Bad Banks Could Be The Much-Needed Vaccine To Check The Zooming NPA Crisis Amid Pandemic

The banking industry in India has a huge canvas of history, which covers the traditional banking practices from the time of Britisher’s to the reforms period, nationalization to privatization of banks and now increasing numbers of foreign banks in India. Therefore, Banking in India has been through a long journey. Banking industry in India has also achieved a new height with the changing times. The use of technology has brought a revolution in the working style of the banks. Nevertheless, the fundamental aspects of banking i.e. trust and the confidence of the people on the institution remain the same. The majority of the banks are still successful in keeping with the confidence of the shareholders as well as other stakeholders. However, with the changing dynamics of banking business brings new kind of risk exposure.

Bank’s purpose is to provide loans to businesses. This creates credit in the economy. But, with credit comes the risk of credit default. The gross non-performing assets (NPAs) of Indian banks may rise to 8-9 per cent by the end of this fiscal year (FY22), 50-150 basis points higher than FY21 levels, but much below the FY18 levels when NPAs reached a peak of 11.2 per cent, said rating agency Crisil in a research note. Also, the stressed assets of the banking sector may touch 10-11 per cent, assuming 2 per cent of assets will be restructured by the end of FY22, the rating agency said.

The projections are made on the assumption that the Indian economy will grow at 9.5 per cent this year and there will be continued improvement in corporate credit quality. However, if there is a third wave of the Coronavirus (Covid-19) pandemic, posing challenges to demand growth then there may be significant downside risks to the estimates made. On the other hand, if the National Asset Reconstruction Company Limited (NARCL) or “bad bank” as it is popularly known gets operationalised this fiscal then the NPAs of the banking system may fall further.

What Is A Bad Bank ?

• A bad bank(also referred to as an asset management company or AMC) is a corporate structure which isolates illiquid and high risk assets (typically non-performing loans) held by a bank or a financial organisation, or perhaps a group of banks or financial organisations.

• A bank may accumulate a large portfolio of debts or other financial instruments which unexpectedly become at risk of partial or full default. A large volume of non-performing assets usually make it difficult for the bank to raise capital, for example through sales of bonds. In these circumstances, the bank may wish to segregate its “good” assets from its “bad” assets through the creation of a bad bank.

• The goal of the segregation is to allow investors to assess the bank’s financial health with greater certainty. A bad bank might be established by one bank or financial institution as part of a strategy to deal with a difficult financial situation, or by a government or some other official institution as part of an official response to financial problems across a number of institutions in the financial sector.

How Can Bad Banks Help

A bad bank conveys the impression that it will function as a bank but has bad assets to start with. Technically, a bad bank is an asset reconstruction company (ARC) or an asset management company that takes over the bad loans of commercial banks, manages them and finally recovers the money over a period of time. The bad bank is not involved in lending and taking deposits, but helps commercial banks clean up their balance sheets and resolve bad loans

The takeover of bad loans is normally below the book value of the loan and the bad bank tries to recover as much as possible subsequently

US-based Mellon Bank created the first bad bank in 1988, after which the concept has been implemented in other countries including Sweden, Finland, France and Germany. However, resolution agencies or ARCs set up as banks, which originate or guarantee lending, have ended up turning into reckless lenders in some countries.

Do We Need A Bad Bank?

The idea gained currency during Rajan’s tenure as RBI Governor. The RBI had then initiated an asset quality review (AQR) of banks and found that several banks had suppressed or hidden bad loans to show a healthy balance sheet. However, the idea remained on paper amid lack of consensus on the efficacy of such an institution. ARCs have not made any impact in resolving bad loans due to many procedural issues.

Now, with the pandemic hitting the banking sector, the RBI fears a spike in bad loans in the wake of a six-month moratorium it has announced to tackle the economic slowdown.

What Is The Stand Of The RBI And Government On A Bad Bank?

• While the RBI did not show much enthusiasm about a bad bank all these years, there are signs that it can look at the idea now. Governor Das indicated that the RBI can consider the idea of a bad bank to tackle bad loans.

• The first is a private asset management company (PAMC), which is said to be suitable for stressed sectors where the assets are likely to have an economic value in the short run, with moderate levels of debt forgiveness.

• The second model is the National Asset Management Company (NAMC), which would be necessary for sectors where the problem is not just one of excess capacity but possibly also of economically unviable assets in the short to medium terms.

Has The Banking System Made Any Proposal?

• The banking sector, led by the Indian Banks’ Association, had submitted a proposal last May for setting up a bad bank to resolve the NPA problem, proposing equity contribution from the government and banks. The proposal was also discussed at the Financial Stability and Development Council (FSDC) meeting, but it did not find favour with the government which preferred a market-led resolution process.

• The idea of a bad bank was discussed in 2018 too, but it never took shape. During the pandemic, banks and India Inc were also pitching for one-time restructuring of loans and NPA reclassification norms from 90 days to 180 days as relief measures to tackle the impact of the lockdown and the slowdown in the economy. Currently, loans in which the borrower fails to pay principal and/or interest charges within 90 days are classified as NPAs and provisioning is made accordingly.

How Serious Is The NPA Issue In The Wake Of The Pandemic?

• Bad loans in the system are expected to balloon in the wake of contraction in the economy and the problems being faced by many sectors.

• Banks will need to respond to lasting social changes, including how consumers select channel preferences, products, and banks for their individual financial needs that are likely to result from the current crisis. Behavioral changes may accelerate the shift of the branch concept away from transactions toward a more complex, high-value operation.

• A special refinance facility of Rs 50,000 crores was announced to meet sectorial credit requirements – this is to specifically boost the liquidity of financial institutions like NABARD, SIDBI, and NHBs. NPA (Non-performing Assets) norms of 90 days have been relaxed.

• The period of the moratorium will be excluded from the 90-day classification norms of NPAs for those accounts, which would avail the moratorium facility. The NBFCs (Non-Banking Financial Companies) have been given the flexibility to give such relief to their borrowers. Though it is very difficult for BANKS to come out from the crisis of NPAs with acceptable strategies, at least they can minimize.

Will A Bad Bank Solve The Problem Of NPAs?

• Despite a series of measures by the RBI for better recognition and provisioning against NPAs, as well as massive doses of capitalisation of public sector banks by the government, the problem of NPAs continues in the banking sector, especially among the weaker banks.

• As the Covid-related stress pans out in the coming months, proponents of the concept feel that a professionally-run bad bank funded by the private lenders and supported the government, can be an effective mechanism to deal with NPAs.

• The bad bank concept is in some ways similar to an ARC but is funded by the government initially, with banks and other investors co-investing in due course. The presence of the government is seen as a means to speed up the clean-up process.