Bad Bank in India

Bad Bank in India: Is it good solution to wipe off NPAs?

Latest Updates: Padmakumar M Nair, Chief General Manager (CGM), SBI in the Stressed Assets Resolution Group (SARG) is the designated Chief Executive of proposed NARC, ‘The Bad Bank’. National Asset Reconstruction Company (NARC), also called a Bad Bank, will function as an entity for taking over bad loans of lenders, predominantly the public sector banks. This ‘Bad Bank’, is expected to be operational in June 2021. Read details below

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In the Union Budget 2021-22, the concept of bad bank came to limelight as our Finance Minister, while presenting the budget on Feb 1, 2021, announced to establish a ‘Bad Bank’ - an Asset Reconstruction Company (ARC) and Asset Management Company (AMC) to address stressed debt of Rs.2.25 lakh crore in the banking sector.  Bad Bank has become a hot topic for group discussion; for Writing Ability Test (WAT) in IIMs and other top MBA colleges as well as top services recruitment. It is an important question in Personal Interview (PI) round for admission.

To help you to succeed in final selection process, MBAUniverse.com has prepared the GD topic and shares below all the details with complete clarity on the ‘Bad Bank’, its meaning and background, functions, Pros & Cons of establishing the Bad Bank, International experience after its establishment and RBI’s take on establishing this new type of banking structure which will serve as a capital adequacy booster for commercial banks. So read on

Even after the largest ever merger in the public sector banking space in India that took place on April 1, 2020, when six Public Sector Banks were merged into four large banks in a bid to make them globally competitive, the high ratio of NPAs in banks has remained alarming. To minimize the ever increasing NPAs and to clean the balance sheets of banks, Mrs Nirmala Sitharaman, the Finance Minister of India, in the Budget of 2021-22, proposed the establishment of a bad bank and announced that the Centre will set up an asset reconstruction company (ARC), commonly referred to as a bad bank, to resolve the issue. Governor of the Reserve Bank of India (RBI), Mr Shaktikanta Das has also agreed to look at a proposal for creating a Bad Bank. 

What is a Bad Bank? Know the Meaning & Background
The idea of a bad bank has been there in the world since 1980s when the US and Sweden established Bad Banks. Following them, more countries, governments, and banks have adopted this idea of establishing Bad Banks.  A bad bank is a bank set up to buy the bad loans and other illiquid holdings of another financial institution. By transferring such assets to the bad bank at market price, the original institution may clear NPAs from its balance sheet. A bad bank also assumes the role of taking over the risky assets of a group of financial institutions, instead of a single bank.

Setting up the Bad banks is considered in times of crisis when long-standing financial institutions are unable to recover their high volume of NPAs and try to recuperate their reputations. The idea gained momentum during Raghuram 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. As such our Finance Minister announced in the Union Budget 2021-22 that an Asset Reconstruction Company (ARC) and Asset Management Company (AMC) would be established to reduce NPAs and boost capital adequacy in the commercial banking sector. 

Bad Banks: A few Examples
Grant Street National Bank is a well-known example of a bad bank. It was created in 1988 to house the bad assets of Mellon Bank. The recession of 2008 revived interest in the bad bank solution as some of the world's largest financial institutions proposed to segregate their nonperforming assets. Federal Reserve Bank Chairman Ben Bernanke proposed the idea of using a government-run bad bank with the purpose to clean up private banks with high levels of problematic assets and allow them to begin lending once more. 

In 2009 the Republic of Ireland formed a bad bank, the National Asset Management Agency, in response to the nation’s own financial crisis.

Why the Bad Bank is needed in India?
A bad bank is needed to help the Indian banks to minimize losses and improve their core lending business to drive profit. There are three main objectives of creation of Bad Bank-

• To minimize the NPAs and clean their balance sheets
• To help and enable the banks to achieve desired capital adequacy by mobilising fresh capital from the market
• To be able to move on with the key lending business and focus on credit growth to help boost investment leading to growth of economy

Since the bad loans in the system inflate during contraction in the economy and the problems go on rising, the need to establish Bad bank is felt  in India after its economy  plunged to historic lows in Covid-hit period of 2020-21. The pandemic dealt a crippling blow to the economy, which suffered an unprecedented 23.9 per cent contraction.

In its recent Financial Stability Report, RBI has noted  that the gross NPAs of the banking sector may go up at 13.5% of total advances by September 2021, from 7.5% in September 2020. The report has warned that if the macroeconomic environment worsens into a severe stress scenario, the ratio may escalate to 14.8%. Among bank groups, the NPA ratio of PSU banks, which was 9.7% in September 2020, may increase to 16.2% by September 2021.

The K V Kamath Committee, which helped the RBI with designing a one-time restructuring scheme, also noted that corporate sector debt worth Rs 15.52 lakh crore has come under stress after Covid-19 hit India, while another Rs 22.20 lakh crore was already under stress before the pandemic. This effectively means Rs 37.72 crore (72% of the banking sector debt to industry) remains under stress. This is almost 37% of the total non-food bank credit.

Companies in sectors such as retail trade, wholesale trade, roads and textiles are facing stress. Sectors that have been under stress pre-Covid include NBFCs, power, steel, real estate and construction. Setting up a bad bank is seen as crucial against this backdrop 

Key Functions of Bad Bank
The bad bank, in fact is an Asset Reconstruction Company (ARC) or an Asset Management Company (AMC). It takes over the bad loans of commercial banks and then manages them with focus to recover the money in due course of time sometimes with full recovery with interest and sometime with compromise proposals. It also uses legal options to realize the money.

The bad bank does not function like a commercial bank and as such it does not either accept deposits or lend money to borrowers. The bad loans of commercial banks are normally taken over by the Bad bank below the book value of the loan.

10 Key Benefits of Bad Bank: How it can help?
There are arguments favouring the establishment of Bad Bank highlighting key benefits that could be derived with the establishment of Bad Bank in India. If the bad bank is designed with a good business model, it can achieve its goal of addressing balance sheet problem as well as capital adequacy concern. With the surge in non-performing assets (NPAs) due to the adverse impact of the pandemic, the Centre has announced to set up Bad Bank - an asset reconstruction company (ARC), to resolve the issue.  Key benefits of setting up the Bad Bank are

1. Bad Bank-a better entity than ARC: The proposed bad bank may prove better than the existing Asset Reconstruction Companies as it will be owned by the government. Once the NPAs are transferred to the bad bank, Public Sector Banks who are reeling under high NPAs, need not resort to higher provisioning and would be better placed to mobilise capital from the market. Since there has been a steep rise in discount rates from 30 to 60 per cent of the book value of bad loans due to regulatory norm of upfront cash payment of 15 per cent by ARCs, it is high time that the bad bank should be established.
2. Bad Bank to Create Faster Process: Commercial Banks in India have been very slow in selling bad assets to the existing ARCs as neither the ARCs nor the banks were ready to bear the losses which prolonged the process of recovery. Bad Bank could remove this flaw and may expedite the process of buying the bad assets and recovering the dues.
3. Better Stress Asset Management to help Credit Growth: Indian banking sector is suffering from rising NPA level which requires for higher provisioning. This results in lower capital adequacy and subdued profitability levels and low growth in lending capacity. All this increases NPAs. Banks have expertise in lending but not in resolving such high volumes of NPAs. If the book value of a bad loan, net of provisions, is lower than its fair value, the selling bank will make a profit, and thus, will have a boost in its capital. Most banks will make a significant amount of provision against their bad loans. Since commercial banks now have to focus on capacity building and re-skilling of their in-house personnel in loan recovery, risk management, in order to stay ahead of the learning curve, they will focus on credit growth with the establishment of Bad Bank.  Besides, they do not have required level of legal expertise nor the proper environment to recover the NPAs. Bad Bank will help in better stress management and will improve the credit growth in banking sector.
4. Privatisation of PSBs: The government is willing to privatise PSBs and is moving ahead with its plan. But, it may amount to a sell-off at unattractive valuations. In this scenario, a bad bank appears to be a good idea among the available options.
5. NPA Valuation by experts: Valuation of the NPAs by recognised, professional, and independent institutions can make Bad Bank successful in achieving its goals. Government of India, however needs to properly reflect its off-balance sheet exposure and smoothen problems arising due to other legal hurdles.
6. Will safeguard Depositors’ Interests: With the establishment of Bad bank, the Banks that become insolvement as a result of the process can be recapitalized, nationalized, or liquidated to safeguard depositors’ interests. If they do not become insolvent, it is possible for a bad bank’s managers to focus exclusively on maximizing the value of its newly acquired high-risk assets.
7. McKinsey outlines four basic models: McKinsey has outlined four basic models for bad banks. They include - An on-balance-sheet guarantee (mostly a government guarantee), which the bank uses to protect part of its portfolio against losses; A  Special Purpose Entity (SPE), wherein the bank transfers its bad assets to another organization. It should be backed by the government; A more transparent internal restructuring, in which the bank creates a separate unit to hold the bad assets (a solution not able to fully isolate the bank from risk); A bad bank spinoff, wherein the bank creates a new, independent bank to hold the bad assets, fully isolating the original entity from the specific risk.
8. Historic Findings:  A paper by Brei, Gambacorta, Lucchetta, and Parigi (Bad Bank Resolutions and Bank Lending, BIS Working Paper No. 837, February 2020) carries good study on bad banks. The results of the study were based on the data set covering 135 banks from 15 European banking systems over the period 2000-2016. The main finding was that bad bank segregations were effective in cleaning up balance sheets and promoting bank lending only if they combined recapitalisation with asset segregation. Used in isolation, neither tool would suffice to spur lending and reduce future NPAs. The authors found that asset segregation was more effective when: (i) asset purchases were funded privately; (ii) smaller shares of the originating bank’s assets were segregated; and (iii) asset segregation occurred in countries with more efficient legal systems.
9. Good International Experience: Many other countries like USA, Sweden, Ireland had set up Bad Banks with appropriate institutional mechanisms to deal with a problem of stress in the financial system. The overall result was good for them as the commercial banks got a boost in Capital Adequacy, improved their lending after their NPAs were substantially reduced.
10. RBI’s Nod: The  Governor of Reserve Bank of India, Mr Shaktikanta Das indicated that the RBI is considering the idea of a bad bank to tackle bad loans. Erstwhile Deputy Governor of RBI, Viral Acharya, had suggested two models of Bad Bank to solve the problem of stressed assets. 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.

Bad Bank May Not Help Much: Critics not in Favour

Some banking and finance experts criticize the setup of bad banks. Many experts are of the view that if states take over non-performing loans, this will encourage banks to take undue risks in lending and in the long run situation will not improve. Key arguments by experts who are against the establishment of Bad Bank in India are as below:

Bad Bank may not help in Credit Growth:  Lending by the public sector banks is not constrained by the lack of Capital. Banks lack the risk appetite to lend to lower rated borrowers. While the aggregate credit by banks to commercial borrowers is growing at 5.6 per cent, their investment in government securities is growing at 18.2 per cent. Providing them with additional capital will not help in boosting the level of lending.

Bad Bank only Shifting Bad Loans: Former RBI Governor Opposed the Idea: Former RBI Governor Raghuram Rajan, an IIM Ahmedabad alumnus, had opposed the idea of setting up a bad bank in which banks hold a majority stake. In his book ‘I do What I do’ he says, “I just saw this (bad bank idea) as shifting loans from one government pocket (the public sector banks) to another (the bad bank) and did not see how it would improve matters. Indeed, if the bad bank were in the public sector, the reluctance to act would merely be shifted to the bad bank.”

No New Professionals for Bad Bank
The professionals for Bad Bank will be drawn from the existing system. The banks, Non-Banking Finance Companies (NBFCs); Asset Reconstruction Companies (ARCs), and special purpose funds have been in the business of recovering dues for a long time, but they are not able to recover the dues from borrowers to the “desired” extent. If they have not been successful enough, despite being smart and sincere professionals in these financial institutions, how can they be successful while working in the Bad Bank.

• Poor Regulations: The regulations about who could buy or sell bad loans, what will be the price, in which form among others are poorly designed and are over prescriptive. As such they do not help much in recovering the dues.
• Prolonged Judicial Process: The Courts and Tribunals in India are overloaded with cases, multiple appeals, and even the laws are twisted in favour of the defaulting borrowers. Even the implementation of Insolvency and Bankruptcy Code (IBC) is not properly effected. All this adds up to high volume of  pending cases which take many years in getting disposed off.
• Banks invest even to Uneconomical Business Entity: At a macro level, Banks value the preservation of an insolvent borrower more than allowing it to close down, even when the business becomes uneconomical. This is one of the shortcomings of our system and hinders recovery of dues. Banks do not make exits from businesses as smooth as entries into them.
• Poor Level of PSB Governance: Lack of competence with regard to the boards of directors of PSBs is well-known. Shareholders are unable to question the Board of a PSB for poor recovery efforts. Since the government is the largest shareholder, this is the major cause of poor governance in a PSB. It’s Board and the Management is faced with conflicting objectives. These issues are to be addressed first instead of putting the blame on the institutions and banking professionals. If this is done, even the ARCs may not be required in future, not to say of a Bad Bank.
• Bad Bank against the Banking Fundamentals:  If it is thought that  commercial banks in India should be specialists only in lending and not in recovering dues because the recovery of dues is a specialised task, it goes against the fundamentals of lending business. The concept of “know your customer” (KYC) encompasses the relationship through the life cycle of a customer.
• Bad Bank will demoralize PSBs: Critics of bad banks say that the option encourages banks to take undue risks, leading to moral hazard, knowing that poor decisions could lead to a bad bank bailout. The public sector banks (PSBs) are relatively more willing to lend to the small and medium enterprises (SMEs) and Agriculture which are relatively riskier. Since, their shareholder is the government, whose objective is not to maximise profits but to enhance lending to the SMEs.

Waiving off  thousands of crores of loans given to agriculture has become the practice of Government and the banks have to bear the brunt of this decision. A recent example is the reported sealing, by administrative order, of a branch of a large PSB, as it did not lend enough to street vendors under the PM SVANidhi programme. Such directed lending is well known to suffer from the issues of moral hazard and poor incentives to recover dues from the borrowers.

The Way Forward
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, it is felt 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 will be funded by the government initially, with banks and other investors co-investing in due course. It’s establishment is seen as a means to speed up the clean-up process. Many other countries had set up institutional mechanisms such as the Troubled Asset Relief Programme (TARP) in the US to deal with a problem of stress in the financial system.

The Indian Banks’ Association (IBA) submitted a proposal 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. A panel on faster resolution of stressed assets in public sector banks headed by former Punjab National Bank Chairman Sunil Mehta, proposed a company, Sashakt India Asset Management, for resolving large bad loans. The idea of a bad bank was discussed in 2018 too, but it never took shape. A few suggestions by experts as below could pave the way for establishing a strong Bad Bank:

• Bad Bank as Last Resort: Before establishing the Bad bank, the approach should be to design specific area wise solutions in accordance with the specific requirement. The Bad Bank should be established as the last resort only.
• Reforms in Governance: Since Governance of Public sector banks is in the hands of politicians and bureaucrats, their professional expertise may not be upto the mark. So before, setting up the Bad Bank, the reforms suggested in Banking Sector should be implemented in accordance with the Indra Dhanush plan 2015.

With Padmakumar M Nair, the Chief General Manager, Stressed Assets Resolution Group (SARG), State Bank of India (SBI), named as the chief executive of National Asset Reconstruction Company (NARCL), it is understood that it will substantially reduce the NPAs in commercial banks, given the fact that Nair is a well experienced career banker and since April 2020, he has worked as CGM of SARG at State Bank of India, India’s largest lender. Has has two decades experience in Corporate Banking and prior to his promotion as CGM, Nair had worked as General Manager at the SARG since 2017.

Besides formation and establishing the structure of the company, the team of Bad Bank would be involved in framing rules for making offers and acquisition of bad assets from banks. The Indian Banks' Association (IBA) is working on all the finer details of the proposed 'bad' bank. The equity structure or holding of lenders, including NBFCs such as PFC and REC, in the bad bank is also being worked out by the IBA. An HR consultancy firm is helping the IBA with the selection of team members.

Hope this topic discussed in detail must have been found useful for you to know all about Bad Bank. MBAUniverse.com will post more relevant topics to help you getting through the GD, WAT and PI round 

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