Bad Bank: Solution or more problems?
Simplifying the existing process and removing inconsistencies in implementation would be better
One sticky problem that is giving nightmares to the policy makers and PSBs is the Non-Performing Assets (NPAs). The government and the RBI have been demonstrating seriousness and commitment towards resolution of NPAs. Various possible ideas for resolution of NPAs have been discussed, debated and some of them have been tried.
One such idea that has been discussed time and again is the formation of a Bad Bank. The idea of a bad bank is to transfer all the non-performing assets (NPAs) of bank/s into a separate entity — a bad bank — thereby cleaning the banks’ balance sheet. The bad bank is then expected to manage these NPAs in suitable ways — liquidation, restructuring, etc. — by focusing on the task of recovery.
However, the following are the challenges in successfully operating a bad bank model.
Given the asymmetry of information regarding quality of assets, government support will be required to give confidence to investors. This could be either through providing sufficient capital to the bad bank or providing a First Loss guarantee to a certain extent.
Transfer pricing of assets to the bad bank needs to be carefully evaluated — price the assets too high and the bad bank itself would fail, price assets too low and the original bank shareholders would be short-changed.
Post transfer of assets, the bad bank will need to recruit personnel specialised in taking strategic decisions regarding the optimal plan — restructuring, partial sale of assets or liquidation — and implementing the same. There is a dearth of such qualified professionals in India. A separate management structure will need to be created in the bad bank with appropriate incentives linked to resolution.
From an investor perspective, bad banks with heterogeneous assets will be more complex to value.
Examples of success in Sweden were Nordbanken and Gota banks where the blanket guarantee of all bank liabilities and recapitalisation of banks by the government played a significant role in success. Neither does the government have the wherewithal to issue blanket guarantees nor have enough resources to recapitalise the bad bank.
Given the above challenges, it would be better to focus on streamlining the resolution process under the Insolvency and bankruptcy code (IBC). Simplifying the existing process and removing inconsistencies in implementation would yield higher dividends than experimenting with a new system such as bad banks. What works in favour of IBC is the possibility of inducting willing investors, both strategic and financial, into the stressed assets. Such a step would increase the chances of resolution of the stressed assets as compared to the bad bank wherein the shareholders are not sure of being part of the upside generated, if any. However, in order to attract and retain investors, the focus should now be on the demand side of stressed assets. It is important to recognise that the real recovery and resolution can happen by creating market for stressed assets. Currently, although the supply of stressed assets is huge, there is very little demand for that. Whatever is the route, bad bank or IBC, strengthening the demand side becomes extremely critical. Framing conducive policies for creating a market for stressed assets and creating adequate number of instruments for investors to invest in those assets for a long-haul is the need of the hour. Funds available with Asset Reconstruction Companies, which could buy bad assets and resolve them, are miniscule compared to the scale of the NPAs. Additionally, such entities are subject to several regulations which have hampered their growth. Creating a vibrant market for securities backed by such bad assets would require incentivising the seller to dispose off the bad assets (through higher provisions on such assets, removal of fear of prosecution of Public Sector Bank employees involved in selling bad assets) as well as the buyers (through allowing efficient tax structuring and possible tax incentives). Additionally, for assets that could take a longer time to restructure and resolve, demand needs to be generated from institutions with long term capital.
While resolution is one aspect of the story, addressing the fundamentals to ensure that this does not become a recurring problem is another issue. Some of the key causes for the current NPA crisis are poor underwriting standards, lack of risk-based loan pricing, lax monitoring, evergreening of bad assets and the lack of appropriate processes to resolve assets in early stages of delinquency and, above all, a weak order of corporate governance. Getting out of the current NPA mess smothering the banking system will require a systemic overhaul of such processes at ailing lenders.
The policy makers and the banking system should send out a consistent message to the proposed investors — domestic and overseas —on the seriousness and commitment to the NCLT and IBC processes. They will dread to participate in the recovery if we send mixed and multiple messages. They will continue to wait till we stabilise our story and recovery will elude us. The need of the hour is to create demand for stressed assets and provide a strong message of consistent commitment to embarked programme to achieve desired outcome.