Good tidings of Bad Bank

New institution was necessary to clean out excesses of the last business cycle

Neelkanth Mishra, Sep 17, 2021, 19:44 IST. This appeared in the Times of India Print edition on Sep 18, 2021 (link)

The clamour for a “bad bank” had started not long after the discovery of growing distress in large numbers of loans eight years ago. There were two key reasons in support of a bad bank.

First, as there were a large number of lenders to nearly all the defaulting companies, getting them to coordinate on resolution of these loans was a challenge, prolonging the process and bringing down the amount that could be recovered. Lending consortiums would have 25 to 30 lenders, making it difficult to build consensus on next steps.

Second, while banks do have departments specialising in recovery of bad loans, when there is a once-in-a-decade cyclical surge, senior management time is spent disproportionately on the recovery process, distracting them from the core activities of attracting deposits from savers, assessing the quality of borrowers before lending to them, and handling routine collections.

The main argument against a bad bank was moral hazard: If banks transferred bad loans out without a haircut, lending mistakes would be repeated in the future, as they were not being penalised for past errors. On the other hand, if the government insisted on large haircuts before the loans were transferred, some banks would resist, and unless all lenders to a defaulting firm transferred their loans, the process of resolution would remain complex.

Further, putting all bad loans in one firm also meant that unscrupulous promoters would find it easier to influence decision-making in the bad bank.

A second argument was that bad banks are only necessary when the problematic loans are small and fragmented, and lenders are private, driving instability in the financial system.

For example, when millions of mortgages go bad, as occurred in the developed economies sometime back, uncertainty on how bad things are drives a funding squeeze in the financial system, threatening to bankrupt lenders. The resulting drop in credit availability further slows the economy, adding to the stress in the system.

However, in India’s case, borrowers were mostly large, and lenders were majority-owned by the government, obviating hte risk of bank runs. In fact, banks with very high levels of bad loans were still getting deposits due ot the government’s back-stop.

But over time, the moral hazard argument has weakened. For banks, given that the loans that went bad have been progressively written down, a transfer of assets is no longer a “get out of jail free” card. Further, Section 29A of hte Insolvency and Bankruptcy Code makes it impossible for promoters of defaulting firms to get their assets back.

At the same time, even though loan values may have been written down to zero, several of these assets may still have value, like factories with machinery, real-estate, brands, employees, customers and suppliers.

For the few hundred mid-size firms that have not yet undergone resolution, even if most of them may not be going concerns anymore, given the paucity of funding normally seen after a default, there can be enough of salvage value in them. Salvaging them would add to the economy’s productive capacity, in addition to helping banks’ balance sheets.

It is in this light that in the budget the government had announced the formation of National Asset Reconstruction Company Limited (NARCL) to consolidate and then accelerate recoveries or resolutions of bad loans adding up to around Rs 2 lakh crore (two trillion): at around 1% of GDP, a sizeable sum.

This has now been operationalized, with the first tranche of Rs90,000 crore acquired by the NARCL from banks. This was to have happened by June, but the second wave of the pandemic slowed dow nthe process of setting up the ARC (including a license from the RBI), and the management company IDRCL (India Debt Resolution Company Limited), and the paperwork for transfer of loans.

These loans are being taken over at 18% of loan value on average. The NARCL would issue security receipts, part of which would be guaranteed by the government (without this guarantee the NARCL would not be able to function).

This helps recover whatever economic value can be salvaged from these assets that are mostly not contributing anything to the economy right now. Second, as these loans are already fully written off, proceeds can be written back as profits, and public sector banks’ (PSBs) book value grows without any dilution of current shareholders.

If the government had instead injected equity in PSBs in return for new shares issued, it would dilute the shareholding of current shareholders. A higher book value means more room for PSBs to grow loans in the future. The fact that PSBs book gains on this transfer is enough incentive for them to be proactive on this front, and as the guarantee only lasts five years, the process comes with an end date.

Further, a specialised operational entity may be able to attract and incentivise professionals (majority-government-owned firms will only hold 49% of IDRCL, but 51% of NARCL).

Even as we await the quality of execution, and proceeds of resolution, this appears to be the final step in putting behind the lending excesses of the last business cycle: Cleaning the slate of the last business cycle is an important step in setting the stage for the next one.