Bad Banks

IN NEWS:

• Reserve Bank of India (RBI) Governor Shaktikanta Das recently agreed to look at the proposal for the creation of a bad bank to tackle the Non-performing assets (NPA) crisis.

NON-PERFORMING ASSETS (NPA):

• A non-performing asset (NPA) is a classification used by financial institutions for loans and advances on which the principal is past due and on which no interest payments have been made for a period of time. In general, loans become NPAs when they are outstanding for 90 days or more.
• Lenders usually provide a grace period before classifying an asset as non-performing. Afterward, Banks are required to classify NPAs further into:

1. Substandard assets: Assets which has remained NPA for a period less than or equal to 12 months.
2. Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
3. Loss assets: Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.

INDIA’S NPA SCENARIO:

• 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.
• A stress test conducted by the Reserve Bank of India suggests that the Covid-19 crisis could push Indian banks’ gross bad loans to their highest in nearly two decades.
• According to the RBI’s Financial Stability Report for January 2021, Gross Non-Performing Asset (GNPA) ratio declined to 7.5% in September, 2020.
• However, due to the pandemic, it may rise to 13.5% to 14.8 % by September 2021 depending on the stress on macroeconomic environment.

WHAT IS A BAD BANK?

• A bad bank is an institution that takes over the bad loans of commercial banks, manages them and recovers the money over a period of time.
• The bank’s only function will be to try to recover, rephase, or convert the Non-performing assets to performing assets.
• 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, Ireland and Germany.
• Bad banks found resonance during the global financial crisis of 2007-09. Citigroup moved loans worth about $900 billion to its bad-bank unit Citi Holdings.

ARGUMENTS FAVOURING BAD BANKS:

• Strengthen banks’ lending capacity: Such a mechanism helps a bank segregate its good assets from bad ones, making it easier for it to raise capital by issuing equity or debt or both.
• Specialisation: A bad bank can act as an aggregator of all stressed assets in the system and work towards the resolution of these assets whereas banks can focus on business. By transferring NPAs to a bad bank, lenders can prioritize financing businesses, while letting a specialized institution focus on maximizing loan recovery.
• Reinvigorates investments: The segregation of toxic assets helps generate confidence among potential investors who can then examine the financial health of the lender with greater clarity.
• The COVID-19 crisis: 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. In this situation, a professionally-run bad bank, funded by the private lenders and supported the government, can be an effective mechanism to deal with the NPAs.
• Limited success of alternatives: Despite a series of measures by the RBI for better recognition and provisioning against NPAs and massive doses of capitalisation of public sector banks by the government, the problem continues in the banking sector.
• Global success stories: 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.
• Timely disposal: Bad banks will ensure that the NPAs are cleaned up in a timely manner. Also, the presence of the government means that the process will be more accountable and judicious.
• Reduce unnecessary scrutiny: Bad banks can eliminate the undue scrutiny by the 4Cs - Courts, CVC, CBI, CAG and thereby foster ease of doing business in the country.
• Minimum government, maximum governance: As India seeks the interest of global investors to partner it in its economic growth, the country needs to demonstrate its non-interference-led-markets-philosophy.

ARGUMENTS AGAINST BAD BANKS:

• Multiple mechanisms: Presently, there exist several private asset reconstruction firms that buy bad loans at a discount. Also, the Bankruptcy Code, though not perfect, has helped in higher recoveries.
• Initial investments: Large financial resources are essential for buying the NPAs from banks. But India’s corporate bond market is not developed enough to cater to such demands.
• Moral hazard: A government-funded bad bank will allow the reckless lending by banks to continue. There is also the fear that it will end up as another case of throwing public money to fund corporate mismanagement.
• Mere shifting of loans: It is poor governance to move a bad loan from one account to another entity, which is owned by the same bank or the original shareholders. There is no surety that it will improve the situation.

WAY FORWARD:

• Banks and other financial institutions are the key drivers of economic growth and their strength is vital for India to attain its ambition of $5 trillion economy. Hence, solving the NPA crisis is urgent.
• Moral hazarding has no place in the high-pressure banking sector, especially in the midst of an economic whirlwind. Hence, strong measures like Bad banks can be looked into.
• Also, long term solutions, as opposed to knee-jerk reactions, are essential. A well-developed corporate bond market is indispensable for the sustainable and ‘inclusive’ growth of India.
• However, the ultimate objective should be to stop the creation of bad debt. This requires strong banking regulators, transparent auditing and a stable resolution mechanism.

PRACTICE QUESTION:

Q. In the wake of the COVID-19 crisis, critically examine the need of Bad banks in resolving the issue of Non-Performing assets (NPA) in India?