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A sovereign guarantee for the security receipts issued by the bad bank being set up to buy out the bad loans weighing down the books and ability of public sector banks (PSBs) is not germane to successful working of the proposal. Rather, three other factors would make or break a bad bank. One is expertise in the bad bank to resolve bad loans or run debtor companies that are in a position to operate. Another is the wherewithal to perform the role of patient capital. The third factor is independent valuation of the assets being transferred.
The bulk of the capital for the bad bank should come from the banks themselves, so that the gains from resolution would also come back to the banks, apart from the sale price of the bad assets. However, the government could also contribute some seed capital. Rightly, RBI, which supports the proposed bad bank, also underscores the need for a well-capitalised entity to strengthen asset resolution. The sale of non-performing assets (NPAs) will make space for PSBs to lend without being burdened by these bad loans, and when the assets underlying these loans are resolved, the bank will reap profits. However, the need is to ensure that the valuation of assets is done by third parties (read: audit firms) in order to shield bank managers from any arbitrary criminalisation of NPA sales. Bankers fear haircuts on sale of bad assets: these might be construed as mala fide moves. Reassurance is possible if third parties determine the value of the assets to be transferred, attested subsequently by a reviewer, another audit firm.
Such arm’s-length pricing and an oversight committee will reassure bankers, and help protect them from charges of causing loss to the exchequer. This is what will make a bad bank succeed.
This piece appeared as an editorial opinion in the print edition of The Economic Times.