SynopsisHere are some basics about bad banks. Commercial banks transfer their bad loans to a newly formed entity — a non-deposit-taking ARC, or a bad bank. This reduces the commercial banks’ loan book risks and provisioning losses; reinforces weakened financials; and allows them, now without bad loans, to refocus on their core business.
Finance Minister Nirmala Sitharaman has committed to setting up an Asset Reconstruction Company (ARC) Ltd and an asset management company (AMC) ‘to consolidate and take over the existing stressed debt and then manage and dispose of the assets to Alternate Investment Funds and other potential investors for eventual value realisation’. It is the sarkari green light for a ‘bad bank’.
Here are some basics about bad banks. Commercial banks transfer their bad loans to a newly formed entity — a non-deposit-taking ARC, or a bad bank. This reduces the commercial banks’ loan book risks and provisioning losses; reinforces weakened financials; and allows them, now without bad loans, to refocus on their core business.
I’m Bad, for the Good
The bad bank typically purchases distressed loans and their associated securities at sizeable discounts to book value. It then searches for buyers. Once found, these are sold, ideally at a profit. When all such assets are sold, the bad bank liquidates itself and, if all goes well, returns money with capital gains to its shareholders.
If only life were that simple….
Type of assets matter: All successful bad banks have dealt almost exclusively with bad housing loans. Consider the Resolution Trust Corporation (RTC) that dealt with the 1980s US savings and loan crisis. Or the Grant Street National Bank in 1988. Or Securum and Retriva in Sweden in the 1990s to deal with bad loans of Nordbanken and Götabanken. Or Arsenal and Sponda in Finland, also in the 1990s. Or Parex (now Reverta) in Estonia. Or the UK Asset Resolution Company (UKAR), which took over the bad loans of Bradford & Bingley and Northern Rock in 2008.
Toxic housing mortgages are simple assets. Each loan is small in value. The mortgage is uncomplicated and entirely contained within a clearly saleable property. These can be bundled, and housing markets tend to improve sooner than many other fixed assets.
In India, home loan recipients don’t default. So, not even a minuscule proportion of bad loans deals with housing. Instead, these are complexly hypothecated corporate fixed assets involving a consortium of lenders, typically to finance large industrial or infrastructure projects. And are much more difficult to resolve than housing loans.
Bad banks have never worked where industrial, corporate- and conglomerate-level bad loans predominate. As examples, look at the failure of bad loan resolutions in Mexico, Brazil, Argentina, Italy, Greece, Turkey, South Korea, Thailand, Malaysia, Indonesia and India.
Pricing matters: Even where accounting and income recognition norms are accurate — as in India — no bad bank will purchase a loan at the seller’s book value. If it does, how can it make a profit, except on a vague hope of things turning for the better? It will insist on a discount of 10-25% of book value, depending on the asset and its saleability.
Who will protect a bank’s senior management if it decides to sell a bad loan at a discount to book value? For private sector banks, it will be a judgement of the bank’s committees and its board. But the bulk of bad loans are with the public sector banks (PSBs). On March 31, 2020, 10 PSBs had gross non-performing assets (NPAs) of 15% or more of their total advances — from the Central Bank of India at 21.6% to the Punjab and Sind Bank at 15.2%.
The Bad Loan Karma Cycle
Under Article 12 of the Constitution, all PSBs constitute ‘the State’ and subject to scrutiny by Parliament and the Central Vigilance Commission (CVC) as well as prosecution by the Central Bureau of Investigation (CBI). How can an executive chairman or CEO of a PSB offer a buyer a discount to the book value of a loan? Who will protect them? I see none today.
Moral hazard 1: Heroically, suppose that there are markets for these complex industrial and corporate bad loans. And that miraculously senior executives of PSBs are somehow protected from commercial ‘discount’ decisions. So, banks have hived off their bad loans. But what will we have done to clean up the structure of these banks after such huge largesse?
We have had at least four recapitalisations of PSBs since 1992-93. What have these done for their efficiency? For return on assets and equity? And for creating modern banking structure? Now, through bad banks, we will again recapitalise through a different scheme. For these PSBs to start their bad loans adventure all over again?
Moral hazard 2: Who will own the bad bank? Ideally, it can’t be the government. Nor should it be a consortium of banks, because they simultaneously can’t be sellers of bad debt and equity holders of an entity that buys such debt. This hasn’t been thought through. Also, consider how the bankruptcy procedure under the Insolvency and Bankruptcy Code (IBC) is being debased, where it is almost reverting to status quo ante.
In such a milieu, I have three comments. First, many reforms are needed in law, legal procedures and in freeing PSBs from debilitating State oversight and investigations before the financial system can resolve distressed loans through bad banks. Second, pots of gold at the end of the rainbow make for good fairy tales. And, third, do some basic research before announcing such policy decisions.
The writer is chairperson, Corporate and Economic Research Group (CERG) Advisory