans which is an added cost in the Profit and Loss Statement, thereby leading to the erosion of profits. This constrains public banks from raising additional capital from the markets subsequently leading to a decline in credit growth (which is a pre-requisite for the Indian economy to return to an 8% growth trajectory).

In context to the above scenario, the Government of India has implemented necessary policies, such as the SARFAESI Act, roped in measures such as Strategic Debt Restructuring and permitted the institutionalization of Asset Reconstruction Companies (ARC’s). However, these efforts have failed to disentangle the bad loans off the banks’ system. For example, the ARC’s low capital position has allowed it to buy off only 5% of the total bad loans book in 2014-2015 and 2015-2016. Similarly, in the case of Strategic Debt Restructuring (where the banks convert their debt into equity in order to make business decisions on behalf of the company to recover the losses), banks have failed to convert their debt into equity (also known as risk of arbitrage) in the stipulated time period of 7 months owing to the resistance of the promoter to get new investors on board. Thus there is merit in contemplating about a new solution which the Government of India has paved way for with the proposition of ‘bad banks’.

In order to make a bare minimum viability case for bad banks, it is imperative to answer the following questions:

Which is the key structural mechanism in which a bad bank can function in India?

How does this happen given the need for the government to execute this proposition at minimum public cost?

# Structural mechanisms of a bad bank

Case 1: On balance sheet guarantee: When the government wants to front-load a minimum amount of capital with limited risk transfer as a subsequent trade-off.

This method involves the bank protecting its bad loans portfolio with the government giving a guarantee against losses. However, this does not lead to a complete de-consolidation of the bad loans from the book of a bank. Hence this is not a viable option given the primary objective of the government to ensure a complete cleaning up off the banks’ balance sheet.

Case 2: Off balance sheet Special Purpose Entity (SPE): When the bank wants complete risk transfer into a separate entity.

In this method, all of the bad loans of a bank are transferred to a government sponsored SPE. From here onwards, the SPE either undertakes resolution or sells the bad loans to investors who obtain strategic positions with regards to the underlying assets of the bad loans in order to make a price differential gain (eg. Buying the bad asset at the clearing price which is typically very low and disposing it off at a mark-up). This is a viable solution when the bad loans as a consolidated picture are homogeneous assets (since an investor typically possesses the expertise in one or two asset classes). However, given the diversified portfolio of Indian banks, an SPE in this case would comprise of heterogeneous assets making this solution less viable.

Case 3: Bad bank spin-off

  • When the government is willing to frontload the maximum amount of capital with complete risk transfer
  • When the bank wants a complete risk transfer with maximum strategic and operational flexibility.

In this case a separate external legal entity is created. All of the non-strategic and toxic assets are transferred to this bad bank. The government will have to create a common legal and regulatory framework and support this entity through funding and loss guarantees.

In light of the recent announcement by Mr. Arun Jaitley (Finance Minister, Government of India), that the bad loans of a bank would be transferred to a separate legal entity, it seems that the government is contemplating about a bad bank spin-off (Case 3).

# Minimum Public Cost

Moving ahead to a scenario where implementation of such a proposition is actually on the books, it is imperative that government execute this plan at minimum public cost. The attempt to revive the financial system and bring an element of stable lending should not impose a huge burden on the taxpayer. One must not forget that the ulterior motive is to provide relief to the banks and not inordinate support. Thus the linkages in a string where one end requires the government to provide capital to the bad bank and the other end where the government reaches into the pockets of the taxpayer to fund such capital requirements needs to be established, communicated and concurred upon with the public at large.

In conclusion, the structural solution of a bad bank must be thoroughly evaluated against a pre-defined set of criteria (including funding requirements, regulatory and accounting issues). In the eyes of the public and foreign investors, there is a modicum of trust in the lending practices of public sector banks. A nationwide robust plan with an overarching goal of financial stability will help restore faith in the sector.

Ayush Banerjee

Ayush Banerjee

Policy Intern at InPRA
Ayush Banerjee has completed his bachelor's in economics from Narsee Monjee Institute of Management Studies. He has been associated with several NGO's (Round Table India, Make a Difference, Save the Children etc.) in the past and is committed to making a positive difference. An avid follower of activist investing and Buffetology, he aspires to become a successful value investor in the Indian equity markets.
Participating in debates and MUN's has motivated him to research on international law and change the public perception about the prevalent laws by conducting a deep dive analysis of policies and it's ramifications. He hopes to do the same by writing for InPRA.
Ayush Banerjee