Chalking the road ahead for a bad bank – The Hindu BusinessLine

Clipped from: https://www.thehindubusinessline.com/opinion/chalking-the-road-ahead-for-a-bad-bank/article34134154.ece

For a bad bank to effectively resolve NPAs, a critical factor would the type of assets it acquires and the price paid for them

The actual stress maybe even worse, as the Supreme Court’s order on maintaining status quo on asset classification has constrained banks to assess the same at this juncture.

In the above context, the announcement in Budget 2021 to establish a ‘bad bank’ — an asset reconstruction and management model for bad-asset resolution in the financial system — could not have come at a more opportune time. Transferring the identified NPAs to a bad bank will help improve the selling banks’ profit and balance sheet, particularly where the loans have been fully provided. It will hopefully stem the flow of incremental growth in NPAs, and allow banks to concentrate on its core activities.

While the formation of a bad bank appears to be a good move, few points merit reflection. First, the bad bank should be set up as a special purpose vehicle to purge the basket of toxic assets it acquires, and must be shut down within a pre-decided timeline. It cannot, and should not, function as a permanent entity for acquiring bad loans from the banks. This may help avoid the moral hazard problem — with a bad bank in place, commercial banks might continue with their prodigal ways.

Second, a critical factor for its success will depend on the type of assets it acquires and the price it pays for those assets. The chances of resolution will be higher for operational assets and which have been ‘bought’ at the ‘right’ price. The price-discovery mechanism can be a major bugbear as most of the high-value bad loans involve a consortium of lenders, where unanimity on price and value can be a roadblock for smooth and quick decision-making. Lack of agreement on the value of the assets have continued to plague the sale of assets to existing ARCs. If the asset sold to the bad bank is ‘overpriced’, the resolution will be difficult and delayed, and the purpose will be defeated. The asset-selling banks also need to be incentivised wherein the bad bank, on the resolution of the asset, will pay a pre-negotiated share of the value it gets over and above the acquisition cost. To enable the consortium to sell an asset in full to the bad bank, the RBI must ensure that in case the majority (or two-third) of the lenders agree for sale at a determined price, the other lenders are bound to follow suit.

Third, considering the large value of these assets and multiple stakeholders like creditors, employees, and lenders, the resolution of the majority of these assets is likely to be under the Insolvency and Bankruptcy Code. With long delays evidenced under the IBC mechanism, it will not be improper for the government to notify enabling guidelines for the expedition of the process.

If resolution takes undue time, not only will it lead to erosion in the value of the assets, but it will also increase the operating cost of the bad bank, thereby reducing the chances of its own gain and that of the original lenders. Further, the delay in resolution will also discourage investors’ interests.

Attracting expertise

Fourth, the success of the entity will also depend on the ability to attract relevant cross-functional expertise — professionals who are not only well-versed with the stressed asset resolution mechanism but who can also work as ‘project managers’ to complete the processes in defined timelines.

Fifth, a recent BIS study by Brei et al., using a novel dataset covering 135 banks from 15 European banking systems over the 2000-16 period, shows that bad bank segregations are effective in cleaning up banks’ balance sheets and in boosting lending only if they combinerecapitalisation with asset segregation tools. The study finds that bank lending grows more when impaired asset purchases are funded privately, whereas future non-performing loans decline more when funding emanates from public sources.

Lastly, as the bad bank shall have an estimated capital of only around ₹10,000 crore, and will reportedly acquire loans above ₹500 crore, commercial banks will continue to handle a sizeable volume of NPAs and stressed loans even after the bad bank is in existence. This underscores the need for strengthening the lending prudence and the existing risk management practices of the banks.

If everything falls in place, the bad bank may prove to be the right vehicle in resolving banks’ burgeoning NPAs, thus opening up a new chapter in the Indian banking landscape.

Royis Deputy General Manager, State Bank of India, and Nandy is Assistant Professor, IIM Ranchi. Views are personal.

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