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VIEW: When something bad is for the larger good

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Why creation of bad bank is a critical move towards the making of a self-reliant $5 trillion Indian economy?

VIEW: When something bad is for the larger good
In 2019 when India had set its eyes on the $5 trillion economy goal by 2024-2025, the Central Government, much like the rest of the world, had no inkling of the scale of disruptions it is going to face in the subsequent year. Half a year later in early 2020, the world was grappling with the unprecedented COVID-19 outbreak and its socio-economic consequences.
The evolving situation has had the world’s most developed economies, with a stronger healthcare infrastructure, much lesser population and a higher per capita income, reeling under the pressures of the pandemic.
Impact of the Pandemic on the Indian Banking System
India too faced tremendous economic challenges caused by the pandemic. However, most of all it’s the banks and financial institutions that have been facing a complex concoction of multipronged challenges.
While they are cushioning the adverse impact of the pandemic on the Indian economy by bringing in lending and other measures to infuse capital liquidity in the market, they are also facing a gigantic challenge in the form of growing non-performing assets (NPA).
The challenge of growing NPAs have been around for some time. As per the Economic Survey 2021, the Reserve Bank of India’s asset quality review (AQR) initiated in 2015 did not have the intended impact of cleaning the banks’ balance sheets.
Hence in subsequent years, “…Gross NPAs increased from 4.3 percent in 2014-15 to 7.5% in 2015-16 and peaked at 11.2% in 2017-18, the AQR could not bring out all the hidden bad assets in the bank books and led to an under-estimation of the capital requirements. This led to the second round of lending distortions, thereby exacerbating an already grave situation.”
Why there was a need for Bad Banks?
Owing to Government’s timely intervention with a series of reforms along with RBI’s carefully calibrated fiscal measures, India has not only been scripting an economic revival but also improving its fiscal state.
Consequently, the economy saw slight improvement in capital to risk-weighted assets ratio (CRAR) of Scheduled Commercial Banks (SCBs). Simultaneously, the gross non-performing asset (GNPA) ratio witnessed a decline from 8.4 percent to 7.5 percent by September 2020.
However, as per the latest Financial Stability Report from RBI, it is estimated that owing to macroscopic stress to the economy, GNPA ratio of all SCBs may jump to 13.5 percent by September 2021 or to 14.8 percent under a severe stress scenario.
Creation of Bad Bank – A Bold Move
To address the matter promptly, the Indian Government has proposed to initiate another bold measure of creating bad banks, which will absorb soured loans from the books of other lenders — an idea which was not given its due weight way back in 2015.
Announced by Finance Minister Nirmala Sitharaman, the bad bank model will be a combination of asset reconstruction company (ARC) and asset management company (AMC) to consolidate and take over the existing stressed debts from banks and then settle the assets via alternative investment funds (AIF) and other potential investors for eventual value realization, enabling the public sector banks to manage their stressed assets.
The Benefits of Bad Banks
The bad banks will benefit the Indian banking system and economy in many ways. To begin with, bad banks will help commercial banks differentiate between the good and bad assets and give a clearer picture of the financial health of the lender.
This will help the RBI gain insight into the state of banking affairs in the country and undertake relevant measures for strengthening the banking ecosystem. The segregation of toxic assets will also boost customer and investor sentiments, with specialised institutions catering to maximum recovery from bad assets.
Furthermore, bad banks are not supposed to be engaged in any other banking activity including lending and taking deposits. Its major purpose is to recover value from non-performing assets of various public sector banks.
The aggregation of all NPAs into a single entity will create avenues for a faster and effective restructuring of the loans. This will also help commercial banks address bad loans and clean-up their balance sheets as well as present them with opportunities to raise adequate capital from the market.
With dedicated focus on NPAs, bad bank are expected to achieve higher realisation for bad assets as well as free-up capital. With an institution overtaking all stressed assets, commercial banks will be able to revive credit growth.
Simultaneously, the commercial banks can leverage the opportunity to focus its resources and energies in economic revival and growth by supporting stressed sectors with calibrated lending and by infusing more liquidity in the market.
One of the larger goals of the Government is privatisation of select banks. By establishing bad banks and by way of diminishing the role of department of financial services, banks will be able to shed-off its NPA weight and the Government will be able to leverage more from the sale of these institutions.
Critical Move towards Atmanirbhar Bharat
The financial ecosystem and companies across sectors including MSMEs are eagerly awaiting the fine print around bad bank. However, there’s still some scepticism around what exactly would the final shape of the banks be.
For larger benefit, bad banks should not entail both COVID stressed assets and pre-Covid stressed assets. The differentiation may as much guide the recovery strategy. However, only covering for either of the categories may not solve the challenges faced by the banking system. It may all the more complicate the situation.
Similarly, there has to be a crystal clear and simple clarity on the kind of loans that the bad banks should take-up. Loans extended to all sectors including power and real estate should be covered. Also, there needs to be a clear policy on the pricing at which these loans are transferred to the bad bank.
The most important aspect of bad banks would be determining the ownership of losses. Assuming that expecting a 100 percent recovery is an ideal situation, there needs for policy clarity to fix accountability and share of the losses.
Despite these concerns not having easy solutions, the creation of bad bank is the way forward for the Indian banking system. It is a strong step towards the making of Atmanirbhar Bharat and a critical move for India to become a USD5 trillion economy.
The author, Mayur R Dwivedi, is Head – Strategy, M&A and Investor Relations at Religare Enterprises Limited. The views expressed are personal