‘Bad bank’: A good idea in bad times

Commenting on the ‘bad bank’ proposal of the 2021-22 Union Budget, K Srinivasa Rao contends that the bad bank is a good idea in bad times – as a transitory solution with defined timelines – but it cannot be a permanent panacea to fault lines in the quality of credit administration.

Banks in India that were struggling with elevated bad debts have been further hit in the past year by the collateral damage of Covid-19-induced stress. The potential increase of bad debts has been well-highlighted by the RBI (Reserve Bank of India) in its Financial Stability Report (FSR) of January 2021. The non-performing assets (NPAs) of banks that saw a high of 11.2% in March 2018 reduced to 7.5% by September 2020 due to standstill clause in the classification of banking assets after the moratorium¹ period ended.

The January 2021 FSR noted that NPAs in banks are set to reach 13.5% in the baseline stress scenario and can be as high as 14.8% if the stress is severe by September 2021, as and when the standstill clause in asset classification is lifted. The public sector banks (PSBs), which have larger penetration in the hinterland and were already holding a higher share of NPAs, could see them reach 17.6% by September 2021.

The additional provision on the newly classified NPAs after the standstill clause is lifted and truncated interest income can push the capital to risk-weighted assets ratio (CRAR) to a low of 12.5% as against the minimum CRAR of 10.9% by 31 March 2021, and 11.5% after banks migrate to Basel - III standards² from 1 April 2021.

Given the inevitable potential rise in toxic assets, stakeholders are considering various alternatives to resolve the woes of crisis-ridden banks. Despite the government exchequer – under tremendous pressure to carve out allocations amid the truncated revenues, the 2021-22 Union Budget has provided Rs. 20,000 crore for capital infusion in PSBs during the fiscal year.

It has also proposed the formation of a separate special purpose vehicle – an Asset Reconstruction Company (ARC) on the lines of a ‘bad bank’ to take over the bad loans of banks. Given the Budget proposal, it is expected that the newly formed ARC (bad bank) will have capital coming from various banks, the details of which are yet to be determined. A bad bank is a corporate structure that isolates risky assets held by banks in a distinct entity, relieving the banks from the flab. It would enable the bank to offload bad debts to a separate entity, and thus banks can concentrate on new business.

Changing policy stance

The proposed structure of a bad bank is based on the earlier recommendations of a panel headed by the former Chairman of Punjab National Bank (PNB), Sunil Mehta, called project ‘Sashakt’ two years ago. However, it did not go through. It perhaps did not merit consideration at that point of time as asset reconstruction companies (ARCs) formed for this purpose have been in operation with similar objectives. However, even ARCs could not come to the rescue of banks in a big way in tackling the bad loan menace. Participating in the discussions on setting up a bad bank, Arvind Panagariya (former Vice Chairman, NITI Aayog) affirmed “there is no need for India to set up a new state-run fund manager to resolve the world’s highest stressed assets ratio as it already has institutions that can deal quickly with the problem”³

But looking to the current situation of NPAs and banks’ inability to muster enough capital for fresh lending, the policy stance on bad bank is undergoing a change. Recently the RBI shared its opinion on the issue: “A bad bank has been under discussion for a very long time. We have regulatory guidelines for Asset Reconstruction Companies (ARCs). If any proposal [for setting up a bad bank] comes, we are open to examining it and issuing required regulatory guidelines”.

Ostensibly, the extraordinary stress situation arising due to the Covid-19 pandemic is leading to the change in perception to provide an out-of-box solution. Hence, setting up a bad bank can be a plausible strategy. It will enable banks to hive off toxic assets out of their credit portfolio to the bad bank. Circumscribed with a potential rise in NPAs, threat of a truncated CRAR, and the need to pump prime credit flow to salvage ailing enterprises in the larger interest of the economy, a policy change may be inevitable.

Bad bank: A transitory tool

The business model of banks, regulatory rigour, corporate governance structure and its implementation strategies, effectiveness of monitoring, and control of credit, should be well-aligned to enable banks to lend and recover loans in normal course of operation. Banks should be capable of managing the level of NPAs arising from usual lending using its prudence and credit administration skills. Depending on external institutions in perpetuity cannot be a sustained model.

A recent RBI report on “Trend and Progress of Banking in India” highlighted that the absence of strong credit appraisal and monitoring standards have been key reasons for the spike in NPAs in banks. Coming from the regulators, these comments must be taken seriously by the banking system. Strengthening credit administration is vital to the sustainability of the business model of banks. With the support of available technologies to augment market and economic intelligence, banks may have to revisit their internal credit-handling processes, procedures, and systemic controls on quality of credit origination.

The Bank for International Settlements (BIS), in its document on credit risk management, outlined the following sound practices in this context: (i) appropriate credit risk environment, (ii) sound credit-granting process, (iii) maintaining appropriate credit administration, and (iv) ensuring adequate controls over credit risk.

Among the available recovery tools, two important ones are the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act (SARFAESI), 2002, and Insolvency and Bankruptcy Code (IBC), 2016, which have shown clear signs of effectiveness.

Hence, a bad bank driven by the impact of Covid-19 can be set up with a clear agenda that NPAs will be permitted to be pooled over say, the next 2-3 years. A timeline of about five years can be fixed for the bad bank to completely resolve the pooled stock of NPAs – say by 2025-26 –beyond which it should stop accepting toxic assets. Once the shadow of the pandemic recedes into history, the bad bank should wind up.

Therefore, the terms on which the bad bank will be formed will be critical in shaping the banking system going forward. In seeking to resolve near-term instability, we ought to be mindful that the fear of incapacitating banks with a sense of complacency, abdicating the onus of responsible lending, can trigger long-term financial instability in a bank-led economy.

The mandarins of the financial sector should therefore be cautious and opt for a one-time self-liquidating structure for the bad bank. It should be very clear that banks are not allowed to kick the can of NPAs down the road. Building resilience of banks with compatible regulatory oversight, and ability of banks to handle the credit administration as an integral part of their operations, is essential to foster efficient financial intermediation.

Shifting credit culture

Another constant endeavour is that of financial-sector regulators, who are working in close collaboration with banks, to develop a positive credit culture. The National Strategy for Financial Education, 2020-25 of the RBI has a long-term agenda of spread awareness regarding financial and digital literacy. It is intended to help people manage money more effectively to achieve financial well-being by accessing appropriate financial products and services through regulated entities with fair and transparent machinery for consumer protection and grievance redressal.

Going forward, every borrower should realise that a delinquent loan is not only a threat to the bank, but it also adversely affects the prospects of their own future enterprise. Banks muddled with large NPAs are unable to recycle loan funds. The pain of asset quality erosion prevents banks from lending to the next generation of entrepreneurs, therefore depriving them of business opportunities. In the larger interest of ensuring seamless opportunity to access loans from banks as a means to economic development, it should be clear to the borrowing community that loan delinquencies can result in a permanent blot to their credit history, making it more difficult for them to be in business.

Robust credit intelligence is meticulously built up by the RBI by introducing systemic controls/information systems e.g. (i) the Central Repository of Information on Large Credit (CRILC) on borrowers of Rs. 50 million and above, (ii) Special Mention Accounts (SMA) for data on early signs of stress (not yet classified as an NPA), and (iii) the Central Registry of Securitisation Asset Reconstruction and Security Interest of India (CERSAI) to identify frauds in lending against equitable mortgages. Banks now will have access to a wider range of data/information to better administer credit.

In the future, the Public Credit Registry (PCR)⁴ of the RBI, which is currently being built, will add on as another tool in the armoury of the financial system to control NPAs. These systematic efforts, together with rising financial and digital literacy levels, will hopefully improve credit culture to make the bad bank irrelevant in the long run. Hence, the bad bank can be a transitory solution with defined timelines but cannot be a panacea against fault lines in the quality of credit administration. Hence, a bad bank, although a good idea in bad times, cannot be good in perpetuity.

Notes:

A moratorium on loan payments refers to a period during the loan term when loan payments are not required to be made. On account of Covid-19, the RBI permitted lending institutions to bring into effect a term-loan moratorium until 1 June 2020, which was extended to 31 August 2020. The asset classification standstill clause changed the bad loan classification period to 180 days from 90 days for all such accounts.
The international norms for maintaining minimum capital in banks are referred to as Basel capital adequacy norms.
The institutions being referred to here are the 29 Asset Reconstruction Companies set up to deal with bad debts of banks.
Public Credit Registry (PCR) of the RBI is a public digital registry of borrowers in India, to capture and store financial information of existing and new borrowers.