Bad Banks: Any Merit to the Idea?

Consider Bank X, who loaned a hefty amount of INR 5000 crores to a big corporate company. While the company had all sources to repay the loan, with the interest, the unanticipated COVID-19 pandemic threw the company into losses. As a result, the bank was able to recover INR 4500 crores only. Due to financial constraints, Bank X cannot spend all its resources chasing down the company to recover the remaining amount as it would drive its attention away from its core operations. So what happens to the 500 crores? Is such a huge non-performing asset (NPA) viable for the functioning of a commercial bank? Is there any alternative to this crisis?

India’s financial system is predominantly bank-based and therefore it is of paramount importance that commercial banks and public sector banks (PSBs) perform well and aid the nation’s economy. This implies that the NPA levels or loans that borrowers have defaulted on must be manageable and ideally less than 5%. However, India’s 19 nationalized banks owed approximately 6.8 trillion rupees as NPAs at the end of the fiscal year 2020. The value dipped from 7.5 trillion rupees in 2019, which, however, offers little relief to the issue at hand. Various analysts have predicted that the proportion of stressed assets may jump to as high as 18% from around 11% at present, calling for immediate government intervention.

To tackle this issue of soaring bad loans, FM Nirmala Sitharaman proposed the idea of a bad banks or asset reconstruction company (ARC) that will assist in taking over the bad loans of commercial banks, manage the funds and finally recover the money over a period of time. The Indian Banks Association (IBA) had submitted a proposal in May 2020 to the finance ministry and the RBI to set up bad banks with equity contributions from banks and the government. The main idea behind taking the defaulted money and other illiquid holdings is to clean up the balance sheets of the commercial banks and help reduce the NPAs over time.

The idea of a bad bank was pioneered at Mellon Bank in 1988 after deep problems in the bank’s real-estate holdings. Following the success of these banks, the model was taken up by Sweden, Germany, and France. The idea may be fruitful for the Indian economy too as it would help improve the wellbeing of the banking sector, said renowned economist K. Sreerama Murty. It would help curb the growing problem of illiquid holdings and NPAs that have spiked in the wake of the coronavirus, placing India on a road to recovery following the recessionary phase. Additionally, large debtors have various creditors. The creation of bad banks can centralize the loan repayment agency and promote smooth coordination. Considering AMCs focus only on recovering the defaulted money, this will help drive a better bargain with borrowers as strict action will be taken against the defaulters.

It is important to take note of an important real-life example of a bad bank system to further understand its viability and impact. To address the liquidity and solvency issues in Irish Banks, Ireland created the National Asset Management Agency (NAMA) in 2009. The main function was to remove problem loans by property and development land when it had considerably slumped. NAMA helped de-risk the balance sheets and contributed to the recovery of the Irish financial structure. Upon its establishment, NAMA acquired loans up to €26.2 billion from the banks and provided €5.6 billion of state aid to the banks. The NAMA website regularly updates detailed information regarding the performance and the quarterly and annual reports. The statistics published concludes that NAMA has made progress in its core activities and has been working well for the Irish banking system.

RBI Governor Shaktikanta Das has agreed to look into the proposal of the creation of a bad bank after the announcement in the Union Budget.

However, the opposition to the idea of bad banks came from former RBI Governor Raghuram Rajan, who wrote about it in his book I Do What I Do. He is of the view that it would make more sense for banks to recover the loans themselves, without relying on an external source. He also maintains that the concept of a good bank or bad bank does not apply to India considering most of the assets backing the banks’ loans are viable or can be made viable. Furthermore, he writes that in cases where loans are not priced appropriately, the transfer of funds to a bad bank may create issues. In general, bad banks may create a moral problem as a bad bank will continue to absorb NPAs at a watered-down rate from banks and deal with them as a mere stock rather than a flow.

In conclusion, the establishment of a new entity in the banking sector is risky. Who will own these banks? Will the financial sector be able to generate results after the establishment of bad banks? While the idea stands to be potentially beneficial, it will only be successful if such questions are answered well.









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