Charting the road for a bad bank

Over the past decade, the boom in non-performing assets (NPAs) has posed a significant challenge for the Indian banking system. The latest RBI Financial Stability Report (FSR) indicates that by September 2021, the gross NPA ratio (GNPA) of public and private sector banks could reach 16.2% and 7.9% respectively in the scenario. benchmark, and 17.6%. and 8.8% respectively in the severe stress scenario, peaking at 22 years.

The real stress may be even worse, as the Supreme Court’s Maintain the Status Quo Order on Asset Classification has forced banks to assess the same at this point.

In the above context, the announcement in the 2021 budget of the creation of a “bad bank” – a model of reconstruction and asset management for the resolution of bad assets in the financial system – could not have been arrive at a more convenient time. Transferring the identified NPAs to a bad bank will help improve the bottom line and balance sheet of selling banks, especially when loans have been fully provided. It should hopefully stem the flow of incremental NPA growth and allow banks to focus on their core businesses.

If the constitution of a bad bank appears like a good initiative, few points deserve reflection. First, the bad bank must be set up as a special purpose vehicle to purge the basket of toxic assets it acquires, and must be closed within a predetermined time frame. It cannot and should not operate as a permanent entity to acquire bad debts from banks. This can help avoid the moral hazard problem – with a bad bank in place, commercial banks could continue to be lavish.

Second, a critical factor in 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 assets that are operational and have been “bought” at the “right” price. The price discovery mechanism can be a major scarecrow as most high value bad debt involves a syndicate of lenders, where unanimity on price and value can be a barrier to smooth and quick decision making. The lack of agreement on asset values ​​continued to hamper the sale of assets to existing CRAs. If the asset sold to the wrong bank is “overvalued”, resolution will be difficult and delayed, and the goal will be defeated. Banks selling assets should also have an incentive that the bad bank, when resolving the asset, pays a pre-negotiated share of the value it obtains on top of the acquisition cost. In order for the consortium to sell an entire asset to the bad bank, the RBI must ensure that in the event that the majority (or two-thirds) of the lenders agree to the sale at a fixed price, the other lenders are required to go with the flow.

Third, given the high value of these assets and the multiple stakeholders such as creditors, employees and lenders, the majority of these assets are likely to be resolved under the Insolvency and Bankruptcy Code. With the long delays highlighted under the IBC mechanism, it will not be inappropriate for the government to notify enabling directives for the acceleration of the process.

If the resolution takes an excessive amount of time, not only will it erode the value of the assets, but it will also increase the operating costs of the failing bank, thus reducing the chances of its own gain and that of the original lenders. In addition, the delay in resolution will also discourage the interests of investors.

Attract expertise

Fourth, the success of the entity will also depend on the ability to attract relevant cross-functional expertise – professionals who not only are familiar with the mechanism for resolving distressed assets, but who can also work as “project managers” for carry out the processes within defined deadlines.

Fifth, a recent BIS study by Brei et al., using a new dataset covering 135 banks from 15 European banking systems over the period 2000-16, shows that bad bank segregation is effective in cleaning up bank balance sheets and stimulating lending only if it breaks down. combine recapitalization with asset segregation tools. The study finds that bank loans increase more when purchases of impaired assets are financed by the private sector, while future non-performing loans decrease more when financing comes from public sources.

LastYes, given that the bad bank will have an estimated capital of only around 10,000 crore and will acquire loans above 500 crore, commercial banks will continue to handle a large volume of APM and stressed loans even after existence. of the bad bank. This highlights the need to strengthen bank credit prudence and existing risk management practices.

If everything falls into place, the wrong bank could turn out to be the right vehicle to resolve booming bank APNs, opening a new chapter in the Indian banking landscape.

Roy is Deputy Managing Director, State Bank of India, and Nandy is Assistant Professor, IIM Ranchi. Opinions are personal.

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