Indian banks’ pile of bad loans is a huge drag on the economy. It’s a drain on banks’ profits. Because profits are eroded, public sector banks (PSBs), where the bulk of the bad loans reside, cannot raise enough capital to fund credit growth. Lack of credit growth, in turn, comes in the way of the economy’s return to an 8 per cent growth trajectory. Clearly, the bad loan problem requires effective resolution.
A proposal floated a few years ago is doing the rounds again, namely, the creation of a ‘bad bank’ that would house the bad loans in the PSB system. The proposal has its merits. However, making a success of it in the Indian context poses significant challenges. Before we examine the proposal, it’s best to have an idea of how banks deal with bad loans.Options for banks
Once an asset is recognised as a non-performing asset (NPA), banks must decide what to do with it. They have several options. One, they can try to seize the assets pledged by the borrower and sell these. This typically involves large losses on loans as the assets have to be sold at steep discounts to their book value.
Two, under the RBI’s Strategic Debt Restructuring (SDR) scheme, they can convert their loans into equity, acquire a majority stake in the firm, dislodge the promoters or management and bring in new promoters and management. While this happens in advanced economies all the time, the SDR scheme has not taken off in India. Indian banks do not have experience in running businesses till such time as new promoters are found. Nor do they have experience in locating promoters and management who can take over the stressed assets.
Three, banks can restructure the loans so that borrowers are able to service them. This involves stretching out the period of payment, or waiving a portion of the loans, or reducing the interest rate on loans, or some combination of these. In any restructuring, banks incur losses on the loans they have made. At PSBs, managers are open to the charge that they have favoured borrowers in a restructuring scheme and can invite action from the investigative agencies. In today’s environment, this has resulted in virtual paralysis at PSBs.
A fourth option for banks is to sell the NPA at a discount to an Asset Restructuring Company. This again involves a significant loss on loans when the transaction is made. But it has the effect of getting an NPA off the books of the bank or ‘cleaning up the balance sheet’. The bank’s capital is eroded to the extent of the loss. However, since 100 per cent of the loan has exited the balance sheet, the ratio of regulatory capital to assets — or what is called ‘capital adequacy’— improves. The bank now looks more attractive to investors.Stake in the bad bank
The bad bank proposal is a variant of the fourth option. The idea is to transfer NPAs of banks, perhaps only PSBs, to the bad bank. The bad bank will manage these NPAs in suitable ways — some may be liquidated, others may be restructured, etc. Getting NPAs off the books will help the PSB management focus on new business instead of having to expend their energies on trying to effect recoveries. A bad bank will be better focussed on the task of recovery. If it’s a private entity, it can also bring in superior expertise. It would appear that the bad bank concept has many things going for it.
Alas, the devil, as always, is in the detail. First, who will have the majority stake in the bad bank? Will it be the government or private investors? Let us suppose it’s the former. Given the size of NPAs at PSBs, the capital required by a bad bank for acquiring NPAs will be substantial. If the government is to be the majority owner, how does it find the required funds? Second, a government-owned bad bank will be subject to the same constraints in managing bad loans as PSBs. Third, managing the sheer size and diversity of bad loans acquired from multiple PSBs will be a tall order. Last, a government entity may not be able to pay specialists what it takes. Whichever way you look at it, a government-owned bad bank appears to be transferring the problem from one part of the government to another.
Now consider the second possibility, namely, that private investors have a majority stake in the bad bank. These could be long-term investors such as sovereign wealth funds and pension funds. In this case, the price at which PSB loans are sold to the bad bank could become a major issue. If the price is too high, the bad bank will not viable. If it’s too low, PSBs will be accused of selling their loans too cheaply to private investors — we will have the makings of an ‘NPA scam’.
There are other issues with transferring NPAs to a bad bank. As former RBI Governor Raghuram Rajan pointed out, a big chunk of NPAs at PSBs pertains to projects that are viable. These projects have not gone through to completion for reasons that are mostly extraneous to the project, such as problems in land acquisition or environmental clearance. With restructuring and additional funding, they can be completed and would create significant capacities.
Selling these loans to a bad bank, on the other hand, would be a time-consuming process. It would impede fresh flow of funds into these projects. Their debt would rise as the interest piles up. Mr. Rajan had pointed out that bad banks were typically intended for situations where projects were not viable. They were not meant for a situation such as ours where projects are viable.
The bad bank idea thus bristles with problems. So what could be the motivation for floating it? Well, a big motivation would be to dress up the PSBs by getting rid of their bad loans. Then, private capital can be attracted to them, perhaps through the sale of small stakes to strategic investors. PSBs would also be able to access the equity markets for funds and would not be as dependent on the government for capital. Today’s weaker PSBs can be merged with the stronger ones.
Is there a way in which the positives can be realised without creating a bad bank that itself requires too much capital and is too big to manage? One answer may be to set up a bad bank to deal with NPAs at some of the weaker PSBs, instead of one that picks up NPAs from all PSBs. It would prove less controversial if the government had a majority stake in it. Let us see how the experiment goes.
This must be complemented with other steps. The government must infuse more capital into the better-performing PSBs. It must also create, through an act of Parliament, an apex Loan Resolution Authority for tackling bad loans at PSBs. The authority would vet restructuring of the bigger loans at PSBs. This would mitigate the paralysis that has set in at the PSBs because of the fear factor and get funds flowing into stalled projects. Resolution of bad loans and restoring the health of PSBs is among the biggest challenges the economy faces today. It’s a challenge that requires a response on multiple fronts. A bad bank cannot be the sole response.
T.T. Ram Mohan is a professor at IIM Ahmedabad. Email: email@example.com