Synopsis–One has to factor in the enormous gains that accrue from enabling bad loan-strapped banks to function smoothly. That said, when policymakers talk of the imperative of making the bad bank a time-bound experiment, one must ask how this time period will be determined. This decision is easy when it comes to buying bad loans.
Backers of India’s mega ‘bad bank’ plan find it useful to draw on the lessons from the history of bad banks.
The first major bad bank experiment in recent history was the Resolution Trust Corporation (RTC) set up in 1989 in the US to help the 1,000-plus savings and loan institutions (small mortgage lenders and deposit takers) that were in severe distress. Most Asian economies used some variant of the bad bank model to handle the strain in their financial system during the Asian financial crisis of 1997.
What are the lessons? First, the good news. Bad banks have, on the whole, been reasonably successful in handling the bad loan problem. The US’ RTC that effectively functioned as a giant property management company is credited to have resolved the problem by the mid-1990s, although there were reservations in some quarters about the tab of about $121 billion to the American taxpayer.
The publicly funded Korean Asset Management Corporation (Kamco), which started buying assets in 1997, managed to dispose of two-thirds of bad loans by 2002. Malaysia’s Danaharta met its projected lifetime recovery target of 30.35 billion Malaysian ringgit (MYR) of the MYR 52.44 billion that it purchased.
There are examples of bad banks even turning in a profit. Citi Holdings is, perhaps, the most successful. This was the repository created in 2009 for the toxic assets of Citigroup that ranged from its retail brokerage and life insurance unit, an array of toxic subprime loans that even included a stake in a Mexican auto supplier.
It was in the black by 2015 and was wound up in 2017. Sweden’s Securum and Retriva that were set up by the government in the early 1990s recouped the public funds deployed by 2007. At the very outset, we must recognise that gauging the success of a bad bank purely on the percentage of initial losses recouped or profits made is a bit unfair.
One has to factor in the enormous gains that accrue from enabling bad loan-strapped banks to function smoothly. That said, when policymakers talk of the imperative of making the bad bank a time-bound experiment, one must ask how this time period will be determined. This decision is easy when it comes to buying bad loans. It is possible to set a terminal date after which the bad bank shutters its purchase window. However, determining the period over which they will be sold becomes tricky. The terminal point could be determined by a target fraction of the assets purchased, or, as with Danaharta, a lifetime recovery target is reached.
What Makes Bad Bank Good
There is another aspect to be considered here. The success of Kamco was driven largely by its ability to ‘make a market’ for bad loans. It attracted a wide spectrum of buyers (international investors in the South Korean case), and created new products by repackaging the bad loans (asset-backed securities, for example).
In a September 2020 paper (bit.ly/3dp89tF), Viral V Acharya and Raghuram G Rajan make a strong case for creating an online platform for selling bad loans. This can be supported by an operational public credit registry (PCR) — similar to the Credit Information Bureau (India) Ltd (Cibil) but for corporate loans — that is currently being implemented by RBI. PCR would take care of some of the information gap that exists between buyers and sellers, and reduce the prospect of buyers being sold the proverbial lemon. Thus, one could argue that the bad bank should continue until an alternative market for bad loans develops.
A couple of other things are important. For one, the ‘bad bankers’ have to take a key decision of which assets are likely to be permanently illiquid to be sold at the first whiff of a reasonable price and those that are likely to find value and a buyer if mothballed long enough. However, mothballing requires capital, and cheaper the cost of this capital, more efficient the bad bank. Government guaranteed credit lines, or direct support from RBI becomes necessary.
Then there is the issue of the purchase price of bad loans. Buying dud loans at book value (that is currently being discussed) may lead to an inflated acquisition price. Policymakers may want to take a look at alternative formulae that were used by successful bad banks like Kamco and Danaharta.
It is possible to argue that the design and ownership structure of India’s bad bank is an astute response to India’s specific problems. The fact that public and private banks are part-owners ensures that they have their skin in the game. This could lead to better price discovery, since these owners are industry insiders themselves and would have a better idea of bad loan’s actual worth. This would reflect in the price that the bad bank offers for purchase or accepts for sale.
Less Stress for Loans
Besides, if the purchase decisions and sales decisions are segregated, and the latter left to the private sector banks — for a management fee — the fear among public sector managers of selling at the wrong price and inviting the ire of vigilance agencies is mitigated.
The ultimate goal, however, should be to create a market for stressed loans so that banks can easily jettison the burden of bad loans, take a quick hit on their profits and move on with their business. This is vital for a sustainable path of high growth.
The writer is chief economist, HDFC Bank. Views are personal