The subject of non-performing assets (NPAs) has caused sufficient worry for the banking system, especially when restructured assets are also included. The number of 11.5% is quite scary and needs to be addressed.
One idea which is not really a bad concept is the concept of a ‘bad bank’. As the name suggests, such a bank will buy bad assets or NPAs from banks and then get around to reviving them or disposing them off. They will be bought at a lower value and could reside in the books of the bad bank until they are sold or even be returned to the bank once they cease to be delinquent.
In fact, it does resemble the outcome of the Bankruptcy Bill, with the difference being that instead of banks getting together and deciding, the assets are offloaded to this new entity and thenceforth it will be business-as-usual for banks.
What exactly is the idea?
The objective is to have banks clean up their balance sheets. If they are permanently selling their bad assets, they write off the loss in year one, and then restart on a clean slate. The capital adequacy ratio improves as they are shrinking their balance sheets, and the level of NPAs and the provisions that have to be made come down sharply. This appears to be a panacea for public sector banks (PSBs) which are currently the focus of attention. Once the balance sheets are cleaned, then they can raise capital as they become stock-market worthy.
The issue is as to who will start this bad bank? Such a bank needs share capital and will have to raise funds to buy these assets and pay off the banks. One idea is to have the government start such a bad bank.
This is different from capitalising a PSB as it involves actually purchasing the assets and then trying to realise the best value. In case of capitalising the bank, one is only covering the liabilities side and not addressing the issue. When assets are bought, it directly lowers the delinquent assets and is hence superior.
As the problem has arisen due to a large-scale clean-up operation of the Reserve Bank of India (RBI)—and the banks affected the most are government-owned institutions—it makes sense for the government to buy the assets, which, in a way, is analogous to a loan waiver scheme in a modified form, as the recoveries will accrue to the government. Having the private sector create a bad bank is similar to an asset reconstruction company (ARC), which currently does not have the financial strength to handle these large amounts.
The creation of bad banks has been pursued after the Asian crisis in 1997 in the East Asian economies. The model has involved an outright purchase, which is called the Swiss approach, and a repurchase option, which is the German way of doing things. The idea is nonetheless compelling because it addresses the issue in a full-hearted manner. There, however, have to be conditions attached to such a bank being crafted which buys bad assets.
The first is that it should be based on a criterion as any such exercise creates a moral hazard which should be eschewed. Second, there have to be strict performance criteria for the banks selling such assets. This can be through a multi-stage approach where these assets are bought piecemeal by the bad bank based on how future incremental assets perform. Third, the criteria for buying assets should be transparent and a pecking order must be drawn up where probably the restructured assets get priority. Last, a competitive approach should prevail among the banks so that they work hard to qualify for the sale of bad assets to the bad bank. This, in fact, will ensure better governance standards too.
We certainly need to attack this problem and, given the scale, the government has to play a role here. The challenge is to structure it in such a way that moral hazard is avoided, which is also the issue with all loan waiver schemes. Fiscal support is a corollary that has to be provided for in the budget and has to be done. Similar to how the UDAY scheme involves state governments working out ways to reduce losses of state electricity boards, the Union government has to take on this responsibility to address the bad assets created by banks owned by them. This would be the ultimate justification for the same.
This clean-up operation will make banks stronger and in a position to lend money when the economic cycle seems to be on the verge of looking up. If it is not done, the regulatory factors could constrain their lending ability. Therefore, this option should be explored and implemented.
A national ‘bad bank’ to cleanse the balance sheets of PSBs is actively being considered by the government, according to reports. This body would take on PSBs’ bad loans in exchange for government debt, freeing them to lend more and promote growth. In principle, separating bad loans from good ones allows a bank to derisk, deleverage, regain investors’ confidence and improve its market value; a bad bank specialises instead in maximising the value of the troubled assets through recovery, sales and so on. But, in practice, achieving success with a bad bank isn’t easy due to numerous tradeoffs related to costs, capital, profits and viability of the business. In India, choices could be both complex and controversial, given the role of the government as the owner of PSBs and its support and involvement in the bad bank.
The organisational structure of the proposed body is not yet known, but the structuring of incentives, which is linked to who has a major say, is crucial. Different varieties exist in countries like Germany, Ireland, the US, Sweden, etc. Reportedly, RBI’s concern is that a majority stake of the very banks whose NPAs are to be bought could create a moral hazard. This is well-justified because key decisions relate to pricing and the eventual management, i.e. recovery, sales, restoring market value, etc, of these bad assets. Such a body necessitates specialised professional skills that can mean ruthless business decisions too.
A couple of problematic issues can be imagined for India. One, the valuation or price at which bad loans are bought from PSBs; two, the implications for public debt. Both are intertwined in a delicate political economy context. If bad assets are bought from lenders at too high a price—say, at a book value or without any discount—PSBs benefit, but the public exchequer or taxpayers bear the losses (it is evident here what a majority say by the banks on the other side, bad bank, implies). In the event NPAs are offloaded with a sharp haircut, PSBs would have to immediately book large losses, and their capital takes a hit; the government would incur a huge expense in purchasing the stressed assets (if providing capital support to the bad bank) and recapitalising PSBs on the other side, with the hope to recoup these costs from future sales, recovery or improved market values of what at present are troubled assets. Were a private bank’s assets to be acquired so, deep discounts would be a positive because buy-cheap-sell-dear is likely to fetch higher profits in the future.
There could be many agreeable price points in between these extremes, but the key point is that price discovery is inherent in the idea; finding just that price that balances economic sense with public acceptability in view of the state-owned nature of lenders could be complex, troublesome. Discount pricing can be a problem, especially if NPAs are offloaded at knock-down prices, but this is not matched by rigorous, professional overhaul. For what prevents recurrence? Controversies could also arise depending upon who the NPAs are eventually sold off to, at what price, who pockets the profits and so forth. And considering that many bad loans are linked with infrastructure, it would be quite tricky to mark down value of the assets to market prices. As observed from some mortgaged property auctions, banks are clearly reluctant to mark down prices.
Some of these issues are evident from observations like that of Uday Kotak of Kotak Mahindra Bank, which deals in stressed assets; he was reported to say that lack of convergence between lenders’ valuations of stressed assets and what his bank judged was a fair price was obstructing deal-making. It appears most of the assets backing banks’ loans are either viable or can be made so. In which case it isn’t clear as to how a separate, public-private body can do a better job. Far more could be achieved, and with greater efficiency, were the government to reduce its shareholdings below 51% instead. Transferring unwanted assets of all PSBs uniformly may end up keeping alive even those banks that are unviable; alternately, choosing could be difficult and quite likely meet with strong resistance.
Last, considering the immediate recapitalisation demands that would arise, public debt levels would be impacted. It is reported that the government is likely to reallocate some parts of the public sector balance sheet so as to not affect increases in public debt. But this must be transparent, free of moral hazard and not set any undesirable precedent for future governments to emulate. If at all the government creates a fund for stressed assets, it needs to draw a clear line for the extent of risk it will assume.